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State Street Corporation (NYSE:STT)

Q2 2007 Earnings Call

Jul 17, 2007, 9:30 AM ET

Executives

S. Kelley MacDonald - Sr. VP, IR

Ronald E. Logue - Chairman and CEO

Edward J. Resch - EVP, CFO and Treasurer

Analysts

Glenn Schorr - UBS

Mike Mayo - Deutsche Bank

Nancy Bush - NAB Research LLC

Brian Bedell - Merrill Lynch

Lori Appelbaum - Goldman Sachs

Kenneth Usdin - Bank of America

Thomas McCrohan - Janney Montgomery Scott

Robert Lee - Keefe, Bruyette & Woods

Jason Goldberg - Lehman Brothers

Betsy Graseck - Morgan Stanley

Presentation

Operator

Please standby. Good morning and welcome to the State Street Corporation's Second Quarter Conference Call and Webcast. Today's discussion is being broadcast live on State Street's website 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 or rebroadcast for distribution in whole or in part without expressed authorization from State Street. And the only authorized broadcast of this call is housed on State Street's website.

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

S. Kelley MacDonald - Senior Vice President, Investor Relations

Good morning everyone. 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 may make forward-looking statements relating to the Corporation's business and financial goals, plans and prospects and its business environment among other things. 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 2006 Annual report on Form 10-K and its subsequent fillings with the SEC.

We encourage you to review those fillings including the sections on risk factors concerning with any forward-looking statements we may make today. Any such forward-looking statements speak only as of today July 17, 2007 and the Corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

In addition, information relating to this webcast, including information concerning and reconciliations of non-GAAP measures referred to in this webcast is available in the Investor Relations section of our website www.statestreet.com/stockholder under the heading Annual Reports & Financial Trends.

Now I'll call... turn the call over to Ron.

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Ronald E. Logue - Chairman and Chief Executive Officer

Thank you, Kelly. Good morning everybody. At State Street, we again are reporting another strong quarter. We are meeting our long-term goals for growth in revenue, earnings per share, through achieving return on equity. Excluding the tax adjustments recorded in the second quarter of 2006, our record operating earnings per share grew 15% and our record revenue grew 16% in the second quarter of 2007. And we achieved 19.2% return on equity.

We once again achieved positive operating leverage on a sequential quarter basis, and when compared with the prior year's quarter. This marks the eleventh consecutive quarter in which we achieved positive operating leverage compared to the prior year's quarter.

We are leaders in fast growing markets, like hedge fund servicing and electronic trading. We continue to make progress in servicing hedge funds where our assets under administration are $242 billion, and when combined with Investors Financial are $441 billion on a pro forma basis.

Our recent acquisition of Currenex which generated significant trading services revenue this quarter, has given us the capability to offer executable streaming prices to the active trading segment of the Fx market, a fast growing segment.

As we said, more than two years ago, we expect to grow non-U.S. revenue to 50% of total revenue over time. For the full year 2006, 43% of State Street's revenue came from non-U.S. sources.

Our objective is to focus on high growth markets and exceed their rates of growth, which is certainly the case in Europe and Asia Pacific where our business is growing about twice as fast as it is in the United States.

For the second quarter, servicing fees, management fess and securities finance revenue all grew in double digits compared to the second quarter of 2006. Servicing fees at 12%, management fess at 22%, and securities finance revenue at 27%; all three were driven by new business from new and existing customers.

We won servicing awards for custody, fund accounting and fund administration from two large U.S. mutual funds, Baron's U.S. mutual funds representing $18 billion in assets as well as $12 billion from Fifth Third Bank's asset management group. SSgA's growth came primarily from new business, particularly in the area of quantitative active management.

Net interest revenue and net interest margin again performed very well, achieving a 44% increase in fully taxable equivalent net interest revenue compared to the second quarter of 2006 and a net interest margin of 164 basis points during the second quarter of 2007. And Ed will provide further details about these results and our outlook in a few minutes.

Trading services revenue increased slightly, up about 1% principally due to the revenue from the Currenex acquisition. As you may remember, trading services revenue in the second quarter of 2006 was its strongest quarter ever growing 53% compared to the second quarter of 2005.

On the expense side, we grew our expenses at a rate less than the rate of growth in revenue, which resulted in about a 130 basis points of positive operating leverage on a sequential quarter basis. We achieved positive operating leverage of about 90 basis points in the second quarter of 2007 compared to the second quarter of 2006, our eleventh consecutive quarter of positive operating leverage compared on this basis.

Now let me give you just a few new business highlights from the second quarter. On the servicing side, in addition to the awards from Baron Funds and the Fifth Third Bank asset management group, both of which I've already mentioned, HSBC Investments has appointed State Street to manage collateral for its institutional clients, managing and tracking collateralized transactions and providing a reporting service that enables clients to customize parameters including eligibility of collateral, mortuary claimants and concentration limits.

Now this collateral management service is a good example of the capabilities we gain when we make acquisitions. We inherited the original version of this service when we acquired the global security services business from Deutsche Bank who have offering this service to its customers in Europe. We have enhanced the service now and it's become a highly sought after by our customers as the role of derivatives plays a much more important role in day to day investment management.

I am sure we will find similar, less evident opportunities to enhance our product lines with the Investors Financial acquisition. We were also appointed to provide global custody accounting, independent swaps pricing and reconciliation services to the Somerfield Pension Scheme for £300,000 million in assets as well as performance measurement services from WM Performance Services, the European performance measurement division of State Street.

In Australia, we were awarded an assignment to service $12 billion with the New South Wale's workers' compensation insurer to provide custody, accounting performance and analytics as well as monitoring and reporting for this government agency.

Together with IFDS, our joint venture with DST which provides transfer agency and registrar services, State Street has been named the trustee, custodian, transfer agent and registrar responsible for the professional funds group of Montreal. The fund manages 1.9 billion Canadian.

State Street Global Advisors also added significant new business. In the second quarter of 2007, about 75% of SSgA's new business was in active management, enhanced indexing, hedge fund strategies and active quantitative management. Net new business at SSgA in the second quarter is $32 billion.

Also during the quarter, State Street Global Advisors, an offering what we call edge strategies reached the $10 billion level. These strategies, known as 130-30, offer investors some of the advantages of a hedge fund while continuing to remain closely tied to a benchmark.

As I said we're pleased to achieve a very strong first half of the year. The consolidation of Investors Financial is now well underway. We will track our progress each quarter through 2008, so you can evaluate our results just as we did with the Deutsche Bank transaction.

Looking into second half of the year, I'll remind you that we typically see a slowing in revenue from trading services as well as securities finance in the third quarter compared to the second quarter. At least that has been the case in the majority of past five years. However like last year, that does not stop us from seeking positive operating leverage on a prior year basis.

Let me now update you on the integration of Investors Financial. Since the announcement in February an experienced group of State Street employees has focused on the planned consolidation. Working with their colleagues from Investors Financial, they have brought together the two businesses as smoothly as possible and more importantly provided for a consolidation that is as seamless as possible for our customers. These two groups, now unified at State Street are continuing their work, meeting with customers, refining our plan for consolidation and implementing specific conversions.

One of the reasons that we're confident that this consolidation will be a success and a win for the customers is that we are retaining the key relationship managers who will continue to provide the high level of customer service that the customers of Investors Financial have been used to. As I announced last quarter, they will work under the direction of Mike Rogers, now an Executive Vice President of State Street and formerly the President and Chief Operating Officer of Investors Financial.

Investors Financial's unaudited results for the first six months of 2007 included annualized revenue growth of 18% and annualized expense growth of 15%. Based on both the strong results at State Street and at Investors Financial in the first half of 2007, we are now revising the financial goals we established in February after we announced the Investors Financial acquisition.

We now expect that revenue will grow between 20% and 22%. Excluding merger and integration charges, we expect that operating earnings per share growth will be between 10% and 15%. And that operating return on equity will be between 14% and 17%.

We also believe that we will perform in the upper half of these ranges for 2007. The EPS and ROE ranges excluding merger and integration charges are the original ranges we established in January before we announced the acquisition of Investors Financial.

Now as a reminder, our operating earnings per share in 2006 was $3.46.

Now I'll turn the call over to Ed who will provide some of the details of our financial performance as well as some details as to our expectations for the rest of the year.

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

Thank you, Ron and good morning everybody. The first half of the year represents a good start for 2007. We reported strong growth in both fee and net interest income. Our growth in asset servicing, asset management and securities finance continues at a combined rate of about 14% compared to the first half of 2006. Securities finance was particularly strong, as is usually the case in the second quarter. We continue to expand globally, introducing new services to a broad base of customers.

We reported strong net interest revenue growth of 44% on a fully taxable equivalent basis, comparing the second quarter of 2007 with the second quarter of 2006. And on the same basis net interest revenue was up 18%, comparing the second quarter of 2007 with the first quarter of 2007.

Our net interest margin improved to 164 basis points in the second quarter, up 44 basis points from last year's quarter and up 19 basis points from the first quarter. Obviously the positive trends in our liabilities, I mentioned last quarter, continued into this quarter. I will provide more detail on our net interest income and margin in a few minutes.

We achieved positive operating leverage compared to the second quarter of 2006 as well as when comparing the second quarter of 2007 with the first quarter of 2007. The eleventh consecutive quarter, our assets under custody were at a record level for State Street at the end of the quarter. On a pro forma basis combined with Investors Financial, our assets under custody would be about $15 trillion at June 30, 2007. Our assets under management of $1.9 trillion also stood at a record level at the end of this quarter. We included the first and second quarter results for Investors Financial on page 3 of our financial trends package, which I encourage you to review on our website.

Based on those six months results, Investors Financial was operating at an annual run rate of about $940 million in revenue and about $660 million in expenses. Those figures represented annualized increase of about 18% in revenue and about 15% in expenses. As you may recall from Investors Financial's fourth quarter conference call, management at that time expected expenses to grow between 21% and 24% in 2007. The difference between the results of the first half and Investors Financial's management's expected increase in expenses is annualized at about $40 million in cost saves and cost avoidance after the acquisition was announced. As a result, our expectations are still that we will remove approximately $350 million from Investors Financial's cost base with approximately $310 million in annualized costs to be removed over the next 18 months.

I hope you find an opportunity to review our earnings press release distributed this morning. Please review the financial statements included with our earnings press release and in our financial trends package on our website for detailed information on our financial results.

Now to discuss our results. We reported earnings per share of $1.07 which were up 57% compared to $0.68 per share from the prior year quarter including the tax adjustments and up 15% excluding those adjustments.

Revenue totaled $1.9 billion for the quarter, an increase of 16.4% from last year's second quarter compared with the 15.5% increase in expenses to $1.4 billion. Return on equity was 19.2% compared with the return on equity from continuing operations of 14% including the tax adjustments and 19.2% excluding those adjustments.

Now I would like to discuss the details of our results compared with the prior year's second quarter. Servicing fees were up 12% to $766 million due to new business from existing and new global clients as well as higher daily average equity valuations.

Assets under custody at the end of the quarter were at a record of $13 trillion, up 20% from $10.9 trillion a year ago. State Street Global Advisors continues to post very strong results. Investment management fees were $284 million, up 22% due to new business and increases in month end equity valuations.

Performance fees were about $20 million, up from $16 million a year ago. Assets under management at the end of the quarter were at a record of $1.9 trillion, up 26% from $1.5 trillion a year ago. Compared to the second quarter of 2006, the month end averages for the S&P 500 in the second quarter of 2007 were up 17%, the EAFE was up 22% and the NASDAQ was up 16%. The Lehman U.S. aggregate total return index was a negative 0.52% at the end of the quarter.

Trading services revenue, which includes foreign exchange trading and brokerage and other services, was up about 1% to $260 million. Weaker volatility partially offset by stronger volumes drove a 9% decline in foreign exchange trading revenue. Foreign exchange trading revenue was down $18 million to $174 million compared with a record quarter in 2006.

Brokerage and other fees were up $20 million to $86 million from the previous year's second quarter. This increase was primarily due to $16 million in fees from Currenex. Securities finance revenue was $162 million, up 27% from last year's second quarter due primarily to an increase on assets on loan. In the second quarter of this year, the average volumes of securities lent increased by more than 30% compared to a year ago and spreads were up slightly.

The processing fees and other revenue were down $9 million to $65 million primarily as a result of the consolidation of tax-exempt investments on to our balance sheet at the end of the third quarter of 2006, offset somewhat by income from joint ventures. The revenue resulting from this consolidation is now recorded in net interest revenue.

Net interest revenue on a fully-taxable equivalent basis increased $122 million or 44% from $275 million to $397 million. In addition, compared to the second quarter of 2006, net interest margin increased 44 basis points from 120 to 164 basis points.

The favorable trends that I cited during the first quarter call continued in the second quarter, higher levels and a favorable mix of customer deposits, a continued favorable non-US rate environment, a higher yield on reinvestments in our securities portfolio and a higher level of lower cost of funds. We increased the average size of the portfolio from $59.4 billion a year ago to $67.7 billion during the second quarter.

Mortgage backed securities in the second quarter of 2007 represented about 38% or $25.4 billion of the average investment portfolio. Floating rate asset backed securities in the second quarter of 2007 represented about 36% of the average investment portfolio or $424.4 billion.

On a pro forma basis, combined with Investors Financial approximately 43% of the portfolio will be in mortgage backed securities and also about 43% in floating rate securities. The total pro forma portfolio for the combined company would have been about $77 billion as of June 30, 2007.

The credit quality of the portfolio at June 30, 2007 has remained about the same as at last year-end, 94% is invested in AAA or AA rated securities. As of June 30, 87% was invested in AAA and 7% in AA related securities. As I mentioned, previously the credit quality of the portfolio will remain relatively unchanged following the consolidation with Investors Financial.

Now, I will provide more detail on comparable expenses. Salaries and benefits expenses were $808 million, up 18% from $684 million last year, largely attributable to the impact of incentive compensation due to our improved performance, increased staffing to support new business and acquisitions, and myriad adjustments.

Transaction processing expenses increased to $141 million, up 5% due to the increased volumes in the asset servicing business.

Other expenses were up 37% at $183 million, due primarily to costs associated with new business initiatives, the acquisitions of Currenex and Investors Financial and increased sales promotional expense.

I'll remind you that we calibrated this expense line to match our strong growth in revenue this quarter. Our expectations are that other operating expenses for State Street alone in the second half of 2007 should be consistent with the average of the first two quarters this year. The effective tax rate for the quarter was 35%.

Let me give you some of the headlines regarding the results of the second quarter compared to this year's first quarter. Revenue was $1.9 billion, up 13.3% or $225 million, compared to $1.7 billion in the first quarter with increases in every line on the income statement except processing fees and other revenues.

Expenses were $1.4 billion, up about 12% or $145 million. Earnings per share of $1.07 in the second quarter were up 15% compared to $0.93 per share in the first quarter of 2007.

Servicing fees were $766 million, up 7% due to new business and improvement in daily average equity valuations. Management fees of $284 million were up 9% due to new business and improvement in month-end equity valuations.

Trading Services revenue was up 18% this quarter compared to the first quarter of 2007 from $220 million to $260 million. This increase was driven by improved volumes in foreign exchange trading, offset partially by lower volatility plus the effect of Currenex in the quarter.

Securities finance revenue was up 65% to $162 million from $98 million due primarily to an increase in spreads as well as seasonal demand. The duration of the lending book stands at 35 days at quarter end.

Processing fee and other revenue were down 11% or $8 million to $65 million due to lower revenue from leasing and structured products, offset partially by increased income from joint ventures.

Net interest revenue and net interest margin improved due to the continuing benefit from execution of our balance sheet strategy as well as continued growth in non-U.S. businesses. As a result, our net interest revenue on a fully-taxable equivalent basis increased by 18% from $337 million to $397 million compared to the first quarter, and net interest margin improved 19 basis points to 164 basis points.

We continue to benefit from our non-U.S. growth and the continued favorable non-U.S. interest rate environment, as well as a higher level of free funds. Also our investment portfolio strategies continue to contribute to growth in net interest revenue through portfolio repricing.

We issued $1.5 billion of debt during the quarter, $800 million in trust preferred and $700 million in senior debt. We also called for redemption, $500 million or outstanding trust preferred securities in June.

I said on last quarter's conference call that, if the current trends we saw continued, we expect our net interest margin for 2007 to be above 135 basis points. Since the trends continued and in fact, improved in the second quarter, we now believe we will be above that level for all of 2007, more likely in the range of 155 basis points.

Our transaction deposits are running at historically high levels and non-U.S. rates continue to rise, a favorable factor for us. In addition, U.S. rates have remained steady for a year now.

We have experienced these favorable trends for three quarters now, and I am comfortable relying on them in providing this outlook. However we are still cautious about this sustainability over the long term.

Also last quarter I was asked about our asset backed securities in the investment portfolio that are backed by sub-prime mortgages. Since there has been continuing interest in that subject, let me add some color.

First of all, these are securities that have been issued with sub-prime mortgages as collateral, and they are 78% AAA rated and 22% AA rated. They have performed very well, and the current ratio is down from 80% AAA and 20% AA in the first quarter, reflects the AAA rated securities paid outs. We have an average dollar price of just over par approximating book value at the end of June. And for each vintage year from 2003 to 2006, we have significantly outperformed the Moody's performance data. In addition, the securities have an average 36% credit enhancement on them versus a 5% to 8% historical cumulative loss experienced in the marketplace.

So what that means is that, even if losses were to double, we still have more than twice as much cushion than it's needed to protect ourselves from losses in this position. So we are very comfortable in terms of our entire asset backed position as well as the position that is backed by the sub-prime mortgages. We don't expect any significant negative financial outcomes due to this element from our investment portfolio.

Regarding net interest revenue, just a few points to keep in mind, our duration gap has not changed significantly from year end. Our assets are about 1.2 years and our liabilities are about 10 months in duration.

The investment portfolio is about 1.7 years in duration, flat for the second quarter of 2006 and up from 1.5 years at March 31st, 2007. On a pro forma basis, combined with Investors Financial, the duration of our investment portfolio would have been about 1.6 years.

In the second quarter, operating expenses increased 12% from $1.2 billion in the first quarter. Salaries and benefits increased 9%. Transaction processing was up 9%. Information systems & communications were up 2%. Occupancy was up 4% and other expenses were up 45%, primarily as a result of increases in costs associated with new business initiatives, the acquisitions of Currenex and Investors Financial and increased securities processing expenses. Return on equity was 19.2%, up from 17.4% in the first quarter,

Let me share with you our plans and outlook relative to capital. In order to protect our regulatory ratios as I mentioned earlier, we have not repurchased any of our stock during the last twelve months due to the adjustments to equity we reported in the fourth quarter of last year and in the first quarter of 2007. Also which we have previously disclosed and which amounted to $390 million after-tax. Additionally we have had to consider the impact of the recent acquisitions of Currenex and Investors Financial in our thinking.

We issued about 61 million shares of State Street common stock to Investors Financial shareholders on July 2. Also, as we have said previously, we intend to repurchase about $1 billion worth of our common stock after the Investors Financial closing.

The principal capital ratio that we managed to was the Tier 1 leverage ratio. We will continue to target between 5.25% and 5.75% but from time to time maybe above that level if prudence dictates. At June 30, our Tier 1 leverage ratio stands at 6.06% and our tangible common equity ratio is 4.83%.

In conclusion, the first half of the year represented a very good start for us. We're continuing to balance growth in revenue against our expenses so as to achieve positive operating leverage on an annual basis. We have revised our expectations for the financial performance of State Street this year due to the performance of Investors Financial in the second quarter and in particular, the strong year-to-date performance of State Street. We are confident about performing the upper half of the revised ranges for all of 2007.

With that, I'll turn the call back to Ron.

Ronald E. Logue - Chairman and Chief Executive Officer

Thank you, Ed. Well we now begin the second half of 2007 with strong first half results from both State Street and Investors Financial and with our plans for consolidation of Investors Financial well underway. We have confidence that we will meet the financial targets we established today, two of which EPS and ROE, were our original financial targets before the Investors Financial acquisition, while the revenue goal has been significantly increased. And again as we have said we believe we will perform in the upper half of these ranges.

We have received excellent feedback from customers with whom we are planning conversions. We have added employees to State Street who have been recognized for their customer service and who will contribute to our ongoing success. The acquisition strengthened our lead in our high growth businesses such as services to mutual funds, hedge funds, offshore funds and investment manager operations outsourcing. And we have added the capability to service private equity investments.

I'd ask you to also keep in mind our long-term objectives. First, to generate non-US revenue of 50% of total revenue over time. While our overall growth is strong, our growth in Europe and Asia continues to outpace of the US. We strengthened our leadership in the past year in non-US locations and those investments are paying off. With the acquisition of Investors Financial, we expect to begin offering our global services to those customers who previously went elsewhere.

Second, to make SSgA a larger contributor to State Street's bottom line. SSgA continues to execute on its strategy of adding quantitative active investment strategies for both new and existing customers which is paying off in growth, in revenue and profits.

And third, to prudently work our balance sheet harder. With our net interest revenue and net interest margin up significantly over the past two years, I hope you will agree we are successfully executing on this objective.

Now Ed and I would be happy to take your questions at this time.

Question And Answer

Operator

Thank you. [Operator instructions]. We will take our first question from Glenn Schorr with UBS.

Glenn Schorr - UBS

Thanks. Okay, so can I just check what is in the... maybe for Ed... what's in the other expense bucket that would cause a big spike? And I am just trying to get my arms around such great revenue growth across the board and expense growth almost keeping pace. I just want to see, how much is in there related to maybe, Currenex IFIN or any discretionary spending if you could?

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

Okay Glenn, as I said, we tried this quarter given our view of very strong revenue to calibrate our expenses accordingly. So we have some discretionary spending in there as well as some elements of expense related to the acquisition. Nothing in it of itself is significant or material if you will, but we have acquisition-related clause both for Currenex and Investors Financial. We booked a fair amount of goodwill associated with Currenex and intangibles and there is amortization associated with the intangibles that will be in the run rate for the next number of years.

We increased professional services expenses for new business initiatives, really across the company. We spent some money... in info technology, treasury, global securities lending and certain marketing expenses and then lastly the other broad categories, sales promotion. We ramped up our sales effort this quarter given the strength in revenue. So nothing in it of itself is significant but if you add them up and... that's what we did in recognition of the strong revenue picture. I think that my comments going forward for the next two quarters would give you an indication of where our thinking is. Again given our forecast for the rest of the year, in terms of the other expense line being in the range of about $150 million per quarter and that's State Street standalone that's not including IFIN.

Glenn Schorr - UBS

Perfect. Exactly what I was looking for. Other... only other question I really have is, so you continue to see good growth in the non-U.S. deposits. And I guess the ability to lag deposit pricing as rates rise. The question I have is, how did the rate go down by 36 basis points in the quarter? In other words, if you look at the interest rate paid on... on interest-bearing non-U.S. deposits. Just interesting, it's great. But it's interesting.

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

Yes, that's really just the function of the mix Glenn. The mix of the deposits drive that result.

Glenn Schorr - UBS

Okay. So is it... is it something that you can influence or is that a function of that's what type of deposits, customers are bringing to you? In other words...

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

It's much more of the latter. I mean, it depends, what form the deposits come in as to the extent to which we can lag or not lag.

Glenn Schorr - UBS

Okay, okay. Just... I guess, difficult for us to project but I understand it and appreciate. Thanks.

Operator

: We will take our next question from Mike Mayo with Deutsche Bank.

Mike Mayo - Deutsche Bank

Good morning.

Ronald E. Logue - Chairman and Chief Executive Officer

Hi Mike.

Mike Mayo - Deutsche Bank

I didn't fully understand your last answer. It's... you are finding costs in $50 billion and non-U.S. deposits are down 36 basis points. And is there some sort of compensating balances you're getting through the processing business or anything else going on there?

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

No Mike, this is Ed. It is as I said a function of mix and you have to get a little bit deeper into that number to recognize that. About 25% of it as of this quarter end is euro-dollar. So it's dollar-based liabilities. And then we have a swap on against some of the residual back into U.S. dollars. So it really is just a function of what the liability mix is at any given quarter as to what we are paying.

Mike Mayo - Deutsche Bank

And with regard to non-U.S., I guess you had 6% linked quarter growth in assets under custody. What was that growth outside U.S. only... U.S. versus non-U.S.?

Ronald E. Logue - Chairman and Chief Executive Officer

It wasprobably a little more than 50% outside the U.S., Mike.

Mike Mayo - Deutsche Bank

Okay. So revenue growth linked quarter was it stronger outside U.S. and how much?

Ronald E. Logue - Chairman and Chief Executive Officer

Yes, we have been seeing that, although recently, citing that the winds of that I just talked about. We've seen I think a resurgence in U.S. growth, particularly in the mutual fund arena.

Mike Mayo - Deutsche Bank

Okay. And why do you think that is a resurgence in mutual funds in the U.S.?

Ronald E. Logue - Chairman and Chief Executive Officer

I think there is more interest in outsourcing and mutual funds in the past had probably done a lot of the accounting themselves and let out custody to more general custodians. And now that there are fewer organizations who can do both custody and accounting, it's becoming apparent that, if they want to do that there aren't so many places they can go to get that done especially not with the IFIN consolidation.

Mike Mayo - Deutsche Bank

And then lastly it looks like you are guiding higher by almost 3% to 4% versus consensus.

Ronald E. Logue - Chairman and Chief Executive Officer

Yes.

Mike Mayo - Deutsche Bank

And is that because you are feeling better about IFIN because you are feeling better about State Street standalone or both?

Ronald E. Logue - Chairman and Chief Executive Officer

Both. I mean like we said before that these two organizations are mirror images of each other and that's playing out.

Mike Mayo - Deutsche Bank

And your retention target for IFIN?

Ronald E. Logue - Chairman and Chief Executive Officer

90%.

Mike Mayo - Deutsche Bank

And...

Ronald E. Logue - Chairman and Chief Executive Officer

Revenue.

Mike Mayo - Deutsche Bank

Are you feeling better about that or...?

Ronald E. Logue - Chairman and Chief Executive Officer

Feeling very good about it.

Mike Mayo - Deutsche Bank

Okay. And what about the Barclays contract, can you give us an update on that or when would we get an update?

Ronald E. Logue - Chairman and Chief Executive Officer

Well, we are servicing them today.

Mike Mayo - Deutsche Bank

Okay. And will there be a change in that or an update or just business as usual?

Ronald E. Logue - Chairman and Chief Executive Officer

Not that I know about. I think there're going to be a lot of... I am sure there are going to be organizations that they are going to look to do things.

Mike Mayo - Deutsche Bank

All right.

Ronald E. Logue - Chairman and Chief Executive Officer

But as I am talking to you today, no one has told us they are leaving.

Mike Mayo - Deutsche Bank

Okay. All right, thanks.

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

Okay.

Operator

Thank you. Wewill take our next question from Nancy Bush with NAB Research.

Nancy Bush - NAB Research LLC

Good morning guys.

Ronald E. Logue - Chairman and Chief Executive Officer

Good morning.

Nancy Bush - NAB Research LLC

Ed, question for you. I guess unlike everybody else now on net interest margin, a sort of question in my head and going how high is up. Is there sort of a structural limitation to margin here or can it continue to advance this way? And if you could just sort of drill down into that number a little bit because I am adjusting by leaps and bounds here and I am trying to figure out whether I should continue to do that.

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

Right. I think probably the best way to think about that is to go back to what I said in February, when we made some comments about '07 through '09 in terms of net interest margin. And there are really, I guess three elements to what I said. One is the investment portfolio and what we're doing on the asset side. The other is our forecast of rates and the third was our liability behavior. And I'd say that from what we've said in February to what we are seeing now we got the first two pretty much right. The investment portfolio on the asset side has behaved as we thought, and our rate prognostication has been pretty good, maybe even a little bit too conservative in that foreign rates have gone up a little more than what we thought. But the big change from what I said earlier and now and what we are thinking about at least the rest of this year is the liability behavior of our customers. And what we are seeing is stronger equity markets and higher volumes and significantly above trend deposits especially in transaction accounts for us. So what we are seeing at least through the rest of the year, Nancy is a continuation of that strength, which is one of the reasons or the main driver of why I said 155 would be the full year margin. But I do have an element of caution to it saying that these balances can be potentially volatile to some degree.

So, we are cautious. I am not updating '08 and '09 at this point. I will probably have some more comments about our outlook for '08 and '09 and update my February comments in September. I don't think that there is an answer to the structural margin question that you posed. I think that, we know, we have seen the liability behavior improve fairly significantly for us. And like I said before, if it continues to improve, we will continue to show a greater margin. Right now, we are seeing out to the end of the year in a 155 margin for the full year.

Nancy Bush - NAB Research LLC

Right. Ron, just a quick question for you. One of your competitors has involved in a very large merger, apparently is doing custody business for free at this point. And you have not responded to that pricing. Can you just tell us how customers are responding to this and how you are responding to those pressures?

Ronald E. Logue - Chairman and Chief Executive Officer

Sure. I guess, probably the best way I could say it Nancy is that the customers seek value. It's all about value. It's not about price. And to the extent that we provide added value, I think customers see through that long term. As you know, we have a policy of not doing things for free, not relying on other types of promises of revenue. I don't... I think in long term it's the wrong thing to do. I can cite lots of examples of the business that we lost against biz that were for free where those customers came back. I think we're going to continue to do that. It's really about value. We're going to keep that strategy. It has worked in the past. I believe we'll continue to work in the future. I am sure that we may lose some pieces of business that were zero price bids. That's going to be okay. The business that we are winning, we are winning because people see value. And I believe strongly the value will win over price.

Nancy Bush - NAB Research LLC

Can you point to one product or... in the delivery value, I mean, I understand the concept. But is their a product or a quality of the company or some thing that tends to be the hook there that keeps that business?

Ronald E. Logue - Chairman and Chief Executive Officer

Well, generally speaking, it probably has to do with some type of accounting components, whether it's daily price mutual funds, hedge funds, private equity, offshore funds. It usually surrounds accounting, because it's much higher degree of difficulty to do and it's very expensive. I think it's one of the reasons why you see a number of organizations outsourcing that because it's getting more difficult and much more complex. Obviously, the emergence of derivatives are a good example of that. It's why we bought Investors Financial because of the strong accounting capability. There are a very few organizations out there who can do it and who can do it at scale. And I think that the real secret there is doing it at a scale and we can, and they can, and not too many others can. And the value is around different types of accounting components. And then from there, there are selective as we call it cross-sell revenue that comes from that.

Nancy Bush - NAB Research LLC

All right. Thank you very much.

Operator

Thank you. We will take our next question from Brian Bedell.

Brian Bedell - Merrill Lynch

Hi thanks, good morning.

Ronald E. Logue - Chairman and Chief Executive Officer

Hi Brian.

Brian Bedell - Merrill Lynch

Just to go back on the non-interest margin question I guess, it's on the fund deposit line. So you would not expect that 329 costs to be sustainable, right? I mean that should be trending back up to a level of at least near what it was in the first quarter, in the second half?

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

Well I mean, I think it depends Brian on what happens with fund rates. I mean the longer that rates continue going up in non-U.S. terms, the longer we have to lag. And in actuality what happened in the second quarter is that our lag lengthened a bit which contributed to another element of our positive results before net interest revenue, net interest margin. But eventually, at some point when rates stop, there will be a rate... the non-U.S. rates stop going up, there will be a cessation of our ability to lag and they'll catch up.

Brian Bedell - Merrill Lynch

Right. But it sounds like you answered earlier, most of that was due to the mix shift, you got just a bunch of deposits in a much, much lower cost, given I guess those customer preferences of the services. So I guess, what I am asking for the third quarter, is that sort of mix shift in aberration for the second quarter? Do you think those lower cost deposits stick around in the second half?

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

I mean we are seeing or we expect to see a continuation of the favorable trends that I have talked about now for the first two quarters of this year continuing into the second half, which is why we increased our full year margin to 155.

Brian Bedell - Merrill Lynch

Okay. And then if you think a better way... no, I know you're not updating your estimates yet, but before we had... I think you had an '09 target of 150 at that time was 15 to 20 basis points higher than where you were operating at. Should we consider, if we had the same type of trends that you have been... that we are seeing right now and if that increase over the next two years was driven really by the reinvestment yields on the portfolio, which is very predictable. Then should we think of you guys getting to suitably 165, 170 by '09?

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

Well, again I don't want to go into '08 and '09 yet, but your basic thesis I think is correct. If I go back to the buildup to the discussion we had in February, which is, we were correct or closely correct on both the asset side and the rate side. If you remember, we forecast rates staying constant both dollar and non-dollar rates for '07, '08, '09 in that workup. So the one big swing factor in the analysis so far has been the liability behavior. And if in fact the liabilities continue to exhibit more favorable characteristics in '08 and '09 than what we modeled them on, yes, we will do better than what we said in February for '08 and '09. That's clearly what's occurred here in the first half of this year and why we are saying what we are saying about all of '07.

Brian Bedell - Merrill Lynch

All right, great. And then you also mentioned when you... before you guys closed the IFIN merger, when IFIN came on, they were doing some things also on the deposit side and having sort of some lower deposit costs than you did. That effect is not in the second quarter '07 I assume and so when IFIN comes on there are potential... I think you can do to lower the organization capacity costs, is that correct?

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

That's right. And just to round that out, when we modeled revenue attrition in the deal we thought that we would be able offset that in total by bringing some of those lower cost IFIN deposits on. So the net effect between revenue, attrition and the uptick in our net interest revenue would be about a push, we sampled in the deal model. So yes, we expect we'll be able to what we've planned relative to IFIN's treasury function and that's all reflected in our thinking about IFIN's improved performance versus what we had modeled back in February.

Brian Bedell - Merrill Lynch

Right. And then in terms of your guidance, it would imply just by going back to sort of what you were pre-IFIN that and I guess, in some ways you could say, there is very limited IFIN dilution in the second half. Should we think about it that way? We were at $0.14 dilution for the second half. I know, you got stronger trends in both which is in the market backdrop but...

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

I wouldn't say that our model is certainly not for no IFIN dilution in the second half. We are modeling a slight improvement to that $0.14 number that we put forth back when we announced the deal. But it's not zero.

Brian Bedell - Merrill Lynch

Right. So it's mostly market. The fact that market's been a lot better really, right?

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

Yes.

Brian Bedell - Merrill Lynch

Great. And then, so you would expect IFIN to be accretive in '08, instead of mutual earnings in '08. Is that correct?

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

Yes, probably better than breakeven, which what we had said when we announced the deal.

Brian Bedell - Merrill Lynch

All right. Okay and just on the cost of servicing fee line that went up a little bit more than I was expecting, anything unusual in that this quarter with HSBC in that this quarter? Is that on a go forward basis?

Ronald E. Logue - Chairman and Chief Executive Officer

No. It's just... it's just, it's both singles and doubles that keep coming.

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

Yes,I mean we had good market, Brian and we had good net new business generation and if you put those two together then you have a 12% year-over-year increase.

Brian Bedell - Merrill Lynch

Right, so HSBC is yet to come in, right?

Ronald E. Logue - Chairman and Chief Executive Officer

Correct.

Brian Bedell - Merrill Lynch

Or are they coming in the second half?

Ronald E. Logue - Chairman and Chief Executive Officer

Correct. It's right in the second quarter.

Brian Bedell - Merrill Lynch

Is it the second half? Or when are you getting...

Ronald E. Logue - Chairman and Chief Executive Officer

Second half. Yes.

Brian Bedell - Merrill Lynch

Second half. Okay. And then and TIAA-CREF [ph] for the securities lending, it was how much of that was in the second quarter?

Ronald E. Logue - Chairman and Chief Executive Officer

I am going to say it, half... a little more than half, has been coming in over time.

Brian Bedell - Merrill Lynch

Okay. So you still have some to go in the third quarter?

Ronald E. Logue - Chairman and Chief Executive Officer

Little bit, yes.

Brian Bedell - Merrill Lynch

Right. And then just naturally second quarter is seasonally strong for safe landing but how much of... and I guess not in precise numbers, but I guess I am looking for... what kind of drop we should expect in the third quarter? Was there a substantial amount that was sort of driven by just the higher interest in borrowing securities that you are not related to the tax dividend arbitrages in the second quarter?

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

Most of the spread this quarter Brian was demand spread. So, yes, I mean I think the broad answer to your question is yes. The seasonality of it, I mean, I point you back to prior years and look at what we have done. It's ranged from 20% down to 45% down on a sequential quarter basis, so...

Brian Bedell - Merrill Lynch

All right. I'd just look at history. All right. Okay. Just one last time on the sub-prime... both the asset back booked, it's like $24 billion, $25 billion, the sub-prime portion of that's like $8 billion, is that correct?

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

About seven.

Brian Bedell - Merrill Lynch

$7 billion.

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

Little over $7 billion. We had about $1 billion in pay down from Q1 to Q2 and that's why the AAA percentage went from 80% to 78%.

Brian Bedell - Merrill Lynch

Right. And do you expect that to wind down substantially over the near to intermediate term?

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

I'd say over the intermediate term. Again assuming we didn't do anything else to the position. Yes over the next couple of years.

Brian Bedell - Merrill Lynch

Okay. Great. Great. Thanks very much.

Ronald E. Logue - Chairman and Chief Executive Officer

Thanks Brian.

Operator

Thank you. We will take our next question from Lori Appelbaum with Goldman Sachs.

Lori Appelbaum - Goldman Sachs

That you have already done and plan to do and on the buyback front, what's the pace that you expect to get the billion dollars of shares of... the billion dollars of potential shareholder purchases out? Do you expect to do an accelerated share purchase program or something slower pace over the coming quarters?

Ronald E. Logue - Chairman and Chief Executive Officer

Lori just to let you know, we didn't hear the first part. I think we are going to answer the buyback piece. But what was the first part?

Lori Appelbaum - Goldman Sachs

Ed mentioned strategies in plan to maximize the capital structure.

Ronald E. Logue - Chairman and Chief Executive Officer

Yes.

Lori Appelbaum - Goldman Sachs

That you're doing and along those lines, I was wondering the pace that you are likely to buy back shares whether an accelerated program's likely or something slower pace over the coming quarters.

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

Well Lori, we haven't specifically announced what our plans are. It could be an accelerated share purchase program. It could be something else. When we have something to say, we will make an announcement, and tell you what we are doing. But I would expect that no matter what we do, we will get the billion dollar buyback done by the end of this year.

Lori Appelbaum - Goldman Sachs

Okay. So wondered, it's either very rapid or fairly rapid.

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

Yes. I mean if you consider over six months, we deal with that.

Lori Appelbaum - Goldman Sachs

Okay.

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

Fairly rapid.

Lori Appelbaum - Goldman Sachs

Okay.And then I know there have been a number of questions on the margin, just one more. It seems to me that there's a fair amount of conservatism in your outlook for 155 margin, because that implies a decline versus the second quarter and client flows are still strong. And Ron mentioned the goal of becoming more international and working the balance sheet harder. If you could just comment on that.

Ronald E. Logue - Chairman and Chief Executive Officer

Well I want to give myself a little bit of room on the downside. I did say that the flows... the client flows while they had been strong, can be volatile. I think that in the past we have seen some decline certainly on a sequential quarter basis for these types of deposit flows. The second quarter was extremely strong with a 164 margin. I just want to be conservative in my outlook for the year. I don't want to set a bar too high and then disappoint. I think 155 for the full year is our best thinking right now as to where we're going to be.

Lori Appelbaum - Goldman Sachs

Okay. Thank you.

Operator

Your next question comes from Ken Usdin of Banc of America.

Kenneth Usdin - Bank of America

Thanks. Good morning. Okay, Ed just one more on the margin. Earlier in the year you had said that you had about $10 billion of the low yielding or low spread securities rolling off the books. I am just wondering how much of that is already rolled off and how much of is it to come.

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

About half of it's done so far. It was fairly linear throughout the year. If you remember we said we had about $10 billion this year, $6 billion next year and $4 billion in '09 and about half of that $10 billion has matured already.

Kenneth Usdin - Bank of America

And what's the incremental pickup you're getting on kind of stuffs that's rolling off versus your... what you are able to reinvest that at?

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

200 basis points.

Kenneth Usdin - Bank of America

Okay. Great. Second question relative to the IFIN deal, I was wondering if you could just give us a little update on both the revenue synergy side and then I have a question about the expense side. On the revenue synergies, you had said you originally expected a kind of a wash of net revenue synergies. From what it sounds is that you're very confident on the retention side, and I am wondering if you could also just talk about the synergy side. Any recognition that you're expecting kind of, off the bat here, how quick and is that net zero, net revenue synergy, in fact, got approved to be quite conservative at the end of the day.

Ronald E. Logue - Chairman and Chief Executive Officer

Ken, this is Ron, it could be, I think it's still too early to tell. We really haven't got into the to the cross-sell piece, which I think is, a lot of it's going to be non-U.S. I think as we are sitting here today, we are probably ahead of our schedule in terms of revenue retention. I think we... in terms of the deal model we assumed that we would have lost some revenue at this point which we haven't. So, to the extent that we can be as successful as we were with Deutsche in cross-sell, which I think we can bring the balances on book here, which we are going to do and continue to be successful in revenue retention. We probably will do better than what we thought in the deal model.

Kenneth Usdin - Bank of America

Okay. And then on the expense side Ed, to your earlier point you said obviously you would initially use the $700 million expense cost base horizon. It's now run rating at $660 million; that includes what's typically a higher second quarter number I would think given the seasonality. So can you just update us relative to the phase-in that you expect? If you're still keeping to your dollar amount over time, can you update us on how you expect phase-in to occur over the second half of this year and then into '08?

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

Yes, we are still expecting the expense reduction to occur in line with the conversions broadly Ken. So our plan right now calls for us to be around 25% completed by the end of the 2007 and approximately 85% to 90% completed by the end of 2008. So the expense reduction and relatively the M&I charges that were merger integration charges that we were talking about incurring will broadly follow that timeline based on our modeling right now.

Kenneth Usdin - Bank of America

So if you kind of gotten 40 out already, just because of the cost avoidance and some in early synergies and you are expecting to get a fourth of 350 that means, in the second half, we've got about plus or minus 50 million bucks to come in to the... on a cost save basis?

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

Yes approximately.

Kenneth Usdin - Bank of America

Okay. Okay, great. As far as... and the last question is just on the... salary line continues to grow faster than the rate of revenues. I think it was 18% this year... this quarter year-over-year versus 16% on the revenue side. And I am just wondering if... is there also incremental spending that you've made either in the hiring side or related to the deals? Could you just give us some more color on why some of the kind of 100% margin stuff like NII isn't falling more directly to the bottom line, especially as it relates to the salaries line?

Ronald E. Logue - Chairman and Chief Executive Officer

Ken this is Ron. One thing I could say is that we added about 400 people in headcount due to the acquisitions. When you add Currenex, Putnam, the primary [ph] group, it's about 400 people into the salary line when you look at that year-over-year.

Kenneth Usdin - Bank of America

Butthat is as it comes with the related revenues, so.

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

Yes.

Kenneth Usdin - Bank of America

So, why don't we see positive operating leverage related to the salary line then?

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

Well I think that the main driver of that increase Ken is the incentive compensation associated with the overall higher level of performance. You have to remember that our money management business, which you know has performed very well. SSgA has an incentive scheme which rewards them for performance as do the other performance... incentive performance programs in the company. But when you look at... the business being up 23% year-over-year that's going to drive the level of incentive comp commensurate with that performance. And then you put on top of that the rest of the company's performance which has been very good also. You get incentive comp levels which drive the increase in the line that you're referring to, which are higher than the total revenue growth you alluded to.

Kenneth Usdin - Bank of America

Got it. And I am sorry, one more follow-up just on the deal again. On IFIN, is there any... is any of the margin guidance for the second half related to picking up IFIN like either funding the buyback or anything related? So, you know all things equal, I would kind of agree with the prior questions that would seem that if your trends continue that the margin should kind of stay in the 160s. So is there anything in there that's also related to the deal that, that would pull it down in the second quarter? Is that already considered in the kind of the current margin?

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

That's all in comment Ken, it considers everything.

Kenneth Usdin - Bank of America

So I am just asking is there an impact from IFIN on the margin in the second half? That's a negative at all because of the deal or financing related to the deal.

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

IFIN standalone, no, but if you put the IFIN deal related costs and including the financing that we talked about, the buyback of stock, yes.

Kenneth Usdin - Bank of America

Right, that's what I am getting at. So I am just wondering... that's what I am wondering. So on a standalone basis, both margins might be held together, but that's what I am asking, is what the incremental drag from the deal on the margin from the deal costs?

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

We have the financing expenses associated with the issuance of the billion dollars of securities. I don't have that number off the top of my head is in terms of margin points but that's reflected in our comments on the 155 margin for the full year.

Kenneth Usdin - Bank of America

Okay.

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

All right? But standalone again State Street and IFIN are above that given that there is a dilutive effect to the margin for the financing.

Kenneth Usdin - Bank of America

Right, that's an important point. Okay, got it, thank you.

Operator

Next question comes from Tom Mccrohan with Janney Montgomery.

Thomas McCrohan - Janney Montgomery Scott

Hi, Good Morning.

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

Good morning.

Thomas McCrohan - Janney Montgomery Scott

Quick question. Sorry to keep asking the same question on net interest margin. But I think, earlier Ed, you said 25% of your foreign client deposits was dollar based. So I have to say that would imply 75% of your funding is non-dollar based. But most of if not all, I would think of your investment securities are dollar based. So are you benefiting of the yield on foreign client deposits benefiting at all, from the weak U.S. dollar? Or any type of derivatives associated with currency?

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

Well overall, we are benefiting by the weaker dollar from a revenue perspective by percentage point or so in total. And that applies also to the net interest revenue. Your premise that all of the investments associated with those deposits are in U.S. dollars is not correct though. We have about 25% or about $15 million equivalent in placements. So those are like currencies.

Thomas McCrohan - Janney Montgomery Scott

Okay.

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

We will move the percentage that we slop back into U.S. versus investing in non-dollar currencies based on our view of where the best opportunities are. But overall there is a benefit to the tune of about a percentage point in terms of growth year-over-year given the weaker dollar, again on a year-over-year basis principally driven again by the strength in the euro and the strength in the pound.

Thomas McCrohan - Janney Montgomery Scott

All right. Do you hedge the risk associated with the net interest margin from currency or is it not hedged at all?

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

No, we don't hedge.

Thomas McCrohan - Janney Montgomery Scott

Okay.

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

We don't hedge and I'd just point out just to clarify that overall from the company's perspective, our revenue and expenses are pretty well matched as the currencies. So there is no net exposure that we're hedging. Our revenue is in like currencies as our expenses with a couple of minor exceptions in our offshore centers.

Thomas McCrohan - Janney Montgomery Scott

Okay. How much of Currenex revenues were in foreign exchange this quarter and I apologize for you to disclose that?

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

None. It's in other trading.

Thomas McCrohan - Janney Montgomery Scott

Other trading. Okay. And did you disclose the dollar amount what that was?

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

Yes, I said $16 million in the quarter, revenue.

Thomas McCrohan - Janney Montgomery Scott

$16 million. Thank you. And in connection with how incentive comp is paid in debt line. Is anyone in your organization incentivized or paid an incentive payment for the improvement in net interest income? Is anyone like one to one... I know overall performance, everyone to some extent is benefited but there is people salvage structure type in net interest income goal?

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

Yes. There is nobody or no group directly that's incentivized on the basis of improving net interest income. That's a very... it's a very complicated relationship in terms of the value of our deposits and what the treasury group does on the investment side given the constraints we self impose. And the largest of those is that we want to run certain regulatory ratios and maintain a AA long-term debt rating. I would say that the corporate staff, if you will, which I put treasury is paid on the basis of overall corporate EPS. So, there is an indirect linkage to how well the treasure group does and how much that improves EPS for the company, but no body is directly incented to generate net interest revenue in the sense I think your question implies.

Thomas McCrohan - Janney Montgomery Scott

Yes, yes I wouldn't think that it will be. And I guess the reason I asked is you guys have done a tremendous job of generating operating leverage. It's just sequentially, I know you had such a good sequential pop in net interest income this quarter but you also had a pretty big sequential pop in staff expenses. So I am wondering if it were not for sequential increase in net interest income this quarter which you still have generated positive operating leverage. And then if payments... incentive payments were tied to the NIIs and the answer will be well yes. But if it's not how much discretion did you have but you have throttled back to growth on staff costs this quarter to generate positive operating leverage if you didn't have the pop in NII.

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

Well, I mean not all of the staff costs that are in the salaries and benefits line relate to the treasury group. As we said, I mean that covers the whole company obviously and the performance of the entire company led by the money management business or is one of the largest drivers of the increase in that line. So I think, if you are looking for... looking at staff costs going up and linking that to treasury and net interest revenue I think that's not the right way to think about it.

Thomas McCrohan - Janney Montgomery Scott

No, what I am trying to link to it is your ability to manage the operating leverage. If your staff costs are growing as you said at the average of what it is in the first half, say 70% in the second half and NII is not going to keep growing at the same rate, maybe will. Can you still manage positive operating leverage if you don't have the same NII benefits in the second half?

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

We think so. Yes, I mean the discretion that we had and the calibration I referred to earlier was a not in the salary line for the most part. It was in the other expense line where we spent the money this quarter on sales promotion and professional fees and things like that, that I have already spoken about. So yes, we try to calibrate our discretionary expense spent in a quarter to our revenue picture.

Thomas McCrohan - Janney Montgomery Scott

Yes, okay. And one last question and I will drop off, on the Investors Financial deal model that you guys put together. Did you incorporate? I mean, did your accretion/dilution analysis and retention rate assumptions... an assumption that you're going to be offering any type of price concessions to the existing Investors Financial clients to retain them?

Ronald E. Logue - Chairman and Chief Executive Officer

We included that in the aggregate Tom, in terms of assuming that we would retain 90% of the current revenue at the time whether that is either lost revenue or price concessions.

Thomas McCrohan - Janney Montgomery Scott

Got you. Thanks very much.

Operator

And your next question from Robert Lee with KBW.

Robert Lee - Keefe, Bruyette & Woods

Thanks. Good Morning. I had quick questions on asset management. And I apologize if I missed this, the comments from before but can you give us some color on specifically, what products are driving some of the unique business trends there? And also geographically where you're seeing that... is that also predominantly outside U.S.? That's first question.

Ronald E. Logue - Chairman and Chief Executive Officer

Rob, this is Ron. Lot of obviously is coming from active. But I think as we said that the 130/30 product is becoming a fast growing product. We have got $10 billion now, probably one of the fastest growing products we have had. Geographically again like in the servicing business a lot from outside the United States. Very, very strong growth rates.

Robert Lee - Keefe, Bruyette & Woods

Okay. And was there any meaningful performance fees in the quarter in the revenue?

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

About $20 million Rob.

Robert Lee - Keefe, Bruyette & Woods

And just gelling on your new business products. Are you starting... are more those... I am assuming that more of those have a performance fee component, although, I guess, 130/30 typically doesn't.

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

Yes, yes I mean, I think probably the way to think about it is that the element of performance fees has roughly doubled over the last couple of years from 3%, 4% of their average revenue to... of the money management businesses average revenue to maybe 8% or 9%. On an annual basis. So around double.

Robert Lee - Keefe, Bruyette & Woods

Sure. You expect that kind of trend giving you, where you see the mix going to, probably, continue for a while?

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

Well, yes but I am not sure, why I am willing to say that it will double by next year. I think our trend and our emphasis has been to grow on the active business. And I think we are continuing to do that. But given the passive core, I don't think it could get to the level of, maybe, some of our competitors, on a percentage basis.

Robert Lee - Keefe, Bruyette & Woods

Okay. And one last question and I am sure we will see this when the Q comes out, but, is it possible just to get a feel for of the positive operating leverage in quarter? Was that... was a lot of that driven by the asset management business, just given the strong revenue growth even though obviously, incentive comp there is going to be up... is that what you are seeing a lot of the incremental operating leverage comes from?

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

We are seeing it across both of the segments. It's not in any one particular segment and I would point out that most of the net interest revenue that is one of the largest drivers of our growth is it accrues to the asset servicing business as we presented in the 10-Q. The asset management business, it doesn't get a lot of benefit from net interest revenue.

Robert Lee - Keefe, Bruyette & Woods

Okay, great. Thank you very much.

Operator

Our next question comes from Jason Goldberg with Lehman Brothers.

Jason Goldberg - Lehman Brothers

It's been answered. Thanks.

Operator

Thank you. We will take our final question from Betsy Graseck with Morgan Stanley.

Betsy Graseck - Morgan Stanley

Hi, Good morning. On the assets under custody line and obviously you talked a little bit about the growth. Is there any way you can just talk about how net inflows from... in our new business or increased business from existing customers impacted your growth year-on-year, Q on Q relative to prior quarters?

Ronald E. Logue - Chairman and Chief Executive Officer

That's yes... obviously there was some net inflow growth, a lot of it was net new business however.

Betsy Graseck - Morgan Stanley

Okay. And then the insurance and other product line within AuC has been stepping up the growth rate pretty nicely there. Could you talk about some of the drivers and outlook?

Ronald E. Logue - Chairman and Chief Executive Officer

Yes, a couple of years ago, we made a concerted effort to really focus on the insurance industry, both outside the United States and inside the United States and we have made some, I think real progress there. Especially as you look at how the pension field is evolving and how insurance companies are playing a more active role there, I would expect that, that will continue to fuel the assets under custody growth, going forward.

Betsy Graseck - Morgan Stanley

Okay. And then just one for Ed on the mortgage securities portfolio that you were talking about with regard to the AAA rated tranches. Are any of those AAA securities, CDOs that have within them sub-prime or not?

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

We have no CDOs that have sub-prime backing them.

Betsy Graseck - Morgan Stanley

Okay. So all your CDOs are AAA tranches within CDOs?

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

All of our.... virtually all, 98% of our CDOs are AAA, 2% are AA.

Betsy Graseck - Morgan Stanley

Okay. And then you mentioned the credit protection?

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

Right.

Betsy Graseck - Morgan Stanley

I mean I was just feeling... I am just trying to understand, what kind of credit protection you are talking about?

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

Well it's quoted in terms of the... the percentage of the underlying mortgages that could default before the asset backed security or the CDO would experience a problem. So, when I say we have 36% credit enhancement, that means the 36% of the mortgage is underlying the securities we have, could default before it worked its way up to our AAA level of protection. And I quote that against the 5% to 8% cumulative loss experience. So you can see that we have in the range of 5 times the level of protection that we feel we need in these security positions.

Betsy Graseck - Morgan Stanley

Okay. Thanks.

Operator

There are no further questions at this time. I would like to turn the conference back over to Mr. Ron Logue for any additional or closing remarks.

Ronald E. Logue - Chairman and Chief Executive Officer

Well,thank you very much. I have no further remarks and we look forward to talking to you again, next quarter. Thank you.

Operator

Thank you. That does conclude today's presentation. Thank you for your participation and have a great day. You may now disconnect.

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Source: State Street Q2 2007 Earnings Call Transcript
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