Northern Trust Q3 2007 Earnings Call Transcript

Oct.17.07 | About: Northern Trust (NTRS)

Northern Trust Corp.(NASDAQ:NTRS)

Q3 2007 Earnings Call

October 17, 2007 12:00 PM ET

Executives

Bev Fleming - Director of IR

Steve Fradkin - CFO

Aileen Blake - Controller

Preeti Sullivan - VP of Investor Relations

Bill Osborn - Chairman and CEO

Analysts

Mike Mayo -Deutsche Bank

Mark Fitzgibbon -Sandler O'Neill

Jason Goldberg -Lehman Brothers

Glenn Schorr -UBS

Gerard Cassidy - RBC Capital Markets

Tom McCrohan - Janney Montgomery Scott

Robert Lee - KBW

Brian Bedell - Merrill Lynch

Ken Usdin - Banc of America Securities

Operator

Good day everyone, and welcome to the Northern TrustCorporation's Third Quarter 2007 Earnings Conference Call. Today's call isbeing recorded.

At this time, I would like to turn the call over to theDirector of Investor Relations, Bev Fleming for opening remarks andintroductions. Please go ahead, Bev.

Bev Fleming

Thank you, Cynthia. Welcome to Northern Trust Corporation'sthird quarter 2007 earnings conference call. Whether you are participating intoday's conference call live or via replay, we sincerely appreciate you takingthe time to listen to Northern Trust's third quarter 2007 financial results.

Joining me this morning are Steve Fradkin, our ChiefFinancial Officer, Aileen Blake, Controller, and Preeti Sullivan from ourInvestor Relations team. In addition, we are joined this morning by BillOsborn, Chairman and Chief Executive Officer, who will provide some openingremarks.

For those of you who have not received our third quarterearnings press release or our financial trend report by e-mail this morning,they are both available on our website at northerntrust.com. In addition, thisOctober 17 call is being webcast live on northerntrust.com. The only authorizedrebroadcast of this call is the replay that will be available through October24. Northern Trust disclaims any continuing accuracy of the informationprovided in this call after today.

Now for our Safe Harbor Statement. What wesay during today's conference call may include forward-looking statements whichare Northern Trust's current estimates or expectations of future events orfuture results. Actual results, of course, could differ materially from thoseindicated by these statements because the realization of those results issubject to many risks and uncertainties. I urge you to read our 2006 FinancialAnnual Report, and our periodic reports to the SEC for detailed informationabout factors that could affect actual results.

Again, thank you for your time today. Let me now turn thecall over to Chairman and Chief Executive Officer, Bill Osborn. Bill?

Bill Osborn

Thank you, Bev. First of all, I want to thank all of you forlistening to me and working with me over the last 12 plus years. I am in anoutside board meeting this morning and therefore I am going to make somecomments, and then I will be available this afternoon back at the bank, ifanyone wants to call me and ask me specific questions. But, let me first of allcomment on the fact that yesterday at our board meeting, the Board of Directorsapproved a succession plan where I will step down at the end of the year asChief Executive Officer, and Rick Waddell will assume the CEO role effectiveJanuary 1 of 2008.

And I will remain Chairman of the Board, and I have not putdown and nor has the Board decided on any specific retirement date for me asChairman. My intention is to continue to work with the company and to befocused very much on client relationships, strategic issues that we are goingto continue to deal with, and doing whatever I can to help Rick and the rest ofthe management group.

I've worked on this transition plan for well over 2 years,actually I started probably twelve and half years ago, but it's really beenaccelerating over the last couple years. And it's really driven at this time bythe fact that I think the company is in absolutely terrific shape. We havegreat momentum as you saw in our third quarter earnings and all of our businessyear-to-date. Our global franchise continues to expand. Our personal business,our high-net-worth business has been doing terrifically well, and I see it hasa lot of momentum.

And we’ve got a great management group. This is really theissue, Rick is ready to go, he's chopping at the bit to take over, and aftertwelve and a half years, it’s time for me to get out of the way and let a grouptake over, that I know that will just drive us to greater heights. I willcontinue to be around to help out wherever I can, and I’m very, very confidentin the future of our organization.

I know that Rick, and Steve, and the whole group willcontinue to have the very open dialogue that I've maintained with all of you,and I appreciate all, that you all have done to support me in the Northern.This is a very special organization, and I know that you'll continue to havethe same relationship with Rick as you have had with me, going forward.

Now, I’m going to just turn this over to Steve, but I justwant to tell you again, if anyone has any specific questions, they can call me.I also want to mention, I know there is a lot of, there will be speculation. Iam in perfectly good health, the company is in great shape, and this isliterally a personal decision based on the fact that we have a great groupthat’s ready to go forward. And again, thanks very much, and I’m going to signoff now. Bye-bye.

Steve Fradkin

Thank you, Bill, and good morning, everyone. Let me extendmy welcome to all of you listening Northern Trust Corporation's third quarter2007 earnings conference call. Now, before I provide you with an overview ofour third quarter performance, let me offer just a few comments on themanagement changes announced yesterday, and just discussed with you by Bill.

I hope that all of you will join me in congratulating Rick Waddell,our new Chief Executive Officer, effective January 1, 2008. As many of you know, Rick is a32 year veteran of Northern Trust with a very diversified experienced set,expanding our banking, private client, strategic planning, wealth management,institutional, and more recently, investment businesses.

Rick has worked for Northern Trust, both in a headquarterscontext and from outside Chicago.And we are delighted to have someone with his breadth of experience andknowledge of Northern Trust, serving as our next CEO.

I would also like to take a moment to offer a few commentson behalf of the management team, with respect to Bill Osborn's decision tostep down as CEO, while remaining Chairman of the Board, again all effectiveJanuary 1.

Bill has been a true leader and steward of Northern TrustCorporation, not only during his twelve years as Chief Executive Officer, butalso across his entire 37 year career. At a time when the conventional wisdomsaid, that size and consolidation were the watchwords for banks, and that onlythe big would survive, Bill executed large scale M&A transaction and filedahead with industry leading growth rates on an organic basis.

When people said that he led a small mid-westerninstitution, Bill defied them by building a premium national wealth managementfranchise in the United States, that now serves approximately 20% ofthe Forbes 400 Wealthiest America. When critics said that he ran a greatcompany, but that the organization would never be able to compete globally, heled the company in a transformation that took it from earning approximately 7%of its net income from international activities in 1992 to approximately 35% in2006. The vast majority of which again, was done organically.

When some said that he was too conservative with the balancesheet, and should take more risk, he ignored their admonitions and avoided thepitfalls of one-time items and restatements that others experienced.

And when people told him that it was either corporateperformance or philanthropy, but that the two could not coexist, he ignoredthem yet again and consistently led the Company in making still in profitcontributions equal to approximately 1.5% of pretax profits per year, inaddition to the countless hours of his own time and energy, that he spends oncivic issues, all while the Company still performed at the highest levelsrelative to others in it's peer group.

On behalf of all of his colleagues and friends here in Chicago, across thecountry and around the world, I want to thank Bill for his incredible and indeliblecontributions to Northern Trust. We look forward to his continuing work as CEOfor the remainder of 2007 and his counsel as Chairman of the Board of Directorsthereafter.

With that, let's move into a discussion of our third quarterperformance. Earlier this morning Northern Trust reported very strong thirdquarter 2007 earnings of $0.93 per share, an increase of 26% compared to the$0.74 that we reported in the third quarter of 2006.

Net income equaled the quarterly record of $208 millionrepresenting an increase of 27% year-over-year. This was our eleventhconsecutive quarter of double-digit, year-over-year growth in earnings pershare, and our tenth consecutive quarter of double-digit year-over-year growthin net income.

Accumulation of client assets under custody and assets undermanagement was robust. Assets under custody equaled a record $4.1 trillion onSeptember 30, representing an increase of 24% compared with one year ago.

Assets that we manage on behalf of our clients experiencedstrong growth as well, equaling $761 billion at September 30th, up 14% comparedwith the year ago.

Now we have organized our earnings call today into threesections: first for the benefit of those of you who maintain detailed models onNorthern Trust, I will outline two items that you should consider as youanalyze our third quarter results.

Second, I'll review our financial performance focusing onthose areas that most impacted the third quarter's results.

And third, I'll comment on an exciting announcement that wemade on Monday, and also offer a few perspectives on the strategic positioningof Northern Trust in-light of the volatile market conditions that existed inthe third quarter. As always, Bev and I will then be pleased to answer yourquestions.

As you analyzed our third quarter financial performance, Iwant to draw your attention to two items that impacted our reported results.First, in the third quarter Northern Trust recorded a gain of $6.3 million onthe sale of shares of CME Group which is the parent company of the ChicagoMercantile Exchange. The gain on the sale of these shares is shown in ourincome statement in the Investment Security Transactions line.

Second, during the third quarter we recorded an income taxbenefit of $5 million. This item relates to new state tax legislation enactedin the third quarter. We currently estimate based on our current interpretationof the tax law, that our deferred income tax reserves will be overstated by $5million as of January 1, 2008,when the new law becomes effective. Therefore, we recorded a $5 million benefitin the third quarter as required by FAS 109.

With that background, let me review the quarter's keyperformance drivers. I will start with revenues focusing on the major itemsimpacted our results.

Total revenues equaled $892.5 million in the third quarter,up a strong 19% or $143 million compared to last year's third quarter. Revenuesgrew 1% or $10 million on a sequential quarter basis. Recall that the secondquarter is typically a seasonally strong quarter as a result of theinternational dividends season in securities lending.

Trust investment and other servicing fees represent thelargest component of our revenue mix, accounting for 57% of total revenues inthe third quarter. We are very pleased with the continued strong growth in thisimportant revenue category across both, our private client and institutionalbusinesses.

Trust investment and other servicing fees increased 16% or$71 million to $509 million compared to the third quarter of last year. Withinthis line item, PFS trust investment and other servicing fees equaled a record,$227 million in the third quarter, and grew 17% or $33 million versus lastyear's third quarter. This is our fourth consecutive quarter of double-digityear-over-year growth in PFS trust fees and the best year-over-year growth ratethat we have achieved in PFS quarterly fees since the third quarter of 2000.

On a sequential quarter basis, PFS trust fees increased 1%or $3 million. Our excellent PFS fee growth reflects strong net new business.PFS net new business on a year-to-date basis represents the best nine monthsperiod achieved since the first nine months of 2001. In addition to excellentnet new business results, the equity market environment relative to ourquarterly PFS fees also provided support for the quarter's 17% year-over-yeargrowth in fees.

Recall that our private client business across all PFSstates is on a consistent monthly fee methodology with a one month flag. Usingthis monthly methodology, the S&P 500 was up 15% compared to one year ago.

Equity market support was not evident on a sequentialquarter basis as the S&P 500 was flat compared to the second quarter, usingthe PFS month flag methodology. Keep in mind too, that PFS manages broadly diversifiedportfolios for client. The asset allocation of PFS Managed Assets as ofSeptember 30th, was 49% equities, 24% fixed income, and 27% cash and otherasset class.

Our fee growth in PFS is derived largely from growth inclient assets, whether winning new clients or doing more to support the needsof existing client. We were very pleased with our ability to aggregate privateclient assets at attractive rates of growth in the third quarter.

PFS assets under management equaled a record, $147 billion atSeptember 30th, up 15% or $19 billion from a year ago, and up 2% or $2.5billion sequentially.

Assets under Custody in PFS also equaled a record, reaching$329 billion at the quarter-end. PFS Assets under Custody increased 36% or $86billion from a year ago, and were up 3% or $10 billion sequentially.

The ultra wealthy client segment within PFS, which we calledthe Wealth Management Group, continues to be an outstanding contributor to ourgrowth. Wealth Management serves the complex needs of some of the world'swealthiest families.

We currently work with 20% of the Forbes 400 richestAmericans. Forbes published its 25th anniversary edition of the Forbes 400 inSeptember. The minimum net worth required to earn a spot on the Forbes 400 listin 2007 rose to $1.3 billion in wealth, signifying the very high-end of thewealth market. The average size of our custody relationships would beapproximately 380 families served in Northern Trust Wealth Management Group,across $0.5 billion mark at September 30.

Fees in our Wealth Management Group for the third quarterequaled $33 million, an increase of 16% or $5 million compared with last year.This fee growth was fueled by excellent year-over-year growth in WealthManagement client assets. Custody assets in Wealth Management equaled $192billion at September 30, up 55% or $68 billion from one year ago.

We also manage a portion of the assets that our WealthManagement clients have placed in custody at Northern Trust. Managed assets inWealth Management totaled $29 billion at September 30, up 18%, or $4 billionyear-over-year. On a sequential quarter basis, Wealth Management fees declined4% or $1 million. This sequential quarter decline in Wealth Management fees isnot reflective of the core positive trends that we are seeing in the business.

Rather the sequential decline in Wealth Management feesresulted from a prior period adjustment. The sequential quarter trend incustody assets was strong in Wealth Management with assets under custodyincreasing $7 billion or 4% compared with June 30.

Wealth Management assets under management equaled to $29billion at September 30, which were all lower than the $30 billion highreported at June 30, again, primarily reflected in the adjustment from theprior period.

Switching to our Institutional business, C&IS trustinvestment and other servicing fees equaled to $282 million in the thirdquarter, an increase of 16% or $38 million year-over-year. C&IS feesdeclined 9% or $27 million, when compared with the seasonally strong secondquarter. C&IS fees includes three primary revenue areas, custody and fundadministration, institutional asset management and securities lending.

Let me discuss the performance of each in the third quarter.C&IS custody and fund administration fees equaled $159 million in the thirdquarter, up 27% or $34 million year-over-year. This strong double-digit custodyfee growth was driven by market growth, new business, particularly in globalcustody and higher transaction volumes during the quarter,

Sequential growth in C&IS custody fees was also strong,up 8% or $11 million compared with the second quarter. Sequential growth wasalso driven by market growth in new business, including strong new business infund administration.

Recall that C&IS custody fees are built on primarily ona one quarter lag basis. For the year-over-year comparison, the S&P 500 wasup 18% versus prior year on a one quarter lag basis. And EAFE Index was up 20%.Market growth on a quarter lag sequential basis, was also supported with feegrowth with the S&P 500 up 5.8% in the second quarter and the EAFE Index up4.9%.

An important contributor to C&IS custody fees is ourability to successfully aggregate client asset. Institutional assets undercustody equaled a record, $3.8 trillion at September 30, up 24% or $722 billionfrom a year ago, and up 3% or $118 billion versus last quarter.

International activities continued to fuel the institutionalassets and fee growth in the third quarter. Global custody assets equaled $2trillion at September 30, an increase of 31% or $476 billion from a year ago.

The third quarter represents the eighteenth consecutivequarter that we have reported double-digit year-over-year growth in globalcustody assets. On a sequential quarter basis, global custody assets were up 5%or $91 billion.

Investment management fees in C&IS equaled $73 millionin the third quarter, an increase of 15% or $9 million year-over-year. Growthwas driven by both, new business and positive markets. New business resultswere strong in short duration assignments, including institutional mutual fundsand cash sweep products, and in quantitative management.

Note too, that in our institutional asset managementbusiness, we manage a wide array of asset classes for clients. The asset allocationof C&IS managed assets, as of September 30 was 33% equities, 9% fixedincome and 58% short duration and other. Institutional investment managementfees increased 2% or $1 million on a sequential quarter basis. Managed assetsfor institutional clients equaled $615 billion at September 30, up 14% or $75billion from last year and down 1% or $8 billion sequentially.

The sequential decline primarily reflects a lower level ofsecurities lending collateral, reflective of the deleveraging phenomenon that occurredduring the third quarter as a result of the challenging fixed incomeenvironment. C&IS securities lending fees equaled $33 million in the thirdquarter, representing a decrease of 19% or $8 million, compared with lastyear's third quarter, and a decrease of 55% or $40 million, compared with therecord $73 million that we posted in the seasonally strong second quarter of2007.

Securities lending collateral equaled $284 billion atSeptember 30, up 14.5% or $36 billion versus one year ago, and down 5% or $16billion compared with June 30. So, let me pause for a moment and provide someperspective around our securities lending results in the third quarter.

Securities lending is a low risk, value added product that hasbeen a consistent source of incremental return for our clients over a longperiod of time. The credit market environment in this year's third quarter hada negative impact on securities lending results that we are reporting today.

Let me start by describing the mechanics of securities lendingto you, after which, I will describe the factors that impacted our thirdquarter securities lending results. Securities lending is a service that isoffered to our clients. Northern Trust acts as agent for our clients in theadministration of the securities lending program.

For those participating clients, we lend their securities tohigh quality, credit committee approved financial institutions. Now I shouldadd as well, that we do not lend securities directly to hedge funds. In returnfor the lend securities, borrowers provide collateral, typically in the form ofcash equal to 102% to 105% of the borrowed amount. The lender of thesecurities, haze the borrower a rate of return on their cash collateral, calledthe rebate rate, which generally floats with the Federal Funds Rate. On behalfof our clients, who have lent their securities to approved borrowers, we investtheir cash collateral in a variety of investment pool. Our clients select whichinvestment pools they would like to have their cash collateral invested in,depending on their return objectives and risk tolerance.

Investment options available to our clients to theirsecurities lending collateral stand a risk reward continuum of short durationinvestment management products. Our clients then earn a return on theirparticipation in securities lending, based on the spread between what is earnedon the collateral and what is paid to the borrower as a rebate rate. Theseearnings are apportioned between the client, the owner of the lend securitiesand Northern Trust, the agent of the program at a negotiated percentage amount.

Our securities lending results in the third quarter wereadversely impacted by this summer's disruption in the credit environment, whichbegan with concerns in the sub-prime mortgage market and spread to thefixed-income arena more broadly.

It is also important to note that there were positiveoffsets in our securities lending business to the sub-prime mortgage contingentin the third quarter, including strong demand for treasury securities and theFederal Reserves 50 basis point reduction in the Federal Funds Rate later inthe quarter. This noted the extreme credit market disruption did negativelyimpact returns achieved in one cash collateral investment fund used for securitieslending.

Approximately 6% of our $284 billion in securities lendingcash collateral is invested at our client's selection and discretion in a totalreturn mark-to-market, short duration, fixed-income fund. This is our onlymeaningful fund that is structured as a mark-to-market fund and understandingthis designation is essential to understanding the impact during the quarter.

Our other tax collateral investment options do not recognizemark-to-market fluctuations in the yield. The consequences of being amark-to-market fund during the third quarter of 2007 worst of the year, asfixed income securities were repriced across even the highest qualityinstruments. Assets value changes, in this case asset value markdowns floweddirectly through to the total return of the fund, thus impacting the earningsof a small numbers of our securities lending clients during this period andNorthern Trust's securities lending fees as well.

While the environment was a challenging one for this fund,in particular. And therefore for our overall securities' lending revenues, I dowant to make a few key points.

First, this mark-to-market fund has followed its investmentguidelines consistently and appropriately. No way typical portfolio managementdecisions were made in the fund prior to, during or after quarter end. Itsperformance results reflect the full impact of the extraordinary marketenvironment.

Second, the fund does not use leverage. Third, the fund didnot post a negative total return for the third quarter. Put in another way, thefund earned a positive annualized return for the third quarter of 2.72% to beprecise.

Keep in mind however, thatsecurities lending revenue is earned based on the spread, between what isearned on the collateral pool and what is paid in terms of the rebate rate.With this fund having earned 2.72% annualized in the third quarter, and Fedfunds averaging a little over 5%, you can see how the negative net spread onthis specific fund would yield negative securities lending earnings across thequarter.

Fourth, the fund has a very highquality profile. 64% of the securities held in it are rated either AAA or AA.

Fifth, the fund is conservativelymanaged with an interest rate sensitivity of 65 days and a credit basedweighted average maturity of 1.65 years as of September 30.

Sixth, the third quarter totalreturn of the fund reflected negative marks-to-market on a broad mix ofholdings. We do not believe at this time that there exists any permanentimpairment of any holdings. All of the asset markdowns recorded in the fundduring the third quarter are unrealized, and we expect given what we know, thatall of the funds holdings will mature at par as expected. Any such futurepositive marks-to-market would similarly be reflected in the yield of the fundand the resultant securities lending revenues.

And lastly, the fund is used as asecurities lending cash collateral option by only a small number, approximately10 of our more sophisticated clients. None of these clients uses thismark-to-market fund exclusively for their collateral investments. All haveother less aggressive funds to round out their total collateral investments.

Moving on through our revenueline items let me shift our discussion to net interest income, which accountedfor 26% of revenues in the third quarter. Net interest income equaled a record$228 million, an increase of 15% or $30 million compared with last year. On asequential quarter basis, net interest income increased a strong at 9% or $20million.

The driver of the year-over-yearincrease in net interest income was balance sheet growth. Average earning assets equaled $54billion in the third quarter, an increase of 18% or $8 billion year-over-year.Growth in average earning assets was broad-based with money market assets up22%, securities up 25%, and loans up 12%.

Client oriented growth on theliability side of the balance sheet continued to fuel the increase in earningassets. Once again and consistent with trends in prior quarters, liabilitygrowth was driven by non-U.S office time deposits, which averaged $28 billionin the third quarter, up 26% or $6 billion versus last year. This strong growthin non-U.S office time deposits is directly related to our internationalsuccess in the institutional custody business, which I discussed earlier.

The strong sequential growth of9% in net interest income was driven by several factors.

First, recall that in the secondquarter, net interest income was reduced by $7 million representing the entirefirst half amount related to our adoption of FSP 13-2, the FASB standardspertaining to Leveraged Lease accounting. The comparable third quarter amountrecorded for FSP 13-2 was $2.5 million resulting in a $4.5 million favorablesequential swing.

In addition, net interest incomein the third quarter benefited from wider spreads between overnight rates andone to three months rate. This widened spread at the short-end of the yieldcurve was driven by the disruption in the credit markets during the quarter,and late in the quarter by the Federal Reserve Banks 50 basis point cut in theFederal funds rate.

Our net interest margin in the third quarter equaled 1.69%,down four basis points from the prior year and up 11 basis points sequentially.The 4 basis point year-over-year decrease in our net interest margin reflectsthe mix shift on the asset side of our balance sheet that I have described inpast call.

As I mentioned earlier, our international business has beena strong growth driver at Northern Trust for over a decade. As this businessgrows, our clients place their short-term cash on our balance sheet in the formof non-US time deposits. These deposits in turn have been predominantlyinvested on the asset side of our balance sheet, in a lower margin short-termmoney market assets and securities, which profile differently when comparedwith the relatively higher margins associated with traditional loans.

This mix shift in earning assets which is directly linked tothe success of one of our core growth strategies is the primary reason for thedecline we reported in our net interest margin. The sequential increase in ournet interest of 11 basis points was driven by the same two factors thatinfluenced the sequential increase in net interest income. First, the lessenedimpact of FSP 13-2, and second, wider spread between overnight rate and one tothree month rate.

Foreign exchange trading income of $92 million equaled arecord up 74% or $39 million compared with the third quarter of 2006. On asequential quarter basis, foreign exchange trading income increased 13% or $11million.

The key drivers of our quarterly results in foreign exchangewere volume and volatility; both were very high in the third quarter, withclient volumes up significantly both year-over-year and sequentially. Currencyvolatility was also quite high, due in large part to the disruptions in thecredit market. This was a clearly an unusual third quarter for our foreignexchange activity, and that the summer months are typically the quietest andtherefore more often they're not the seasonally slowest of the year for foreignexchange trading. The normal July-August slowdown certainly did not occur inthe summer of 2007.

Other operating income equaled $23 million, a decrease of19% or $5.5 million compared with the prior year and a decrease of 21% or $6million sequentially. The majority of the year-over-year and sequentialdeclines resulted from currency revaluations intended to hedging activities,and a small additional loss accrued in the third quarter for the disposition ofIsle of Man fund administration business.

Recall that other operating income in the second quarter of2007 was elevated, as it included a $4.9 million gain on the sales of leasedequipment, partially offset by a $3 million initial loss on the Isle of Man business.

As I mentioned at the outset of this call, during the thirdquarter we sold shares of the Chicago Mercantile Exchange and recorded a gainof $6.3 million. Northern Trust has held seats on the Chicago MercantileExchange and the Chicago Board of Trade for many years. The initial publicoffering of the CME and its subsequent merger with the Chicago Board of Traderesulted in a publicly traded share ownership position by Northern Trust in CMEGroup, which was the source of the shares that we sold.

During the third quarter, we recorded a loan loss provisionof $6 million compared with the provision of $6 million in the third quarter oflast year, and $4 million in the second quarter of this year. The majority ofour loan loss provision this quarter reflects loan growth as average loansincreased 12% year-over-year and 3% sequentially.

Non-performing assets totaled $29 million at quarter-end,down $3 million from $32 million at June 30, and equaled only 12 basis pointsof total loans on September 30. We recorded $2 million in net charge-offsduring the third quarter.

Now let me shift my comments to a review of the key expensecategories that impacted our third quarter performance.

Expenses during the third quarter of 2007 equaled $567million, up 19% or $90 million from the year ago quarter. On asequential-quarter basis, expenses were up 2% or $11 million. Compensationexpense equaled $260 million and increased 20% or $44 million from the year agoperiod. The year-over-year increase in compensation expense reflects higherincentive compensation, additional staff to accommodate growth and expansion,our April 2007 annual salary merit increases, and market and promotionalincreases.

Staffing levels equaled approximately 10,600 full-timeequivalent positions at quarter-end, including approximately 630 staff at ouroperation center in Bangalore, India. Totalstaff count was up 11% from last year. Staff in India was up, 430 full-timeequivalent positions year-over-year from the 200 reported last year andincreased 26% from last quarter.

On a sequential-quarter basis, compensation expenseincreased 3% or $8 million, primarily reflecting increased staff level.Employee benefit expenses equaled $57 million in the third quarter up 8% or $4million versus last year, and down 3% or $2 million sequentially. Theyear-over-year increase was primarily driven by higher staff levels, partiallyoffset by lower pension costs. The sequential decline primarily reflects normalseasonal declines in freighter insurance.

Outside services equaled $99 million, an increase of 31% or$24 million compared with last year and 6% or $6 million sequentially. Theyear-over-year increase primarily reflects higher expenses driven by increasein client volumes, such as global sub-custodian fees and investment managementsub-advisory fees. In addition, technical and consultant services increasedyear-over-year. The sequential increase was driven primarily by higherconsulting services.

Equipment and software related expense equaled $54 millionin the third quarter, up 4% or $2 million year-over-year and down 4% or $2million sequentially. The year-over-year increase is primarily attributable tohigher software amortization resulting from continued investment in technology.The sequential decline primarily reflects a $3 million software write downtaken in this year’s second quarter.

Occupancy expense in the third quarter equaled $39 million,up 16% or $5 million, year-over-year and down 7% or $3 million sequentially.The year-over-year increase is primarily attributable to higher rent andbuilding operation cost. The sequential decline primarily reflects a $3 millionrent expense adjustment in the second quarter of 2007, which represented acatch up related to certain rent escalation causes in existing leases.

Other operating expense equaled $58 million in the thirdquarter, an increase of 21% or $10 million compared with last year.

On a sequential basis, other operating expense increased 8%or $4 million. The primary drivers of both the year-over-year and sequentialincreases were charges related to securities processing activities and employeehiring and relocation expense.

Our provision for income taxes in the third quarter equaled$93 million resulting in a tax rate equal to 30.8%. This compares to a tax rateof 34.6% in the third quarter of last year and 33.2% in the second quarter ofthis year.

The lower tax-rate on a year-over-year basis primarilyreflects two items: first, we recorded a state tax benefit of $5 million relatedto the new tax legislations, as I mentioned in my opening remarks.

And second, we continue to benefit from our adoption of APB23. Recall that in the fourth quarter of 2006 and in the first two quarters of2007, we recorded tax benefits associated with our decision to indefinitelyreinvest earnings of certain non-U.S subsidiaries. The sequential decline inour tax-rate primarily reflects the $5 million state tax benefit.

Northern Trust repurchased 1.2 million shares of commonstock in the third quarter at a cost of $77 million. Diluted shares averaged$224 million. We can purchase an additional 9.8 million shares under a buybackauthorization approved by our Board of Directors in October of 2006.

In keeping with our practice, we increased average commonequity by 11% versus one year ago to a record $4.2 billion at September 30.

Let me close with one exciting update that I hope you allheard about and then a few thoughts on the positioning of Northern Trust,particularly in light of the volatile and disruptive market environment that weall had to contend with in the third quarter.

This past Monday, we jointly announced with the PGA Tour,that Northern Trust has become the title sponsor for the PGA's historic golftournament at Riviera Country Club in Los Angeles, beginning in February 2008.

With this five year agreement the tournament will be namedthe Northern Trust Open, marking the beginning of a transformation processthrough this high profile tournament. The Northern Trust Open will provide uswith another platform to showcase our premier brand and raise our brandawareness. The men and women who play, who watch, play and enjoy golf mirrorour target demography. We have been continuously building and extending ourglobal brand awareness through increased advertising in print, online, and ontelevisions, and through prominent sponsorships.

The Northern Trust Open will help continue to drive ourbrand awareness both in the United States and the around the world. This majorevent enjoys great media exposure, reaching more than 450 million households inmore than a 150 countries.

Viewed from any angle, global reach, demographic fit, clientinteraction, philanthropic support, and brand synergy, the Northern Trust Openrepresents a terrific platform to strengthen the Northern Trust brand.

And now let me shift from marketing to the marketenvironment. As you know the third quarter posed extremely challenging marketconditions, particularly in the month of August. We saw the result of this inthe variety of company crisis, earnings preannouncements and earnings releaseswith weaker results.

Financial services firms had to contend with the sub-primemortgage crisis, which then morphed into a broader contingent. Equity fixedincome and currency markets were all volatile and the Federal Reserve alsojumped into the fray with the 50 basis point rate cut late in the quarter.

The environment tested many great firms and a wider array offinancial services business model. This was a period in which the strength ofNorthern Trust strategy, business position and execution was clearly inevidence. Though not immune from the dynamics of the broader environment inwhich we and our clients operate, we were very pleased with the strength of ourresults and the inherent quality embedded in our management prophecy.

Our client focus and conservatism across cycles continues toserve Northern Trust and its shareholders well. We have in our view, anattractive and enduring business model. Our attractive and enduring business modelis evident in the intensity of our focus. We concentrate our efforts on onlytwo, very targeted clients' segments; institutional clients, served by ourCorporate and Institutional Services business unit and private clients, servedby our Personal Financial Service business unit.

These two clients facing business units are supported by ourinvestment management arm, Northern Trust Global Investments, which delivers awide range of investment management solutions to our target clients. And by ourWorldwide Operations and Technology unit, which delivers products and servicesto our clients on one integrated operations and technology platform globally.

We have not strayed from this focus. We have not sort entryinto 10 gentle businesses, such as retail consumer lending, sub-prime mortgageorigination, sub-prime mortgage packaging or wholesaling, credit cards orinvestment banking.

Our attractive and enduring business model is evident in ourcommitment to our organic growth. We have not chosen to take or undertakerather large scale, culture changing mergers and acquisitions to drive ourrevenue growth.

Our use of M&A has been very selective and strategic. Wehave undertaken acquisitions only to facilitate entry into new geographicmarkets or to assist us from a product perspective in meeting the needs of ourtarget clients. And where we have undertaken acquisitions, they have beenmanaged within the broader enterprise and the management of our overall riskprofile.

Our attractive and enduring business model is evident in thestrength of our balance sheet. We maintain a conservative securities portfoliothat takes limited credit, currency and interest rate risk. That conservativestand positioned us well to manage through the difficult fixed income environmentin the third quarter.

We also have excellent loan quality, a hallmark of NorthernTrust relationship lending strategy for many years. Our relationship lendingstrategy consistently applied across the years means that we do not providerich financing on private equity or leveraged buyout yield.

Non-performing assets actually declined in the third quarterand represented a minimal 12 basis points of loans. A figure that historicallyranks among the best of the largest banks in the United States. In addition, we donot have any off-balance sheet commercial paper conduit facility.

Our attractive and enduring business model is evident in ourcapital strength. Northern Trust maintains very strong regulatory capitalratio. All of our subsidiary banks maintain capital ratios above the levelrequired for classification, as well capitalized. And we have increased ourstockholder's equity at Northern Trust for 78th consecutive quarters or over 19years, a record that we believe is unmatched among large banks in the United States.

And our attractive and enduring business model is alsoevident in our asset management business, where we have dramatically expandedthe array of capabilities available to our clients in recent years. We makelittle use of various strategies that have been in the headlines of late.

Our investment strategies do not employ leverage with thevery small exceptions of modest leverage employed in our 130-30 strategies. Wealso have only very small holdings of sub-prime asset backed securities in someof our investment portfolios, and those holdings are limited to short-term AAAtranches representing the most senior tranches in the structure.

In short, we continue to focus on the targeted market andclient segments that we have served well for many years, and that we continuedto have excellent long-term growth demographics. This is a strategy that hasserved us well, in both good times and tumultuous times such as thoseexperienced in the most recent quarter.

In closing, our performance in the third quarter againvalidated our focused business strategy and our consistent attractive andenduring business model. We are very pleased with the financial results that weare reporting to you today including strong top-line revenue growth andattractive double-digit earnings per share and net income growth.

And now, Bev and I would be happy to answer your questions.Cynthia, please open the call for questions.

Question-and-AnswerSession

Operator

Thank you, sir. (Operator Instructions). We will take ourfirst question from Mike Mayo with Deutsche Bank. Please go ahead.

Mike Mayo - DeutscheBank

Good afternoon.

Steve Fradkin

Hi Mike.

Mike Mayo - Deutsche Bank

Just some questions on the one-timers, you mentioned rightoff at that, the tax benefit and the sale of the CME shares, it seems like thecouple of other items. Outside services, it was up $6 million, should weconsider that core or was that temporary?

Steve Fradkin

You're with me, Mike.

Mike Mayo - DeutscheBank

I am really just trying to see if there's any unusually highexpenses that might go away?

Steve Fradkin

No, I think, Mike, obviously, the CME is one-time, the taxrate was one-time, but there was nothing dramatic that comes to my mind thatwould be additive to that.

Bev Fleming

And Mike, when we do have items that we know that you allwould consider as one-time, we do try to disclose that in that upfront sectionof our call. So, had we had any other items that we felt, you should be awareof, we would have mentioned them during the call.

Mike Mayo - Deutsche Bank

Okay. Andother income being down $6 million from the second quarter?

Bev Fleming

Well, we gave some of the detail, Mike there, during theprepared remarks. We did so Mike.

Steve Fradkin

I don't think there is anything to add.

Mike Mayo - DeutscheBank

And you spent a lot of time on securities lending, if wewere thinking about normalizing that, how might we go about that?

Steve Fradkin

Well, I think Mike, as I said on securities lending, youreally have to understand this constructive and mark-to-market fund versus aconstant dollar NAV and there are a variety of guidelines that drive theappropriateness of when one would have one structure versus another, but I wantto emphasize understanding that vehicle structure really is critical becausethe mark-to-market fund is fully transparent. And if you had the same holdingsin a custom account, a non-mark-to-market fund, we would have reporteddramatically, different results.

So, for example, our holding in the mark-to-market fund, ifyou had the exact same holding, exact same profile, and put those in a customaccount, our securities lending results would have increased by approximately70%, compared to what we reported, which was a 19% year-over-year decline. So, Imean it’s a very dramatic point that needs to be understood.

Bev Fleming

The other point that I would make, Mike, is, it’s difficult,I think for any of us to “normalize” the securities lending. Keep in mind that,typically the third quarter would have seen a decrease from the second quarter,which is typically the seasonal peak, and of course, as you saw it, some ofpeers, that didn’t happen, because it affected the market environment was sotumultuous in the third quarter. So, it’s difficult to normalize when you arecoming off of such a tumultuous period.

Steve Fradkin

The other thing I will add, Mike, to that, because I’m sure,you or someone else would have the question is, when you think about the timingof the recruitment of that yield, that is going to be very difficult topredict. And it’s impossible for me to predict exactly how quickly that’s goingto happen because you need the credit markets to stabilize, but I guess what Iwould say, without giving forward-looking guidance which we don’t give, is thatwith all those caveats noted, and assuming that there is no change inimpairments or anything like that, we would estimate that the yield on themark-to-market fund would reflect positive marks as we progress from nowthrough 2008. So, sometime over the next 18 months, the headwind that we got onmark-to-markets this quarter will be recouped as we move into 2008.

Mike Mayo - DeutscheBank

So, we do not long to wait to see that?

Steve Fradkin

No. Again, I cannot predict with pinpoint accuracy, butthat’s our best guess at this point in time.

Mike Mayo - DeutscheBank

And then, just one separate question on the processingbusiness, good revenue growth, but the revenue growth is almost twice as fastas the growth in assets under custody linked quarter. Just wondered, if you hadany color on that, and you are operating in a consolidating world. Are youseeing any benefits from that and also the international growth withinprocessing?

Steve Fradkin

That’s about half hour question. But, what I would say Mikeis, look, we feel terrific about our asset servicing business and the growthrates there, and have no apology for the success that we have had in keepingand aggregating new clients on that front. Pipelines remain strong,international growth as in past quarter has been strong.

As to the asset management business, we feel very good aboutthe growth this quarter on the assets under management front. You are correctin noting that the rate of growth, if you want to compare that to our assets undercustody differs, but remember, you have a vastly different asset allocationparadigm for our managed assets. So, I think it' being a relatively smallequity asset manager, I think it’s a mistake to impute market growth to ourassets under management growth. But we feel good about the growth this quarter.

Mike Mayo - DeutscheBank

And international?

Steve Fradkin

International continues to be terrific, global custodyassets up 31% year-over-year, pipelines are strong, had a great win with Stateof Tennessee, which was a $29 billion public fund and tempo is consistent withpast quarters.

Mike Mayo - DeutscheBank

And pipelines are strong. Do you ever quantify that as someof your competitors do?

Steve Fradkin

No, we don't give any metrics on number of clients in thepipeline or profits in the pipeline or dollar value. But we continue to feelvery good and as you said the market is consolidating, there is a small groupof players there. So, there is I think plenty of opportunities for all of us.

Mike Mayo - DeutscheBank

Alright. Thank you.

Steve Fradkin

You're welcome.

Operator

We will take our next question from Mark Fitzgibbon withSandler O'Neill. Please go ahead.

Mark Fitzgibbon - SandlerO'Neill

Thank you for taking my question. First let me echo mycongratulations to Bill and Rick on their new roles. Steve, I wanted to firstjust ask the securities lending question in different way. How much would youestimate that one mark-to-market fund affected the securities lending line inthis quarter?

Steve Fradkin

Well, again Mark if you think about it, we reported resultsthat were down 19% year-over-year. If you impute and this is rough math, but ifyou take the exact same holdings as resided in that fund and their status andyou put them in a custom account, which is not mark-to-market, that resultwould have swung us from being down 19% to up 70%. So the transparency of amark-to-market fund had a dramatic affect on reported result. And again, Ithink the key point here is absence impaired holdings or a change in what weknow, is that that should be a tail win for us, again difficult to predictexactly when it will hit, but it should strengthen our securities lendingresults over the next 15 months or so.

Mark Fitzgibbon - Sandler O'Neill

Okay. Andthen the second question, I had relates to assets under management which weredown, I think about $5 billion or 1% linked quarter, was that a function ofperformance within the products or was it a function of fund flows or fundoutflows actually?

Steve Fradkin

Sorry. The assets under management was really just afunction of the securities lending collateral and the de-leveraging that wesaw. So, it wasn't really what you might think of this traditional core assetmanagement.

Mark Fitzgibbon - Sandler O'Neill

Okay.

Bev Fleming

Mark, if you take securities lending out of the total assetsunder management, the sequential growth goes from a decline as you mentioned of5% to actually an increase of 2.4%. And I am sure that the Equity 500 was up a littleless than 2%, and we are not exclusively equity managers. So, I think actuallywe feel quite good about that, when you take into account the de-leveragingphenomenon in securities lending.

Mark Fitzgibbon - Sandler O'Neill

Okay. Andthen, also I noticed your non-U.S. loans have risen fairly rapidly, and arejust approaching $2 billion now. Could you give us a sense for the kind ofloans that you are making outside the U.S?

Steve Fradkin

A lot of that Mark, relates to the fund administration businessthat we acquired several years ago from FSG. These are liquidity lines. Theseare not traditional, if you will corporate loans. These are all attendant tothe business we undertake with fund managers. So, it's a very, very cleanportfolio and one that we are very comfortable with.

Mark Fitzgibbon - SandlerO'Neill

And the last question is, I wondered if you can give us asense for what the pipeline looks like in the C&IS business, is itincreasing, decreasing, stable and maybe where is that coming from?

Steve Fradkin

I think the pipeline is terrific. And we have attempts toimply a level of precision on increasing, decreasing, relative to last quarter.But I'd say, it's very strong, we've got a lot of great activities. Greatopportunities, they are all around the globe. They cross a wide array ofsegments. And I think that's one of the things you got to think about. You gotto think about the whole world, opportunities in virtually every country. Yougot to thing about the wide array of segments from insurance companies, tofoundations, to endowments, to fund managers, to pension funds, a whole host ofopportunities. And then you have to think in terms of the relatively smallnumber of firms globally that are equipped to serve those opportunities. And Ithink, when you look at it in that construct you can understand just how bigthe opportunities are, I think for all of us.

Bev Fleming

And Mark if I could add one point on your question about ournon-U.S loan portfolio, when we issue our 10-Q in a few weeks, we include atable on loans and one of the things that you'll see in the table and you wouldhave seen in the past is that, included in that non-U.S line item in additionto what you would consider to be traditional lending as Steve described, wouldbe short-term advances associated with processing of Custody assets. So, andthat you will see when we issue our 10-Q that that line item, short durationadvances actually was a significant driver of the growth in non-U.S loans.

Steve Fradkin

So, there is a traditional overdraft phenomenon associatedwith being custodians to these funds.

Mark Fitzgibbon - SandlerO'Neill

Thank you.

Steve Fradkin

Welcome.

Operator

We will take our next question from Jason Goldberg withLehman Brothers. Please go ahead.

Jason Goldberg - LehmanBrothers

Thank you. You mentioned security process related charges,it standardizes [quite to], that you guys are not doing something on timelybasis and can you quantify that?

Steve Fradkin

Sure. Jason, we have as you know, we process trillions andbillions and at any given point. Though there is a lot of automation and a lotof high quality, there will be losses associated with mis-processing,mis-input, not timely handling a corporate action or what not, and so, we did havea modest degree of that this quarter. It's a normal part of the business, youcan't get away from it but, and we'll go and system starts. So, that is anaspect that we had to deal with this quarter, but I don't look at it as a majorfactor in anyways signaling a trend.

Jason Goldberg - LehmanBrothers

Okay. You don't care to quantify it?

Steve Fradkin

No, we're not quantifying it.

Jason Goldberg - LehmanBrothers

And then you mentioned the Wealth Management, that'sthroughout this quarter it sounded like?

Steve Fradkin

Sorry. Say that again Jason.

Jason Goldberg - LehmanBrothers

You mentioned an adjustment in the Wealth Management line orit sounds like may be it was a throughout or something you can expand on?

Steve Fradkin

It was just a prior period adjustment to what we have, theinstance that comes to mind, we had a client come-in very late in the secondquarter and we misquoted them in terms of assets under management versus assetsunder custody, we caught it after we had released results. So, it's just aprior period adjustment to what we had said last quarter. I think the key pointJason is, you wouldn't want to look at the reported downdraft sequentially asindicative with the trend because it's just an adjustment.

Jason Goldberg - LehmanBrothers

Got you. And then, I guess any thoughts on eliminating themark-to-market funds from your sec lending offerings?

Steve Fradkin

This is a client-driven decision, if clients want to be in apooled vehicle with this kind of profile, it really has to be a mark-to-marketfund. So there is not a lot of discretion. To the extent that if you want to bein a fund with this characteristic, you couldn't make this account, if youcouldn't appropriately make this accounts to dollar NAV. The question would be,do clients want separate accounts, rather than participating in a pooledvehicle? And obviously if they do want that, we would be happy to accommodatethem. But again, I think you would want to look closely, if this is a timingphenomenon.

Jason Goldberg - LehmanBrothers

Got you. And then, also, if I guess what would be thenormalized, I guess tax-rate I know the last couple of quarters a bit -- havebeen a bit, at not the normal?

Steve Fradkin

Well, we’ve traditionally been at 35% plus or minus tax-rate,as you may recall back in 2006 we talked about the implementation of APB 23 andhow that would likely on average overtime bring it down a point. We've beenlower than that more recently. Again in this quarter at 30.8%, but we also havethis, the one time state tax benefit. So, I don't know that I can give youabsolute guidance on that.

Bev Fleming

The one thing that you can do Jason, is you can adjust the30.8% for the $5 million tax law change impact and that would get you to 32.5%for the quarter. So, it would be appropriate to remove that $5 million fromyour thinking going forward because that was affected by just this tax lawchange.

Steve Fradkin

And again, this is going to move around a bit, because ofthe growth in our -- to the extent that our international business rose at amore rapid rate and the business in those tax beneficial jurisdictions thatwill have a more dramatic effect. So, there will be a little bit of movement inthe tax-rate.

Jason Goldberg -Lehman Brothers

Okay, and then just lastly, I guess year-to-date theoperating leverage is running at bit negative, you guys have a long history ofpositive operating leverage, particularly when the markets are higher, and Iguess you have just any just thoughts around expense management?

Steve Fradkin

Well, I think essentially we were neutral this quarter 19%revenue growth, 19% expense growth, I think if you -- depending on whatadjustments you want to make, I think we are modestly positive year-to-date,but you are right the operating leverage is much closer to neutral than it isto significantly positive. I guess on the expense front Jason, I would offer acouple of observations. One, remember that we have a fair amount of volumeassociated growth; we've got a lot of activity sub-custody fees, sub-advisorfees. So, as our assets grow as we win new clients, we are just, that is partof the scenario that we have to deal with.

We've also brought on a fair number of staff, you're seeingour headcount is up 11% year-over-year and the overall, not withstanding thethird quarter turmoil, the competition for talent has been high and that drivessome of our expense. And we are continuing to invest on a variety of fronts incapabilities, if you look at our back and middle office outsourcing, if youlook at our pooling, you look at derivatives, alternative asset processing andalike, some of the things we are doing on the technology, our geographicexpansion, our expansion in India.

So, as always, we are trying to balance the expense growthwithin the construct of our revenue profile and so far, I think we've got itwhere we wanted to be. But, it is not as positive as we've been in the pastquarters, but again we look at that as a time and space thing and we feel nowis the right time to do some things that are going to help our clients and themarket opportunities that we are seeing.

Jason Goldberg -Lehman Brothers

That's helpful. Thank you.

Operator

We will take our next question from Glenn Schorr with UBS.Please go ahead.

Glenn Schorr - UBS

Thank you. Just one quickie, that the yield on PFS assets asin perfect as the calculation it is, but assets are growing at a lot quickerpace than the revenues. I am just curious on how much would you attribute thattowards things like open architecture versus specific products that clients aremore interested in these days?

Steve Fradkin

I think Glenn, you have to remember that our PFS assetsinclude the wealth management, in fact the wealth management being the very,very large end of the market. And so when you try and look at the sort of themanaged asset equation, it's going to get skewed a bit because when we bring onthese very large wealth management clients, while we almost always are managingsome assets, it’s a relatively smaller proportion. When you manage money for $5million client, you tend to manage all of it directly or through openarchitecture. When you take on a $5 billion client, we manage -- haveinvestment management fees for 15% to 20%. So I think if I understand the rootof your question, the phenomenon you're seeing is the dramatic growth in ourassets under custody, driven by our wealth management franchise.

Glenn Schorr - UBS

Is it fair to say, then the real question becomes, is thelike-for-like margin stable enough? In other words, within wealth managementspecifically the yield on incremental assets, similar to what's on the booksfor other wealth management customers?

Steve Fradkin

I don’t have the signs in front of me, so I am just going togive you a directional observation. But we have not seen in our PFS business adegradation at all of the pre-tax profit margin. Now, again you have toremember some of it gets skewed because using the wealth management example, youcan take on a very large family that has a very significant single stockconcentration, and so the assets can go up quiet dramatically. But the feeswon't go up as dramatically and they may be affected in part by a single stockconcentration as well. So if you look at our pre-tax profit margins at thecorporate level, at the segment level they've been rock solid and consistent soI don't see any degradation at this point.

Glenn Schorr - UBS

Okay that’s helpful, thank you.

Steve Fradkin

Welcome.

Operator

We'll take our next question from Gerard Cassidy with RBCCapital Markets. Please go ahead.

Gerard Cassidy - RBCCapital Markets

Thank you, and good afternoon, Steve.

Steve Fradkin

Hi, Gerard.

Gerard Cassidy - RBCCapital Markets

Can you guys give us any color on how the foreign exchangemarkets are behaving so far in this month, I know it’s early, only a couple ofweeks, but are you guys seeing any follow through on increased volatility involumes like you saw in the third quarter?

Steve Fradkin

Well, you know I don't really have any comments on thefourth quarter. What I would say is A, we had a terrific third quarter results,$92 million up, 74%. I think all of you know 74% year-over-year and 14%sequentially, all of you know that that was a very unusual phenomenon relativeto history. Just to put that, Gerard, in context for you, in 1998, our fullyear foreign exchange trading results were in the $100 million to $304 millionrange. So really a very, very strong quarter and you just oppose it sequentially,if you look at the last six years, on average we have seen a 23% decline fromsecond quarter to third quarter in foreign exchange, as compared with our 14%increase. So, it was very unusual period, August was clearly a significantcontributor to that, but we'll have to see, you know its a very difficult lineto predict. So we'll have to see what everyone wants to do in the fourthquarter.

Gerard Cassidy - RBC Capital Markets

Sure. Wasn't there a period, I don't know if it was '04,where we had this happen once before the third quarter outdid the secondquarter, because traditionally as you pointed out, everybody's foreign exchangerevenues dropped in this quarter meaning your competitors and yourself. Ithought this happened once before?

Steve Fradkin

I don't have the data going back. It certainly can happenand as you know there is a lot of variability around foreign exchange in anygiven quarter. But I think it's fair to say on average over time all of youtake a summer holiday and it slows things down for us. This quarter that wasnot the case and it was not the case in a pretty significant way.

Gerard Cassidy - RBCCapital Markets

Okay, and the second question was; I know you address theCME Group stock gains. Is there still more on your books, unrealized gains inthat particular security or ownership position?

Steve Fradkin

Yes. We continue to own about 13,000 shares rather of theCME Group stocks.

Gerard Cassidy - RBCCapital Markets

Okay. Thank you.

Steve Fradkin

Welcome.

Operator

We will take our next question from Tom McCrohan with JanneyMontgomery Scott. Please go ahead.

Tom McCrohan - JanneyMontgomery Scott

Hi Steve. Hi Bev.

Steve Fradkin

Hi Tom.

Bev Fleming

Hi Tom.

Tom McCrohan - JanneyMontgomery Scott

I've a question on India. When do you think we willstart to see, or you'll start to see some of the benefits from moving more ofyour staff to India?With staff costs up 18% year-over-year, I was kind of wondering when you'regoing to see the growth rates in staff costs come down a little bit?

Steve Fradkin

Well, I think Tom, we are already seeing the benefits of Indiain terms of a stable workforce, in terms of a talented workforce, in terms ofour primary mission which was to have an operation center in the time zone asopposed to replacing staff elsewhere. So we feel very, very good about India.It has been an incredible success story for us and we anticipate that that willcontinue to be a growth area for us.

So, in terms of the overall growth picture the other thingTom to remember is that Indiathough it's successful, though it's growing and though it's important is not areplacement for operating in London, Chicago, New York,LA and many other expensive centers. So as our business grows, we still needtalented people in what I'll call more expensive places and we have to hirethem. So, I would not encourage you to look at India as a direct offset for staffelsewhere. Our staff is growing everywhere around the world, its just growingin Indiafaster.

Tom McCrohan - JanneyMontgomery Scott

Okay, well just trying to get a read on your thoughts kindof longer term capability to generate operating leverage. Is this kind of a newmodel where staff cost, because the fight for talent is so fierce in those kindof geographies you talked about and the skill levels you need to justpermanently become more of this one sophisticated though. You're just paying aheck a lot more for people you have to run your fund administration business,assets management that's what we're kind of seeing and they're going to be afactor over the next couple of years.

Steve Fradkin

Well, Tom, I think we go through lots of cycles both withinquarters and across years. And I guess my response would be, as always we aretrying to balance the revenue and expense equation. And I think we've done avery good job of that historically. We won't get it every quarter, we won't getit every year, but certainly 16 out of 19 years we've done it. And year-to-datedepending on how you want to do your calculation, I think we are right therethus far. But it is fair to say we are continuing to invest in the business.

We had a top line revenue growth of 19% and we are workinghard to keep up with the demands of those clients and what they need. So restassured we are very mindful of the balance that we want to have. Its one of ourstrategic financial targets on average overtime across cycles, whateverterminology you want to use and we are working to manage to it. But it can't bethe only thing that we think about in managing the business. So, you know, Indiais a piece of that but certainly not all of it.

Tom McCrohan - JanneyMontgomery Scott

That's great. And then just on business disruptions, I thinkI want to ask a follow-up, have you seen any new business wins this quarter asa consequence of or is a benefit of some of the industry merger and acquisitionactivity both on a high network side and the client side?

Steve Fradkin

Well, I can't speak for the client's reason as to why, so Iwould [be lows] to make that attribution. What I'd say is, we continue to likeour position demographically without disruption. From what I've seen I can seesome clients that have moved, my guess is, if not exclusively because ofdisruption but that's probably wasn't additive. But you know there hasn't beena sea-change in the environment and as we've talked about in the past calls, wewouldn't expect that. We expect this to the extent that disruption is additivetask, we expect it to happen over time, one client at a time. So I think thereare some anecdotes that I can point to but it's not a wholesale sea-change.

Tom McCrohan - JanneyMontgomery Scott

Fair enough. Thank you.

Steve Fradkin

You're welcome.

Operator

We will take our next question from Robert Lee with KBW.Please go ahead.

Robert Lee - KBW

Thanks, good afternoon.

Steve Fradkin

Hi, Rob.

Robert Lee - KBW

Hey. Two quick questions, the risk of beating a dead horsethe Sec lending. Understanding how it should reverse over time, I am assumingthat depends on that taken to that is the assumption that the 10 or soinvestors in that fund maintain there investments and don't choose to liquidatein which case it ends up sort of -respectively locking in the lower values?

Steve Fradkin

That's correct. You would need that to happen and you wouldof course you need to not have any impairments on any of the holdings. I thinkon the client dimension of that, these are sophisticated clients thatunderstand that phenomenon and I can't speak for them but, that's an accuratestatement.

Robert Lee - KBW

Okay. And secondly, and I apologize if you had addressedthis before. But, can you talk a little bit about Fed rate cut? And how weshould be thinking about your net interest margin, if the Fed is pursing on thecourse of cutting Fed funds rate, would it have much of an impact or you'rerelatively neutral at this point?

Steve Fradkin

We think on an annualized basis Rob, that it would berelatively neutral. We're short, we're relatively well matched and so, when youlook at it on an annualized basis, it's not a significant driver for us.

Robert Lee - KBW

Okay, great. That was it, thank you very much.

Steve Fradkin

Thank you, Rob.

Operator

We will take our next question from Brian Bedell withMerrill Lynch. Please go ahead.

Brian Bedell -Merrill Lynch

Hi. Good afternoon .Most of my question have been asked,answered. But, just on the sec lending once again. Steve, you said, actually ifI heard you right, you said about a 70% increase year-over-year, if it were notfor the markdown on the book?

Steve Fradkin

That's correct.

Brian Bedell -Merrill Lynch

So, it was about $36 million in additional Sec lendingrevenues. So that would have been depending on what kind of operating marginyou're putting on that, get a $0.08 or $0.09 of EPS this quarter?

Steve Fradkin

But why, I won't do that math for you but I'd say, yes itwould've dramatically changed results.

Brian Bedell -Merrill Lynch

Right. And given you by my calculations well over another100 additional basis points of operating leverage. But, what you're saying isover the next 18 months, is when those securities within that pool mature. Isthat correct?

Steve Fradkin

Well, I think what we believe is that over the next and --again, this is not, its sounds more pinpoint then it is, but we believe thatover the next 15 months or so we would see the head win that we experiencedthis quarter become a tail win. Again to Rob's point, that assumes that theclients don't lead the fund and force us to realize losses and it assumes thatno credit degradation, no default on any of the securities. But, yes, difficultto predict but over the next 15 months or so.

Brian Bedell -Merrill Lynch

Right. So, if they were to redeem that and you realizedabout it, you have already marked them down, so you would not realizeadditional losses, you mean that the market hasn’t changed?

Steve Fradkin

I believe that's correct.

Brian Bedell -Merrill Lynch

Okay. And then secondly, just given that that your normalrun rate was closer to $70 million in the quarter would suggest that, onceagain there is several cents of EPS that we would back into your normalized runrate. I know it's very difficult to predict Sec lending quarter-by-quarterinclude, this quarter was strong but clearly your core trend's run rate issignificantly higher than that?

Steve Fradkin

Well again, we don't give guidance so I can't help you withthat, but what I can say is, as I tried to suggest you, the construct of thisvehicle is critically important to understand the accounting. And if you justlook at the headline, but don't understand why it happens, you might have in myview at least the wrong contexts around at least what we think is going on forus and perhaps for others.

Brian Bedell -Merrill Lynch

Right. But, I guess the other question would be, given thatthis does create volatility in your Sec lending business, just having amark-to-market fund is it something that you would consider either letting arun down, so that you don't have that option anymore for client or you juststick with treasuries or is it something that you could keep, you keep going?

Steve Fradkin

Well, I think couple of points on that Brian. One, rememberthis was an extremely, extremely unusual period. We haven’t, we've hadvolatility in other quarters, but it hasn't manifested itself as dramatically.So, I think you do probably have an outlier in terms of the event. Two, itsclient driven, if clients want to be in a pooled vehicle with this kind ofprofile, it has to be mark-to-market. So, we could only do that if clients saidto us, we want a custom account, we don’t want to be in pooled vehicles andobviously if they did we would be happy to help them with that.

Brian Bedell -Merrill Lynch

Right, but your client shared in the loss, and in this aswell, is that correct?

Steve Fradkin

Correct.

Brian Bedell -Merrill Lynch

Right. So, may be going forward may be still the client willuse this type of product I would think?

Steve Fradkin

I am not sure about that, I think these are prettysophisticated clients. They understand what happened with credit spread andagain, I am imputing across a number of people, but I think most of themunderstand that this and believe that this will revert and are comfortable withthat.

Brian Bedell -Merrill Lynch

Right. I will get that back. Okay. Just a couple question,some questions have that were asked before, did you say there was a $3 millionloss in other operating income on the sale of the equipment from Isle of Man in third quarter?

Steve Fradkin

We had a, $3 million last quarter and we had a very modest,I would say it was about $1 million this quarter in addition to that.

Brian Bedell -Merrill Lynch

In other operating income.

Steve Fradkin

Yes.

Brian Bedell -Merrill Lynch

Right okay. And then similar things with other operatingexpenses, does include some of the charges for the securities processingactivities. I know, you didn’t want to frame that, but clearly the $4 millionincrease was at least partially due to that. I would assume?

Steve Fradkin

That’s correct.

Brian Bedell -Merrill Lynch

Right, okay.

Steve Fradkin

And again, that’s, obviously we don't want any, or if wehave them, we want them to be as small as possible but you just can't processtrillions, billions and millions of transactions, and never have any of that,so that's something we are still.

Brian Bedell -Merrill Lynch

Are part of the business trends of the trade, and then doyou, you talked about some small sub-prime positions in portfolios. Can youjust elaborate on that? Are these portfolios on the balance sheet or are thesein investment management products?

Steve Fradkin

Our sub-prime, if you step back and look at it, Brian, froma corporate level on this total picture, sub-prime is extremely modest and notof concern. On the credit front loan portfolio, no direct exposure to anyamount of line broker or originator or sub-prime mortgages, and we have noexposure to any organization whose business is exclusively in sub-primelending. If you look at the securities portfolio, the balance sheet, oursub-prime exposure is really relative to the overall investment portfolio isminimal. And the holdings that we do have, are of sub-prime asset backedsecurities. They are at the front end of the capital structure, very shortaverage lives from our vantage point not at all of a concern.

And then, within our asset management business, we have veryto minimum exposure in our active equity mutual funds and separate accounts, nodiscernible exposure in our fixed income mutual funds or separate accounts. So,we feel very, very comfortable with, and we don't like the environment thatit’s causing, but from a corporate standpoint, we just don't see it as a majorissue for us.

Brian Bedell -Merrill Lynch

Alright great. That's helpful. And then, just on the, interms of the NIM expansion in the quarter, I know the money market as theyields went up pretty significantly, in line quite sort of the major driver,the yields going from 450 to 487. What was the major lead, sort of the maincause of that?

Steve Fradkin

We had on the NIM, I guess first you got to go back andremember that in the second quarter we had reduced our net interest income byabout $7 million, because of the adoption of FSP 13-2, the Leveraged Leasematter. So, you've got to remember that that was the first half year effectdegradation in the first quarter. So, if you adjusted that, we reported a netinterest margin of 1.58 in the first quarter, it would have been, sorry, in thesecond quarter, it would have been 1.61, and then, so I think that was aprominent aspect of the differential.

Brian Bedell -Merrill Lynch

Right. But you still got a pretty good yield jump on yourmoney market assets, it would be in that specific line is there more allocationto [buy broad-based] products within that?

Bev Fleming

The money market assets on our balance sheet, Brian, arepredominately time deposits with foreign banks. So you would be seeing impactof those, the Euro and the Sterlingin there.

Brian Bedell -Merrill Lynch

Okay. So that's good then with the Fed environment, right?Because then, if you have any kind of extension of duration with time deposits,especially if they are at international yield and then you have the Fed cuttingrates late in the quarter that could reduce your liability funding in certainareas on the funding sides, while your asset yields periodically woulddepreciate as much. So, that should bode well for clearing.

Steve Fradkin

But remember, our duration is still pretty short.

Brian Bedell - Merrill Lynch

Yeah. I know, I was just looking for the near-termdirectional impact. I know, you don't typically give color on future directionof NIM. But I'm just trying to get a sense of that. Okay, great. And then, justlast on the tax rate, same lending there, I know you don't give guidance onthat, but what is the case -- it seems like your tax rate has been trendingdown, and that has been driven by a greater business in internationaljurisdictions which might have lower tax rate. What would be the case for thetax rate going up? Is there any kind of good case for that or should weconsider your growing international business overtime, it's growing at a morerapid rate than your USbusiness as positive for potential decline in the tax rate over time?

Steve Fradkin

Yeah. The tax rate is going to move around, but I thinkBrian you've got it right. At the end of the day, the driver of the -- forgetthis quarter, but just on an average, more recently, the driver of the declinehas been our adoption of APB 23, and the growth of our international businesswhich is consistent with that. So, difficult to predict exactly where it wouldland, but we did say that when we adopted in 2006, that we thoughtdirectionally it would improve our tax rate overtime and that certainly seemsto be the case.

Brian Bedell - Merrill Lynch

Great. Thanks very much.

Steve Fradkin

You're welcome.

Bev Fleming

Cynthia, if there is anybody in the queue I think we'veprobably got time for may be one more and then we'll let people get back towork.

Operator

And we do have one final participant in the queue. And wewill take our last question from Ken Usdin with Banc of America Securities.Please go ahead.

Ken Usdin - Banc of America Securities

Thanks. Hey guys, I promise to make it real quick.

Steve Fradkin

Thank you.

Ken Usdin - Banc of AmericaSecurities

Two quick ones. First of all, just on the credit front,you've build the reserve a little bit through the last couple of quarters. NPAjust fell down. I am just wondering, any migration strength that you are seeinglike in the 7-8 buckets or any change in the quality of the portfoliounderneath that's causing a fruition?

Steve Fradkin

The answer is no. Our 7 and 8 rated loans -- we are at $76million at quarter end, compared with 75 last quarter. So, we have not had asignificant change in the view there.

Ken Usdin - Banc of AmericaSecurities

Okay. And the second one is just on the institutional assetmanagement front, was the sec lending collateral decline, the sole reason forAUMs to be down sequentially?

Steve Fradkin

Yes.

Ken Usdin - Banc of America Securities

Okay. And any color on just how fund flows were in theinstitutional asset management business ex-sec lending?

Steve Fradkin

Well, we don't do fund flows like the mutual fund company,but if you took out that degradation, our institutional assets under managementwere up little over 2% exactly.

Bev Fleming

And we talked about short duration and quantitative beingthe two drivers there.

Ken Usdin - Banc of AmericaSecurities

Yes, right. Okay, great. That's what I was looking for.Thanks again.

Steve Fradkin

Okay. Well, thank you all. It's been a long call. Weappreciate your listening in and your questions and we look forward to givingyou an update at our next quarterly conference call. Have a great day.

Operator

Ladies and gentlemen, this will conclude today's conferencecall. We do thank you for your participation and you may disconnect at thistime.

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