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State Street (NYSE:STT)

Q2 2012 Earnings Call

July 17, 2012 9:30 am ET

Executives

S. Kelley MacDonald - Former Senior Vice President of Investor Relations

Joseph L. Hooley - Chairman, Chief Executive Officer, President, Chairman of Executive Committee and Member of Risk & Capital Committee

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

Analysts

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Howard Chen - Crédit Suisse AG, Research Division

Brian Bedell - ISI Group Inc., Research Division

Alexander Blostein - Goldman Sachs Group Inc., Research Division

Vivek Juneja - JP Morgan Chase & Co, Research Division

Andrew Marquardt - Evercore Partners Inc., Research Division

Operator

Good morning, and welcome to State Street Corporation's Second Quarter 2012 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 for rebroadcast or distribution, in whole or in part, without expressed written authorization from State Street, and the only authorized broadcast of this call is housed on State Street's website. [Operator Instructions]

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

S. Kelley MacDonald

Before Jay Hooley, our Chairman, President and Chief Executive Officer; and Ed Resch, our Chief Financial Officer, begin their remarks, I'd like to remind you that during this call, we will be making forward-looking statements. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in State Street's 2011 annual report on Form 10-K and its subsequent filings with the SEC.

We encourage you to review those filings, including the sections on risk factors concerning any forward-looking statements we make today. Any such forward-looking statements speaks only as of today, July 17, 2012, and the corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

I'd also like to remind you that you can find a presentation regarding the corporation's investment portfolio, as well as our second quarter 2012 earnings news release, which includes reconciliations of non-GAAP measures referred to on this webcast, in the Investor Relations portion of our website. Also in the addendum to the news release on the last page, you will find some specific estimates of our Basel III ratios giving effect to the notices of proposed rulemaking issued in June, 2012.

Now I'll turn the call over to Jay.

Joseph L. Hooley

Thanks, Kelley, and good morning, and thanks to all of you for joining us on the call this morning. Overall our financial results improved in our second quarter from our first quarter of 2012, with a 20% increase in operating basis earnings per share, but were affected by increasing weakness in international markets, reflecting global concern about the stability of the Eurozone.

We remain cautious in our outlook for the second half of the year and very focused on delivering value-added solutions to our clients and controlling expenses.

Our Business Operations and Information Technology Transformation Program has contributed to our results in a difficult market environment, while positioning us favorably when the economic outlook improves, and has also enabled us to accelerate new product development for our clients.

In addition, the reduction in compensation expenses and strong expense control, coupled with business momentum, enabled us to achieve positive operating leverage in the second quarter compared to the first quarter of 2012 on an operating basis.

The ratio of compensation expenses to total operating basis revenue improved to 38.8% in the second quarter, as a result of the absence of the seasonal accounting effects related to retirement-eligible employees recorded in the first quarter and a continuing success of the Business Operations and Information Technology Transformation Program. Our capital position remained very strong and allowed us to repurchase 480 million of our common stock in the second quarter of 2012 and to increase our quarterly common stock dividend in 2012 to $0.24 per share.

In addition to remarks about our second quarter results, this morning I'll address our continuing success in generating new business in our core asset servicing and asset management business, our economic outlook, the ongoing progress of our Business Operations and Information Technology Transformation Program, as well as our strong capital position.

The growth of both our fee-based businesses and our total revenue in the second quarter compared to the first quarter was affected by the derisking activity of our clients in the second half of the second quarter. Our results reflect stronger U.S. equity valuations early in the quarter, as well as the seasonal strength in securities finance, but equity markets became more volatile later in the quarter and remain so today. Capital markets affecting foreign exchange and trading were weak throughout the quarter.

Compared to the first quarter, the impact of the new business we won and installed, plus the business we won in past quarters, provided some strength in our core business revenue in the second quarter.

We continue to add new servicing business to the core franchise. Of the $133 billion in assets we won in the second quarter, about 48% were from the U.S. and 52% from international markets. The Board of Trustees of the $36 billion Maryland State Retirement and Pension System renewed its global custody contract. We won a significant mandate for servicing collective funds from a Middle Eastern client to service their conventional and Sharia-compliant fund umbrellas.

Mitsui Fudosan, a Japanese real estate firm, has extended its relationship with State Street to include administration, registrar and trustee services for 2 additional Jersey property unit trusts. The endowment fund at Emory University has expanded its custody and accounting services, now including risk analytics services for its $5 billion endowment.

The integration of the acquired Intesa Securities Services business has met our stated targets, and our presence in Italy continues to attract new business. Just recently, SSgA was appointed as investment manager for EUR 110 million in assets for the Italian pension fund of employees of Rai, the Italian public television network. SSgA has also been selected by family investments to manage a combination of passive equity and fixed income strategies for GBP 1.5 billion in asset, as well as the tactical asset allocation overlay for the majority of these assets.

Regarding the timing of asset servicing installations, during the second quarter we installed $130 billion, $79 billion of which was awarded in the second quarter and $51 billion was awarded previously. Of the total business award in the second quarter, about $55 billion remains to be installed.

In the alternative asset servicing area, demand remains strong. In the second quarter, we added 32 new mandates in our alternative investment servicing business, and our assets under administration were $877 billion as of June 30, 2012.

We announced the proposed acquisition of Goldman Sachs' hedge fund administration business early today. This business had a total of $200.6 billion in assets under administration as of March 31, 2012.

This acquisition would increase our alternative assets under administration to a level which solidifies our lead in servicing this fast growing asset category. We expect this acquisition to be accretive in earnings in the first year of operation on a cash basis, excluding one-time costs.

Let me now share our outlook for the global economy. The lack of stability in Europe seems to be dominating every macroeconomic headline for the past 2 months. The election in Greece was positive, but the outcome has not been persuasive enough to alleviate concerns that Greece may exit the euro. Questions were also raised in the market about the stability of Italy and Spain. The decision by European leaders in late June to create a single supervisory body to oversee the recapitalization of euro area banks alleviated some of the concern, but until the European stability mechanism is in place and functioning, the uncertainty in Europe will overhang the economy.

Looking forward, we expect global GDP to rise at somewhat anemic 3.2% in 2012, reflecting slow growth in the advanced economies and more marked slowing in the developed ones. We expect the U.S. recovery to remain lackluster, with 2012 GDP slightly -- growing slightly above 2%, up from 1.7% in 2011, but slow by historic standards.

While we currently believe that the GDP may increase in 2013, our view of 2013 is dependent on a likelihood of legislation to extend the Bush tax cuts and reductions in the federal budget.

Although consumer confidence in the U.S. has improved slightly and there are signs that housing prices are stabilizing, unemployment continues to be a problem with a worsening in the expected rate of unemployment for 2012.

In the U.K., the GDP declined in the first 2 quarters of 2012, the number of unemployed increased, and so technically, the country has slipped back into recession. The Eurozone economy rebounded in the first quarter, but then stagnated in the second. Based on our current outlook, we expect the GDP in the Eurozone to contract about 0.5% in 2012, followed by a slight improvement in 2013.

On balance, our outlook is cautious, primarily due to European uncertainty and the effects that it may have on the U.S. economy.

The performance of our Business Operations and Information Technology Transformation Program continues to meet our expectations. In 2012, we expect that we'll achieve approximately $94 million in annual pre-tax run rate operating basis expense savings, resulting in a total of $180 million of pre-tax run rate operating basis expense savings since the beginning of the program.

In 2012, we expect the greatest benefit to come from the business operations transformation, as we deploy automation and reconfigure our operations to more efficiently meet the needs of our global client base. We are also focusing on transferring certain aspects of our IT management to our service providers, as we prepare for the migration of many of our existing and new applications to the cloud environment in 2013 and 2014.

We are training our IT developers on cloud technology and are currently running application using this technology in our production environment.

Our capital ratios remained strong, after paying a $0.24 per common share quarterly dividend and purchasing $480 million of our common stock in the second quarter. In addition, we announced the proposed acquisition of Goldman Sachs' hedge fund administration business at a purchase price of $550 million, which we expect to close in the fourth quarter, subject to regulatory approval.

I'll now turn the call over to Ed, then I'll provide some final remarks before we open the call to your questions. Ed?

Edward J. Resch

Thank you, Jay, and good morning, everyone. This morning, I'll review 3 areas. First, the results for the second quarter. Second, I'll summarize the performance of an outlook for the investment portfolio, as well as worldwide interest rates and the impact on our net interest margin. And finally, I'll review our strong capital ratios. I'll present some of the more significant results comparing the second quarter of 2012 to the second quarter of 2011, as well as to the first quarter of 2012.

This morning, all of my comments will be based on our operating basis results as defined in today's earnings news release.

Our total revenue was down 2% compared to the second quarter of 2011, and increased 1% compared to the first quarter of 2012. The year-over-year decline was primarily due to the effects of weaker international markets. The quarter-over-quarter increase was due to seasonality in securities finance and strength in net interest revenue, offset partially by weakness in international markets.

Fee-based revenue in the second quarter was down 6% compared to the second quarter of 2011 and was approximately flat with the first quarter.

Compared to the second quarter of 2011, servicing fee revenue declined 3%, primarily due to the impact of weakness in international markets and the effect of the weaker euro, offset partially by net new business and a 2% increase in the daily average of the S&P 500. Compared to the first quarter of 2012, servicing fees increased 1% due to net new business, offset partially by weaker international daily equity valuations.

In our servicing business, clients derisked their investment preferences later in the second quarter, primarily moving from U.S. domestic and emerging market equity funds to fixed income and government funds. Management fees were down 2% from the second quarter of 2011, primarily due to weakness in month-end international equity valuations, offset partially by new business, and increased 4% from the first quarter due to new business, offset partially by weaker international month-end equity valuations.

Given the continued weakness in international markets, we are adjusting our assumption for the 2012 EAFE average to decline to about 1,400 for the full year, down 12% from 1,590 in 2011 and revised from our assumption of 1,490 earlier this year.

At SSgA, net new business was a negative $6 billion. This was composed of inflows into ETFs, adding about $7 billion in net inflows, with about $1 billion net into institutional and fixed-income funds, which were primarily passive, offset partially by $12 billion in cash outflows, primarily due to the reduced positions in securities lending collateral as the seasonal impact of the dividend season in Europe dissipated, and $2 billion of outflows from active and enhanced equity funds as clients derisked.

Our money market fee waivers were $7 million, a decline from $9 million from the first quarter of 2012. Regarding trading services and securities finance, trading services in the second quarter of 2012 declined 18% compared to the second quarter of 2011 and declined 9% compared to the first quarter of 2012.

Compared to the year ago quarter and the first quarter of 2012, second quarter foreign exchange revenue decreased 24% and 13%, respectively, with both declines due primarily to lower volatility reflecting weak capital markets, offset partially by slightly higher volumes. Compared to the second quarter of 2011 and the first quarter of 2012, brokerage and other fee revenue declined 11% and 4%, respectively, due primarily to weaker revenue from sales and trading.

In foreign exchange, the second quarter of 2012, the percentage of total foreign exchange revenue generated by our indirect offering decreased about 12% from the first quarter compared to a 15% decline in revenue from the direct foreign exchange services, both of which reflected overall weakness in the capital markets.

Compared to the second quarter of 2011, securities finance revenue increased 4% in the second quarter of 2012 due to higher spreads, offset partially by lower volumes, and increased 47% compared to the first quarter of 2012, due primarily to the normal second quarter seasonal increase.

In the second quarter of 2012, the average 3-month LIBOR to Fed funds effective rate was 30.2 basis points, compared to 16.1 basis points in the second quarter of 2011 and to 39.9 basis points in the first quarter of 2012.

Securities on loan averaged $337 billion for the second quarter of 2012, down from $379 billion for the second quarter of 2011 due to lower demand and up from $331 billion for the first quarter of 2012, due principally to seasonality.

Average lendable assets for the second quarter of 2012 were about $2.36 trillion, down 0.5% from $2.37 trillion in the second quarter of 2011 and flat with the first quarter of 2012.

As of June 30, 2012, the duration of the securities finance book was approximately 18 days, flat with the second quarter of 2011 and up slightly from 16 days in the first quarter of 2012.

Processing fees and other revenue was $48 million, down 31% from $70 million in the second quarter of 2011, due primarily to a gain on a early termination of a lease in the second quarter of 2011 and additional amortization expense in the second quarter of 2012 related to our tax-advantaged investments.

Compared to the first quarter of 2012, processing fees and other revenue decreased 49% from $94 million, due primarily to the positive first quarter 2012 impact of fair-value adjustments related to positions in the fixed-income trading initiative and second quarter 2012 amortization expense related to our tax-advantaged investments.

Operating basis net interest revenue of $629 million in the second quarter of 2012 increased about 14% compared to the second quarter of 2011, primarily due to a higher level of earning assets, including a larger investment portfolio, as well as lower funding costs, partially offset by lower yields on our earning assets.

Compared to the first quarter of 2012, operating basis net interest revenue increased 4%, primarily due to lower funding costs and a larger investment portfolio, partially offset by lower yields on assets generally.

In the second quarter, excess client deposits averaged about $15 billion compared to $18 billion in the first quarter. Our operating basis net interest margin was 154 basis points in the second quarter of 2012, up slightly from 152 basis points in the first quarter of 2012.

Now turning to expenses. Compensation and benefit expenses decreased 7%, or $67 million, to $942 million from the second quarter of 2011, primarily due to the impact of cost savings resulting from lower incentive compensation, and 11% or $122 million from the first quarter of 2012, primarily due to the impact of the seasonal accounting effects of approximately $105 million of equity compensation for retirement-eligible employees and payroll taxes in the first quarter. Additionally, both periods benefited from the Business Operations and Information Technology Transformation Program savings, which were offset partially by the effect of merit increases effective April 1, 2012.

In the second quarter of 2012, compensation and benefits expenses were approximately 38.8% of total operating basis revenue, down from 44.3% in the first quarter.

For the full year, we continue to target a reduction of the ratio of compensation and benefits expenses to total operating basis revenue by about 100 basis points compared to 40.2% in 2011, assuming a modest increase in total operating basis revenue, an outlook which appears less certain now than in the first quarter.

The increases of 5% and 9% in information systems and communications expenses compared to the second quarter of 2011 and the first quarter of 2012, respectively, were due primarily to the transfer of certain IT functions to our service providers as part of the Business Operations and Information Technology Transformation Program.

Operating basis other expenses were $291 million, up 20% compared to the second quarter of 2011 and up 19% compared to the first quarter of 2012. Both increases were due to higher securities processing costs and increased professional fees driven by regulatory initiatives. Our Business Operations and Information Technology Transformation Program is on track. You can particularly see the progress we are making in the reductions in compensation and benefits expenses. In our operating basis expenses, we incurred $25 million of nonrecurring costs related to the program, consisting of $20 million in compensation and benefits expenses and $5 million in several other expense lines in the income statement.

As you may recall, we have previously indicated that we expect our nonrecurring costs to peak in 2012 at an average of about $25 million per quarter.

Now let me turn to the investment portfolio. Our investment portfolio as of June 30, 2012, of $114.4 billion increased about $8 billion compared to June 30, 2011.

During the second quarter, we invested about $7.9 billion in highly rated securities at an average price of $102.5 and with an average yield of 1.95% and a duration of approximately 2.54 years.

During the quarter, we invested about $3.3 billion in agency mortgage-backed securities and $2.7 billion in asset-backed securities. The remainder was primarily invested in small denominations of commercial mortgage-backed securities and in corporate and municipal bonds. The aggregate net unrealized after-tax loss in our available-for-sale and held-to-maturity portfolios as of June 30, 2012, was $54 million compared to a net unrealized after-tax loss of $81 million as of March 31, 2012. The improvement in the net unrealized after-tax position compared to March 31, 2012, was due primarily to the benefit of lower rates, offset partially by the impact of wider spreads.

In our investment portfolio presentation, we have updated the data through quarter-end for you to review. As of June 30, 2012, our portfolio was 89% AAA or AA-rated. The duration of the investment portfolio was 1.59 years at June 30, 2012, up slightly from 1.57 years at March 31, 2012.

The duration gap of the entire balance sheet was 0.41 years, down from 0.49 years at March 31, 2012. And this duration gap is in line with our guidelines.

As of June 30, 2012, 57% of our investment portfolio was invested in floating-rate securities and 43% in fixed rate securities.

Regarding the European assets. We have no direct sovereign debt exposure to the peripheral countries of Greece, Spain, Portugal, Italy or Ireland in our investment portfolio.

Of our non-U.S. assets, we hold about $900 million in securities from 4 of those peripheral countries, primarily RMBS and all floating-rate securities. These entail $400 million of securities from Italy; $300 million from Spain; and about $100 million each from Ireland and Portugal. All of these securities are performing well, except for a few bonds. We sold all of our Greek securities during the second quarter, about $91 million worth, and recorded a non-operating pre-tax loss of about $46 million.

On Page 7 of the investment portfolio presentation, we list all of our non U.S. investments and show the average rating, as well as the types of assets we hold.

Our primary non-U.S. holdings are British, Australian, German, Canadian and Netherlands securities, totaling 91% of the non-U.S. investment portfolio. At SSgA, our Eurozone exposure in the investment funds is consistent with client mandates. We hold the non-U.S. fixed income portfolios in line with our benchmark weightings and our actively managed cash portfolios have no direct exposure to the peripheral countries.

Regarding pre-tax conduit-related accretion. We recorded $123 million in the first half of 2012. Looking forward, we expect to record a total of about $900 million in interest revenue from July 1, 2012, through the remaining terms of the former conduit securities.

These expectations are based on numerous assumptions, including holding the securities to maturity, anticipated prepayment speeds, credit quality and sales.

Now for our outlook for net interest margin. First of all, let me emphasize that we continue to believe that we should invest through the cycle. We also intend to invest almost exclusively in highly rated AAA or AA agency mortgage-backed and asset-backed securities. I'll now review some of the assumptions we use in determining our 2012 outlook for net interest revenue and net interest margin. We believe that the Federal Reserve will leave interest rates on hold through the end of 2014. The ECB has recently cut rates to 75 basis points and adjusted its deposit facility rate to 0%. We expect these 2 actions to reduce our net interest revenue in the second half of 2012 by about $20 million.

We expect the ECB to hold these rates through the end of 2012. We believe the Bank of England will hold its base rate at 50 basis points through 2012. If the Bank of England were to lower its base rate by 25 basis points, it would lower our net interest revenue by about $5 million annually, assuming market rates fall in relation to administered rates.

Based on these rate assumptions and our second quarter results, if our excess deposits remain at the current level, our net interest margin for the full year 2012 will likely be in the middle of our 145 to 155 basis point range.

Finally, I'll briefly review our capital ratios. In the second quarter, State Street Corporation's capital ratios under Basel I remained very strong. As of June 30, 2012, they were -- our Tier 1 risk-based capital ratios stood at 19.9%, our total capital ratio stood at 21.5%, and our Tier 1 common ratio was 17.9%. Our Tier 1 leverage ratio stood at 7.7% and our tangible common equity ratio was 7.2%.

The impact under Basel I of the acquisition of Goldman Sachs' hedge fund administration business is expected to reduce our June 30, 2012, Tier 1 risk-based capital ratio by 75 to 80 basis points.

I'll now direct your attention to the last page of the addendum including in this morning's news release. Column A shows our Basel I capital ratios. Column B shows our estimated Basel III ratios applying the rules effective as of January 1, 2013, to our balance sheet on June 30, 2012, and are calculated consistently with our disclosure of these ratios in prior quarters.

Our Tier 1 risk-based capital ratio was estimated to be 13.9%; our total capital ratio, 15.5%; our Tier 1 common ratio, 12.7%; and our Tier 1 leverage ratio, 6.1%. For ease in the following discussion, I will just refer to our Tier 1 common ratio, unless otherwise noted, although Basel III will have an impact on all the ratios.

The Federal Reserve recently published 830 pages of notices of proposed rulemaking, or NPRs, to implement Basel III in the United States. Like our peers, we are still reviewing the potential impact of these proposals, and the table on the last page of the addendum and my comments reflect our best estimates as of June 30, 2012, of the impact of these proposed rules. It is important to note that the rules recently proposed in the NPRs are not final, and once finalized, are expected to be phased in over several years. The regulators have specifically asked for comments regarding the inclusion of the mark-to-market on certain available-for-sale securities in other comprehensive income for the purposes of calculating regulatory capital. We intend to comment on this proposal.

Based on our understanding of the proposals, we believe that the simplified supervisory formula approach, or SSFA, that deals with the risk weighting of securitized assets is expected to be implemented on January 1, 2015. These proposed regulations have both positive and negative implications. As written today, higher quality assets are being disproportionately penalized in that they receive a higher risk weighting compared to the previous Basel III proposals, moving from 7% to 20% or higher depending on the securities.

In contrast, those securitized assets with lower ratings, such as those rated below BB- received more favorable treatment under the NPRs than under the previous Basel III proposals, adjusting the risk weightings from 1,250% to as low as 20%. During the comment period, we intend to present the regulatory authorities the disproportionate effect of these rules.

In Column C on the last page of the addendum, we display the estimated impact of these proposed changes to our Tier 1 common ratio under Basel III, including our estimate of the proposed impact of the SSFA as we understand it today. These estimates are subject to change based on regulatory clarification and further analysis.

The implementation of the SSFA, without giving effect to asset run-off in the investment portfolio or any management actions, is expected to reduce our Tier 1 common ratio to 9.8%, approximately 290 basis points lower than the 12.7% ratio as calculated prior to the recently published NPRs and as shown in Column B.

Column D shows our estimate of our Tier 1 common ratio after getting effect to both the SSFA and the investment portfolio runoff and assumes reinvestment of $16 billion of relevant securitized assets.

As you can see, runoff alone is expected to bring the ratio back up to 12.0%. Finally, Column E shows that management actions, if needed, are expected to lower our risk-weighted assets to approximately $96.2 billion and fully restore our Tier 1 common ratio to 12.7%. Therefore, based on our current understanding of the proposed rules, the net effect of the risk weighting of the securitized assets under the SSFA, after investment portfolio runoff and with the potential management actions, is expected to be neutral to our Tier 1 common ratio by the assumed implementation date of January 1, 2015. We believe that 10% continues to be a reasonable long-term target for our Basel III Tier 1 common ratio using the same assumptions we outlined at our investor and analyst forum in February of this year. This 10% ratio is the foundation for our 12% to 15% target range for our operating basis return on common equity goal.

In conclusion, while we saw signs of improvement in the U.S. during the first quarter, that improvement seemed to slow a bit during the second quarter given the uncertainty that exists in the Eurozone. We still face a low interest rate environment, new regulatory requirements and increased compliance costs. We remain focused on growing our revenue modestly, controlling expenses and executing on our Business Operations and Information Technology Transformation Program. Now I'll turn the call over to Jay to conclude our remarks.

Joseph L. Hooley

Thanks, Ed. Although we maintain business momentum through the second quarter, the increased weakening of global macroeconomics later in the quarter, especially the situation in Europe, leaves us with a cautious outlook for the remainder of 2012.

Our clients reacted to the uncertain environment by reducing risk in their investment choices, moving from U.S. and emerging market equities to bond funds. However, we did achieve positive net new business in the servicing segment of our business.

We're pleased that our Business Operations and Information Technology Transformation Program is on track with our plans and is contributing to the achievement of our 2012 goals.

Our capital position remains very strong, allowing us to return capital to our shareholders in the form of a quarterly common stock dividend, stock buybacks and through strategic acquisitions.

We look forward to closing the acquisition of the Goldman Sachs' hedge fund servicing business, which we believe will benefit our shareholders over the long term, and which enables us to expand our hedge fund client base in this fast-growing market. Now Ed and I are happy to entertain your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Glenn Schorr with Nomura.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Just a quick wrap-up on the Goldman deal, makes plenty of sense strategically in line with everything you've done in the past, and you've got a lot of capital sitting around, so I get it. I'm sorry if I missed it, but did you tell anything about revenue earnings impact and any of the main assumptions you get to on the -- be accretable in the first year?

Joseph L. Hooley

No, we didn't report that. We just reported it was some $200 billion in assets under management, 150 customers. But just reported the conclusion. On a cash basis, it's accretive in the first year.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Okay. So I should stop trying on the spot [ph] assumptions, right? I have a bunch of follow-up questions on that?

Edward J. Resch

Yes.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Okay, cool. And then on the Basel III. I think this got a lot of attention so far this morning. I was just wondering if you could oversimplify it for us. Walking from the 12.7% to the 9.8% and back to the 12.7% in that great table you laid out, what are the securities that are getting the biggest increase in the risk weighting? And that -- is that just a runoff of them getting back to the 12.7%? And over what period of time do you get the bulk of that?

Edward J. Resch

Yes, Glenn. I mean, it is basically the effect that I explained in my comments, where the higher rated securities, apparently, we have a lot of AAA-rated securities that are adversely treated under this proposal, may serve to increase our risk-weighted assets. Okay? And offsetting that are some of the lower-rated securities, the ones that are currently subject to the securitization deduction, under current rules, that actually benefit us from a risk-weighted asset perspective. Okay? So you have 2 opposing comments going on there in terms of the risk-weighted asset calculation. And that is what's moving the ratio down to the 9.8%. And conversely, going back up to the 12.7%, there's 2 things going on. One, the portfolio runoff that is scheduled to occur between now and December 31, 2014, so another 1.5 years or so before the -- I'm sorry, 2.5 years, before the implementation date of 1/1/15. As well as, if we need to, potential management actions to get the ratio back to the 12.7%, which is where we started from.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

I guess the main thing is this is highly likely included in your CCAR plan and approved, and you're not changing the way you conduct business. I know I'm putting words in your mouth, but is that correct?

Edward J. Resch

Well, it's not included in the CCAR plan that was just approved, because the rules have just been issued. I would expect that it will be factored in to the next CCAR. But more importantly, the bigger point that you raise is right, we're not changing the way that we conduct business based on this. We feel like we have ample capital, enough room to react to this if we need to. Remember the rules are proposed, they're not final. And a lot could change between now and implementation date.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Okay. And a follow-up on the Greek securities sale, and I apologize if I missed this, too. But did you say what exactly they were? What -- where they were held? And if all the mark-to-market was taken this quarter?

Edward J. Resch

I didn't, but I'm happy to go into it with you. There were 5 bonds. They were all RMBS. They were held in our investment portfolio and held to maturity. They totaled $91 million of principal amount, and we booked a $46 million loss on them. It's a total exit of our Greek position. We thought that given the uncertainty in Europe, and more specifically, the extraordinary events in Greece, that it was wise -- and we did this before the election on June 17, it was wise for us to exit the position.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Got it. And I take it you're assessing the other periphery -- the securities held in the other periphery on the same basis right now?

Edward J. Resch

Well, yes, I mean, obviously, there is still a lot of disruption in the Eurozone. We have about $900 million of securities in the peripheral countries, they are virtually all RMBS. They're all performing well, with the exception of a handful of a couple of bonds that are on our watch list. But we don't think that the situation, as it relates to those specific securities that we hold, is anywhere close to our analysis of what we saw as the potential on the Greek position, which is why we sold the Greek position and we still are holding securities in the other peripheral countries.

Glenn Schorr - Nomura Securities Co. Ltd., Research Division

Okay, now, that's very helpful. Last one is just curious...

S. Kelley MacDonald

Glenn, we really need to move along. We've kind of given you a little bit of our time. But you can get back to me, Kevin or Valerie, later today and we could be helpful.

Edward J. Resch

Yes. I'm happy to get back on, Glenn.

Operator

Your next question comes from Ken Usdin with Jefferies.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

Just a follow-up on capital. I just wanted to -- from a big picture perspective, you've got the NPR changes, 75 to 80 basis points also from the deal today. So as you look forward, does this at all change the way you're looking at the buyback? Will you continue to pour through the buyback as planned in this year's allowable? And then will it change at all the way you think about capital return into next year and acquisitions as well?

Joseph L. Hooley

Yes, Ken, let me pick that up. The proposed acquisition of Goldman Sachs' hedge fund administration business will go through a regulatory approval process. And we'll conclude, based on that, the deal, hopefully, in the fourth quarter is our current plan. I guess the point about capital decisions, I go back to the kind of point in time, we plan to continue to execute the buyback. But should other acquisition opportunities come along, we would evaluate those from a standpoint of shareholder return versus continuing to buy back our stock based on what's outstanding and where the stock is trading. So our plan is to continue it, but it could be interrupted by other possible acquisition opportunities.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

But that will -- okay. So -- and that's my second question, was just related to -- you're talking about using 75, 80 basis points of capital on something that will be cash accretive but GAAP dilutive next year. First of all, can you talk about when this deal will turn to GAAP accretive, and any magnitude, if you can help us on that? And then secondly, how do you think through that deals versus buyback? Is it in fact the trade-off? I thought it was always supposed to be kind of separate from however you think through your buyback? And what changed? Did something change with this NPR restatement?

Edward J. Resch

Yes. I mean, nothing has changed in terms of our thinking relative to the NPR, Ken. The deal on a GAAP basis is slightly dilutive currently. It will turn to be accretive out in 2014, 2015, in that timeframe. But the thinking has not changed. I mean, we're in a bit of a unique position, I think, in that the pure numerical analysis of buyback versus acquisition is somewhat constrained because of the CCAR and the plan that we have approved, okay? So it's not a pure analysis of one versus the other. The way that we looked at this transaction was it made sense. It was strategic. It was opportunistic. Obviously, it may not necessarily been here in the future. And we had a CCAR plan approved. So we thought it made sense to do it. Going forward, as I said before, it depends how the Fed factors the Basel III proposals, and I underscore proposals, into the next CCAR and what effect that has on any potential capital distribution next year or any potential acquisitions.

Kenneth M. Usdin - Jefferies & Company, Inc., Research Division

All right. Okay. And then last little one, just on other expenses was much higher this quarter versus last, anything you can point out in there?

Edward J. Resch

Sure. Yes. Other expenses are really 2 things going on. One was our securities processing costs. We're comparing a low quarter, Q1 actually had a credit for those securities processing cost, a small credit, but it's relevant to a higher level of securities processing expenses in Q2. So you've got that delta. And then you have a ramp up in professional services, Q1 to Q2. That's driven by 2 things. One, these regulatory initiatives were talking so much about. We're spending on -- spending money on professional services in order to evaluate them. And two, the expenses associated with the transformation program. Those also incur some professional services, some consulting costs. So those 2 things are the drivers.

Operator

Your next question comes from Howard Chen with Crédit Suisse.

Howard Chen - Crédit Suisse AG, Research Division

You're making really good progress on the long-term transformation program. But could we just get an update on the asset servicing competitive landscape or the conversations on pricing changing or the composition of what clients are asking for a change and all?

Joseph L. Hooley

Sure. Let me take a good shot at that, Howard. The -- on the asset servicing, second quarter, you saw that revenues were up 1%. We just begin to frame the question. S&P was up slightly quarter-to-quarter. The EAFE average daily was down, I think, 7%. So that performance was constrained by the market. The -- I'd say from a standpoint of market activity, pipeline, deal flow, pretty constant through the quarter. I'd say the demand is high and pretty consistent from a standpoint of customer deal flow and prospect pipeline. I'd say on the pricing point, which is the other point you raised, the longer this environment hangs around and the more constraining it is on some of our revenue lines, the more aggressive, I'd say aggressive, or the more formalized our plans are to make sure that we're capturing fair economics from our customers. So we have a pretty broad-based effort underway across, obviously, only those customers that require some remediation to get the margin up to our target margin internally, and have gone out to customers with requests for increases in fees, broader servicing relationships in order to correct some of those situations. So I would characterize that as more of a journey as far as the pricing environment. From a standpoint of the competitive pricing environment, I would say it's mixed. It's probably mix by geography, mix by asset class, but generally, it doesn't feel that changed from prior quarters. Did that capture, Howard, your -- the essence of your question?

Howard Chen - Crédit Suisse AG, Research Division

Yes, that was very comprehensive. And Ed, on the NPR, you focused a lot of your commentary on the risk weightings for securitized assets and the non-investment grade securities. But putting those 2 elements aside, do you have any thoughts on some of the other factors that we heard about, including counter-party risk and the supplemental leverage ratio and potential impact on you all?

Edward J. Resch

Well, our analysis so far on those other elements is ongoing. And our view is that a lot of them are immaterial to us and net probably don't have much of an effect on us. The 2 things that I mentioned in the call are the ones that we're the most focused on, and I think, potentially have the most effect, which is the mark, OCI and the SSFA, Howard.

Howard Chen - Crédit Suisse AG, Research Division

Okay. And then final one, you have both been really conservative about the FX outlook and what mix shift you might see. I guess with all that said, I would have thought maybe we could see a sequential quarter-on-quarter lift to given international dividend season? I mean, could you just put a little bit more content around what you already said in the prepared remarks, Ed?

Edward J. Resch

Yes, I mean, we saw both the sales and trading and the indirect FX both down sequential quarter. It was across-the-board in both of the areas. Indirect FX volumes were down a bit. The FX sales and trading, which includes direct, the volumes were up a little bit. But overall, it was a quarter where it was tough in our FX business, Howard.

Joseph L. Hooley

And our FX business would be proportionately more tied to the core asset servicing business. So some of the derisking or the lack of risking that went on with regard to emerging market investing and global investing obviously had a bearing on that.

Operator

Your next question comes from Brian Bedell with ISI Group.

Brian Bedell - ISI Group Inc., Research Division

Just one more on the Basel III. I assume the ratio out to 2015, of 12.7%, that assumes no -- or I guess what level of buyback does that assume? Is it really just at the second quarter share levels and assumes no buybacks? Or do you have an assumption in there?

Edward J. Resch

Continuing at the current rate.

Brian Bedell - ISI Group Inc., Research Division

Continuing at the second quarter pace through that, through the end of 2014?

Edward J. Resch

Yes.

Brian Bedell - ISI Group Inc., Research Division

Okay, that's great. Okay. And Ed, going back to your comments on the revenue growth -- and maybe this is a question for both Ed and Jay. So in terms of your new modest revenue growth assumption, obviously, a little bit at risk with the environment being a little trickier. What -- to what degree do you think the comp revenue ratio will be pressuring that? You were saying, obviously, trying to get to about 39%, if we have a more, say, flat to slightly up revenue year in 2012 versus 2011, what would -- roughly, what would you envision the comp revenue ratio to be? And then, adding onto that for Jay, if you can talk a little bit about client derisking at the end of the second quarter. If you think that's a material impact to third quarter realization rates and the servicing business?

Edward J. Resch

Yes, I'll take the first one, Brian. I mean, we start off at 40.2%, the last year's ratio. We said we'd target 39.2% for this year, assuming modest revenue growth. Now the first half of this year versus last year, revenue growth is about 0.6%. So it's pretty modest 6 months year-to-date, which is why I said that if second half is relatively weaker, the 39.2% target is going to be very, very difficult to achieve. It's hard to put a point estimate on it. But I mean, I would think we're talking about 39.5%, 39.6%, something like that, if revenue in the second half of the year is challenged. I mean, we're not going to do anything relative to compensation just to hit 39.2%, if revenue is not strong. I mean, we have to balance out the needs of everybody, shareholders, employees, et cetera, to make sure that we're maintaining the appropriate level of staffing for the business.

Brian Bedell - ISI Group Inc., Research Division

And that's still year-on-year progress, isn't that? I would regard that as good.

Joseph L. Hooley

And Brian, to your other question. The volatility here just continues. If you think back to the first quarter, the first quarter started out slow and then the back end of the first quarter, clients began to re-risk as we get into the second quarter. Mid-point, the re-risking went to derisking. So I just think, we are cautious because as we look out from where we sit here, we have worries about the U.S., the election cycle, the fiscal cliff. Europe is, at times, day-to-day, if not week-to-week. So we sit looking forward saying, "It's hard to envision a short-term scenario where there will be a shift back to re-risking." That could happen, but we're not planning for it, which is why we make the cautious comments.

Brian Bedell - ISI Group Inc., Research Division

Right, right, that's helpful. And then just lastly on the securities processing costs, Ed. Can you frame how much that impacted the second quarter in terms of higher level versus the credit in the first quarter?

Edward J. Resch

In the range of $0.03.

Operator

Your next question comes from Alex Blostein with Goldman Sachs.

Alexander Blostein - Goldman Sachs Group Inc., Research Division

So wanted to go back to the capital question just one more time, I guess. In previous discussions, I think we talked about potentially the regulators looking at Basel III framework a little bit more in determining how they will allow banks return capital in 2013 and beyond. How does that change? How does this revision, I guess, change your view on whether or not you might be able to return the same level of capital kind of post this year?

Edward J. Resch

Well, I mean, we don't know. We have to see how the rules evolve, what the comments are. I've outlined what we're planning on commenting on at this point, the 2 big items I noted. And we have to see how the regulators factor these proposals or maybe some revisions to the proposals in their thinking about the next CCAR. We just don't know at this point.

Alexander Blostein - Goldman Sachs Group Inc., Research Division

Okay, understood. And then on net interest margin and I appreciate guidance you guys give around some sensitivity into the back half of the year. But I guess looking at the balances, can you give us a little bit more granularity on maybe where the deposits sort of sit with you guys, with which central banks versus the Fed or the ECB, just to get a sense of the sensitivity from here, if there's further rate cuts?

Edward J. Resch

Yes, they're mainly with the Fed, but they're also in part with the ECB. And they can ebb and flow, Alex. It depends where those deposits actually come in. Right now, the excess deposits are largely DDA in the U.S. So we're leaving them at the Fed, principally.

Alexander Blostein - Goldman Sachs Group Inc., Research Division

Okay. And then the last question that I have for you guys is just on bigger picture on the margins, which you look at over the last, call it, 2 quarters. Your pre-tax margins is in the high 20s, call it 28%, 29%. If you go back to when you announced the program, you were kind of in this high 20% range still. It feels like, call it, $100 million of the program on a net savings basis is already in the run rate. That's a good chunk, I think, of what the -- of the total savings that you outlined. But the margin hasn't really moved. So I guess what gives us some -- can you give us some confidence, I guess, around that 400 basis points of margin expansion given the fact that so far we really haven't seen any?

Edward J. Resch

Yes. I mean, remember, we pegged that margin improvement off of the 2010 results. And obviously, the world has changed since 2010. So the answer is a complex one, but I'll try to take you through it because we breakdown how we think about the margin in terms of various categories to try to frame the changes from 2010. So starting with the effect of transformation. We think we've gotten around 100 basis points of transformation. This is June year-to-date 2012 versus June year-to-date 2011. So that's the relevant -- that's the right way, we think, to look at it, 6 months versus 6 months. So there's 100 basis points of improvement there. You have some one-timers which need to be adjusted for. Those reduce the margins by about 90 basis points. So they roughly offset the effect of transformation right there. And then if you look at the core business, which includes market impact, that's down, in terms of margin, about 1.5%, given the environment that we're operating in. Okay? So those are the 3 broad buckets, Alex, that we look at in terms of the margin effect, giving recognition to the achievement of the ops and IT transformation savings.

Alexander Blostein - Goldman Sachs Group Inc., Research Division

Got it. I guess, said another way, if you look at -- to get to your 400 basis points of margin expansion, I guess, what did you guys assume for revenue growth for the next few years?

Edward J. Resch

We assumed various levels of revenue growth and just struck a number. And it really didn't matter much, frankly. We just assumed revenue growth grew at, pick a percentage, Alex, 5%, 6%, 7%, 8%, 10%, whatever. And we also increased expenses at the same growth rate. Not making any assumptions about operating leverage. Okay? Just to simplify things. Obviously, we target operating leverage, we say that every year. But just for this model, bring expenses and revenue up at the same rate from 2010 and add in the $600 million savings, and then you'll see that approximately the margin increases by around 400 basis points. It doesn't matter what revenue growth you took, as long as expenses grow at the same rate.

Operator

Your next question comes from Vivek Juneja with JPMorgan.

Vivek Juneja - JP Morgan Chase & Co, Research Division

A couple of questions. Firstly, one small clarification. Let me get that out of the way. There was a securities loss in your reported earnings, but a securities gain in the operator, can you just clarify why the difference and what causes that?

Edward J. Resch

Sure. We recorded the Greek exit as nonoperating. Our thinking there was that it was unique, extraordinary, given the circumstances in Europe, and particularly Greece. And we exited an entire position in the country, Vivek. Okay? So it's something that we think is more appropriately viewed as nonoperating, given that our view of operating should be to give the reader a view of the core earnings power of the company. And I think if we're talking about exiting a position or several -- 5 positions, specifically in Greece, at the class of item is operating, that would be, in my view anyway, not the appropriate way to look at it. In operating earnings, we have both purchases and sales, some gains, some losses that are at the margin, if you will. And we've done those over time and we report them as part of the core earnings of the company, and we had that this quarter, too.

Vivek Juneja - JP Morgan Chase & Co, Research Division

Okay, okay, okay. That's an easy one. Let's go back -- I want to go back to the buyback question that's been asked. So looking at your 9.7% Basel III Tier 1 common ratio, that would be, I guess, 9% if the acquisition were pro forma that of June 30. And you said you've continued to buy back at the current pace that you have in the second quarter, you intend to continue that. But if you do that, that would have no growth in the capital ratios, because essentially you're buying -- you bought back almost as much as you made in net income. And given that your target at your Investor Day was to try and keep your Tier 1 common at 10%, can you reconcile how you get to 10% if you're going to be -- when would you get to 10%? Since I know you've said there's going to be some runoff in securities. But clearly, looking back over the last few quarters, it hasn't run off that fast that it's led to any improvement in the capital ratio. Your Tier 1 common didn't really change if we adjust for OCI, quarter-over-quarter from Q1 to Q2?

Edward J. Resch

Yes, I mean, it's not much of an OCI effect, right? But the growth from the 9.7% up to 10% and over 10% will occur over the next 2.5 years from the mid-point this year to the end of 2014, as those securities that are subject to the higher risk weighting run off.

Vivek Juneja - JP Morgan Chase & Co, Research Division

And so are these what the AAA's subprime asset-backed that you have moved into your -- that were part of the conduit that have been moved to held to maturity that you're hoping will pay down over time? And does it come more in '13 or is it more back-ended? Can you give any more color?

Edward J. Resch

No, it's not those securities at all, Vivek. It's some of our actually higher rated, we believe higher-quality RMBS securities. Some, mostly foreign, that are driving the increase in risk weighted assets. And that is actually offset by a benefit on some of the securities that I think your question refers to. Okay? Some of the lower-rated securities that some of which we sold in 2010 in order to reposition the portfolio. Those securities are actually benefiting in this calculation.

Vivek Juneja - JP Morgan Chase & Co, Research Division

Okay. So you're thinking that your 9.7% goes to 9%. And then you still intending to stick to the 10% target?

Edward J. Resch

Yes. And 9.7% going to 9% is just layering in the Goldman Sachs' acquisition in those calculations, right?

Vivek Juneja - JP Morgan Chase & Co, Research Division

And how long do you think does it take for you to get back to 10%?

Joseph L. Hooley

1 year.

Edward J. Resch

1 year. Certainly by the end of 2013.

Operator

Our final question comes from Andrew Marquardt with Evercore Partners.

Andrew Marquardt - Evercore Partners Inc., Research Division

Just on the derisking commentary. It sounds like it wasn't fully reflected in this quarter's run rate. How do we think about the go-forward implications from the derisking stepping down, and maybe put in the context of what we saw last year, if possible?

Joseph L. Hooley

Yes. It's a hard one to answer, Andrew. I attempted to do that a few questions ago by talking about -- the first quarter had the same dynamic, which is the derisking started slow and then people re-risked in the second half of the first quarter, and now we've cycled back down again. So I think you should look at it more from a go-forward perspective of the U.S. and European markets and whether the confidence steps down again or whether it remains where it is right now. I mean, that's really what I'm signaling.

Andrew Marquardt - Evercore Partners Inc., Research Division

Got it. It seems like in the fourth quarter, even last year, like that was maybe more reflective kind of in the numbers. Is that fair?

Joseph L. Hooley

Yes, that is fair.

Andrew Marquardt - Evercore Partners Inc., Research Division

Is that how we should think about it going forward? Or are we not there yet in terms of kind of just if you were to rank them or put them in a magnitude?

Joseph L. Hooley

It's just that it's hard to give you a signal on that.

Andrew Marquardt - Evercore Partners Inc., Research Division

Okay, got it. And then in terms of the comp to revenue target. It sounds like modest revenue growth, less confidence in that now. How do you guys think about modest? What is the definition of modest? And why even kind of keep that target out there if there is less confidence?

Edward J. Resch

Well, I mean, I've used the term modest and the way that I have defined it without putting a point estimate on it, Andrew, is to say, clearly, 60 basis points first 6 months, the first 6 months. 1% or 2% is not modest, and 7% or 8% is above modest. Okay? So it's somewhere in between. That was our thinking coming into the year. But based on the first half results, that thinking is lower.

Andrew Marquardt - Evercore Partners Inc., Research Division

Okay. And then just a ticky-tack question on the processing fee line. It came in at $48 million this quarter, I know there was some noise last quarter, too. How should we think about it going forward? Is that -- second quarter, is some of that non-repeatable? Or should we go back to 70, 75 type quarterly range or are we resetting lower?

Edward J. Resch

We're not resetting lower. I mean, I'd say, again, it's tough to predict the line. But I think I've said in the past, 70, 75 per quarter is probably a good number to use. This quarter was significantly below that for a couple of reasons that I think I touched on it in my script.

Andrew Marquardt - Evercore Partners Inc., Research Division

Got it. And then the tax rate, just the last ticky-tack, tax rate also lower?

Edward J. Resch

Yes, yes.

Andrew Marquardt - Evercore Partners Inc., Research Division

Is it also reset lower. Or should we also think about it kind of going back to the 27, 28?

Edward J. Resch

No. I think we're -- in our press release, I think we signaled that we expect 25% to 26% effective for the full year. And that's a combination of 2 things. One, the overall mix of revenue. We're obviously getting some advantage there. And then secondly, we have, and this is one of the benefits in the second quarter, a renewable energy investment which is generating some positive tax effects and will be for the full year.

Joseph L. Hooley

Thank you. I appreciate all your time this morning. We look forward to speaking with you again after the third quarter. Thank you.

Operator

Thank you. This concludes the conference. You may now disconnect.

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