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State Street Corporation (NYSE:STT)

Q2 2008 Earnings Call

July 15, 2008 9:30 am ET

Executives

Kelley MacDonald - Senior Vice President, Investor Relations

Ron Logue - Chairman and Chief Executive Officer

Ed Resch – Chief Financial Officer

Analysts

Glenn Schorr - UBS

Nancy Bush - NAB Research

Mike Mayo - Deutsche Bank

Ken Usdin - Banc of America Securities

Brian Bedell - Merrill Lynch

Thomas McCrohan - Janney Montgomery Scott

Operator

Welcome to State Street Corporation's second quarter call and webcast. (Operator Instructions)

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

Kelley MacDonald

Before Ron Logue, our Chairman and CEO, and CFO Ed Resch begin their remarks, I'd like to remind you that during this call we will be making forward-looking statements relating to the corporation's financial outlook and business environment, investment portfolio, asset-backed commercial paper program, and consolidation of Investors Financial Corp, among other things.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in State Street's 2007 annual report on Form 10K and its subsequent filings with the SEC, including in particular its current report on Form 10K dated June 2, 2008. We encourage you to review those filings, including the sections on risk factors, concerning any forward-looking statements we may make today. Any such forward-looking statements speak only as of today, July 15, 2008, and the corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

In addition, information related to this webcast, including information concerning and reconciliations of non-GAAP measures referred to in this webcast is available in the Investor Relations section of our website under the heading Annual Reports and Financial Trends. I'd also like to remind you that you can find additional detail regarding the performance of the assets in the corporation's investment portfolio and of the assets in the commercial paper conduits on our website.

Now I'll turn the call over to Ron.

Ron Logue

Thank you, Kelley, and good morning. Let me start by characterizing our performance in view of the continuing market turmoil that all financials have been dealing with since last August.

I think the question for all of us is: How are we going to look once we emerge from this crisis? The answer for us and for other trust banks, I think, lies in four areas.

First, how is our core business doing, and are we continuing to grow revenue?

Second, what will be the effect of future market-driven revenue compared to current elevated levels?

Third, how are we dealing with expense control?

And fourth, what will be the outcome of our on and off-balance sheet issues?

Our core business continues to remain very strong, as evidenced by our second quarter results. Two indicators that are telling of a strong sequential quarter growth in servicing fee revenue, fueled by large new business wins in previous quarters and continuing this quarter and better-than-expected results in asset management fee revenue.

Second, our securities finance revenue continues to be very strong, taking advantage of disrupted financial markets, but we would expect this uncharacteristic growth to moderate in the second half of 2008.

Foreign exchange revenue has already begun to decrease this quarter from previously elevated levels, and as Ed will report shortly, we expect net interest margin to increase slightly from our previous outlook.

Third, balancing our spending to ensure a long-term success with the need to consistently generate positive operating leverage has never been more important than it is now. I'm pleased with our ability to moderate the growth of our salary and benefit expense first quarter to second quarter, and we need to continue to place a strong emphasis on controlling expense and we will.

And last but not least, the quality of the assets in our investment portfolio and asset-backed commercial paper program continues to be strong, as Ed will discuss. The respective marks on the investment portfolio and the conduits have stayed pretty much the same quarter to quarter, and we currently believe that the investment portfolio is not other than temporarily impaired and that the conduits do not need to be consolidated onto our balance sheet. Regardless, we have strengthened our capital position and our tangible common equity with the issuance of $2.8 billion of equity capital and by continued strong internal capital generation in the second quarter.

Because of our strong performance in the first half of 2008, we now expect our growth in operating earnings per share to approach the high end of the 10% to 15% range and operating return on equity to also approach the high end of the 14% to 17% range. We also believe our revenue growth will exceed the high end of the 14% to 17% range.

So let me talk about our accomplishments this quarter in some more detail. State Street this morning reported a strong quarter's performance, with increased revenue on nearly every line of the income statement when compared to the prior year's second quarter and was up on nearly every line compared to the first quarter of '08.

Compared to the first quarter, our total revenue increased 4% and our operating earnings per share, excluding the merger and integration costs in the second quarter of 2008, was up 1% compared to the first quarter of 2008. Also excluding these costs, we achieved 19.3% operating return on equity in 2008 compared to 19.4% in the first quarter of 2008. Overall, the results of the first half are very strong.

Even excluding the revenue and operating earnings from Investors Financial and comparing the second quarter of 2008 with the second quarter of 2007, revenue grew 27% and operating earnings per share increased 29%. Also excluding the merger and integration costs in the second quarter of 2008, on an operating basis we achieved positive operating leverage of 650 basis points, our 15th consecutive quarter of positive operating leverage when measured on a year-over-year basis. On a quarter-to-quarter basis, we achieved about 30 basis points of positive operating leverage.

Considering the market challenges, we are pleased with the strong growth in our core businesses in the first half of 2008. Compared to the first quarter of 2008, we increased servicing fees 2% and management fees grew a little less than 1%. Trading services revenue was down 13% in the second quarter from the first quarter, a trend which may continue into the third quarter, when we typically experience lower revenues compared to the second quarter.

Also looking at the second quarter of 2008, we enjoyed a certain amount of overperformance in securities finance. Securities finance revenue was up more than 16% comparing the second quarter with the first quarter. I caution you, however, that you cannot extrapolate the strong results in securities finance revenue in forecasting the second half of 2008. Typically, we see a decline in securities finance revenue from the second quarter to the third quarter.

Partially offsetting the expected slowdown in trading and securities finance revenue is the expected strength in net interest revenue in the second half of 2008 compared to the second half of 2007, and Ed will provide more details about this shortly.

We've now completed the first 12 months of the consolidation of Investors Financial, and we remain confident that we will retain at least 91% of the customer revenue. As you can see from the press release issued this morning, the performance of the business we acquired from Investors Financial continues to exceed our expectations, adding $253 million in fully taxable equivalent revenue in the second quarter from Investors Financial. We reported $0.02 in operating earnings per share this quarter from Investors Financial, up from a neutral result in the first quarter. We now expect the acquisition to be accretive this year, significantly ahead of our original plan.

The consolidation is proceeding according to plan. We've already converted about 47% of the customer products. As customers convert, we are removing costs while also providing access for those customers to a broad range of new products and services.

Regarding new business won during the quarter, we won $400 billion of asset servicing new business. Some of the second quarter wins include, on the servicing side, John Hancock consolidated an additional $24 billion in assets with State Street to provide custody and fund accounting for 43 additional funds, bringing the total assets serviced for all John Hancock funds to $125 billion in 228 funds. The Federal Reserve Bank of New York, as managing member of Maiden Lane LLC, awarded State Street a mandate to provide custody, collateral administration, and LLC administration services for $30 billion in assets.

State Street renewed contracts with five long-standing public fund clients for whom it services around $181 billion in combined assets. These included the state retirement and pension system of Maryland, the University of California Regents' scheme, the Montana Board of Investments, the State of Nebraska, as well as the Minnesota State Board of Investment, a State Street customer for over 20 years. We also renewed the contract with the Teachers Retirement System of Texas, the fourth-largest public pension fund in the United States, for a variety of custody, accounting, analytics and securities lending for $110 billion in assets.

Apostle Asset Management, an Australian asset management firm, has appointed State Street to provide custody and investment administration services for 2 billion Australian dollars in five Apostle-branded funds being offered to local investors.

This quarter, we also acquired Deutsche Bank's Swiss fund accounting business, which will enable us to provide fund accounting services for Swiss-domiciled funds. We will initially service 16 investment funds with approximately 4 billion Swiss francs in assets.

State Street Global Advisors added significant new business as well. San Bernardino, California County Employee's Retirement Association approved investing $360 million in SSgA's liquidity strategy cash portfolio. Lincoln Financial has selected SSgA for an extensive sub-advisory relationship and management of six new investment portfolios and two existing index funds. In the second quarter, 35% of our new business came from active strategies, a continuing emphasis for SSgA.

Now turning to our balance sheet, net interest revenue and net interest margin again performed very well, achieving a 73% increase in fully taxable equivalent net interest revenue in the second quarter of 2008 compared to the second quarter of 2007, and a net interest margin of 231 basis points in the second quarter of 2008. Ed will provide further details about these results and our outlook for net interest margin in a few minutes.

So, despite the continued turmoil in the financial markets over the past quarter, I'm very pleased with State Street's performance, both growth in revenue as well as operating earnings per share. We will continue to watch expenses closely as we target positive operating leverage on an annual basis and maintain our focus on continued global growth across our business.

Now I'll turn the call over to Ed, who will provide some of the details of our financial performance last quarter as well as further information about the performance of the assets in our investment portfolio and the asset-backed commercial paper program.

Ed Resch

Thank you, Ron. Good morning, everyone.

This quarter again underscored the strength of our business. We reported strong growth in both fee and net interest revenue, and please note that the numbers I am presenting for the first two quarters of 2008 include the results of the acquired Investors Financial business.

Our growth in asset servicing, asset management, and securities finance revenue continued at a combined rate of about 33% compared to the second quarter of 2007. Trading services took advantage of volatility in the market, and securities finance revenue benefited from steepness in the short end of the yield curve. We also reported strong growth in net interest revenue. We continued to benefit from the action in late March by the Federal Reserve; however, we expect the benefit of the recent cuts will moderate over the second half of 2008. I'll provide more detail on our net interest income and margin and the outlook for 2008 in a few minutes.

Our assets under custody at June 30, 2008 were $15.3 trillion compared to $13 trillion on June 30, 2007. Our assets under management stood at $1.9 trillion at the end of this quarter, down slightly from June 30, 2007.

As Ron noted, the business acquired from Investors Financial continued to perform well. As we reported this morning, total revenue in the second quarter of 2008, including Investors Financial, compared to the second quarter of 2007 was up 39%. And excluding Investors Financial, total revenue was up 27%. Investors Financial contributed $0.02 to the operating earnings per share in the second quarter, ahead of our original outlook.

Excluding variable expenses resulting from revenue growth at Investors Financial, in the second quarter of 2008 we saved an additional $69 million. As a result, the savings over the last four quarters is $209 million, and we are on track to achieve our annualized target of $350 million we set in February of 2007.

We previously thought that the Investors Financial transaction would be modestly accretive in 2008 excluding the impact of the merger and integration costs. Due to continued strength in revenue growth, we now expect the acquisition to be about $0.05 to $0.06 accretive to our 2008 results, significantly ahead of our original plan at the time of the acquisition.

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

Now on to the results. This morning, all of my comments will be based on our operating basis results, excluding the merger and integration costs associated with the acquisition of Investors Financial in the first and second quarters of 2008.

On an operating basis, earnings per share in the second quarter were $1.40, up 31% from $1.07 per share last year and up 1% from $1.39 in the first quarter. Revenue on a fully taxable equivalent basis totaled $2.7 billion for the quarter, an increase of 39.7% from last year's second quarter, compared with a 33.2% increase in expenses to $1.809 billion on an operating basis.

Compared to the first quarter of 2008, revenue on a fully taxable equivalent basis was up 3.8% and expenses on an operating basis increased 3.5%.

Return on equity on an operating basis was 19.3% in the second quarter, up from 19.2% in the second quarter of 2007 and down from 19.4% in the first quarter.

Servicing fees were up 28% from the second quarter of 2007 due to the additional revenue from Investors Financial customers as well as increases in new business from existing and new customers, offset partially by an 8% decline in the daily average equity market valuations. They were up about 2% from the first quarter due to growth in net new business and a slight increase in daily equity valuations.

Management fees were down 1% compared with the second quarter of 2007 due primarily to the impact of a 10% decline in the average month end equity valuations and a decline in performance fees, offset partially by business from existing and new customers. Management fee revenue was up slightly from the first quarter due primarily to a slight increase in the average month end equity valuations offset partially by lower performance fees.

Performance fees were about $4 million, down from $18 million a year ago and from $7 million in the first quarter of 2008.

Our cash and money market assets under management were down slightly, about 3%, from last year's second quarter.

We experienced a 6% decrease in equity assets from the second quarter of 2007, a good performance when compared with the 15% decline in quarter end equity valuations.

Fixed income assets increased about 19% compared to the second quarter of 2007, a rate higher than the market averages.

Increased volatility and higher volumes in our foreign exchange business drove a 30% increase in foreign exchange trading revenue compared with the second quarter of 2007. Foreign exchange revenue was down 14% from the first quarter, due primarily to lower volatility and a slight decline in volumes.

Brokerage and other fees were up $7 million or 8% to $93 million from the previous year's second quarter. This improvement was due primarily to strength in electronic trading and current ex businesses.

Brokerage and other fee revenue was down 8% from the first quarter due to a decline in third-party trading revenue, offset partially by an increase in U.S. transition management mandates.

Also, the steepness of the short end of the yield curve contributed to the increase in revenue from securities finance in the second quarter compared to the year ago quarter. Securities finance revenue was up 117% from last year's second quarter, due primarily to improved spreads partially offset by lower demand, and was up 16% compared to this year's first quarter, also primarily due to a continuation of improved spreads and the impact of the dividend season in Europe. We expect the benefit from spreads to moderate in the second half of this year.

We had $672 billion in average securities on loan and the duration on the securities lending book at June 30, 2008 was 25 days.

Processing and other fees increased 18% from the prior year's second quarter. This improvement was due to revenue associated with Investors Financial. The revenue increased 43% from the first quarter, primarily due to structured products. Asset-backed commercial paper related revenue of $13.2 million was down 23% compared to the second quarter of 2007 and up $2 million from the first quarter of 2008.

Net interest revenue on a fully taxable equivalent basis increased from the second quarter of 2007 by $288 million or 73% from $397 million to $685 million and was up $37 million from the first quarter. In addition, compared to the second quarter of 2007, net interest margin of 231 basis points was up 67 basis points and was up 11 basis points from the first quarter of 2008.

Some of the trends that drove our improved performance in the second quarter compared to the year ago quarter include a larger balance sheet, improved spreads on our fixed rate portfolio caused primarily by the lower cost funding due to the recent actions by the Federal Reserve, the impact of additional revenue from the acquired Investors Financial business, a steeper yield curve from overnight to three months, and the impact of our equity offering in June.

Compared to the first quarter of 2008, in the second quarter of 2008 we benefited from improved spreads due to the actions of the U.S. Federal Reserve, offset partially by a lower rate environment. We generated lower revenue from noninterest bearing deposits and our equity.

Now let me turn to the investment portfolio. The average investment portfolio increased from $67.7 billion to $71.7 billion during the second quarter from the year ago quarter due to the impact of the Investors Financial acquisition and was down slightly from $73.3 billion in the first quarter of 2008.

Mortgage-backed securities in the second quarter of 2008 represented about 38% or $27 billion of the average investment portfolio.

Floating-rate asset-backed securities in the second quarter of 2008 represented about 34% of the average investment portfolio or $24.6 billion.

We believe this portfolio is conservatively structured and is well seasoned. The portfolio has been performing well, is diversified, and has been withstanding market stresses. All of the assets are current as to principal and interest.

During the quarter, particularly in late May and early June, we saw credit spreads tighten, causing an improvement in the after-tax unrealized mark of about $500 million. But offsetting that we had a increase in the after-tax and unrealized mark of about $600 million due to the impact of higher U.S. rates on fixed-rate securities. As a result, while the tone of the market is slightly improved, the unrealized marked-to-market loss after tax is about $2.0 billion, up about $72 million from March 30, 2008.

We continue to believe that these prices are not reflective of the underlying value of the securities if held to term, but indicate a continuing lack of liquidity in the fixed-income market. In past quarters I have presented considerable detail about the investment portfolio, specifics about the ratings of each asset type, and considerable detail on the subprime portfolio. I recently have also added data on the unrealized loss by asset type as well as stresses we applied to each of these assets to give us confidence as to their underlying quality. Those are updated and available to you on our website. As I just indicated, the amount of unrealized loss has not changed materially from the first quarter level, and I strongly urge you to review those slides.

In addition, you're probably aware of the downgrades to the monoline insurance providers during the past quarter. Those downgrades had a minimal effect on the unrealized losses in our investment portfolio. Almost all of those downgrades affected our municipal bond portfolio, which is in an unrealized gain position at the end of the quarter.

Now, as to our outlook for net interest revenue for the remainder of 2008, last quarter I revised our outlook for net interest margin for 2008. I said that we expected the margin to be between 200 and 210 basis points, probably nearer the high end of the range. In the current environment, we now expect our margin on average for the full year to be about 215 basis points or slightly higher based on the following assumptions:

That we maintain the existing favorable mix of customer liabilities.

An expectation that the investment portfolio will reprice as about $7 billion in older fixed-rate securities mature in 2008, but that these will be reinvested on average at modestly lower rates than in 2007. Also I should mention that we continue to minimize our portfolio reinvestment as we maintain our liquidity in the face of the current market environment.

And lastly, that the level of non-U.S. transaction balances remains at current levels.

In February we provided an outlook that the ECB will reduce rates by 50 basis points to about 3.5% by year end, and that the Bank of England will reduce rates by about 75 basis points to about 4.75%. Since the ECB has already raised rates once in early July, we now believe that these two central banks will either hold steady from here or possibly raise slightly, either of which action is slightly beneficial to us for the rest of this year.

As the U.S. Fed stops cutting rates, the benefits we have seen and been enjoying will abate, and so in the second half of the year we may not see the net interest margin at the level we reported this quarter.

We continue to expect our '08 average balance sheet to be roughly flat with the average balance sheet in the first quarter of 2007.

Our duration gap has not changed significantly from year end. Our assets are about 11 months, and our liabilities are about 9 months. The investment portfolio duration is about 1.5 years, down slightly from the second quarter of 2007 and flat with the first quarter of 2008.

I'll now turn back to expenses, and just as a reminder, I'm speaking about expenses on an operating basis.

Salaries and benefits expenses increased 31% compared to the second quarter of 2007 due primarily to the impact of additional staff from Investors Financial and higher staffing levels to service new business as well as increased benefits expense. Compared to the first quarter of 2008, salaries and benefits expense was approximately flat, primarily due to a lower level of incentive compensation, offset partially by higher benefit costs and the impact of increased staffing levels to support growth.

Transaction processing expenses increased 22% compared to the year ago quarter, primarily due to the acquisition of Investors Financial and increased volumes in asset servicing and the trading businesses. They increased 6% from the first quarter of 2008, due primarily to the impact of the receipt of a depository rebate in the first quarter.

Expenses for information systems and communication increased $36 million or 28%, primarily due to the impact of Investors Financial and costs to support growth in Europe.

Occupancy expense increased 17% from the second quarter of 2007 due primarily to the cost associated with Investors Financial and was up 5% from the first quarter of 2008 due to investments to support growth, particularly in Europe.

Other expenses were up 63% compared to the year ago quarter primarily due to the impact of professional fees and the amortization expenses associated with Investors Financial, as well as securities processing costs. They were up 15% compared to the first quarter of 2008, primarily due to professional fees and globalization efforts.

Our tax rate for the first quarter was 34%, flat with the first quarter. As we disclosed in this morning's press release, we completed the divestiture of our 50% investment in CitiStreet in early July, resulting in a gain of about $0.47 per share. Taking into account this divestiture, we expect the effective tax rate for 2008 to be 34.6%. Excluding the impact of the divestiture of CitiStreet, the expected effective tax rate for 2008 remains at 34.0%.

Now turning to our capital ratios, the principal-capital ratio that we manage to the Tier 1 leverage ratio, we have historically targeted between 5.25% and 5.75%, but given the market environment, we expect our leverage ratio to grow to a level above the top of that range in order to preserve flexibility in what appears to be continuing volatility in the market. At June 30, 2008, our Tier 1 leverage ratio stands at 8.24%, up from 6.09% as of March 31, 2008.

Our tangible common equity ratio was 5.40%, up from 2.92% at March 30, 2008. The increase was driven by the $2.8 billion equity issuance we completed in June and approximately $550 million of organic capital that we generated in the second quarter.

Next, I will briefly describe the conduit assets in our asset-backed commercial paper program. As in the past, you can find a detailed quarterly review of the assets displayed by type, country of origin and ratings on our website located with the second quarter materials. Also there you will find the unrealized after-tax marked-to-market losses for each asset type and the stresses we applied to them. In the interest of time, I will not discuss them in detail today.

As of June 30, 2008, the conduits held assets of $28.4 billion, nearly flat from $28.3 billion on March 31, 2008. The asset amortization was offset partially by new asset purchases as well as the impact of the continued weak dollar. Also during the quarter we issued $15 million of additional subordinated debt to further mitigate consolidation risk, bringing the total amount of first loss notes available to the conduits to $67 million.

As I stated last quarter, we created this program in 1992 primarily to address customer requests for high-quality, highly rated commercial paper. The conduits have never suffered a credit loss on any asset they purchased, evidence of our strong credit discipline. Eighty-two percent of the assets are rated single A or above.

In the second quarter, 125 additional securities were downgraded due to the downgrade of the monoline insurance providers, and none of the assets in our conduits are subprime nor are any structured investment vehicles in the conduits.

The unrealized loss on the conduit assets as of June 30, 2008 is about $1.6 billion after tax, again reflective of the illiquidity in the market, up from $1.5 billion after tax at March 31, 2008.

The assets continue to have an average - weighted average maturity of about four years, and the paper has a weighted average maturity of 20 days, up from 16 days at March 31.

As of June 30, we had funded about $212 million of our asset-backed commercial paper on our balance sheet, and all the securities in the conduits are current as to principal and interest. Due to the high quality of the assets and their performance, we do not currently believe we need to consolidate the conduits. On a pro forma basis as of June 30, the consolidation of the conduit assets onto our balance sheet would reduce our leverage ratio by about 117 basis points from 8.24% to 7.07%, and the tangible common equity ratio about 182 basis points from 5.40% to 3.58%.

From a funding standpoint, the risk of consolidation is included in our contingency funding plan. As of June 30, 2008, we carried about $18 billion in liquid assets on our balance sheet given the market environment. In addition, we believe that we can access multiple sources of liquidity to fund any asset purchases from the conduits. Our sources of this liquidity include borrowing from the overnight interbank or repurchase markets, issuing corporate commercial paper, issuing bank CDs and time deposits, and/or accessing the Fed discount window.

So overall, in the second quarter we continued to perform well in what we think was an economically challenging period. We hope that you review the information we have provided on our website, adding further detail to our discussion of the investment portfolio and our conduit program.

And now I'll turn the call back to Ron.

Ron Logue

Thank you, Ed.

As outlined at the beginning of this call, I'm very pleased with State Street's performance, both on a sequential quarter and year-over-year basis. Not only have we built momentum in growing our core business but also we've proven our resiliency in the face of quite unprecedented market conditions.

Although the declines in the equity markets have pressured our fee revenue in the second quarter compared to a year ago, our new business won over the past few quarters has contributed to that strong performance. We continue to benefit from our focus and our ability to cross sell into our existing and acquired customer base as well as our solid global footprint.

Our strong position in our trading business and in securities finance benefited the second quarter results, which should moderate in the second half of the year. While our net interest revenue continued to be strong, we can expect those results to moderate also as we will no longer benefit from the Fed rate cuts of late 2007 and the first quarter of 2008. And we look forward to continued stronger-than-expected performance from SSgA as the new asset management team makes an impact.

I want to assure you that we continue to watch our expenses carefully, recognizing that these challenging times continue. We are committed to achieving annual positive operating leverage, so we must be sure that our rate of revenue growth exceeds our rate of expenses growth, even in more difficult markets.

Specifically, I will just remind you of my earlier comments regarding our outlook for 2008. The achievement of all of these goals excludes the non-operating gain from the divestiture of CitiStreet, which closed in the third quarter. We expect our earnings per share on an operating basis, excluding merger and integration costs but including the recent capital raise, to increase 10% to 15% compared to the 2007 operating basis results of $4.57 per share, approaching the high end of that range. We expect our operating return on equity to be between 14% and 17%, also approaching the high end of the range. And we expect our revenue growth to exceed the high end of our 14% to 17% range.

We revised our outlook regarding our level of performance to these goals based on the strength of the first half of 2008. In the second half of the year we anticipate the comparisons will be more challenging.

Our consolidation of Investors Financial continues to outperform our original expectation, retaining 91% of their revenue and earning $0.02 per share excluding the merger and integration costs in the second quarter.

In addition, based on our performance in the first half of 2008, our core businesses are core businesses are performing well, fueled by continued new business wins and a strong pipeline.

We continue to watch our costs carefully, as we head into a more challenging period.

Ed and I will now be happy to take your questions.

Questions-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

I'm not sure if I missed it or not. Did you talk about where you envision the size of the conduit and securities portfolio to be as of year end based on maturities coming due and paydowns?

Ed Resch

In terms of the conduits, the maturities in the conduits are about $1 billion a quarter, and we're committed to right-size those conduits, as we've said since we've been talking about them in great degree since the last year.

The issue there is, though, that we cannot just have a linear decay because of the impact of the FIN 46 models, so I don't have a target that I could say that we're reaching for by the end of the year. But our commitment is still the same. We're looking to decrease the size of the conduits overall.

In terms of the portfolio, I'd say it's probably going to be in line with where it is now, in the $75 billion range or so at year end. We don't anticipate many changes there.

Glenn Schorr - UBS

And then, when unrealized losses come up, whether they be produced by higher Treasuries or wider spreads, how do the rating agencies and the regulators view the impact on capital ratios? In other words, is it the same as if it was produced by lower earnings in the quarter? Do they test - the impairment test? What are they looking at when they see the same numbers we look at?

Ed Resch

Well, they're looking at the entire picture. You know, I don't think that an unrealized loss is viewed the same as a lesser level of core earnings, certainly. But the fact that the unrealized loss increases or decreases is certainly taken into account by both the regulators and the rating agencies when they look at our capital position. We have ongoing dialogue with both of them.

Glenn Schorr - UBS

A couple of quickies. Other expense is up big. I saw some comments in the text; part of it related to the integration, part of it was related to securities processing. Was that a little bit of a jump up this quarter and you should see some moderation in the second half?

Ron Logue

I think, as we said in the past, when we get opportunities to invest in some places, we usually take that. You'll find professional fees up, for example. So I think this is another example of us taking advantage of spending some money when we can.

Glenn Schorr - UBS

And maybe, last one, any word - back to the conduit - any latest word in terms of FASB's comments on potential consolidation, you know, comments around FAS 140 and FIN 46 and removing the QSP rule in terms of timing and potential construct of changes there?

Ed Resch

Our understanding, Glenn, is really just from public sources, which is that the FASB is expected to issue an exposure draft around the end of this month. And the contents of that are still, I guess, up in the air as far as I know.

The issue of the FAS 140 affects the QSPEs, which does not affect us. The issue of the FIN 46 revision is the thing that does potentially affect the consolidation requirements or the rules under which conduit consolidation would be required.

But end of the month I think is something to target for from a release standpoint.

Operator

Your next question comes from Nancy Bush - NAB Research.

Nancy Bush - NAB Research

A couple of questions here. You know, everybody I think is sort of having a hard time getting their head wrapped around where net interest revenues go from here because it has been such a bigger piece of the earnings equation I think this year than anybody expected. I mean, how should we think about net interest revenue going forward. If the Fed does nothing or for some insane reason decides to tighten, how do you look at NIR going into 2009?

Ed Resch

Well, I really don't want to get too far ahead of things and talk about 2009 yet, Nancy, given the uncertainty, but I'll tell you our thinking in terms of the second half of this year.

As I said, we expect the full year to be, from a margin standpoint, in the range of 215 or maybe a little bit above, and that obviously implies a little bit of a weaker second half than what we had in the first half. The first half, we think, was extraordinarily strong, mainly driven by the pace and the depth to which the U.S. Fed cut rates. So we're expecting to see less of a benefit there in the second half as that kind of works through.

We're anticipating the U.S. Fed to stay the same, at about 2%. To your question if the Fed were to decide to increase rates, that would have a depressing effect on our second half expectation for net interest margin. So that's a possible downside to our forecast.

We're expecting, though, strong transaction deposit flows to continue, which we've had for awhile. Obviously if the opposite were to be the case, we could have a slightly negative effect on the margin.

We're expecting the yield curve at the short end to remain fairly steep, as it was in the first quarter - in the first half of this year, excuse me. We think the ECB and the Bank of England will stay about where they are, and we're expecting an average balance sheet size in the $140 billion range.

So you could take the opposite of a lot of those factors that I just said and construct a scenario where perhaps our margin compresses in the second half. And we are, as I said, expecting a less-robust net interest revenue, net interest margin second half of the year, but overall in the range of 215 or so for the full year from a margin standpoint.

Nancy Bush - NAB Research

Secondly, losses in the investment portfolio since quarter end, has there been any material change?

Ed Resch

Since quarter end the losses actually widened out a little bit. From June 30, it was just about $2 billion on the nose after tax. It's a little shy of $2.2 billion as of the close of last Friday - $2.185 billion is the exact number as of last Friday.

Nancy Bush - NAB Research

And Ron, just a question for you. Given the environment, can you just kind of give us - I think we're all sitting here stunned. Can you give us sort of your take on how this - and you've been around the banking industry for awhile  stacks up to sort of the '89-'91 period? And I would assume that you are going to be one of the beneficiaries of flight quality here, and whether indeed you're seeing that.

Ron Logue

Well, I think '89 and '91 was a very difficult time, probably the most difficult that I've ever experienced. This may be approaching that. I'm not too sure it's there yet. But I think were are a lot of lessons learned during that period of time, and I think we've got a number of people in the company that have experienced that. So my sense is that we have been and we'll continue to prepare well for any extended period of time like that.

We have seen I guess you could call it a flight to quality. We have seen cash balances increase somewhat. I would expect that would continue over time, and I think we're going to be in a position to deal with that, though. That would be an expectation of ours, as history has proven.

Operator

Your next question comes from Mike Mayo - Deutsche Bank.

Mike Mayo - Deutsche Bank

Two follow ups - you said the unrealized securities losses - what are the unrealized losses in the conduits since quarter end, and have you moved any of those assets on balance sheet since quarter end?

Ed Resch

In terms of the conduits, same thing but to a lesser degree. From June 30th through last Friday, the 11th, the loss on an after-tax basis increased by about $60 million.

Mike Mayo - Deutsche Bank

So not much, okay.

Ed Resch

A little bit shy of $1.7 after tax. In terms of any assets from the conduits coming on the balance sheet, the answer is no.

Mike Mayo - Deutsche Bank

And how much again of the assets from the conduit came on balance sheet this quarter?

Ed Resch

This quarter?

Mike Mayo - Deutsche Bank

In the second quarter.

Ed Resch

Second quarter was $850 million of triple A rated securities under [ALAPA].

Ron Logue

No, that was first quarter.

Ed Resch

That was first quarter. None this quarter, Mike.

Mike Mayo - Deutsche Bank

So you moved zero additional assets from the conduit on balance sheet in the second quarter?

Ed Resch

Correct.

Mike Mayo - Deutsche Bank

All right, so you've moved no additional assets on balance sheet, and if the FIN 46 decision comes out in your favor, what do you do with all the capital you raised recently? I mean, I saw that as an insurance policy in case you needed to use it. Do you want to keep that insurance policy around for longer or might you put some of that capital to work?

Ed Resch

Well, in a perfect world, Mike, we would hope that over time the markets would come in and that opportunities would present themselves to us. I mean, that's how we'd like to see that play out, but who knows.

Mike Mayo - Deutsche Bank

Okay. And then separately, your pipeline, the backlog, kind of tone of the market?

Ron Logue

Yes, very strong. Very strong. Again, this quarter, some real good wins. And I think the other thing that I probably didn't spend some time on, but I talked about a lot of re-bids, one, just about all of the re-bids that we had we won, you know, six huge re-bids. I think if you add Texas Teachers plus the other five, it's close to $300 billion of assets won. We've been extremely successful in retaining our business in the last couple of quarters.

Mike Mayo - Deutsche Bank

Can you give some kind of context as to what is really strong pipeline mean as a percentage of, say, current revenues or assets under custody?

Ron Logue

Well, I don't know if I could give it to you as a percentage, but probably more in absolute. I think we've been winning somewhere between $400 and $600 billion of assets for the last two or three quarters, which traditionally has been more than we have done, if you go back and look in recent years. That's been a lot more.

I think some of it has to do with flight to quality. I think some of it has to do with dislocation of others in the marketplace or preoccupation.

Mike Mayo - Deutsche Bank

And so would that be some of the other kind of Big Five players, Big Four or Big Five players, or the tier below that?

Ron Logue

No, it'd be the Big Five.

Operator

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

Ken Usdin - Banc of America Securities

A couple of quick clean up ones. Can you just confirm again that the CitiStreet gain is not included in your operating guidance?

Ed Resch

It is not.

Ron Logue

It is not.

Ken Usdin - Banc of America Securities

And what again is the [TC] expected impact from the gain in the third quarter, the benefit?

Ed Resch

It would be about 14 basis points, Ken.

Ken Usdin - Banc of America Securities

Are there any other potential calls on capital out there, you know, whether it's SSgA reserve or SILO/LILO exposure, etc., you know, that we may not have seen yet?

Ed Resch

Ken, in terms of the second quarter results, the issue of SSgA reserve was evaluated as was our reserve for our SILO exposure, and both were considered to be adequate. So the answer to your question is no.

Ken Usdin - Banc of America Securities

And then as far as the investment portfolio, obviously the incremental downgrades that there were this quarter were mostly related to the monolines. As you look at the portfolio vis-à-vis the rating agencies, how do you generally continue to feel about forward-looking, I guess, waves of downgrades as far as the overall credit environment is concerned? Taking your points about money good quality of the portfolio, but just any change as far as the potential to have to even potentially impair investments even if they are, quote-unquote, money good, or is it just status quo?

Ed Resch

I think it's more or less status quo. I think that we've been doing a lot of work obviously for the last number of quarters that we've been talking about, and our work supports what we believe and what we think the rating agencies believe in terms of the asset quality. So at this point, I'm not anticipating that we'd have significant downgrades or significant impairment charges. That could obviously always change if circumstances change, but we feel pretty comfortable with where the portfolio is and where the rating agencies are and where our stress tests come out.

Ken Usdin - Banc of America Securities

And the last question is just as far as your forward thinking as far as the guidance and the kind of implied raising of the second half guidance even though you're talking about making sure we don't run rate second quarter results, I'm just wondering if you can kind of give us a thought process on what's better, what's worse versus your prior own budgeting expectations rather than consensus expectations? So as you look forward, just wondering where those kind of implicit hedges are in the business model, if any.

Ron Logue

I'd say that probably in a couple of areas, first of all, the core revenue strength is very strong. You know, we've won a lot of new business. We continue to install a lot of new business. We've also been very successful in cross selling, especially into the Investors Financial book of business. And that seems to continue, so we feel good about that.

But we also have quite a focus on expense control, which I talked about in the past. If in fact you believe we're going into a slower growth environment, we have to deal with expenses today not next quarter or the quarter after that or next year. And we're doing that, and we're doing it carefully.

And when we get an opportunity to invest a little money, we do that.

So I think core revenue strength, expense control, and I think net interest revenue, at least for the rest of the year, will be pretty much beneficial to us.

Ken Usdin - Banc of America Securities

And one quick last one, just on the conduit question, Ed, to your point before about issuing of some more sub debt, can you just speak about how comfortably above the trigger thresholds for automatic consolidation as opposed to on your own doing, you know, that the conduits remain? Like, I don't know, how much cushion there just is on both the profitability test and the credit test?

Ed Resch

Sure. There is no automatic trigger, if you will. I mean, it's governed by our FIN 46 model, but to put it in the context of how much sub debt we need versus how much we have and therefore the cushion, Ken, on our two big conduits, you know, the ones that are over $10 billion each, one has an 84% cushion - that's excess sub debt versus required sub debt - and the other one has a 50% cushion, so we've significantly increased our cushions relative to our FIN 46 model requirements.

Ken Usdin - Banc of America Securities

Okay, and it's a non-issue with the smaller ones?

Ed Resch

Yes. Smaller cushions, but much smaller conduits. I was just giving you the big ones that would have the most balance sheet impact if they were to come on.

Ken Usdin - Banc of America Securities

So you feel that there's a lot of room that you aren't anywhere close? Would the only reason you brought the conduits on be because FIN 46 changes?

Ed Resch

Yes.

Operator

Your next question comes from Brian Bedell - Merrill Lynch.

Brian Bedell - Merrill Lynch

Just a few quick questions. First, on the foreign deposit costs, what's your flexibility to bring them down further? We've already seen them come down from 2.24% in the second quarter - I'm sorry, in the first quarter - down to, you know, 153 here in the second quarter.

Kelley MacDonald

Brian, can you talk more into your telephone? It's a little hard -

Brian Bedell - Merrill Lynch

Sorry about that. Sorry. Can you hear me now?

Kelley MacDonald

Yes, much better.

Brian Bedell - Merrill Lynch

Sorry about that, yes. Foreign deposit rates, what's your flexibility to bring that down more? We've seen that come down from 224 down to 153 in the second quarter here. That's almost, you know, about a 70 basis point drop despite the ECB, well, I guess, in the third quarter, raising rates here. I'm just trying to gauge how much more flexibility you have to take that down further, or do you think, you know, that could move up a little bit in the second half?

Ed Resch

I don't think you should be thinking about a lot of flexibility there, Brian. I mean, one of the main drivers of that decline was due to the dollar component of that which is Eurodollar, okay? So those deposits benefited from the decline in the U.S. rate environment, which is manifesting itself in the numbers that you just quoted. We're not anticipating the Fed, as we said, to decline any further, so I don't think there's a lot more downside there in terms of decreasing those deposit costs.

Brian Bedell - Merrill Lynch

And you still see inflows, I mean, despite being, you know, paying rates that are lower than your peers, you still saw about $5 billion of inflows of custody deposits. Do you expect to be able to retain that, or do you think we'll see some switching out in the second half?

Ed Resch

Well, we've been retaining it pretty steadily and actually growing it a little bit so far so, yes, we do expect to retain it. Although, you know, coming into the year we said we didn't think that those deposits would exhibit the growth in '08 that they exhibited in '07, and that's really not been the case.

But yes, I mean, we expect to retain it. I mean, one potential upside there is that if for some reason rates were to go up in Europe, the ability to lag pricing could present itself again. But we're really not expecting that, as I said, in our rate forecast.

Brian Bedell - Merrill Lynch

So actually that brings me to the next question. In terms of reinvesting the $7 billion of sub debts running off the balance sheet, what do you expect to invest that in? Is that mostly going to be invested in Europe?

Ed Resch

No, not necessarily. I mean, some of it may be, but overall we're expecting to continue to invest it, you know, very conservatively, very short, given the disruptions that we've talked so much about.

Brian Bedell - Merrill Lynch

So you're going to stay away from credit risk, I assume.

Ed Resch

Yes.

Brian Bedell - Merrill Lynch

And then so if the ECB and Bank of England do raise, you might invest a little more in Europe and then try to lag the deposit rates on the foreign side?

Ed Resch

Perhaps. I mean, you know, certainly the deposit rate lagging is a potential if they were to raise.

Brian Bedell - Merrill Lynch

And then just on client conversions, Ron, you talked about $400 billion of new business being won in the second quarter. I assume all of that will be converted in the second half, and then if you can talk about what's also left to be converted in the second half from prior wins.

Ron Logue

There's some left to be converted from prior wins. Most of what we talked about today will be converted in the second half of the year.

Brian Bedell - Merrill Lynch

Any [magnitude] of what's left to be converted in the second half?

Ron Logue

I'm sorry, Brian, I couldn't hear that.

Brian Bedell - Merrill Lynch

Any magnitude of what's left to be converted in the second half? Is it relatively small compared to the --

Ron Logue

Oh, I don't know. Maybe a half.

Brian Bedell - Merrill Lynch

Half of that. Okay. And then what's your assumption for the average S&P 500 level with the new guidance?

Ed Resch

1350 for the full year average.

Brian Bedell - Merrill Lynch

You're staying at 1350, okay.

Ed Resch

Yes.

Brian Bedell - Merrill Lynch

And [BGI] re-pricing, when does that occur exactly?

Ed Resch

Well, I mean, there is no - that's all - we don't talk about that.

Brian Bedell - Merrill Lynch

That's in the run rate essentially?

Ed Resch

Yes.

Brian Bedell - Merrill Lynch

The renewal date has already passed is what you're saying?

Ed Resch

Yes.

Brian Bedell - Merrill Lynch

And it's in the run rate?

Ed Resch

Yes.

Brian Bedell - Merrill Lynch

Okay, great. And then just the processing fees, up to $77 million from - I think I may have missed that in your comments - from $54 million in the first quarter. What was that due to?

Ron Logue

I didn't hear the question, Brian.

Brian Bedell - Merrill Lynch

I'm sorry. The processing fees, going from $54 million in the first quarter to $77 million in the second quarter. Just trying to get a -

Ed Resch

I mean, that's really due to the absence of the charges that we took in the first quarter to move the conduit assets onto the balance sheet, so the absence of the charge. So other than that, it's kind of status quo for the quarter.

Brian Bedell - Merrill Lynch

Okay, so your run rate is in the 70s there basically.

Ed Resch

Right. Exactly.

Brian Bedell - Merrill Lynch

And then just one last question. What's your flexibility to reduce expenses in the second half if we are in a tougher just revenue environment for whatever reason?

Ed Resch

Well, we're doing that right - we're looking at that right now, Brian. Obviously, as you know, we're in a high fixed-cost business, so we take a look at what we can do. Obviously, we need to make sure we hire the people we need to do the processing, but we don't necessarily have to hire as many senior people. So, you know, that's one of the people issues. And then we obviously look at - one of the variables is the professional fees and the contract expenses that we do have some flexibility in increasing or decreasing over time.

Brian Bedell - Merrill Lynch

So should we think of the other expense line as being a little flexible and, I guess, on the comp line as well. You can basically take down the [inaudible].

Ed Resch

Yes, on both lines.

Operator

Your last question comes from Thomas McCrohan - Janney Montgomery Scott.

Thomas McCrohan - Janney Montgomery Scott

I just want to understand how you guys are approaching unrealized losses for both the conduit and the investment portfolio? Should we go under the assumption that the methodology you're using to value the securities for both conduits is the same?

Ed Resch

Yes. Yes, it is. It's the same for the asset classes that are the same. The conduits have more broker quoted prices than the portfolio does. The portfolio is virtually all service driven. But for the asset classes that are common to both, it's the same methodology.

Thomas McCrohan - Janney Montgomery Scott

It seems, and maybe you can add some clarification there, it seems like your - the methodology seems a little more conservative on the conduits, and here's why I'm coming to that conclusion.

Kelley MacDonald

Tom, you're breaking up. Can you try to speak a little more slowly?

Thomas McCrohan - Janney Montgomery Scott

Is this better?

Ron Logue

Yes.

Kelley MacDonald

Yes, much better.

Thomas McCrohan - Janney Montgomery Scott

Okay. It seems like the conduit assets, the valuation methodology seems to be a little bit more conservative versus the securities portfolio. And the way I'm arriving at that conclusion is if you look at, say, Page 8 of your PowerPoint presentation for the conduits, you have, you know, $15 billion worth of mortgage-backed securities, $3.8 billion of which are U.S. residential mortgage-backed securities, and as you said in your prepared remarks, there's no subprime in that bucket of $3.8 billion of U.S. residential mortgage-backed securities. And the mark on that portfolio's about 19%, so if you take the unrealized loss as compared to the face value, you know, you're carrying those at about $0.80 on the dollar.

Conversely, if you look at the securities portfolio, you have $5.7 billion of subprime assets which are marked at $0.90 on the dollar, assuming the unrealized loss is [inaudible] $92 million as of the quarter is correct, you know, which I'm sure it is. So you have assets in the conduit that don't include subprime that are related to mortgages that you're marking at $0.80 on the dollar, you have $5.7 billion of subprime assets on your balance sheet that you're marking at $0.90 on the dollar. So either I'm just looking at it the wrong way or - I just want to get some insight on that.

Ed Resch

Well, I mean, I think you have to look at a level below the aggregates. The methodology and the service that we use for both of those asset classes is the same, so while I don't dispute your math in terms of average dollar price, the build up to the aggregates is what's most important at a [QSP] level.

Brian Bedell - Merrill Lynch

The subprime assets, 62% are rated triple A.

Ed Resch

Right.

Brian Bedell - Merrill Lynch

The U.S. residential mortgage backeds, which don't include subprime, 72% are rated triple A.

Ed Resch

Correct.

Brian Bedell - Merrill Lynch

So just on the surface on your numbers, you know, it looks like it's a much more, you know, [inaudible] risky, but you're marking it down more than the securities portfolio.

Ed Resch

Relative to the subprime specifically, Tom, you have to look at the 62% triple A being actually a positive factor because of the paydowns that we're receiving on those securities. If you look back at the triple A component over time you'll see that it's declined from a much higher level down to the current level, and that's because of the structure of those securities, where the payments that we get come down from the top and the losses that are incurred come up from the bottom. Since we're at the top of the stack from a credit perspective, we're receiving paydowns and that's why we say none of those securities are in arrears as to principal or interest.

So it's simply the mathematical calculation of triple A and double A bucketing relative to the paydowns that's driving the 62% number that you quoted. That's actually a good thing.

Brian Bedell - Merrill Lynch

What's the average FICO for that subprime exposure? Do you have that?

Ed Resch

I can find it. Do you see it?

Kelley MacDonald

No, I don't have it.

Ed Resch

I'm sorry. I don't have it at hand. We'll have to find out.

Kelley MacDonald

I can get it for you. I'll get it for you, Tom.

Thomas McCrohan - Janney Montgomery Scott

Thanks, Kelley.

Kelley MacDonald

Oh, wait a minute. It's 626.

Thomas McCrohan - Janney Montgomery Scott

626, okay.

Operator

Ladies and gentlemen, we have reached the end of allotted time for questions and answers.

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Source: State Street Corporation Q2 2008 Earnings Call Transcript
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