道富銀行 (STT) 2002 Q3 法說會逐字稿

Please stand by.

Good day, everyone, and welcome to the Investors Financial Services Corporation third quarter earnings release conference call.

Today's call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to Mr. Joe DeChristofero.

Please go ahead, sir.

Joe DeChristafarro(ph): Thanks, Operator.

Thank you for joining us on today's call.

We'll be making a number of forward looking statements which are based on management's assumptions and predictions as of today.

The company's actual results may differ materially from our current predictions due to any one of a number of factors.

Information regarding the factors that may affect our actual results is set forth in the MD and A (ph) section of our most recent 10(k) and 10(q).

I recommend that anyone listening to this call review those reports carefully.

Because this call will be archived on our web site, I want to emphasize again for anyone listening at a later date that the statements made today are based on our assumptions as of today, October 10th, 2002.

These assumptions may change, but the recording of this call will not be updated.

Joining us on today's call are Kevin Sheehan, Chairman and Chief Executive Officer, Mike Rogers, President, and John Spinney, Chief Financial Officer.

I will now turn the call over to Kevin Sheehan .

I will begin by reviewing some key points from the third quarter and then John Spinney will discuss the financial results in more detail and update your guidance for your models.

Diluted EPS for the third quarter came in at 26 cents.

Essentially flat on a late quart basis and up 6 cents or 30 percent from quarter 3 of last year.

As of September 30th, we processed approximately 742 billion of assets for our clients, down approximately 93 billion from 835 billion as of June 30th, 2002 and down 72 billion from the year-end 2001.

The third quarter , to the surprise of no one on this call, was difficult, to say the least, for capital markets.

To recap for the quarter (ph) the S&P 500 index declined approximately 18 percent and the Nasdaq declined approximately 20 percent.

We converted approximately 4.6 billion in assets from new clients during the quarter.

These assets represented the I-dex (ph) mutual fund business that we announced on last quarter's call as well as the new assets from A I G. In addition, we added 7.4 billion in new assets from existing clients during the quarter.

Sales to existing clients came from Eat on Vance(?), [inaudible] fixed income I shares and Goldman Sachs.

Finally, market depreciation in client fund flows resulted in 6 billion decrease in our assets processed during the quarter.

The pipeline for new business remains at 40 million in annualized revenue.

To review, we define pipeline as the annualizes revenue on outstanding bids we believe we have a 50 percent or greater likelihood of winning the business.

As of today, substantially all the assets assumed from the outsourcing of B GI's North American operation have been converted to our platform.

The BGI conversion will be completed in the fourth quarter.

To summarize, we again delivered solid results for our investors during the third quarter in an extremely difficult market.

These results have been driven by our business' diversified revenue mix and continued favorable interest rate environment.

Now I'd like to turn the call over to John Spinney, who will review the quarter's financial results in more detail.

Good morning.

As Kevin mentioned, third quarter diluted EPS came in at 26 cents a share, basically flat on a late quarter basis.

Our diluted EPS at 26 cents represents a 30 percent increase over the third quarter of 2001's EPS of 20 cents and our year to date EPS of 76 cents represents a 41 percent increase over 2001's year to date EPS of 54 cents.

As we have stated on prior calls, diluted earnings per share and net income for 2002 both exclude the amortization of good will in accordance with the provisions of FASB 142.

Net operating revenue, which is made up of net interest income, fee income and transaction income, increased 1 percent late quarter in 14 percent over the same quarter of last year.

For financial statement presentation purposes, we report two components of our revenue, net interest income and fee income which includes our transaction based fees.

But each of our revenue sources is derived from the same core securities processing business.

We did not gather deposits for their own sake like a retail bank.

Instead, we generate net interest income by investing the residual cash of our asset processing clients who use our balance sheet as a convenient way to invest their excess cash.

As I mentioned before, we generate fees based on assets under administration, net interest income and the number of transactions generated by our clients.

It has been our experience that during market down turns, our net interest income and transaction volumes typically increase providing a hedge to our asset sensitive revenues.

The break down of our revenue stream for the third quarter was 51 percent asset based 33 percent net interest income and 16 percent transaction based.

I'll now walk through the significant income and expense components in more detail.

Net interest income increased 4 percent late quarter primarily due to the growth of our balance sheet which is driven by an increase in client funding and borrowings.

Offsetting this was a prepayment penalty as a result of an asset liability strategy.

To prepay a high rate F H L B advance with one of their (?) lower rate.

We maintained healthy net interest margins spread percentages despite the flattening of the yield curve during the third quarter.

The late quarter interest rate spread contracted 7 basis points to 2.1 9 percent, where the length quarter net interest margin contracted by 6 basis points to 2.39 percent.

Compared to the same quarter of last year, net interest income was up 24 percent due both to a steep EL (ph) curve and the increased size of our balance sheet.

Our fixed rate mortgage backed portfolio, like many others, has experienced higher than normal prepayments as a result of drop in the 10 year treasury.

While we are experiencing these higher than normal prepayments, we have been able to reinvest these cash flows in mortgage back securities with attractive spreads.

Over the past year, we have shifted our focus on new purchases to short duration pass through MBS's especially 3-1 and 5-1 hybrid arms.

These securities help keep our yield up while minimizing extension risk.

Our liability sensitivity has shrunk since the beginning of the year due to shorter duration but we still remain liability sensitive.

As long as interest rates remain low or go lower, we intend to maintain the same posture, replacing fixed rate run-off with short duration fixed rate paper. 90 percent of our investment portfolios invested in securities backed by the U.S. government or triple A rated Muni (ph) securities.

As a result we've been able to avoid credit losses and maintain strong net interest income and margin.

Asset based fee income decreased 1 percent late quarter despite 11 percent decrease in our assets under administration.

Our ability to win business and the ability of our clients to sell additional product, thus generating fund flows, allowed us to minimize the impact of the pronounced market downturn of the third quarter.

Also contributing to this positive lack of correlation is our tiered pricing structure for asset based fees since we have detrimental pricing schedules for asset based fees as asset values deteriorate, revenue is only impacted by the asset decline at the then marginal rate.

Transaction driven income, in which we include our ancillary services such as securities lending foreign exchange fees and cash management fees, increased 6 percent late quarter and 37 percent year over year, driven by strong foreign exchange and securities lending revenues over the past year.

Linked quarter foreign exchange fees increased due to higher transaction volumes and volatility in the currencies traded by our clients, while securities lending was down 34 percent in late quarter as a result of market value declines, spread compression and the continued lack of capital markets activity.

Also Q2 is seasonally higher due to the payment of dividends on foreign stocks.

Total operating expenses increased 1 percent in late quarter.

We were able to reduce our compensation and benefits expense by 2 percent on a late quarter basis. an increase in occupancy expense accounted for the majority in the increase in our operating expenses.

Occupancy expense was up 21 percent in late quarter as a result of or need to take down additional space and in anticipation of future revenue growth driven by new client wins and expansion of existing relationships.

We continue to maintain strict cost controls especially in the face of weaker equity markets.

As mentioned on our last call, the Massachusetts Department of Revenue has issued the bank a notice of intent to assess data excess taxes of 6.2 million related to dividends it received from its majority owned REIT (ph).

The bank along with over 40 others has joined a coalition to obtain a declaratory judgment from the state's supreme judicial court.

We are currently in that process and expect to prevail.

As such we have not provided for any additional state excise tack.

Despite the market value decline experienced during the third quarter and the prepayments on our mortgage backed portfolio, we are made comfortable with our 2002 EPS guidance at 101 to 103.

Absent another severe sustained downturn in the equity markets, we remain comfortable with our long term EPS growth rate of 25 percent.

I'd now like to open up this call for your questions.

Thank you. the questions and answer session will be conducted electronically.

If you would like to ask a question, press star 1 on your touch tone keypad.

We will take as many questions as time permits and take the questions in the order we receive them.

Again if you would like to ask a question, please press star 1.

Our first question will come from Tom McCanliss (ph) with Keith Brett wood.

Tom McCanliss (ph): Yes, good morning, gentlemen and congratulations.

Several questions.

You talk about how your comp. and bennies (ph) went down, when your head count, I guess, is going up.

Is there any kind of reversal going on there?

That's the first first question.

Yes, comp and benefits is down as a result of some head count reduction and lower bonus accruals in the third quarter because we had bonus accruals in the first and second quarter, but it's a combination of two things: head count down quarter to quarter and excessive cost accruals now.

Tom McCanliss (ph): Second question is: It looks like you had a terrific success in your cash management business this quarter.

Could you talk about what was driving the success there?

I think a couple of things are driving that: Further penetrations of our clients due to continuing sales, as well as market conditions that result in a natural hedge.

You know, this is one business that we look at and our customers, you know, pay us servicing fees and sometimes they want that servicing fees paid by compensating us with balances.

Tom McCanliss (ph): Okay. and the next question I have is for Kevin and anybody else I suppose, but could you talk a bit about the environment today, what it's like, your ability to generate, you know, keep a pipeline that's around 40 million of new business when the way you all define it, I would anticipate it's tougher to make the sales, tougher to make close the sale.

Is there any light at the end of the tunnel, or are my perceptions more generic and you all are able to do things that are unique to RFN (ph)?

I think we've seen a pretty active market.

This is typically a time when portfolio managers and investment management companies are looking at ways to reduce their operating costs.

They look more strategically at their business.

I think from sales standpoint here we have tremendous level of activity.

Exactly when those pieces of business will close is essentially unknown to us, but I will say that there's been extremely high levels of activity in the sales process.

Tom McCanliss (ph): Do you get a sense you all are looking at bigger business, bigger pieces of business than you were 6 to 9 months ago?

Certainly on the outsourcing side of the equation there are more and more people looking at more comprehensive undertakings in terms of externalizing their component of the business and their business needs are broader based right through their middle office operations.

Tom McCanliss (ph): One other question in terms of your assets under administration.

How do they break down between equities, bonds and cash?

At the end of the quarter, Tom, 69 percent were in equities and 31 percent was in fixed income.

We don't break up fixed income by bonds and money markets.

Tom McCanliss (ph): And then finally, what appears to be a little bit of reduced leverage on your balance sheet, net interest income growing, has the duration changed?

Are your purchases, your new money purchases a little bit longer duration than what your existing duration is in the investment street book?

Our duration is down from 1.6 years to 2 at the beginning of the year.

I think what we've done very effectively here is to buy securities that don't have extension risk if rates go up and have used these market conditions to lower risk in our portfolio.

Tom McCanliss (ph): Terrific.

Thank you all very much.

Sure.

Thank you.

Our next question will come from John Ofstrum (ph) with RBC Capital Markets.

John Ofstrum (ph): Good morning, guys.

Good morning, John.

John Ofstrum (ph): Can you talk about the historical success you've had in converting the pipeline, you talk about greater than 50 percent probability, but what has that been historically, is it higher than 50?

Basically, John, we prevail on about 25 percent of the business that we chase, so I would say that our historical conversions at least been one out of every four.

RFP's and proposals we go out on we're winning.

John Ofstrum (ph): But the pipeline, the pipeline number that you give, you talk about having it greater than 50 percent success potential?

Yes.

John Ofstrum (ph): So it's likely to be higher than 50 percent , is what you're saying

Yeah, it could be.

John Ofstrum (ph): And then in terms of your net interest income assumptions, particularly when you talk about your larger than 25 percent growth rate, what assumptions are you making for '03?

Right now we're making assumptions that fed funds rate will stay where it is until about July and then over the next 30 months after that at 225 basis point rise in that; that's what's baked in our model.

And we're assuming, with that, we're talking about a flat net interest income line item for '03 right now.

John Ofstrum (ph): So flattening of the curve?

The other thing, then, would be just in terms of client fund flows: You talked a little bit about market declines versus client fund flows.

How are your clients performing?

Are they seeing increased fund flows in general, can you make a generalization there?

I think -- we don't track the actual fund flows because we're not the T A for the clients.

But intuitively what I like to tell investors and folks like yourself is that we've got a client base that's not necessarily retail focused, but more institutional focused, that sells a lot of retirement product. and as a result, we've got that recurring asset flow every single year from the $11,000 that people put into 401(K)'s and 403 B's and those type of retirement plans.

So although we don't break it out intuitively based on our ability to our assets to go down less than the marketplace, we're probably gathering more assets than probably most other institutions.

John Ofstrum (ph): The last question for Kevin.

How confident are you in your ability to sell through this, in other words, to be able to sell enough business to get to that 125?

I think every year we're confronted with this.

I don't think this is anything unusual for us.

We come into the end of the year with a certain amount of business on our books and typically the progression we've made in the ensuing years is business that we have to close out of the pipeline.

And I think our history suggests we've been pretty effective in doing that.

We've certainly pulled back to 25 percent growth rate in the face of declining markets, but I think we're very bullish on our business and we think we can drive that 25 percent next year.

John Ofstrum (ph): Okay.

Thanks a lot, guys.

You're welcome.

Thank you.

Our next question will come from (inaudible) Cinto (?) with Cinto (?) Capital.

Cinto (?): Good morning.

I was wondering if you guys can talk about your tier 1 leverage.

Just doing sort of back of the envelope calculation, I have you guys at something like six and a half percent including trust preferreds. and then I guess what I'm really sort of getting at is: what does that really mean in terms of growth of average-earning assets going forward?

I think our leverage capital ratio is closer to 5 and-a-half to 5.6.

And I think, with the leverage ratio, we've said to the regulators we're going to maintain that above 5 percent.

So I think we do have room for growth in the balance sheet and earning assets.

However, that said, the driver of the earning asset side is typically the ability to track more deposits from our clients and that's typically how we grow the balance sheet.

However we do ALCO (?) policies that allow us to borrow he and require us to maintain no greater than a 40 percent borrowed funds position at any point in time.

We've actually been running much lower than that as client funding has been very strong and our balance sheet is about 80 percent client funded right now.

Cinto (?): What does that mean in terms of where you can get average earning assets can go from here?

I think they could go up as far as 8 billion by the end of next year.

Cinto (?): Wouldn't that take you below 5 percent in terms of tier 1?

We're going to generate capital every single quarter that will keep us within that 5 and-a-half to 5 percent band.

Cinto (?): Your outlook for margin over that time frame is?

Pretty much flat with this year which is probably expected around 140 million.

Cinto (?): Okay.

Thank you very much.

Yep.

Thank you.

Again, if you would like to ask a question today, please press star 1.

We'll now go to Charles Trafton (ph) with Adams Harkness.

Charles Trafton (ph): Hi thanks.

Good morning.

The 93 million in asset decrease from June to September, could you shed a little light on how much was lost clients versus fund flows and market gains?

There were no losses.

Charles Trafton (ph): Okay.

What about sales to new clients in September?

Let's see.

I think I covered that.

We converted about 4.6 billion from new clients and 7.4 billion in new assets from existing clients during the quarter and the market depreciation was about 106 billion.

Charles Trafton (ph): Great.

You had a similar kind of market depreciation a year ago in the 80 billion range and you seem to come through the last four quarters pretty well.

A lot of that was because you got very large clients.

Is your average deal that you guys are pitching now much larger than in the past because of the BGI (ph) business has allowed you to pitch for larger business?

I wouldn't say -- I would say there are certainly larger pieces of business in the mix, but I think it's right across the board.

I don't think we're focused on any one specific tier of business.

Charles Trafton (ph): Is the sales cycle for that business in the last year the same, longer, shorter? more of an urgency to out source right now or are people [inaudible]?

I would say in the last couple months there's been some reluctance to pull the decision making.

I think a lot of firms have been caught up with the budgeting process trying to figure out what the impact is going to be for them in the coming year, but I expect that to turn around fairly shortly.

Charles Trafton (ph): Do you think that will loosen up at year-end, is that when a lot of those decisions are made?

I think so.

Charles Trafton (ph): Great.

And the occupancy has gone up 40 something percent this quarter.

What do you think that will do in the next four quarters?

I think we've got adequate space to carry us into most of next year.

So I don't think we'll see much of an uptick except for -- I'm sorry, we're going to add some space in Dublin next year so we'll get a little bit of increase in '03 related to Dublin.

But, that space that came on this quarter with some space in Boston...

Charles Trafton (ph): Right.

We won't be adding space in Boston for the next 12 months or so at this point.

Charles Trafton (ph): What about head count between now and the end of the year?

In order to make your growth goals, do net add 5 percent heads, zero?

I'd say as it's 5 percent.

Charles Trafton (ph): Okay.

Thanks .

Thank you.

Our next question will come from Tom Williams with C W.

Good morning.

Quick question on your investment portfolio: The disclosure previously said about 75 percent of your portfolio was in mortgage backs.

Can you talk to me about how you calculate your duration?

And if you're buying 5-1 arms and funding those with the overnight sweep and deposit, how do you feel your durations matched?

First on the match, while they have a -- those deposits are core, they're part of the business, they're here all the time.

We've had some outside firms review that and they've concluded that they're also core.

And we look at our portfolio and it's 48 percent fixed and the remainder is floating rate or adjustable rate of securities.

So we feel comfortable that the liabilities do match to the assets.

Every two weeks we run an assimilation of interest rate shop, up 200 basis points, up 300 basis points, down 100 basis points, and we aggressively manage the result of that so that we can grow the company long term.

Charles Trafton (ph): When you say it's reviewed, can you tell us who reviews these?

We have a treasury operations and treasury department produces the documents and they're reviewed at ALCO (?) that this is Mike I sit on, Kevin sits on, John Finney sits on as well as the Head of Treasury Spike Sylvester.

Charles Trafton (ph): And when you talk about your mortgage portfolio being -- or that the deposits being core, if your assets under custody go down, certainly that's going to impact the deposits that are there, that's the mutual fund companies, correct?

It typically has not because the float that's coming from fail activity, redemption activity, other residual cash, really hasn't -- doesn't change based on market conditions.

Or if anything, as the market goes down, those redemptions pick up, people become more conservative and leave more cash with us.

Charles Trafton (ph): All right.

So I just want to make it clear, the review that you spoke of is really an internal review?

Yes, but we also have an outside consultant come in and validate that our assumption and our process is sound.

Charles Trafton (ph): And your net interest margin sounds like declined 6 or 7 basis points depending on how you look at it?

That's right.

This quarter.

Charles Trafton (ph): What's your outlook, you know, given the flat and the yield curve and the very high prepayment fees on the mortgage portfolio?

We have it coming down throughout the next 12 months which is why we believe, even though we're going to increase deposits on the balance sheet, that management's income is going to stay flat.

Charles Trafton (ph): So, increase the investment portfolio will enable you to maintain your net interest income, but the margin will decline?

That's right.

You know, I think it's important to note here that less than a billion dollars of those assets that are on the balance sheet, liabilities are on the balance sheet are not core to the business.

So these deposits, again, are generated by our clients and we feel comfortable here in an increasing market and in a decreasing market.

Charles Trafton (ph): I guess your deposits are 2.7 billion?

But also on the line that is borrowed funds or repo's, many of those are repo's come from our clients that are required to have them collateralized.

Charles Trafton (ph): All right.

So the line that reads short term and other borrowings, a significant portion of that is generated by our clients and is just the deposit that's collateralized.

Charles Trafton (ph): And finally, what percentage of your estimate of [inaudible]

They're about 60 percent.

I can give you that.

Hold on a second.

Yeah, just under 60 percent.

Charles Trafton (ph): Thank you very much.

Yep.

Thank you.

Our next question will come from Brian (inaudible) with Standard Morris.

Hi, guys.

Just wondering what capitalized software expense was in the quarter.

It looks like June 30th of '02 was 16.3 million.

Can you comment, about a third of pretax income, it looks like it represented the entire year over year, increase in net income in the first half?

Also, why was it up so much year over year in the first half versus one H O '01 (ph)?

Capitalized software for the quarter was 8.9 million Q2 was 8.6, Q1 was 7.7.

And primarily the reason it's up was that we've got some major initiatives going on straight through processing and the remainder of the builds that are being done for the Barclay's (ph) conversion also some software we've written to totally replace our future fund add min (ph) system, and also a couple of web products to enable our clients to get data and manage some of their assets -- asset information independently.

The other thing is: the only reason we capitalize this stuff is because the FAS (ph) standard 98.1 requires us to do it and that's why we're capitalizing what we're capitalizing.

What's the amortization policy?

The amortization policy is three to five years depending on the useful life of the asset.

Thanks a lot.

Sure.

Thank you.

Our next question will come from Kathy Kerry (ph) with Robert W. Baird.

Kathy Kerry (ph): Good morning.

Good morning, Kathy.

Kathy Kerry (ph): Just a quick question, John, about your assumptions for market values on you're talking about the net interest income portion being flat.

Are you looking at the market and staying at the levels that it's at?

And I guess from your comments coming off the 25 percent growth rate, if we were to see a significant decline, is that like another 20 percent down?

Yeah, I would say it's fair to say another 20 percent down.

My assumptions for '03 are flat equity markets.

We haven't baked in any ramping up of the equity markets to achieve the $1.27.

So I think if we had a major melt down from here we'd have to relook at our guidance for next year.

Kathy Kerry (ph): Okay.

I saw an article recently I think it was in the Wall Street Journal about BGI closing down a couple of their I share funds.

Just in general, is that something that's hurting asset values, too, as companies start to shut down or consolidate funds that don't have a lot of assets in them or aren't performing well?

You know, I think at least on the B GI example they closed three down and opened four up and they were extremely successful with their new fixed income products that they rolled out this quarter.

So I think we see that across the board with all of our clients, if there are some products that are not working, they are closing down, but they're finding other products that will be successful and opening those up.

Kathy Kerry (ph): Great.

Thanks.

Thank you.

We'll next hear from Brad Moore (ph) with Putnam Lovell.

Brad Moore (ph): Hi, good morning. a couple things: First off on the revenue pipeline, can you just take me through that again?

Is that the 40 million in annualized revenue, is that from both new and existing clients and does that include net interest income as well?

No, that pipeline is primarily from new clients and it does not include net interest income.

Brad Moore (ph): Okay. with regard to the -- is it safe to say, then, -- well, let me just shift tax. with regard to BGI, has there been any success at all in terms of moving that client relationship to a new level, or is it basically currently just the custody and the accounting work?

I think there's been some huge success in terms of moving into the next level that we are essentially done with the conversion, and that we achieved moving the largest outsourcing deal in the industry's history to a scalable platform that can be reused and I think they're very pleased with the effort that we've done in hitting our time goals there.

We have been able to upgrade a couple of the accounts to include FX trading and we'll continue to pursue that and other opportunities.

Brad Moore (ph): Okay. with regard to the competitive landscape, are you still seeing the same competitors currently in the environment?

Yes.

Brad Moore (ph): OK.

With regard to pricing trends, are you sensing that your clients are now getting more competitive or no change in pricing?

[inaudible] pricing continues to be relatively stable but as we always told you it's very competitive out there, so.

Brad Moore (ph): OK.

And then can you give us shares outstanding at the end of the quarter?

Sure.

It's 64,547,952 and fully diluted, 66,276,997.

Brad Moore (ph): Okay. and last question, I think you gave us the revenue changes securities lending down 34 percent late quarter.

Was that correct?

34 percent, right.

Brad Moore (ph): OK.

And then FX, can you repeat that?

That was up 24 percent in late quarter.

Brad Moore (ph): OK.

Great.

Thank you.

Yep.

Thank you.

Our next question will come from Jim Jones (ph) with Caribbean Partners.

Jim Jones (ph): Good morning.

I have a couple of questions: the first, just going back to the question about capitalized software expenses -- if I do my math right, if you go to your pretax and you do the numbers without the software, capitalized software expenses, I assume that they are expensed, your year to year comparison would be that there was little or no growth.

Yeah, I see what you're saying.

Yep.

Jim Jones (ph): Is that correct?

That would be pretty correct assumption, but I think the value of capitalized software is creating an asset to drive the revenue and the growth of the company in the future and that's why it's capitalized as an asset.

Jim Jones (ph): Okay, I understand.

Another question.

I believe that all of the members of the financial services round table which includes some of your competitors like State Street and Bank of New York, plus most of the other large money center banks have agreed to extend stock options.

Yes.

Jim Jones (ph): I think in the past this has had a pretty big impact on your net income delusion factor some 30 odd percent, 37 percent, I think, in 1991.

What are your plans on future expensing of stock options and what is the likely impact on 2002 EPS and also your current estimate of impact on projected 2003 earnings?

Well, I think, first of all, that 2002, I don't think will be impacted by expensing options as we haven't made a decision to do that yet.

We're waiting for the FAS-B (ph) (inaudible) exposure draft this past week on transition rules to 123. and also still kind of looking at the calculation of the value under the (inaudible) other method which is similar to what that group of institutions you mentioned earlier came out with.

They all said they were adopted and they're waiting for what's the right valuation methodology.

I think we're going to evaluate the transition rules and make our decision as we move into '03, the first year that would impact us.

And our planning assumptions, we're planning to have some expense in '03 and just haven't bona fide the exact amount based on what the grants we're going to provide.

Jim Jones (ph): But in terms of us being able to do our analysis, should we assume something around sort of 30, 37 percent level?

No.

Actually, last quarter on our call, I came out with some revised guidance on that footnote you're referring to. and in our assumptions in that 2001 annual report, a 10- year life was assumed and, in reality, the average life of the options was 2.8 years.

However, because the FAS-B (ph) requires you to use the longer of the vesting period or the average life, we had to go to a default of four years.

Using a four- year life on those options created a 20 percent delusion versus 37 percent delusion.

Jim Jones (ph): Okay.

So roughly a 20 percent delusion going forward from stock options expense if you decide to go forward with it?

From an EPS perspective, yes.

Jim Jones (ph): Just one more question on capitalized software costs.

How much have you capitalized in total in round numbers?

I'm going to say about 35, 40 million since we started capitalizing Jim Jones (ph): Okay.

Thank you.

Yep.

Thank you.

We'll next here hear from Jerry Swank (ph) D Swank Group Brokerage (ph).

Jerry Swank (ph): Hi, guys.

Some of my questions in the custody business have already been answered, but a couple things.

When you look at your numbers it's obvious in the business model that, you know, the custody business without the deposits loses some money.

Is there any reason to change that model?

And secondly, you comment on the competition, but I'm surprised given that some of your competitors are having pretty big problems as it relates to businesses you're not in, like commercial loans, etc., that the pricing environment in the custody business isn't alleviated somewhat.

Could you comment on that?

And then I have a couple portfolio questions to ask.

I think the biggest misconception about the business is that we're in multiple different businesses as they relate to the net interest, income and asset based fees.

The reality is: when we go out to price a piece of business we go through an expense buildup process and then we give the client the opportunity to pay us an asset base fees, transactions fees, or any kind of a sweep or overnight product that goes on our balance sheet. and that is taken through a comprehensive analysis to put us in a position where we're generating a positive performance on that piece of business.

We don't have any independent deposit gathering function that we drive in the organization.

It all relates specifically to the asset processing business.

That's how we get those deposits.

Jerry Swank (ph): Let me asking something here.

Do your competitors use that same model and does the absolute level of rates in the curve matter when you do that or is your model kind of been the same on pricing today as it was a few years ago?

I think it's relatively the same, and I think our competitors use very similar models. and we give the client the host of capabilities to employ with his cash: they can be third-party vehicles, it can be on our balance sheet, they have various in terms of currencies that they put in those deposits, time frames that they utilize during the day to place and invest those deposits with us overnight.

So I think there's a tremendous level of flexibility all of us extend to the client bases.

Jerry Swank (ph): Do you feel you ever lose business because one of your competitors is more aggressive on a curve trade or on quality of the taking lower quality or more riskier assets on the balance sheet than you do?

I think fundamentally the drivers in the business have always been service levels and technology.

Those to me are the two most finite deliverables.

I don't think there is enough differentiation in the pricing of deposit products or some of the other aspects of the business to make that much of a difference.

I think we're extremely competitive and we use the technology to get us to competitive pricing across the board with the day to day servicing components.

Jerry Swank (ph): And so the other thing, given some of the loan problems your competitors has it still hasn't impacted their attitude or pricing in the marketplace?

I don't think so.

I think they see that as a different component of the business.

Those are typical corporate relationships that have nothing to do really with the asset servicing side of their model Jerry Swank (ph): A couple other things on the portfolio and your ALCO (ph) committee meetings and your portfolio monitoring and you're up and down which is very interesting stuff.

Could you share with us, are you using your own software?

We saw yesterday we had a couple guys in your neighborhood smart head fund guys blow up because obviously their prepayment model wasn't very good.

Could you share with us whose model you use, Merrill's model or Gold man's model?

And as it relates to your portfolio?

Surely you must be more nervous than you were three months ago about prepayment, just about prepayment models for all mortgage securities being valid.

We use several different models and look at the results that come out of all of them.

You know, we have tried to since 1998 buy securities that don't have a premium or only have a slight premium, so we don't get hit with a huge penalty.

We do have some reinvestment risk and I think that's why reinvesting the security at a lower rate which is why we are forecasting net interest income to stay flat. the example that I think you referred to of yesterday's announcement was the situation where people were selling securities short and we don't take those types of bets.

We are trying to hit singles over and over again and not take on huge risk here that, if our model doesn't work, we will have a problem.

Jerry Swank (ph): Thanks.

Thank you.

Our next question will come from John Henry (ph) with Vicar Young Capital Management (ph).

John Henry (ph): Yes.

Thank for taking the call.

A quick question for you.

You answered most of my questions in regards to the custody sign ins.

Historically it looks like most of your custody growth has come from acquisition.

Is that a strategy going forward as well?

I would say historically, absent the Bar clay's(ph) piece of business which is the largest outsourcing to date in the industry, our assets primarily have come from sales to new clients and existing clients and this hasn't been a grow by acquisition type strategy.

So I don't think that's a fair statement.

John Henry (ph): I just look at the Chase acquisition and a few of the others as well.

Just going forward, though, is that a major part of your growth strategy or it's not I guess from what you're saying?

I think the growth rates we've put out there and the guidance we've provided is purely organic.

John Henry (ph): OK.

Anything that we do would be above and beyond that.

John Henry (ph): OK.

Your revenues for the most recent quarter and your pure custody revenues, actually, went up quite a bit despite the decline in the overall custody growth.

Is that because you're actually get being better pricing power on a per asset under administration basis?

Well, the core fees late quarter are actually down about a million and a half.

As I said earlier, I think one of the benefits that we have is I did a little analysis of our revenue streams and as the assets come down there's a lot of funds that are at a higher key on their sliding scale the decremental fee schedule.

So as assets came down 20 percent, a lot of the thresholds are still at the upper levels which minimize the impact on the revenues for the quarter.

John Henry (ph): Okay.

All right.

Thank you very much.

Thank you.

We'll next hear from David Foster (ph)with Body Brown Asset Management (ph).

David Foster (ph):Hi, thanks.

Most of my questions have been answered, but following up on an earlier question, could you provide a breakdown of your short term borrowings, how much was repo and how much was federal home loan bank and others?

Of the 3.4 that is in the results, about 2 billion of that was internal repo with our clients, approximately half a billion of that was long term federal home loan advancers that we use to hedge some risk, and about a billion was short term financing through either reverse repo's or fed fund borrow.

David Foster (ph): The billion, the last part, the billion financing, that's not client driven ; is that correct?

Right.

David Foster (ph): Okay. and do you also -- can you give us some idea or break down of what percent of your deposits come from some of your major clients, how much from Eton Vance (ph), Bar clay's, any other clients that are significant sources for these deposits?

We don't give out that information.

David Foster (ph): Okay.

That's all I have.

Thank you.

Yep.

Thank you. and we'll now hear from Glen Shapiro (ph) with Sigma Capital.

Glen Shapiro (ph): Hi.

I think my question is a follow-up to an earlier question which was just looking at the core custody business and what it is as a percentage of assets under administration.

I'm wondering if you can walk me through the pricing a bit because quarter over quarter it went from -- and I'm looking at end of period but from 27 basis points up to 31 basis points.

So I'm wondering if that's a sustainable new level of fees as a percentage of assets under administration that you guys are going to be able to maintain or is it a bulk of the assets priced off earlier in the quarter so I should expect the percentage to come down once assets under administration stabilize and as a result that fee line to be lower than the 57 million probably more than the 54, 55ish range?

How did you come up with 27 basis points on that?

Glen Shapiro (ph): I took in the second quarter I took 57 million and annualized it and divided by the end of period, 835 billion.

That's not right.

We're not even near 27 basis points on custody assets.

Glen Shapiro (ph): OK.

Can you walk me through -- I'm just looking at it.

Maybe I'm not using the right number I'm getting a miscalculation.

But just looking at it, the custody dollar amount actually stayed relatively constant quarter over quarter but the assets under administration went down, as you said, 93 billion?

Yes.

Glen Shapiro (ph): Can you walk me through how the pricing is working for the fact that the dollar amount of fees generated off of significantly lower asset base, how that works in terms of if it's sustainable or not or pricing went up or priced off the beginning of the quarter?

First of all, a majority of our revenues are derived from average daily net asset values.

They're not period end assets. and then I think, as I said earlier from a revenue perspective, you know, we're in decremental fee schedule similar to investment advisors.

So if you're at quarter of a basis point or half a basis point or basis point at the upper level tier of that fee schedule on any particular client, in the next tier down is one basis point or one and a half.

As the assets come down right now in this down draft we've suffered, we're losing revenue at let's say half to a quarter or one basis point. and then as you move down the decrements, the basis points go up.

So as you stop moving down, you would have more revenue impact.

But we haven't seen that yet because the assets are over those thresholds.

Glen Shapiro (ph): Okay.

I apologize.

What I've done is I just grossed it up into basis points so it would be easier for me to look at.

I agree it's not 27 basis points.

It's some hundredths of it.

So I guess my question is, is there pricing jump ups because assets are falling per customer?

So the pricing scale is actually going up so that you guys can maintain the same dollar amount, or should I expect that line item to go down over time?

If the markets go down you should probably see that number go down.

Glen Shapiro (ph): Okay.

So I'm looking at assets under administration down 100 billion, quarter over quarter.

I'm just wondering, is it 57 million I should be expecting kind of in the lower to mid 50s for the fourth quarter?

For asset fees?

Glen Shapiro (ph): Yes, for custody fees.

I don't know off the top of my head, but it's probably somewhere north of that.

Glen Shapiro (ph): Okay.

Do you see where I'm going with it?

I know you guys have reaffirmed guidance for the fourth quarter.

I guess my question was: I see kind of the core business coming down a little bit, so where is it getting made up in the fourth quarter [inaudible] you have a new level down on the amount of assets that you guys administer?

I would stay relatively flat from where we are today, maybe down a little bit.

We've got other business that will potentially convert in the fourth quarter that will add assets, that will add fees.

So I wouldn't move too far off where we are today.

Glen Shapiro (ph): Okay.

So I mean I was just thinking I should expect a sharp uptick in the assets, holding markets flat I should expect a sharp uptick into the assets under administration in the fourth quarter, back up by 100 billion. and it would have to come on pretty early in the quarter so that you can hold those daily averages pretty constant over the course of the quarter?

I think what we showed you in the last quarter was assets came down 11 percent and it had what...

1 percent decrease in ...

So I think if you saw a similar impact, that's what you'd see in term of decremental, if you saw asset recoveries, you'd see it work literally in the inverse of that equation.

But offsetting that will be new business that comes in the across a broad base of tiers, depending what size piece of business comes in.

You don't have to see $100 billion jump up to get us back to where we were.

Glen Shapiro (ph): Okay.

I don't want to take a lot of you guys time.

I'll call you off line.

I'm just having trouble understanding that with assets under administration being 100 (?) billion in the quarter that you guys would be able to maintain the same dollar amount in custody...

Call us.

Glen Shapiro (ph): Okay.

I appreciate it.

Our next question will come from Tom McCanlis (ph) with Keith Brettwood.

Tom McCanlis (ph): Yes, just related to your initiatives, I know STP is a prerequisite for you and your major competitors.

And I think I understand that you're going to be somewhat STP ready mid year next year.

Is that a factor that goes into your planning process for new business next year?

And specifically, what is the thoughts towards planning for deposit growth next year?

What kind of deposit growth are you guys looking for?

Is it contingent upon clients more new business once you get to that next level of technology readiness, is it contingent upon new business that you're pretty sure you're going to win in the first quarter?

I'm just trying to get a better handle on deposit growth how and/or if there is any linkage to STP along with [inaudible] curiosity in interest as to how you will be positioned on the STP front.

I think deposit growth is linked to just core business growth.

I don't think that's directly related to STP.

We believe we have some huge advantages with STP.

Over 90 percent of our trades today come straight through to us from our clients and get turned around all electronically without human hands touching them. and we believe our technology platform gives us a long-term competitive advantage, because when most of our competitors talk about STP, they talk about STP only through the settlement of the securities.

When we talk about STP, it includes settlement of the security, but it also includes the portfolio economy, the general ledger accounting and the pricing and NAV calculation of the impact of those transactions all hit straight through processing.

Tom McCanlis (ph): Along with order process, trade order processing and messaging?

That's right.

Tom McCanlis (ph): So and the other 10 percent of your trades I suppose, is that what I understand will be more electronically driven...

I think 5 percent of those get implemented in the next week or so with BGI switching to our technology, and the other 5 percent right now with advisors that can't get us those trades electronically, and we're working with them to get them so it will all be straight through processing.

Tom McCanlis (ph): Then going -- that's great.

Then going back to the deposit question, what kind of deposit growth are you all anticipating and how much of that will be driven by new business versus taken more from existing clients?

From that standpoint, we don't care whether it comes from new business but we prefer to penetrate existing clients.

I think as I said earlier, we're looking at balance sheet of 8 billion at the end of the year, Tom.

In order to get there it's going to be through mostly client deposits.

Tom McCanlis (ph): OK.

In '03.

End of '03, 8 billion.

Tom McCanlis (ph): And then finally, could I just go back and revisit the competitive question, it would seem that investors financial would be in a good position to lease from a marketing perspective as you're going out to get new business because so many of your competitors have credit or have had credit related issues and/or are focused elsewhere, particularly just looking at what's going on with JP Morgan Chase.

Are you finding attitudinal change among your client base in the bidding process?

I don't think related specifically to credit exposure, no.

Tom McCanlis (ph): Great.

Well, thank you very much.

Yep.

Thank you.

We'll now have a follow-up question from Brian (inaudible) with Standard Morris.

My follow-up has been asked.

Thank you.

Thank you. and we'll now have a follow-up question from Tom Williams (ph) with C W. Tom Williams (ph): Yes.

If you could just please clarify, it appears as though despite an 11 percent drop in your assets in your custody, your asset servicing and other fee revenues actually increased sequentially.

How did you accomplish that?

It's pretty extraordinary.

Well, I think we talked a little bit about pricing in that I think the other piece that drives that is the FX was a good quarter for us and sweep fees were good.

John, I think the other thing, sorry to interrupt you, that is impacting here is the new business that was sold both and converted in both the second and third quarter helped offset some of the market value declines.

That's correct.

Tom Williams (ph): Could you briefly give us a run down of those non-interest revenue line items?

Yes.

The FX -- actually it's on an 8(k), but the FX was 7.7 million.

That was up 24 percent.

Securities lending was 2.4 million, down 34 percent.

Sweep fees were 4.4 million, up 18 percent. and investment advisory was flat at 1.8 million.

Tom Williams (ph): And then the expense breakdown again?

Between...

Tom Williams (ph): Operating expense breakdown, please.

Yeah, hold on a second.

The ones we talked about comp and benefits was down 2 percent.

Occupancy was up 21 percent.

Those were the two biggest ones of note.

Tom Williams (ph): All right.

Thank you.

Yep.

Thank you. and we'll have a follow-up question from Jim Jones (ph) with Caribbean Partners.

Jim Jones (ph): Yeah.

I'm trying to revisit my projections for 2003.

If we take the quarter just announced and annualize your net interest income to get to roughly 140 million of net interest income for next year which is what you've said you're expecting, and then we take the asset servicing fees which have declined about 1 percent, I'm also looking at your total operating expenses which have gone up about 4.2 percent on eye quarter on quarter basis I'm struggling to get to the point where I take that bottom line of 26 cents a share and I get to a growth of 25 percent from that number, which if you annualize is a dollar 4 to the $1.20 to $1.25 range we're expecting for next year because your expenses are growing and even if you get did you remember you're going to have to get a lot more servicing business in order to make up for that growth in expenses.

I think in our projections for '03, we've annualized our current book of business and we've also factored in the 140 million of net interest margin.

And I think coming out of the blocks we were probably only 17 cents off of hitting a buck 27 at that point in time. and we clearly have said to everybody we talk to that we realize that net interest income is going to be flat and we are going to make a dollar 27 by sales to new clients and existing clients which we have done historically in the past and are comfortable with doing.

And I think from an expense perspective, some of the expense growth you're seeing is step variable in terms of like the occupancy that came on this quarter.

We're going to have very little increase in occupancy expense relative to next year's revenue growth.

So we're getting a little bit of a pinch for that right now, but and the other thing you're going to see is just a reduction, I think, in expenses on the run rate going into '03 as we've just been through the 2003 budget process and have revise revisited all expense items and re-forecasted those to get to our dollar 27 Jim Jones (ph): So your run rate now on your current analysis if I understand you gets you -- means that you have to get 17 cents worth of new business in order to make the number for next year?

Yeah, in a simplistic model, yes.

Jim Jones (ph): Okay.

I understand. and that's excluding the impact of any changes in options expensing and things that were discussed earlier?

At the buck 27, there's no option expense number in that.

Jim Jones (ph): Thank you.

Yeah.

Thank you.

And we do have another follow-up question from Brian (inaudible)with Standard Morris.

Yes.

You haven't announced in the large custody business signings.

Do you have any expectations for Q4 and '03 for new custody signings in your assumptions for the buck 20 and change?

Like I said, we've got pipeline of 40 million of annualized revenue.

It's good business in that pipeline.

And I think what I'm kind of hearing is you're looking for big chunks of custody assets, but I think I want to clarify that whether it's 100 billion or 10 billion, I could end up with the same revenues.

It really depends on what services the clients takes.

I think from an analyst's perspective I'd focus on the services that are sold to the assets versus the absolute size of the assets that are brought in.

But are you looking at any acquisitions in this area of the business?

And I guess if so, what kind of [inaudible] rates are you using, what are your acquisition metrics?

First of all, we're not specifically looking at any acquisition in this space right now. and our acquisition matrix or criteria is basically it's got to be fit into the current, you know, operating strategy and it's got to be accretive within the first 12 months of its life with us. and those are the base criteria.

We don't want to denigrate our growth margin.

Excuse me.

What do you attribute this strong growth in FX revenues to?

This quarter it was-- we came out in July the first few weeks in July strong transaction volume, it continued into the August time frame, a little slower towards September, beginning of July we had some good volatility in the marketplace.

It's really two way flows and additional penetration of our clients.

Why would this be sustainable, given only 3 percent of international assets?

Because we've made further penetration with different advisors and we think they are going to continue to trade both in and out of the U.S. dollar.

Thank you.

Thank you.

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