道富銀行 (STT) 2007 Q2 法說會逐字稿

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  • Operator

  • Good morning, and welcome to the State Street Corporation second quarter conference call and webcast.

  • Today's discussion is being broadcast live on State Street's website at www.StateStreet.com/stockholder.

  • This call is also being recorded for replay.

  • State Street's call is copyrighted.

  • All rights are reserved.

  • The call may not be recorded or rebroadcast or distributed for distribution in whole or in part without expressed authorization from State Street.

  • And the only authorized broadcast of this call is housed on State Street's website.

  • Now I would like to introduce Kelley MacDonald, Senior Vice President for Investors Relations at State Street.

  • Please go ahead.

  • Kelley MacDonald - SVP, IR

  • Good morning, everyone.

  • Before Ron Logue, our Chairman and CEO and CFO Ed Resch begin their remarks I would like to remind you that during this call we may make forward-looking statements relating to the Corporation's business and financial goals, plans and prospects and its business environment, among other things.

  • Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in State Street's 2006 annual report on form 10-K and its subsequent filings with the SEC.

  • We encourage you to review those filings including the sections on risk factors concerning with any forward-looking statements we may make today.

  • Any such forward-looking statements speak only as of today, July 17, 2007 and the Corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

  • In addition, information relating to this webcast including information concerning and reconciliations of non-GAAP measures referred to in this webcast is available in the Investors Relations section of our website, www.StateStreet.com/stockholder under the heading "annual report and financial trends." Now I will turn the call over to Ron.

  • Ron Logue - Chairman, CEO

  • Thank you, Kelley.

  • Good morning, everybody.

  • At State Street we again are reporting another strong quarter.

  • We are meeting our long-term goals for growth in revenue, earnings per share and for achieving return on equity.

  • Excluding the tax adjustments recorded in the second quarter of 2006, our record operating earnings per share grew 15%, and our record revenue grew 16% in the second quarter of 2007.

  • And we achieved 19.2% return on equity.

  • We once again achieved positive operating leverage on a sequential quarter basis and were compared with the prior year's quarter.

  • This marks the 11th consecutive quarter in which we achieved positive operating leverage compared to the prior year's quarter.

  • We are leaders in fast-growing markets like hedge fund servicing and electronic trading.

  • We continue to make progress in servicing hedge funds where our assets under administration are $242 billion.

  • And when conbined with Investors Financial are $441 billion on a pro forma basis.

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

  • As we said, more than two years ago, we expect to grow non-US revenue to 50% of total revenue over time.

  • For the full year 2006, 43% of State Street's revenue came from non-US sources.

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

  • For the second quarter servicing fees, management fees and securities finance revenue all grew in double digits compared to the second quarter of 2006.

  • Servicing fees at 12%, management fees at 22% and securities finance revenue at 27%.

  • All three were driven by new business from new and existing customers.

  • We won servicing awards for custody, fund accounting and fund administration from two large US mutual funds, Baron's US mutual funds representing $18 billion in assets, as well as $12 billion from Fifth Third Bank's asset management group.

  • SSgA's growth came primarily from new business, particularly in the area of quantitative active management.

  • Net interest revenue and net interest margin again performed very well, achieving a 44% increase in fully taxable equivalent net interest revenue compared to the second quarter of 2006, and a net interest margin of 164 basis points during the second quarter of 2007.

  • And Ed will provide further details about these results and our outlook in a few minutes.

  • Trading services revenue increased slightly, up about 1% principally due to the revenue from the Currenex acquisition.

  • As you may remember, trading services revenue in the second quarter of 2006 was its strongest quarter ever growing 53% compared to the second quarter of 2005.

  • On the expense side we grew our expenses at a rate less than the rate of growth in revenue which resulted in about 130 basis points of positive operating leverage on a sequential quarter basis.

  • We achieved positive operating leverage of about 90 basis points in the second quarter of 2007 compared to the second quarter of 2006, our 11th consecutive quarter of positive operating leverage compared on this basis.

  • Now let me give you just a few new business highlights from the second quarter.

  • On the servicing side, in addition to the awards from Baron's Funds and the Fifth Third Bank asset management group, both of which I've already mentioned, HSBC Investments has appointed State Street to manage collateral for its institutional clients, managing and tracking collateralized transactions and providing a reporting service that enables clients to customize parameters, including eligibility of collateral, margin requirements and concentration limits.

  • Now this collateral management service is a good example of the capabilities we gain when we make acquisitions.

  • We inherited the original version of this service when we acquired the global securities services business from Deutsche Bank who had been offering this service to its customers in Europe.

  • We've enhanced the service now and it has become a highly sought after by our customers as the role of derivatives plays a much more important role in day-to-day investment management.

  • I am sure we will find similar, less evident opportunities to enhance our productline with the Investors Financial acquisition.

  • We are also pointed to provide global custody accounting, independent swaps pricing and reconciliation services to the Somerfield Pension Scheme for GBP300 million in assets, as well as performance measurement services from WM Performance Services, the European performance measurement division of State Street.

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

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

  • State Street global advisors also added significant new business.

  • In the second quarter of 2007 about 75% of SSgA's new business was in active management, enhanced indexing, hedge fund strategies and active quantitative management.

  • Net new business at SSgA in the second quarter was $32 billion.

  • Also during the quarter, State Street Global advises an offering what we call edge strategies reached the $10 billion level.

  • These strategies, known as 130/30, offer investors some of the advantages of a hedge fund while continuing to remain closely tied to a benchmark.

  • As I said, we are pleased to achieve a very strong first half of the year, the consolidation of Investors Financial is now well underway.

  • We will track our progress each quarter through 2008 so you can evaluate our results just as we did with the Deutsche Bank transaction.

  • Looking into the second half of the year, I remind you that we typically see a slowing in revenue from trading services, as well as securities finance in the third quarter compared to the second quarter, at least that has been the case in the majority of the past five years.

  • However, like last year that does not stop us from seeking positive operating leverage on a prior year basis.

  • Let me now update you on the integration of Investors Financial.

  • Since the announcement in February, an experienced group of State Street employees has focused on the planned consolidation, working with their colleagues from Investors Financial they have brought together the two businesses as smoothly as possible.

  • And more importantly, provided for a consolidation that is as seamless as possible for our customers.

  • These two groups, now unified at State Street, are continuing their work, meeting with customers, refining our plan for consolidation and implementing specific conversions.

  • One of the reasons that we are confident that this consolidation will be a success and a win for the customers is that we are retaining the key relationship managers who will continue to provide the high level of customer service that the customers of Investors Financial have been used to.

  • As I announced last quarter, they will work under the direction of Michael Rogers, now an Executive Vice President of State Street and formerly President and Chief Operating Officer of Investors Financial.

  • Investors Financial's unaudited results for the first six months of 2007 included annualized revenue growth of 18% and annualized expense growth of 15%.

  • Based on both the strong results at State Street and at Investors Financial in the first half of 2007, we are now revising the financial goals we established in February after we announced the Investors Financial acquisition.

  • We now expect that revenue will grow between 20% and 22%.

  • Excluding merger and integration charges, we expect that operating earnings per share growth will be between 10% and 15% and that operating return on equity will be between 14% and 17%.

  • We also believe that we will perform in the upper half of these ranges for 2007.

  • The EPS and ROE ranges, excluding merger and integration charges, are the original ranges we established in January before we announced the acquisition of Investors Financial.

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

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

  • Ed Resch - EVP, CFO, Treasurer

  • Thank you, Ron, good morning everybody.

  • The first half of the year represents a good start for 2007.

  • We reported strong growth in both fee and net interest income.

  • Our growth in asset servicing, asset management and securities finance continues at a combined rate of about 14% compared to the first half of 2006.

  • Securities finance was particularly strong as is usually the case in the second quarter.

  • We continue to expand globally, introducing new services to a broad base of customers.

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

  • Our net interest margin improved to 164 basis points in the second quarter, up 44 basis points from last year's quarter and up 19 basis points from the first quarter.

  • Obviously the positive trends in our liabilities I mentioned last quarter continued into this quarter.

  • I will provide more detail on our net interest income and margin in a few minutes.

  • We achieved positive operating leverage compared to the second quarter of 2006, as well as when comparing the second quarter of 2007 with the first quarter of 2007.

  • The 11th consecutive quarter our assets under custody were at a record level for State Street at the end of the quarter.

  • On a pro forma basis combined with Investors Financial our assets under custody would be about $15 trillion at June 30, 2007.

  • Our assets under management of $1.9 trillion also stood at a record level at the end of this quarter.

  • We included the first and second quarter results for Investors Financial on page 3 of our financial trends package which I encourage you to review on our website.

  • Based on those six-month results, Investors Financial was operating at an annual run rate of about $940 million in revenue and about $660 million in expenses.

  • Those figures represent an annualized increase of about 18% in revenue and about 15% in expenses.

  • As you may recall from Investors Financial's fourth quarter conference call, management at that time expected expenses to grow between 21 and 24% in 2007.

  • The difference between the results of the first half and Investor Financials management's expected increase in expenses is annualized at about $40 million in cost saves and cost avoidance after the acquisition was announced.

  • As a result, our expectations are still that we will remove approximately $350 million from Investors Financial's cost base with approximately $310 million in annualized costs to be removed over the next 18 months.

  • I hope you have 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 to discuss our results.

  • We reported earnings per share of $1.07, which are up 57% compared to $0.68 per share from the prior year quarter included the tax adjustments and up 15% excluding those adjustments.

  • Revenue totaled $1.9 billion for the quarter, an increase of 16.4% from last year's second quarter compared with a 15.5% increase in expenses to $1.4 billion.

  • Return on equity was 19.2% compared with the return on equity from continuing operations of 14% including the tax adjustments and 19.2% excluding those adjustments.

  • Now I would like to discuss the details of our results compared with the prior year's second quarter.

  • Servicing fees were up 12% to $766 million due to new business from existing and new global clients, as well as higher daily average equity valuations.

  • Assets under custody at the end of the quarter were at a record of $13 trillion, up 20% from $10.9 trillion a year ago.

  • State Street Global Advisors continues to post very strong results.

  • Investment management fees were $284 million, up 22% due to new business and increases in month end equity valuations.

  • Performance fees were about $20 million, up from $16 million a year ago.

  • Assets under management at the end of the quarter were at a record of $1.9 trillion, up 26% from $1.5 trillion a year ago.

  • Compared to the second quarter of 2006, the month end averages for the S&P 500 in the second quarter of 2007 were up 17%.

  • EAFE was up 22%, and the NASDAQ was up 16%.

  • The Lehman US aggregate total return index was a -0.52% at the end of the quarter.

  • Trading services revenue, which includes foreign exchange trading and brokerage and other services, was up about 1% to $260 million.

  • Weaker volatility, partially offset by stronger volumes, drove a 9% decline in foreign exchange trading revenue.

  • Foreign exchange trading revenue was down $18 million to $174 million compared with a record quarter in 2006.

  • Brokerage and other fees were up $20 million to $86 million from the previous year's second quarter.

  • This increase was primarily due to $16 million in fees from Currenex.

  • Securities finance revenue was $162 million, up 27% from last year's second quarter due primarily to an increase on assets on loan.

  • In the second quarter this year the average volumes of securities lent increased by more than 30% compared to a year ago and spreads were up slightly.

  • Processing fees and other revenue were down $9 million to $65 million, primarily as a result of the consolidation of tax-exempt investments onto our balance sheet at the end of the third quarter of 2006, offset somewhat by income from joint ventures.

  • Revenue resulting from this consolidation is now recorded in net interest revenue.

  • Net interest revenue on a fully taxable equivalent basis increased $122 million or 44% from $275 million to $397 million.

  • In addition, compared to the second quarter of 2006, net interest margin increased 44 basis points from 120 to 164 basis points.

  • The favorable trends that I cited during the first quarter call continued in the second quarter.

  • Higher levels and a favorable mix of customer deposits, a continued favorable non-US rate environment, a higher yield on reinvestments in our securities portfolio and a higher level of lower-cost funds.

  • We increased the average size of the portfolio from $59.4 billion a year ago to $67.7 billion during the second quarter.

  • Mortgage-backed securities in the second quarter of 2007 represented about 38% or $25.4 billion of the average investment portfolio.

  • Floating-rate asset-backed securities in the second quarter of 2007 represented about 36% of the average investment portfolio or $24.4 billion.

  • On a pro forma basis combined with Investors Financial, approximately 43% of the portfolio will be in mortgage-backed securities and also about 43% in floating-rate securities.

  • The total pro forma portfolio for the combined company would have been about $77 billion as of June 30, 2007.

  • The credit quality of the portfolio at June 30, 2007 has remained about the same as at last year end, 94% is invested in AAA or AA rated securities.

  • As of June 30th, 87% with invested in AAA, and 7% in AA rated securities.

  • As I have mentioned previously, the credit quality of the portfolio will remain relatively unchanged following the consolidation with Investors Financial.

  • Now I'll provide more detail on comparable expenses.

  • Salaries and benefits expenses were $808 million, up 18% from $684 million last year, largely attributable to the impact of incentive compensation due to our improved performance, increased staffing to support new business and acquisitions and merit adjustments.

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

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

  • I will remind you that we calibrated this expense line to match our strong growth in revenue this quarter.

  • Our expectations are that other operating expenses for State Street alone in the second half of 2007 should be consistent with the average of the first two quarters this year.

  • The effective tax rate for the quarter was 35%.

  • Let me give you some of the headlines regarding the results of the second quarter compared to this year's first quarter.

  • Revenue was $1.9 billion, up 13.3% or $225 million compared to $1.7 billion in the first quarter with increases in every line on the income statement except processing fees and other revenue.

  • Expenses were $1.4 billion, up about 12% or $145 million.

  • Earnings per share of $1.07 in the second quarter were up 15% compared to $0.93 per share in the first quarter of 2007.

  • Servicing fees were $766 million, up 7% due to new business and improvement in daily average equity valuations.

  • Management fees of $284 million were up 9% due to new business and an improvement in month end equity valuations.

  • Trading services revenue was up 18% this quarter compared to the first quarter of 2007 from $220 million to $260 million.

  • This increase was driven by improved volumes in foreign exchange trading offset partially by lower volatility plus the effect of Currenex in the quarter.

  • Securities finance revenue was up 65% to $162 million from $98 million due primarily to an increase in spreads, as well as seasonal demand.

  • The duration of the lending book stands at 35 days at quarter and.

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

  • Net interest revenue and net interest margin improved due to the continuing benefit from execution of our balance sheet strategy, as well as continued growth in non-US businesses.

  • As a result, our net interest revenue on a fully taxable equivalent basis increased by 18% from $337 million to $397 million compared to the first quarter.

  • Net interest margin improved 19 basis points to 164 basis points.

  • We continue to benefit from our non-US growth and the continued favorable non-US interest rate environment as well as a higher level of free funds.

  • Also our investment portfolio strategies continue to contribute to growth in net interest revenue through portfolio repricing.

  • We issued $1.5 billion of debt during the quarter, $800 million in trust preferred and $700 million in senior debt.

  • We also called for redemption $500 million or outstanding trust preferred securities in June.

  • I said on last quarter's conference call that if the current trends we saw continued, we expect our net interest margin for 2007 to be above 135 basis points.

  • Since the trends continued and in fact improved in the second quarter, we now believe we will be above that level for all of 2007 more likely in the range of 155 basis points.

  • Our transaction deposits are running historically high levels and non-US rates continue to rise, a favorable factor for us.

  • In addition, US rates have remained steady for a year now.

  • We have experienced these favorable trends for three quarters now and I am comfortable relying on them in providing this outlook.

  • However, we are still cautious about their sustainability over the long-term.

  • Also last quarter I was asked about our asset-backed securities in the investment portfolio that are backed by subprime mortgages.

  • Since there has been continuing interest in that subject, let me add some color.

  • First of all, these are securities that have been issued with subprime mortgages as collateral, and they are 78% AAA rated and 22% AA rated.

  • They have performed very well and the current ratio is down from 80% AAA and 20% AA in the first quarter, reflect the AAA rated securities paydowns.

  • We have an average dollar price of just over par, approximating book value at the end of June.

  • And for each vintage year from 2003 to 2006 we have significantly outperformed the Moody's performance data.

  • In addition, these securities have an average 36% credit enhancement on them versus a 5% to 8% historical cumulative loss experience in the marketplace.

  • So what that means is that even if losses were to double we still have more than twice as much cushion than is needed to protect ourselves from losses in this position.

  • So we are very comfortable in terms of our entire asset-backed position, as well as the position that is backed by the sub prime mortgages.

  • We don't expect any significant negative financial outcomes due to this element of our investment portfolio.

  • Regarding net interest revenue, just a few points to keep in mind.

  • Our duration gap has not changed significantly from year end.

  • Our assets are about 1.2 years, and our liabilities are about 10 months in duration.

  • The investment portfolio is about 1.7 years in duration, flat for the second quarter of 2006 and up from 1.5 years at March 31, 2007.

  • On a pro forma basis combined with Investors Financial the duration of our investment portfolio would have been about 1.6 years.

  • In the second quarter operating expenses increased 12% from $1.2 billion in the first quarter.

  • Salaries and benefits increased 9%, transaction processing was up 9%, information systems and communications were up 2%, occupancy was up 4% and other expenses were up 45%, primarily as a result of increases in costs associated with new business initiatives, the acquisitions of Currenex and Investors Financial and increased securities processing expenses.

  • Return on equity was 19.2%, up from 17.4% in the first quarter.

  • Let me share with you our plans and outlook relative to capital.

  • In order to protect our regulatory ratios, as I mentioned earlier, we have not repurchased any of our stock during the last 12 months due to the adjustments to equity we recorded in the fourth quarter of last year and in the first quarter of 2007, both of which we have previously disclosed and which amounted to $390 million after tax.

  • Additionally, we've had to consider the impact of the recent acquisitions of Currenex and Investors Financial in our thinking.

  • We issued about 61 million shares of State Street common stock to the Investors Financial shareholders on July 2nd.

  • Also, as we have said previously, we intend to repurchase about $1 billion worth of our common stock after the Investors Financial closing.

  • The principal capital ratio that we manage to is the Tier 1 leverage ratio.

  • We will continue to target between 5.25 and 5.75% but from time to time may be above that level if prudence dictates.

  • At June 30th our Tier 1 leverage ratio stands at 6.06%, and our tangible, common equity ratio is 4.83%.

  • In conclusion, the first half of the year represented a very good start for us.

  • We continue to balance growth in revenue against our expenses so as to achieve positive operating leverage on an annual basis.

  • We have revised our expectations for the financial performance of State Street trade this year due to the performance of Investors Financial in the second quarter and in particular the strong year-to-date performance of State Street.

  • We are confident about performing the upper half of the revised ranges for all of 2007.

  • With that, I will turn the call back to Ron.

  • Ron Logue - Chairman, CEO

  • Thank you, Ed.

  • We now begin the second half of 2007 with strong first-half results from both State Street and Investors Financial.

  • And with our plans for consolidation of Investors Financial well underway.

  • We have confidence that we will meet the financial targets we established today, two of which EPS and ROE, were our original financial targets before the Investors Financial acquisition, while the revenue goal has been significantly increased.

  • And again, as we have said, we believe we will perform in the upper half of these ranges.

  • We have received excellent feedback from customers with whom we are planning conversions.

  • We have added employees to State Street who have been recognized for their customer service and who will contribute to our ongoing success.

  • The acquisition strengthened our lead in our high-growth businesses such as services to mutual funds, hedge funds, offshore funds and investment manager operations outsourcing.

  • And we've added the capability to service private equity investments.

  • I would ask you to also keep in mind our long-term objectives.

  • First, to generate non-US revenue or 50% of total revenue over time.

  • While our overall growth is strong, our growth in Europe and Asia continues to outpace the US.

  • We strenghened our leadership in the past year in non-US locations and those investments are paying off.

  • With the acquisition of Investors Financial we expect to begin offering our global services to those customers who previously went elsewhere.

  • Second, to make SSgA a larger contributer to State Street's bottom line.

  • SSgA continues to execute on its strategy of adding quantitative, active investment strategies for both new and existing customers, which is paying off in growth in revenue and profits.

  • And third, to prudently work our balance sheet harder.

  • With our net interest revenue and net interest margin up significantly over the past two years, I hope you will agree we are successfully executing on this objective.

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

  • Operator

  • (OPERATOR INSTRUCTIONS) Glenn Schorr, UPS.

  • Glenn Schorr - Analyst

  • Thanks.

  • Can I just check what is in the -- maybe for Ed -- what is in the other expense bucket that would cause the big spike?

  • I'm just trying to get my arms around such great revenue growth across the board and expense growth almost keeping pace.

  • I just want to see how much is in there related to maybe Currenex, IFIN or any discretionary spending, if you could.

  • Ed Resch - EVP, CFO, Treasurer

  • Okay, Glenn.

  • As I said, yes, we tried this quarter given our view of very strong revenue to calibrate our expenses accordingly.

  • So we have some discretionary spending in there, as well as some elements of expense related to the acquisitions.

  • Nothing in and of itself is significant or material, if you will, but we have acquisition related costs both for Currenex and Investors Financial.

  • We booked a fair amount of goodwill associated with Currenex and intangibles, and there is amortization associated with the intangibles that will be in the run rate for the next number of years.

  • We increased professional services expenses for new business initiatives really across the Company; we spent some money in information technology, treasury, global securities lending and certain marketing expenses.

  • And then lastly, the other broad category is sales promotion; we ramped up our sales efforts this quarter given the strength in revenue.

  • So nothing in and of itself significant, but if you add them up and that's what we did in recognition of the strong revenue picture, I think that my comments going forward for the next two quarters would give you an indication of where our thinking is.

  • Again, given our forecast for the rest of the year in terms of the other expense line being in the range of about $150 million per quarter, and that is State Street stands alone.

  • That is not including IFIN.

  • Glenn Schorr - Analyst

  • Perfect.

  • Exactly what I was looking for.

  • Only other question I really have is so you continue to see good growth in the non-US deposits.

  • And I get the ability that a lag deposit pricing as rates rise; the question I have is how did the rate go down by 36 basis points in the quarter?

  • In other words, if you look at the interest rate paid on interest-bearing non-US deposits just interesting it is great, but it is interesting.

  • Ed Resch - EVP, CFO, Treasurer

  • That is really just a function of the mix, Glenn, the mix of the deposits drive that result.

  • Glenn Schorr - Analyst

  • Okay, so is it something that you can influence, or is that a function of that is what type of deposits customers are bringing to you?

  • In other words --

  • Ed Resch - EVP, CFO, Treasurer

  • It is much more the latter.

  • It depends what form the deposits come in as to the extent to which we can lag or not lag.

  • Glenn Schorr - Analyst

  • Okay, just I guess difficult for us to project, but understand it and appreciate it.

  • Thanks.

  • Operator

  • Michael Mayo, Deutsche Bank.

  • Michael Mayo - Analyst

  • I didn't fully understand your last answer.

  • Your funding costs and $50 billion of non-US deposits are down 36 basis points; and is there some sort of compensating balances you are getting for the processing business or anything else going on there?

  • Ed Resch - EVP, CFO, Treasurer

  • No, this is Ed, it is as I said a function of mix, and you have to get a little bit deeper into that number to recognize that about 25% of it as of this quarter end is Eurodollar, so it is dollar-base liabilities.

  • And then we have a swap on against some of the residual back into US dollars.

  • So it really is just a function of what the liability mix is at any given quarter as to what we're paying.

  • Michael Mayo - Analyst

  • And with regard to non-US I guess you add 6% linked quarter growth in assets under custody.

  • What was that growth outside the US only?

  • US versus non-US?

  • Ron Logue - Chairman, CEO

  • It is probably a little more than 50% outside the US, Mike.

  • Michael Mayo - Analyst

  • Okay, so revenue growth linked quarter, was it stronger outside the US?

  • Ron Logue - Chairman, CEO

  • Yes, we've been seeing that.

  • Although recently citing the wins that I just talked about, we are seeing I think a resurgence in US growth particularly in the mutual fund arena.

  • Michael Mayo - Analyst

  • Okay, and why do you think that is a resurgence in mutual funds in the US?

  • Ron Logue - Chairman, CEO

  • I think there is more interest in outsourcing and mutual funds in the past had probably done a lot of the accounting themselves and let out custody to more general custodians.

  • And now that there are fewer organizations who can do both custody and accounting, it is becoming apparent that if they want to do that, there are only so many places they can go to get that done especially now with the IFIN consolidation.

  • Michael Mayo - Analyst

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

  • Ron Logue - Chairman, CEO

  • Yes.

  • Michael Mayo - Analyst

  • Is that because you are feeling better about IFIN, because you're feeling better about State Street stand alone or both?

  • Ron Logue - Chairman, CEO

  • Both.

  • Like we said before, these two organizations are mirror images of each other, and that is playing out.

  • Michael Mayo - Analyst

  • And your retention target for IFIN?

  • Ron Logue - Chairman, CEO

  • 90% Revenue.

  • Michael Mayo - Analyst

  • And are you feeling better about that?

  • Ron Logue - Chairman, CEO

  • Feeling very good about it.

  • Michael Mayo - Analyst

  • And what about the Barclays contract?

  • Can you give us an update on that or when would we get an update?

  • Ron Logue - Chairman, CEO

  • Well, we are servicing them today.

  • Michael Mayo - Analyst

  • Okay, and will there be a change in that or an update or it is just business as usual?

  • Ron Logue - Chairman, CEO

  • Not that I know about.

  • There are going to be a lot of -- I'm sure there are going to be organizations that are going to look to do things; but as I'm talking to you today no one has told us they are leaving.

  • Michael Mayo - Analyst

  • Okay.

  • All right.

  • Thanks.

  • Operator

  • Nancy Bush, NAB Research.

  • Nancy Bush - Analyst

  • Good morning, guys.

  • Ed, question for you.

  • I guess I'm like everybody else now in net interest margin.

  • I'm sort of scratching my head and going, how high is up?

  • Is there sort of a structural limitation to margin here, or can it continue to advance this way?

  • If you could just sort of drill down into that number a little bit because I'm adjusting by leaps and bounds here, and I'm trying to figure out whether I should continue to do that.

  • Ed Resch - EVP, CFO, Treasurer

  • Right, I think probably the best way to think about that is to go back to what I said in February when we made some comments about '07 through '09 in terms of net interest margin.

  • And there are really I guess three elements to what I said.

  • One is the investment portfolio and what we are doing on the asset side.

  • The other is our forecast of rates, and the third was our liability behavior.

  • And I would say that from what we said in February to what we are seeing now, we got the first two pretty much right.

  • The investment portfolio on the asset side has behaved as we thought, and our rate prognostication has been pretty good, maybe even a little bit too conservative in that foreign rates have gone up a little more than what we thought.

  • But the big change from what I said earlier and now, and what we're thinking about at least the rest of this year is the liability behavior of our customers.

  • And what we are seeing is stronger equity markets and higher volumes and significantly above trend deposits, especially in transaction accounts for us.

  • So what we are seeing at least through the rest of the year, Nancy, is a continuation in that strength which is one of the reasons or the main driver of why I said 155 would be the full-year margin.

  • But I do have an element of caution to it saying that these balances can be potentially volatile to some degree.

  • So we are cautious.

  • I am not updating '08 and '09 at this point.

  • I will probably have some more comments about our outlook for '08 and '09 and update my February comments in September.

  • I don't think that there is an answer to the structural margin question that you posed.

  • I think that we have seen the liability behavior improve fairly significantly for us.

  • And like I said before, if it continues to improve we will continue to show a greater margin.

  • Right now we are seeing out to the end of the near and a 155 margin for the full-year.

  • Nancy Bush - Analyst

  • Ron, just a quick question for you.

  • One of your competitors that is involved in a very large merger apparently is doing custody business for free at this point.

  • And you have not responded to that pricing.

  • Can you just tell us how customers are responding to this and how you are responding to those pressures?

  • Ron Logue - Chairman, CEO

  • Sure.

  • I guess probably the best way I could say it, Nancy, is that customers seek value.

  • It's all about value.

  • It's not about price.

  • And to the extent that we provide added value I think customers see through that long-term.

  • As you know, we have a policy of not doing things for free, not relying on other types of promises for revenue.

  • I think long-term that is the wrong thing to do.

  • I can cite lots of examples of business that we lost against bids that were for free where those customers came back.

  • I think we're going to continue to do that, and it's really about value.

  • We are going to keep that strategy.

  • It has worked in the past.

  • I believe will continue to work in the future.

  • I am sure that we may lose some pieces of business that were zero price bids.

  • That is going to be okay.

  • The business that we are winning, we are winning because people see value.

  • And I believe strongly that value will win over price.

  • Nancy Bush - Analyst

  • Can you point to one product or in the delivery of value, I mean I understand the concept but is there a product or a quality of the Company or something that tends to be the hook there?

  • That keeps that business?

  • Ron Logue - Chairman, CEO

  • Generally speaking it probably has to do with some type of accounting component, whether it is daily price mutual funds, hedge funds, private equity, offshore funds; it usually surrounds accounting because it is much higher degree of difficulty to do and it's very expensive.

  • And I think is one of the reasons why you see a number of organizations outsourcing that because it is getting more difficult and much more complex; obviously the emergence of derivatives are a good example of that.

  • It is why we bought Investors Financial, because of their strong accounting capability.

  • There are very few organizations out there who can do it, and who can do it at scale.

  • And I think the real secret there is doing it at scale, and we can and they can, and not too many others can.

  • And the value is around different types of accounting components and then from there, there are all sorts of, as we call it, cross-sell revenue that comes from that.

  • Nancy Bush - Analyst

  • Thank you very much.

  • Operator

  • Brian Bedell.

  • Brian Bedell - Analyst

  • Just to go back on the net interest margin question, I guess just on the foreign deposit line.

  • So you would not expect that 329 cost to be sustainable, right?

  • I mean, that should be trending back up to a level at least nearer what it was in the first quarter, in the second half?

  • Ed Resch - EVP, CFO, Treasurer

  • I think it depends, Brian, on what happens with foreign rates.

  • The longer that rates continue going up in non-US terms, the longer we have to lag.

  • And in actuality, what happened in the second quarter is that our lag lengthened a bit, which contributed to another element of our positive result of foreign net interest revenue and net interest margin.

  • But eventually at some point when rates stop, there will be a -- when non-US rates stop going up, there will be a cessation of our ability to lag, and it will catch up.

  • Brian Bedell - Analyst

  • Right, but it sounds like you answered earlier, most of it was due to the mix shift.

  • You got just a bunch of deposits and at much, much lower costs, given those customer preferences of the services.

  • So I guess what I'm asking for the third quarter, is that sort of mix shift in aberration for the second quarter, or do you think those lower cost deposits stick around second half?

  • Ed Resch - EVP, CFO, Treasurer

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

  • Brian Bedell - Analyst

  • Okay.

  • And then as we think about '08, '09, I know you're not updating your estimates yet, but before I think you had an '09 target of 150 that at that time was 15 to 20 basis points higher than where you were operating at.

  • Should we consider if we have the same type of trends that you -- that we are seeing right now and if that increase over the next two years was driven really by the reinvestment yields on the portfolio, which is very predictable, then should we think of you guys getting to sort of like 165, 170 by '09?

  • Ed Resch - EVP, CFO, Treasurer

  • Again, I don't want to go into '08 and '09 yet, but your basic thesis I think is correct.

  • I go back to the buildup to the discussion we had in February, which is we were correct or close to correct about the asset side and the rate side.

  • If you remember, we forecast rates staying constant, both dollar and nondollar rates, for '07, '08 and '09 in that workup.

  • So the one big swing factor in the analysis so far has been the liability behavior.

  • And if, in fact, the liabilities continue to exhibit more favorable characteristics in '08 and '09 than what we modeled them on, yes, we will do better than what we said in February for '08 and '09.

  • That's clearly what has occurred here in the first half of this year and why we are saying what we're saying about all of '07.

  • Brian Bedell - Analyst

  • Great.

  • Then you also mentioned when you -- before you guys closed the IFIN merger, when IFIN came on they were doing some things also on the deposit side in having sort of some lower deposit costs than you did.

  • That effect is not in the second quarter '07, I assume, and so when IFIN comes on, there are potentially things you can do to lower the overall organizations deposit cost; is that correct?

  • Ed Resch - EVP, CFO, Treasurer

  • Yes, that's right.

  • And just to round that out, when we modeled revenue attrition in the deal, we thought that we would be able to offset that in total by bringing some of those lower cost IFIN deposits on.

  • So the net effect between revenue attrition and the uptick in net interest revenue would be about a push from the standpoint of the deal model.

  • So, yes, we expect to be able to do what we had planned relative to IFIN's treasury function, and that is all reflected in our thinking about IFIN's improved performance versus what we had modeled back in February.

  • Brian Bedell - Analyst

  • Right, and then in terms of your guidance, it would imply just by going back to what you were pre IFIN that I guess in some ways you could say there is very limited IFIN dilution in the second half.

  • Should we think about it that way?

  • We were at $0.14 dilution for second half.

  • I know we've got stronger trends on both just in the market backdrop but --.

  • Ed Resch - EVP, CFO, Treasurer

  • Yes.

  • I wouldn't say our model is certainly not for no IFIN dilution in the second half.

  • We are modeling a slight improvement to that $0.14 number that we put forth back when we announced the deal, but it is not zero.

  • Brian Bedell - Analyst

  • Okay, so it is mostly market, the fact that the market has been a lot better, really?

  • Right?

  • Ed Resch - EVP, CFO, Treasurer

  • Yes.

  • Brian Bedell - Analyst

  • Right, and then so you would expect this then to be accretive in '08 instead of neutral to earnings in '08.

  • Is that correct?

  • Ed Resch - EVP, CFO, Treasurer

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

  • Brian Bedell - Analyst

  • Okay and then just on the core servicing fee line that went up a little bit more than I was expecting.

  • Anything unusual in that this quarter with HSBC in that this quarter, or is that on a go forward basis?

  • Ron Logue - Chairman, CEO

  • No, it is just -- it is those singles and doubles that keep coming.

  • Ed Resch - EVP, CFO, Treasurer

  • We had good markets, Brian, and we had good net new business generation and you put those two together and you have a 12% year-over-year increase.

  • Brian Bedell - Analyst

  • Right, so HSBC is yet to come, then, right?

  • Is that going to be second half?

  • Ron Logue - Chairman, CEO

  • Correct.

  • (multiple speakers) in the second quarter.

  • Brian Bedell - Analyst

  • Is it the second half or when (multiple speakers)?

  • Ron Logue - Chairman, CEO

  • Second half, yes.

  • Brian Bedell - Analyst

  • Second half, okay.

  • And then TIAA-CREF for the securities lending was, how much of that was in the second quarter?

  • Ron Logue - Chairman, CEO

  • I'm going to say half -- a little more than half, it's been coming in over time.

  • Brian Bedell - Analyst

  • Okay, so you still have some to go in the third quarter?

  • Ron Logue - Chairman, CEO

  • A little bit, yes.

  • Brian Bedell - Analyst

  • Right, and then just naturally the second quarter seasonally strong for security lending but how much of -- and I guess not in precise numbers but I guess I'm looking for what kind of drop we should expect in the third quarter.

  • Was there a substantial amount that was driven by just the higher interest in borrowing securities that is not related to the tax dividend arbitrage season in the second quarter?

  • Ed Resch - EVP, CFO, Treasurer

  • Most of the spread this quarter, Brian, was demand spread.

  • So yes, I think that the broad answer to your question is yes.

  • The seasonality of it, I'd point you back to prior years and look at what we've done.

  • It has ranged from 20% down to 45% down, on a sequential quarter basis.

  • Brian Bedell - Analyst

  • Right, just look at history.

  • All right, okay.

  • And one last on the subprime, the asset-backed both, it is like 24, 25 billion.

  • The subprime portion of that is like $8 billion; is that correct?

  • Ed Resch - EVP, CFO, Treasurer

  • About 7 -- a little over $7 billion.

  • We had about $1 billion in paydown from Q1 to Q2, and that is why the AAA percentage went from 80% to 78%.

  • Brian Bedell - Analyst

  • Do you expect that to wind down substantially over the near to intermediate-term?

  • Ed Resch - EVP, CFO, Treasurer

  • I would say over the intermediate-term.

  • Again assuming we didn't do anything else to the position, yes, well in the next couple of years.

  • Brian Bedell - Analyst

  • Great.

  • Thanks very much.

  • Operator

  • Lori Appelbaum, Goldman Sachs.

  • Lori Appelbaum - Analyst

  • (technical difficulty) that you have already done, plan to do, and on the buyback front, what is the pace that you expect to get the $1 billion of shares of the $1 billion of potential share repurchases out?

  • Do you expect to do an accelerated share purchase program or something slower paced over the coming quarters?

  • Ron Logue - Chairman, CEO

  • Lori, just to let you know we didn't hear the first part; I think we can answer the buyback piece, but what was the first part?

  • Lori Appelbaum - Analyst

  • Ed mentioned strategies in place to maximize the capital structure that you are doing, and along those lines I was wondering the pace that you are likely to buy back shares; whether an accelerated program is likely or something slower paced over the coming quarters.

  • Ed Resch - EVP, CFO, Treasurer

  • Well, Lori, we haven't specifically announced what our plans are.

  • It could be an accelerated share purchase program.

  • It could be something else.

  • When we have something to say, we will make an announcement and tell you what we're doing.

  • But I would expect that no matter what we do, we will get the $1 billion buyback done by the end of this year.

  • Lori Appelbaum - Analyst

  • So it is either very rapid or fairly rapid?

  • Ed Resch - EVP, CFO, Treasurer

  • If you consider over six months we do it, that is fairly rapid.

  • Lori Appelbaum - Analyst

  • And I know there have been a number of questions on the margin; just one more.

  • It seems to me that there is a fair amount of conservatism in your outlook for a 155 margin because that implies a decline versus the second quarter and client flows are still strong.

  • And Ron mentioned the goal of becoming more international and working the balance sheet harder.

  • If you could just comment on that.

  • Ed Resch - EVP, CFO, Treasurer

  • Well, I want to give myself a little bit of room on the downside.

  • I did say that the flows, the client flows while they have been strong can be volatile.

  • I think that in the past we've seen some decline certainly on a sequential quarter basis for these types of deposit flows.

  • The second quarter was extremely strong with a 164 margin.

  • I just want to be conservative in my outlook for the year.

  • I don't want to set a bar too high and then disappoint.

  • I think 155 for the full year is our best thinking right now as to where we're going to be.

  • Lori Appelbaum - Analyst

  • Okay, thank you.

  • Operator

  • (technical difficulty) Banc of America.

  • Ken Usdin - Analyst

  • Ed, just one more on the margin.

  • Earlier in the year you had said that you had about $10 billion of low yielding or low spread securities rolling off the books.

  • I am just wondering how much of that has already rolled off, and how much of it is to come?

  • Ed Resch - EVP, CFO, Treasurer

  • About half of it is done so far, as was fairly linear throughout the year.

  • If you remember, we said we had about $10 billion this year, $6 billion next year and $4 billion in '09.

  • And about half of that $10 billion has matured already.

  • Ken Usdin - Analyst

  • And what is the incremental tick-up you are getting on kind of stuff that is rolling off versus your -- what you are able to reinvest it at?

  • Ed Resch - EVP, CFO, Treasurer

  • 200 basis points.

  • Ken Usdin - Analyst

  • Okay, great.

  • Second question, relative to the IFIN deal, I was wondering if you could just give us a little update on both the revenue synergy side?

  • And then I have a question about the expense side.

  • On the revenue synergies you had said you originally expected a kind of a wash of net revenue synergies.

  • From what it sounds it is that you are very confident on the retention side and I am wondering if you could also just talk about the synergy side; any recognition that you are expecting kind of off the bat here, how quick?

  • And is that net zero, net revenue synergy in fact going to prove to be quite conservative at the end of the day?

  • Ron Logue - Chairman, CEO

  • It could be.

  • I think it is still too early to tell.

  • We really haven't gotten into the cross-sell piece which I think a lot of it is going to be non-US.

  • I think as we are sitting here today we are probably ahead of schedule in terms of revenue retention.

  • I think in terms of the deal model we assume that we would have lost some revenue at this point, which we haven't.

  • So to the extent that we can be as successful as we were with Deutsche in cross-sell which I think we can, bring the balances on book here, which we are going to do and continue to be successful in revenue retention.

  • We probably will do better than we thought in the deal model.

  • Ken Usdin - Analyst

  • Okay, and then on the expense side, Ed, to your earlier point you said obviously you would initially use the $700 million expense cost base for IFIN.

  • It is now run rating at 660.

  • That includes what is typically a higher second-quarter number I would think, given the seasonality.

  • So can you just update us relative to the phase in that you expect?

  • If you're still keeping to your dollar amount over time, can you update us on how you expect phase in to occur over the second half of this year and then into '08?

  • Ed Resch - EVP, CFO, Treasurer

  • We are still expecting the expense reduction to occur in line with the conversions broadly, Ken, so our plan right now calls for us to be around 25% completed by the end of 2007, and approximately 85 to 90% completed by the end of 2008.

  • So the expense reductions and relatedly the M&I charges, the merger integration charges that we are talking about incurring will broadly follow that timeline based on our modeling right now.

  • Ken Usdin - Analyst

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

  • Ed Resch - EVP, CFO, Treasurer

  • Yes, approximately.

  • Ken Usdin - Analyst

  • Okay, okay.

  • Great.

  • As far as -- the last question is just on the salary line continues to grow faster than the rate of revenues.

  • I think it was 18% this quarter year-over-year versus 16% on the revenue side.

  • And I'm just wondering if is there also incremental spending that you have made either in the hiring side or related to the deals?

  • Or could you just give us some more color on why some of the 100% margin stuff like NII isn't falling more directly to the bottom line, especially as it relates to the salaries line?

  • Ron Logue - Chairman, CEO

  • One thing I can say is that we added about 400 people in headcount due to the acquisitions.

  • When you add Currenex, Putnam, the [Palmary] Group, it is about 400 people into the salary line when you look at that year-over-year.

  • Ken Usdin - Analyst

  • But that also comes with the related revenues, so why don't we see positive operating leverage related to the salary line, then?

  • Ed Resch - EVP, CFO, Treasurer

  • I think the main driver of that increase, Ken, is the incentive compensation associated with the overall higher level of performance.

  • You have to remember that our money management business, which has performed very well, SSgA, has an incentive scheme which rewards them for performance as due the other performance, incentive performance programs in the Company.

  • But when you look at the business being up 23% year-over-year, that is going to drive a level of incentive comp commensurate with that performance.

  • And then you put on top of that the rest of the Company's performance, which has been very good also, you get incentive comp levels which drive the increase in the line that you are referring to, which are higher than the total revenue growth you alluded to.

  • Ken Usdin - Analyst

  • Got it.

  • And I'm sorry, one more follow-up just on the deal again on IFIN.

  • Is there any -- is any of the margin guidance for the second half related to picking up IFIN?

  • Like either funding the buyback or anything related so all things equal I would kind of agree with the prior question that it would seem that if your trends continue that the margin should kind of stay in the 160's.

  • So is there anything in there that is also related to the deal that would pull it down in the second quarter or is that already considered in the kind of the current margin?

  • Ed Resch - EVP, CFO, Treasurer

  • It is an all-in comment, Ken.

  • It considers everything.

  • Ken Usdin - Analyst

  • That's what I was just asking, is there an impact?

  • Is there an impact from IFIN on the margin in the second half that is a negative at all, because of the deal or financing related to the deal?

  • Ed Resch - EVP, CFO, Treasurer

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

  • Ken Usdin - Analyst

  • Right, that's what I'm getting out.

  • So I am just wondering -- that's what I'm wondering.

  • So on a standalone basis both margins might be held together, but that's what I'm asking is what is the incremental drag from the deal on the margin from the deal cost.

  • Ed Resch - EVP, CFO, Treasurer

  • We have the financing expense associated with the issuance of the billion dollars of securities.

  • I don't have that number off the top of my head in terms of margin points but that is reflected in our comments on the 155 margin for the full-year.

  • Ken Usdin - Analyst

  • Okay.

  • Ed Resch - EVP, CFO, Treasurer

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

  • Ken Usdin - Analyst

  • Important point.

  • Okay, got it.

  • Thank you.

  • Operator

  • Tom McCrohan, Janney Montgomery Scott.

  • Tom McCrohan - Analyst

  • A quick question.

  • Sorry to keep asking the same question on net interest margin, but I think earlier, Ed, you said 25% of your foreign time deposits was dollar-based.

  • So obviously that would imply 75% of your funding is non dollar-based.

  • But most of, if not all I would think of your investment securities are dollar-based.

  • So are you benefiting if the yields on foreign time deposits benefiting at all from the weak US dollar?

  • Or any type of derivatives associated with currency?

  • Ed Resch - EVP, CFO, Treasurer

  • Well, overall we are benefiting by the weaker dollar from a revenue perspective, by a percentage point or so in total, and that applies also to the net interest revenue.

  • Your premise that all of the investments associated with those deposits are in US dollars is not correct, though.

  • We have about 25% or about $15 million equivalent in placement, so those are light currencies.

  • We will move the percentage that we swap back into US versus invest in nondollar currencies based on our view of where the best opportunities are.

  • But overall there is a benefit to the tune of about a percentage point in terms of growth year-over-year given the weaker dollar.

  • Again on a year-over-year basis, principally driven again by the strength in the euro and the strength in the pound.

  • Tom McCrohan - Analyst

  • Do you hedge the risk associated with the net interest margin in currency, or is this not hedged at all?

  • Ed Resch - EVP, CFO, Treasurer

  • No, we don't hedge.

  • Tom McCrohan - Analyst

  • Okay.

  • Ed Resch - EVP, CFO, Treasurer

  • We don't hedge.

  • And I just point out just to clarify that overall from the Company's perspective our revenue and expenses are pretty well matched as to currency so there is no net exposure that we are hedging.

  • Our revenue is in light currencies, as are expenses with a couple minor exceptions in our offshore centers.

  • Tom McCrohan - Analyst

  • Okay.

  • How much of Currenex of revenues were in foreign exchange this quarter?

  • And I apologize if you have disclosed that.

  • Ed Resch - EVP, CFO, Treasurer

  • None.

  • It is in other trading.

  • Tom McCrohan - Analyst

  • Other trading, okay.

  • And did you disclose the dollar amount, what that was?

  • Ed Resch - EVP, CFO, Treasurer

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

  • Tom McCrohan - Analyst

  • And $16 million, thank you.

  • And in connection with how incentive compensation is paid on the staff line, is anyone in your organization incentivized or paid an incentive payment for the improvement in net interest income?

  • Is anyone like one-to-one -- I know overall performance everyone to some extent gets benefited but are people's salary structure tied to net interest income at all?

  • Ed Resch - EVP, CFO, Treasurer

  • Yes, there is nobody or no group directly that is incentivized on the basis of improving net interest income.

  • That is a very -- it is a very complicated relationship in terms of the value of our deposits and what the treasury group does on the investment side given the constraints that we self-impose, and the largest of those is that we want to run certain regulatory ratios and maintain a AA long-term debt rating.

  • I would say that the corporate staff, if you will, of which I would put treasury, is paid on the basis of overall corporate EPS.

  • So there is an indirect linkage as to how well the treasury group does and how much that improves EPS for the Company.

  • But nobody is directly incented to generate net interest revenue in the sense I think your question implies.

  • Tom McCrohan - Analyst

  • Yes, yes, I wouldn't think there would be.

  • And I guess the reason I asked you guys and a tremendous job of generating operating leverage, was just sequentially you had such a good sequential pop in net interest income this quarter but you also had a pretty big sequential pop in staff expenses.

  • So I am wondering if it were not for the sequential increase in net interest income this quarter, would you still have generated positive operating leverage?

  • And if payments, incentive payments were tied to the NII then the answer would be well yes, but if it's not, how much discretion did you have to have throttled back the growth on staff costs this quarter to generate positive operating leverage if you didn't have this pop in net interest income?

  • Ed Resch - EVP, CFO, Treasurer

  • Well, not all of the staff costs that are in the salary and benefit line relate to the treasury group.

  • As we said, that is driven -- that covers the whole Company, obviously, and the performance of the entire Company, led by the money management business is one of the largest drivers of the increase in that line.

  • So I think if you are looking at staff costs going up and linking that to treasury and net interest revenue, I think that is not the right way to think about it.

  • Tom McCrohan - Analyst

  • I'm trying to link it to, Ed, is your ability to manage the operating leverage.

  • If your staff costs are growing as you said at the average of what it did the first half, say 17% in the second half and NII is not going to keep growing at the same rate, maybe it will, can you still manage positive operating leverage if you don't have the same NII benefit in the second half?

  • Ed Resch - EVP, CFO, Treasurer

  • We think so, yes.

  • The discretion that we had and the calibration that I referred to earlier was not in the salary line for the most part.

  • It was in the other expense line where we spent the money this quarter on sales promotion and professional fees and things like that that I have already spoken about.

  • So yes, we try to calibrate our discretionary expense spend in a quarter to our revenue picture.

  • Tom McCrohan - Analyst

  • Okay.

  • And one last question and I'll drop off on the Investors Financial deal model that you guys put together, did you incorperate when you did your accretion dilution analysis and retention rate assumptions, an assumption that you're going to be offering any type of price concessions to the existing Investors Financial clients to retain them?

  • Ron Logue - Chairman, CEO

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

  • Tom McCrohan - Analyst

  • Thanks very much.

  • Operator

  • Robert Lee, KBW.

  • Robert Lee - Analyst

  • Some quick questions on asset management.

  • I apologize if I missed this, the comments from before, but could you give us some color on specifically what products are driving some of your new business trends there and also geographically where you are seeing that?

  • Is that also predominately outside the US?

  • That's the first question.

  • Ron Logue - Chairman, CEO

  • A lot of it obviously is coming from active, but I think as we said the 130/30 product is becoming a fast-growing product.

  • We've got $10 billion now, probably one of the fastest-growing products we've had.

  • Geographically again, like in the servicing business, a lot from outside the United States, very strong growth rates.

  • Robert Lee - Analyst

  • Okay, and was there any meaningful performance fees in the quarter in the revenue?

  • Ed Resch - EVP, CFO, Treasurer

  • About $20 million, Rob.

  • Robert Lee - Analyst

  • And just generally on your new business products, are you starting -- are more of those -- I'm assuming that more of those had a performance fee component, although I guess 130/30 typically doesn't.

  • Ed Resch - EVP, CFO, Treasurer

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

  • Robert Lee - Analyst

  • You expected that kind of trend given where you see the mix going should probably continue for a while?

  • Ed Resch - EVP, CFO, Treasurer

  • Well, yes, but I'm not sure why I'm willing to say that it will double by next year.

  • I think our trend and our emphasis has been to grow in the active business, and I think we are continuing to do that.

  • But given the passive core I don't think it could get to the level of maybe some of our competitors on a percentage basis.

  • Robert Lee - Analyst

  • And one last question, and I am sure we will see this when the Q comes out but is it possible just to get a feel for the positive operating leverage in the quarter?

  • Was that, was a lot of that driven by the asset management business just given the strong revenue growth?

  • And even though you obviously the incentive compensation there is going to be (inaudible) is that where you are seeing a lot of the incremental operating leverage come from?

  • Ed Resch - EVP, CFO, Treasurer

  • We're seeing it across both of the segments.

  • It is not in any one particular segment, and I would point out that most of the net interest revenue that is one of the largest drivers of our growth is accrues to the asset servicing business as we present in the 10-Q.

  • The asset management business doesn't get a lot of benefit from net interest revenue.

  • Robert Lee - Analyst

  • Okay, great.

  • Thank you very much.

  • Operator

  • Jason Goldberg, Lehman Brothers.

  • Jason Goldberg - Analyst

  • Asked and answered.

  • Thanks.

  • Operator

  • Betsy Graseck, Morgan Stanley.

  • Betsy Graseck - Analyst

  • On the assets under custody line, and obviously you talk a little bit about the growth.

  • Is there any way you can just talk about how net inflows from either new business or increased business from existing customers impacted your growth, year-over-year or Q on Q relative to prior quarters?

  • Ron Logue - Chairman, CEO

  • Betsy, obviously there was some net inflow growth.

  • A lot of it was net new business, however.

  • Betsy Graseck - Analyst

  • Okay, and then the insurance and other productline within AUC has been stepping up the growth rate pretty nicely there.

  • Could you talk about some of the drivers and outlook?

  • Ron Logue - Chairman, CEO

  • Yes, a couple years ago we made a concerted effort to really focus on the insurance industry, both outside the United States and inside the United States.

  • And we've made some I think real progress there, especially as you look at how the pension field is evolving and how insurance companies are playing a more active role there.

  • I would expect that that will continue to fuel the assets under custody growth going forward.

  • Betsy Graseck - Analyst

  • Okay, and then just one for Ed on the mortgage securities portfolio that you were talking about with regard to the AAA rated tranches.

  • Are any of those AAA securities CDOs that have within them subprime or not?

  • Ed Resch - EVP, CFO, Treasurer

  • We have no CDOs that have subprime backing them.

  • Betsy Graseck - Analyst

  • Okay, so all your CDOs are AAA tranches within CDOs?

  • Ed Resch - EVP, CFO, Treasurer

  • All of our -- well virtually all, 98% of our CDOs are AAA.

  • 2% are AA.

  • Betsy Graseck - Analyst

  • Okay, and then you mentioned the credit protection.

  • It would just be interesting to understand what type of credit protection you're talking about.

  • Ed Resch - EVP, CFO, Treasurer

  • Well, it is quoted in terms of the percentage of the underlying mortgages that could default before the asset-backed security or the CDO would experience a problem.

  • So when I say we have 36% credit enhancement, that means that 36% of the mortgages underlying the securities we have could default before it worked its way up to our AAA level of protection.

  • And I quote that against the 5 to 8% cumulative loss experience, so you can see that we have in the range of five times the level of protection that we feel we need in the security positions.

  • Betsy Graseck - Analyst

  • Okay, thanks.

  • Operator

  • There are no further questions at this time.

  • I would like to turn the conference back over to Mr.

  • Ron Logue for any additional or closing remarks.

  • Ron Logue - Chairman, CEO

  • Thank you very much.

  • I have no further remarks, and we look forward to talking to you again next quarter.

  • Thank you.

  • Operator

  • Thank you.

  • That does conclude today's presentation.

  • Thank you for your participation, and have a great day.

  • You may now disconnect.