道富銀行 (STT) 2008 Q3 法說會逐字稿

Good morning and welcome to State Street Corporation's third-quarter call and webcast.

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

This call is also being recorded for replay.

State Street's call is copyrighted.

All rights are reserved.

The call may not be recorded for rebroadcast or distribution in whole or in part without expressed written authorization from State Street and the only authorized broadcast of this call is housed on State Street's website.

At the end of today's presentation, we will conduct a question-and-answer session.

(Operator Instructions).

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

Good morning.

Before Ron Logue, our Chairman and Chief Executive Officer, and Chief Financial Officer, Ed Resch, begin their remarks, I would like to remind you that, during this call, we may be making forward-looking statements.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those filed on a Form 8-K this morning, as well as State Street's 2007 annual report on Form 10-K and its subsequent filings with the SEC.

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

Any such forward-looking statements speak only as of today, October 15, 2008, and the Corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

I would also like to remind you that you can find slide presentations regarding the Corporation's investment portfolio and asset-backed commercial paper conduits, as well as a separate presentation regarding the AMLF and the CPFF programs and our third-quarter 2008 earnings press release, which includes reconciliations of non-GAAP measures referred to on this webcast in the Investor Relations section of our website as referenced in our press release this morning.

Now I'll turn the call over to Ron.

Kelley, thank you and thank all of you for being here so early this morning.

Given the events of the last couple of days, we thought it best to move our earnings call ahead and provide as much information as quickly as possible.

Now I can't recall a time when the need for clarity and understanding of issues is more important.

So I want to do something a little different today.

I want to spend the time talking about the challenges we have faced in the current market and how we have managed them.

I want to spend only a short time discussing the results of the third quarter, which were very good and continued to show momentum.

I will let Ed, as he usually does, discuss the details of the third quarter.

So let me focus on the actions we have taken as a result of the extraordinary events taking place each day in our industry.

Our purpose, obviously, is to emerge from these difficult times a stronger company.

Not just from a capital adequacy perspective, but from a risk control perspective and importantly, from a customer perspective, protecting not only our franchise, but also the interest of our customers.

But first, let me bring you up to date with some of the current activities we have been involved with.

We are pleased to be included as one of the nine institutions chosen by the U.S.

Treasury to take a leadership role in the recently announced capital purchase program that forms part of the TARP.

Our selection demonstrates our role as a firm integral to the health and stability of the infrastructure of the financial markets and we are confident that the plan helps to restore stability and confidence to the financial markets.

We are also participating as a service provider in a number of Federal Reserve and Treasury programs to address the financial crisis.

Acting on behalf of money market funds, we have been one of the leading participants in the asset-backed commercial paper money market facility known as AMLF.

We have also, just yesterday, been selected as the custody provider for the recently announced commercial paper funding facility or CPFF as it is known.

State Street Global Advisers is also pleased to be one of the two managers selected by the U.S.

Treasury to manage the assets of the mortgage-backed securities program.

So let me begin with a summary of our participation in the capital purchase program.

We have agreed to sell to the U.S.

Treasury Department $2 billion of preferred shares, as well as warrants to purchase common stock, which we anticipate will be minimally dilutive to our shareholders.

We have a strong track record, a business model focused on continuing the success and strong prospects for continuous earnings and whatever advantage of strength we gain from this program will benefit us in the future.

That does not mean, however, that we will not consider raising additional capital to further strengthen our capital positions under the right conditions.

The CPFF, in particular, will help the market for asset-backed commercial paper in these distressed markets.

The intent of the CPFF is to support the market for commercial paper, which is vital to the capital markets.

We believe that, together with the AMLF, this program should restore confidence to the commercial paper markets.

Specifically, until the market becomes more liquid, the program will also provide an alternative source of liquidity to our conduits, reducing the need to hold commercial paper on our balance sheet during these disruptive markets.

Also this morning, I would like to discuss the following issues that I know are on your mind -- our securities lending program, our investment portfolio and the asset-backed commercial paper program, other issues that we addressed in the press release, including the Lehman reserve and the possibility of an additional fourth-quarter nonoperating charge to protect our customers and certain managed accounts.

There has clearly been a flight to quality and safety, particularly near the end of the quarter and our deposit base and our custody, trading and asset management businesses have benefited from our reputation for stability.

We received a number of questions about our securities lending program.

Details about how it works, as well as our view as to the future of this business given the decision by several lenders to suspend participation.

First, let me say that securities lending provides a vital source of liquidity to equity, bond and money markets, as well as reduces the cost of trading and settlement thereby benefiting all market participants.

Our securities lending, registered and nonregistered funds, are operating as we expected.

Our program remains strong and these funds are invested conservatively.

None of our funds that support State Street's securities lending business have lost money for our customers.

Due primarily to declines in the market, but also suspension or reductions in securities lending by some customers, we have seen assets in our lending program decline by approximately 20%.

As a result, we have seen increased withdrawal activity from the collateral pools, but we have been able to manage these outflows in a manner that protects our customers from loss.

Current spreads and volatility are expected to at least partially offset the impact of lower volumes.

I'm going to talk about the asset-backed commercial paper program and the investment portfolio.

As we said in the past and Ed will discuss in a minute, the assets in our investment portfolio and asset-backed commercial paper program are of high quality.

Very few have been downgraded and none are in default.

We continue to believe that the prices are not reflective of the underlying value of these securities if held to term, but reflect a continuing lack of liquidity in the market.

Next, the Lehman-related reserve.

As we stated publicly, we have no unsecured exposure to Lehman Brothers.

We do have a secured exposure to Lehman, which is now part of the bankruptcy proceeding.

We have indemnified certain of our customers with respect to repurchase agreements with Lehman Brothers Commercial Paper Inc.

These repurchase agreements of $1 billion were collateralized by $1.25 billion of mortgages.

Following the Lehman bankruptcy, in light of current market conditions, we value this collateral less than the repurchase obligations, so recorded a $200 million reserve.

We believe this reserve will be adequate, although we will not know the ultimate outcome until the collateral is sold or matures.

We manage accounts that have the benefit of contractual arrangements with other financial institutions that allow the accounts to issue and redeem units at book value rather than at market value.

The difference between market and book value on these accounts has increased to levels that may result in these financial institutions requiring that we sell the fixed income securities held in these accounts to limit any further risk to these other financial institutions.

Such an action could negatively affect our customers and our reputation.

Although we are not contractually obligated to do so, we are evaluating whether we should provide support to these accounts.

Although we have not currently committed to any course of action, a decision to support these accounts could result in a non-operating pretax charge of between $400 million and $450 million in the fourth quarter.

While we are still considering our options, we want to disclose the possibility of a charge of this magnitude to you.

Now before I turn the discussion over to Ed, let me remind you, our third-quarter performance, especially in light of the environment in which we are operating, was excellent.

On an operating basis, earnings per share in the third quarter were $1.24, up 8% from $1.15 per share last year and down 11% from $1.40 in the second quarter.

Operating revenue on a fully taxable equivalent basis totaled $2.5 billion for the quarter, an increase of 12.4% from last year's third quarter compared with a 9.5% increase in expenses to $1.7 billion on an operating basis.

Compared to the second quarter of 2008, operating revenue on a fully taxable equivalent basis was down 6.1% and expenses on an operating basis decreased 6.3%.

Return on equity on an operating basis was 15.4% in the third quarter, down from 15.8% in the third quarter of 2007 and down from 19.3% in the second quarter of 2008.

Our operating expenses in the third quarter declined 6% from the second quarter due to our successful expense controls and we will continue to exercise this expense discipline as we have in the past.

Also, excluding the nonoperating items in the quarter, we achieved 290 basis points of positive operating leverage when measured on a year-over-year basis, our 16th sequential quarter and 20 basis points when measured on a quarter-over-quarter comparison.

In addition to the government mandate, we won $280 billion of assets servicing new business, including names such as Lazard Asset Management, the UK operations of Sun Life of Canada, the State of Georgia Pension Fund, and the London Borough of Enfield Superannuation Fund.

SSgA won mandates from the Cambridgeshire County Council Pension Fund, the Bank Pension of Denmark, the Massachusetts State Pension Fund and the Teachers Retirement System for the State of Illinois.

These new wins, as well as the continuing installations of previous wins, are expected to help offset some of the revenue loss due to reduced market valuations over our existing book of business.

Now I will turn the call over to Ed.

Thank you, Ron and good morning, everyone.

This morning, all of my comments will be based on our operating basis results, excluding the CitiStreet gain, the Lehman-related reserve, the SILO-related charge, the impact of the asset-backed commercial paper liquidity facility offered through the Federal Reserve and the merger and integration costs associated with our acquisition of Investors Financial.

Ron provided an overview of the various issues in the quarter.

Let me just briefly explain the additional SILO reserve.

In the third quarter, we recorded a $98 million pretax charge against net interest revenue and a $39 million increase on the tax line.

We believe that a majority of the pretax charge will come back into income over time.

The Company previously settled with the IRS on our LILO leases and over previous quarters, has increased our reserve against the silo exposure.

During the third quarter, as the IRS began to become more successful at increasing its rate of settlement, particularly in light of recent court decisions, we decided that the more prudent course of action was to increase our silo reserve again.

Let me now highlight certain components of our income statement.

Servicing and management fees both performed well, particularly in light of the significant declines in market valuations on both the S&P and the EEFA.

The continuing volatility in the market benefited our trading revenue growth, particularly foreign exchange.

Performance in securities finance was also strong on a year-over-year basis and was down about 30% from the second quarter due to the impact of the dividend season in Europe in the second quarter.

The decline in processing and other fees on both a year-over-year and a sequential quarter basis was due to lower fees.

Of particular note are the lower fees from the asset-backed commercial paper program where fees from this program declined from $13.2 million in the second quarter to $5.7 million in the third quarter.

Regarding the Investors Financial acquisition, all of our metrics are on track and we continue to expect the transaction to be about $0.04 to $0.05 accretive to our 2008 results, significantly ahead of our original plan at the time of the acquisition.

Regarding expenses, a 6% decline in third-quarter expenses compared to the second quarter, I will comment on only two areas.

First, salaries and benefits expenses declined 4% from the second quarter due primarily to a lower level of incentive compensation.

And other expenses were down 19% compared to the second quarter, primarily due to reductions in professional fees, lower cost in bank operations and lower securities processing costs as we controlled expenses in anticipation of a lower revenue environment.

As we anticipated on last quarter's conference call, net interest revenue was down from the second quarter due to lower asset yields.

In addition, net interest margin of 222 basis points was down nine basis points from the second quarter of 2008.

Now let me turn to the investment portfolio.

The investment portfolio has not changed significantly in credit quality or size since the second quarter.

However, the unrealized mark-to-market losses have widened as of quarter-end as a result of illiquidity in the market and the general global market stress.

I will refer you to our investment portfolio slide presentation for the particulars of our portfolio composition.

During the quarter, particularly following the Lehman bankruptcy in mid-September, we saw spreads further widen in an incredibly illiquid market.

The unrealized after-tax mark widened by $1.3 billion from $2.0 billion at June 30, 2008 to $3.3 billion at September 30, 2008.

To give you some idea of the impact of the Lehman bankruptcy, the mark as of September 12, 2008 before the Lehman bankruptcy was $2.8 billion after tax.

We continue to believe that these prices are not reflective of the underlying value of the securities if held to term, but indicate a continuing lack of liquidity in the fixed income market.

You will note that our entire portfolio remains rated as it was in June, 84.4% AAA-rated and 8.7% AA-rated.

We have had only minimal downgrades, no defaults and all securities are current as to principal and interest.

As in past quarters, on our website, you will find the investor portfolio detail about the third quarter compared to the data we have presented for previous quarters.

I strongly urge you to review those slides.

Our portfolio was well-diversified with over 9300 QSIPS and if you look at the slides, you will notice that only 49 additional securities, of which 13 were municipal bonds, were downgraded in the third quarter.

These additional downgrades represent about $1.4 billion in asset value or less than 2% of the total portfolio.

All are current and none are in default.

In the context of a difficult market, more than 60% of these downgrades were one letter grade or less.

The slides also contain data indicating the stresses we applied in testing our analysis of the portfolio.

Rather than go through them all this morning, I will point out two examples, which represent asset classes we're often asked about.

We have about $2.3 billion or 4269 securities wrapped by an insurance provider.

Of this number, more than 99% or 4242 are municipal bonds.

Excluding these, the remaining wrapped securities, 16 HELOCs and 10 subprime asset-backed securities, equal about $300 million or 26 securities.

With the exception of the insurer FSA, we removed all of the wraps and stressed the bonds.

As you can see on the slides, the total HELOC loss would be about $29 million after tax.

The subprime assets, which have declined more than $1 billion since last year's third quarter, now have 45% credit enhancement, which comes from the structure itself and means that even if every mortgage in the security were to default, we would not lose one dollar until the recovery rate for those assets fell below 55%.

Now as to our outlook for net interest revenue for the remainder of 2008, last quarter, we increased our outlook for net interest margin for 2008.

I said that we expected the margin to be around 215 basis points or slightly higher.

In the current environment, excluding the impact of the AMLF, we now expect our margin on average for the full year to be around 220 basis points.

As you can see, our balance sheet grew considerably during the quarter, especially following the Lehman bankruptcy and the commencement of the AMLF.

Increased liquidity from our customer deposits in the recent market environment and our participation in the AMLF have caused our balance sheet to grow temporarily.

As of September 30, 2008, we had deposited an additional $54 billion in excess balances with central banks plus an additional $77 billion related to the AMLF program.

I remind you that we bear no credit or capital risk for holding the AMLF assets.

On the subject of the AMLF, I direct you to the AMLF slide presentation to give you some idea of the nonoperating revenue we will learn as a facilitator of this program.

For the last two weeks of September, we earned about $8 million and for the fourth quarter, assuming an average balance of around $30 billion, we anticipate earning between $50 million and $60 million in the quarter.

Let me review our capital ratios now.

The principal capital ratio that we manage to is the tier one leverage ratio.

We have historically targeted between 5.25% and 5.75%, but given the market environment, we expect our leverage ratio to continue to grow to a level above the top of this range in order to preserve flexibility in what appears to be a continually volatile market.

Had the capital purchase program been in place at September 30, 2008, the pro forma tier one ratio for the Corporation would have been 18.84% and the pro forma leverage ratio would have been 9.76%.

As of September 30, 2008, our tier one leverage ratio stands at 8.36%, up from 8.25% as of June 30, 2008.

At September 30, 2008, our adjusted tangible common equity ratio is 4.80%, down from 5.40% at June 30, 2008, primarily due to an increase in the unrealized loss on the investment portfolio.

We have adjusted the TCE ratio for the impact of the AMLF, the excess balances left with the Federal Reserve banks and other central banks and the deferred tax liability.

I refer you to the slides entitled Asset-Backed Commercial Paper Conduits for a description of the methodology used to calculate the adjusted TCE ratio.

Next, a discussion of the asset-backed commercial paper program.

As in the past, you can find a detailed quarterly review of the assets displayed by type, country of origin and ratings in the asset-backed commercial paper slide presentation.

Also, there, you will find the unrealized after-tax mark-to-market losses for each asset type and the stresses we apply to them.

In the interest of time, I will not discuss them in detail today.

At September 30, 2008, the conduits held assets of $25.5 billion, down from $28.4 billion on June 30, 2008 due to asset amortization and the strengthening US dollar.

As in the investment portfolio, the illiquidity in the market resulted in an increase in the unrealized after-tax mark-to-market loss to $2.1 billion, an increase of about $500 million from June 30, 2008, due primarily to higher credit spreads on US mortgages.

As I have stated many times, we created this program in 1992 primarily to address customer requests for high quality, highly rated commercial paper.

The conduits have never suffered a credit loss on any asset they've purchase, evidence of our strong credit discipline.

80% at the assets are rated AAA, AA or A.

None of the assets in our conduits are subprime nor are there any SIVs in the conduit program.

As of September 30, 2008, the assets continue to have an average weighted maturity of about four years and the paper has a weighted average maturity of 15 days, down from 20 days at June 30.

All securities in the conduits are current as to principal and interest.

As I am sure you are aware, the commercial paper market has been considerably strained, particularly near the end of the third quarter.

Following the Lehman bankruptcy and with several prominent money market funds having NAV less than $1.00, many investors withdrew from or limited their exposure to the ABCP market.

As of September 30, 2008, excluding our own commercial paper pledged by money market funds to the Federal Reserve, we held $6.2 billion of our asset-backed commercial paper on our balance sheet.

However, to give you some idea of the impact of the Lehman bankruptcy, as of September 12, the day before the bankruptcy was declared, we held $1.5 billion on our balance sheet.

If the disrupted markets continue and we are unable to sell the asset-backed commercial paper to customers, we expect that a substantial amount of the commercial paper issued by our conduits will be eligible for sale to the Federal Reserve under the commercial paper funding facility.

If the commercial paper funding facility had been available at September 30, 2008, we believe that the amount of commercial paper we held on the balance sheet would have been materially lower.

This program is described further in the slides we have provided.

Due to the high quality of the assets and their performance, we do not currently believe we need to consolidate the conduits.

However, we are well-prepared for consolidation if required by FASB as of January 1, 2010.

From a funding standpoint, the risk of a more immediate consolidation continues to be included in our contingency funding plan.

As of September 30, 2008, given the market environment, we carried about $68 billion in liquid assets on our balance sheet, $54 billion of which was the excess reserves held at the central banks.

On a pro forma basis, as of September 30, the consolidation of the conduit assets onto our balance sheet would reduce our leverage ratio by about 151 basis points from 8.36% to 6.85% and the tangible common equity ratio about 175 basis points from 4.80% to 3.05%.

I should also remind you that we have been generating 40 to 50 basis points of organic capital per quarter.

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

Thanks, Ed.

Looking at the turmoil resulting from the illiquidity in the capital markets, I am particularly proud of the performance of State Street, not only in the third quarter, but in many of the decisions we've made over the past year to prepare for the current market environment.

I am also very proud of our employees around the globe who have focused on helping our customers to navigate the considerable challenges and complexities that I just outlined.

Because of our strong performance in the first nine months of 2008, we continue to confirm our earlier statements regarding our performance to our financial goals.

We continue to expect our growth in operating earnings per share to be approaching the high end of the 10% to 15% range, operating revenue to be about the high end of the 14% to 17% range and the operating return on equity to approach the high end of the 14% to 17% range.

As I said at the beginning of my comments this morning, the companies that will emerge from this turmoil in a position of strength are those with the right mix of businesses, with a focus on customer service and a prudent plan for this environment.

We will continue to respond to changes in the environment and take whatever steps are necessary to enhance the strength and value of our unique franchise.

So Dennis, Ed and I will now be happy to take questions.

(Operator Instructions).

Glenn Schorr, UBS.

Thanks very much.

Ron, I was wondering if we could talk a little bit more about the situation at SSgA and the third-party financial guarantors.

I appreciate that you are not financially or contractually obligated, but you are thinking about doing the right thing by customers.

What drives it and maybe you can give us a little bit more color because what seems -- I mean I think the situation in the short-term duration of funds was different, but what we are seeing in money market funds and sec lending funds and now this, a lot of companies making a lot of clients whole and just trying to figure out how we draw the boundaries of clients having any risk at all.

Yes, that is going to be a gray area, obviously, Glenn.

I think the factor there is going to be the, I guess, the attitude and the condition of the financial guarantors there.

It is really not a situation that we can control as much as a situation that the financial guarantors can control.

So it depends on, I guess, their attitude towards what they want to do.

There is not much more I can tell you there.

So this is not a State Street management decision.

It depends on the guarantor and your --?

Yes, absolutely.

What is a State Street decision, however, is to determine what we would want to do in terms of protecting our customers.

Even though, as we said, and you have said, we are not contractually obligated to do that.

To your knowledge, is this an industrywide phenomenon where everyone is in the same boat?

It could be.

I honestly don't know.

(multiple speakers).

I am sure it's different for each organization depending on where they are, but the situation is, in terms of who is responsible for what, is probably the same.

Okay.

And then finally on that, does the 400, 450 represent the full amount or is that the clients' portion?

Meaning are you making them fully whole if you made that decision?

It will bring them up to an appropriate level, yes.

We are conservatively reserving for that.

Okay.

You made a comment that I took as just kind of blanket cautionary, but I just want to ask for further color on the -- we have big capital ratios, we got our money from the government, but this does not mean we wouldn't raise further capital.

That's correct.

Is that just kind of blanket cautionary?

In other words, I could appreciate having maybe deal-related capital raised, but at an 18% plus tier one, even the consolidation of the full conduit would keep you at pretty reasonable levels.

I am just trying to think about what kind of situation would bring a capital raise in the foreseeable future.

I guess more disruptive markets potentially.

I think, obviously, what is important is our capital base.

We don't have any immediate plans to raise capital right now, but I don't want anyone to think that just because we have got $2 billion from the capital purchase program that we are not thinking about a strong capital base.

That was really the intent there.

Got it.

And then you affirmed your financial projections on '08.

At any point are you going to be thinking about '09 as difficult as that task might be?

We are in the process of looking at that right now.

I think the good news is that we have, for a couple of quarters, been working on the expense side.

Obviously, if we think we are going to get into a slower growth environment, we have to look at the expense side of the equation.

We have been doing that and I think a good proof point is the fact that we generated sequential quarter positive operating leverage and so we got that machine working.

No doubt about it.

All right, thanks very much, Ron.

Kenneth Usdin, Banc of America Securities.

Hi, good morning, guys.

Just a question on the conduits.

Ed, you mentioned that you don't have any current plans to consolidate and would be prepared, assuming that the FASB did make the changes.

Can you just talk through, outside of the FASB changes, what would cause the triggers for consolidation in any interim period?

Meaning where are you relative to the test and how much flexibility do you still have right now?

Well, the things that could cause a conduit consolidation are the same ones we have always talked about, Ken, which are that if we were to, for some reason, to not be on the right side of the FIN 46 model, which I will talk about in a moment in terms of our cushions, but it is basically that, as well as any issues that were of a protracted nature that could cause the conduit's funding costs to greatly exceed the asset yield.

And that is kind of a going concern concept under the accounting rules.

We are not in that position.

We don't have any expectation of being in that position, but that could cause a consolidation.

In terms of our cushions, the cushions, they are very strong.

Actually a little bit stronger on one of the conduits, one of the big ones than they were last quarter and I define cushion again as the available subdebt versus the requirement.

On one of the large conduits, it is well-above 100% cushion and on the other large conduit, it is just over 40% cushion.

And on the two smaller conduits, one is at 40% and the other is about 30% cushion.

So we are in a very strong position in terms of our subordinated debt, first loss notes versus our requirement.

And Ed, as you gave some color relative to pre-Lehman/post-Lehman, can you give us any color as far as that profitability or ongoing concern test?

Have the conduits on a day-to-day basis remained in the black so to speak?

I mean have there been some days or weeks in the last couple of weeks of the quarter where that test got tougher on a day-to-day basis I guess?

I know it is measured over a longer period as far as the consolidation test is concerned, but can you just give us some color there?

Yes, yes, absolutely.

Post the Lehman bankruptcy, we saw the amount on our balance sheet go up, as I said.

Investors pulled back.

Cash was king.

They were hoarding cash, not investing in our asset-backed commercial paper or others we believe as the market kind of froze up.

And in terms of placing the paper that we did place, it was all overnight and it was at a much higher rate for that overnight period because of the market conditions.

So given that the assets did not reprice overnight, we were in, for that increment of paper that we priced overnight at a high rate, we were in a negative position.

But overall, that was for a shorter period of time and not of concern from the standpoint of the going concern test.

Okay.

And then as far as the forward-looking, can you just talk about how much changes of -- changes in kind of the LIBOR rate would benefit that test and also how you expect the CPFF to work as far as when it starts on October 27 and any expectation of how quickly the market could start to improve?

Well, first, in terms of overall improvement, I mean we would expect that the intended effect of a lot of these government programs would kick in and three-month LIBOR versus Fed funds would come in from where it is, which has been, obviously, at a very, very high level as the stress has actually increased over the end of the third quarter.

So we would expect that to occur and that would, obviously, be a positive for the conduits in terms of their funding costs on their paper, as well as the term to which we could place the paper.

But that has yet to be determined.

As we move forward, it is a little early to say what we precisely think the effect is going to be on the conduits, but we have over $22 billion of our $25 billion we believe as being eligible for the CPFF if we needed to avail ourselves of that.

So we feel pretty comfortable that even if the market did not repair itself as quickly as maybe everybody would like, we would still have the alternative funding source with the CPFF.

Okay, thanks a lot, guys.

Brian Bedell, Merrill Lynch.

Hi, good morning, folks.

Just on the conduit again, for the decline from a $28.4 billion to $25.5 billion, what portion of that was due to the strengthening dollar and what portion was due to amortization?

About $1 billion was due to the strengthening dollar, Brian.

Okay, okay.

And would you expect that amortization portion of about $2 billion to be a straight-line level or was that a little bit lumpy in the quarter?

No, the overall conduit amortization is about $1 billion per quarter, but, again, you can't assume that that is going to be a straight line down in terms of the amortization because of the requirement to make sure we stay on sides with the FIN 46 model.

Right, in terms of keeping the credit quality at A1-T1, I guess, right?

Right.

Right, okay.

Just to go back to the test on FIN 46 again, what type of timeframe would you need to be in a loss position to be forced to consolidate the conduits?

It would certainly be over a quarter or more, Brian.

It is not a day or a week or a month test.

Right.

Right, okay.

What levels were the -- I know the CP funding spreads were at 24 basis points for the average for the quarter.

What were those funding spreads in the last two weeks of September post the Lehman bankruptcy?

Don't have that number at hand, Brian.

We will have to get that to you.

Okay.

So right, obviously, it spiked up somewhat and you were in a loss position in certain days.

I guess what I'm trying to get at is to what degree going forward will the ability to lay that off on the Fed, would that program sort of guarantee you an ability to run this conduit profitably?

Do you guys feel pretty comfortable in that?

Well, it is kind of I think a win-win, Brian, in that if the program works and spreads come back in, then we will be able, more likely than not, to be having less paper on our balance sheet and continue placing it as we had before the Lehman bankruptcy.

If in fact it takes longer for normalcy to return then the Fed program, the CPFF, is available to us and is very attractive.

So either way, whether the market repairs quickly or it takes a little bit longer, we feel like the conduits will be fine.

Right, right.

So the Fed program really guarantees you -- the rates that they are doing it at, the swap plus the 300 basis points, but you're saying you are comfortable that that will keep you in a profitable position even if you have to use the Fed program?

Yes.

In a disrupted market, as we have today, that is exactly right.

Okay, great.

And then just on the default risk on the conduits, what type of magnitude of defaults would trigger a FIN 46 consolidation?

You said default?

Yes, if you experienced an actual default within some of the paper -- no, not the paper, but the actual securities within the conduits.

So you have a loss within the conduits and you have a reasonable cushion for protection against that.

I know that is another thing that can trigger FIN 46 and I was just trying to --.

Right.

I mean that is asset-specific.

That is not taking into account any liquidity asset backstop that we have, but the technical answer is that an asset default would go against the subordinated debt in a conduit.

Right, right.

So as long as you have that cushion, --.

Yes.

That would absolutely reduce the cushion if an asset were to default, but I would remind you that we have never had that happen.

Right.

And do you have the ability to essentially buy that component of the conduit and bring that onto your balance sheet to avert a consolidation?

And then just, obviously, that portion you would just mark-to-market on your balance sheet.

Yes, there are specific conditions under which that can occur, but generally speaking, that is what the liquidity asset purchase agreements are for in order to protect the conduits and have State Street Bank and Trust backstop their liquidity.

Great.

Okay, then just on the central banks, the $54 billion, I know that came out at the end -- sort of towards the end of the quarter, but is that reflected in your average balance sheet?

It looks like your average interest earning assets are pretty steady.

Yes.

It is reflected in your balance sheet?

Yes, it is.

It is.

So if that is coming at the very end of the quarter, what we should have, if that is sticky into the fourth quarter, we should have a pretty significant inflation in your operating interest earning assets, correct?

Yes.

If the liquidity position still carries forward into the fourth quarter, yes.

Okay.

So does your comment on the NIM guidance include an assumption that the central -- that you will continue to have that type of level of central bank deposits through much of the fourth quarter?

Not that level, but lower than $50 billion.

We are assuming that some level of normalcy will return and the excess liquidity will diminish over the quarter.

Okay, great.

What drove the higher funding costs on the -- within the average balance sheet here in terms of the other short-term borrowings and then your actual rates on the non-US transaction deposits went up a little bit?

What drove those two factors?

I think your other short-term borrowing costs went from 310 basis points to 384 and then your non-US deposit costs went from 153 to 169.

I would've expected both of those to be stable or down.

We will have to get back to you on that answer, Brian.

I don't have it specifically at hand right now.

Okay, great.

And then just for managing to capital ratio, obviously, the tangible common equity is going to continue to potentially be constrained here if we get more marks, unrealized marks on the portfolio.

To what degree do you think the rating agencies might begin looking at tier one capital as more of a primary driver of your ratings rather than the tangible common equity?

And then also in valuing the securities on the portfolio, can you make a comment on mark-to-market accounting, to what degree you might be able to make some of those securities level three assets because, as you said, there is not a great market for some of those securities?

Well, I mean in our conversations with the rating agencies, they start from the regulatory ratios and go on from there.

So I think the prerequisite on the part of the rating agencies, at least as they have expressed it to us, is strong regulatory ratios.

Then they move on to the tangible common and other things.

Whether or not they move away from a focus on tangible common to just the regulatory ratios or something else, that is a waiting question which I guess they probably best address.

But up till now, it has been a focus on regulatory number one and then other ratios number two.

In terms of the mark to market, I mean we have prepared our financials consistently through time before the crisis hit the summer of '07 and up to now.

We are aware of the discussion and the emphasis that the FASB has placed on mark to market accounting.

Most of our assets are level two.

They will continue to be level two this quarter.

About 90% of our assets are in the level two bucket under FAS 157.

We are evaluating what FASB says about fair value accounting, but for this quarter we have used the consistent methodology which for the investment portfolio is a third-party pricing service.

Right.

So you could potentially, if they ease that somewhat from a FASB perspective, your accountants might be able to go back to using that as an input and then also use a potential model for some of those assets?

I mean that would sort of ease the unrealized losses a little bit.

Well, I mean we look at that.

We are looking at that, but at this point we have reached no conclusion.

We have to have a basis, obviously, to determine if there is a disrupted market under this new guidance or this guidance that is confirming FAS 157.

And we would have to have a better view which is surrounded by a very rigorous process in order to make a change to our methodology on valuing our securities.

Just lastly, Ron, if you want to just comment on maybe the new business pipeline.

Obviously, this has been a very stressed environment for everyone.

What are you seeing from your potential custody customers that you've been talking with for some time in terms of their business decisions, whether they are more willing to outsource right now?

Brian, it is almost impossible to hear you because you are on a headset.

Can you hear me now?

Yes, that is better, Brian.

I'm sorry.

I just had to move it closer to my mouth.

The pipeline for custody mandates, are you seeing people slow down their decision-making?

And then also in conjunction with that, do you see pension plans curtailing their securities lending activity at least in the near-term?

Yes.

Well, let me answer the second question first.

We are seeing some curtailment, obviously, in the securities lending programs.

I think I said we had about a 20% reduction in volume.

That is happening in a very orderly fashion.

I would expect over time they would come back.

I think we reported very robust new business wins.

I think it was $280 billion, some big wins.

If we are seeing anything in reduction, it is in new fund openings from existing customers.

There has probably been a slowdown there.

But the new business wins continue to be strong as evidenced by the $280 billion.

You know, if there is one thing we are seeing is this flight to quality.

You know, one thing I could say is that the customers are not only concerned about their securities; they are concerned about the cash that goes along with the securities, evidence of the $54 billion in excess deposits.

We have seen this -- I remember 15 years ago having the same issue and where there was a flight to quality.

So I think that is playing some role in some of the new business, which has been helpful for us that is showing up in some of the names.

The $280 billion in net new business is good, and the pipeline for new business continues to be strong.

So if there is a slowdown, it is probably new funds being opened.

Great.

That's very helpful.

Thanks so much.

Mike Mayo, Deutsche Bank.

Hey, good morning.

It's actually Rob Rutschow.

Just a quick follow-up on the conduit.

Is it your understanding that all of the assets that are in the conduit are available for these various Fed programs to be pledged?

Well, our understanding right now is that most of them, but to have them actually put into the TARP would require us to bring them on the Company's balance sheet.

I don't believe they could go, as we know right now, directly from the conduit into the TARP.

And which of the assets are available for the CP program?

Which of the assets are available for the CPFF, Rob?

Yes.

Okay.

It is not the assets in the conduits.

It's the actual commercial paper that the conduits issue and it is all of our dollar-denominated paper for less than 90 days maturity issued by US issuers.

We have two conduits that are non-US issuers and those are the ones that would be excluded, but those are the smaller ones.

We said about 22 out of 25.

Right.

Those are the two big conduits in the US.

Okay.

Second question is on, I guess, the interest income.

It seems like there is several moving parts there.

So you have the $50 million to $60 million from the Fed program.

Can you tell us what the spread is or what sort of spread you are earning on those central bank assets or excess reserves?

And then separately, what the outlook is sort of excluding those two factors?

Yes, what we are earning on the central bank reserves is zero, which is why we are highlighting it, separating it out from the various calculations given the unique nature of the quarter and the liquidity position that we have.

In terms of the other side of the balance sheet, we have demand deposits on which we pay nothing, okay, of $70 billion.

So it is a little bit of a unique situation where we have zero earning assets in the central banks and we have a lot of liquidity as we described on the liability side.

In terms of going forward, we are going to be excluding the AMLF from our operating results.

We think that that is the right way to look at it as the program may be rather shorter term in nature.

And in terms of the central bank balances, we will break them out if in fact they continue to be of a significant size.

I would just point out that the normal excess liquidity that we have has been in the range of $15 billion to $20 billion.

We have been carrying that since the stress started in the summer of '07 and obviously, that is much lower than $54 billion.

In terms of the earnings, we earn 75 basis points going forward on the excess Fed balances as they pay on reserves.

Okay, thanks.

A question on the securities lending.

I think you have said you had maybe 400 clients.

How many of those have sort of ceased operations at this point?

About 5%.

Okay.

And last question is on asset management.

It seems like your assets under management were down a little bit more than the market, so I'm curious as to whether there are any areas in particular where you are seeing weakness or outflows, and also if you can comment on what is happening with your Quantum funds, which I guess is probably not specific to you.

No, there is not one particular area where we have seen a big decrease.

What we are beginning to see is an increase, however, in the passive funds and I think you're going to continue to see that trend over the coming months.

So I would expect that there will be some inflows on the passive side, probably more than there had been in the past.

But there is no one area that I can point to that has had a significant outflow.

Okay, thanks a lot.

Nancy Bush, NAB Research LLC.

Good morning.

Ron, if you could just speak to the implications for your participation in whatever they are calling the thing that came out yesterday, you being one of the nine banks.

I think you said there was a $2 billion investment versus the $3 billion that has been reported?

Is that correct?

$2 billion, yes.

Okay.

What does this mean in terms of payment of dividends?

What are the constraints that are put upon you by participation in this program because there is a tremendous amount of information and disinformation out there?

Yes.

Well, there is a 5% coupon on it.

Can't raise the dividend, can't buy back stock are probably the biggest ones, without approval, excuse me, yes.

And at what point do you buy this back?

Are you able to buy this back?

Are you compelled to buy this back?

How do you get out of this?

We can buy it back probably anytime in the next three years.

The intent here is, I think to put it in my words, to jumpstart the capital formation.

Obviously, as we go forward, the way we look at this is an opportunity to, during a difficult time, to get some more strength, but we need to continue to look at how we are going to strengthen our balance sheet and we also believe that we will pay this back within that period of time.

I don't know how else to ask this, but were you compelled to receive this investment as sort of a quid pro quo for being involved in these programs?

No.

I think there was general consensus in that room that this is the right thing to do and I don't feel that at all.

Okay.

This was important.

This was important for all of us to do this.

Secondly, on the TCE ratio at 4.8%, obviously, that is still quite high.

Is there a level at which you would feel that you would need to raise common equity again?

I think we have, in the past, always targeted around 3%, anything lower than 3%.

Okay.

So there is quite a ways to go there.

Yes.

And thirdly, just finally, if I could get your and Ron's observations.

I mean your and Ed's observations on the credit market environment.

Are we seeing any loosening of the credit markets, etc.?

I think we saw some spreads come in yesterday a little bit.

So I would -- a little too early to tell, but we did see some effect yesterday and we will closely watch it.

Ed, do you want to add anything to that?

No, I think that's right.

We saw a very good day yesterday overall, but just one day.

Okay.

Thank you.

Brian Foran, Goldman Sachs.

Good morning.

I guess on that 3% target you have talked about in the past, should we think of that including or excluding conduit consolidation and should we think of it including or excluding the government preferreds?

Well the government preferred has no effect on it, but in terms of conduit consolidation, we present the pro forma ratio for that very purpose.

Our lower boundary as we think about TCE is 3% and we include the conduit consolidation on a pro forma basis there.

Okay, so to be clear, the 3.05% right now is the number we should be focused on relative to your 3% minimum?

Yes.

Okay.

And then I guess secondly as I go through the transcript here, there has been about 10 questions on the conduit for every one question on the core business.

Is there any point where you would consider proactively consolidating the conduit and just try to put it behind you and get people refocused on what seemed like some pretty results in a difficult environment?

No, because I don't think that is not the way to spend the shareholders' money.

We think this is money good.

I can think of a lot of better ways to spend the shareholders' money.

And then lastly if I could, at what point does positive operating leverage become impossible to maintain if ever if the market continues to be flat to down from here?

Is there a point where the reinvestment needs of the business just become so big that you can't cut costs?

No, I think we're doing a pretty good job cutting the costs.

Obviously, depending on how disrupted things could potentially get in the future, that would have an effect.

But I think we are getting a lot better at creating that lever.

As we have said many times in this business, you can't completely stop reinvesting because if you do, you fall behind and that is going to have long-term effects as we have seen in the past.

So it is really more a question of how you spend the money as opposed to not spending the money and it is an art and I think we are beginning to learn how to do that pretty well.

Again, evidenced this quarter and if you think that we are going to be in a slower growth environment, we are going to have to continue to do that.

So we are not going to change our view or our objectives of trying to generate positive operating leverage.

If it is -- the way we will look at it, if it is going to be a slower growth environment next year, fine, but we are going to have to grow faster than our competitors and if it is not 10%, 12%, 15%, whatever it is, we have to target it to grow what we think is going to be faster than our competitors and that is kind of the mindset that we go into this with and positive operating leverage plays a big role in that.

Thank you.

Vivek Juneja, JPMorgan.

Hi, a couple of questions.

Firstly for Ed.

Ed, tangible common equity ratio, you changed your methodology this quarter.

So I guess apples-to-apples versus where you were last quarter, you were probably around the 2.75 range, 2.75% range.

I want to confirm that and then given that change in methodology, did you change your thinking on your target?

You are correct in highlighting the fact that we added the deferred tax liability in this quarter.

We felt that that was more appropriate to do given the rating agency treatment of the deferred tax liability, as well as what some of our peers do and relative to changing the target, that is something that we have under consideration.

Okay.

Ron, you mentioned that you are seeing more of an influence of passive assets under management.

Is that a shift from the enhanced or is that just a shift from active?

Can you talk a little more about that?

Are you seeing people move out of those categories where they took on a little more risk for supposedly higher yield or return?

Yes, I think it is just some new money coming in being parked for a while.

That is what I really think is going on.

I guess you could say it is from both, but we are also seeing new money coming in actually being parked for a while.

And I think the opportunity for us, obviously, is once we have it as things get better, can we convert it.

Ed, going back to the AMLF, obviously, the initial fees, as you are buying this paper, you are benefiting from where the paper has been trading at.

But when you look at it on an ongoing basis, what is the fee that you would earn on this?

Assuming a certain level of the AMLF on average for the quarter, we think we could get in the range of $40 million to $50 million of fees on this.

But it is over 10 basis points of actual --.

Excuse me.

About $50 million to $60 million in the fourth quarter.

So is that a fee that you get for actually just buying the paper and selling it to the Fed and you're charging a 10, 15 basis point fee?

Yes, that's the program.

Okay.

And where are your unrealized losses post the quarter currently and where are assets under custody and assets under management levels currently, given what has happened thus far in the fourth quarter?

Okay.

The unrealized after-tax losses on the portfolio as of last night are $3.8 billion.

So they have increased a bit since quarter end.

And on the conduits, it has increased slightly to $2.2 billion.

Overall conduit size though, however, has decreased to $24.7 billion from the quarter-end balances.

AUC and AUM I do not have for you as of the close of last night.

Vivek, we don't keep usually disclose quarter-end interim month.

My sense, Vivek, it is not a whole lot different than quarter-end.

Okay, great.

Thanks.

Betsy Graseck, Morgan Stanley.

That will be the last question, Dennis.

Okay, thanks.

I've got two questions.

One is on SSgA, the strategies that you are taking in the liquidity space, the fixed income space.

I mean, clearly we are moved from enhanced more towards passive.

But I guess I'm wondering going forward as you kind of look at this business, is there anything you would do structurally differently to either capture more client assets in a world where enhanced index might not be what the flavor of the day is over the next several years?

I think generally what -- the opportunity for us here is to capture new relationships, because there is this -- I think you are going to see this flight to passive.

So the opportunity is once you capture a new relationship that you had not had in any way, shape or form, how you can increase that relationship in SSgA.

It is about, obviously, moving up the spectrum if you will into more active products, and this is where the synergy takes place.

Because no matter how you capture a new relationship, if you don't have it on the servicing side as well, there is an opportunity for you.

So I think the strategy for us is to capture new relationships and find ways to cross-sell into that new relationship that we would not normally have had if it weren't for this situation.

Can you give us a sense as to the number of new clients that you have been able to capture over the past couple of quarters here?

I can't, other than the ones if you go back and look at the last two quarters, I have probably identified maybe 15 or 20 pretty significant names.

I would say at least half of those are brand-new relationships, if not more.

Then in the past, you have spoken about the opportunities in Europe.

Clearly Europe is having similar kinds of dislocations that we are seeing here.

How does that impact the opportunities for you?

I think -- this is my opinion and something that we need to prepare for -- as soon as we begin to see more normalized markets, there are going to be significant opportunities.

Because I think organizations are going to focus on how do we trim ourselves down and how are we going to be able to deal with maybe not this level of disruption, but continued disruption.

So we are planning to see, I think, some significant opportunities.

When is that going to happen?

I don't know.

First, second, third quarter of next year, assuming some more normalized markets.

But history does repeat itself, and usually after some level of disruption there is this introspection that goes on and a willingness to find ways to turn fixed costs into variable costs in the asset management business.

And I think that we are going to see some opportunities, especially in Europe, actually.

I just wonder because of the degree of government involvement, does that push off potentially some of these strategic changes in the industry?

No, I think just the opposite.

I think to the extent that asset management would want to offload operations that are, I guess, not government controlled but where the government is involved, they would want to do that and get back to what they do best, which is investing money.

So I think that will probably add to that.

Thanks.

Okay, we need to wind up here.

Ron, you may want to just close with a few comments.

I don't have any real comments.

Again, we just thought it was important that we accelerate our earnings call just because of what has been going on this weekend, to get out as much clarity and information as we possibly could as fast as we could.

We look forward to participating with the government and getting to a point where we get back to normal markets.

So thank you again, and thank you very much for coming early this morning.

We appreciate it.

Ladies and gentlemen, this does conclude the State Street Corporation third-quarter call and webcast.

You may now disconnect.