道富銀行 (STT) 2009 Q2 法說會逐字稿

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

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

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 express 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 now like to introduce Kelley MacDonald, Senior Vice President for Investor Relations at State Street.

Please go ahead.

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 will be making forward-looking statements.

Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in State Street's 2008 annual report on Form 10-K and its subsequent filings with the SEC, including its current report on Form 8-K dated May 18, 2009.

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

Any such forward-looking statements speak only as of today, July 21, 2009, 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, as well as our second-quarter earnings press release, which includes reconciliations of non-GAAP measures referred to on this webcast in the Investor Relations portion of our website as referenced in our press release this morning.

Ron?

Thank you, Kelley.

Good morning, everybody.

The story of the second quarter can be told in two parts -- first, the events that occurred and the decisions we made to put behind us the capital issues that we and the industry faced and the attendant government involvement in those issues; and second, the hard work being done every day by thousands of State Streeters building their businesses, deepening their relationships with their customers and strengthening their control environments.

The first part of the story received all the headlines, but it is the second part of the story that is quietly building the strong post-TARP State Street.

Let me quickly review the significant capital-related milestones of the quarter, which have positioned us to take advantage of opportunities as they present themselves.

First, we passed a stress test administered by the Federal Reserve Bank, finishing with one of the highest Tier 1 capital and Tier 1 common ratios among the banks tested.

Importantly, the stress test assumed consolidation of the conduits and applied what the Fed defined as a more adverse scenario to the assets.

Even under the more adverse scenario, we finished with more than twice the required minimum for Tier 1 capital and Tier 1 common ratios at the end of the tested scenarios.

Given our strong results in passing the stress test, we elected to take action that resulted in consolidations of the conduits onto our balance sheet effective May 15, 2009.

Under the new accounting rules, we would have been required to do so like everyone else on January 1, 2010.

At the same time, we saw an opportunity to raise capital and raise $2.3 billion of common equity, up from our original target of $1.5 billion due to increased investor demand.

We also issued $500 million of nongovernment guaranteed long-term senior debt, demonstrating our ability to access the capital markets.

Actually we are the only bank of the original nine TARP banks to raise more capital than we were asked to take by the Treasury back in October 2008.

With strong stress test results and a highly successful capital raise completed, which resulted in strong capital ratios even after consolidation of the conduits, we applied to the Treasury to redeem the preferred stock issued to the Treasury in October of 2008.

We returned the money in June, and in the first week of July, we were the first of the original nine TARP banks to repurchase the related warrant issued to the Treasury when we were asked to take the money in October of 2008.

As you know, in February of this year, we announced the tangible common equity improvement plan that we continue to execute against.

As of June 30, 2009, our tangible common equity ratio stands at 4.96%, up from 1.19% adjusted for consolidation of the conduits at the end of 2008 and now above the original year-end target of 4.91% we set for ourselves back in February.

As Ed will discuss, we are now targeting the tangible common equity ratio to be about 6.5% by the end of the year, all else equal.

So we have come a long way in a very short time, but we can not be satisfied with where we are.

The economy is still fragile, our markets are still repairing, unemployment is still high, and housing is still a problem.

The strong capital position we have created must not only be protected, but it must continue to grow this year if we are to be successful in this new emerging environment.

And the best way to do that is with consistently strong earnings.

So let me focus now on the second part of the story.

Given what we have all been through and what awaits us on the other side of this crisis, coupled with the record results in 2008, it is hard to define strong earnings on a year-over-year basis.

So what I'm looking for is quarterly progress.

And I'm defining that quarterly progress as new sales, strong expense control, and improving risk management.

So let's talk about new sales first.

As investment managers are faced with weak markets and increasing expenses, they are looking to us to turn some of their fixed costs into variable costs.

In the second quarter, we won mandates of $347 billion of assets to be serviced.

State Street Global Advisors added net inflows, an increase of $45 billion in the second quarter, especially into passive and ETF strategies.

We continue to win hedge fund servicing mandates like Caxton Associates, which we announced recently.

As alternative funds are beginning to move away from prime brokers to independent third-party administrators and custodians, we are seeing substantial new business.

Caxton is the hedge fund manager for whom we will provide fund accounting, fund administration and tax services for five funds totaling $6 billion in assets.

As of the second quarter of 2009, we now service $263 billion in hedge fund assets, up from $252 billion in the first quarter.

In addition, we have successfully converted from a competitor 38 John Hancock retail funds with approximately $15 billion in assets.

Vanguard Investments UK awarded us and our joint venture partner, International Financial Data Services, a mandate to provide an extensive range of service solutions for its launch of UK domicile funds.

State Street has been retained by Goldman Sachs for services in Luxembourg, providing custody, fund administration and other services for $13 billion in assets.

Goldman Sachs has been a client of State Street since 1992 in Luxembourg.

We are also providing custody, accounting and securities lending for the city of Edmonton, Canada for $2.2 billion.

Wells Fargo awarded us additional $170 billion in assets as part of the acquisition of Wachovia.

We will provide custody and accounting services for them.

We have also been appointed by PensPlan, a pension fund service provider in Italy to provide a range of investment services for EUR100 million.

Our private equity servicing business has added 10 new clients during the second quarter and now has $136 billion in assets under administration, up from $101 billion in the second quarter of 2008.

In addition to winning the service business for the city of Edmonton, SSgA also won an equity mandate.

The Arizona Public Safety Retirement System has selected SSgA to run a $2 billion impact of equity.

Our securities finance business is stabilizing, growing 11% from the first quarter, primarily due to seasonal demand.

Since the end of the third quarter of 2008, of the customers who suspended their participation in our program, more than half have returned to the market.

Spreads, however, have continued to compress from all time highs in 2008.

It has become increasingly important to us as we operate in a lower growth environment to continue to build a core competency and expense control, which I think we have been demonstrating during this difficult period.

Again, this quarter we achieved positive operating leverage compared to last year's second quarter and also this quarter on a sequential quarter basis, each on an operating basis.

The investments we made during the higher revenue growth periods over the past several years are paying off in efficiencies without the sacrifice of quality.

Our reduction in force is substantially complete.

Our realigned fund groups are efficiently installing our new business.

Expenses are well monitored, and we are making additional investments in our IT and risk management infrastructures.

Notwithstanding our positive achievements in cost control, we have continued to invest in risk management personnel and infrastructure.

I believe one of the strengths that has enabled us to navigate through this economic crisis these last two years is our ability to balance our well-known capability to generate revenue with an increased competency to efficiently install it and to consistently generate positive operating leverage.

Now I will turn the call over to Ed.

Thank you, Ron.

Good morning, everybody.

Ron has covered many of our significant accomplishments in the second quarter, and I will explain in detail how some of those affect our Company.

First, the progress on our tangible common equity improvement plan that we announced at our Investor & Analyst Day on February 5.

Second, the impact of the consolidation of the asset-backed commercial paper conduits onto the ballot sheet.

Third, the improvement in the unrealized losses in our investment portfolio, and finally, I will review the results of the second quarter.

First, the progress on our TCE improvement plan.

In the second quarter, we improved our TCE ratio from 2.22% at March 31, 2009, which assumed consolidation of the conduits, to 4.96% of June 30, 2009, ahead of our original target of 3.62% when we introduced the plan in February.

188 basis points came from the equity issuance in May.

51 basis points of this improvement came from our organic capital generation.

51 basis points also came from price improvement in the investment portfolio.

26 basis points came from securities paying down or maturing the investment portfolio and 8 basis points from our dividend reductions.

These contributors to improvement were offset partially by a negative 41 basis points due to an increase in the size of the balance sheet following consolidation of the conduits and another negative 9 basis points following the repayment of the TARP CPP investment.

By the end of the year, we are targeting our TCE ratio to be about 6.5% with the effects of the fixed income markets on our investment portfolio and our actual financial results being the primary factors that could influence this result.

The details behind this target displayed on a quarterly basis are listed on slide 15 in the slides detailing the investment portfolio, which you can find on our website.

Second, the consolidation of the asset-backed commercial paper conduits onto our balance sheet.

On May 15, 2009, we consolidated the conduits on our balance sheet, adding $16.1 billion of assets and recognizing a $3.7 billion after-tax loss as an extraordinary charge in our income statement.

Consistent with our estimates of the credit quality of the assets described in the slides, we expect the vast majority of this loss to accrete back into earnings over the next eight years with about 2/3 of it occurring in the first five years.

In the second quarter, the discount accretion on the investment securities recorded in net interest revenue was about $112 million.

For the remainder of 2009, we expect about an additional $365 million to accrete into net interest revenue with about $900 million in 2010 and about $800 million in 2011.

This outlook is based on the same assumptions that we disclosed on May 15 that the CPR is in the range of 8 to 12 and that our credit analysis on the securities is correct.

Third, the improvement in unrealized losses in our investment portfolio.

The unrealized after-tax loss improved again this quarter due principally to spread compression following an improvement last quarter.

It has improved by about $1.6 billion after tax since December 31, 2008 to approximately a $4.7 billion unrealized after-tax loss at June 30, 2009, an improvement from the $5.9 billion after-tax unrealized loss at March 31, 2009.

Now let me move on to a discussion of our second-quarter results.

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

Comparing the second quarter of 2009 with the first quarter, servicing fee revenue increased 4% and management fee revenue was up 7%.

Clearly securities, finance and trading services revenue were weaker when compared with the very strong second quarter in 2008, which represented unusual growth for both businesses.

Both improved, however, compared to the first quarter.

Securities finance revenue increased 11%, primarily due to seasonality, and trading was up 27%, particularly due to strength in brokerage and other.

Compared to the first quarter, foreign exchange was down slightly due to lower spreads, offset partially by higher volumes, but brokerage and other fee income was up significantly, over 100%.

Transition management was particularly strong as pension plans began to reallocate assets as markets start to repair.

We had $359 billion of securities on loan on average in the second quarter of 2009 compared with $660 billion in the second quarter of 2008 and down from $399 billion on average in the first quarter of 2009.

About 16 customers who temporarily suspended participation in our program have reentered our program in the second quarter, and about five new customers have joined our program.

So, in addition to the eight customers who returned in the first quarter, we believe participation in our program is firming.

Our program has also attracted customers from competitors who have confidence in the management and quality of our program.

However, with spreads continuing to contract, we expect revenue in the second half of the year to continue to trend down from last year's record.

Average lendable assets for the second quarter of 2009 were $1.9 trillion, down about 32% from $2.8 trillion in the second quarter of 2008, in line with market declines as measured by the S&P 500 or the EFA.

The duration of the securities finance book is approximately 25 days.

The decline in processing and other fees on a sequential quarter basis was primarily due to decreases in product-related revenue.

Of particular note is the effect of the consolidation of the asset-backed commercial paper conduits onto the balance sheet.

Fees from those products are now reported as net interest revenue.

Net interest revenue on a fully taxable equivalent basis declined about 11% from the second quarter of 2008 and was up 4% from the first quarter of 2009.

The decline from the second quarter of 2008 was primarily due to a decline in customer deposit volumes and spreads, partially offset by the $112 million of discount accretion following the consolidations of conduits on May 15, as well as wider spreads on the fixed rate securities in the investment portfolio.

The increase compared to the first quarter of 2009 was due primarily to the discount accretion.

Otherwise, net interest revenue would have declined due to narrower spreads in both the investment portfolio and on customer deposits.

Net interest margin of 193 basis points was down 10 basis points from the first quarter of 2009 on a fully taxable equivalent basis.

Excluding discount accretion, the net interest margin would have been 157 basis points, which is in line with our prior outlook.

We recorded $26 million of net securities gains in the quarter.

This is comprised of about $90 million in gains and about $64 million in OTTI.

The OTTI was primarily due to anticipated credit losses in Alt-A and RMBS securities.

In addition, we added $14 million to the allowance for loan losses in order to provide for expected losses on $580 million of commercial mortgage loans held on our balance sheet that were acquired in the fourth quarter of 2008.

Regarding operating basis expenses, a 25% decrease in second-quarter expenses compared to the second quarter of 2008 and a 5% increase from the first quarter of 2009, I will comment on two areas.

First, salaries and benefits declined 34% from the second quarter of 2008, due primarily to a reduction in incentive compensation in the second quarter of 2009, as well as the effect of our reduction in force, which was substantially complete by the end of the first quarter.

Salaries and benefits decreased 5% compared to the first quarter, primarily due to a lower level of accrual for incentive compensation in the second quarter of 2009.

We substantially reduced incentive compensation in the first half of 2009 as part of our TCE improvement plan.

In the second half of 2009, however, we expect to accrue incentive compensation at a more normal rate, of course, based on our overall performance.

Other expenses also declined significantly in the second quarter of 2009, down about 26% from the second quarter of last year, but up 55% from the first quarter of 2009, which was at an unusually low level.

This increase was due primarily to the special assessment of $26 million from the FDIC in the second quarter and unusually low securities processing costs in the first quarter.

We will continue to be vigilant in managing these expenses.

As I indicated last quarter, we expect these expenses on an annual basis to be down about 15% from last year.

While they are running lower than this percentage reflects in the first half of the year, we continue to carefully monitor these so as to be sure that we align our revenues with our expenses.

Now let me turn to the investment portfolio.

The size of the average investment portfolio in the second quarter has increased about $4 billion since the second quarter of 2008, due primarily to the consolidation of the conduit assets, offset partially by runoff and sales from the portfolio.

The unrealized after-tax losses in our investment portfolio improved about $1.1 billion from March 31, 2009.

In our investment portfolio slide presentation, we have updated the data through quarter-end for you to review.

As of June 30, 2009, our portfolio is 79.6% rated AAA or AA, 67.3% AAA and 12.3% AA.

While overall performance of the investment portfolio continues to be good, during the quarter we experienced 164 downgrades, excluding the municipal bonds and seven defaults.

Compared to the first quarter, the pace of downgrades in the second quarter slowed significantly by almost half.

Most of the second-quarter downgrades were in non-agency mortgages, corporate bonds and HELOCs.

Our excess liquidity returned to more normalized levels and stood at about $15 billion at June 30, down $9 billion from March 31, 2009 as investors began to deploy their cash.

As of June 30, 2009, we deposited about $20 billion in excess balances with central banks, down from $52 billion at the end of 2008 and down from $30 billion at March 31, 2009.

Let me make a few brief comments about our outlook for net interest margin in 2009.

First of all, 2008 was an anomalous year with unusually strong growth in net interest revenue and atypical net interest margin expansion.

Our assumptions for the rest of 2009 include that we will begin to reinvest those assets that have matured or are paying down, given our strong capital ratios in order to better position us for the future.

We plan to keep our investments very conservative, investing mostly in AAA asset-backed and mortgage-backed securities, as well as agency securities.

As of June 30, 2009, we have about $13 billion in assets, which we expect to mature or pay down in the remaining two quarters of 2009, which are currently priced at a dollar price of about $86 on average.

We expect interest earning assets to decrease between 5% and 10% over the remainder of 2009.

This decline is dependent on the continued gradual improvement in the markets and our ability to carry lower levels of excess liquidity.

We continue to expect the net interest margin to be between 210 and 220 basis points on average for the year, excluding the impact of the [AML left] in the first quarter of this year.

In the first quarter, the Bank of England reduced its overnight rate to 50 basis points, and we expect it to remain there for the rest of the year.

In the second quarter, the ECB cut its overnight rate to 100 basis points, and we also expect it to remain there for the rest of the year.

And we expect the Fed to keep the overnight Fed Funds rate at 0 to 25 basis points for the rest of the year.

So in conclusion, the capital markets appear to us to be recovering slowly, and if that trend continues, we expect revenues in the second half to strengthen slightly as compared to the first half.

Servicing and management fees are recovering somewhat, and our pipeline is strong, although decision-making is slower than we expected coming into the year.

Participation in our securities lending program is firming, but we expect securities lending to be negatively impacted by contracting spreads in the second half of the year compared to the second half of 2008.

Unrealized losses appear to be improving as well, decreasing significantly from year-end as I just covered.

We maintained good expense control this quarter and intend to continue this vigilance throughout the year.

We remain committed to achieving positive operating leverage on an annual basis, although not necessarily every quarter.

We are maintaining the full-year outlook we announced on May 18.

Operating earnings per share we expect to be between $4.25 and $4.50 per share.

We expect a decline in operating revenue of approximately 12% compared to operating revenue in 2009 with the record year in 2008, and operating return on equity of approximately 17%.

Now I will turn the call back to Ron.

Thank you, Ed.

So in conclusion, where do we stand?

While signs of improvement continue to give us more confidence, we are still cautious about the outlook for the economy and the recovery.

To address the uncertainties, we are focused on the factors we can control, like servicing our customers, managing our expenses and investing for the future.

In doing so, we are well-positioned for a return to more normalized markets.

Our pipeline continues to be strong.

But, as Ed pointed out, decision-making is slow as our customers are distracted by the many challenges of the unprecedented economic climate.

The 7% increase in our total fee revenue in the second quarter from the first quarter represents a trend which we hope to build upon in the second half of 2009.

As a result of the capital raise and the conduit consolidation, we believe we have put the capital issues behind us, and we can now spend more time talking to you about business trends.

We believe we are well positioned for a market recovery, even if that recovery reflects a period of slower growth and to increase our market share both in the US and abroad.

So with that, Ed and I will be happy to take your questions.

(Operator Instructions).

Mike Mayo, CLSA.

Your assets under custody were up more than the fees, at least the way I'm looking at it linked quarter.

And I'm just wondering why that might be the case.

It raises questions, are you -- is it a timing issue?

Are you cutting price, or am I missing something?

No, we are not necessarily cutting price.

It could be just the conversion process itself as the assets come on and the lag in recognition of the income as we go through phases of installation.

That is probably the only nugget I can give you.

But there has been no change.

And the new business as a percentage of assets under custody, I mean it is an impressive list.

You led off with Wells Fargo and everybody else, all this business you are getting.

But can you give us some context for what that new business represents as a percentage of assets under custody?

I don't know if I could give you a percentage of assets under custody.

There are a couple of variables there.

First of all, they are coming in bigger chunks.

$170 billion is a big piece.

I think one of the things we have said in the past is we are usually the beneficiary of merger and acquisition activity, and the Wells situation is a good example, Wells Fargo buying Wachovia where we were servicing most of the Wachovia assets.

The other thing that is a variable is we win a lot of business, but don't necessarily get the assets right away or may not at all, assets under administration.

And so we have been basically just showing you assets under custody.

So we will be getting the service fee revenue without necessarily getting some of the assets.

Fund administration is a good example.

Investment manager outsourcing is a second example.

So there are a couple of variables here that skew those.

And then secondly, personnel expenses were down for the second quarter in a row.

Are there any new initiatives, and is that sustainable?

No, there are not any new initiatives.

We are still watching very carefully.

As you know, when we had the reduction in force we focused on the higher levels and kept the service units basically intact.

I think we are just going to continue to watch that very, very closely.

And then last question.

The core margin, just based on what you said, is down almost 50 basis points.

Is that -- I mean, in other words, from 2.03 on a core basis down to 1.57.

That is kind of like a wow sort of change.

And I guess the difference there is the accretion back to earnings after your charge.

How should we think about that margin change, and how should we think about the accretion back into earnings?

Do you get compensated based on the benefits from that accretion to earnings?

Just some context on how we should think about that as investors.

Let me take the first part, and I will turn it over to Ed as well.

There is nothing different in terms of the margin of the basic service business.

If anything, I think those fees and margins have been firming.

Let me ask Ed to --

You are addressing [NIR], the diminished margin?

Yes.

Yes.

I mean I think part of the reason, excluding the discount accretion, the fact that we have not been investing aggressively as part of the TCE improvement plan is part of the decline that you noted, excluding the effect of the discount accretion.

That is one of the reasons why we want to start in the second half of the year gradually going back in at the AAA level and investing some more in order to bolster that margin going forward.

In terms of the question on are we compensated based on the discount accretion, the answer is no.

Our comp plans exclude the discount accretion coming back in in this year and in future years.

Ken Usdin, Bank of America Securities.

So just one quick follow-up on margins.

So if we are still expecting a 210 to 220 full-year margin, that assumes a meaningful jump from the 193.

I'm just wondering have you already started putting money back to work?

So do you get that snap back in the second quarter, or does it really kind of power up as you get through the year and move into next?

Well, we have not started yet.

We are planning on starting shortly.

It will be more back loaded to the fourth quarter just given the timing of things.

But there will be some effect in the third quarter as we see it.

And I guess the bigger question on the margin also is just as far as understanding, so that should carry then into next year as a positive because if I'm assuming that you are going to be continuously reinvesting and seeing the benefits of moving a lot amounts of low spread names and rolloff into higher yielding, should we presume also that that should carry into next year as a trend?

Well, yes.

One of the reasons why we want to start doing it now is we have a lot of the issues that Ron talked about in terms of the capital raise, consolidation, etc.

behind us.

Ratios are real strong.

We want to make sure that we capture at least some of the value that we see out there.

Spreads have come in a lot on a lot of the securities that we have invested in.

We have benefited from that in terms of the mark clearly.

But yes, we definitely want to start positioning us for the second half of this year and into 2010.

Okay.

My second question, just with regards to the OTTI that you took in the portfolio this quarter and the rest of the book, can you give us an understanding again of how much of the conduit -- what are the implied credit losses that you have built into your conduit re-accretion?

Meaning 900 next year and then 800 the following year, what proportion of the re-capture is that of the total on your write-down?

Well, let's start with the total charge, which was about $6.1 billion pretax, and based on our credit analysis, we would expect all but, let's say, $500 million of that to come back in overtime.

I'm just using a round number for illustration.

But that is in the range that we actually expect.

So we would make a judgment that we have $500 million of credit losses coming our way in the future, which we will not accrete back.

So that leaves $5.6 billion pretax to come back in over the next eight years, as I said, with the majority of it being frontloaded into the remainder of this year and 2010 and 2011.

So those are the high level assumptions.

Relative to OTTI, there were no conduit-related assets or former conduit assets that were part of the OTTI this quarter.

They were all the legacy portfolio before the consolidation of conduits.

Okay.

And then can you give us then that same kind of math on the rest of the portfolio?

So if it is 500 on a $6.1 billion number, can you give us the relative similarity on the investment portfolio?

No.

I mean there is not similarity in terms of us having to make a judgment about expected credit losses relative to the portfolio.

We do that every quarter, and that is the basis for OTTI.

I mean we do still firmly believe -- and this was validated by the results of the stress test -- that the mark on the portfolio is reflective of very significant still illiquidity and not fundamental economic weakness, not fundamental credit losses underlying those securities in the vast majority.

So we are still of that view.

But I don't have an analogous number for you on the portfolio as I just described for the conduits.

Okay.

Got it.

All right.

Thanks a lot.

Brian Foran, Goldman Sachs.

I'm sorry if I missed it, but in terms of the EPS guidance, historically you have given guidance.

Where do we stand relative to that historical guidance, and if you are absolutely not giving guidance anymore, any rationale on the decision of why not to do so anymore?

No, Ed gave guidance in his piece.

It is basically the same as we gave on I think it was May 18.

(multiple speakers) -- no change.

No change to previously announced guidance.

And then the impact of the Wells notice you announced during the quarter?

I have nothing to say about that.

I mean don't know any impact.

And then finally, your TCE improvement plan.

You are obviously tracking ahead of schedule here.

Should we still expect in the February schedule you gave 100 to 150 basis points of back-half TCE improvement, or is it more in line with kind of the core earnings generation of more like 35 bps a quarter?

So 70 bps over the back half of the year?

Well, you know, we are targeting 6.5% by the end of the year, and we're going to continue to achieve against that plan.

So the TCE improvement plan is laid out quarter by quarter in the investment portfolio deck, Brian.

(multiple speakers) Slide 15 gives you the quarterly breakdown.

Got it.

Thank you.

Glenn Schorr, UBS.

Just a couple of more questions around the securities portfolio.

If you look at the consolidated report, you see the breakdown of the 90, the 167 OTTI, and the 103 losses not related to credit.

Can you just give a little detail on -- you just mentioned on Ken's question that the 167 was OTTI but not related to conduit consolidated assets.

It is from the legacy securities portfolio.

Can you just give a little bit more color on where the gains were taken, where the OTTI -- what kind of assets produced the OTTI and 167, and then a little bit more detail on the 103 because that is the piece I'm not quite sure on.

Okay.

Can I just clarify before I start answering what page you are referring to?

Page one, the first page of the trends, quarterly financial trends.

You have gains and losses related to investment securities.

You have got the 90, the 167, and the 103.

Okay.

Let me tell you where we took gains, which is the $90 million or so, and the impairments that we took.

First of all, in terms of the gains, we saw in the portfolio a fair amount of agency mortgage-backed securities get what we thought were pretty rich, and that is the entire asset class that we generated the gains from.

A lot of the securities saw significant price appreciation and were significantly over par, some in the range of 105 or so, and we took our gains there based on what we thought was an appropriate timing given the valuations that we saw in the market.

The net of the 167 and the 103 is the 64, which is the impairment that we took net.

That is in two asset classes.

It is Alt-A and non-agency mortgage-backed securities, the securities that have been on a watch list for awhile.

We do, as you know, a stress test every month, every quarter -- excuse me -- on those securities.

And we saw that as time has passed, the year in which the securities first broke under the stress had moved in by a couple of years.

And again, this is measured over a couple of quarters' worth of time.

And based on that, we made the determinant that it was appropriate to impair these securities.

It was a relatively small amount.

I think it was in the range of five to 10 securities that we actually impaired.

But it was based on our stress analysis, and we did it under the new FAS 115 rule that came into effect this quarter.

And is the separation in this display, the 167, 103, just semantics?

In other words, when we think of a security that is impaired, it is just worth less period and the net is the 164?

You are just breaking out credit versus noncredit?

No, this is just a presentation.

167 is the old rule for OTTI.

103 is the noncredit element, which is based on the new rule.

Right?

So the new 115.

And 64 is the present value of the loss that we take.

Remember, the old rule required us (multiple speakers) that if we decided to impair securities, to bring it all the way down from book to market.

The new rule requires us to take it from book down to just the credit loss, not all the way down to market if that happens to be lower.

So this is just presentation.

Okay.

I'm with it.

So then can we talk about what -- how often is the test, and what would produce a change to the accretion?

Because I know that you had lower amount of downgrades as you mentioned, but the general portfolio of credit quality still continues to move in that wrong direction.

What produces a change in the accretion formula, and is it all back loaded?

In other words, how does the trigger work such that if downgrades in OTTI are produced such that that 365, 900 and 800 remaining guidance on the accretion, does that get impacted?

Well, I mean the fundamental thing that could change our expectation there is that we have a change in view of credit.

So using the numbers I used before when I answered Ken's question, if the $500 million became something other than $500 million, that would obviously affect the amount left to accrete, and we have to make that judgment on the remaining conduit, former conduit securities every quarter as to what our credit view is.

So that is the talk of the change in the accretion.

Okay.

I just want to make sure it is viewed as a total portfolio, and the accretion works from there, as opposed to if certain securities start actually realizing losses earlier, it actually flows through to OTTI?

No, no, it is viewed as on a security by security basis.

Okay?

Okay.

So the credit view is one thing that could change our future accretion.

The other thing that could significantly change our future accretion is the level of prepayments that actually occur.

Okay?

We have an assumption built in to our expectation for the rest of this year and the numbers for next year and the year after that assume pre-pays.

So if those pre-payments accelerate from what we are assuming, accretion will be higher.

If they decelerate, accretion will be lower in future periods.

So credit assumptions and speed of pre-payments are the two main drivers of that accretion coming back in.

Okay.

Another quickie.

The lower tax rate that you gave some guidance in the text of your release, what is producing the lower tax rate for the rest of this year because it is pretty low?

Is it the loss obviously taken on the conduit consolidation?

Well, that is part of it, but the driver certainly this quarter and for the full year is that we are seeing more non-foreign income than -- more foreign income than US, which is driving it a bit lower.

And then we are seeing the effect in this quarter, and we will see a bit of an affect in the next two quarters, of the election we made in the first quarter under APB 23 to permanently reinvest overseas earnings.

Those are the two things that are driving the tax rate.

Okay.

Last one, more theoretical.

When I listen to the discussion on the first couple of questions on net interest margin, I'm sitting here thinking it is a little deja vu.

And the way you guys and others had gotten into the situation we are in with having these huge unrealized losses and having the capital tested was reaching for yield a little bit.

I feel like there have been lots of lessons learned, but I cannot help but think, is it a bit too early to start reaching for yield?

Because Ken's earlier question and the NIM guidance on the second half implied it has implicitly a pretty big boost in the second half?

Well, I mean, you know, the question as to when we started reinvesting is one that we have talked a lot about, and we've made a judgment to start, as I said, soon.

So basically for the second half of this year we are of a view that the securities that we have invested in and we expect to in the future invest in, are going to be high-quality securities that we will subject to our normal credit processes and surveillance processes and everything that we have talked about.

We don't think we are acting inappropriately and reaching for yield too early.

We think there is a judgment to be made obviously between staying out and continuing to basically invest in cash versus going back in and investing and starting to reinvest in order to again position us for the second half of this year and into next year.

I mean I hear you, and to be fair you did say you will reinvest in AAA mortgage agency asset-backed --

Right.

What type of duration securities are we talking so I can keep it in perspective?

Two to three-year duration.

Two to three-year duration, so like five-year type maturities?

Yes.

I mean we are not going out there.

(multiple speakers)

Are you going to take the gap up, the asset liability gap -- duration gap?

Well, I mean right now the gap is probably the narrowest it has ever been.

It is about 10 basis points overall.

So we feel like we could widen it out a little bit, notwithstanding the fact that rates are probably at some point going to go up and not down further.

Okay.

Cool.

I'm good.

Thanks for all the answers.

Betsy Graseck, Morgan Stanley.

Could we talk a little bit about just the size of the balance sheet?

I'm just interested in understanding on the deposit side where you feel deposits are relative to "stabilizing" those excess deposits over the last couple of quarters.

How do you feel that is trending?

Where do you think it goes to from here?

Do you feel you still have excess deposits or not?

And then talk a little bit about the assets.

Let me start, Betsy.

The level of deposits to a great extent are consistent with the level of new business.

Because with the new business come the deposits, and it's either DDA here in the US or transaction accounts outside the US.

So my sense is deposits will continue -- the volume of deposits will continue to increase as we bring on new business.

And I think that has been proven out in the past, and I would expect that -- that is going to continue.

I see no change there.

Let me ask Ed to add to that.

Yes, I mean I think we are seeing customers put money back to work, which we think overall is a positive thing.

The markets are getting better.

I hope our comments have reflected that kind of overall.

We are seeing some movement in deposits back to what we call more normalized levels as that phenomenon occurs.

But it is hard to say when normal will be reached, whatever that is.

But, as Ron said, as we have seen in the past, as the business grows, especially non-US, the deposits go with that.

So we would expect to see that occur over the next couple of years, frankly.

But right now I would say we are coming back into more normalized deposit levels.

I think if you just look at the amount of cash that we have on deposit from year-end to June 30, you will see a decline from roughly $50 billion down to $20 billion over that period of time, and that is a reflection of things getting back to normal and deposit levels getting back to more normal levels.

Okay.

And then just a question on the capital.

You indicated TCE going to 6.5% based on your current forecasts by year-end.

How do you think about what your new normal is coming out of this environment?

And, well, maybe you could comment first on that before I ask my second question.

Well, we have not defined what a new normal is at this point.

We continue to be, as we said, cautious.

We continue to want to grow capital.

We are staying with our -- I mean at this point our previous guidelines in terms of 4.25 to 4.75 on the TCE ratio.

We have to revisit that to define what a new normal is.

But at this point, we are comfortable with the TCE growing from where it is now up to where we project it to be at year-end, and we will assess as we get further into the year and into 2010.

Obviously the other side of that impact is ROE, and were you anticipating ROE, and at what point do you start to think about either dividends or buybacks?

And maybe you can give us some color as to how you are thinking through capital management and what you would use first and why.

I think one of the first things we want to take a look at it is to see if there are opportunities to put some of that capital to work in terms of accretive deals.

Our sense is we are going to begin to see some of those things, and I think there are going to be some attractive opportunities.

It is the first place I would go to utilize some of this capital because I think there is going to be an opportunity, and I think we are going to be able to execute because I think one of our core competencies is to integrate books of business.

I think you are going to begin to see some of that probably starting outside the United States before it starts inside the United States.

So that is the first place we would go.

Okay.

And then if those are not available?

Well, then obviously we will take a look at -- (multiple speakers).

We will take a look at the dividend sometime in the future, and I think it is just going to depend on the situation at the time.

Howard Chen, Credit Suisse.

In your prepared remarks, you spoke about the firming of the transition management revenues driving the brokerage fees this quarter.

Can you just remind me how lumpy or not the revenues typically are in that business?

I'm just trying to gauge how to think about the resilience of those strong brokerage fees.

Well, I think what we have seen is, as I think as Ed said, money being put back to work by the pension funds.

I think we are going to continue to see that over time.

I don't know if you have a comment about lumpiness, Ed.

It is a bit episodic, Howard.

If you look at our volumes in transition management, you know, from the first quarter up to the second quarter, they tripled, resulting in the doubling of the results.

And non-US went up about 50%.

But to put that in some context, the second quarter this year was about flat with the second quarter of last year in terms of volume.

So it can move around.

It is dependent on what customers are thinking about in terms of moving from one asset manager to another.

Okay.

Thanks.

And Ed, just to follow up on other fee revenue line items within the FX and SEC lending businesses, in the past you have been really helpful in providing color on the movement and the balance of volumes and spreads.

I was hoping you could do the same again this quarter with those two businesses, the FX and the SEC lending.

Okay.

SEC lending, SEC lending.

For this quarter, the second quarter, we had assets on loan of about [400 to $15 billion].

That compares to the second quarter of a year ago $670 billion.

The spread was actually flat, driven by the International Equities program, and the split was just down slightly from last year to this year.

If you want to look at sequential quarter, actually volume was up from about $400 million to the [415] as I mentioned since spread was up about 5 basis points with those fees actually being about flat.

So those are the high level metrics on securities finance.

In terms of FX, total revenue was just about flat as we noted from Q1 to Q2 in the $190 million range.

Volume was up about 9%, and the customer weighted volatility was actually down from about 1.82% to 1.42% signed from Q1 to Q2.

Those are the high level metrics on FX.

Thanks, Ed.

That is really, really helpful.

And then finally, for me, Ron, in your prepared remarks, you alluded to expense containment becoming increasingly more important for the firm's strategy.

I was curious, are the workforce reductions announced in December and now fully realized in the second?

Can you speak to some of the other potential levers you have to maintain that operating leverage that you and Ed were speaking about?

Yes, what we announced in, I guess, in January is complete.

I have not got 2000 people left right now that we had.

It is totally complete.

We do have some other levers.

Obviously IT is one.

I think in the past we have talked about modulating that somewhere between 21%, 22% and 25% of operating expense, and we do do that.

The good news I think is that in the past we have significantly invested in IT, and we are in pretty good shape in terms of one) capacity and two) I think in terms of product depth.

So there is not a whole lot of new, significant IT expense.

So we're able to put that back a little bit.

Obviously I think we have also done a good job in moving work around and realigning the way we do things.

When we did the reduction of force, it was not just 2000 people across the board.

It was a realignment of work, which is also I think bringing efficiencies to us, and I would expect some of that to continue.

Stephen Wharton, JPMorgan.

Betsy actually asked my question, but maybe I will just follow up a little bit.

One of the things I'm curious about, Ron, is you mentioned acquisition, accretive acquisitions.

It seems like you guys have deemphasized active asset management.

I know you had taken some actions there, and yet I know that there are a number of properties on the market or rumored to be on the market.

Is that an area you are thinking that would interest you from an acquisition standpoint, or are you thinking more on the custody side?

Well, I was speaking more on the servicing side because I think there are going to be some opportunities there as well.

Obviously there are some other type of opportunities.

But there have been some inflows in passive and ETF, so that seems to be working pretty well.

But I was speaking mostly on the servicing side.

And then I guess just one follow-up again.

I mean 6.5% tangible common is pretty high, especially in light of the TCE to risk weighted asset and the Tier 1 common ratio that you already have and we're not even at the year-end.

And I don't want to get ahead of ourselves, but if you had to prioritize, would your preference be share buyback before a dividend increase or vice versa?

My preference would be accretive acquisitions.

Well, that is not the question.

Well, you know, I think we have to take a look at the dividend obviously, and we probably will sometime next year, and then we will take a look at share buybacks.

But I think there are a lot of lessons that have been learned here, and I think we cannot lose sight of those lessons.

So the preservation of capital is something that is also very important.

I don't know what the new normal is going to be, or even what the new metric is going to be.

So I think we have to be a little careful and not be premature in doing things.

So there is a balance here I think that will evolve over two or three quarters, and I think we will get to that point.

But we have to attain that balance and not be too premature.

Gerard Cassidy, RBC.

The question I had was, Ed, you had talked about the customers coming back into the securities lending program.

I think you mentioned in the first half you had about 24 of them come back.

How many did you lose, and what is the potential for more customers coming back in the second half of this year?

Yes, the number that we have talked about us having temporarily we hope departed from the program was in the fourth quarter where we said about 10% of our customers in securities lending, which is about 45.

So based on the numbers that you just quoted, 24 is about half of them.

We obviously don't know when and if the remaining customers are going to come back in or begin participating again in the program.

They clearly have not left State Street as customers.

They have just withdrawn from the securities lending program we hope temporarily.

So there is another 24, 25 of those customers that went on the sidelines in the fourth quarter that could potentially come back in.

This call has gone on about an hour.

We are going to have to end with this questioner.

Gerard, you have one more question.

Sure.

Can you touch on the commercial mortgage-backed securities that you have from the Lehman collateral?

What is the status of that?

I know you have marked it down.

How comfortable are you with the mark, and when do you think you could sell it or get rid of it?

Well, we have about $580 million on the books.

It is marked at less than a $0.50 price at this point.

We are trying to manage it to realize the appropriate value.

I mean clearly if we had an opportunity to sell at what we thought was a reasonable price we would clearly do so.

It is not a core competency or a business or an asset class that we particularly know or like.

But we have it.

You know, it is something that we evaluate every quarter.

It is obviously in a sector that is experiencing some stress.

If you look at what we have done the last two quarters, we have taken just about $100 million, $84 million last quarter, $14 million this quarter, against those loans to write them down based on our evaluation of expected cash flows.

We will do it every quarter, and it is something that we are monitoring very closely.

Okay.

Well, thank you very much.

I appreciate your time and attention this morning, and we will talk to you again soon.

Thank you.

This concludes today's conference.

You may now disconnect.