道富銀行 (STT) 2009 Q4 法說會逐字稿

Good morning and welcome to State Street Corporation's 2009 year-end and fourth-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 for 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.

Ms.

MacDonald, you may begin.

Thank you.

Before Ron Logue, our Chairman and Chief Executive Officer; Jay Hooley, our President and Chief Operating Officer; and Chief Financial Officer 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, January 20, 2010, 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 a slide presentation regarding the corporation's investment portfolio as well is our fourth-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?

Kelley, thank you.

Good morning, everybody.

Now let me start the call with some reflections on 2009 and the fourth quarter, and then I will hand over to Ed who will provide a financial perspective.

Jay Hooley, our President and Chief Operating Officer, who will succeed me as CEO on March 1 of this year, will then provide some detail about our outlook for 2010.

Then the three of us will be happy to take your questions.

Due to actions we took in 2009 we are now well positioned for the future.

Let me briefly describe some of those actions.

In 2009 we grew our core servicing fee and management fee revenues on a quarter-over-quarter basis.

We reduced the run rate of expenses on a year-over-year basis.

We consolidated the asset-backed commercial paper conduits we administered.

We were among the first to repay TARP and buy back the warrants.

We strengthened our capital position and we announced two proposed acquisitions -- that of the security services business of Intesa Sanpaolo, a premier provider of investment services in Italy and Luxembourg, and Mourant International [Financial] Administration, a leading servicer of alternative investments.

New business continues to be strong.

In 2009 we added $1.13 trillion in assets to be serviced and $248 billion in net new business in asset management.

These wins support the momentum we have seen this year in our core business.

Let's take a look at revenue growth.

In the fourth quarter alone in our investor services operations we added more than $500 billion in assets to be serviced, including a mandate to provide investment manager operations outsourcing for approximately $300 billion for Morgan Stanley Investment Management.

We continue to see growth in servicing for alternative asset management.

This quarter we added 14 customers and 65 in total in 2009.

In the fourth quarter our assets to be serviced in alternative investments have grown 5%, up from $421 billion as of September 30, 2009, to $443 billion.

When we complete the acquisition of Mourant we expect State Street to be the largest servicer of alternative investments in the world.

In addition to Morgan Stanley Investment Management, some of our investment servicing wins in the fourth quarter included -- Intermountain Equity Group, which awarded us a mandate to support its new $400 million private equity real estate fund with a full range of administration services.

Saskatchewan Teachers Federation selected State Street to provide custody, fund accounting, and securities lending services for CAD2.2 billion in pension and group benefit fund assets.

Also in Canada, State Street was appointed by the McCain Foods pension plan to provide custody, accounting, benefit payments, and investment analytics for more than CAD300 million in assets.

And Caldwell Investment Management Limited appointed us, along with our joint venture partner IFDS Canada, to provide custody, fund accounting, fund administration, registered trustee services, foreign exchange, transfer agency, and unit holder recordkeeping services for its fund complex.

Again in Canada, State Street was appointed by MD Physician Services to provide a range of investment services for CAD15.6 billion in assets including custody, fund accounting, and fund valuation services.

State Street now provides full back-office services for all of Calamos Investments' collective fund structures, recently adding custody and fund administration services for its more than $21 billion in collective fund structures including open and closed-end mutual funds, double (inaudible) and private funds.

In the United States we won a mandate from Ford Motor Company for servicing an $8 billion defined contribution plan and issuing benefits payments.

We also won a mandate to provide a range of servicing, including custody, accounting, performance and analytics, and securities lending, for Intel's defined contribution plan of $7.5 billion.

State Street Global Advisors during the quarter added $142 billion, including a $1.5 billion mandate for implementing a passive strategy for Massachusetts pension reserves which builds on our existing relationship with this customer.

SSgA successfully won a renewal by the Illinois State Board of Investment Chicago to run a $513 million MSCI all country ex-US equity index.

Moving on to our other business lines, we like many others, face declines in trading services and securities finance revenues.

As we said in the third-quarter call, as spreads compressed further securities finance revenue declined in the fourth quarter compared to the third quarter.

With respect to securities finance revenue, we believe we are at or near the trough.

In the fourth quarter we added several new customers in our securities finance business.

As we said last quarter, our participation in the program has stabilized and now it's beginning to grow again.

Net interest revenue on a fully tax equivalent basis decreased 3% from the third quarter due primarily to lower conduit discount accretion as a result of the absence of one-time pay downs and a slowing in prepayments fees.

Ed will provide some more detail shortly.

Spreads on fixed income securities have compressed significantly improving State Street's unrealized securities losses in our investment portfolio.

As liquidity began a return to the market, the after-tax unrealized losses were cut by about 65% from the December 2008 level from $6.32 billion to $2.29 billion.

It's also important to us as we operate in a lower growth environment to execute our core competency and expense control, which I think we have been demonstrating during this difficult period.

You will notice that our salaries and benefits expenses declined from the third-quarter by about $28 million due to lower cash incentive compensation accruals.

I will now turn the call over to Ed who will provide further detail about our financial performance in 2009 and provide several comments affecting our business in 2010.

Thank you, Ron.

Good morning, everyone.

This morning I will review three areas.

First, the results of the fourth quarter and the year.

Second, the improvement in the unrealized losses in the investment portfolio, the overall performance of the portfolio, as well as our outlook for net interest margin in 2010.

And third, a review of our capital ratios and the execution of our tangible common equity improvement plan.

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

Comparing the fourth quarter of 2009 with the third quarter, servicing fee revenue increased 6% and management fee revenue was up 5%, primarily due to new business wins as well as market increases.

Both items were up compared to the fourth quarter of 2008 due primarily to market improvement.

Clearly revenue from securities finance was weaker when compared either with the very strong fourth quarter of 2008 or with the third quarter of 2009.

In each case this weakness was primarily due to further compression in spreads.

Foreign exchange revenue declined on a year-over-year basis due to lower volatility and lower volumes.

On a quarter-over-quarter basis foreign exchange revenue declined due to lower volumes offset partially by slightly higher volatility.

The mix of foreign exchange business between custody foreign-exchange and third-party foreign exchange remained fairly constant.

Brokerage and other revenue, which is reported as part of trading services, was up 47% when compared to the fourth quarter of 2008 and was up 8% compared to the third quarter of 2009 due primarily to strength in transition management and electronic trading.

We had $405 billion of average securities on loan in the fourth quarter of 2009 compared with $440 billion in the fourth quarter of 2008 and up from $399 billion for the third quarter.

We saw significant compression in spreads in 2009.

The Fed funds to three-month LIBOR spread began the year at about 135 basis points and ended the end of the year at approximately 13 basis points.

We believe that spread compression is near or at a trough and we are hopeful that securities finance revenue is at or near the bottom, assuming volumes remain relatively flat.

While we believe that the securities finance market will continue to be an important source of revenue for State Street, it will take some time for this market to return to historical levels.

Average lendable assets for the fourth quarter of 2009 were about $2.3 trillion, up 10% from $2.1 trillion for the third quarter of 2009, and up about 21% from $1.9 trillion for the fourth quarter of 2008.

As of December 31, 2009, the duration of the securities finance book was approximately 25 days.

Now for the remaining items in the income statement.

Compared to the fourth quarter of 2008 processing and other fee revenue declined 28%, but was up 33% in the third quarter.

The changes in revenue were due to a number of factors, none of which was individually material.

Net interest revenue on a fully taxable equivalent basis declined about 10% from the fourth quarter of 2008 due primarily to the impact of the continuing low interest rate environment, compressed spreads, and the decline in customer balances from the abnormally high levels in the fourth quarter of 2008, offset partially by the impact of discount accretion from the consolidated conduit assets.

Compared to the third quarter of 2009 net interest revenue on a fully taxable equivalent basis declined 3% due to a lower level of discount accretion as a result of the absence of one-time pay downs and slower prepayment rates, offset partially by the positive impact of the investment strategy which we began to execute in the third quarter.

Net interest margin of 235 basis points in the fourth quarter of 2009 was down 12 basis points from the third quarter of 2009 on a fully taxable equivalent basis.

Excluding discount accretion of $230 million, net interest margin in the fourth quarter would have been 161 basis points.

The net interest margin for the full year is 220 basis points including discount accretion of $621 million and is 169 basis points excluding discount accretion.

In the fourth quarter of 2009 we recorded about $108 million of net gains and separately about $51 million of credit-related OTTI resulting in a $57 million net gain related to investment securities.

The OTTI was primarily due to increases in expected future credit losses in US non-agency mortgage-backed securities.

In the fourth quarter we also recorded a loan loss provision of $35 million primarily related to a commercial real estate exposure.

Regarding operating basis expenses, fourth-quarter expenses increased 1.8% compared to the fourth quarter of 2008 and increased 5.7% from the third quarter of 2009.

In the fourth quarter of 2008 we reduced our full-year cash incentive compensation accrual by about 50%, given our tangible common equity improvement plan and the financial market disruption.

As previously disclosed, no performance-based cash incentive compensation was accrued in the first half of 2009 in support of our TCE improvement plan.

Following the repayment of TARP, conduit consolidation, our successful equity raise, and the progress in achieving our TCE improvement plan, we began to accrue discretionary cash incentive compensation in the third quarter of this year.

Note that compared to the third quarter of 2009 salaries and benefits expenses declined 3% in the fourth quarter primarily due to a lower level of accrual of performance-based cash incentive compensation.

We accrued approximately $50 million for this item in the fourth quarter of 2009 compared to the $100 million we estimated we would accrue in the fourth quarter on the third-quarter call.

Other expenses declined 17% in the fourth quarter of 2009 compared to the fourth quarter of 2008, but increased 48% from the third quarter of 2009 due primarily to an adverse judgment of $60 million rendered by a Netherlands court in a matter related to the Lehman bankruptcy, as well as other securities processing costs.

On a year-over-year basis, comparing 2009 with 2008 on an operating basis, other expenses declined 23%.

We will continue to be vigilant in managing these expenses.

Now let me turn to the investment portfolio.

The average size of the investment portfolio in the fourth quarter has increased about $22 billion to $94 billion compared to the fourth quarter of 2008.

This increase is due primarily to the consolidation of the conduit assets with a fair value of approximately $16.6 billion, as well as the execution of our reinvestment strategy in the second half of 2009, offset partially by maturities and sales from the investment portfolio.

Excluding treasury bills, during the fourth quarter we invested about $4.4 billion in highly rated securities at an average price of $99.81 with an average yield of 2.37% and a duration of approximately 2.08 years.

Those $4.4 billion are primarily comprised of the following securities, 99.7% of which are rated AAA -- $1.3 billion in agency mortgage-backed securities; $2.4 billion in asset-backed securities including about $1 billion of foreign RMBS and about $0.5 billion of credit card receivables; $0.2 billion in non-agency mortgage-backed securities; and $0.5 billion in corporate and municipal bonds.

The aggregate unrealized after-tax losses in our available for sale and held to maturity portfolios as of December 31, 2009, were $2.3 billion, an improvement of about $700 million from September 30, 2009, and about $4.0 billion or about 65% from December 31, 2008.

In each case after giving effect to conduit consolidation.

As of last Friday, January 15, 2010, the comparable unrealized after-tax loss had improved from year-end by nearly $500 million to about $1.8 billion.

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

As of December 31, 2009, our portfolio is 80.2% AAA or AA rated, similar to September 30, 2009.

The amount of downgrades diminished significantly from the prior quarter as well.

The former conduit assets, now included in the investment portfolio, continue to improve in price during the quarter as general capital market conditions improve.

We continue to estimate that we will not accrete back into net interest revenue of about $850 million of the charge we took upon consolidation.

This is expected to occur over the remaining lives of the conduit assets and is consistent with the level we estimated on our third-quarter conference call.

The accretion into net interest revenue in the fourth quarter was $230 million for a total of $621 million in 2009.

We continue to expect about $900 million of discount accretion in 2010 and about $700 million in 2011 to accrete back into net interest revenue, further bolstering our already very strong capital position.

We also continue to expect about two-thirds of the total expected discount accretion to occur in the first five years after consolidation, assuming we continue to hold the securities.

As you are undoubtedly aware, a significant number of assumptions go into the estimate of future discount accretion including estimated prepayment speeds and expected future credit losses across the various asset classes.

I will now provide some of the assumptions we used in creating our 2010 outlook for net interest revenue and net interest margin.

First, that we continue to execute on the portfolio reinvestment plan that we adopted in the second half of 2009.

We intend to reinvest about 80% of the approximately $15 billion in assets due to mature or pay down in 2010.

We intend to continue to invest in highly rated agency mortgage-backed securities and highly rated asset-backed securities.

As we stated when we announced the proposed acquisition of Intesa's securities services business, we expect to invest approximately $16 billion of customer deposits in euro-denominated government bonds and bank placements.

We expect our net interest margin, including the impact of the Intesa acquisition but excluding the conduit discount accretion, to be between 150 and 160 basis points on average for the year.

Excluding discount accretion we expect the net interest margin to be down from 169 basis points on average in 2009 due to an anticipated significantly tighter spread environment for all of 2010 as compared to the first half of 2009.

We expect the Bank of England rate to remain at 50 basis points for the rest of the year, we expect the ECB rate to remain at 100 basis points for the rest of the year, and we expect the Fed to keep the overnight Fed funds rate at 25 basis points for all of 2010.

We further expect earning assets to increase between 6% and 8% from the average in 2009, primarily due to the expected acquisition of Intesa's securities services business.

We expect the S&P 500 to average about 1125 in 2010, up about 19% from 948 which was its average in 2009.

Lastly, I will briefly update our capital ratios and the successful execution of our TCE improvement plan that we announced last February.

In the fourth quarter State Street Corporation's capital ratios continued to improve such that as of December 31, 2009, compared to September 30, 2009, our Tier 1 leverage ratio stood at 8.5%, up from 8.0%.

Our Tier 1 capital ratio stood at 17.5%, up from 15.3%.

In the fourth quarter we improved our tangible common equity ratio from 5.6% at September 30, 2009, to 6.6% at December 31, 2009, ahead of our original target of 4.91% when we introduced the plan in February 2009.

The majority of this quarterly improvement came from price improvement in the investment portfolio and organic capital generation.

The details behind the TCE ratio displayed on a quarterly basis are listed on our website on slide 15 in the investment portfolio presentation.

We expect all of our capital ratios to continue to be strong, including following the acquisition of Intesa's securities services business expected to close in the second quarter of 2010.

In conclusion, we strengthen the Company through our actions in 2009 to prepare us for the future.

We believe the economy is recovering, but that it will be slow and our approach will continue to be cautious.

Now I will turn the call over to Jay who will provide our view of our financial goals and the operating environment.

Thank you, Ed, and good morning.

I am excited about leading State Street into the second decade of this century and believe that we are well positioned to take advantage of growth trends in the global financial markets.

We have emerged as a stronger company after two very disruptive years, 2008 and 2009, when financial markets nearly collapsed and our revenue soared in one year due to strength in market-driven revenue and then fell in the next as volume and volatility in market-driven revenue fell below historical norms.

Continued weakness in market-driven revenue is expected to be a headwind in 2010.

In 2009 growth in our core businesses, securities servicing, and investment management, were the two consistent bright lights and we are optimistic that this trend will continue into 2010.

We continue to win new business and our pipeline is promising.

We see growth opportunities across all geographies and in particular in investment manager operations outsourcing, quantitative asset management, and alternative investment servicing.

We expect to close two acquisitions in the first half of the year, as Ron mentioned -- Intesa Sanpaolo's securities servicing business and Mourant.

Both acquisitions will provide additional capabilities for our customers in Europe and both are expected to be modestly accretive in 2010.

First, Intesa Sanpaolo's securities services business.

This acquisition brings us about $500 billion in custody assets to be serviced, a significant majority of which is Intesa Sanpaolo's own investment management affiliates.

In addition, we will provide accounting services for about $250 billion and [depo bank] services for about $200 billion.

With 80% of the assets in Italy and the other 20% in Luxembourg, as the business becomes integrated into our business model we see opportunities for additional crossover avenue which was not included in the valuation models for the transaction.

As we said when announcing the transaction, we will assume about $16 billion in deposits which we intend to invest in euro-denominated government debt as well as bank placements.

Then Mourant; this acquisition will solidify our position as the leader in servicing investment -- alternative investments and as the number one servicer of private equity investments in the world.

We gained expertise in servicing private equity following the acquisition of Investors Financial and Palmeri in 2007 and Mourant adds to that capability.

So our own organic growth plus the long-term growth of these two acquisitions position us very well for the future.

With this as an introduction, let me remind you that we believe that our long-term financial goals remain in place.

Last spring I led a strategic view of our company.

Our senior most staff reviewed the markets, both geographic and product related, for all of our businesses and compared the outlook of those to our long-term financial goals.

We assessed our market position and our existing solutions and services, as well as those in development.

The result -- those goals are still appropriate and I expect them to be achieved over economic and market cycles.

They are growth and operating basis revenue of between 8% and 12%; growth and operating basis earnings per share of between 10% and 15%; and achievement of operating basis return on equity of between 14% and 17%.

Given the volatility of the past two years, we expect that 2010 is going to be a transition year.

We expect our core businesses' servicing fees and management fees to continue to grow and become a larger percentage of the total revenue.

If we include discount accretion associated with the conduit consolidation into our calculations, we expect our operating basis earnings per share in 2010 to be approaching the lower end of the 10% to 15% range.

However, to achieve greater transparency into the performance of our core business going forward we will report our operating basis financial results, excluding merger and integration costs, as well as the impact of discount accretion associated with the conduit assets.

So to level set, let me remind you that our operating basis revenue, excluding discount accretion, in 2009 was $8.138 billion and our operating earnings per share would have been $3.32.

We expect our 2010 operating earnings per share, excluding the merger and integration costs and discount accretion, to be only slightly above 2009, reflecting in part a higher average outstanding share count.

To achieve success going forward I have several targets I intend to drive through the organization.

Let me give those to you.

Number one, double our non-US revenue over the next five years.

Two, drive industry innovation by maintaining technology investment at 20% to 25% of operating expenses.

Three, accelerate global market share growth in core businesses organically and through acquisition.

Four, refine our industry-leading operating model so as to achieve positive operating leverage annually in more normal markets.

And finally, to enhance our risk management capabilities across the organization.

So 2010 is expected to be a year of transition, one in which our core businesses continue to grow, but sources of market-driven revenue represent a headwind.

We look forward to closing the two transactions we announced in the fourth quarter and integrating them into our business.

And I look forward to meeting with many of you in the future, especially at our Investor and Analyst Forum which is scheduled for May 5 in New York.

Now I will turn it back to Ron.

Thank you, Jay.

I feel very confident about State Street's future as I turn over CEO responsibilities to Jay.

We are completing a very successful management succession that will allow State Street, without interruption, to continue to execute its strategy.

Jay has been critical to our past success and our present strategy, and with the Board has laid out a plan to continue that success in the future.

As a company we have persevered through what is arguably the most difficult financial period since the Great Depression.

And because of that we have forged a management team that is expert in their respective disciplines, collaborative and customer sensitive, and shaped by successfully dealing with the difficulties of the last two years.

Jay and I have worked together for almost 20 years.

We have marketed to and serviced our customers together, integrated our acquisitions together, and built our management team together.

We sit here today with a strong capital position, a strong track record in acquiring and integrating global investor services businesses, and a core competency of managing our expenses against our revenue.

Since the late 1970s, regardless of who was the CEO, we followed the principle of making sure we delivered value to the four constituencies we serve -- our shareholders, our customers, our employees, and the communities in which we work.

We may execute differently given the times and circumstances, but for what now begins a fifth decade we remain true to the values that emerged as a result of a different financial crisis in the '70s -- focus on the constituencies you serve and serve them well.

Now Jay, Ed, and I are happy to take your questions.

(Operator Instructions) Ken Usdin, Bank of America.

Thanks, good morning.

Just trying to understand the guidance a little bit in more detail.

I would back out some of the one-time things like the CRE charge and the Lehman-related charge and go to the kind of tax rate you are going to go for next year.

I can see the Company making somewhere around call it $0.80 this quarter.

And then -- the guidance that you are saying on a core basis, ex the accretion -- so the guidance is some, is said to be up off of the 3.32 core for the full year.

And I just wanted to -- if you could just kind of qualitatively help us understand what is going to actually be the growth drivers given that you have kind of said the core margin will be 150 to 160.

So can you just maybe from a business line to business line perspective just help us understand what line -- what areas of the Company are going to truly lead the growth and what area would be the more specific headline challenges as you look forward?

Yes, Ken, this is Jay.

Let me start that one out.

As we end 2009 I think you saw and we know particular strength in the investor services and investment management lines.

We think those businesses continue to be positioned against good growth trends, whether it's passive asset management or continued outsourcing both domestically and globally.

So we think those core revenue engines are set up well for good growth in 2010.

As mentioned, the market-driven revenues, beginning with the securities lending business, is still in a constrained environment.

We think it's at a trough, but recovery will be slow.

And in net interest revenue, as Ed mentioned, we see that as flattish throughout the year.

So I think the core drivers have always been the core drivers, which is the core investor services and investment management fees, which we are pretty optimistic about as we sit here today.

So the core businesses just have that much more of an overpowering effect versus the kind of the flatness of those other business lines -- of the kind of market-related and NII?

Yes.

Okay, great.

And just to --

Hey, Ken, the other thing to note is -- and you probably know this -- but included are the two acquisitions as well.

So you have Intesa and Mourant which are expected to close in late first and during the second quarter.

Of course.

Right, okay.

And then the second question just on expenses.

Can you just -- Ed, maybe you can just help us understand.

With the kind of the reversal back out of some of that cash-based incentive comp, how will it work going forward as far as your planning and incentive compensation plans as far as resetting that accrual, and how we should be thinking about that -- those relative changes?

Yes, just to clarify, there was no reversal.

There was just less accrual in the fourth quarter than what we had signaled in our third-quarter call.

So we accrued cash-based incentive comp in the second half of the year in a total amounts of $150 million; $100 million in the third quarter, $50 million in the fourth quarter.

I think going forward our expectation -- and again, this is all performance dependent -- is that we will accrue a more normal level on a full-year basis of incentive compensation in 2010 with the mix between cash and stock still to be determined.

And obviously this is all a function of what our, the comp committee of our Board, ultimately settles on in their evaluation of the market and our performance and how much incentive comp will be set at.

Okay.

And my last small question on expenses also.

Ex the Lehman-related charge, the other expenses area was still I guess meaningfully higher third to fourth quarter.

Was there anything else specific in that line item and how much more discretion do you have as far as control in that other expense line?

Thanks.

In the other expense line there is nothing of particular note that I would mention to you other than the Lehman charges, as you said.

That is a line that we have had -- we have an amount of flexibility on in terms of pacing various levels of expense.

We have ramped it up in the past and used consultants and professional services to get ahead of some IT projects, for example.

And the converse was true this year where we brought it back down given the revenue outlook.

So there is some level of leverage there going forward.

It's not huge.

It's in the tens of millions of dollars, not hundreds of millions of dollars, Ken, but it's a line that we have a lot of focus on.

Okay, great.

Thanks a lot, everyone.

Howard Chen, Credit Suisse.

Good morning, everyone.

A follow-up on the core operating guidance; thanks for all the detail on the major assumptions.

Could you just provide us with some of the refreshed sensitivities on some of the bigger ticket items like Fed funds and the S&P levels?

Well, the S&P level I think you should think of in terms of the historical guidance which we have given is 10% up on that metric or 10% down is in total revenue; 2% up or 2% down.

That still holds.

We think that that is a level from a planning standpoint that is reasonably conservative given where the S&P is now.

In terms of Fed funds, we expect rates, as I said, to be basically flat at the short end for most of the year.

We expect the economy to improve, but as I said, slowly with an expectation that as we end 2010 the environment will be getting better and rates will start to slowly rise.

That is still a good thing for us; it always has been.

Slowly rising rates are a positive to us and that continues to be the case.

If that series of assumptions holds true, it should position us in reasonably good shape in terms of the portfolio moving into 2011.

Okay.

Thanks, Ed.

And then second, I think you have been speaking to expectations for further balance sheet contraction before we saw growth again and deposits grew nicely this quarter.

What do you think has changed?

Is it an inflection point?

And what is driving your thinking that you won't grow the balance sheet much ex-Intesa in 2010?

Well, we are just being I think conservative in our thinking.

We expect, I would say, a historically-based level of customer deposit expansion, but we want to reduce some of our overall liquidity position which we carry coming into year-end, Howard.

We again this quarter were conservative in our thinking given that our view is, again, to be cautious.

And moving into 2010, if we are right in our planning assumptions, we should find ourselves in a position to carry less excess liquidity because the environment will not be quite as potentially disruptive as it was coming into 2009's year-end.

Okay.

Thanks, Ed.

And then, apologies if I missed this in the prepared remarks, but what are you selling in the securities portfolio and what is driving that decision?

Yes, we sold some securities; a little over $1 billion of agency mortgage-backed this quarter.

And there is -- I think the same approach that we had in the third quarter which was, given the quantitative easing that has been going on, we felt that some of the securities were trading at what we thought were prices that were above fair value.

So on the agency mortgage-backed it's $1.1 billion to be specific.

We had an average price on that of a little over $104 price.

We thought that those were rich and we sold them, and we reinvested at an average dollar price coming back into the market at about $102.

We thought that made sense given the richness and we thought it took some potential prepayment risk off the table.

And then as a secondary item, some minor sales really in the scheme of things, in the range of $300 million in total of former conduit assets that we thought were good derisking trades.

Okay.

And then just one final housekeeping question for me, Ed.

Just could you provide us with the [seg] lending spreads as you have done the past for the quarter?

Sure.

Thanks so much.

Okay.

Year-over-year, Q4 to Q4, Howard, the average spread last year was 137 basis points.

This year-end it was up 41 basis points.

And sequential quarter, third quarter of 2009 50 basis points; down to the 41 basis point level Q4 2009.

Great, thank you.

Those spreads were the main drivers, as I said, of the decline in securities lending revenue.

Got it.

Nancy Bush, NAB Research.

Good morning; a couple of questions.

I guess I am a little confused on the whole issue of core earnings because your contention has been that the accretion is cash, it can be used as cash is used to pay dividends, do acquisitions, etc.

So why the decision to change your reporting?

Nancy, this is Jay.

Over the past several months, after it was announced that I would succeed Ron, I spent a fair amount of time with many of you and it appeared to me that we are creating confusion in your world by continuing to explain our core earnings with discount accretion.

So in order to create more clarity and transparency I thought it was important to separate those concepts.

You are absolutely right; discount accretion does build capital that is available for acquisitions, dividends, and other capital management activities.

But I think it's important to focus on the core as we think about the core and how it grows in the out years.

So it was really a decision I made based on what I thought was a lack of clarity in the analyst community and a better reflection on what the core is and how it's likely to grow going forward.

So are you also -- I mean, will there be a report of earnings with accretion as well so we will know both numbers and can pick and choose?

Absolutely.

Yes, we have no intent not to continue to disclose discount accretion, but I think it's important that we view the core as core ex-discount accretion.

And if you could just remind us, the discount accretion -- at what point do core earnings and, quote, what is now non-core become the same?

I mean, we are still several years away from that, right?

Yes, I think we said five years the majority of the discount accretion would have run through.

Two-thirds.

Two-thirds of it in five years.

Okay.

Secondly, could you just -- or just give us a little more color on this, the loan loss provision, the necessity for the loan loss provision?

I think you said it was related to a CRE exposure.

Whether that exposure is now on non-performing and etc.?

Nancy, this is Ed.

I will take it.

It was one mortgage exposure that we took on a year or so ago.

It is marked down now to a carrying value which we think is reflective of the expected future cash flows that we are going to get off that property.

The remaining balance is around $50 million after we have taken the allowance against it.

And we, as I have said before, analyzed the commercial real estate exposures we have, which are right now in total about $560 million quarterly, and provide if we feel the need is there.

On the rest of them we did that analysis and concluded that no incremental provision was necessary.

All right.

But is this non-performing?

You have not had a non-performing total I think prior to this.

Do you now have non-performing assets?

No, it's not non-performing.

Just -- remember, there is different accounting for loans that you originate versus loans that you acquire.

We acquired these; we have to do a cash flow-based analysis and conclude that the cash flows you expect to receive will cover the balance that is on your books.

So that is what we did.

It's not considered nonperforming, but we thought that looking forward that the expectation of future cash flows on this on this one loan did not justify our carrying value so we took a provision.

Okay, thank you.

Brian Bedell, ISI Group.

Good morning, folks.

Can you just talk about within your 2010 outlook to what degree you have further other than temporary impairment factored into that along with securities gains?

The 2010 outlook does not include any securities gains, nor does it include any expected impairments.

Okay.

And as you sit right now, do we see risk of I guess further OTTI?

And how -- can you talk little bit about the strategy of selling more securities and downsizing the securities portfolio in 2010?

Well, there is always a risk of further OTTI.

Again, it's very fact and circumstances dependent.

At every quarter end I have described the process we go through.

I couldn't sit here and tell you that I expect any more given that what we have done is what we think is appropriate as of 12/31/09.

We don't have an explicit strategy, Brian, of taking securities gains to offset OTTI.

I mean, we have been in a situation where we think, as I have said on third- and fourth-quarter calls, the market has been a bit rich in terms of some of the mortgage-backed securities specifically and we have availed ourselves of that.

If the market continues to be rich as we move into 2010, then we will look at them on a case-by-case basis.

But there is no explicit strategy to take securities gains moving in to this year.

So much more opportunistic?

Yes.

All right, great.

And then on the NIM outlook, just to reiterate, you said 150 to 160 basis points on a core basis for --

Brian, we can't hear you.

Could you take off your headset please?

Can you hear me now?

Yes.

The NIM of 150 to 160 basis points on a core basis for full year 2010, did I have that right?

Yes.

Okay.

And if you could also talk about the $1.13 trillion of custody assets that you won in 2009, what proportion of that has been already converted during the full year?

I think, Brian, maybe a little bit -- this is Jay -- a little bit more precise to your question, I think in the fourth quarter we booked $500 billion.

So I think that the difference between the [one three] and the five is largely implemented.

And of the $500 billion in the quarter, you can assume that most of that is not implemented and it will be implemented in the first half of 2010.

Okay, great.

So the Morgan Stanley deal is mostly converted already?

No, it's not.

That would be a first to second quarter of 2010 installation.

Okay, great.

And then, Jay, can you just talk a little bit about -- you did mention your five long-term goals.

Can you talk about the risk mitigation strategy longer-term reflecting back on what has happened over the last couple of years?

What are some of the key things you plan to do over the next two to three years to reduce risk in the franchise, particularly on the balance sheet side?

I think that we have all learned something over the course of the last couple of years -- not just the world but State Street.

I feel like we need to redouble our efforts across the spectrum.

So some of the things that we have done structurally are we continue to build up our internal control functions, not just risk management but audit, legal, as well as compliance.

We have applied additional resources to build technology and reporting.

So from a standpoint of enhancing and building up the function, that is well under way but there is always more to do.

I guess maybe more broadly and perhaps more importantly, I think that we are in a transition where risk management has become a broader part of the culture of how we view business opportunities going forward.

So I think across the Company, whether it's running a line business or a support staff group, there is much more attention at my level, at Ron's level, at Ed's level to managing risk in a prudent way.

That doesn't mean not taking risk, but being aware of when you are taking risk what the risk return looks like.

So I would characterize it, Brian, as strengthening the functions and embedding risk management into the core fabric of State Street in a more meaningful way going forward so that hopefully we avoid some of the issues that we had in the past.

Right.

And I just think about a couple areas where we might actually see that; I guess one is in the other expense line in terms of operational [areas].

Of course, all the custodial banks have them from quarter to quarter.

It looks like they were a little bit elevated in the fourth quarter I guess relative to a couple prior quarters.

Is that fair?

I don't think -- in fact, I think we are making good headway there.

And just to pick on that and expand on what I was mentioning earlier, we now have a process and have had it in play through half of -- the last half of 2009 where every loss is examined, evaluated, look for root cause.

We are looking across multiple instances of issues to try to find what areas need the application of an improved process, technology, training.

So I think we are doing a much better job of fundamentally getting at root cause in some of the operating areas.

And I would expect through that over time we will continue to manage down operating losses.

All right, okay.

And then just lastly, I guess also with this question on the balance sheet, say three years from now.

Obviously the conduit assets and some of the legacy portfolios are maturing.

But on a go-forward basis do you expect to run a securities portfolio that is of much lower risk component and you would have potentially lower yield?

You know, I think we are always evaluating, as you would expect, the risk return equation in our portfolio investment management strategy.

As Ed went through, going into 2010 we are not anticipating any material shift.

But, again, we are always evaluating market conditions and are willing to adjust if it feels like the return doesn't warrant the risk that we are taking.

Okay, great.

Thank you.

Glenn Schorr, UBS.

Thank you.

Can you give a little color further on the rising interest rate thing?

We get it if they go up slowly it's a good thing for everybody.

If they go up a little fast just because we are coming off of such a low bottom, how does the sensitivity around that work in the short term?

I know long term it's a good thing, but in the short term how sensitive is the P&L?

Well, it obviously depends on the pace with which the increase occurs and when it occurs, Glenn.

I would say that if you look at the 25 basis point increase and it were to occur sort of in the second half of this year, probably not much of an effect on us for 2010's results.

If it were to be let's say steeper than that and faster than that, the effect would be, obviously, more pronounced.

I don't want to put a specific percentage on it, but I think if you look at the shock and the ramp test that we disclosed that should give you an idea of what it would mean.

Obviously, we are not expecting a huge shock up in rates, but if that happens the effect would be more negative to us than a slower ramp.

Okay, I got it.

One other thing, and I have -- to your credit I haven't heard much on this but I am curious.

And I am not asking you to try this online.

But the California attorney general FX suit, that is ongoing, correct?

Glenn, this is Jay.

That is ongoing and we wouldn't comment on it but --

I am with you.

I just wanted to make sure that nothing happened that we didn't know about.

No, nothing has happened.

Anything to comment on?

Have there been follow on audits by other clients or other AGs?

Yes, I think that as a result of the publicity gained by the California AG we have talked to many of our customers and made sure they fully understood the custody FX service.

And what I would tell you today is that following that situation we have seen really no change in customer relationships, no change in volume around custody FX.

Yet as you would expect, we have talked to a lot of people to make sure that they are comfortable with how the service works.

And then CalPERS --- obviously, CalPERS is still an ongoing client?

Yes, they are.

Absolutely.

Great.

Have been trading and servicing with us.

Awesome.

All right, thank you.

Robert Lee, KBW.

Thank you.

Good morning.

A couple quick questions on asset management, and I apologize if you mentioned this on the call.

I came a little late.

First, could we get some color on where within asset management you are seeing kind of the strongest flows?

Is it all coming from the ETF business or the index business?

And if there's any one or two particular product lines or strategies, if you will, that are driving a lot of your net new business?

Robert, this is Jay.

You hit on -- within asset management both the quantitative or the passive business saw excellent flows in 2009 and into 2010 as I think more managers allocated more of their portfolio to passive or beta-driven strategies.

So we saw that; we think that is a trend that is probably sustainable.

The other place is ETFs and you have seen a lot of press recently about the growth of ETFs.

I think they just crested $1 trillion in total.

So we are, as a major provider of ETF products and services, we are seeing great growth there.

Just to single out a few products, the one I would just -- it may be obvious, but the gold ETF had great growth.

Not surprising given the attractiveness of gold through 2009.

But those are really broadly the two product categories that -- the quantitative and ETFs where we have seen growth and we anticipate we will continue to see growth.

And maybe as a follow-up, you have had this pretty strong year-over-year growth in AUM -- I think it was up 35% or something like that -- and pretty good organic growth.

Yet certainly management fee revenues, while up, is kind of lagging behind suggesting there is kind of a mix shift taking place.

Can you maybe expand on that a little bit and any prospects do you think for that kind of reverse in course as you head into 2010?

I think you again hit on the point which is there is a mix shift between a little bit of reallocation from active to passive which drives AUM but has less revenues associated with it.

I think that I would expect that beta will continue to be a major source of allocation for institutions, but I also would expect that you will see more risk taking as we get into 2010.

We have seen some early indications of that which would support may be more growth prospects on the active side as well.

So I think it's hard to say whether we are at that inflection point.

But it feels like some confidence is returning and the active side will get more attention as we move into 2010 which would obviously support more growth in our active product, that as well.

Okay, that was it.

Thank you very much.

We have time for one more question.

Gerard Cassidy, RBC.

Thank you.

Good morning.

You guys mentioned when you announced the acquisition in December that raising the dividend is something that you are very interested in doing in 2010.

Can you share with us your thoughts on the prospects of possibly a dividend increase sometime this year?

Gerard, this is Ron.

I think we said on the last call that obviously raising the dividend is a priority.

There are guidelines that are being -- continue to come out of the Fed.

We will continue to discuss that.

I think a lot of it is going to depend on opportunities that present themselves as well in terms of the Intesa-like kind of opportunities and timing.

But dividend restoration is definitely one of our priorities.

We will continue to discuss that with the Fed.

If we see some other opportunities, I think one of the things this company has is a capacity to integrate multiple acquisitions.

It has proven that before.

I don't know whether there will be any.

So it's really going to be a question of timing, but we will definitely look at restoring the dividend as a priority.

Would the capital ratios that you folks have built up, whether it's the TCE ratio or the Tier 1 common, is there one that will take priority over the other in terms of determining, if there aren't alternatives to maybe make an acquisition, to increase the dividend?

Are you focusing on the TCE possibly over the Tier 1 common or vice versa?

To answer that question directly, we focus on the TCE ratio.

Great, thank you.

(multiple speakers) There are no further questions at this time.

Well, thank you very much.

We appreciate -- I know it's a busy day for all of you, so I appreciate your time and attention on the call.

We will talk to you again soon.

Thank you.

This concludes today's conference call.

You may now disconnect.