DBRS Comments on Q1 Results of State Street – Sr. at AA (low) Unaffected; Trend Remains Negative

DBRS has today commented that its ratings for State Street Corporation (State Street or the Company), including its Issuer & Senior Debt Rating of AA (low), are unchanged following the Company’s announcement of its Q1 2009 financial results. The trend on State Street’s ratings, except for the Company’s Short-Term Instruments, remains Negative. The rating on the Company’s Short-Term Instruments remains Stable.

The Negative trend reflects DBRS’s view that earnings from servicing fees remain constrained due to the decline in asset values and margins on securities lending remain tight in the current low rate environment and volumes remain low. DBRS expects that earnings from highly rated issuers be predictable, recurrent and less volatile. Moreover, the Company’s tangible capital ratios remain under pressure from mark-to-market valuations of its investment portfolio and conduit securities. There is also the potential of consolidating its conduits on balance sheet at the beginning of 2010 (based on proposed accounting guidelines). Furthermore, these pressures come at a time when capital markets remained stressed and there is a reduced financial flexibility for financial institutions seeking capital.

For the quarter, State Street reported operating income of $482 million, down from $547 million in the prior year’s quarter and $702 million in Q4 2008 (excluding a $467 million pre-tax charge to support certain stable value funds). First quarter operating revenues were down 22% from Q1 2008 to $2.03 billion while fourth quarter 2008 operating revenues were $2.64 billion. Revenues were pressured across the board, but to its credit State Street was still able to generate positive year-over-year operating leverage as costs dropped 26% from Q1 2008 to $1.3 billion, largely due to headcount reductions (salary and benefits expense was down 31%). First quarter 2009 operating results included a pair of offsetting one-time items: an $84 million loan loss provision (State Street’s first since 2002) related to two commercial mortgages acquired in Q4 2008 and a $63 million gain related to the reversal of taxes accrued on foreign earnings since the Company intends to reinvest those earnings abroad.

All revenue lines were pressured in the quarter as asset values declined, interbank market spreads tightened, foreign currency markets became less volatile and central bank interest rates were at historic lows. Weaker equity markets drove declines in servicing and management fees, which fell 20% and 35%, respectively, from Q1 2008. Securities lending revenues of $181 fell 40% from the prior year’s quarter on low volume albeit with slightly improved spreads. Trading revenues were also down sharply (33%), due to less volatile currency markets and lower values on a few trading securities acquired in 2008. Fully-taxable equivalent net interest revenue of $589 was down 9% and 27% from Q1 2008 and Q4 2008, respectively. Net interest margin (NIM) of 203 basis points (bps) was down 25 bps from the fourth quarter of 2008 on an operating basis. Further NIM compression is expected going forward in part due to the low rate environment and management’s conservative practice in maintaining liquidity by placing proceeds from security paydowns or maturities into Fed deposits.

DBRS is mindful that State Street has a $77.5 billion investment portfolio that carries an unrealized mark-to-market loss of $5.9 billion (after-tax) at March 31, 2009, down from $6.3 billion at year end but up from $5.6 billion at the end of January. DBRS continues to believe that the Company’s intent and ability to hold these securities to maturity somewhat mitigates the risk implied in the unrealized loss. Moreover, State Street has assembled this high-quality portfolio (84.3% is rated AA or AAA) using conservative investment guidelines and has a robust surveillance capability to monitor the underlying cash flows and project each security’s expected performance. The unrealized mark-to-market loss on the Company’s asset-backed commercial paper conduits was $3.6 billion at March 31, 2009, unchanged from year end. State Street did not transfer any conduit assets on to the balance sheet in the quarter and conduit assets declined $1.4 billion in the quarter to $22.5 billion.

Regulatory capital ratios remain among the highest in the industry, with a Tier 1 ratio of 19.1%, down 120 bps from year end. The adjusted tangible common equity ratio increased to 5.9% at March 31, 2009, from 4.6% at December 31, 2008, but is a weak 2.22% assuming the consolidation of conduits onto the balance sheet. Management had previously forecast building its TCE (assuming consolidation of the conduits) to 2.62% at the end of Q1 2009 from 1.19% at year end, through a combination of internal capital generation, security paydowns and maturities, and improvement in unrealized losses. Driving the shortfall was price declines in the assets held in conduits and in the Company’s investment portfolio in the last two months of the quarter.

State Street’s ratings are underpinned by its large-scale, broad-range and global nature of its well-respected financial services offerings. With $11.3 trillion in assets under custody (down 6% from Q4 2008) and $1.4 trillion in assets under management (down 3% from Q4 2008) as of March 31, 2009, State Street enjoys a position as one of the world’s leading providers of financial services to institutional investors. In DBRS’s view, the weaker revenue performance in some ways belies the strength of the Company’s franchise and that building out its revenue base in the current environment will strengthen its competitive position. State Street Global Advisors added $37 billion in net new business in the first quarter. The Company expects to benefit from the trend of large investment managers outsourcing middle office operations and, in Q1 2009, State Street won $111 billion of mandates for assets to be serviced.

That said, further meaningful revenue declines, a lack of progress in re-building TCE (including material additional misses on incremental targets for the ratio) or large realized losses could result in negative ratings actions. Conversely, a return of tangible capital to prior levels (above the adjusted 3.5% range) assuming conduit consolidation, coupled with stable revenue generation and asset values could return the trend to Stable. Even with its strong internal capital generation capability and the shrinking of its conduits, DBRS would view building its tangible common equity favorably.

Note:
All figures are in U.S dollars unless otherwise noted.

The applicable methodologies are Rating Banks and Bank Holding Companies Operating in the United States, and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.