DBRS Comments on Q2 Results of State Street – Senior 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 Q2 2009 financial results. The trend on State Street’s ratings, except for the Company’s Short-Term Instruments, remains Negative. The trend on the Company’s Short-Term Instruments remains Stable.

The Negative trend on the Company’s ratings reflects DBRS’s view that earnings from fees and other revenues in its custody and trust businesses remain constrained due to lower activity, the decline in asset values and disrupted capital markets. Like other industry participants in the asset management business, State Street is exposed to legal risk and reputational risk or possible business loss from customers in relation to the Company’s roles as agent, custodian or lender. As with other asset managers, these risks have been elevated by the impact of market turmoil on investors and clients. DBRS believes that these risks, although not easily quantified, are inherent in State Street’s business and pose risk. The “Wells” notice received on June 25, 2009 from the SEC relating to the Company’s SSgA fixed-income strategies is one example of these types of risk. While there are indications that the worst period of volatility and uncertainty may have already passed for trust banks, nevertheless, the unprecedented period of stress has left a legacy of potential issues to be resolved. These issues may result in unexpected expenses and add a degree of earnings volatility to State Street’s financial performance.

The Company reported a net loss of $3.18 billion ($3.31 billion loss available to common stockholders) for Q2 2009. The loss was driven by an extraordinary loss of $3.68 billion from the marking-to-market of State Street’s $22.7 billion conduit portfolio that was brought back on balance sheet effective May 15, 2009. At July 21, the vast majority of the conduit securities were current in the payment of principal and interest. If the securities perform as expected to maturity, the loss will be gained back through earnings accretion to net interest revenue over the next 8 years (the majority to be earned back within the next 5 years). In Q2 2009, the Company earned $112 million through earnings accretion and expects to earn back an additional $365 million for the remainder of 2009. DBRS is also mindful, however, that the conduit securities, which are of generally lower credit quality than State Street’s legacy investment portfolio, could experience real credit losses on the securities that could reduce the expected earnings accretion. The Company has indicated that an estimated $500 million in securities losses are built into its earnings accretion projections.

Total revenue in Q2 2009 declined 21% from the same quarter a year ago but increased 6% on a linked quarter basis. Servicing fees were down 19% in the second quarter to $795 million from $977 million in Q2 2008. Investment management fees were down 31% from $280 million in the year-ago quarter. The decrease in both servicing and investment management fees was attributable to a significant decline in daily average equity valuations. Trading services revenue was down 3% from the same period a year ago. Brokerage and other fees increased 29% due primarily to improved transition management business. Securities finance revenue was up 11% from the sequential quarter but was down 43% compared to the unusually strong second quarter of 2008 due primarily to lower volumes, offset partially by slightly higher spreads.

Net interest revenue declined 11% from the second quarter of 2008, but was up 4% from Q1 2009. The decline from the second quarter of 2008 was attributable to a decline in customer deposit volumes and spreads partially offset by the $112 million of earning accretion on securities in the investment portfolio following the consolidation of the conduits in May. The increase in net revenue compared with the first quarter of 2009 was due primarily to the effect of the $112 million of earnings accretion, offset partially by a decline in LIBOR rates and narrower spreads in the investment portfolio and on customer deposits. Net interest margin of 1.93% was down 10 bps from Q1 2009 and would have been 1.57% in the quarter if not for the $112 million in earnings accretion.

Operating expenses declined to $1.35 billion, down 25% from $1.81 billion in the year-ago quarter due primarily to a 34% reduction in salaries and benefits related to a lower level of accrual for incentive compensation as well as the benefit of a reduction in headcount. On an operating basis, the Company achieved positive operating leverage in the second quarter compared to last year’s second quarter and on a sequential quarter basis which DBRS views positively.

DBRS is mindful that State Street has an $87 billion investment portfolio that carries an unrealized mark-to-market loss of $4.75 billion (after-tax) at June 30, 2009, down from $5.9 billion at March 31, 2009. 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 (80% 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 Company recorded a $64 million other than temporary impairment charge in its available for sale investment securities portfolio in the second quarter.

Regulatory capital ratios remain among the highest in the industry, with a Tier 1 ratio of 14.5% and Total capital ratio of 16%. The Tangible common equity to Total assets (TCE) ratio rose to 5% at June 30, 2009 as a result of a $2.2 billion common equity raise (net of fees) in the quarter in combination with internal capital generation, security paydowns and maturities, and improvement in unrealized losses. Offsetting these gains to State Street’s TCE ratio was the consolidation of the conduits along with the repayment of its TARP obligation. Nonetheless, DBRS believes that State Street has demonstrated a strong ability to build its TCE through its access to capital markets and organic growth.

State Street’s ratings are underpinned by its large-scale, broad-range and global nature of its well-respected financial services offerings. With $12.3 trillion in assets under custody (up 9% from Q1 2009) and $1.56 trillion in assets under management (up 11% from Q1 2009) as of June 30, 2009, State Street enjoys a position as one of the world’s leading providers of financial services to institutional investors. The Company expects to benefit from the trend of large investment managers outsourcing middle office operations and, in Q2 2009 State Street won $347 billion of mandates for assets to be serviced.

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.