DBRS Comments on Q3 2009 Results of State Street Corp. – 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 Q3 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 volumes, the decline in asset values (that have partially recovered in the past few quarters), low interest rates and disrupted capital markets. DBRS also believes that the stressed investment climate has likely changed investor behaviors and will present new challenges to the Company’s ability to evolve its investment products and strategies to meet investor demand. 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 acceptable quarterly performance, but still-constrained revenues, reporting improved net income of $516 million for Q3 2009 compared to a $3.18 billion loss in Q2 2009 and net income of $477 million in Q3 2008. The improvement came from a relatively clean quarter with few one-time charges and good expense control. The prior quarter 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 on balance sheet effective May 15, 2009. If the securities perform as expected to maturity, the loss will be gained back through earnings accretion to net interest revenue (NIR) over the next 8 years (with approximately two-thirds to be earned back in the first 5 years from consolidation). In Q3 2009, the Company earned $279 million through earnings accretion and expects to earn back an additional $209 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. In fact, the Company’s previous estimate of $600 million in securities losses built into its earnings accretion projections has already been revised upward to $850 million.

Total operating revenue in Q3 2009 declined 10.6% to $2,267 million from the same quarter a year ago but increased 5.3% on a linked quarter basis as all fee income categories were down from the prior year, however, net interest revenue increased 18% on an operating basis due to the ABCP conduit consolidation discount accretion. Servicing fees were down 14% in the third quarter to $833 million from $966 million in Q3 2008. Investment management fees were down 16% to $219 million from $261 million in the year-ago quarter. The decrease in both servicing and investment management fees was attributable to a significant decline in equity valuations and some asset management composition shift from active to passive strategies. Trading services revenue was down 26% from the same period a year ago from lower foreign exchange volatility and volumes. Securities finance revenue was down 57% compared to the third quarter of 2008 due primarily to compressed spreads and lower volumes.

Operating net interest revenue (FTE) grew 17.8% from the third quarter of 2008 and was up 23.4% from Q2 2009. The increases were attributable to $279 million of earnings accretion on securities in the investment portfolio in Q3 2009 following the consolidation of the ABCP conduits in May and NIR would have otherwise declined slightly. The increase was partially offset by lower asset rates coupled with lower volumes and spreads on deposits. Net interest margin of 2.47% was up 25 bps from Q2 2009 and would have been 1.56% in the quarter if not for the $279 million in earnings accretion.

Operating expenses declined to $1.472 billion, down 13% from $1.695 billion in the year-ago quarter due primarily to a 20% 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 third quarter compared to last year’s third quarter but not on a linked quarter basis primarily because of the weak linked quarter revenue generation and the higher accrual for incentive compensation.

DBRS is mindful that State Street has a $98 billion investment portfolio that carries an unrealized mark-to-market loss of $2.99 billion (after-tax) at September 30, 2009, reflecting considerable improvement in the quarter from $4.75 billion at June 30, 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. Nonetheless, the Company recorded a $99 million other than temporary impairment charge in its available for sale investment securities portfolio in the third quarter primarily due to expected losses in U.S. non-agency mortgage-backed securities.

Regulatory capital ratios remain among the highest in the industry, with a Tier 1 ratio of 15.6%, Tier 1 common of 13.6% and Total capital ratio of 16.8%. The adjusted tangible common equity to total assets (TCE) ratio rose to 5.73% at September 30, 2009 primarily as a result of the improvement in unrealized security losses, organic capital growth, and maturing or paying off securities. Offsetting these gains to State Street’s TCE ratio was the growth in the balance sheet along with the repayment of its TARP obligation. DBRS believes that State Street has demonstrated a strong ability to build its TCE through its access to capital markets and organic growth and the recovery in security prices.

State Street’s ratings are underpinned by its large-scale, broad-range and global nature of its well-respected financial services offerings. With $13.3 trillion in assets under custody (up 10% from Q2 2009) and $1.74 trillion in assets under management (up 21% from Q2 2009) as of September 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 Q3 2009, State Street won mandates for assets to be serviced from Morgan Stanley and ING Bank Canada among others.

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.