DBRS Comments on Q4 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 Q4 2009 financial results. The trend on State Street’s ratings, except for the Company’s Short-Term Instruments and Senior Notes, Guaranteed by FDIC remains Negative.

The Company reported satisfactory yet still-constrained revenue and quarterly performance, reporting operating net income of $492 million for Q4 2009 down from $523 million in Q3 2009 and $680 million in Q4 2008. While the quarter was relatively clean with few one-time charges, results did reflect negative operating leverage with only 2.0% operating revenue growth outstripped by 5.7% operating expense growth. Revenues are weaker primarily due to spread compression that particularly pressured securities finance revenues and also foreign exchange’s weaker volumes only partially offset by slightly higher f/x volatility. A $60 million adverse judgment related to the Lehman bankruptcy and a rise in consultant and professional expense were primarily responsible for the increase in expenses that more than offset the decline in salaries and employee benefits.

Full-year operating results reflected a 23% decline in fee revenues and 16% decline in total operating revenues to $8.8 billion while net operating income to common shareholders contracted 17% to $1.9 billion. Full-year consolidated earnings were more volatile moving from a $1.8 billion 2008 profit to a $1.8 billion 2009 loss primarily due to the extraordinary Q2 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 over the next 8 years (with approximately two-thirds to be earned back in the first 5 years from consolidation). In Q4 2009, the Company earned $230 million through earnings accretion and earned $621 million in total for 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.

State Street’s ratings are underpinned by the large-scale, broad-range and global nature of its well-respected financial services offerings. The Company holds significant and defensible market positions in its scale-dependent business lines amidst industry consolidation. With $13.7 trillion in assets under custody (up 3.7% from Q3 2009) and $1.91 trillion in assets under management (up 10% from Q3 2009) as of December 31, 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. Moreover, in December the Company announced the acquisition of Intesa Sanpaolo’s Securities Services Business which will add approximately USD 500 billion (EUR 343 billion) in average custody assets, EUR 173 billion in fund administration and additional depository and correspondent banking assets upon the expected closing in Q2 2010.

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, spread compression due to low interest rates, the decline in asset values (that have partially recovered in the past few quarters), and disrupted capital markets. DBRS also sees that the stressed investment climate has shifted investor behaviors to less profitable products (e.g. passive strategies, ETFs and index funds) 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 including regulatory uncertainty and the challenges of returning to formerly higher levels of profitability. These issues may result in unexpected expenses and add a degree of underperformance and earnings volatility to State Street’s financial performance.

DBRS is mindful that State Street has a $97 billion investment portfolio that carries an unrealized mark-to-market (MTM) loss of $1.8 billion (after-tax) at January 15, 2010, reflecting considerable improvement of $700 million in the fourth quarter and another $500 million in 2010 but even more dramatic progress from a $6.3 billion MTM loss position just one year ago. DBRS continues to believe that the Company’s intent and ability to hold these securities to maturity somewhat mitigates the risk implied in the much improved unrealized loss. Moreover, State Street has assembled this high-quality portfolio (over 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 an improved $51 million other than temporary credit impairment charge in its available for sale investment securities portfolio in the fourth 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 Capital Ratio of 17.5%, Tier 1 common of 15.3% and total capital ratio of 18.8%. The adjusted tangible common equity to total assets (TCE) ratio rose to 6.64% at December 31, 2009 primarily as a result of organic capital growth, the improvement in unrealized security losses, maturing or paying off securities and balance sheet shrinkage. DBRS believes that State Street therefore offers strong bondholder protection and has demonstrated a correspondingly strong ability to build its TCE through its access to capital markets, organic growth and the recovery in security prices.

Notes:
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.