State Street Corporation — Q2 2009 Form 10-Q
Business context and reporting period
State Street provides investment servicing and investment management to institutional investors. This filing covers the quarter and six months ended June 30, 2009, compared with the corresponding 2008 periods. At quarter-end, the company reported $153.42 billion in assets, $85.58 billion in deposits, $12.10 billion in shareholders’ equity, 26,950 employees, $16.39 trillion in assets under custody and administration, and $1.56 trillion in assets under management.
Financial results and key metrics
| Metric | Q2 2009 | Six months 2009 | Comparison with 2008 |
|---|---|---|---|
| Total revenue | $2.122 billion | $4.124 billion | Down 21% for both periods |
| Fee revenue | $1.516 billion | $2.938 billion | Down 24% and 26% |
| Net interest revenue, GAAP | $580 million | $1.144 billion | Down 12% and 11% |
| Expenses | $1.364 billion | $2.668 billion | Down 26% for both periods |
| Income before extraordinary loss | $502 million | $978 million | Down 8% and 9% |
| Net income (loss) | $(3.182) billion | $(2.706) billion | Includes $3.684 billion after-tax extraordinary loss |
| Net income before extraordinary loss available to common shareholders | $370 million | $815 million | Down 32% and 24% |
| Diluted EPS before extraordinary loss | $0.79 | $1.81 | Versus $1.35 and $2.70 |
The conduit-related extraordinary loss drove reported net losses. Excluding it, second-quarter and first-half earnings available to common shareholders were positive. Net interest margin on a fully taxable-equivalent basis declined to 1.93% in Q2 from 2.31% a year earlier and to 1.96% for the first half from 2.26%. The company reported positive operating leverage because expenses fell more than revenue. Return on common equity before the extraordinary loss was 13.0% for Q2 and 14.4% for the first half.
Fee revenue reflected weaker markets and activity: servicing fees fell 19% in both comparisons; management fees fell 31% in Q2 and 33% year to date; securities finance revenue fell 43% and 42%. Assets under custody and administration were down 17% year over year, while assets under management were down 18%. Both were higher than at December 31, 2008. The company generated $458 billion of gross new servicing business and $41 billion of net new assets to manage during the first half.
Operating cash flow was $(5.006) billion for the first six months; investing cash flow was $36.315 billion and financing cash flow was $(30.446) billion. Cash and due from banks rose by $863 million to $4.044 billion. The company reported $65.45 billion of liquid assets under its definition, down from $85.81 billion at year-end, and said liquidity was sufficient for current commitments and business needs.
At June 30, total assets were $153.42 billion versus $173.63 billion at year-end, deposits were $85.58 billion versus $112.23 billion, and shareholders’ equity was $12.10 billion versus $12.77 billion. Long-term debt was $8.98 billion; other short-term borrowings were $19.94 billion, in addition to repurchase agreements and federal funds purchased. State Street and State Street Bank remained above regulatory well-capitalized thresholds: the parent’s Tier 1 risk-based and total risk-based ratios were 14.5% and 15.9%; the bank’s were 13.4% and 15.0%.
Material changes, outlook, and risks
- Conduit consolidation: In May, State Street consolidated four administered asset-backed commercial paper conduits for financial reporting purposes after redeeming their first-loss notes. It recognized approximately $6.10 billion of pre-tax, or $3.68 billion after-tax, extraordinary loss, added about $16.6 billion of assets at fair value and $20.95 billion of conduit commercial paper liabilities, and recorded $112 million of discount accretion in Q2 net interest revenue. Management expected accretion to be a material component of second-half 2009 interest revenue. The conduits remained separate legal entities and continued operating.
- Capital actions: A May common-stock offering of approximately 58.97 million shares at $39 raised net proceeds of about $2.23 billion. State Street redeemed the Treasury’s $2 billion TARP preferred investment in June; the discount prepayment reduced retained earnings and earnings available to common shareholders by approximately $106 million. It repurchased the related warrant for $60 million in July.
- Management outlook: The filing provides no numerical full-year earnings or revenue guidance. Management said future net interest revenue would depend on deposit mix, rates, yield curves, market conditions, and reinvestment decisions. A more conservative investment strategy—in part placing excess liquidity at central banks—reduced interest revenue and margin. Management expected comparatively higher salary and benefit expense in the second half as incentive compensation accrued in line with performance.
- Credit and securities risks: First-half loan-loss provision was $98 million, primarily for commercial real estate loans acquired under indemnified repurchase agreements; $66 million of those loans were classified as non-performing. The investment portfolio had $4.47 billion of pre-tax unrealized losses on available-for-sale securities; approximately 80% of the portfolio was rated AA or AAA, down from 89% at year-end. Management considered most remaining declines temporary, but recognized impairment losses and noted possible further loan provisions.
- Securities-lending collateral and legal matters: Cash collateral pools had a weighted-average NAV of $0.958 per unit at June 30, while transactions continued at $1.00 and withdrawal limits remained in place. A purported class action and regulatory inquiries relate to certain pools. Separately, an SEC Wells notice concerned SSgA active fixed-income strategies; the SEC staff said it would recommend an enforcement action. Of a $625 million reserve established in 2007 for related exposures, $193 million remained; the company cautioned that it might not cover litigation and any penalties or remedies. Other legal matters include client claims involving funds using Lehman Brothers International (Europe) as prime broker.
- Other exposures: Fair-value assets included $14.71 billion classified as Level 3, relying on significant unobservable inputs. The filing also describes substantial securities-lending indemnities and contingent liquidity and credit commitments. Management identified risks from market disruption, counterparties, funding access, securities impairment, regulation, litigation, and reputation.
Investor facts to verify
- Whether conduit-asset cash flows support the assumed discount accretion, and how consolidation affects funding, liquidity, and capital ratios.
- Performance and credit quality of the investment portfolio, including Level 3 valuations, sub-prime exposure, downgrades, and further impairment risk.
- Recovery in servicing, management, trading, and securities-finance revenues as markets and customer activity change.
- Cash-collateral pool NAVs, withdrawal restrictions, related litigation and regulatory inquiries, and potential effects on SSgA’s business and reputation.
- Developments in the SEC and other proceedings concerning active fixed-income strategies, and whether the $193 million reserve is adequate.
- Commercial real estate loan collections, non-performing balances, and any additional provisions.
The independent registered public accounting firm performed an interim review, not an audit, and reported that it was not aware of material modifications needed for GAAP conformity.