Bank Of New York Mellon Corp quarterly report, Q2 FY2012

Business context and reporting period

The Bank of New York Mellon Corporation (BNY Mellon) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2012. It is a global financial-services company focused on investment management and investment services, including custody, asset servicing, clearing and payments. At quarter-end, it reported $27.1 trillion in assets under custody and administration and $1.3 trillion in assets under management.

Financial results and condition

Amounts are in millions of dollars unless otherwise indicated. Quarter comparisons are year over year unless stated otherwise.

Metric	Q2 2012	Comparison
Net income attributable to common shareholders	$466	$735 in Q2 2011; $619 in Q1 2012
Diluted EPS	$0.39	$0.59 in Q2 2011; $0.52 in Q1 2012
Total revenue, GAAP	$3,617	$3,850 in Q2 2011; $3,646 in Q1 2012
Fee and other revenue	$2,826	$3,056 in Q2 2011
Net interest revenue	$734	$731 in Q2 2011; $765 in Q1 2012
Noninterest expense	$3,047	$2,816 in Q2 2011; $2,756 in Q1 2012
Net interest margin, FTE	1.25%	1.41% in Q2 2011; 1.32% in Q1 2012

Q2 pretax income was $589 million and the effective tax rate was 15.8%; the filing attributes the unusually low rate in part to the tax effect of the litigation charge. The adjusted operating tax rate was 26.1%. GAAP return on common equity was 5.5% and the GAAP pretax operating margin was 16%; management’s adjusted non-GAAP figures were 8.9% and 29%, respectively.

For the first six months, net income applicable to common shareholders was $1.085 billion versus $1.360 billion in 2011; diluted EPS was $0.90 versus $1.08. GAAP total revenue was $7.263 billion versus $7.496 billion, and noninterest expense was $5.803 billion versus $5.513 billion. Net interest revenue rose to $1.499 billion from $1.429 billion.

Balance sheet, liquidity, debt and capital

• Total assets were $330.3 billion at June 30, 2012, versus $325.3 billion at December 31, 2011. Deposits were $221.1 billion, versus $219.1 billion.
• Available funds were $129.1 billion, including $48.3 billion of liquid funds; available funds equaled 39% of total assets, compared with 42% at year-end 2011. Management said the decline reflected greater investment in securities and higher loan levels.
• Investment securities totaled $93.3 billion and loans totaled $45.4 billion. The securities portfolio had a $1.4 billion unrealized pretax gain, primarily reflecting lower market interest rates.
• Long-term debt was $19.5 billion, down from $19.9 billion at year-end. The Parent had $1.8 billion of long-term debt maturing in the remainder of 2012.
• For the six months, operating cash flow was $374 million, compared with $997 million in 2011; investing activities used $5.8 billion and financing activities provided $5.8 billion.
• The estimated Basel III Tier 1 common equity ratio was 8.7%, based on June 2012 proposed rules and the final market-risk rule; it was 7.6% at March 31 under earlier guidance. Basel I Tier 1 and total capital ratios were 14.7% and 16.4%, respectively. The company reported that it and its bank subsidiaries were well capitalized under Basel I guidelines.
• The allowance for credit losses was $467 million; nonperforming assets were $294 million, or 0.65% of loans. Management expected a third-quarter provision for credit losses of approximately $0–$15 million.

Material changes versus comparable periods

• Q2 net income and diluted EPS fell from a year earlier, with the $212 million after-tax ($350 million pretax) securities-lending litigation charge a major factor. Excluding specified items, adjusted returns and margin were also below Q2 2011.
• Fee and other revenue declined 8% year over year. Drivers included lower issuer-services and foreign-exchange revenue, lower investment and other income, money-market fee waivers and the prior sale of Shareowner Services. Investment management and performance fees rose 2%, helped by performance fees and net new business.
• Net interest revenue was nearly flat year over year, but margin compressed 16 basis points. Higher client deposits and lending balances were offset by narrower spreads, lower accretion and investment of deposits in lower-yielding assets.
• Noninterest expense rose 8% year over year, principally due to the litigation charge. Excluding specified items and Shareowner Services direct costs, management reported a 1% decrease in expenses year over year.
• Assets under custody and administration increased 3% year over year to a record $27.1 trillion, supported by net new business, partly offset by lower equity market values. Assets under management increased 2% year over year but declined 1% sequentially.
• First-half operating cash flow was lower than in 2011, while investing cash outflows were substantially lower, chiefly reflecting different movements in central-bank deposits and securities activity.

Outlook, commentary, risks and unusual items

• Litigation settlement: On July 5, 2012, the company entered into a settlement agreement in the Oklahoma securities-lending class action concerning Sigma investments. The expected $280 million payment is subject to court approval; the Q2 charge also covers related claims. Management said legal and litigation costs were expected to remain elevated.
• Interest rates: Following the ECB’s July 5 rate cuts, management estimated a potential $20–$25 million adverse effect on second-half 2012 net interest revenue, substantially mitigable through investment strategies. The filing also highlights sensitivity to persistently low rates, deposit behavior and market spreads.
• Cost program and tax outlook: Management said it remained on track for $240–$260 million of 2012 annualized pretax net savings from operational-excellence initiatives. It expected an effective tax rate of approximately 27%–28% in Q3 2012.
• Legal and tax contingencies: The filing describes ongoing securities-lending, foreign-exchange standing-instruction, Madoff-related, mortgage-securitization and other matters. For certain legal matters, the aggregate reasonably possible loss was estimated at up to $520 million above accrued liabilities, excluding the specified tax matters; management could not estimate a range for some proceedings. A Tax Court dispute over foreign tax credits involves approximately $900 million including interest, and uncertain-tax-position reserves could increase by up to $930 million within 12 months, according to the filing.
• Other risks: The company cited regulatory uncertainty, including Basel III, Dodd-Frank and SIFI requirements; European economic and counterparty risks; securities and mortgage-credit exposures; foreign-exchange competition and litigation; and operational, cybersecurity and technology risks. Net exposure to Ireland, Italy, Spain and Portugal was reported at $1.036 billion after collateral and guarantees; the company reported no Greek or sovereign exposure to those countries.
• Capital returns: The 2012 capital plan, not objected to by the Federal Reserve, provided for up to $1.16 billion of common-stock repurchases and a quarterly dividend of $0.13 per share. Q2 repurchases totaled $286 million. A $500 million Series A non-cumulative perpetual preferred stock issuance qualified as Tier 1 capital under the newly proposed rules.

Investor verification priorities

1. Confirm the settlement’s final court approval, payment and ultimate scope of releases, and assess whether additional securities-lending claims could create further charges.
2. Review the foreign-exchange standing-instruction investigations and lawsuits, related client retention and pricing pressure, and any developments in Madoff, mortgage-trust and other proceedings.
3. Track net interest margin, deposit mix and balances, ECB-related effects, and whether management’s mitigation assumptions and Q3 tax and credit-provision outlook are borne out.
4. Assess asset quality and reserve adequacy, particularly purchased residential mortgages (29% of a specified $542 million pool was at least 60 days delinquent), commercial exposures and securities-lending collateral risks.
5. Validate the estimated Basel III ratio under final rules, capital implications of trust-preferred phase-out, debt maturities, liquidity levels, and execution of planned repurchases and dividends.
6. Separate recurring operating performance from litigation, merger, restructuring and other excluded items when evaluating the company’s non-GAAP measures and cost-savings progress.