DBRS Comments on State Street’s 4Q10 and 2010 Results; Sr. at AA (low) Unchanged; Trend Stable

DBRS Inc. (DBRS) has today commented on the 4Q10 results of State Street Corporation (STT or the Company). The Company recorded net income available to common shareholders of $81 million compared to $540 million in 3Q10 and $498 million in the year-ago period. Results were primarily impacted by the previously announced (Dec. 2, 2010) information technology transformation, a reduction of approximately 1,400 employees or 5 percent of the Company’s work force, and an investment portfolio restructuring featuring the sale of approximately $11 billion in investment portfolio securities (Dec. 9, 2010). The ratings for State Street, including its Issuer & Senior Debt Rating of AA (low), are unchanged and the trend on its ratings remains at Stable.

DBRS sees the recent announcements as financially disappointing in the near term, but at the same time, necessary and forward-looking given the dynamic operating and regulatory environment. DBRS notes that despite the weaker quarterly results precipitated by the actions taken in 4Q10, these transactions were consistent with State Street’s medium to long-term goals of managing efficiency, lowering operating costs, and materially reducing the Company’s risk profile. Also, the sale of securities generated sufficient capital relief for State Street to put it in approximate Basel III compliance (based on current proposals). Nonetheless, DBRS notes that State Street has taken several meaningful one-time charges for a variety of reasons over the past few years that have reduced the level and stability of earnings. DBRS will have a diminishing tolerance for quarterly extraordinary charges at the issuer’s high rating level going forward.

Total 4Q10 revenue was $2.04 billion, declining 12% to $2.31 billion in the prior quarter and 10% to $2.28 billion from year-end 2009. Total revenue for the full year stood at $8.95 billion, up around 4% from $8.64 billion a year earlier. On an operating basis, State Street reported net income from continuing operations of $441 million on revenue of $2.28 billion, up from net income of $432 million in the prior quarter and from $353 million in 4Q09.

DBRS believes that State Street’s fourth quarter results exhibited positive trends across many of State Street’s core businesses, despite the continued low rate environment and the challenges surrounding the changes in the regulatory environment. The Company maintains a strong new business pipeline, with positive momentum in service fees, management fees and trading revenues. Total operating revenues climbed $127 million from 3Q10, benefiting most notably from a 36% increase to $310 million in trading services revenue. This was driven by higher volatility and volumes in foreign exchange fees and from higher fees primarily from transition management in broker and other fees. Servicing fees were up 6% to $1.06 billion, favorably impacted by new business and higher average equity valuation. Management fees were up 13% to $221 million attributable to improved average month-end equity valuations and new businesses, while securities finance revenue and processing fees were essentially flat to the prior quarter.

Net interest revenue (FTE, operating basis) was $550 million, a marginal decline from $568 million in the prior quarter due to the repositioning of its investment portfolio. Net interest margin (NIM) narrowed 12 bps to 1.65% (excluding discount accretion) due to lower yields and restructuring of the investment securities portfolio. Including the $139 million in discount accretion at 4Q10, NIM rises to 2.07% compared to 2.36% in the prior quarter and 2.35% in 4Q09.

State Street’s total operating expenses increased 7% to $1.6 billion compared to 3Q10. Salaries and benefits expense increased 7% to $935 million, primarily due to incentive compensation and increased fees for contract services. Higher global infrastructure costs drove information systems and communications expense up 6% sequentially to $191 million, while other expenses climbed 11% from 3Q10 to $210 million.

After the sale of approximately $11 billion in securities and from runoff of assets, 89.6% of State Street’s $95.3 billion investment securities portfolio is now rated AA or higher in the fourth quarter. The Company reinvested approximately $10.1 billion in highly rated securities (93% rated AAA) with an average yield of 2.4% and approximately 3.3 years in duration. The aggregate net unrealized after-tax loss on the portfolio increased to $504 million from a loss position of $281 million in the prior quarter, impacted by the steepening of the yield curve in the second half of the quarter, partially offset by narrowing of spreads. Nonetheless, the position improved solidly by approximately $1.8 billion, or 78%, compared to a year ago same quarter. Other-than-temporary impairment charges in its available-for-sale investment portfolio netted to $7 million in 4Q10, primarily due to the timing of cash flows related to former conduit securities. DBRS views that the Company’s conservative investment guidelines and recent actions have reduced risk in the portfolio while also generating the aforesaid capital relief.

Despite a difficult operating environment characterized by low interest rates, compressed spreads and shifting investor preferences, the Company experienced favorable growth in certain business lines. Assets under custody and administration grew 6.4% from 3Q10 to $21.5 trillion and assets under management increased 2.6% in the quarter to $2.01 trillion.

In DBRS’s view, the Company maintains sound capital levels while the fourth quarter actions positioned the Company for the implementation of Basel III capital requirements. Tier 1 capital ratio of 20.5%, Total capital ratio of 22.0%, and Tier 1 leverage ratio of 8.2% increased over the quarter and benefited from the 20.4% linked-quarter decline in the Company’s risk-weighted assets. TCE capital ratio improved sequentially to 7.6% while Tier 1 common rose to 18.1%. State Street estimates its Basel III (under current proposals) capital ratios to be 11.6%, 10.6% 5.9% and 9.4% for Total capital, Tier 1 capital, leverage, and Tier 1 common ratios, respectively. DBRS notes that the Company had $1.5 billion in Trust Preferred Securities (corresponding to 240 basis points of Tier 1 capital as of 12/31/10) that will be phased out over a three year period in accordance to financial reform legislation beginning in 2013.

Currently, State Street is one of the 19 banks subject to a second round of Federal Reserve stress tests to ensure capital adequacy. The stress tests will test a bank’s ability to absorb losses over the next two years under at least two scenarios (baseline and adverse) and will take the proposed Basel III capital requirements into account. Test results will also determine whether an institution may resume capital distributions (stock dividends and/or repurchases). The stress test results are expected to be communicated to BHCs (not publicly) no later than March 21, 2011. Given its robust capital ratios, DBRS expects a positive result.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Global Methodology for Rating Banks and Banking Organizations, Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the company documents, the Federal Deposit Insurance Corporation and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: William Schwartz

Initial Rating Date: 11 November 2005
Most Recent Rating Update: 4 June 2010

For additional information on this rating, please see linking document below.