DBRS Comments on State Street’s 3Q11 Earnings; Sr. at AA (low) Unchanged; Trend Stable

DBRS Inc. (DBRS) has today commented that the ratings for State Street Corporation (State Street or the Company), including its Issuer & Senior Debt Rating of AA (low), remain unchanged, following the release of its 3Q11 financial results. The trend on its ratings remains at Stable. On an operating basis, State Street reported net income available to common shareholders of $476 million in 3Q11 that was relatively flat to the $483 million recorded in the prior quarter. The third quarter results reflected a 1.4% decline from 2Q11, but improved 11.5% from a year ago same quarter. This quarter’s operating results included a net tax benefit of $107 million related to a restructuring of former non-U.S. conduit assets and excluded $85 million related to acquisition and restructuring costs.

DBRS views that State Street’s 3Q11 core operating results reflect resiliency as demonstrated by generally consistent performance in its core businesses in what still remains a challenging operating environment. Indicative of its strong market position and competitiveness, the Company reported new business wins of approximately $245 billion in AUC/A (17% from the U.S. and 83% from non-U.S. mandates) that highlighted both the product and geographic diversity of its franchise. State Street notes however, that the volatile market conditions continue to shift customers focus and investment trends into more conservative bonds, mutual funds and alternative investments. The new business pipeline remains strong as demands for outsourcing of investment management operations continue. DBRS sees the Company as well-positioned to meet the growing preferences from passive to ETF strategies as well as increasing demand for alternative asset servicing.

State Street’s operating revenue remains consistent to the prior quarter but stronger compared to $2.2 billion recorded a year ago. Total revenue declined modestly by 2.4% or $60 million, sequentially, to $2.4 billion with fee revenues down approximately 2.5% ($48 million). Weaker equity markets and average equity valuations resulted in the slightly lower total fee revenue of $1.8 billion. Servicing fees were down 2% QoQ and asset management revenue declined 8% from the prior quarter. Higher volatility in 3Q11 average equity valuations benefited trading services revenue to grow 7.5% sequentially. The growth reflected a 21% linked-quarter increase in foreign exchange revenue that was partially offset by an 8% QoQ decline in brokerage and other revenue. Also, processing fees and other revenue grew 29% to $90 million from 2Q11 and benefited from a $22 million gain related to real estate and leases. A weaker linked-quarter securities finance performance reflected decreases in average lendable assets and lower securities on loan balances. This, coupled with a seasonally stronger second quarter, resulted in a 38% sequential decline in securities finance revenue to $85 million in 3Q11. AUC/A compressed 5.5% sequentially to $21.5 trillion driven by a general asset value contraction in the equity markets.

Net interest revenue (on an FTE basis and excluding discount accretion) grew approximately 2% QoQ to $564 million in 3Q11. Client deposits continued to grow, in part reflecting the considerable uncertainty surrounding the sovereign risks as well clients’ growing conservatism. In the quarter, the incremental $15 billion in average client deposits contributed to higher levels of earning assets that led to a modest improvement in net interest revenue and a lower NIM of 1.44% on an operating basis. Excluding the impact from the deposits, NIM was 4 bps lower than 2Q11 at 1.57%.

DBRS views State Street as continuing to practice tight controls on expenses in 3Q11. The Company’s operating-basis expenses declined 2.5% from 2Q11 to $1.7 billion for 3Q11, resulting in a positive operating leverage compared to the prior quarter. Salaries and benefits expense decreased 4.4% due to reductions in incentive compensation and benefits achieved from its Business Operations and IT transformation program and remains in line with its annual compensation to revenue target ratio of 40%. State Street noted that its Business Operations and IT transformation program remains on track to deliver an annual pre-tax run-rate expense savings of approximately $600 million by the end of 2014, with the full effect achieved in 2015. In succeeding in its expense reduction plans, State Street plans to standardize and automate key business processes, establish global centers for excellence to implement a more flexible global operating model, and introduce new technology architecture and processes while optimizing infrastructure and its workforce. The Company anticipates achieving about one-third or $200 million of the expected net benefits by the end of 2012.

State Street’s investment securities portfolio grew a relatively modest $700 million from the prior quarter end to $107 billion. The portfolio remains sound, in DBRS’s view, with 89% of the securities in the portfolio rated AA-rated or above at September 30, 2011, compared to 90% in the last quarter. DBRS notes that in 3Q11, State Street reported a net unrealized after-tax loss position of $259 million driven by widening spreads partially offset by lower interest rates. On a linked-quarter basis, the net unrealized after-tax position deteriorated by $165 million and improved approximately $245 million from year-end 2010. State Street does not own any sovereign debt from Greece, Italy, Ireland, Portugal, and Spain (GIIPS) in its investment portfolio, but holds about $1.1 billion in securities from GIIPS in its RMBS book. Italy and Spain each comprise $400 million and Ireland, Greece and Portugal each represent $100 million in its exposures. State Street indicated that these securities are all performing well and consist of prime mortgages and low loan-to-value ratios. Of the Company’s non-U.S. holdings, 91% represent British, Australian, German Canadian and Netherlands securities.

Overall, capital levels remains solid at 3Q11 and DBRS sees State Street as well-positioned to meet the Basel III capital requirements with very strong capitalization. Though capital metrics softened QoQ due primarily to growth in risk-weighted assets, the Company’s capitalization remains strong including a top-tier estimated Basel I Tier 1 Common ratio of 16.0% at quarter end. Tier 1 capital, Total capital, and Tier 1 leverage ratios stood at 18.0%, 19.6% and 7.8%, respectively, at 3Q11. Under Basel III, State Street estimates its Tier 1 Common ratio to be 11.7% while Tier 1 capital, Total capital, and Tier 1 leverage ratios would be 12.8%, 14.5% and 6.0%, respectively, at 3Q11.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the 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, all of 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
Approver: Alan G. Reid
Initial Rating Date: 11 November 2005
Most Recent Rating Update: 11 March 2011

For additional information on this rating, please refer to the linking document under Related Research.