DBRS Comments on BNY Mellon’s 3Q11 Earnings; Sr. Debt at AA (low) Unchanged; Trend Stable

DBRS Inc. (DBRS) has today commented that its ratings for The Bank of New York Mellon Corporation (BNY Mellon or the Company) including its AA (low) Issuer & Senior Debt rating and its R-1 (middle) Short-Term Instruments rating, are unchanged following the release of the Company’s 3Q11 earnings. The trend on all ratings remains Stable.

For the quarter, BNY Mellon reported net income from continuing operations of $651 million, down 11.4% from $735 million in 2Q11, but up 4.2% from $625 million in 3Q10. The year over year improvement benefited from the Company’s 2010 acquisitions, net long-term asset flows and increased deposits. DBRS sees the year over year improvement as reflective of mostly positive underlying business and revenue trends. The difficult operating environment was evident in quarterly comparisons to a strong 2Q11; however, DBRS believes BNY Mellon’s results generally continued to reflect its revenue diversity, resilience and strong competitive position. One manifestation of the difficult environment was the increase in money market fee waivers. The waivers impact many businesses and are now at record levels increasing $50 million over the year and $24 million over the quarter. The Company expects the fee waivers to remain at the current high level in 4Q11. The investment servicing pipeline remains solid, however, and in Asset Management 3Q11 long term net inflows slowed to $4 billion from the robust $32 billion in 2Q11. DBRS notes that 50% of the current new business pipeline in Asset Servicing is middle office outsourcing which enhances revenue rather than AUM. In DBRS’s view, significant deposit flows again this quarter highlight the considerable uncertainty surrounding sovereign risk, the low rate environment, and BNY Mellon’s status as a safe haven for customers globally. Nevertheless, the low-rate environment and higher expense levels remain headwinds.

Excluding net securities gain/loss, total 3Q11 revenues were $3.7 billion, down 3% from 2Q11. Total fee revenues this quarter were $2.9 billion, about 78% of total revenues (excluding net securities losses) with most key fee lines showing good year over year growth. Impacted by seasonally lower securities lending and lower equity values, Asset Servicing fees decreased 5% from 2Q11 to $928 million and at quarter end, assets under custody and administration (AUC/A) decreased 1.5% to $25.9 trillion as lower equity market values outstripped net new business gains. Depositary receipt seasonality, usually experienced in 4Q, contributed to the 21% increase in issuer services revenues (which are therefore expected to decline in 4Q11), while a 2% sequential increase in clearing revenues came from higher cash management balances and a 6% increase in DARTS that was only partially offset by higher money market fee waivers.

Investment Management had a difficult quarter due to market conditions in DBRS’s view, and AUM declined to $1.2 trillion at September 30 as lower equity markets and short-term outflows more than offset the long-term inflows. Total Investment Management revenues were $811 million in the quarter, down 4% from 3Q10, and down 11% from 2Q11. Regarding foreign exchange revenues, which were $221 million in 3Q11, BNY Mellon noted that roughly 40% of these revenues were related to standing instructions which have increased over the past two years. While the revenue impact surrounding these issues is clearly minimal, DBRS is concerned that reputational costs to the Company could be higher, especially if the Company’s name remains in the news cycle and litigation is protracted. That being said, BNY Mellon has actually seen an increase in standing instruction volumes although negotiated trades have increased more rapidly due to market conditions. The Company has been meeting with clients and going over talking points for clients to communicate to their boards, management and/or trustees.

BNY Mellon’s net interest revenue (FTE) totaled $782 million in 3Q11, up 6% from 2Q11 and driven by substantially higher average noninterest-bearing deposit balances that were up $30 billion or 71% over the quarter to $73.4 billion. As the Company reinvested these funds conservatively, higher levels of average earning assets drove the increase in net interest revenue, as the net interest margin (NIM) declined 11 basis points (bps) q-o-q to 1.30%. The Company noted that the increase in lower yielding assets associated with the substantial deposit growth drove the NIM compression in 3Q11 (partially offset by the increase in the securities portfolio) and it anticipates net interest revenues will remain at 3Q11 levels in the coming quarter.

Positively, core operating expenses trended lower in the third quarter. Year-over-year expenses increased 6% to $2.8 billion but were outpaced by 7.9% revenue growth, generating positive operating leverage. Relative to 2Q11, noninterest expense adjusted for restructuring charges, M&I expenses and amortization of intangibles decreased 1.4%. The decrease over the quarter was primarily from lower benefits, business development expenses, and state investment tax credits. DBRS notes that 3Q11 expenses were inflated by $80 million of litigation expense and a $22 million charge due to the departure of the former CEO. The Company expects to lay out its plan to reduce expenses later this year. DBRS notes the 3Q11 provision for credit losses was a $22 million credit as nonperforming assets continued to decline.

BNY Mellon’s $76.5 billion (fair value) investment securities portfolio remained in a solidly positive position with an unrealized pre-tax gain of $863 million, an improvement from the unrealized gain of $770 million at the end of 2Q11. DBRS notes that the approximately $4.0 billion (fair value) of non-agency RMBS, 96% of which are sub-investment grade that were previously included in the former Grantor Trust, had an unrealized pre-tax gain of $334 million at the end of 3Q11. Paydowns on these securities were $300 million in the third quarter.

The Company continues to generate substantial levels of capital organically. BNY Mellon generated $36 million of net Tier 1 common equity in the third quarter after paying $160 million in dividends and spending $462 million on share buybacks. Combined with risk-weighted asset (RWA) growth, up 1.0% to $106.4 billion, the estimated Tier 1 common ratio was a strong 12.5%, down 10 bps from the end of 2Q11. BNY Mellon’s estimated Basel III Tier 1 common ratio was flat over the quarter at 6.6%. DBRS notes that the elimination of the sub-investment grade, non-agency RMBS securities would theoretically add roughly 250 bps to the Basel III tier 1 common ratio.

Note:
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: 2 July 2007
Most Recent Rating Update: 10 December 2010

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