- ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------------------------------- Form 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 1999 [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From to Commission File No. 0-5108 STATE STREET CORPORATION (Exact name of registrant as specified in its charter) <TABLE> <S> <C> COMMONWEALTH OF MASSACHUSETTS 04-2456637 (State or other jurisdiction (I.R.S. Employer of incorporation) Identification No.) 225 Franklin Street 02110 Boston, Massachusetts (Zip Code) (Address of principal executive office) </TABLE> 617-786-3000 (Registrant's telephone number, including area code) ----------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] The number of shares of the Registrant's Common Stock outstanding on October 31, 1999 was 159,976,514. - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
STATE STREET CORPORATION Table of Contents <TABLE> <CAPTION> Page ---- <S> <C> PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Income........................................ 1 Consolidated Statement of Condition...................................... 3 Consolidated Statement of Cash Flows..................................... 4 Consolidated Statement of Changes in Stockholders' Equity................ 5 Notes to Consolidated Financial Statements............................... 6 Independent Accountants' Review Report................................... 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................... 15 Item 3. Quantitative and Qualitative Disclosure About Market Risk........ 26 PART II. OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds........................ 26 Item 6. Exhibits and Reports on Form 8-K................................. 26 Signatures............................................................... 27 </TABLE> Exhibits
PART I. ITEM 1. FINANCIAL STATEMENTS Consolidated Statement of Income - State Street Corporation (Unaudited) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> (Dollars in millions, except per share data) Three months ended September 30, 1999 1998 - ------------------------------------------------------------------------------ <S> <C> <C> Fee Revenue Fiduciary compensation...................................... $ 452 $ 379 Foreign exchange trading.................................... 68 73 Servicing and processing.................................... 47 48 Other....................................................... 4 11 -------- -------- Total fee revenue.......................................... 571 511 Net Interest Revenue Interest revenue............................................ 626 602 Interest expense............................................ 428 415 -------- -------- Net interest revenue....................................... 198 187 Provision for loan losses................................... 4 4 -------- -------- Net interest revenue after provision for loan losses....... 194 183 -------- -------- Total Revenue.............................................. 765 694 Operating Expenses Salaries and employee benefits.............................. 321 297 Information systems and communications...................... 73 62 Transaction processing services............................. 60 49 Occupancy................................................... 48 43 Other....................................................... 74 77 -------- -------- Total operating expenses................................... 576 528 -------- -------- Income before income taxes................................. 189 166 Income taxes................................................ 63 55 -------- -------- Net Income................................................. $ 126 $ 111 ======== ======== Earnings Per Share Basic...................................................... $ .78 $ .69 Diluted.................................................... .77 .68 Average Shares Outstanding (in thousands) Basic...................................................... 160,829 161,145 Diluted.................................................... 163,316 163,906 Cash Dividends Declared Per Share .......................... $ .15 $ .13 </TABLE> - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. 1
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Consolidated Statement of Income - State Street Corporation (Unaudited) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> (Dollars in millions, except per share data) Nine months ended September 30, 1999 1998 - ------------------------------------------------------------------------------ <S> <C> <C> Fee Revenue Fiduciary compensation...................................... $ 1,292 $ 1,106 Foreign exchange trading.................................... 231 215 Servicing and processing.................................... 148 127 Other....................................................... 27 19 -------- -------- Total fee revenue.......................................... 1,698 1,467 Net Interest Revenue Interest revenue............................................ 1,800 1,649 Interest expense............................................ 1,214 1,104 -------- -------- Net interest revenue....................................... 586 545 Provision for loan losses................................... 12 13 -------- -------- Net interest revenue after provision for loan losses....... 574 532 -------- -------- Total Revenue.............................................. 2,272 1,999 Operating Expenses Salaries and employee benefits.............................. 953 857 Information systems and communications...................... 218 174 Transaction processing services............................. 169 146 Occupancy................................................... 140 121 Other....................................................... 230 211 -------- -------- Total operating expenses................................... 1,710 1,509 -------- -------- Income before income taxes................................. 562 490 Income taxes................................................ 192 165 -------- -------- Net Income................................................. $ 370 $ 325 ======== ======== Earnings Per Share Basic...................................................... $ 2.30 $ 2.02 Diluted.................................................... 2.26 1.98 Average Shares Outstanding (in thousands) Basic...................................................... 160,939 161,080 Diluted.................................................... 163,794 164,214 Cash Dividends Declared Per Share........................... $ .44 $ .38 </TABLE> - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. 2
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Consolidated Statement of Condition - State Street Corporation - -------------------------------------------------------------------------------- <TABLE> <CAPTION> September 30, December 31, (Dollars in millions) 1999 1998 - ------------------------------------------------------------------------------ (Unaudited) <S> <C> <C> Assets Cash and due from banks............................ $ 1,573 $ 1,365 Interest-bearing deposits with banks............... 14,076 12,085 Securities purchased under resale agreements and securities borrowed............................... 13,312 13,979 Federal funds sold................................. 230 Trading account assets............................. 510 335 Investment securities (principally available-for- sale)............................................. 14,354 9,737 Loans (less allowance of $92 and $84).............. 7,034 6,225 Premises and equipment............................. 726 700 Accrued income receivable.......................... 686 610 Other assets....................................... 2,471 2,046 -------- -------- Total Assets.................................... $ 54,972 $ 47,082 ======== ======== Liabilities Deposits: Noninterest-bearing............................... $ 7,539 $ 8,386 Interest-bearing: Domestic......................................... 2,720 2,520 Non-U.S.......................................... 21,694 16,633 -------- -------- Total deposits.................................. 31,953 27,539 Securities sold under repurchase agreements........ 15,398 12,563 Federal funds purchased............................ 924 914 Other short-term borrowings........................ 622 431 Accrued taxes and other expenses................... 1,007 943 Other liabilities.................................. 1,684 1,459 Long-term debt..................................... 922 922 -------- -------- Total Liabilities............................... 52,510 44,771 Stockholders' Equity Preferred stock, no par: authorized 3,500,000; issued none....................................... Common stock, $1 par: authorized 250,000,000; issued 167,225,000 and 167,225,000................ 167 167 Surplus............................................ 47 63 Retained earnings.................................. 2,572 2,272 Net unrealized (losses) gains...................... (40) 22 Treasury stock, at cost (7,315,000 and 6,560,000 shares)........................................... (284) (213) -------- -------- Total Stockholders' Equity...................... 2,462 2,311 -------- -------- Total Liabilities and Stockholders' Equity...... $ 54,972 $ 47,082 ======== ======== </TABLE> - -------------------------------------------------------------------------------- The accompanying notes are an integral part of these financial statements. 3
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Consolidated Statement of Cash Flows - State Street Corporation (Unaudited) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> (Dollars in millions) Nine months ended September 30, 1999 1998 - --------------------------------------------------------------------------------- <S> <C> <C> Operating Activities Net Income.................................................... $ 370 $ 325 Non-cash charges for depreciation, amortization, provision for loan losses and deferred income taxes ....................... 253 274 ------- ------- Net income adjusted for non-cash charges................. 623 599 Adjustments to reconcile to net cash (used) provided by operating activities: Securities gains, net....................................... (11) (6) Net change in: Trading account assets..................................... (175) (105) Other, net................................................. (271) 207 ------- ------- Net Cash Provided by Operating Activities................ 166 695 ------- ------- Investing Activities Payments for purchases of: Available-for-sale securities................................ (9,685) (5,166) Held-to-maturity securities.................................. (667) (1,993) Lease financing assets....................................... (171) (738) Premises and equipment....................................... (148) (200) Proceeds from: Maturities of available-for-sale securities.................. 4,192 5,418 Maturities of held-to-maturity securities.................... 641 1,704 Sales of available-for-sale securities....................... 804 755 Principal collected from lease financing..................... 55 63 Net (payments for) proceeds from: Interest-bearing deposits with banks......................... (1,991) (2,209) Federal funds sold, resale agreements and securities borrowed.................................................... 437 (10,002) Loans........................................................ (746) (556) ------- ------- Net Cash Used by Investing Activities.................... (7,279) (12,924) ------- ------- Financing Activities Proceeds from issuance of: Long-term debt............................................... 149 Non-recourse debt for lease financing........................ 127 524 Treasury stock............................................... 20 17 Payments for: Non-recourse debt for lease financing........................ (80) (95) Maturity of notes payable.................................... (44) Long-term debt............................................... (1) (1) Cash dividends............................................... (70) (61) Purchase of common stock..................................... (125) (88) Net proceeds from: Deposits..................................................... 4,414 3,037 Short-term borrowings........................................ 3,036 8,490 ------- ------- Net Cash Provided by Financing Activities................ 7,321 11,928 ------- ------- Net Increase (Decrease).................................. 208 (301) Cash and due from banks at beginning of period................ 1,365 2,411 ------- ------- Cash and Due From Banks at End of Period................. $ 1,573 $ 2,110 ======= ======= Supplemental Disclosure Interest paid................................................ 1,215 1,091 Income taxes paid............................................ $ 57 $ 94 </TABLE> - -------------------------------------------------------------------------------- The accompanying notes are in integral part of these financial statements. 4
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Consolidated Statement of Changes in Stockholders' Equity - State Street Corporation (Unaudited) - -------------------------------------------------------------------------------- <TABLE> <CAPTION> (Dollars in millions, except share data) Nine months ended September 30, 1999 1998 - -------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Common Stock Balance at end of period (no change during period)......................................... $ 167 $ 167 Surplus Balance at beginning of period................... 63 102 Treasury stock issued............................ (54) (54) Stock options exercised.......................... 38 17 ------- ------- Balance at end of period........................ 47 65 ------- ------- Retained Earnings Balance at beginning of period................... 2,272 1,920 Net Income....................................... 370 $ 370 325 $ 325 Cash dividends declared ($.44 and $.38 per share).......................................... (70) (61) ------- ------- Balance at end of period........................ 2,572 2,184 ------- ------- Net Unrealized Gains (Losses)--Other Comprehensive Income Balance at beginning of period................... 22 11 Foreign currency translation..................... (4) (4) 3 3 Change in net unrealized holdings on available- for-sale securities............................. (58) (58) 9 9 ------- ----- ------- ----- (62) 12 ----- ----- Balance at end of period........................ (40) 23 ------- ------- Comprehensive Income............................. $ 308 $ 337 ===== ===== Treasury Stock, at Cost Balance at beginning of period................... (213) (205) Common stock acquired (1,894,000 and 1,500,000 shares)......................................... (125) (88) Treasury stock issued (1,139,000 and 1,536,000 shares)......................................... 54 72 ------- ------- Balance at end of period........................ (284) (221) ------- ------- Total Stockholders' Equity..................... $ 2,462 $ 2,218 ======= ======= </TABLE> - -------------------------------------------------------------------------------- The accompanying notes are in integral part of these financial statements. 5
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note A--Basis of Presentation State Street Corporation ("State Street" or the "Corporation") is a financial services corporation that provides banking, trust, investment management, global custody, administration and information services to both U.S. and non-U.S. customers. State Street reports three lines of business. Services for Institutional Investors include accounting, custody, daily pricing, administration, foreign exchange, cash management and information services to support institutional investors. Investment Management provides an extensive array of services for managing financial assets worldwide for both institutional and individual investors as well as recordkeeping, administration and investment services for defined contribution plans and other employee benefit programs. Commercial Lending includes lending activities and other banking services for regional middle-market companies, companies in selected industries and institutional investor customers, along with capital lease financing. The consolidated financial statements include the accounts of State Street and its subsidiaries, including its principal subsidiary, State Street Bank and Trust Company ("State Street Bank"). The preparation of financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. All significant intercompany balances and transactions have been eliminated upon consolidation. The results of operations of businesses purchased are included from the date of acquisition. Investments in 50%-owned affiliates are accounted for using the equity method. Certain previously reported amounts have been reclassified to conform to the current method of presentation. For the Consolidated Statement of Cash Flows, State Street has defined cash equivalents as those amounts included in the Consolidated Statement of Condition caption, "Cash and due from banks". Effective for the year ended December 31, 1998 and all ensuing periods, State Street adopted disclosures required by SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". The requirements of this statement are presented in Note H to the Consolidated Financial Statements. Effective January 1, 1999, State Street adopted AICPA Statement of Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 requires the capitalization of certain compensation costs relating to internal-use software development projects. State Street's policy is to capitalize costs relating to systems development projects that provide significant functionality enhancement. State Street considers projects for capitalization that are expected to yield long-term operational benefits, such as replacement systems or new applications which result in operational efficiencies and/or incremental revenue streams. Software development projects that modify existing applications to achieve regulatory compliance or which extend the lives of existing software are deemed maintenance and are expensed as incurred. In addition, software customization costs relating to specific customer enhancements are expensed as incurred. During the first nine months of 1999, State Street capitalized approximately $12 million of salary and related benefit costs as a result of adopting SOP 98-1. SFAS Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" was issued in June 1998. This statement requires companies to record the fair value of derivatives on the balance sheet as assets or liabilities. Fair market valuation adjustments for derivatives meeting hedge criteria will be recorded in either other comprehensive income or through earnings in the Consolidated Statement of Income, depending on their classification. Derivatives used for trading purposes will continue to be marked to market through earnings. State Street will adopt this statement, as required, beginning January 1, 2001. Management does not expect the adoption of this statement to have a material impact on the financial statements. 6
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note A--Basis of Presentation (continued) In the opinion of management, all adjustments, consisting of normal recurring accruals, which are necessary for a fair presentation of the financial position of State Street and subsidiaries at September 30, 1999, and December 31, 1998; its cash flows for the nine months ended September 30, 1999 and 1998; and consolidated results of its operations for the three months and nine months ended September 30, 1999 and 1998, have been made. These statements should be read in conjunction with the financial statements and other information included in State Street's latest annual report on Form 10- K. Note B--Business Divestiture On October 1, 1999, State Street completed the sale of its commercial banking business and the four associated branch offices to Citizens Financial Group. The commercial banking business, consisting of approximately a $2.4 billion loan portfolio, a $36 million allowance for loan losses, and $1.1 billion in deposits, includes commercial lending, deposits and other banking services for New England regional middle-market companies and companies in selected industries nationwide. Approximately 300 State Street employees joined Citizens as a result of the sale. The premium received on the sale was $350 million; exit and other associated costs were $68 million. The after-tax gain, net of exit and other associated costs, on the sale totaled approximately $164 million, or $1.00 in earnings per share, and will be recorded in the fourth quarter of 1999. Note C--Investment Securities Available-for-sale securities are recorded at fair value and held-to- maturity securities are recorded at amortized cost on the Consolidated Statement of Condition. Investment securities consisted of the following as of the dates indicated: <TABLE> - ------------------------------------------------------------------------------------- <CAPTION> September 30, 1999 December 31, 1998 ------------------------------ ---------------------------- Unrealized Unrealized ------------ Fair ------------ Fair (Dollars in millions) Cost Gains Losses Value Cost Gains Losses Value - ------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Available for sale: U.S. Treasury and federal agencies...... $ 7,364 $ 4 $ 47 $ 7,321 $ 3,690 $ 7 $ 2 $ 3,695 State and political subdivisions.......... 1,786 5 7 1,784 1,598 17 3 1,612 Asset-backed securities............ 2,775 5 11 2,769 1,717 3 1 1,719 Collateralized mortgage obligations........... 741 7 734 727 1 2 726 Other investments...... 544 2 542 791 17 808 -------- ---- ---- -------- ------- ---- --- ------- Total.................. $ 13,210 $ 14 $ 74 $ 13,150 $ 8,523 $ 45 $ 8 $ 8,560 ======== ==== ==== ======== ======= ==== === ======= Held to maturity: U.S. Treasury and federal agencies...... $ 1,204 $ $ 8 $ 1,196 $ 1,177 $ 3 $ 1 $ 1,179 ======== ==== ==== ======== ======= ==== === ======= </TABLE> - ------------------------------------------------------------------------------- During the nine months ended September 30, 1999, there were gross gains of $12 million and gross losses of $1 million realized on the sales of $804 million of available-for-sale securities. During the nine months ended September 30, 1998, there were gross gains of $7 million and gross losses of approximately $1 million realized on the sales of $755 million of available- for-sale securities. 7
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note D--Allowance for Loan Losses The adequacy of the allowance for loan losses is evaluated on a regular basis by management. Factors considered in evaluating the adequacy of the allowance include previous loss experience, current economic conditions and adverse situations that may affect the borrowers' ability to repay, timing of future payments, estimated value of underlying collateral and the performance of individual credits in relation to contract terms, and other relevant factors. The provision for loan losses charged to earnings is based upon management's judgment of the amount necessary to maintain the allowance at a level adequate to absorb probable losses. While the allowance is established to absorb probable losses inherent in the total loan portfolio, management allocates the allowance for loan losses to specific loans, selected portfolio segments and certain off-balance sheet exposures and commitments. Adversely classified loans in excess of $1 million are individually reviewed to evaluate risk of loss and assigned a specific allocation of the allowance. The allocations are based on an assessment of potential risk of loss and include evaluations of the borrowers' financial strength, discounted cash flows, collateral, appraisals and guarantees. The allocations to portfolio segments and off-balance sheet exposures are based on management's evaluation of relevant factors, including the current level of problem loans and current economic trends. These allocations are also based on subjective estimates and management judgment, and are subject to change from quarter-to-quarter. In addition, a portion of the allowance remains unallocated as a general reserve for the entire loan portfolio. The general reserve is based upon such factors as portfolio concentration, historical losses and current economic conditions. Changes in the allowance for loan losses were as follows: <TABLE> - -------------------------------------------------------------------------------- <CAPTION> Three Months Nine Months Ended Ended September 30, September 30, -------------- -------------- (Dollars in millions) 1999 1998 1999 1998 - -------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Balance at beginning of period.................. $ 88 $ 93 $ 84 $ 83 Provision for loan losses....................... 4 4 12 13 Loan charge-offs................................ (3) (15) (7) (15) Recoveries...................................... 3 1 3 2 ------ ------ ------ ------ Balance at end of period....................... $ 92 $ 83 $ 92 $ 83 ====== ====== ====== ====== - -------------------------------------------------------------------------------- </TABLE> As part of the sale of the Commercial Banking business, State Street agreed to transfer, as of October 1, 1999, $36 million of the allowance for loan losses. See Note B for further information. 8
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note E--Regulatory Matters The regulatory capital amounts and ratios at September 30, 1999 and December 31, 1998 were as follows: <TABLE> - ----------------------------------------------------------------------------------------------------- <CAPTION> Regulatory Guidelines(1) ------------------------------ State Street State Street Bank Well ------------------ ------------------ (Dollars in millions) Minimum Capitalized 1999 1998 1999 1998 - ----------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Risk-based ratios: Tier 1 capital............ 4% 6% 12.6% 14.1% 11.6% 12.9% Total capital............. 8 10 12.8 14.4 12.0 13.3 Leverage ratio............. 3 5 5.3 5.4 5.3 5.3 Tier 1 capital............ $ 2,911 $ 2,725 $ 2,658 $ 2,453 Total capital............. 2,958 2,773 2,750 2,537 Adjusted risk-weighted assets and market-risk equivalents: On-balance sheet......... $ 17,031 $ 14,599 $ 16,758 $ 14,374 Off-balance sheet........ 5,553 4,435 5,553 4,435 Market-risk equivalents.. 569 232 556 232 -------- -------- -------- -------- Total................... $ 23,153 $ 19,266 $ 22,867 $ 19,041 ======== ======== ======== ======== - ----------------------------------------------------------------------------------------------------- </TABLE> (1) The regulatory designation of "well capitalized" under prompt corrective action regulations is not applicable to bank holding companies (State Street). Regulation Y defines well capitalized for bank holding companies for the purpose of determining eligibility for a streamlined review process for acquisition proposals. For such purposes, well capitalized requires a minimum Tier 1 risk-based capital ratio of 6% and a minimum total risk-based capital ratio of 10%. 9
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note F--Net Interest Revenue Net interest revenue consisted of the following: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Three Months Ended Nine Months September Ended 30, September 30, ----------- ------------- (Dollars in millions) 1999 1998 1999 1998 - ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Interest Revenue Deposits with banks................................. $ 121 $ 145 $ 372 $ 406 Investment securities: U.S Treasury and federal agencies.................. 112 72 274 237 State and political subdivisions (exempt from federal tax)...................................... 18 20 51 59 Other investments.................................. 59 39 153 122 Loans............................................... 117 104 337 294 Securities purchased under resale agreements, securities borrowed and federal funds sold.................... 193 219 600 524 Trading account assets.............................. 6 3 13 7 ----- ----- ------ ------ Total interest revenue............................ 626 602 1,800 1,649 ----- ----- ------ ------ Interest Expense Deposits............................................ 183 172 526 493 Other borrowings.................................... 227 225 635 562 Long-term debt...................................... 18 18 53 49 ----- ----- ------ ------ Total interest expense............................ 428 415 1,214 1,104 ----- ----- ------ ------ Net interest revenue.............................. $ 198 $ 187 $ 586 $ 545 ===== ===== ====== ====== </TABLE> - ------------------------------------------------------------------------------- Note G--Operating Expenses--Other The other category of operating expenses consisted of the following: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Nine Months Three Months Ended Ended September September 30, 30, ------------- ----------- (Dollars in millions) 1999 1998 1999 1998 - ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Professional services................................ $ 29 $ 27 $ 84 $ 74 Advertising and sales promotion...................... 12 17 42 46 Other................................................ 33 33 104 91 ------ ------ ----- ----- Total operating expenses--other..................... $ 74 $ 77 $ 230 $ 211 ====== ====== ===== ===== </TABLE> - ------------------------------------------------------------------------------- Note H--Lines of Business Further financial information by lines of business is contained within the Lines of Business section of Management's Discussion and Analysis of Financial Condition and Results of Operation on pages 20 and 21. 10
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note H--Lines of Business (continued) The following is a summary of the lines of business operating results for the nine months ended September 30: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Services for Investment Commercial Institutional Investors Management Lending ----------------------- ----------- ----------- (Dollars in millions; taxable equivalent) 1999 1998 1999 1998 1999 1998 - ------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Total revenue................. $ 1,592 $ 1,448 $ 516 $ 405 $ 191 $ 176 Income before income taxes.... 384 354 96 66 109 100 Average assets (billions)..... 48.0 39.2 1.1 1.1 4.6 3.6 </TABLE> - ------------------------------------------------------------------------------- Note I--Income Taxes The provision for income taxes included in the Consolidated Statement of Income consisted of the following: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Three Months Nine Months Ended Ended September 30, September 30, -------------- -------------- (Dollars in millions) 1999 1998 1999 1998 - -------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Current......................................... $ 27 $ 3 $ 95 $ 37 Deferred........................................ 36 52 97 128 ------ ------ ------ ------ Total provision................................ $ 63 $ 55 $ 192 $ 165 ====== ====== ====== ====== Effective tax rate.............................. 33.5% 33.2% 34.1% 33.6% ====== ====== ====== ====== </TABLE> - ------------------------------------------------------------------------------- A tax benefit of $41 million and a tax provision of $7 million related to fair value adjustments for the investment portfolio were included in other comprehensive income for the nine months ended September 30, 1999 and 1998, respectively. A tax benefit of $3 million and a tax provision of $2 million relating to foreign currency translation were included in other comprehensive income for the nine months ended September 30, 1999 and 1998, respectively. Note J--Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Three Months Nine Months Ended Ended September 30, September 30, --------------- --------------- (Dollars in millions, except per share data; shares in thousands) 1999 1998 1999 1998 - ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net Income..................................... $ 126 $ 111 $ 370 $ 325 Earnings per Share: Basic......................................... .78 .69 2.30 2.02 Diluted....................................... .77 .68 2.26 1.98 Basic Average Shares........................... 160,829 161,145 160,939 161,080 Stock options and stock awards................ 1,722 1,932 2,074 2,265 7.75% convertible subordinated debentures..... 765 829 781 869 ------- ------- ------- ------- Dilutive average shares........................ 163,316 163,906 163,794 164,214 ======= ======= ======= ======= </TABLE> - ------------------------------------------------------------------------------- 11
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Financial Statements - State Street Corporation (Unaudited) Note K--Commitments and Contingent Liabilities State Street provides banking, trust, investment management, global custody, administration and information services to both U.S. and non-U.S. customers. Assets under custody and assets under management are held by State Street in a fiduciary or custodial capacity and are not included in the Consolidated Statement of Condition because such items are not assets of State Street. Management conducts regular reviews of its responsibilities for these services and considers the results in preparing its financial statements. In the opinion of management, there are no contingent liabilities at September 30, 1999, which would have a material adverse effect on State Street's financial position or results of operations. State Street is subject to pending and threatened legal actions that arise in the normal course of business. In the opinion of management, after discussion with counsel, these actions can be successfully defended or resolved without a material adverse effect on State Street's financial position or results of operations. Note L--Off-Balance Sheet Financial Instruments, Including Derivatives State Street uses various off-balance sheet financial instruments, including derivatives, to satisfy the financing and risk management needs of customers, to manage interest rate and currency risk, and to conduct trading activities. A derivative instrument is a contract or agreement whose value is derived from interest rates, currency exchange rates or other financial indices. Derivative instruments include forwards, swaps, options and other instruments with similar characteristics. The use of these instruments generates fee, interest or trading revenue. Associated with these instruments are market and credit risks that could expose State Street to potential losses. The following table summarizes the contractual or notional amounts of derivative financial instruments held or issued by State Street for trading and balance sheet management: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> September 30, December 31, (Dollars in millions) 1999 1998 - ------------------------------------------------------------------------------- <S> <C> <C> Trading: Interest rate contracts: Swap agreements................................... $ 1,423 $ 1,234 Options and caps purchased........................ 77 21 Options and caps written.......................... 209 158 Futures--short position........................... 1,884 1,130 Options on futures purchased...................... 10 Options on futures written........................ 10 Foreign exchange contracts: Forward, swap and spot............................ 157,600 136,781 Options purchased................................. 433 572 Options written................................... 485 571 Balance Sheet Management: Interest rate contracts: Swap agreements................................... 325 427 Options and caps purchased........................ 30 30 </TABLE> - ------------------------------------------------------------------------------- 12
PART I. ITEM 1. FINANCIAL STATEMENTS (continued) Notes to Consolidated Finanacial Statements - State Street Corporation (Unaudited) Note L--Off-Balance Sheet Financial Instruments, Including Derivatives (continued) The following table represents the fair value as of September 30, 1999 and December 31, 1998 and average fair value for the nine and twelve months then ended, respectively, for State Street's financial instruments held or issued for trading purposes: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> December 31, September 30, 1999 1998 ------------------ --------------- Average Average Fair Fair Fair Fair (Dollars in millions) Value Value Value Value - ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Foreign exchange contracts: Contracts in a receivable position........ $ 1,279 $ 1,224 $ 1,240 $ 1,284 Contracts in a payable position........... 1,247 1,267 1,241 1,289 Other financial instrument contracts: Contracts in a receivable position........ 24 15 3 4 Contracts in a payable position........... 5 4 8 4 </TABLE> - ------------------------------------------------------------------------------- The preceding amounts have been reduced by offsetting balances with the same counterparty where a master netting agreement exists. Contracts in a receivable position are reported in other assets in the Consolidated Statement of Condition and contracts in a payable position are reported in other liabilities. Credit-related financial instruments include indemnified securities on loan, commitments to extend credit, asset purchase agreements, standby letters of credit and letters of credit. The maximum credit risk associated with credit- related financial instruments is measured by the contractual amounts of these instruments. The following is a summary of the contractual amount of State Street's credit-related, off-balance sheet financial instruments: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> September 30, December 31, (Dollars in millions) 1999 1998 - -------------------------------------------------------------------------------- <S> <C> <C> Indemnified securities on loan....................... $ 76,376 $ 66,236 Loan commitments..................................... 12,558 10,539 Standby letters of credit............................ 2,939 2,129 Letters of credit.................................... 188 220 </TABLE> - ------------------------------------------------------------------------------- On behalf of its customers, State Street lends their securities to creditworthy brokers and other institutions. In certain circumstances, State Street may indemnify its customers for the fair market value of those securities against a failure of the borrower to return such securities. State Street requires the borrowers to provide collateral in an amount equal to or in excess of 102% of the fair market value of the securities borrowed. The borrowed securities are revalued daily to determine if additional collateral is necessary. State Street held, as collateral, cash and U.S. government securities totaling $80 billion and $68 billion for indemnified securities on loan at September 30, 1999, and December 31, 1998, respectively. Loan commitments (unfunded loans, asset purchase agreements and unused lines of credit), standby letters of credit and letters of credit are subject to the same credit policies and reviews as loans. The amount and nature of collateral is obtained based upon management's assessment of the credit risk. Approximately 80% of the loan commitments expire one year or less from the date of issue. Since many of the commitments are expected to expire without being drawn, the total commitment amounts do not necessarily represent future cash requirements. 13
Independent Accountants' Review Report The Stockholders and Board of Directors State Street Corporation We have reviewed the accompanying consolidated statement of condition of State Street Corporation (State Street) as of September 30, 1999, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 1999 and 1998, and the statements of cash flows and changes in stockholders' equity for the nine month periods ended September 30, 1999 and 1998. These financial statements are the responsibility of State Street's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the accompanying consolidated financial statements referred to above for them to be in conformity with generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated statement of condition of State Street Corporation as of December 31, 1998 (presented herein), and the related consolidated statements of income, cash flows and changes in stockholders' equity for the year then ended (not presented herein), and in our report dated January 18, 1999, we expressed an unqualified opinion on those consolidated financial statements. Ernst & Young LLP Boston, Massachusetts October 18, 1999 14
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Summary Earnings per share for the third quarter were $.77 on a diluted basis, an increase of 13% from $.68 in the third quarter of 1998. Revenue grew 10% from $704 million to $775 million. Net income was $126 million, up 13% from $111 million a year ago. Return on stockholders' equity was 20.1%. Condensed Income Statement--Taxable Equivalent Basis - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, -------------------------------- --------------------------------- (Dollars in millions except per share data) 1999 1998 Change % 1999 1998 Change % - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Fee revenue: Fiduciary compensation: Services for Institu- tional Investors........ $ 297 $ 254 $ 43 17 $ 860 $ 754 $ 106 14 Investment Management.... 155 125 30 24 432 352 80 23 -------- -------- ------- ------ -------- -------- ------- ----- Total fiduciary compensation........... 452 379 73 19 1,292 1,106 186 17 Foreign exchange trading.. 68 73 (5) (8) 231 215 16 7 Servicing and processing.. 47 48 (1) 148 127 21 17 Other..................... 4 11 (7) (69) 27 19 8 42 -------- -------- ------- ------ -------- -------- ------- ----- Total fee revenue....... 571 511 60 12 1,698 1,467 231 16 Net interest revenue....... 208 197 11 6 613 575 38 7 Provision for loan losses.. 4 4 12 13 (1) (8) -------- -------- ------- -------- -------- ------- ----- Total revenue........... 775 704 71 10 2,299 2,029 270 13 Operating expenses......... 576 528 48 9 1,710 1,509 201 13 -------- -------- ------- ------ -------- -------- ------- ----- Income before income taxes.................. 199 176 23 13 589 520 69 13 Income taxes............... 63 55 8 15 192 165 27 16 Taxable equivalent adjustment................ 10 10 (4) 27 30 (3) 9 -------- -------- ------- ------ -------- -------- ------- ----- Net income.............. $ 126 $ 111 $ 15 13 $ 370 $ 325 $ 45 14 ======== ======== ======= ====== ======== ======== ======= ===== Earnings Per Share Basic..................... $ .78 $ .69 $ .09 13 $ 2.30 $ 2.02 $ .28 14 Diluted................... .77 .68 .09 13 2.26 1.98 .28 14 </TABLE> - ------------------------------------------------------------------------------- (Percentage change based on dollars in thousands, except per share data) Total Revenue Total revenue for the quarter was $775 million, up $71 million, or 10%, from a year ago. The increase was due primarily to growth in fiduciary compensation fee revenue. For the nine months ended September 30, 1999, total revenue was $2.3 billion, up $270 million, or 13%, from 1998. The increase was primarily due to growth in fee revenue. 15
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Fee Revenue Fee revenue for the third quarter of 1999 was $571 million, up $60 million, or 12%, over 1998 and accounted for 74% of total revenue. Fee revenue growth came from strong growth in State Street's core fiduciary compensation revenue. Fiduciary compensation is the largest component of fee revenue and is derived from accounting, custody, daily pricing, information services, securities lending, trusteeship services and investment management. Fiduciary compensation was $452 million, up 19% from a year ago. The increase reflected continued business growth for Services for Institutional Investors and Investment Management. Third quarter fiduciary compensation for Services for Institutional Investors was $297 million, up 17% from the third quarter of 1998, reflecting continued business growth. Revenue growth from servicing U.S. mutual funds primarily reflected growth in assets serviced including expanding relationships with existing customers. Total mutual fund assets under custody as of September 30, 1999 was $2.4 trillion, up 29% over the prior year. Revenue from servicing U.S. pension plans increased, reflecting new business with new and existing corporate clients, and securities lending services. Revenue from serving institutional investors outside the United States increased primarily due to new business from both existing and new customers. Assets under custody outside the U.S. of $453 billion, increased 54% from the prior year. At quarter end, total assets under custody totaled $5.3 trillion, up 22%, from a year earlier. Fiduciary compensation for investment management was $155 million, up 24% from 1998. The increase in revenue reflected growth across all services but was principally due to strength in investment management for institutional investors and in benefit outsourcing services. Benefit outsourcing services includes both recordkeeping and investment management services for defined contribution plans and health and welfare benefits processing. Assets under management totaled $582 billion, up 38% from a year earlier. Foreign exchange trading revenue was $68 million, compared to $73 million a year ago. Foreign exchange trading revenue was affected by currency volatility this quarter, as measured by State Street's index of 40 currencies. That index showed significantly less volatility this quarter, as compared to the third quarter last year. The revenue achieved in this environment of lower currency volatility reflects the strength and breadth of services offered by State Street, including trading via FX ConnectSM, State Street's electronic trading platform delivered via State Street Global Link(R). Servicing and processing revenue for the third quarter was $47 million compared to $48 million in the third quarter of 1998. Excluding the impact of the sale of two non-strategic businesses, one in the fourth quarter of 1998 and one in the second quarter of 1999, revenue was up 18%. Other fee revenue of $4 million was down from $11 million in the third quarter of 1998. Other fee revenue consists of gains and losses on securities, trading account losses and miscellaneous fees. For the nine months ended September 30, 1999, fee revenue was $1.7 billion, up $231 million, or 16% from a year ago. Fiduciary compensation increased $186 million, or 17%. Foreign exchange trading revenue increased $16 million, or 7%. Net Interest Revenue Taxable-equivalent net interest revenue for the third quarter was $208 million, up $11 million, or 6%, from a year ago. This increase was driven by growth in State Street's balance sheet and a more favorable mix of non-U.S. deposits, partially offset by lower long-term interest rates worldwide. Further, two recent increases in the federal funds rate had a short-term negative impact on net interest revenue. 16
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) In serving institutional investors worldwide, State Street provides short- term funds management including deposit services and repurchase agreements for cash positions associated with customers' investment activities. The revenue associated with deposit services and repurchase agreements, as well as from lending and lease financing activities, is recorded as net interest revenue. State Street's customers, in conjunction with their worldwide investment activities, increased use of deposits and securities sold under repurchase agreements, which were invested primarily in low-risk assets. Average non-U.S. deposits increased $3.8 billion or 23% from the same quarter last year. Average securities sold under repurchase agreements were $17.2 billion, an increase of 13% from the same quarter last year. Net interest margin, which is defined as taxable-equivalent net interest revenue as a percent of average interest-earning assets, declined from 1.79% in the third quarter 1998 to 1.66% in the third quarter of 1999, due to lower average interest rates in the United States, the European community and elsewhere. - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Three Months Ended September 30, ---------------------------- 1999 1998 ------------- ------------- Average Average (Dollars in millions) Balance Rate Balance Rate - -------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Interest-earning assets........................... $ 50,024 5.04% $ 43,922 5.54% Interest-bearing liabilities...................... 43,243 3.92 37,349 4.39 ---- ---- Excess of rates earned over rates paid........... 1.12% 1.15% ==== ==== Net interest margin.............................. 1.66% 1.79% ==== ==== </TABLE> - ------------------------------------------------------------------------------- For the nine months ended September 30, 1999, taxable equivalent net interest revenue was $613 million, up $38 million, or 7%, from the same period in 1998. Operating Expenses Operating expenses for the quarter were $576 million, up 9%, from $528 million in the third quarter of 1998. The year-over-year increase is due to business growth and expansion. Salaries and employee benefits were $321 million in the third quarter, up 8% from last year, primarily due to increased staffing in support of business growth. Effective January 1, 1999, State Street adopted AICPA Statement of Position (SOP) 98-1 which requires the capitalization of certain compensation costs relating to internal-use, software development projects. During the third quarter of 1999, State Street capitalized approximately $4 million in salary and related benefit costs; see Note A to the Consolidated Financial Statements for a more detailed discussion. Information systems and communications expense was $73 million in the third quarter, up 17% from last year, reflecting capacity expansion for mainframes, storage hardware, servers and software to handle increased business volume. Transaction processing services expense was $60 million in the third quarter, up 22% from last year, reflecting increased volumes. Occupancy expense was $48 million in the third quarter, up 13% from last year, and reflects additional office space required in support of worldwide business expansion. 17
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) For the nine-months ended September 30, 1999, operating expenses were up $201 million, or 13%, from the first nine months of 1998 as a result of business growth. Income Taxes The effective tax rate for the third quarter was 33.5% reflecting a revision to adjust the full year rate to 34.1%. The revision is due primarily to a lower full year effective state tax rate. The 34.1% rate for 1999 is up from 33.6% rate for 1998, due to a change in the mix of taxable and non-taxable revenue and a reduction in the level of tax credits. Year-2000 Readiness Disclosure The following discussion updates the description of the Year-2000 efforts contained in State Street's Annual Report on Form 10-K for the year ended December 31, 1998 and in its Quarterly Reports on Form 10-Q for the periods ended March 31, and June 30, 1999. The update should be read in conjunction with the information contained in those reports. As of October 31, 1999, State Street completed testing for all internal mission-critical and non-critical projects. Accordingly, the status of State Street's Year-2000 efforts as of October 31, 1999, is as follows: - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Regression Testing and Internal Production Year-2000 Year-2000 Readiness Projects Correction Implementation Testing - ------------------------------------------------------------------------------- <S> <C> <C> <C> IT infrastructure....................... 100% 100% 100% Global data networks.................... 100 100 100 Core application software............... 100 100 100 Business area supported applications.... 100 100 100 Facilities.............................. 100 100 100 - ------------------------------------------------------------------------------- </TABLE> Status of third party readiness at September 30, 1999, is as follows: Internal communications with vendors to obtain information on the Year- 2000 readiness status of the products and services provided to State Street have been completed, and a program for monitoring purchases continues. State Street has completed development of remediation contingency plans for those products and services that are considered high-risk. Key vendors have presented updates to State Street on their Year-2000 readiness programs and related progress, including contingency planning. The current focus has turned to implementation of business resumption contingency planning. Year-2000 readiness has been incorporated into State Street's existing due diligence procedures performed with business partners and counterparties. Year-2000 assessments of business partners and counterparties have been completed, and the focus has turned to implementation of business resumption contingency planning. Year-2000 readiness has been incorporated into the existing due diligence procedures for State Street's subcustodian bank network. State Street has completed its analysis of subcustodians' readiness and will continue to monitor the subcustodian bank network. Subcustodian testing was successfully completed during the third quarter of 1999 for all subcustodians where assets are currently held. In addition, State Street has contingency plans in place that include, where appropriate, identification of alternative subcustodian banks in each of State Street's markets. 18
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) State Street has previously successfully completed the final stages of testing with key industry service providers such as the Federal Reserve, Depository Trust Company ("DTC") and 400 securities industry firms, including brokerage companies, stock exchanges and clearing organizations. Other external testing efforts with customers, industry service providers, data service providers and key partners are essentially complete. Remaining tests are expected to be completed in October. Operational Readiness progress as of September 30, 1999 is as follows: Operational Readiness is the final stage of planning, validation and implementation of workflow within each business, operations and support unit. Operational Readiness includes four elements: Clean Management, Contingency Planning, Operational Planning and Event Management. Clean Management is the process for controlling changes and additions to State Street's environments so that Year-2000 risks inherent in any change or addition are understood and effectively mitigated. Increasingly tightened Clean Management controls began in July 1999, were enhanced on October 1, 1999, and will be further enhanced on December 1, 1999. Development and validation of contingency plans have been completed. State Street has developed an Operational Planning process which entails the development of corporate-wide monitoring plans by business and support areas to track the state of affairs worldwide, including major market and infrastructure events, throughout critical event periods. The operational planning process builds upon State Street's existing response infrastructure. Corporate-wide "dress rehearsals", in which State Street will conduct internal simulations of critical event scenarios, have been scheduled and will take place throughout the fourth quarter of 1999. Event Management will begin prior to December 31, 1999, with the monitoring of business and market trends for the purposes of early issue detection. As part of the Event Management process, each business unit of State Street has developed a core communication strategy, supported by a Central Corporate Communications Center ("CCC"). The business command center network comprises 21 business unit command centers and more than 80 satellite command centers. The CCC is responsible for monitoring and tracking the activities of the various business command centers and communicating cross-organizational status during the Year- 2000 critical event periods. Business command centers are responsible for monitoring their satellite command centers and communicating regularly with the CCC on a predetermined schedule. These business command centers will act as the business unit's decision-making headquarters and will coordinate communications directly with customers, vendors and counterparties, including the delivery of an official corporate statement, as necessary. State Street is essentially complete with its Operational Planning and Event Management Plans. Costs as of September 30, 1999: Management currently estimates the aggregate cost of the Year-2000 efforts to be less than 2% of total operating expenses for the five-year period 1996-2000. As of September 30, 1999, cumulative program expenditures were $116 million, of which $12 million was incurred during the third quarter of 1999. Such costs are expensed as incurred and include approximately 400 full-time and part-time staff and consultants, equipment and other expenses. 19
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Credit Quality At September 30, 1999, total loans gross of allowance for loan losses were $7.1 billion. At quarter end, the allowance for loan losses was $92 million, an increase from $83 million a year ago. During the quarter ended September 30, 1999, net charge-offs were less than $1 million, and the provision for loan losses charged against income was $4 million. At September 30, 1999, non-performing loans were $17 million. This compares to $17 million in the prior quarter and $13 million a year ago. Lines of Business Following is a summary of line of business operating results for the nine months ended September 30, - ------------------------------------------------------------------------------- <TABLE> <CAPTION> Services for Investment Commercial Institutional Investors Management Lending Taxable equivalent basis ------------------------ ------------ ------------ (Dollars in millions) 1999 1998 1999 1998 1999 1998 - ------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Fee revenue: Fiduciary compensation.. $ 860 $ 755 $ 432 $ 351 $ $ Foreign exchange trading................ 231 215 Other................... 85 81 49 21 41 44 ----------- ----------- ----- ----- ----- ----- Total fee revenue...... 1,176 1,051 481 372 41 44 Net interest revenue..... 416 397 35 33 150 132 ----------- ----------- ----- ----- ----- ----- Total revenue.......... 1,592 1,448 516 405 191 176 Operating expense........ 1,208 1,094 420 339 82 76 ----------- ----------- ----- ----- ----- ----- Income before income taxes................. $ 384 $ 354 $ 96 $ 66 $ 109 $ 100 =========== =========== ===== ===== ===== ===== Pretax margin............ 24% 24% 19% 16% 57% 57% Average assets (billions).............. $ 48.0 $ 39.2 $ 1.1 $ 1.1 $ 4.6 $ 3.6 - ------------------------------------------------------------------------------- </TABLE> Services for Institutional Investors. Services for Institutional Investors include accounting, custody, daily pricing, and information services. Customers around the world include mutual funds and other collective investment funds, corporate and public pension plans, corporations, investment managers, non-profit organizations, unions, and other holders of investment assets. Institutional investors are offered State Street services, including foreign exchange, cash management, securities lending, fund administration, recordkeeping, banking services, and deposit and short-term investment facilities. These services support institutional investors in developing and executing their strategies, enhancing their returns, and evaluating and managing risk. Revenue from this line of business comprised 69% of State Street's total revenue for the nine months ended September 30, 1999. Total revenue for the nine months ended September 30, 1999 increased to $1.6 billion, up 10% from $1.4 billion reported for the first nine months of 1998. The increase in revenue primarily reflected growth in assets serviced including expanding relationships with existing customers. Fee revenue was up $125 million, or 12%, due to growth in fiduciary compensation, foreign exchange and other fee revenue. Fiduciary compensation, up 14%, reflected revenue growth from accounting, custody, securities lending, U.S. pension plans, and customers outside the United States. Foreign exchange trading revenue grew 7% from a year ago due to growth in the volume of transactions and volatility within currency markets. Other fee revenue grew 5%. Net interest revenue, up 5%, reflected balance sheet growth from the increased use of securities sold under repurchase agreements and deposits by institutional investors, offset by lower interest rates and spread compression. 20
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Operating expenses for the nine months ended September 30, 1999 were $1.2 billion, 11% higher than a year ago, supporting business growth. Income before income taxes was $383 million, an increase of $29 million, or 9%, from 1998. Investment Management. State Street manages financial assets worldwide for both institutions and individuals and provides related services, including participant services for defined contribution and other employee benefit programs, and brokerage services. Investment management offers a broad array of services, including passive and active equity, money market, and fixed income strategies. Revenue from this line of business comprised 23% of State Street's total revenue for the first nine months of 1999. Revenue for the nine months ended September 30, 1999 increased to $516 million, up 27% from $405 million reported for the first nine months of 1998. Fiduciary compensation, for the first nine months of 1999, grew 23% to $432 million, due to growth across all services, primarily investment management for institutional investors. Revenue growth was driven principally by customers' use of passive international and domestic equity strategies, asset allocation and fixed income strategies, and securities lending. Revenue from providing participant services to defined contribution and other employee benefit programs grew as a result of both new business and growth in existing business. Benefits outsourcing services experienced strong revenue growth driven by new client relationships. Operating expenses of $420 million, increased $81 million, or 24%, for the first nine months of 1999, reflecting the addition of information systems, staff and office space to expand the product line and broaden State Street's worldwide reach. Income before income taxes for the first nine months of 1999 was $96 million, an increase of $30 million, or 45%, from the first nine months of 1998. Positive operating leverage contributed to the growth in income before income taxes. Commercial Lending. Reported in this line of business are lending activities and other banking services, including trade finance, cash management and deposit services for regional middle-market companies, companies in selected industries, and institutional investor customers. Commercial Lending also includes the lease financing portfolio comprised primarily of large capital equipment transactions. Revenue from this line of business comprised 8% of State Street's total revenue for the first nine months of 1999. Total revenue of $191 million grew $15 million for the first nine months of 1999, up 9% from a year ago, due primarily to a higher volume of lending and lease financing. Operating expenses of $82 million, increased $6 million, or 8%, for the nine months ended September 30, 1999. Income before income taxes was $109 million, an increase of $9 million, or 9%, from 1998. Acquisitions and Divestitures In July 1999, State Street entered an agreement with Lloyds TSB Group whereby they will recommend that the custody and trustee clients of Lloyds TSB Group's securities services business transfer to State Street Bank. As part of the agreement, State Street will be the preferred provider of custody, trustee and administration services to Lloyds TSB Group's proprietary business. In September 1999, State Street entered into an agreement under which State Street Bank will purchase the institutional trust and custody business from Wachovia Bank, N.A., representing approximately $61 billion in assets under custody. 21
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) On October 1, 1999, State Street completed the sale of its commercial banking business and the four associated branch offices to Citizens Financial Group. The commercial banking business, consisting of approximately a $2.4 billion loan portfolio, a $36 million allowance for loan losses, and $1.1 billion in deposits, includes commercial lending, deposits and other banking services for New England regional middle-market companies and companies in selected industries nationwide. Approximately 300 State Street employees joined Citizens as a result of the sale. The premium received on the sale was $350 million; exit and other associated costs were $68 million. The after-tax gain, net of exit and other associated costs, on the sale totaled approximately $164 million, or $1.00 in earnings per share, and will be recorded in the fourth quarter of 1999. Based on pro-forma financials for the first six months of 1999, management anticipates a revenue reduction of approximately 3% and earnings per share dilution of approximately 6% resulting from the sale. State Street intends to offset dilution resulting from the sale within the next three years through acquisitions, internal growth programs, and the corporate stock purchase program. State Street will continue to offer lending and banking services to institutional and global trade banking customers, including credit, deposit and cash management services, and lease financing for large capital equipment transactions. New Accounting Developments Information related to new accounting developments appears in Note A to the Consolidated Financial Statements. Liquidity and Capital Liquidity. The primary objective of State Street's liquidity management is to ensure that the Corporation has sufficient funds to meet its commitments and business needs, and to accommodate the transaction and cash management requirements of its customers. Liquidity is provided by State Street's access to global debt markets, its ability to gather additional deposits from its customers, maturing short-term assets, the sale of securities and payment of loans. Customer deposits and other funds provide a multi-currency, geographically diverse source of liquidity. State Street maintains a large portfolio of liquid assets. As of September 30, 1999, the Corporation's liquid assets were 80% of total assets. Capital. State Street's objective is to maintain a strong capital base in order to provide financial flexibility for its business needs, including funding corporate growth and customers' cash management needs. As a state- chartered bank and member of the Federal Reserve System, State Street Bank, State Street's principal subsidiary, is regulated by the Federal Reserve Board, which has established guidelines for minimum capital ratios. State Street has developed internal capital adequacy policies to ensure that State Street Bank meets or exceeds the level required for the "well capitalized" category, the highest of the Federal Reserve Board's five capital categories. State Street's capital management emphasizes risk exposure rather than simple asset levels. At September 30, 1999, the Bank's Tier 1 risk-based capital ratio was 11.6% and the Corporation's Tier 1 risk-based capital ratio was 12.6%. Both significantly exceed the regulatory minimum of 4%. See Note E to the Consolidated Financial Statements for further information. State Street's Board of Directors has authorized the purchase of State Street common stock for use in employee benefit programs and for general corporate purposes. State Street purchased 1,389,000 shares in the third quarter of 1999 as part of the stock purchase program. As of September 30, 1999, an additional 1.5 million shares may be purchased within the stock purchase program. There were an additional 10,000 shares acquired during the third quarter of 1999 for other deferred compensation plans that are not part of the stock purchase program. 22
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Trading Activities: Foreign Exchange and Interest Rate Sensitivity As part of its trading activities, the Corporation assumes positions in both the foreign exchange and interest rate markets by buying and selling cash instruments and using financial derivatives, including forward foreign exchange contracts, foreign exchange and interest rate options, and interest rate swaps. As of September 30, 1999, the notional amount of these derivative instruments was $162.5 billion, of which $157.6 billion were foreign exchange forward contracts. Long and short foreign exchange forward positions are closely matched to minimize currency and interest rate risk. All foreign exchange contracts are valued daily at current market rates. The Corporation uses a variety of risk measurement and estimation techniques including value at risk. Value at risk is an estimate of potential loss for a given period of time within a stated statistical confidence interval. State Street uses a sophisticated risk management system to estimate value at risk daily for all material trading positions. The Corporation has adopted standards for estimating value at risk, and maintains capital for market risk, in accordance with the Federal Reserve's Capital Adequacy Guidelines for market risk. Value at risk is estimated for a 99% one-tail confidence interval and an assumed one-day holding period using an historical observation period of one year. A 99% one-tail confidence interval implies that daily trading losses should not exceed the estimated value at risk more than 1% of the time, or approximately three days out of the year. The methodology utilizes a simulation approach and is based on observed changes in interest rates and foreign exchange rates, and takes into account the resulting diversification benefits provided from the mix of the Corporation's trading positions. Like all quantitative measures, value at risk is subject to certain limitations and assumptions inherent to the methodology. State Street's methodology gives equal weight to all market rate observations regardless of how recently the market rates were observed. The estimate is calculated using static portfolios consisting of positions held at the end of the trading day in Boston. Implicit in the estimate is the assumption that no intraday action is taken by management during adverse market movements. As a result, the methodology does not represent risk associated with intraday changes in positions or intraday price volatility. The following table presents State Street's market risk for its trading activities as measured by its value at risk methodology: Value at Risk as of September 30, <TABLE> - -------------------------------------------------------------------------------- <CAPTION> (Dollars in millions) Average Maximum Minimum - -------------------------------------------------------------------------------- <S> <C> <C> <C> 1999: Foreign exchange contracts............................. $ 1.7 $ 4.0 $ .8 Interest rate contracts................................ .2 .6 1998: Foreign exchange contracts............................. .8 3.0 .3 Interest rate contracts................................ .1 .3 </TABLE> - ------------------------------------------------------------------------------- State Street compares actual daily profit and losses from trading activities to estimated one-day value at risk. During the first nine months of 1999, State Street did not experience any one-day trading loss in excess of its end of day value at risk estimate. Financial Goals and Factors That May Affect Them State Street's primary financial goal is sustainable real growth in earnings per share. The Corporation has two supporting goals. The revenue goal is a 12.5% real, or inflation adjusted, compound annual growth rate of revenue through 2010. This translates to approximately a 15% nominal compound annual growth rate for the decade to date. The goal for return on common stockholders equity is to achieve 18%. 23
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) State Street considers these to be financial goals, not projections or forward-looking statements. However, the discussion included in Management's Discussion and Analysis of Financial Condition and Results of Operations, and in other portions of this report on Form 10-Q, does contain statements that are considered "forward-looking statements" within the meaning of the federal securities laws. These statements may be identified by such forward-looking terminology as "expect," "look," "believe," "anticipate," "may," "will," or similar statements or variations of such terms. The Corporation's financial goals and such forward-looking statements involve certain risks and uncertainties, including the issues and factors listed below and factors further described in conjunction with the forward-looking information, which could cause actual results to differ materially. Factors that may cause such differences include, but are not limited to, the factors discussed in this section and elsewhere in this Form 10-Q. Each of these factors, and others, are also discussed from time to time in the Corporation's other filings with the Securities and Exchange Commission, including in the Corporation's Form 10-K. Based on evaluation of the following factors, management is currently optimistic about the Corporation's long-term prospects. Cross-border investing. Increases in cross-border investing by customers worldwide benefit State Street's revenue. Future revenue may increase or decrease depending upon the extent of increases or decreases in cross-border investments made by customers or future customers. Savings rate of individuals. State Street benefits from the savings of individuals that are invested in mutual funds or in defined contribution plans. Changes in savings rates or investment styles may affect revenue. Value of worldwide financial markets. As worldwide financial markets increase or decrease in value, State Street's opportunities to invest and service financial assets may change. Since a portion of the Corporation's fees are based on the value of assets under custody and management, fluctuations in worldwide securities market valuations will affect revenue. Dynamics of markets served. Changes in markets served, including the growth rate of U.S. mutual funds, the pace of debt issuance, outsourcing decisions, and mergers, acquisitions and consolidations among customers and competitors, can affect revenue. In general, State Street benefits from an increase in the volume of financial market transactions serviced. State Street provides services worldwide. Global and regional economic factors and changes or potential changes in laws and regulations affecting the Corporation's business, including volatile currencies and changes in monetary policy, and social and political instability, could affect results of operations. Interest rates. Market interest rate levels, the shape of the yield curve and the direction of interest rate changes affect net interest revenue as well as fiduciary compensation from securities lending. All else being equal, in the short term, State Street's net interest revenue benefits from falling interest rates and is negatively affected by rising rates because interest- bearing liabilities reprice sooner than interest-earning assets. In general, sustained lower interest rates have a constraining effect on the net interest revenue growth rate. Volatility of currency markets. The degree of volatility in foreign exchange rates can affect the amount of foreign exchange trading revenue. In general, State Street benefits from currency volatility. Pace of pension reform. State Street expects to benefit from worldwide pension reform that creates additional pools of assets that use custody and related services and investment management services. The pace of pension reform may affect the pace of revenue growth. 24
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Pricing/competition. Future prices the Corporation is able to obtain for its products may increase or decrease from current levels depending upon demand for its products, its competitors' activities and the introduction of new products into the marketplace. Pace of new business. The pace at which existing and new customers use additional services and assign additional assets to State Street for management or custody will affect future results. State Street believes that uncertainties resulting from the Year-2000 issues could have an impact on new business for 1999 such that customers and potential customers of State Street will be less inclined in the second half of 1999 to consider changing their business relationships. Business mix. Changes in business mix, including the mix of U.S. and non- U.S. business, may affect future results. Rate of technological change. Technological change creates opportunities for product differentiation and reduced costs, as well as the possibility of increased expenses. State Street's financial performance depends in part on its ability to develop and market new and innovative services and to adopt or develop new technologies that differentiate State Street's products or provide cost efficiencies. There are risks inherent in this process. These include rapid technological change in the industry, the Corporation's ability to access technical and other information from customers, and the significant and ongoing investments required to bring new services to market in a timely fashion at competitive prices. Further, there is risk that competitors may introduce services that could replace or provide lower-cost alternatives to State Street services. State Street uses appropriate trademark, trade secret, copyright and other proprietary rights procedures to protect its technology, and has applied for a limited number of patents in connection with certain software programs. The Corporation believes that patent protection is not a significant competitive factor and that State Street's success depends primarily upon the technical expertise and creative abilities of its employees, and the ability of the Corporation to continue to develop, enhance and market its innovative business processes and systems. However, in the event a third party asserts a claim of infringement of its proprietary rights, obtained through patents or otherwise, against the Corporation, State Street may be required to spend significant resources to defend against such claims, develop a non-infringing program or process, or obtain a license to the infringed process. Year-2000 modifications. The costs and projected completion dates for State Street's Year-2000 program are estimates. Factors that may cause material differences include the availability and cost of systems and personnel, non- compliance of third-party providers, and similar uncertainties. If necessary modifications and conversions are not completed in time, or if key third-party providers are not Year-2000 ready, or if the global interactive system in which State Street is a participant and is codependent fails in a material way, the Year-2000 issues could affect State Street's performance. Acquisitions and alliances. Acquisitions of complementary businesses and technologies, and development of strategic alliances are an active part of State Street's overall business strategy, and the Corporation has completed several acquisitions and alliances in recent years. However, there can be no assurance that services, technologies, key personnel and businesses of acquired companies will be effectively assimilated into State Street's business or service offerings or that alliances will be successful. 25
PART I. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) PART I. ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK See information under the caption "Trading Activities: Foreign Exchange and Interest Rate Sensitivity" on page 23. PART II -- Other Information Item 2. Changes in Securities and Use of Proceeds (C) Directors of the Corporation who are not employees receive an annual retainer of $35,000, payable at their election in shares of Common Stock of the Corporation or in cash. In April 1999, a total of 5,643 shares were issued and receipt of 627 shares was deferred as payment for the 1999 annual retainer. In July, these directors also received an annual deferred stock award which totaled 7,028 shares. Exemption from registration of the shares is claimed by the Corporation under Section 4 (2) of the Securities Act of 1933. Item 6. Exhibits and Reports on Form 8-K (a) Exhibit Index <TABLE> <CAPTION> Exhibit Number Page of this Report ------- ------------------- <C> <S> <C> 12 Ratio of Earnings to Fixed Charges.............. 28 15 Letter regarding unaudited interim financial information..................................... 29 27 Financial data schedule......................... 30 </TABLE> (b) Reports on Form 8-K A current report on Form 8-K dated October 1, 1999 was filed on October 5, 1999 with the Securities and Exchange Commission which reported completion of the sale of State Street's commercial banking business and associated four retail branches to Citizens Financial Group. The transaction will be recorded during the fourth quarter of 1999. 26
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. State Street Corporation Date: November 15, 1999 /s/ Ronald L. O'Kelley By: _________________________________ Ronald L. O'Kelley Executive Vice President and Chief Financial Officer Date: November 15, 1999 /s/ Rex S. Schuette By: _________________________________ Rex S. Schuette Senior Vice President and Chief Accounting Officer 27