UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
Form 10-Q
Commission File No. 0-5108
STATE STREET CORPORATION (Exact name of registrant as specified in its charter)
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
The number of shares of the Registrant's Common Stock outstanding on October 31, 2004 was 333,410,769.
STATE STREET CORPORATION
Table of Contents
PART I. ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED STATEMENT OF INCOME—STATE STREET CORPORATION (UNAUDITED)
The accompanying notes are an integral part of these financial statements.
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CONSOLIDATED STATEMENT OF CONDITION—STATE STREET CORPORATION
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CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY—STATE STREET CORPORATION (UNAUDITED)
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CONSOLIDATED STATEMENT OF CASH FLOWS—STATE STREET CORPORATION (UNAUDITED)
Non-cash transactions for the nine months ended September 30, 2004 and 2003 included $189 million and $220 million, respectively, of leases capitalized in property, plant and equipment, with a corresponding increase in long-term debt for those periods.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—STATE STREET CORPORATION (UNAUDITED)
Note 1—Basis of Presentation
Organization and Nature of Operations
State Street Corporation ("State Street" or the "Corporation") is a financial holding company and reports two lines of business. Investment Servicing provides services for U.S. mutual funds, collective funds worldwide, corporate and public retirement plans, insurance companies, foundations, endowments, and other investment pools. Products include custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; recordkeeping; foreign exchange and trading services; securities lending; deposit and short-term investment facilities; loans and lease financing; investment operations outsourcing; wealth manager and hedge fund manager services; and performance, risk and compliance analytics to support institutional investors. Investment Management offers a broad array of services for managing financial assets, including investment management and investment research services, primarily for institutional investors worldwide; these services include passive and active U.S. and non-U.S. equity and fixed income strategies, and other related services, such as securities lending.
Basis of Presentation
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, 2004 and December 31, 2003, its cash flows for the nine months ended September 30, 2004 and 2003, and consolidated results of its operations for the three and nine months ended September 30, 2004 and 2003, have been made. Operating results for the three and nine months ended September 30, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. 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.
The Statement of Condition at December 31, 2003, has been developed from the audited financial statements at that date, but does not include all footnotes required by accounting principles generally accepted in the United States ("GAAP") for complete financial statements.
Principles of Consolidation
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"). All significant intercompany balances and transactions have been eliminated upon consolidation.
The assets and liabilities of non-U.S. operations are translated at month-end exchange rates, and revenue and expenses are translated at rates that approximate average monthly exchange rates. Gains or losses from the translation of the net assets of non-U.S. subsidiaries and branches, net of related taxes, are reported in accumulated other comprehensive (loss) income.
Use of Estimates
The preparation of financial statements in accordance with GAAP 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.
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Investments in Affiliates
Investments in affiliates in which the Corporation has the ability to exercise significant influence, but not control, are accounted for using the equity method, unless the affiliate is determined to be a variable interest entity ("VIE") for which State Street absorbs the majority of expected losses, in which case State Street consolidates the VIE.
Revenue Recognition
Revenue recorded as servicing fees, management fees, securities lending fees, foreign exchange trading, brokerage fees and certain types of revenue recorded in processing fees and other is recognized when earned based on contractual terms and is accrued based on estimates, or is recognized as transactions occur or services are provided and collectibility is reasonably assured. Revenue on interest-earning assets is recognized based on the effective yield of the financial instrument.
Stock-Based Compensation
State Street expenses stock options using the fair value method in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" using the prospective transition method afforded under SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure," an amendment to SFAS No. 123. The following table illustrates the pro forma effect on net income and earnings per share as if the fair value method had been applied to all outstanding and unvested stock options in each period:
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Information related to option activity is as follows:
Reclassification
Certain previously reported amounts have been reclassified to conform to the current method of presentation.
Accounting Changes and Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). As a result of this Interpretation, State Street deconsolidated the trusts that issued trust preferred capital securities in the fourth quarter of 2003. In December 2003, the FASB issued a revised version of FIN 46 ("FIN 46-R") that deferred the effective date of the Interpretation as it related to certain types of variable interest entities until March 31, 2004. The adoption of FIN 46-R as of March 31, 2004, did not materially impact either the financial position or results of operations of the Corporation.
Note 2—Acquisitions and Divestitures
On October 31, 2003, State Street completed the sale of its Private Asset Management business to U.S. Trust. Under the terms of the agreement, the transaction was valued at $365 million, about five percent of which is subject to the successful transition of the business over the subsequent 16 months.
On January 31, 2003, State Street completed the primary closing of its acquisition of a substantial part of the Global Securities Services ("GSS") business of Deutsche Bank AG ("Deutsche Bank") for a premium of $1.10 billion. In July 2003, separate closings were held for the GSS business units in Italy and Austria, upon receipt of regulatory approvals. Under the terms of the sale and purchase agreement, State Street could have been required to make contingent additional purchase price payments. During the second quarter of 2004, State Street and Deutsche Bank determined that under the terms of the sale and purchase agreement, no additional consideration is payable by State Street.
In connection with the acquisition, approximately 2,800 employees of Deutsche Bank became employees of State Street. For the three and nine months ended September 30, 2004, State Street paid $3 million and $10 million, respectively, of severance costs related to an overall GSS workforce reduction, primarily in the U.S. The severance liability outstanding was $9 million as of September 30, 2004.
In January 2003, the Corporation issued equity, equity-related and capital securities under an existing shelf registration statement. State Street issued $283 million, or 7,153,000 shares of common stock, $345 million, or 1,725,000 units of SPACESsm, and $345 million of floating-rate, medium-term capital securities due 2008. Proceeds, net of issuance costs, of $595 million from these security issuances were used to partially
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finance the acquisition of the GSS business. The remainder of the purchase price was financed using existing resources.
State Street receives payments from Deutsche Bank representing amounts earned on client deposits of the GSS business that have not yet converted to State Street. For the three months ended September 30, 2004 and 2003, payments of $8 million and $29 million, respectively, were included in processing fees and other revenue in the Consolidated Statement of Income. For the nine months ended September 30, 2004 and 2003, payments of $41 million and $76 million, respectively, were included in processing fees and other revenue. Once converted, GSS deposits will be reflected as deposits on State Street's Consolidated Statement of Condition and the related earnings on those deposits will be included in net interest revenue.
In July 2002, State Street completed the purchase of International Fund Services, a leading provider of fund accounting and administration as well as securities trade support and operational services for hedge funds. In connection with this transaction, an additional $60 million of the purchase price was recorded as goodwill during the second quarter of 2004 based upon certain performance measures with payment made in the third quarter of 2004. Final settlement, which will occur in 2005, could require State Street to make another payment of up to $60 million.
Note 3—Investment Securities
Available-for-sale securities and held-to-maturity securities consisted of the following as of the dates indicated:
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Gross gains and losses realized on the sale of available-for-sale securities were as follows for the periods indicated:
Note 4—Allowance for Loan Losses
State Street establishes an allowance for loan losses to absorb probable credit losses. Changes in the allowance for loan losses were as follows:
During the first quarter of 2004, State Street reclassified $25 million of the allowance for loan losses to other liabilities as a reserve for off-balance sheet commitments. Subsequent to the reclassification, the reserve for off-balance sheet commitments was reduced by $10 million, and recorded as an offset to other operating expenses.
Note 5—Other Assets and Other Liabilities
Other assets included $1.88 billion and $3.82 billion of unrealized gains on foreign exchange contracts at September 30, 2004, and December 31, 2003, respectively.
Other liabilities included $1.77 billion and $3.61 billion of unrealized losses on foreign exchange contracts at September 30, 2004, and December 31, 2003, respectively.
Note 6—Stockholders' Equity
SPACES
In January 2003, in connection with its acquisition of the GSS business (see Note 2), State Street issued $345 million, or 1.7 million units, of SPACESsm. SPACES are collateralized, forward purchase contract units for additional shares of common stock of State Street. Each of the SPACES has a stated amount of $200 and consists of PACESsm, a fixed-share purchase contract and treasury securities, and COVERSsm, a variable-share repurchase contract. The SPACES investors will receive total annual payments of 6.75% on the units, payable quarterly, consisting of an annual 4.00% contract payment on the COVERS, an annual 0.75% contract payment on the PACES and a 2.00% annual return on the underlying treasury securities. The present value of the contract payments totaled $45 million, and was treated as a cost of capital and
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charged to surplus upon issuance. State Street will receive the proceeds of $345 million and issue common stock upon settlement of the fixed-share purchase contracts underlying the SPACES units on November 15, 2005.
Effective March 22, 2004, State Street exercised its right to fix the variable-share settlement rate of the variable-share repurchase contracts constituting part of the SPACES or existing separately as Separate COVERS, in accordance with the terms of the contracts. The variable-share settlement rate is fixed at 0.6949 shares per contract in accordance with a formula specified in the contracts.
After the effective date, a holder of a variable-share repurchase contract (whether held as a component of a SPACES or as a Separate COVERS) may settle the variable-share repurchase contract by delivery to the Purchase Contract Agent of that number of shares of common stock of State Street equal to the variable-share settlement rate, as fixed.
The impact of fixing the settlement rate for the SPACES and Separate COVERS was a reclassification of the recognized gains of $26 million associated with the mark-to-market of the variable-share contracts from other assets to a reduction of surplus in stockholders' equity.
Accumulated Other Comprehensive (Loss) Income
The components of accumulated other comprehensive (loss) income, net of related taxes, were as follows:
Total comprehensive income for the three and nine months ended September 30, 2004, was $268 million and $508 million, respectively, and for the three and nine months ended September 30, 2003, was $182 million and $295 million, respectively.
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Note 7—Regulatory Capital
The regulatory capital amounts and ratios were as follows as of September 30, 2004, and December 31, 2003:
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Note 8—Net Interest Revenue
Net interest revenue consisted of the following:
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Note 9—Employee Benefit Plans
The components of net periodic benefit cost were as follows:
Employer Contributions
Expected employer contributions to the tax-qualified U.S. defined benefit pension plans, non-qualified supplemental employee retirement plans ("SERPs") and post-retirement plan for the year ending December 31, 2004 are $55 million, $18 million and $3 million, respectively.
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Note 10—Restructuring Costs
During the second quarter of 2003, State Street implemented an expense reduction program to decrease operating expenses. The expense reductions were achieved through a decrease in direct controllable expenses and by a voluntary separation and enhanced severance program ("VSP"), primarily in the United States. At June 30, 2003, approximately 3,000 individuals accepted the VSP. Subsequent to the VSP, approximately 1,000 positions were replaced. State Street incurred $3 million and $295 million of restructuring costs for the three and nine months ended September 30, 2003, as a result of the program, as follows:
No VSP-related expenses were incurred during the nine months ended September 30, 2004. Following is a rollforward of the restructuring accrual for the nine months ended September 30, 2004:
The restructuring costs were recorded at the time the accounting events and measurement date occurred. Severance costs included salaries and related benefits to be paid out over a defined period of up to two years. Pension costs will be paid out primarily in equal annual installments over a five-year period. Stock compensation expense was attributable to the modification of various stock options and restricted and deferred stock awards for individuals who accepted the VSP (see the Stock-Based Compensation disclosures in Note 1). Other restructuring costs include outplacement services associated with the termination of employees and professional and actuarial fees incurred.
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Note 11—Operating Expenses—Other
The other category of operating expenses consisted of the following:
Note 12—Income Taxes
State Street recorded tax expense of $91 million for the third quarter of 2004, compared to $103 million in the third quarter of 2003. Tax expense for the nine months ended September 30, 2004 and 2003, was $299 million and $159 million, respectively.
Tax expense for the nine months ended September 30, 2004, included a cumulative benefit of $18 million recorded in the first quarter of 2004 resulting from a change in the effective state tax rate applied to leveraged leasing transactions.
Tax expense for the nine months ended September 30, 2003 included an after-tax charge of $12 million for the settlement of a tax matter with the Massachusetts Department of Revenue.
The effective tax rate for the third quarter of 2004 was 34% and for the nine months ended September 30, 2004, was 32.8%, including the impact of the leveraged lease tax benefit. The expected tax rate for the full year 2004 is 33.0%, compared with an effective tax rate of 35.1% for full year 2003.
Note 13—Lines of Business
State Street has two primary lines of business—Investment Servicing and Investment Management.
Investment Servicing provides services for U.S. mutual funds, collective funds worldwide, corporate and public retirement plans, insurance companies, foundations, endowments, and other investment pools. Products include custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; recordkeeping; foreign exchange and trading services; securities lending; deposit and short-term investment facilities; loans and lease financing; investment operations outsourcing; wealth manager and hedge fund manager services; and performance, risk and compliance analytics to support institutional investors. State Street has a 50% interest in Boston Financial Data Services, Inc. and the International Financial Data Services group of companies, which provide shareholder services, including mutual fund and collective fund shareholder accounting. Revenue from Investment Servicing comprised 85% of State Street's total revenue for the nine months ended September 30, 2004.
Investment Management offers a broad array of services for managing financial assets, including investment management and investment research, primarily for institutional investors worldwide. These services included passive and active U.S. and non-U.S. equity and fixed income strategies, and other related services, such as securities lending. Retirement benefit services are provided through CitiStreet, LLC, in which State Street has a 50% interest. Revenue from the Investment Management line of business comprised 15% of State Street's total revenue for the nine months ended September 30, 2004.
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Business Divesture consisted of revenue and expenses related to the Private Asset Management operations sold in October 2003.
Other/One-Time charges for 2004 consisted of merger and integration costs related to the acquisition of GSS; Other/One-Time charges for 2003 consisted of restructuring, merger and integration costs included in operating expenses and for the nine months ended September 30, 2003, included the loss on the sale of certain real estate included in processing fees and other revenue.
The total columns represent consolidated results in accordance with accounting principles generally accepted in the United States as they appear in the Consolidated Statements of Income.
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Note 14—Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
As of September 30, 2004 and 2003, 14.2 million and 11.9 million of potentially-dilutive stock options were outstanding, but not included in the computation of diluted average shares because the exercise prices of the instruments were greater than the average fair value of State Street's common stock.
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Note 15—Contingent Liabilities
State Street provides custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; investment management; recordkeeping; foreign exchange and trading services; securities lending; deposit and short-term investment facilities; loans and lease financing; investment operations outsourcing; wealth manager and hedge fund manager services; and performance, risk and compliance analytics to clients worldwide. 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, no contingent liabilities existed at September 30, 2004, that would have a material adverse effect on State Street's financial position or results of operations.
In the normal course of business, State Street is subject to challenges from U.S. and non-U.S. tax authorities regarding the amount of taxes due. These challenges may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions.
The Internal Revenue Service ("IRS") completed its review of State Street's federal income tax returns for 1997, 1998 and 1999 in the third quarter and has issued Notices of Proposed Adjustment with respect to the tax treatment of lease-in-lease-out transactions. The proposed adjustments relate to the timing of recognition of income for tax purposes; for financial reporting purposes, deferred taxes have been provided. State Street believes that it properly reported the tax effects of these transactions based on applicable statutes, regulations and case law in effect at the time they were entered into; a court or other judicial or administrative authority could disagree. The IRS has indicated that it may consider settling such disputes with taxpayers. State Street has begun settlement discussions.
While it is unclear whether State Street will be able to reach an acceptable settlement, management believes the Corporation is appropriately accrued for tax exposures and related interest expense, including for lease-in-lease-out transactions. The Corporation understands that FASB may currently be reviewing the GAAP treatment of negotiated settlements of tax disputes involving leases accounted for under SFAS 13. It is possible that FASB's review could affect the accounting recognition of any potential settlement with IRS, and could result in a charge to earnings. If State Street prevails in a matter for which an accrual has been established, or is required to pay an amount exceeding its reserve, the financial impact will be reflected in the period that the matter is resolved.
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Note 16—Derivative Financial Instruments
State Street uses various derivatives to support clients' needs, conduct trading activities and manage its interest rate and currency risk. The following table summarizes the contractual or notional amounts of derivative financial instruments held or issued for trading and balance sheet management:
In connection with its interest-rate risk management strategies, State Street has executed interest-rate swap agreements with a notional value of $1.84 billion as of September 30, 2004, designated as fair value hedges to hedge the changes in the fair value of certain securities. For the three and nine months ended September 30, 2004, State Street recognized net pre-tax gains of $1 million and $3 million, respectively, which represented the ineffective portion of the hedge.
State Street has designated interest-rate swaps with a notional value of $150 million as cash flow hedges to its floating-rate debt. These interest-rate swaps qualify as fully effective hedges. In addition, $1.20 billion was designated as fair value hedges to hedge certain of its fixed-rate debt. The fair value hedge swaps increased the value of long-term debt presented in the Statement of Condition by $76 million at September 30, 2004. For the three and nine months ended September 30, 2004, the Corporation's overall weighted average interest rate for long-term debt was 6.1% and 6.2% on a contractual basis and 4.3% and 4.2% including the effects of derivative contracts, respectively.
During the third quarter of 2004, State Street entered into forward foreign currency swaps with a basis of €300 million, or approximately $373 million, to hedge the Corporation's net foreign investment in certain non-U.S. subsidiaries. As a result, less than $1 million of translation gains for certain non-U.S. subsidiaries were offset by a loss on the hedge contract within the category foreign currency translation, recorded as a component of accumulated other comprehensive income in stockholders' equity.
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Note 17—Commitments and Off-Balance Sheet Activities
The following is a summary of the contractual amount of State Street's credit-related, off-balance sheet financial instruments:
On behalf of its clients, State Street lends their securities to creditworthy brokers and other institutions. In certain circumstances, State Street may indemnify its clients 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 $326.46 billion and $271.30 billion for indemnified securities on loan at September 30, 2004 and December 31, 2003, respectively.
Loan commitments (unfunded loans and unused lines of credit), liquidity asset purchase agreements and standby letters of credit are issued to accommodate the financing needs of State Street's clients and to provide liquidity and credit enhancements to variable interest entities. Loan commitments are agreements by State Street to lend monies at a future date. Liquidity asset purchase agreements are commitments to purchase receivables or securities, subject to conditions established in the agreements.
Approximately 86% of the loan commitments and liquidity asset purchase agreements will expire within one year from the date of issue. Since many of the commitments are expected to expire or renew without being drawn, the total commitment amounts do not necessarily represent future cash requirements.
State Street provides liquidity and credit enhancement facilities in the form of liquidity asset purchase agreements, lines of credit, and standby letters of credit to two types of off-balance sheet entities. One type, structured as special purpose entities ("SPEs"), as defined by FIN 46 (revised), which are administered by State Street, issues asset-backed commercial paper ("ABCP"). At September 30, 2004 and December 31, 2003, State Street's commitments under liquidity asset purchase agreements and lines of credit to these SPEs were $13.89 billion and $11.88 billion, respectively, and standby letters of credit were $646 million and $644 million, respectively. Amounts committed, but unused, under the liquidity asset purchase agreements, lines of credit and standby letters of credit that State Street provides to these SPEs are included in the preceding table. Asset performance deterioration or certain other factors may cause the asset risk to shift from the ABCP investors to State Street as the liquidity and/or credit enhancement provider through the liquidity asset purchase agreements, lines of credit and standby letters of credit, as the SPE may need to repay maturing commercial paper by drawing the liquidity facilities. State Street would acquire the assets at fair market value at the date of transfer. Potential losses, if any, from these SPEs are not expected to materially affect the financial condition or results of operations of the Corporation.
For a second type of off-balance sheet entity, structured as qualified special-purpose entities ("QSPEs") in accordance with accounting principles generally accepted in the United States, State Street distributes and sells equity interests in tax-exempt investment-grade assets that are primarily sold to mutual fund clients. For these QSPEs, State Street transfers the assets from its investment portfolio at fair market value. Such
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transfers are treated as sales. The QSPEs finance the acquisition of these assets by selling equity interests to third-party investors. State Street owns a minority residual interest in these QSPEs of less than 7.1%, or $138 million at September 30, 2004. These trusts have a weighted average life of approximately 5.2 years. In a separate agreement, State Street provides liquidity asset purchase agreements to these entities. These liquidity asset purchase agreements obligate State Street to buy the equity interests in the underlying portfolio at par, which approximates market value, in the event that the re-marketing agent is unable to place the equity interests of the off-balance sheet entity with investors. The liquidity asset purchase agreements are subject to early termination by State Street in the event of payment default, bankruptcy of the issuer or credit enhancement provider, taxability, or downgrade of an asset below investment grade. State Street's liquidity asset purchase agreements to these off-balance sheet entities were $1.47 billion at September 30, 2004, and $1.24 billion at December 31, 2003, none of which were utilized and are included in the preceding table.
For the nine months ended September 30, 2004, State Street acquired and transferred approximately $387 million of investment securities out of its available-for-sale portfolio at fair market value in exchange for cash to another off-balance sheet entity structured as a QSPE. These transfers were accounted for as sales. State Street provides investment management services to this unaffiliated QSPE.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Stockholders and Board of DirectorsState Street Corporation
We have reviewed the condensed consolidated statement of condition of State Street Corporation as of September 30, 2004, and the related condensed consolidated statements of income for the three-month and nine-month periods ended September 30, 2004 and 2003, and the condensed consolidated statements of changes in stockholders' equity and cash flows for the nine-month periods ended September 30, 2004 and 2003. These financial statements are the responsibility of the Corporation's management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of condition of State Street Corporation as of December 31, 2003, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for the year then ended not presented herein, and in our report dated January 12, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of condition as of December 31, 2003, is fairly stated, in all material respects, in relation to the consolidated statement of condition from which it has been derived.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
State Street prepares and reports its financial information in accordance with accounting principles generally accepted in the United States ("reported" results). Unless otherwise indicated, results discussed in this Form 10-Q refer to reported results.
Results for the Three Months Ended September 30, 2004 and 2003
Condensed Income Statement—Reported Results
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Supplemental Financial Information
In order to provide information on a comparable basis from period to period and to assist stockholders, analysts, other external parties and management in analyzing the financial results and trends of its ongoing businesses and operations, supplemental financial results on an "operating" basis are presented below. In this Management's Discussion and Analysis of Financial Condition and Results of Operations section, the discussion will reference reported results, as previously defined, and "operating" results. Operating results are defined as reported results on a taxable equivalent basis, excluding merger and integration costs and for 2003, restructuring costs, the loss on the sale of certain real estate, the results of the divested Private Asset Management ("PAM") business and the impact of a state tax matter.
Supplemental Financial Information—Operating Basis Reconciliation
Reported results agree with the Corporation's Consolidated Statement of Income
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Supplemental Financial Information—Reconciliation of Reported Results to Non-GAAP Measures
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Supplement Financial Information—Operating(1)—Consolidated Statement of Income
Summary
State Street reported net income for the third quarter of 2004 of $.52 per share, reflecting net income of $177 million and total revenue of $1.17 billion. These results compare to earnings per share of $.60, reflecting net income of $202 million and total revenue of $1.13 billion in the third quarter of 2003. Total expenses in the third quarter of 2004 were $906 million compared to $821 million in the year-ago quarter.
Results for the third quarter of 2004 included pre-tax merger and integration costs of $16 million, or $.03 per diluted share, due to the continuing integration of the Deutsche Bank Global Securities Services business (GSS), acquired in January of 2003, compared with $26 million, or $.05 per diluted share, for the year earlier period. Results for the third quarter of 2003 also included pre-tax restructuring costs of $3 million, or $.01 per diluted share. Third-quarter 2003 reported results also included the results of the divested PAM business, which was sold on October 31, 2003.
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On an operating basis, which excludes merger and integration costs and for 2003, excludes restructuring costs and the results of the divested PAM business, operating earnings per share for the third quarter of 2004 were $.55, down 15% compared to operating earnings per share of $.65 for the third quarter of 2003. Operating earnings per share for 2003 have been reduced from the previously reported $.66 per share to exclude the results of the divested PAM business from the prior period.
Operating revenue of $1.18 billion in the third quarter of 2004 was up 6% from the third quarter of 2003, reflecting increased servicing fees largely offset by decreases in market-driven revenue, namely securities lending and foreign exchange trading revenue. Operating expenses of $890 million in the third quarter of 2004 were up $109 million, or 14%, from the third quarter of 2003. Return on stockholders' equity on an operating basis was 12.3% for the quarter.
State Street experienced declines in securities lending and foreign exchange trading revenue in the third quarter due to market activity. Related expenses were not lowered at a significant enough level to offset the decline in market-driven revenue.
State Street is taking steps to align its expenses with revenue, to better absorb shifts in market-driven revenue. In October 2004, the Corporation announced that it was limiting its near term investment in wealth management services and exiting the "529 education plan" servicing business. As a result of these decisions and others, State Street expects to eliminate about 425 positions, with annualized savings of approximately $50 million, with little impact on revenue. The Corporation expects to incur a charge of approximately $25 million in the fourth quarter of 2004 as a result.
State Street has announced revised financial goals for the Corporation. The revised goals are (1) annual growth in operating earnings per share of 10% to 15%, (2) annual operating revenue growth of 8% to 12%, and (3) annual operating return on stockholders' equity of 14% to 17%.
Near-term steps are being taken to better align expenses with revenue including the reorganization of significant operating groups, modification of the Corporation's incentive compensation plans and focus on balance sheet management. While State Street does not provide specific future earnings guidance, the Corporation expects 2005 operating results to fall in the lower end of the range for the operating revenue and earnings per share goals.
Total Revenue
In the third quarter of 2004, total reported revenue was $1.17 billion, up $48 million, compared to $1.13 billion a year ago, which included $19 million of management fees from the divested PAM business. On an operating basis, total revenue was $1.18 billion compared to $1.12 billion in 2003, an increase of $64 million, or 6%.
Fee Revenue
Fee revenue for the third quarter of 2004 was $961 million on both a reported and operating basis. Reported fee revenue for 2003 was $928 million and included $19 million of fee revenue from the divested PAM business. On an operating basis, fee revenue increased $52 million from $909 million in 2003. Combined, servicing and management fees were up 15% from the year ago quarter. Declines in market-driven revenue, defined by State Street as securities lending, foreign exchange trading and brokerage fee revenue, in large part, offset these increases.
Servicing fees are derived from custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; recordkeeping; investment operations outsourcing; wealth manager and hedge fund manager services and performance, risk and compliance analytics. Servicing fees for the third quarter of 2004 were $568 million, up $63 million, or 12%, from $505 million a year earlier. The increase was attributable to new business from existing and new clients and higher equity market valuations in 2004.
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At September 30, 2004, total assets under custody were $9.00 trillion, up 3% from $8.75 trillion a year earlier. The value of assets under custody is a broad measure of the relative size of various markets served. Changes to the value of assets under custody do not result in proportional changes in revenue. Many services are priced on factors other than asset values, including the mix of assets under custody, securities positions held, portfolio transactions, and types of products and services. State Street uses relationship pricing for clients who take advantage of multiple services.
Management fees from investment management services, generated by State Street Global Advisors®, were $156 million, compared to $141 million a year ago. Fees from the PAM business added $19 million to 2003 management fees. On an operating basis, management fees were up $34 million, or 28%, from $122 million in 2003, reflecting continued new business success and an increase in average month-end equity valuations. Total assets under management were $1.24 trillion, up 28%, compared to $965 billion the previous year.
Securities lending revenue was $48 million in the third quarter of 2004, compared to $61 million in the third quarter of the previous year, a decrease of 21%. The decrease reflected short-term pressure on spreads from the three rapid-succession increases in the target federal funds rate by the Federal Open Market Committee of the Federal Reserve ("FOMC") in June, August and September of this year, partially offset by a 22% increase in the volume of securities on loan.
Foreign exchange trading revenue was $75 million for the third quarter of 2004 compared to $101 million a year ago, a decline of 26%. The decline was attributable to lower currency volatility, lower cross-border investment activities of State Street's clients, and changes to the mix of business.
Brokerage fee revenue was $31 million in the third quarter, up 11% from $28 million in 2003 due to increased transition management for State Street's clients and higher equity trading volumes.
Processing fees and other revenue, which includes certain fees from Deutsche Bank related to the GSS business, profits and losses from joint ventures and other items, was $83 million in the quarter compared to $92 million a year ago.
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Net Interest Revenue
Net interest revenue for the third quarter of 2004 was $213 million, up $10 million or 5% from the third quarter of 2003. On an operating, tax-equivalent basis, net interest revenue was $223 million, up $7 million, or 3%, from $216 million in the third quarter of 2003. An increase in the average balance sheet for the third quarter of 2004 offset the decrease in the interest rate spread that resulted from the rapid succession of increases in the target federal funds rate by the FOMC.
Net interest margin for the three months ended September 30, 2004 was 1.05%, a decrease of twelve basis points from the third quarter of 2003. Rates earned in excess of rates paid decreased by eight basis points year-over-year.
Gains on the Sales of Available-for-Sale Securities
State Street realized no net gain or loss on sales of available-for-sale securities in the third quarter of 2004, compared with a net loss of $5 million in the third quarter of the prior year.
Operating Expenses
Operating expenses for the third quarter of 2004 were $906 million, up from $821 million a year ago. Operating expenses for the third quarter of 2004 included $16 million of merger and integration expenses. Operating expenses for the third quarter of 2003 included merger and integration costs of $26 million, as well as a restructuring charge of $3 million related to a voluntary employee separation program and $11 million of expenses from the divested PAM business. Excluding merger and integration costs in both years and in 2003, restructuring costs and PAM, operating-basis operating expenses were $890 million, up $109 million, or 14%, from $781 million, largely driven by higher salaries and employee benefits, transaction processing services and other expenses.
Salaries and employee benefits expense was $474 million in the third quarter of 2004, compared with $407 million in 2003 on a reported basis, or $402 million, excluding expenses from the divested PAM business. The increase in salaries and employee benefits expense is primarily attributable to higher incentive compensation expense due to the Corporation's improved year-to-date earnings performance in 2004 of 20% in operating earnings per share. Also contributing to the increase were higher costs of benefits, merit increases and stock option expensing.
Information systems and communications expense for the third quarter of 2004 was $127 million, down $13 million from a year ago on both a reported and operating basis.
Transaction processing services expense increased $15 million on a reported basis, up $16 million on an operating basis, to $95 million, principally to support the increased volume in the investor services business.
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Occupancy expense for the third quarter of 2004 was $88 million, up $4 million on a reported basis, or $5 million on an operating basis, from the third quarter of 2003, largely related to the space at State Street Financial Center, located in Boston, Massachusetts, which was not as fully occupied in the third quarter of 2003.
Merger and integration costs totaled $16 million for the quarter, down from $26 million a year earlier. These expenses consisted primarily of professional fees and systems integration costs incurred related to the GSS acquisition.
During the second quarter of 2003, State Street implemented an expense reduction program to decrease operating expenses. The expense reductions were achieved through a decrease in direct controllable expenses and by a voluntary separation and enhanced severance program ("VSP"), primarily in the United States. At June 30, 2003, approximately 3,000 individuals accepted the VSP. Subsequent to the VSP, approximately 1,000 positions were replaced. State Street incurred $3 million of restructuring costs for the three months ended September 30, 2003, as a result of the program. No amounts were incurred in the three months ended September 30, 2004.
Other operating expenses in the third quarter of 2004 were $106 million, compared with $81 million a year earlier on a reported basis and $77 million a year earlier on an operating basis. The increase is primarily due to professional service costs related to growth initiatives and compliance requirements, such as Sarbanes-Oxley readiness and Basel II.
Income Taxes
State Street recorded tax expense of $91 million for the third quarter of 2004, compared to expense of $103 million in the third quarter of 2003.
The effective rate for the third quarter of 2004 and 2003 was 34.0%. The expected tax rate for the full-year 2004 is 33.0%, including the impact of adjustments to state income taxes on leveraged lease transactions recorded in the first quarter of 2004. This rate compares with an effective full year tax rate of 35.1% in 2003, which included the settlement of a REIT-related tax matter.
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Results for the Nine Months Ended September 30, 2004 and 2003
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State Street reported net income for the first nine months of 2004 of $1.80 per share, reflecting net income of $614 million and total revenue of $3.68 billion. In the first nine months of 2003, State Street earned $.82 per share, reflecting net income of $275 million and total revenue of $3.23 billion. Total expenses in the first nine months of 2004 of $2.77 billion are down $27 million compared to the year-ago period.
Results for the first nine months of 2004 included pre-tax merger and integration costs of $50 million, or $.10 per share due to the continuing integration of the GSS business, acquired in January of 2003. On an operating basis, State Street earned $1.90 per share, reflecting net income of $647 million on taxable equivalent revenue of $3.71 billion.
Results for the first nine months of 2003 included a pre-tax loss on the sale of certain real estate of $13 million, or $.02 per share, merger and integration costs of $81 million, or $.16 per share related to the GSS acquisition, restructuring costs of $295 million, or $.58 per share, and an after-tax charge of $12 million, or $0.04 per share related settlement of a tax matter with the Commonwealth of Massachusetts. Combined, these items decreased earnings per share by $.80. The first nine months of 2003 included the operating results of the divested PAM business which contributed $.04 per share. On an operating basis, net income for the first nine months of 2003 was $1.58 per share, reflecting net income of $529 million on taxable-equivalent revenue of $3.22 billion.
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On an operating basis, earnings per share for the first nine months of 2004 were $1.90, up 20% compared to operating earnings per share of $1.58 for the first nine months of 2003. Favorable market conditions in the first half of the year more than offset the decline in the year-over-year performance of the third quarter. Operating revenue of $3.71 billion in the first nine months of 2004 was up 15% from the first nine months of 2003, primarily due to increases in servicing and management fees and foreign exchange trading revenue. Operating expenses of $2.72 billion in the first nine months of 2004 were up $333 million, or 14%, from the first nine months of 2003. Return on stockholders' equity on an operating basis was 14.5% for the first nine months of 2004.
In the first nine months of 2004, total reported revenue was $3.68 billion, up $452 million, compared to $3.23 billion a year ago. Reported revenue for 2003 included $56 million of revenue attributable to the PAM business. On an operating basis, total taxable-equivalent revenue was $3.71 billion compared to $3.22 billion in 2003, an increase of $489 million, reflecting an increase of $463 million in fee revenue and $36 million of net interest revenue, offset somewhat by a $10 million decline in gains on sales of available-for-sale securities. Total revenue for 2004 included nine months of GSS results compared with only eight months in 2003. The GSS business was acquired on January 31, 2003.
Servicing fees for the first nine months of 2004 were $1.69 billion, up $268 million, or 19%, from servicing fees of $1.43 billion a year earlier. The increase was attributable to the full nine months of servicing fee revenue generated by the GSS business, higher equity market valuations and new business from existing and new clients in 2004.
Management fees from investment management services were $456 million, compared to $396 million a year ago. Fees from the PAM business added $55 million to 2003 management fees. On an operating basis, management fees were up $115 million, or 34%, from $341 million in 2003, reflecting continued new business success and an increase in average month-end equity valuations.
Securities lending revenue was $201 million in the first nine months of 2004, compared to $192 million in the first nine months of the previous year, an increase of 5%. Securities lending revenue in 2004 reflected a full nine months of fees from GSS and a 33% increase in the volume of securities lent, largely offset by a decrease in interest rate spreads in the third quarter of 2004 that were attributable to the rapid succession of increases in the target interest rate by the Federal Reserve.
Foreign exchange trading revenue was $309 million for the first nine months of 2004, up 12% from $276 million a year ago. The increase was attributable to significantly higher currency volatility, and higher volumes reflecting increased cross-border investment activities of State Street's clients in the first and second quarter of 2004. For the first six months of 2004, foreign exchange trading revenue was up 34%, but during the third quarter of 2004, market conditions, including lower volatility and lower volumes, caused foreign exchange trading revenue to decline 26% from the year earlier quarter.
Brokerage fee revenue was $112 million in the first nine months, up 32% from $85 million in 2003 due to an increase in transition management for State Street's clients and growth in electronic trade execution and equity trading volumes.
Processing fees and other revenue, which includes certain fees from Deutsche Bank related to the GSS business, profits and losses from joint ventures and other items, was $248 million in the first nine months of 2004 compared to $225 million a year ago, or $237 million on an operating basis, excluding the loss on the sale of certain real estate and revenue from the PAM business. The increase was primarily driven by improved performance by the Corporation's joint ventures.
Net interest revenue for the first nine months of 2004 was $642 million, up $42 million, or 7% from $600 million to the first nine months of 2003. On an operating, tax-equivalent basis, net interest revenue was $675 million, up $36 million, or 6%, from $639 million in the first nine months of 2003. The increase in
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net interest revenue reflected an increase in the average balance sheet for the period and higher interest-rate spreads for the first six months of 2004. Somewhat offsetting these increases, net interest revenue for 2004 was reduced by a cumulative charge of $19 million recorded in the first quarter of 2004 that resulted from a change in effective state tax-rate assumptions used for recognition of income from leveraged lease transactions. Net interest revenue was impacted by lower interest rate spreads in the third quarter of 2004 from the rapid succession of increases in the target interest rate by the Federal Reserve.
State Street realized securities gains of $19 million in the first nine months of 2004, compared with gains of $29 million in the first nine months of the prior year.
Operating expenses for the first nine months of 2004 were $2.77 billion, down $27 million from a year ago, and included $50 million of merger and integration costs. Operating expenses for the first nine months of 2003 were $2.79 billion, and included restructuring charges of $295 million, merger and integration costs of $81 million and expenses related to the divested PAM business of $34 million. Excluding merger and integration costs from both years, and in 2003, excluding restructuring costs and expenses related to PAM, operating-basis operating expenses in 2004 were $2.72 billion, up $333 million, or 14%, from 2003. The increase is due, in large part, higher incentive compensation costs, transaction processing expenses and professional fees.
Salaries and employee benefits expense was $1.45 billion in the first nine months of 2004, compared with $1.29 billion in 2003 on a reported basis, or $1.28 billion excluding $18 million related to PAM. The increase in salaries and employee benefits expense is primarily attributable to higher incentive compensation expense due to the Corporation's improved earnings performance in 2004.
Information systems and communications expense for the first nine months of 2004 was $396 million, down $14 million from a year ago on a reported basis and down $13 million from a year ago on an operating basis.
Transaction processing services expense increased $63 million to $294 million due to substantially higher global clearance fees expense related to higher volumes of transactions.
Occupancy expense for the first nine months of 2004 was $262 million, up $31 million on a reported basis, or $35 million on an operating basis from the first nine months of 2003. The increase in occupancy expense is primarily attributable to additional space at State Street Financial Center, located in Boston, Massachusetts, and new office space in Luxembourg.
Merger and integration costs totaled $50 million for the quarter, down from $81 million a year earlier. These expenses consisted primarily of professional fees and systems integration costs incurred related to the GSS acquisition.
Other operating expenses in the first nine months of 2004 were $319 million, compared with $252 million a year earlier on a reported basis and $242 million a year earlier on an operating basis. State Street recorded a provision for securities processing losses of $31 million in the first nine months of 2004. This compared to $5 million in the first nine months of 2003. Increases in the costs of professional services and a full nine months of GSS-related expenses also contributed to the increase. During the first nine months of 2004, State Street reclassified $25 million of reserves for off-balance sheet commitments from the allowance for loan losses to other liabilities. Subsequent to the reclassification, State Street reduced its reserve for off-balance sheet commitments, reducing other expenses by $10 million.
State Street recorded tax expense of $299 million for the first nine months of 2004, compared to $159 million in the first nine months of 2003. Tax expense for the first nine months of 2004 included a
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cumulative benefit of $18 million resulting from a change in the effective state tax rate applied to leveraged leasing transactions. The reduction in effective state tax rate reflects the relative increase in non-U.S. activity resulting from State Street's recent acquisitions and divestitures. Tax expense for the first nine months of 2003 included a one-time $12 million after tax charge for a REIT-related state tax matter.
The effective rate for the first nine months of 2004 was 32.8%, including the impact of the leveraged lease adjustment. The expected tax rate for the full year 2004 is 33.0%, compared with an effective tax rate of 35.1% in 2003, which included the settlement of the state tax matter.
GSS Acquisition Update
Excluding merger and integration costs, State Street's first nine months of 2004 included $.08 per share of net income attributable to the GSS business compared with a loss of $.01 per share a year earlier. Based on current estimates, State Street now believes that the total GSS business will contribute between $0.08 to $0.10 in operating earning per diluted share for 2004. The GSS business contributed $465 million to revenue in the first nine months of 2004, net of financing costs, compared with $405 million in the prior year, and added $383 million of expenses in 2004, compared with $374 million in the first nine months of 2003. This comparison reflects eight months of recorded operating activity in 2003 for the GSS business acquired on January 31, 2003, compared with nine full months in 2004.
Merger and integration costs related to client conversions were $50 million for the first nine months of 2004. State Street estimates merger and integration costs of approximately $50 to $60 million for the full year 2004. The Corporation expects to substantially complete worldwide client conversions by the end of 2004, with the exception of Germany, which is expected to be completed by the end of 2005.
Acquisitions and Divestitures
In October 2004, State Street announced its intent to divest its ownership interest in Bel Air Investment Advisors LLC. This divestiture will likely occur in the first half of 2005, resulting in a pretax charge of approximately $150 to $170 million.
Lines of Business
Investment Servicing provides services for U.S. mutual funds, collective funds worldwide, corporate and public retirement plans, insurance companies, foundations, endowments, and other investment pools. Products include custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; recordkeeping; foreign exchange and trading services; securities lending; deposit and short-term investment facilities; loans and lease financing; investment operations outsourcing;
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wealth manager and hedge fund manager services; and performance, risk and compliance analytics to support institutional investors. State Street has a 50% interest in Boston Financial Data Services, Inc. and the International Financial Data Services group of companies, which provide shareholder services, including mutual fund and collective fund shareholder accounting. Revenue from Investment Servicing comprised 85% of State Street's total revenue for the nine months ended September 30, 2004.
Investment Servicing
Total revenue for the three months ended September 30, 2004, increased $28 million to $986 million, up 3% from the comparable period in 2003, driven by growth in fee revenue.
Growth in fee revenue of $16 million for the third quarter of 2004 to $784 million was primarily attributable to servicing fees, largely offset by declines in securities lending and foreign exchange trading
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revenue. Servicing fees, securities lending, foreign exchange trading and brokerage fee revenue for this line of business are virtually identical to the consolidated results of the Corporation. See the fee revenue section of the consolidated results for the three months ended September 30, 2004 and 2003 for further details.
Net interest revenue after provision for loan losses for the third quarter of 2004 was $202 million, up $7 million from the third quarter of 2003. A decline in interest rate spreads largely offset the increase in net interest revenue attributable to increased average balance sheet volumes.
Operating expenses for the third quarter of 2004 were $754 million, up $88 million from the prior year. The majority of the increase was attributable to higher incentive compensation costs related to the Corporation's year-to-date improvement in earnings, growth in transaction processing costs and higher professional services costs related to growth initiatives and regulatory compliance requirements.
Investment Management
Total revenue for the third quarter of 2004 was $188 million, up $39 million, from $149 million reported in the third quarter of 2003, primarily attributable to growth in management fees.
Management fees from investment management services, delivered through State Street Global Advisors, were $156 million in the third quarter of 2004 compared to $122 million a year ago, and are identical to the consolidated results of the Corporation. See the fee revenue section of the consolidated results for the three months ended September 30, 2004 and 2003 for further details.
Operating expenses for the three months ended September 30, 2004, were $136 million, up from $115 million a year ago, primarily attributable to higher incentive compensation costs.
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Total revenue for the nine months ended September 30, 2004, increased $350 million to $3.11 billion, up 13% from the comparable period in 2003, driven by growth in servicing fees, foreign exchange trading revenue and brokerage fee revenue and net interest revenue. Growth in revenue for this line of business reflects a full nine months of GSS business in 2004, compared with eight months in 2003 for the business acquired January 31, 2003.
Growth in fee revenue of $320 million for the first nine months of 2004 to $2.48 billion was primarily attributable to servicing fees, foreign exchange trading and brokerage fee revenue. Servicing fees, securities lending, foreign exchange trading and brokerage fee revenue for this line of business are virtually identical to the consolidated results of the Corporation. See the fee revenue section of the consolidated results for the nine months ended September 30, 2004 and 2003 for further details.
Net interest revenue after provision for loan losses for the first nine months of 2004 was $612 million, up $40 million from the first nine months of 2003. Net interest revenue for the first nine months of 2004 was reduced due to lower interest rate spreads as a result of rapid rate increases in third quarter and a cumulative charge of $19 million resulting from a change in assumptions used for recognition of income from leveraged lease transactions due to a change in the effective state tax rate. However, these factors were more than offset by increased earnings resulting from an increase in the average balance sheet in 2004 and a steeper U.S.-dollar yield curve in the first two quarters of 2004.
Operating expenses for the first nine months of 2004 were $2.29 billion, up $262 million from the prior year. The majority of the increase was attributable to higher incentive compensation, transaction processing and professional services costs.
Total revenue for the first nine months of 2004 was $566 million, up $145 million, from $421 million reported in the first nine months of 2003, driven by growth in management fees.
Management fees from investment management services, delivered through State Street Global Advisors, were $456 million in the first nine months of 2004 compared to $341 million a year ago, and are identical to the consolidated results of the Corporation. See the fee revenue section of the consolidated results for the nine months ended September 30, 2004 and 2003 for further details.
Operating expenses for the nine months ended September 30, 2004, were $423 million, up from $352 million a year ago, largely driven by higher incentive compensation expense.
Financial Goals and the Factors That May Affect Them
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State Street considers these to be financial goals, not projections or forward-looking statements. However, the discussion in this Management's Discussion and Analysis of Financial Condition and Results of Operation, and in other portions of this report on Form 10-Q, may 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. The following issues and factors should be carefully considered. The forward-looking statements contained in this report speak only as of the time the statements were given. The Corporation does not undertake to revise those forward-looking statements to reflect events after the date of this report.
Cross-border Investing. Increased cross-border investing by clients worldwide benefits State Street's revenue. Future revenue may increase or decrease depending upon the extent of increases or decreases in cross-border investments made by clients. Economic and political uncertainties resulting from terrorist attacks, subsequent military actions or other events could result in decreased cross-border investment activities.
Savings Rates of Individuals. State Street generally benefits when individuals invest their savings in mutual funds and other collective funds or in defined contribution plans. Changes in savings rates or investment styles may affect revenue. If there is a decline in the savings rates of individuals, or if there is a change in investment preferences that leads to fewer investments in mutual funds, other collective funds, and defined contribution plans, State Street's revenue may be adversely affected.
Asset Values in Worldwide Financial Markets. As asset values in worldwide financial markets increase or decrease, State Street's opportunities to invest and service financial assets may change. Since a portion of the Corporation's fees is based on the value of assets under custody and management, fluctuations in the valuation of worldwide securities markets will affect revenue. State Street estimates that a 10% increase or decrease in worldwide equity values would result in a corresponding change in State Street's total revenue of approximately 2%. If fixed income security values worldwide were to increase or decrease by 10%, State Street would anticipate a corresponding change of approximately 1% in its total revenue.
As asset values increase or decrease due to external credit factors, State Street has exposure related to its own investing activities. The impact of such exposure would be reflected in the Corporation's statement of income, statement of condition and statement of changes in stockholders' equity.
Dynamics of Markets Served. Changes in markets served, including the growth rate of collective funds worldwide, outsourcing decisions, mergers, acquisitions and consolidations among clients and competitors and the pace of debt and equity issuance, can affect revenue. In general, State Street benefits from increases 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, pace of inflation, changes in monetary policy, changes in domestic and international banking supervisory regulations including capital requirements, and social and political instability—could affect results of operations. The terrorist attacks that took place in the United States on September 11, 2001, and subsequent military action and terrorist activities, have caused economic and political uncertainties. These activities and the national and global efforts to combat terrorism, and other military activities and outbreaks of hostilities have affected and may further adversely affect economic growth, and may have other adverse effects on many companies, including State Street, in ways that are not predictable. Financial reporting irregularities involving large and well-known companies and regulatory investigations of securities and mutual fund industry practices and behavior may have adverse effects on State Street in ways that are not predictable. State Street is broadly involved with the securities industry including, in particular,
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the mutual fund industry, and governmental agencies have sought information from it in connection with investigations relating to that industry.
Legislation may cause changes in the competitive environment in which State Street operates, which could include, among other things, broadening the scope of activities of significant competitors, or facilitating consolidation of competitors into stronger entities, or attracting new large and well-capitalized competitors into State Street's traditional businesses. Such factors and changes, and the ability of the Corporation to address and adapt to the regulatory and competitive challenges, may affect future results of operations.
On June 26, 2004, the Basel Committee on Banking Supervision released the final version of its capital adequacy framework ("Basel II"). Basel II's framework includes minimum capital requirements, including a capital charge for operational risk. U.S. banking regulatory agencies must now apply international risk-based capital guidance to rules to be implemented in the U.S. The U.S. regulatory agencies are expected to release proposed new rules for comment by mid-2005, with the final version anticipated by mid-2006. The new rules as applied in the U.S. are expected to become effective by January 1, 2007, subject to transitional implementation arrangements, and will become fully operational by January 1, 2008. Mandatory compliance will be required for large, internationally-active U.S. institutions, such as State Street. In preparation for compliance, the Corporation has developed a comprehensive implementation program to monitor the status and progress of Basel II, and is in the process of implementing the requirements and assessing the potential impact of Basel II on the Corporation. At this time, the Corporation cannot predict the final form of the rules in the U.S., nor their impact on the Corporation's risk-based capital.
Accounting Principles. Changes in accounting principles generally accepted in the United States applicable to State Street could have a material impact on the Corporation's reported results of operations. While such changes may not have an economic impact on the business of State Street, these changes could affect the attainment of the current measures of the Corporation's financial goals.
Tax Legislation. Changes in tax legislation or the interpretation of existing tax laws worldwide could have a material impact on the Corporation's reported results of operations.
Interest Rates. The levels of market interest rates, the shape of the yield curve and the direction and speed of interest rate changes relative to the geographic mix of interest-bearing assets and liabilities affect net interest revenue and securities lending revenue. In the short term, State Street's net interest revenue and securities lending revenue benefit from falling interest rates and are negatively affected by rising interest rates because interest-bearing liabilities reprice sooner than interest-earning assets. The rate of adjustment to higher or lower rates will depend on the relative duration of assets and liabilities. In general, sustained lower interest rates and a flat yield curve have a constraining effect on net interest revenue and securities lending revenue growth. Market interest rates also impact the value of certain derivative products whose change in value is reflected in processing fees and other in the Consolidated Statement of Income.
Liquidity. Any occurrence that may limit the Corporation's access to the funds markets, such as a decline in the confidence of debt purchasers, depositors or counterparties participating in the funds markets in general or with State Street in particular, or a downgrade of State Street's debt rating, may adversely affect State Street's ability to raise capital and, in turn, its liquidity.
Capital. Under regulatory capital adequacy guidelines, State Street and State Street Bank must meet guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items. Failure to meet minimum capital requirements could have a direct material effect on State Street's financial condition; failure to maintain the status of "well capitalized" under the regulatory framework could affect State Street's status as a financial holding company and eligibility for a streamlined review process for acquisition proposals.
In addition, failure to maintain the status of "well capitalized" could affect the confidence of State Street's clients in the Corporation and could adversely affect its business. In addition to being well-capitalized,
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State Street and State Street Bank are subject to guidelines that involve qualitative judgments by regulators about the entities' status as well-managed and the entities' compliance with Community Reinvestment Act obligations.
Federal laws and related regulations limit the amount that banks, including State Street Bank, may invest in international subsidiaries. This limitation may affect the pace of future international expansion by State Street Bank through this type of subsidiary.
Volatility of Currency Markets. The degree of volatility in foreign exchange rates can affect foreign exchange trading revenue. In general, State Street benefits from currency volatility. Accordingly, foreign exchange revenue is likely to decrease during times of decreased currency volatility. In addition, as State Street's business grows globally, State Street's exposure to changes in foreign currency exchange rates could impact State Street's level of revenue and expense and net income and the value of State Street's investments in its non-U.S. operations.
Pace of Pension Reform. State Street expects its business 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 and resulting programs, including public and private pension schemes, may affect the pace of revenue growth. If the pace of pension reform and resulting programs, including public and private pension schemes, slows down or if pension reform does not occur, revenue growth may be adversely affected.
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, customer pricing reviews and the introduction of new products into the marketplace.
Pace of New Business; Business Mix. A decline in the pace at which State Street attracts new clients, and the pace at which existing and new clients use additional services and assign additional assets to State Street for management or custody, may adversely affect future revenue and earnings growth. A decline in the rate at which clients outsource functions, such as their internal accounting activities, could also adversely affect revenue and earnings growth. In addition, changes in business mix and in the source of revenue, including the mix of U.S. and non-U.S. business, may affect future results of operations, depending on the economic and competitive conditions of those geographic areas at the time.
Business Continuity. State Street has business continuity and disaster recovery plans in place. However, external events, including terrorist or military actions and resulting political and social turmoil, could arise that would cause unforeseen damage to State Street's physical facilities or could cause delays or disruptions to operational functions, including information processing and financial market settlement functions. Additionally, State Street's clients, vendors and counterparties could suffer from such events. Should these events affect State Street, or the clients, vendors or counterparties with which it conducts business, State Street's results of operations could be adversely affected.
Rate of Technological Change. Technological change often creates opportunities for product differentiation and reduced costs, as well as the possibility of increased expenses. Developments in the securities processing industry, including shortened settlement cycles and straight-through-processing, will result in changes to existing procedures. Alternative delivery systems have emerged, including the widespread use of the Internet. 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.
The risks inherent in this process include rapid technological change in the industry, the Corporation's ability to access technical and other information from clients, and the significant and ongoing investments required to bring new services to market in a timely fashion at competitive prices. A further risk is the introduction by competitors of services that could replace or provide lower-cost alternatives to State Street services.
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State Street uses 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. Despite these efforts, State Street cannot be certain that the steps taken by it to prevent unauthorized use of proprietary rights are sufficient to prevent misappropriation of technology, particularly outside the United States where laws or law enforcement practices may not protect proprietary rights as fully as in the United States. In addition, no assurance can be given that the courts will adequately enforce contractual agreements that State Street has entered into to protect its proprietary technology. If any of its proprietary information were misappropriated by or otherwise disclosed to its competitors, State Street's competitive position could be adversely affected. 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.
Acquisitions, Alliances and Divestitures. Acquisitions of complementary businesses and technologies and development of strategic alliances and divestitures of portions of its business are an active part of State Street's overall business strategy. The Corporation has completed several acquisitions, alliances and divestitures in recent years. However, there can be no assurance that services, technologies, key personnel or businesses of acquired companies will be effectively assimilated into State Street's business or service offerings or that alliances will be successful. In addition, State Street may not be able to successfully complete any divestiture on satisfactory terms, if at all, and divestitures may result in a reduction of total revenue and net income.
FINANCIAL CONDITION
Credit Quality
At September 30, 2004, total gross loans were $5.55 billion. At quarter end, the allowance for loan losses was $36 million, down from $61 million a year ago due to a first quarter reclassification of reserves for off-balance sheet commitments from the allowance for loan losses to other liabilities. During the first quarter, subsequent to the reclassification, the reserve for off-balance sheet commitments was reduced by $10 million based on management's assessment of risk in these exposures. For the nine months ended September 30, 2004, no provision for loan losses was charged against income; there were no charge-offs and no recoveries. Non-performing assets at September 30, 2004, were $7 million, all of which were non-performing investment securities.
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, including accommodating the transaction and cash management requirements of its clients. Liquidity is provided by State Street's access to global debt markets, its ability to gather additional deposits from its clients, maturing short-term assets, sales of securities, and repayment of clients' loans. Client deposits and other funds provide multi-currency, geographically diverse sources of liquidity. During the third quarter of 2004, State Street increased its maximum commercial paper issuance from $1.00 billion to $3.00 billion.
State Street maintains a large portfolio of liquid assets. As of September 30, 2004, the Corporation's defined liquid assets were $87.02 billion or 87% of total assets, the vast majority of which can be sold on the open market to meet liquidity needs. At September 30, 2004, State Street had defined short-term liabilities of $86.01 billion, which included deposits and borrowings with maturities of less than a year. State Street had $21 million in pre-tax net unrealized losses on available-for-sale investment securities at September 30, 2004, which the Corporation does not consider to be other than temporary.
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 supporting clients' cash management needs.
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As a state-chartered bank and member of the Federal Reserve System, State Street Bank, State Street's principal subsidiary, is primarily 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 levels required for the "well-capitalized" category, the highest of the Federal Reserve Board's five capital categories. State Street Bank must meet the regulatory designation of "well capitalized" in order for State Street to maintain its status as a financial holding company. State Street's capital management emphasizes risk exposure rather than asset levels.
At September 30, 2004, the Corporation's Tier 1 risk-based capital ratio was 13.3% and State Street Bank's Tier 1 risk-based capital ratio was 11.5%. These ratios are down from 14.0% for the Corporation and 12.4% for State Street Bank at year-end 2003, primarily due to a change in balance sheet mix. At September 30, 2004, both ratios significantly exceeded the regulatory minimum of 4% and the well-capitalized threshold of 6%. State Street and State Street Bank had Tier 1 leverage ratios of 5.6% and 5.3%, respectively, at September 30, 2004, exceeding the regulatory minimum of 3% and the well-capitalized threshold of 5%. See Note 7 to the Notes to 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. As of September 30, 2004, 8.3 million shares may be purchased under the stock purchase program. In October 2004, State Street announced it was re-activating its stock purchase program, which had been relatively inactive since the January 2003 acquisition of a substantial part of the Deutsche Bank GSS business. State Street employs a third-party broker-dealer to acquire shares on the open market for the Corporation's stock purchase program.
During the third quarter of 2004, State Street entered into forward foreign currency swaps with a basis of €300 million, or approximately $373 million, to hedge the Corporation's net foreign investment in certain non-U.S. subsidiaries and manage the volatility in stockholders' equity that results from translation gains and losses. As a result, less than $1 million of translation gains for certain non-U.S. subsidiaries were offset by a loss on the hedge contract within the category foreign currency translation, recorded as a component of accumulated other comprehensive income in stockholders' equity.
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 foreign-exchange forward contracts, foreign exchange and interest rate options, and interest rate swaps. As of September 30, 2004, the notional amount of these derivative instruments was $381.93 billion, of which $331.74 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.
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The following table presents State Street's market risk for its trading activities as measured by its value at risk methodology:
State Street compares actual daily profits and losses from trading activities to estimated one-day value at risk. During the first nine months of 2004, State Street did not experience any trading losses in excess of its end-of-day value at risk estimate.
CRITICAL ACCOUNTING ESTIMATES
The Securities and Exchange Commission ("SEC") issued disclosure guidance for "critical accounting estimates." The SEC defines "critical accounting estimates" as those that require application of management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.
State Street's significant accounting policies are described in detail in Note 1 in the Notes to the Consolidated Financial Statements as included in State Street's Annual Report on Form 10-K for the year ended December 31, 2003, and have been updated in Note 1 to the consolidated financial statements included in this Quarterly Report on Form 10-Q. State Street's critical accounting estimates are described in management's discussion and analysis of results of operations and financial condition as included in State Street's Annual Report on Form 10-K for the year ended December 31, 2003. There have not been any significant changes in the factors or methodology used by management in determining its critical accounting estimates since December 2003, that are material in relation to the Corporation's financial condition, changes in financial condition and results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See information under the caption "Trading Activities: Foreign Exchange and Interest Rate Sensitivity" on pages 45-46.
State Street's Risk Management function was described in detail in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
The Corporation has established and maintains disclosure controls and other procedures that are designed to ensure that material information relating to the Corporation and its subsidiaries required to be disclosed by the Corporation in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to the Corporation's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. For the period covered in this report, the Corporation carried out an evaluation, under the supervision and with the participation of the Corporation's management, including the Corporation's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Corporation's disclosure controls and
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procedures. Based on that evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures were effective as of September 30, 2004.
In the ordinary course of business, the Corporation routinely enhances its internal controls and procedures for financial reporting by either upgrading its current systems or implementing new systems. In addition, the Corporation is currently in the process of reviewing and formalizing its internal controls and procedures for financial reporting in accordance with SEC rules implementing the internal control reporting requirements included in Section 404 of the Sarbanes-Oxley Act of 2002. Changes have been made and will be made to the Corporation's internal controls and procedures for financial reporting as a result of these efforts. However, the Chief Executive Officer and Chief Financial Officer have concluded that there were no changes in the Corporation's internal control over financial reporting identified in connection with the evaluation described in the preceding paragraph that occurred during the quarter ended September 30, 2004, that have materially affected, or are reasonably likely to materially affect, the Corporation's internal control over financial reporting.
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PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The following disclosure supplements the disclosure in the Corporation's Current Report on Form 8-K filed March 9, 2004, and the Corporation's Quarterly Reports on Form 10-Q for the quarters ended March 31, 2004 and June 30, 2004:
The Corporation continues to respond to subpoenas from the SEC and to examinations, inquiries and requests for information from the SEC, the Department of Labor, and other regulatory and law enforcement agencies, relating to the securities industry, including in particular mutual fund-related matters.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(c) State Street's Board of Directors has authorized a publicly-announced stock purchase program for State Street Common Stock for use in employee benefit programs and for general corporate purposes. The program was first announced in 1995 and has been increased several times, most recently in December 2001. As of September 30, 2004, the number of shares purchased under the program aggregated 34,689,000, and authorization for the purchase of an additional 8,311,000 shares remained available for purchase under the program. State Street employs a third-party broker-dealer to acquire shares on the open market for the Corporation's stock purchase program. There were no shares purchased under the publicly-announced stock purchase program in the quarter ended September 30, 2004. Additionally, shares may be acquired in open market purchases by a third-party trustee for a consolidated trust for deferred compensation plans that are not part of the publicly-announced stock purchase program. There were no shares purchased by the trust in the quarter ended September 30, 2004. The following table discloses purchases of Common Stock by the Corporation and related information for the three months ended September 30, 2004:
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ITEM 6. EXHIBITS
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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.
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EXHIBIT INDEX
(filed herewith)
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