State Street Corporation - 10-Q quarterly report FY

STATE STREET CORPORATION

Table of Contents

PART I—FINANCIAL INFORMATION

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS 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 mutual funds and collective funds, corporate and public retirement plans, insurance companies, foundations, endowments, and other investment pools worldwide. Products include custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; recordkeeping; foreign exchange, brokerage and other trading services; securities lending; deposit and short-term investment facilities; loans and lease financing; investment and hedge fund manager operations outsourcing; 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. Financial information about these business lines is provided in the “Line of Business Information” section of this discussion and analysis.

In executing its strategic plan, from time to time State Street may enter into business acquisitions and strategic alliances, and may divest non-strategic operations. State Street continuously reviews and assesses various business opportunities related to this strategy. For information about the Corporation’s current acquisition and divestiture activities, see Note 2 to the Consolidated Financial Statements in this Form 10-Q.

This discussion and analysis updates State Street’s 2004 Annual Report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ended March 31, 2005, both of which were previously filed with the Securities and Exchange Commission (“SEC”), and should be read in conjunction with the financial information included in those reports. Certain prior period amounts presented in this discussion have been reclassified to conform to current period classifications. The preparation of financial statements requires management to make estimates and assumptions in the application of certain accounting policies that materially affect the reported amounts of assets, liabilities, revenue and expenses. Actual results could differ from those estimates. Information related to new accounting developments is included in Notes 1 and 12 to the Consolidated Financial Statements in this Form 10-Q.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

SUMMARY FINANCIAL INFORMATION

OVERVIEW

State Street Corporation’s second-quarter earnings per share were $.66, up 2% from $.65 in the second quarter of 2004. Revenue of $1.36 billion in the second quarter of 2005 increased 6%, or $74 million, compared to $1.29 billion in the second quarter of 2004. Total operating expenses for the second quarter of 2005 of $1.03 billion increased 8%, or $75 million, compared to $953 million in 2004. Net income of $220 million was flat from a year earlier. For the second quarter of 2005, return on shareholders’ equity was 14.4% compared to 14.9% in the second quarter of 2004.

For the six months ended June 30, 2005, earnings per share were $1.33, up 4% from $1.28 for the comparable period in 2004. Revenue of $2.67 billion in 2005 increased 7%, or $163 million, compared to $2.51 billion in 2004. Total operating expenses for year-to-date 2005 of $1.99 billion increased 7%, or $133 million, compared to $1.86 billion in 2004. Net income was $446 million for the first six months of 2005, up $9 million compared to $437 million a year earlier. For the six months ended June 30, 2005, return on shareholders’ equity was 14.7% compared to 14.9% in 2004.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

Results for the three and six months ended June 30, 2005 included $26 million of occupancy expense, or $.05 per share, related to a sub-lease agreement with an unrelated third party. Results for the second quarter of 2004 included $16 million of merger and integration costs, or $.03 per share, associated with the acquisition of a substantial portion of the Global Securities Services (“GSS”) business of Deutsche Bank AG (“Deutsche Bank”). For the first six months of 2004, these merger and integration costs were $34 million, or $.07 per share.

Results for the second quarter and first six months of 2005 compared to the 2004 periods reflected higher revenue, particularly servicing and investment management fees and securities lending revenue, partly offset by lower gains on sales of available-for-sale investment securities and higher operating expenses.

The impact of seasonality is expected to temper the Corporation’s rate of growth in market-driven revenue, particularly from securities lending, for the third quarter of 2005. See the section titled “Financial Goals and the Factors that May Affect Them” for a discussion of State Street’s financial goals.

In October 2004, State Street announced its intent to divest its ownership interest in Bel Air Investment Advisors LLC. This divestiture, expected to occur in 2005, will result in a pre-tax charge of approximately $150 million to $170 million.

RESULTS OF OPERATIONS

Total Revenue

For the second quarter of 2005, total revenue was $1.36 billion, an increase of $74 million compared to $1.29 billion a year earlier. For the six months ended June 30, 2005, total revenue was $2.67 billion, an increase of $163 million compared to $2.51 billion a year earlier. Fee revenue growth was strong across servicing and management fees due to new business from existing and new clients and higher average equity market valuations, and securities lending revenue increased due to higher spreads and a higher volume of securities lent. Net interest revenue in 2005 was down $9 million in the second quarter compared with a year earlier, and flat for the first six months of 2005 as a result of the challenging interest-rate environment.

Fee Revenue

Fee revenue for the second quarter of 2005 was $1.14 billion, an increase of $98 million from $1.05 billion in the second quarter of 2004. Servicing fees were up 8%, management fees were up 13%, and securities lending revenue was up 27% from a year earlier. For the six months ended June 30, 2005, fee revenue was $2.24 billion, reflecting 8% growth in servicing fees, 17% growth in management fees and 20% growth in securities lending revenue.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

Servicing fees are derived from custody, product- and participant-level accounting, daily pricing and administration; recordkeeping; investment manager and hedge fund manager services; master trust and master custody; and performance, risk and compliance analytics. Servicing fees for the second quarter of 2005 were $618 million, up 8% from $570 million in the second quarter of 2004. For the six months ended June 30, 2005, servicing fees were $1.22 billion, up from $1.13 billion a year earlier. The increases in 2005 were attributable to new business from existing and new clients, particularly in the United States, Europe, Asia and the United Kingdom, and higher average equity market valuations.

Total assets under custody were $9.62 trillion at June 30, 2005, up 1% from $9.50 trillion at December 31, 2004, and up 5% compared with $9.15 trillion at June 30, 2004. Compared with the prior year periods, daily average values for the S&P 500 Index were up 5% for the three- and six-month periods ended June 30, 2005; daily average values for the MSCI® EAFE Index were up 13% for the second quarter and first six months of 2005. 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.

Investment management fees, generated by State Street Global Advisors, were $173 million for the second quarter of 2005, up 13% from $153 million a year earlier, and for the six months ended June 30, 2005, grew 17% to $350 million. These increases reflected continued new business and an increase in average month-end equity valuations from a year earlier. Total assets under management were $1.37 trillion at June 30, 2005, up from $1.22 trillion a year earlier, reflecting new business and higher equity market valuations, although equity market valuations are down from December 31, 2004. The following table presents a summary of activity in assets under management for the twelve months ended June 30, 2005.

Securities lending revenue for the second quarter of 2005 was $113 million, up 27% compared to $89 million in the second quarter of 2004. Results for both quarters reflected seasonally high activity, which resulted, in large part, from heavy customer demand to borrow large volumes of European equities corresponding to their annual dividend payment dates. For the six months ended June 30, 2005, securities lending revenue was $183 million, up $30 million from a year earlier, due to higher spreads and an approximate 7% increase in the average volume of securities lent.

Trading services revenue, which includes foreign exchange trading and brokerage revenue and certain other fees, was $169 million for the second quarter of 2005, up 8% compared to $156 million from the same period in 2004. Foreign exchange trading revenue increased $2 million. Volatilities were down 24%, but were offset substantially by a 44% increase in volume. Brokerage and other fees increased $11 million from a year earlier, primarily due to increases in the transition management business.

Trading services revenue was $336 million for the first six months of 2005, up from $323 million a year earlier. Foreign exchange trading revenue was down $7 million to $227 million, reflecting a strong first

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

quarter in 2004. The decrease in volatilities exceeded the impact of increased volumes. Brokerage and other fees increased $20 million, to $109 million from $89 million a year earlier, primarily due to increases in the transition management business, including a significant number of mandates completed during the first quarter of 2005.

Processing fees and other revenue was $70 million in the second quarter of 2005 compared to $77 million a year earlier. For the six months ended June 30, 2005, processing fees and other revenue was $154 million, compared to $157 million for the same period a year earlier. The declines in both comparisons were largely attributable to lower fees from Deutsche Bank as deposits of GSS clients are converted to State Street’s systems.

Net Interest Revenue

Net interest revenue for the second quarter of 2005 was $217 million, down $9 million, or 4%, from the second quarter of 2004. For the six months ended June 30, 2005, net interest revenue was flat at $429 million compared to the 2004 period, which included the first-quarter impact of a $19 million reduction in interest revenue due to a change in the applicable state tax rate for leveraged lease transactions. Excluding this reduction from 2004 amounts, net interest revenue would have declined by $19 million during the first six months of 2005.

These declines were principally due to the rising interest-rate environment driven by eight federal funds rate increases over the preceding twelve months, offset partially by increases in the size of the Corporation’s balance sheet, including the conversion of GSS deposits to State Street’s balance sheet, and the size of and changes in the composition of the investment securities portfolio. At June 30, 2005, State Street’s investment securities portfolio included a higher percentage of collateralized mortgage obligations and floating rate, asset-backed securities when compared to a year earlier, and a lower percentage of U.S. Treasuries and direct obligations of federal agencies. The shift in the portfolio was designed to better position the Corporation in a rising interest rate environment without significantly increasing overall risk by continuing to invest conservatively in predominantly triple-A-rated securities.

(1)                 Rates were calculated on a taxable-equivalent basis where the tax savings generated by tax-exempt investments was recorded as net interest revenue, with a corresponding charge to income tax expense. Tax savings were computed using a federal income tax rate of 35%, adjusted for applicable state income taxes, net of the related federal tax benefit.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

Gain on Sales of Available-for-Sale Securities

State Street realized a net gain of $1 million on sales of available-for-sale securities in the second quarter of 2005, compared with a net gain of $16 million in the second quarter of the prior year. No net gain was recorded for the six months ended June 30, 2005, down from a net gain of $19 million for the same period a year earlier.

Operating Expenses

Total operating expenses increased from $953 million in the second quarter of 2004 to $1.03 billion in 2005, up $75 million, or 8%. For the first six months of 2005, total operating expenses of $1.99 billion were up $133 million, or 7%, from $1.86 billion a year earlier. Both comparisons reflected $26 million of occupancy expense related to a long-term sub-lease of a portion of the Corporation’s headquarters recorded in the second quarter of 2005. Operating expenses for the second quarter and first six months of 2004 included $16 million and $34 million, respectively, of merger and integration costs related to the acquisition of the GSS business of Deutsche Bank. Increases in salaries and employee benefits, occupancy and other expenses were somewhat offset by declines in merger and integration costs and information systems and communications expense.

Salaries and employee benefits expense was up 8% to $552 million for the second quarter of 2005 compared to the same period in 2004, and increased 11%, to $1.08 billion, for the six months ended June 30, 2005, compared with the same period a year earlier. These increases were primarily due to the higher cost of benefits and the impact of merit adjustments.

Information systems and communications expense for the second quarter of 2005 declined $9 million, or 7%, to $121 million from the second quarter of 2004, and declined $22 million, or 8%, for the first six months of 2005 compared to a year earlier, due to reductions related to the integration of the GSS business to State Street systems, partially offset by increases related to the new data center coming fully on line in the fourth quarter of 2004.

Transaction processing expense increased $9 million, or 9%, to $112 million for the second quarter of 2005 compared to a year earlier, and increased $21 million for the first six months of 2005 compared to a year earlier, due to higher volumes in the brokerage business, especially associated with growth in the non-U.S. business.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

For the second quarter of 2005, occupancy expense increased $30 million to $114 million from a year earlier and increased $32 million for the first six months of 2005 compared to a year earlier. Consistent with measures being taken to reduce future occupancy costs, State Street recognized a pre-tax charge of $26 million in the second quarter of 2005 related to a long-term sub-lease agreement with an unrelated third party for approximately 150,000 square feet in its headquarters building. State Street expects that this transaction will reduce average annual occupancy costs going forward by $7 million to $8 million beginning in 2006. As the Corporation completes the realignment of its real estate portfolio, additional sub-leasing agreements may be entered into to eliminate excess space.

Other expenses for the second quarter of 2005 rose 17%, or $19 million, to $129 million, and were up $32 million, or 15% for the year-to-date period, primarily due to professional services fees related to the expansion of the Corporation’s Treasury group infrastructure, as well as increased costs for compliance, regulatory reform and other professional services.

Income Taxes

State Street recorded income tax expense of $113 million for the second quarter of 2005, down slightly from $114 million in the second quarter of 2004, and recorded income tax expense of $229 million for the first six months of 2005, compared to $208 million in 2004. Tax expense for the first six months of 2004 included a cumulative tax benefit of $18 million resulting from a change in the effective state tax rate applied to leveraged leasing transactions.

The effective tax rate for both the second quarter and first six months of 2005 was 34.0%, compared to 34.0% and 32.3% for the three and six months ended June 30, 2004. The expected tax rate for full-year 2005 is 34.0%, compared with an effective tax rate of 33.1% for full-year 2004, which reflected the previously mentioned $18 million tax benefit from leveraged leases. Excluding the tax benefit from leases, the effective rate for full-year 2004 would have been 34.0%.

During the third quarter of 2005, the Financial Accounting Standards Board (“FASB”) issued a proposed FASB Staff Position (“FSP”) for comment addressing accounting for changes in the expected timing of tax-related cash flows of leveraged leases. The guidance in the proposed FSP, if finalized, will require companies to record the adoption of the FSP as a cumulative effect of a change in accounting principle as of December 31, 2005. If issued in its present form, the guidance may require a material cumulative charge to State Street’s income in the fourth quarter of 2005. However, future income would be expected to increase over the remaining terms of the leases by an amount approximately equal to the charge, exclusive of any tax-related interest and penalties that may be included in the charge. For additional information about this matter and other proposed new accounting guidance, refer to Note 12 to the Consolidated Financial Statements in this Form 10-Q.

Line of Business Information

State Street reports two lines of business: Investment Servicing and Investment Management. Given State Street’s services and management organization, the results of operations for these lines of business are not necessarily comparable with those of other companies, including companies in the financial services industry. Additional information about State Street’s lines of business is included in Note 13 to the Consolidated Financial Statements in the Corporation’s 2004 Annual Report on Form 10-K.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

The following is a summary of line of business results:

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

Investment Servicing

Total revenue for the three and six months ended June 30, 2005 was $1.13 billion and $2.20 billion, respectively, an increase of 4% for both periods from the comparable periods in 2004. The increases were driven by growth in fee revenue, offset somewhat by declines in net interest revenue and lower gains on sales of available-for-sale securities.

Fee revenue was $928 million and $1.81 billion for the three and six months ended June 30, 2005, respectively, up $70 million and $112 million, respectively, attributable to growth in servicing, securities lending and trading services fees, somewhat offset by declines in processing fees and other. Servicing fees, securities lending, and trading services fee revenue for this line of business were virtually identical to the consolidated results of the Corporation. Refer to the “Results of Operations—Fee Revenue” section of this discussion and analysis for additional information.

Net interest revenue after provision for loan losses for the three and six months ended June 30, 2005 was $199 million and $393 million, respectively, down in both comparisons from the comparable period in 2004 due to narrower interest-rate spreads, somewhat offset by increases and changes in the mix of the balance sheet.

Operating expenses for the second quarter of 2005 were $873 million, and were $1.68 billion for the six months ended June 30, 2005, increases of 11% and 9%, respectively, from the comparable periods in 2004. The increases were attributable to higher salaries, reflecting the higher costs of benefits and merit increases, growth in transaction processing costs reflecting higher volumes for this line of business and higher professional services costs related to compliance and growth initiatives, somewhat offset by lower information systems and communications costs due to the integration of the GSS business to State Street’s systems.

Investment Management

Total revenue for the three and six months ended June 30, 2005 was $233 million and $465 million, respectively, up 18% and 23%, respectively, from the comparable periods in 2004. The increases were driven by growth across all lines of revenue.

Management fees from investment management services, delivered through State Street Global Advisors, were $173 million for the second quarter of 2005 and $350 million for the year-to-date period and are identical to the consolidated results of the Corporation. Refer to the “Results of Operations—Fee Revenue” section of this discussion and analysis for additional information. Improvement in securities lending revenue reflected higher spreads and an increase in the volume of securities lent.

Operating expenses for the three and six months ended June 30, 2005, were $155 million and $318 million, respectively, up 2% and 11% from the comparable periods in 2004, primarily attributable to higher salaries and employee benefits.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

Financial Goals and the Factors That May Affect Them

State Street has announced financial goals for the Corporation for 2005 and beyond. The 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 shareholders’ equity of 14% to 17%. State Street expects to be at the lower end of these ranges for the year ending December 31, 2005.

The Corporation prepares its consolidated statement of income in accordance with accounting principles generally accepted in the United States (“GAAP”); however, it measures the achievement of its financial goals on an operating basis. Operating basis results are based on GAAP results, excluding the impact of significant, non-recurring transactions and activities, presented on a fully taxable equivalent basis. Operating basis results for full-year 2005 will exclude the possible loss related to Bel Air Investment Advisors LLC and any charges that could result from the application of proposed new accounting guidance related to leveraged leases and tax contingencies. More information about these matters is included in Notes 2 and 12 to the Consolidated Financial Statements in this Form 10-Q.

State Street considers these to be financial goals, not projections or forward-looking statements. However, this discussion and analysis and other portions of this 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 Form 10-Q 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.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

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 consolidated statements of income, condition and changes in shareholders’ 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, the 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. Terrorist activities and related military actions have caused economic and political uncertainties, 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 governmental 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, the mutual fund industry, and governmental and regulatory agencies have sought information from State Street 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 competitive challenges, may affect future results of operations.

Regulation and Supervision.   State Street’s businesses are subject to stringent regulation and examination by governmental and regulatory agencies and self-regulatory organizations (including securities exchanges) both inside and outside the U.S. State Street has established policies, procedures, and systems designed to comply with these regulatory requirements. However, as a global financial services institution, State Street faces complexity and costs in its worldwide compliance efforts, and faces the potential for loss resulting from failure to comply with these requirements, which could have a material impact on the Corporation’s future results of operations. Also, adverse publicity and damage to its reputation arising from the failure or perceived failure to comply with legal or regulatory requirements could affect State Street’s ability to attract and retain customers or maintain access to capital markets, or could result in enforcement actions, fines, penalties and lawsuits.

Operational Risk.   State Street has the potential to incur losses resulting from inadequate or failed internal processes, people and systems. In addition, 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, which may impact State Street. The Corporation has well-established policies, procedures, systems, and business continuity and disaster recovery plans in place that are designed to address these operational risks. However, an adverse effect on State Street’s financial results could occur.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

GAAP.   Changes in GAAP applicable to State Street could have a material impact on the Corporation’s consolidated 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 results of operations.

Interest Rates.   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 Corporation’s consolidated statement of income.

Liquidity.   The Corporation’s ability to maintain consistent access to liquidity is fostered by strong credit ratings from the major independent credit rating agencies. Factors considered by the rating agencies in assigning high credit ratings include diverse and stable core earnings; strong risk management; strong capital ratios; diverse liquidity sources, including the global funds markets and client deposits; and strong liquidity monitoring procedures. Any occurrence that may limit the Corporation's access to liquidity, 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 credit ratings, could affect State Street’s capital costs and its ability to raise capital and, in turn, its liquidity.

Capital.   Under regulatory capital adequacy guidelines, State Street and State Street Bank  and Trust Company (“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, 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

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

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 and 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.

Investment Manager and Hedge Fund Manager Operations Outsourcing.   The Corporation enters into long-term contracts to provide middle office or investment management operations outsourcing services to clients. Services include trade order management, trade support and fail management, reconciliations, cash reporting and management, custodian communications for settlements, accounting systems, collateral management and information technology development. These contracts often extend for eight to ten years and require considerable up-front investments, including technology and conversion costs. Performance risk exists in each contract as these contracts are dependent upon the successful conversion and implementation of the activities onto State Street’s operating platforms.

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.

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

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

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, Outsourcing Agreements and Divestitures.   Acquisitions of complementary businesses and technologies, development of strategic alliances, execution of outsourcing agreements 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, outsourcing agreements and divestitures in recent years. However, there can be no assurance that services, technologies, key personnel or businesses of acquired companies or from outsourcing agreements will be effectively assimilated into State Street’s business or service offerings, that alliances will be successful, or that future revenue growth or expense savings will be achieved in outsourcing agreements. 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

Capital

At June 30, 2005, State Street and State Street Bank met all capital adequacy requirements to which they were subject. The regulatory capital amounts and ratios were as follows at June 30, 2005, and December 31, 2004:

(1)         State Street Bank must meet the regulatory designation of “well capitalized” in order to maintain State Street’s status as a financial holding company, including maintaining a minimum Tier 1 risk-based capital ratio (Tier 1 capital divided by adjusted risk-weighted assets and market-risk

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

equivalents) of 6%, a minimum total risk-based capital ratio (total capital divided by adjusted risk-weighted assets and market-risk equivalents) of 10%, and a Tier 1 leverage ratio (Tier 1 capital divided by quarterly average adjusted assets) of 5%. In addition, Federal Reserve Regulation Y defines “well capitalized” for a bank holding company such as State Street for the purpose of determining eligibility for a streamlined review process for acquisition proposals. For such Regulation Y purposes, “well capitalized” requires State Street to maintain a minimum Tier 1 risk-based capital ratio of 6% and a minimum total risk-based capital ratio of 10%.

The Corporation's and State Street Bank's Tier 1 and total risk-based capital ratios were down from year-end 2004. Modest capital increases were more than offset by higher risk-weighted assets.  Tier 1 and total risk-based capital for the Corporation and State Street Bank remained relatively flat, up 1 to 2%, as increases from net income were largely offset by foreign currency translation losses, unrealized losses on the available-for-sale securities portfolio, and for the Corporation, the impact of the stock purchase program. Higher risk-weighted assets resulted primarily from changes made to the investment securities portfolios and an increase in overdrafts in the loan portfolio from year-end. Both ratios significantly exceeded the regulatory minimum and well-capitalized thresholds.

On June 26, 2004, the Basel Committee on Banking Supervision released the final version of its capital adequacy framework (“Basel II”). 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, with the final version anticipated by mid-2006. State Street has developed a comprehensive implementation program to achieve Basel II compliance. The new rules as applied in the U.S. are expected to become effective on January 1, 2007, subject to transitional implementation arrangements, and will become fully operational on January 1, 2008. Mandatory compliance will be required for large, internationally-active U.S. institutions, such as State Street. At this time, State Street cannot predict the final form of the rules in the U.S., nor their impact on the Corporation’s risk-based capital.

State Street’s Board of Directors (“Board”) has authorized the purchase of State Street common stock for use in employee benefit programs and for general corporate purposes. During the first quarter of 2005, 2.9 million shares were purchased under the 1995 stock purchase program. In February 2005, the 1995 stock purchase program was terminated, and in its place, the Board authorized the purchase of 15 million shares under the 2005 stock purchase program. During the second quarter of 2005, 2.2 million shares were purchased under the 2005 stock purchase program, and at June 30, 2005, 12.8 million shares remained available for future purchases. See Note 6 to the Consolidated Financial Statements in this Form 10-Q for additional information.

In connection with the acquisition of the GSS business of Deutsche Bank in January 2003, State Street issued $345 million, or 1,725,000 units, of “SPACES.” For a description of the SPACES contracts, refer to Note 10 to the Consolidated Financial Statements in State Street’s 2004 Annual Report on Form 10-K. On November 15, 2005, State Street will receive proceeds of $345 million and issue approximately 8,712,000 shares of its common stock upon settlement of the fixed share purchase contracts underlying the SPACES units. Shares receivable under the variable-share repurchase contracts will be received by State Street on February 15, 2006. On December 15, 2005, State Street will be required to redeem $345 million of trust preferred securities which are included in long-term debt in its consolidated statement of condition, provided that the Corporation is well-capitalized and receives consent to do so from the Federal Reserve.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

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.

State Street maintains a large portfolio of liquid assets, defined as cash and due from banks, interest-bearing deposits with banks, securities purchased under resale agreements, federal funds sold, trading account assets and investment securities. At June 30, 2005, the Corporation’s liquid assets were $87.55 billion, or 84% of total consolidated assets, a significant portion of which can be sold in the open market to meet liquidity needs. At December 31, 2004, liquid assets were $79.31 billion, or 84% of total consolidated assets. Securities with a carrying value of $20.69 billion at June 30, 2005, and $24.77 billion at December 31, 2004, were pledged, primarily for public and trust deposits, certain short-term liabilities and for other purposes as provided by law. At June 30, 2005, State Street’s short-term liabilities, defined as deposits, securities sold under repurchase agreements, federal funds purchased and other short-term borrowings, were $87.76 billion, compared to $78.79 billion at December 31, 2004. State Street had $165 million in pre-tax net unrealized losses on available-for-sale investment securities at June 30, 2005, due primarily to short-term interest rate movements, and the Corporation does not consider these investments to be permanently impaired. Net unrealized losses on available-for-sale securities at December 31, 2004 were $96 million.

State Street maintains a universal shelf registration that allows for the offering and sale of unsecured debt securities, capital securities, common stock, depositary shares and preferred stock, and warrants to purchase such securities, including any shares into which the preferred stock and depositary shares may be convertible, or any combination thereof. At June 30, 2005, $469 million of State Street’s shelf registration was available for issuance.

State Street can issue commercial paper with an aggregate limit of $3.00 billion and with original maturities of up to 270 days from the date of issue. At June 30, 2005, State Street had $1.29 billion of commercial paper outstanding, compared to $966 million at December 31, 2004.

State Street Bank can issue bank notes with an aggregate limit of $750 million and with original maturities ranging from 14 days to five years. At June 30, 2005, no notes payable were outstanding and all $750 million was available for issuance. In 2003, State Street Bank was authorized to issue $1 billion of subordinated bank notes. At June 30, 2005, $600 million remained available for issuance.

State Street Bank currently maintains a line of credit of CAD $800 million to support its Canadian securities processing operations. The line of credit has no stated termination date and is cancelable by either party with prior notice. At the close of business on June 30, 2005, State Street Bank did not have any balance due on the line of credit.

State Street endeavors to maintain high investment-grade ratings on its debt, as measured by the major independent credit rating agencies. High ratings on debt minimize borrowing costs and enhance State Street’s liquidity by ensuring the largest possible market for the Corporation’s debt.

Based upon the Corporation’s level of liquid assets and its ability to access the capital markets for additional funding when necessary, including its ability to issue debt and equity securities under its current

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

shelf registration, management considers overall liquidity at June 30, 2005 more than sufficient to meet its current commitments and business needs, including accommodating the transaction and cash management needs of its clients.

Risk Management

Economic Capital

During 2004, State Street implemented a methodology to quantify its economic capital needs. The Corporation defines economic capital as the common equity required to protect debt holders against unexpected economic losses over a one-year period at a level consistent with the solvency of a firm with State Street’s target debt rating. State Street quantifies capital requirements for the risks inherent in its business activities and groups them into one of the following broadly-defined categories.

·       Market risk: the risk of adverse financial impact due to fluctuations in market prices, primarily as they relate to State Street’s trading activities.

·       Structural interest-rate risk: the risk of loss in non-trading, asset-liability management positions, primarily the impact of adverse movements in interest rates on the repricing mismatches that exist between balance sheet assets and liabilities.

·       Credit risk: the risk of loss that may result from the default or downgrade of a borrower or counterparty.

·       Operational risk: the risk of loss from inadequate or failed internal processes, people, and systems, or from external events, which is consistent with the Basel II definition.

·       Business risk: the risk of adverse changes in the Corporation’s earnings from business factors, including changes in the competitive environment, changes in the operational economics of business activities, and the effect of strategic and reputation risks.

Economic capital for each of these five categories is estimated on a stand-alone basis using statistical modeling techniques applied to internally-generated and external data. These individual results are then aggregated at the State Street consolidated level. A capital reduction or diversification benefit is then applied to reflect the unlikely event of experiencing an extremely large loss in each risk type at the same time.

Because the amount of economic capital varies directly with the Corporation’s overall level of risk, it has become an integral part of State Street’s internal capital management process. Economic and regulatory capital are key metrics used by management to ensure that State Street’s actual level of capital is commensurate with its risk profile, in compliance with all regulatory requirements, and sufficient to provide the Corporation with the financial flexibility to undertake future strategic business initiatives.

The framework and methodologies used to quantify capital for each of the risk types have been developed by Enterprise Risk Management and Treasury and are designed to be generally consistent with the Corporation’s risk management principles. This framework has been approved by senior management and has been reviewed by the Executive Committee of the Board. Due to the evolving nature of quantification techniques, State Street expects to continue refining the methodologies used to estimate its economic capital requirements, which could result in a different amount of capital needed to support its risk profile.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

Market Risk

Trading Activities: Foreign Exchange and Interest Rate Sensitivity

As part of its trading activities, the Corporation takes 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. At June 30, 2005, the notional amount of these derivative instruments was $478.79 billion, of which $463.31 billion were foreign exchange forward contracts. In the aggregate, long and short foreign exchange forward positions are closely matched to minimize currency and interest rate risk. All foreign exchange contracts are valued daily at current market rates.

The following table presents State Street’s market risk for its trading activities as measured by its value-at-risk methodology:

State Street compares daily profits and losses from trading activities to the estimated one-day value at risk. This information is reviewed and used to assure that the value-at-risk model is properly calibrated and that all relevant trading positions are being taken into account.

Non-Trading Activities—Interest-Rate Sensitivity

The objective of interest-rate sensitivity management is to provide sustainable net interest revenue under various economic environments and to protect asset values from adverse effects of changes in interest rates. State Street manages the structure of its interest-earning assets and interest-bearing liabilities by adjusting the mix, yields and maturity or repricing characteristics based on market conditions. During 2004, State Street created a centralized treasury function to manage State Street’s interest-rate risk. Since interest-bearing sources of funds are predominantly short-term, State Street maintains a relatively short-term structure for its interest-earning assets, including money market assets, investments and loans. Interest-rate swaps are used minimally as a part of overall asset and liability management to augment State Street’s management of its interest-rate exposure.

State Street uses three tools for measuring interest-rate risk: simulation, duration and gap analysis models. Key assumptions in the models include the timing of cash flows, maturity and repricing of financial instruments, changes in market conditions, capital planning, and deposit sensitivity. These assumptions are inherently uncertain and as a result, the models cannot precisely calculate net interest revenue or precisely predict the impact of changes in interest rates on net interest revenue and economic value. Actual results may differ from simulated results due to the timing, magnitude and frequency of interest-rate changes and changes in market conditions and management strategies, among other factors.

Simulation models facilitate the evaluation of the potential range of net interest revenue under a “most likely” scenario, alternative interest-rate scenarios and rate shock tests. Duration measures the change in

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

the economic value of assets and liabilities for given changes in interest rates. Gap analysis is the difference in asset and liability repricing on a cumulative basis within a specified time period.

If all other variables remained constant, in the short term, falling interest rates would lead to net interest revenue that is higher than it would otherwise have been, and rising rates would lead to lower net interest revenue. Other important determinants of net interest revenue are balance sheet size and mix, interest-rate spreads, the slope of the yield curve, the pace of increases in rates and rate levels. Measures of interest-rate sensitivity are monitored by the respective business units, Treasury and the Investment and Financial Policy Committees.

Credit Risk

At June 30, 2005, total gross loans were $6.37 billion compared to $4.63 billion at December 31, 2004, reflecting a large increase in daily overdrafts, which do not represent a significant increase in credit risk due to their short-term nature. The allowance for loan losses was $18 million, unchanged from December 31, 2004, and down from $36 million compared to June 30, 2004. For the six months ended June 30, 2005, no provision for loan losses was charged against income, and there were no charge-offs or recoveries. Non-performing assets at June 30, 2005, were $4 million, consisting of one non-performing investment security, compared to $7 million at December 31, 2004. In addition to credit risk in the loan and lease portfolio, State Street also assumes credit and counterparty risk in other on- and off-balance sheet exposure categories.

Operational Risk

State Street defines operational risk as the potential for losses resulting from inadequate or failed internal processes, people and systems, or from external events. State Street is the world’s leading provider of services to institutional investors, and the Corporation’s clients have a broad array of complex and specialized servicing, confidentiality and fiduciary requirements. Active management of operational risk is an integral component of all aspects of State Street’s business and responsibility for the management of operational risk lies with every individual in the Corporation. State Street’s Operational Risk Policy Statement defines operational risk and details roles and responsibilities for managing operational risk. It provides a mandate within which sound practices, including programs, processes, and those elements required by regulation, are implemented to ensure that operational risk is identified, measured, managed and controlled in an effective and consistent manner across the Corporation.

State Street maintains an operational risk governance structure to ensure responsibilities are clearly defined and to provide independent oversight of operational risk management. Enterprise Risk Management oversees the Corporation’s enterprise-wide operational risk management program. The Major Risk and Operational Risk Committees review key metrics and policies related to operational risk, provide oversight functions to ensure compliance with the operational risk program, and escalate operational risk issues of note to the Executive Committee of the Board. Corporate Audit performs independent reviews of the application of operational risk management practices and methodologies and reports to the Examining and Audit Committee of the Board.

State Street’s internal control environment is designed to provide a sound operational environment. The Corporation’s discipline in managing operational risk provides the structure to identify, evaluate, control, monitor, measure, mitigate and report operational risk.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (Continued)

CRITICAL ACCOUNTING ESTIMATES

Critical accounting estimates are those that require management, in the preparation of consolidated financial statements, to make difficult, subjective or complex judgments in the application of certain accounting policies, 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 were described in detail in Note 1 to the Consolidated Financial Statements in State Street’s Annual Report on Form 10-K for the year ended December 31, 2004. State Street’s critical accounting estimates were described in Management’s Discussion and Analysis of Financial Condition and Results of Operations in its Annual Report on Form 10-K for the year ended December 31, 2004. There were no significant changes in the first six months of 2005, in the factors or methodology used by management in determining its critical accounting estimates that were material in relation to the Corporation’s consolidated financial condition, changes in financial condition and results of operations.

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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by this item is included in the “Risk Management—Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q.

State Street’s market risk management function was described in detail in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2004.

CONTROLS AND PROCEDURES

The Corporation has established and maintains disclosure controls and procedures that are designed to ensure that material information relating to the Corporation and its consolidated  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 SEC’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 procedures as of the end of the fiscal quarter. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures were effective as of June 30, 2005.

The Corporation has also established and maintains internal control over financial reporting as a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States. 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 any change in the Corporation’s internal control over financial reporting that occurred during the period covered by the report that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting. 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. 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 was no change in the Corporation’s internal control over financial reporting identified in connection with the evaluation described in this paragraph that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

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STATE STREET CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

The accompanying condensed notes are an integral part of these financial statements.

22

STATE STREET CORPORATION
CONSOLIDATED STATEMENT OF CONDITION