AMENDMENT NO 1 TO FORM 10-Q
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

Form 10-Q/A

Amendment No. 1

 

x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For The Quarterly Period Ended March 31, 2004

or

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For The Transition Period From                     to                    

 

Commission File No. 0-5108

 

STATE STREET CORPORATION

(Exact name of registrant as specified in its charter)

 

MASSACHUSETTS   04-2456637

(State or other jurisdiction

of incorporation)

 

(I.R.S. Employer

Identification No.)

225 Franklin Street

Boston, Massachusetts

 

02110

(Zip Code)

(Address of principal

executive office)

   

 

617-786-3000

(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes x    No ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes x    No ¨

 

The number of shares of the Registrant’s Common Stock outstanding on April 30, 2004 was 335,919,316.

 



Table of Contents

EXPLANATORY NOTE

 

As a result of error by the Registrant’s filing agent, an incomplete draft of the Registrant’s Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2004 was filed prematurely without authorization of the Registrant. That draft Form 10-Q, as filed, had not been subject to State Street’s normal completion and review process. This Form 10-Q/A contains the final and complete Form 10-Q for the Registrant for the period.

 

Included in the updated information contained in this Form 10-Q/A, among other changes and edits, is insertion of the amount of securities pledged for the first quarter of 2004 on the Consolidated Statement of Condition, on page 2; and a correction to the percentage increase in the volume of securities on loan for the first quarter of 2004, compared to the first quarter of 2003 figure, from 35% to 47%, on pages 21 and 25.


Table of Contents

STATE STREET CORPORATION

 

Table of Contents

 

          Page

PART I.    FINANCIAL INFORMATION     
Item 1.    Financial Statements     
Consolidated Statement of Income    1
Consolidated Statement of Condition    2
Consolidated Statement of Changes in Stockholders’ Equity    3
Consolidated Statement of Cash Flows    4
Notes to Consolidated Financial Statements    5
Independent Accountants’ Review Report    16
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    17
Item 3.    Quantitative and Qualitative Disclosures About Market Risk    32
Item 4.    Controls and Procedures    32
PART II.     OTHER INFORMATION     
Item 1.    Legal Proceedings    33
Item 2.    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities    33
Item 4.    Submission of Matters to a Vote of Security Holders    34
Item 6.    Exhibits and Reports on Form 8-K    34
Signature    36
Exhibits     


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS

 

Consolidated Statement of Income—State Street Corporation (Unaudited)

 


(Dollars in millions, except per share data) Three months ended March 31,

     2004      2003

Fee Revenue:

             

Servicing fees

   $ 555    $ 438

Management fees

     147      125

Securities lending

     64      55

Foreign exchange trading

     118      72

Brokerage fees

     45      30

Processing fees and other

     84      70
    

  

Total fee revenue

     1,013      790

Net Interest Revenue:

             

Interest revenue

     384      397

Interest expense

     181      193
    

  

Net interest revenue

     203      204

Provision for loan losses

         
    

  

Net interest revenue after provision for loan losses

     203      204

Gains on the sales of available-for-sale investment securities, net

     3      26
    

  

Total Revenue

     1,219      1,020

Operating Expenses:

             

Salaries and employee benefits

     462      443

Information systems and communications

     139      130

Transaction processing services

     96      72

Occupancy

     90      71

Merger and integration costs

     18      37

Other

     103      81
    

  

Total operating expenses

     908      834
    

  

Income before income taxes

     311      186

Income tax expense

     94      90
    

  

Net Income

   $ 217    $ 96
    

  

Earnings Per Share

             

Basic

   $ .65    $ .29

Diluted

     .63      .29

Average Shares Outstanding (in thousands)

             

Basic

     334,635      329,569

Diluted

     342,129      332,054

Cash Dividends Declared Per Share

   $ .15    $ .13

 

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

 

1


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Consolidated Statement of Condition—State Street Corporation

 


 

(Dollars in millions)

    
 
March 31,
2004
 
 
   
 
December 31,
2003
 
 

 
     (Unaudited)     (Note 1)  

Assets

                

Cash and due from banks

   $ 2,379     $ 3,376  

Interest-bearing deposits with banks

     27,228       21,738  

Securities purchased under resale agreements

     13,968       9,447  

Federal funds sold

     1,000       104  

Trading account assets

     347       405  

Investment securities (including securities pledged of $15,386 and $13,278)

     34,605       38,215  

Loans (less allowance of $36 and $61)

     4,968       4,960  

Premises and equipment

     1,238       1,212  

Accrued income receivable

     1,014       1,015  

Goodwill

     1,329       1,326  

Other intangible assets

     542       525  

Other assets

     4,278       5,211  
    


 


Total Assets

   $ 92,896     $ 87,534  
    


 


Liabilities

                

Deposits:

                

Noninterest-bearing

   $ 9,352     $ 7,893  

Interest-bearing—U.S.

     6,826       5,062  

Interest-bearing—Non-U.S.

     37,334       34,561  
    


 


Total deposits

     53,512       47,516  

Securities sold under repurchase agreements

     21,811       22,806  

Federal funds purchased

     2,083       1,019  

Other short-term borrowings

     1,434       1,437  

Accrued taxes and other expenses

     2,386       2,424  

Other liabilities

     3,484       4,363  

Long-term debt

     2,244       2,222  
    


 


Total Liabilities

     86,954       81,787  

Stockholders’ Equity

                

Preferred stock, no par: authorized 3,500,000 shares; issued none

                

Common stock, $1 par: authorized 500,000,000 shares, issued 337,130,000 and 337,132,000

     337       337  

Surplus

     298       329  

Retained earnings

     5,174       5,007  

Accumulated other comprehensive income

     207       192  

Treasury stock, at cost (1,705,000 and 2,658,000 shares)

     (74 )     (118 )
    


 


Total Stockholders’ Equity

     5,942       5,747  
    


 


Total Liabilities and Stockholders’ Equity

   $ 92,896     $ 87,534  
    


 


                  

 

 

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

 

2


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Consolidated Statement of Changes in Stockholders’ Equity—State Street Corporation (Unaudited)

 


 
    Common Stock

  Surplus    

Retained

Earnings

   

Accumulated

Other

Comprehensive

Income (Loss)

    Treasury Stock

       
(Dollars in millions, shares in thousands)   Shares     Amount         Shares     Amount     Total  

 

Balance at December 31, 2002

  329,992     $ 330   $ 104     $ 4,472     $ 106     5,065     $ (225 )   $ 4,787  

Comprehensive income:

                                                         

Net income

                        96                             96  

Change in net unrealized gains/losses on available-for sale securities, net of related taxes of $(16)

                                (19 )                   (19 )

Foreign currency translation, net of related taxes of $4

                                8                     8  

Change in unrealized gains/losses on cash flow hedges, net of related taxes of $(1)

                                (1 )                   (1 )
   

 

 


 


 


 

 


 


Total comprehensive income

                        96       (12 )                   84  

Cash dividends declared-$.13 per share

                        (43 )                           (43 )

Common stock acquired

                                      71       (2 )     (2 )

Common stock issued pursuant to:

                                                         

January 14, 2003, Registration Statement

  7,153       7     260                                     267  

Present value of the estimated fees payable with respect to SPACES, pursuant to January 14, 2003 Registration Statement

                (57 )                                   (57 )

Stock awards and options exercised, including tax benefit of $2

                (1 )                   (373 )     16       15  

Debt conversion

                (1 )                   (14 )     1        
   

 

 


 


 


 

 


 


Balance at March 31, 2003

  337,145     $ 337   $ 305     $ 4,525     $ 94     4,749     $ (210 )   $ 5,051  
   

 

 


 


 


 

 


 


Balance at December 31, 2003

  337,132     $ 337   $ 329     $ 5,007     $ 192     2,658     $ (118 )   $ 5,747  

Comprehensive income:

                                                         

Net income

                        217                             217  

Change in net unrealized gains/losses on available-for sale securities, net of related taxes of $21

                                34                     34  

Change in minimum pension liability

                                (23 )                   (23 )

Foreign currency translation, including tax benefit of $5

                                8                     8  

Change in unrealized gains/losses on cash flow hedges, net of related taxes of $(3)

                                (4 )                   (4 )
   

 

 


 


 


 

 


 


Total comprehensive income

                        217       15                     232  

Cash dividends declared-$.15 per share

                        (50 )                           (50 )

Impact of fixing the variable-share settlement rate of SPACES

                (26 )                                   (26 )

Common stock issued pursuant to:

                                                         

Stock awards and options exercised, including tax benefit of $10

  (2 )           (5 )                   (953 )     44       39  
   

 

 


 


 


 

 


 


Balance at March 31, 2004

  337,130     $ 337   $ 298     $ 5,174     $ 207     1,705     $ (74 )   $ 5,942  
   

 

 


 


 


 

 


 



 

 

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

 

3


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Consolidated Statement of Cash Flows—State Street Corporation (Unaudited)

 


 

(Dollars in millions) Three months ended March 31,

     2004       2003  

 

Operating Activities

                

Net Income

   $ 217     $ 96  

Adjustments to reconcile net income to net cash provided (used) by operating activities:

                

Non-cash charges for depreciation, amortization, provision for loan losses and deferred income taxes

     195       190  

Securities gains, net

     (3 )     (26 )

Change in trading account assets, net

     58       (332 )

Other, net

     (106 )     (440 )
    


 


Net Cash Provided (Used) by Operating Activities

     361       (512 )

Investing Activities

                

Net (increase) decrease in interest-bearing deposits with banks

     (5,490 )     7,136  

Net (increase) decrease in federal funds sold and securities purchased under resale agreements

     (5,417 )     1,544  

Proceeds from sales of available-for-sale securities

     3,586       3,862  

Proceeds from maturities of available-for-sale securities

     2,872       9,323  

Purchases of available-for-sale securities

     (2,812 )     (13,774 )

Proceeds from maturities of held-to-maturity securities

     579       293  

Purchases of held-to-maturity securities

     (587 )     (289 )

Net decrease (increase) in loans

     32       (489 )

Principal collected from lease financing

     61       41  

Business acquisitions, net of cash acquired

     (10 )     (1,078 )

Purchases of equity investments and other long-term assets

     (23 )     (10 )

Purchases of premises and equipment

     (101 )     (98 )
    


 


Net Cash (Used) Provided by Investing Activities

     (7,310 )     6,461  

Financing Activities

                

Net increase (decrease) in deposits

     5,995       (7,063 )

Net increase in short-term borrowings

     66       831  

Payments for non-recourse debt for lease financing

     (83 )     (65 )

Proceeds from issuance of long-term debt, net of issuance costs

           343  

Payments for long-term debt and obligations under capital leases

     (5 )      

Proceeds from issuance of common stock/SPACES, net of issuance costs

           257  

Proceeds from issuance of treasury stock

     29       11  

Payments for cash dividends

     (50 )     (43 )
    


 


Net Cash Provided (Used) by Financing Activities

     5,952       (5,729 )
    


 


Net (Decrease) Increase

     (997 )     220  

Cash and due from banks at beginning of period

     3,376       1,361  
    


 


Cash and Due From Banks at End of Period

   $ 2,379     $ 1,581  
    


 



 

 

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

 

4


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

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, 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; 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 March 31, 2004 and December 31, 2003, its cash flows for the three months ended March 31, 2004 and 2003, and consolidated results of its operations for the three months ended March 31, 2004 and 2003, have been made. Operating results for the three months ended March 31, 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 generally accepted accounting principles 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 income.

 

Use of Estimates

 

The preparation of financial statements in accordance with accounting principles generally accepted in the United States 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.

 

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”) of which State Street absorbs the majority of expected losses, in which case State Street consolidates the VIE.

 

5


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 1—Basis of Presentation (continued)

 

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:

 


    

Three Months

Ended

March 31,


 
(Dollars in millions, except per share data)        2004             2003      

 

Net income, as reported

   $ 217     $ 96  

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects at the effective tax rate

     3        

Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects at the effective tax rate

     (10 )     (15 )
    


 


Pro forma net income

   $ 210     $ 81  
    


 


Earnings per share:

                

Basic—as reported

   $ .65     $ .29  

Basic—pro forma

     .63       .25  

Diluted—as reported

     .63       .29  
Diluted—pro forma      .61       .24  

 

 

A total of 768,000 options were exercised during the three months ended March 31, 2004, with a weighted average option price of $29.26 per share. During the three months ended March 31, 2004, 2,200,000 options were granted with a weighted average option price of $52.78 per share.

 

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

 

6


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 1—Basis of Presentation (continued)

 

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 for a premium of $1.1 billion. The purchase price is subject to adjustments based upon performance of the acquired business for the year following the closing. State Street may make additional payments up to an estimated €360 million; however, State Street anticipates that the actual payment will be much less.

 

In connection with the acquisition, approximately 2,800 employees of Deutsche Bank became employees of State Street. For the three months ended March 31, 2004, State Street paid $2.1 million of severance costs related to an overall workforce reduction, primarily in the U.S., and the severance liability outstanding as of March 31, 2004, was $16.9 million.

 

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 finance the acquisition of the GSS business. The remainder of the purchase price was financed using existing resources.

 

Note 3—Investment Securities

 

Available-for-sale securities and held-to-maturity securities consisted of the following as of the dates indicated:

 


     March 31, 2004

   December 31, 2003

    

Amortized

Cost

   Unrealized

  

Fair

Value

  

Amortized

Cost

   Unrealized

  

Fair

Value

(Dollars in millions)       Gains    Losses          Gains    Losses   

Available for sale:

                                                       

U.S. Treasury and federal agencies

   $ 19,380    $ 110    $ 9    $ 19,481    $ 22,695    $ 73    $ 20    $ 22,748

Asset-backed securities

     9,564      46      4      9,606      9,852      46      13      9,885

State and political subdivisions

     1,958      30           1,988      1,961      38           1,999

Collateralized mortgage obligations

     1,242      6      1      1,247      1,338      2      7      1,333

Other debt investments

     284      8           292      304      6           310

Money market mutual funds

     123                123      85                85

Other equity securities

     247      9      12      244      238      6      6      238
    

  

  

  

  

  

  

  

Total

   $ 32,798    $ 209    $ 26    $ 32,981    $ 36,473    $ 171    $ 46    $ 36,598
    

  

  

  

  

  

  

  

Held to maturity:

                                                       

U.S. Treasury and federal agencies

   $ 1,353    $ 5           $ 1,358    $ 1,345    $ 3           $ 1,348

Other investments

     271                  271      272                  272
    

  

         

  

  

         

Total

   $ 1,624    $ 5           $ 1,629    $ 1,617    $ 3           $ 1,620
    

  

         

  

  

         


 

7


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 3—Investment Securities (continued)

 

During the three months ended March 31, 2004, gross gains of $20 million and gross losses of $17 million were realized on the sales of available-for-sale securities. During the three months ended March 31, 2003, gross gains of $26 million and gross losses of less than $1 million were realized on the sales of available-for-sale securities.

 

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:

 


    

Three Months

Ended

March 31,


(Dollars in millions)    2004     2003

Balance at beginning of period    $ 61     $ 61
Reclassification      (25 )    
    


 

Balance at end of period    $ 36     $ 61
    


 


 

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 $2.7 billion and $3.8 billion of unrealized gains on foreign exchange contracts at March 31, 2004, and December 31, 2003, respectively.

 

Other liabilities included $2.7 billion and $3.6 billion of unrealized losses on foreign exchange contracts at March 31, 2004, and December 31, 2003, respectively. Other liabilities also included a restructuring accrual related to a voluntary separation program initiated in the second quarter of 2003. As of March 31, 2004, the liability was $32 million, reflecting payments of $52 million and reclassifications of $92 million during the three months ended March 31, 2004.

 

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 SPACES. 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 were treated as a cost of capital and 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.

 

8


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 6—Stockholders’ Equity (continued)

 

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 has been 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 rate for the 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 Income

 

At March 31, the components of accumulated other comprehensive income, net of related taxes, were as follows:

 


 
(Dollars in millions)    2004     2003  

 
Unrealized gain on available-for-sale securities    $ 108     $ 80  
Minimum pension liability      (23 )      
Foreign currency translation      136       27  
Unrealized loss on cash flow hedges      (14 )     (13 )
    


 


Total    $ 207     $ 94  
    


 



 

 

Note 7—Net Interest Revenue

 

Net interest revenue consisted of the following:

 


    

Three Months Ended

March 31,


(Dollars in millions)        2004            2003    

Interest Revenue:              
Deposits with banks    $ 125    $ 125
Investment securities:              
U.S. Treasury and federal agencies      116      96
State and political subdivisions (exempt from federal tax)      15      17
Other investments      69      66
Securities purchased under resale agreements and federal funds sold      40      51
Commercial and financial loans      14      14
Lease financing      2      23
Trading account assets      3      5
    

  

Total interest revenue      384      397
Interest Expense:              
Deposits      104      100
Other borrowings      56      76
Long-term debt      21      17
    

  

Total interest expense      181      193
    

  

Net interest revenue    $ 203    $ 204
    

  


 

9


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 8—Operating Expenses—Other

 

The other category of operating expenses consisted of the following:

 


     Three Months Ended
March 31,


(Dollars in millions)      2004        2003  

Professional services    $ 33    $ 20
Advertising and sales promotion      11      11
Other(1)      59      50
    

  

Total operating expenses–other    $ 103    $ 81
    

  


(1)   Includes $17 million and $2 million of provisions for securities processing losses, respectively

 

Note 9—Income Taxes

 

State Street recorded tax expense of $94 million for the first quarter of 2004, compared to $90 million in the first quarter of 2003. Tax expense for the first quarter of 2004 included a cumulative benefit of $18 million resulting from a change in the effective state tax rate applied to 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 quarter of 2003 included a one-time $25 million after-tax charge for a REIT-related tax matter later settled with the Massachusetts Department of Revenue.

 

The effective rate for the first quarter of 2004 was 30%, 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.

 

Note 10—Employee Benefit Plans

 

The components of net periodic benefit cost for the three months ended March 31, were as follows:

 


     Pension Benefits

     Other Benefits

     2004      2003      2004    2003

Service cost    $ 11      $ 11      $ 1    $ 1
Interest cost      9        9        1      1
Expected return on plan assets      (10 )      (9 )          
Transition (asset)/obligation             (1 )          
Amortization of prior service cost      (1 )                 
Amortization of net loss      5        4            
    


  


  

  

Net periodic benefit cost    $ 14      $ 14      $ 2    $ 2
    


  


  

  


 

Employer Contributions

 

As previously disclosed in its financial statements for the year ended December 31, 2003, 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, $6 million and $3 million, respectively.

 

10


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 11—Regulatory Capital

 

The regulatory capital amounts and ratios were the following at March 31, 2004, and December 31, 2003:

 


     Regulatory Guidelines(a)

    State Street

    State Street Bank

 
(Dollars in millions)    Minimum     Well
Capitalized
    2004     2003     2004     2003  

 
Risk-based ratios:                                             
Tier 1 capital    4 %   6 %     13.9 %     14.0 %     12.3 %     12.4 %
Total capital    8     10       15.6       15.8       13.4       13.7  
Tier 1 leverage ratio    3     5       5.5       5.6       5.3       5.4  
Tier 1 capital                $ 4,960     $ 4,822     $ 4,268     $ 4,185  
Total capital                  5,558       5,450       4,657       4,601  

Adjusted risk-weighted assets and market-risk equivalents:

                                            
On-balance sheet                $ 21,501     $ 19,681     $ 20,618     $ 18,814  
Off-balance sheet                  13,837       14,385       13,842       14,391  
Market-risk equivalents                  399       436       383       421  
                


 


 


 


Total                $ 35,737     $ 34,502     $ 34,843     $ 33,626  
                


 


 


 


Quarterly average adjusted assets                $ 90,898     $ 85,562     $ 80,744     $ 76,888  
                


 


 


 



 
(a)   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 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, 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%.

 

Note 12—Lines of Business

 

State Street has two primary lines of business - Investment Servicing and Investment Management.

Investment Servicing includes custody, 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; wealth manager and hedge fund manager services; and performance, risk and compliance analytics to support institutional investors. State Street’s 50%-owned affiliates, Boston Financial Data Services, Inc. and the International Financial Data Services group of companies, 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 three months ended March 31, 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

 

11


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 12—Lines of Business (continued)

 

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 State Street’s 50%-owned affiliate, CitiStreet, LLC. Revenue from the Investment Management line of business comprised 15% of State Street’s total revenue for the three months ended March 31, 2004.

 

Business Divesture included the revenue and expenses related to the Private Asset Management operations sold in October 2003.

 

Other/One-Time charges for the first three months of 2004 and 2003 included merger and integration costs related to the acquisition of GSS of $18 million and $37 million, respectively.

 

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 included in the financial statements.

 


     For the Three Months Ended March 31,

     Investment
Servicing


   

Investment

Management


   

Business

Divestiture


   Other/
One-Time


    Total

(Dollars in millions, except

where otherwise noted)

   2004     2003     2004     2003     2004    2003    2004     2003     2004    2003

Fee Revenue:

                                                                         

Servicing fees

   $ 555     $ 438                                                 $ 555    $ 438

Management fees

               $ 147     $ 108          $ 17                      147      125

Securities lending

     53       47       11       8                                 64      55

Foreign exchange trading

     118       72                                             118      72

Brokerage fees

     45       30                                             45      30

Processing fees and other

     70       64       14       5            1                      84      70
    


 


 


 


      

                  

  

Total fee revenue

     841       651       172       121            18                      1,013      790

Net interest revenue after provision for loan losses

     194       194       9       10                                 203      204

Gains on the sales of available-for-sale investment securities, net

     3       26                                             3      26
    


 


 


 


      

                  

  

Total Revenue

     1,038       871       181       131            18                      1,219      1,020

Operating Expenses

     755       669       135       116            12    $ 18     $ 37       908      834
    


 


 


 


 
  

  


 


 

  

Income (Loss) Before Income Taxes

   $ 283     $ 202     $ 46     $ 15          $ 6    $ (18 )   $ (37 )   $ 311    $ 186
    


 


 


 


 
  

  


 


 

  

Pre-tax margin

     27 %     23 %     25 %     12 %                                         

Average assets (billions)

   $ 90.6     $ 75.8     $ 2.4     $ 1.8          $ .1                    $ 93.0    $ 77.7
    


 


 


 


 
  

  


 


 

  


 

12


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 13—Earnings Per Share

 

The following table sets forth the computation of basic and diluted earnings per share:

 


     Three Months Ended
March 31,


(Dollars in millions, except per share data; shares in thousands)    2004    2003

Net income    $ 217    $ 96
Earnings per share:              
Basic    $ .65    $ .29
Diluted      .63      .29
Basic average shares      334,635      329,569
Effect of dilutive securities:              
Stock options and stock awards      7,356      2,336
Equity-related financial instruments      138      149
    

  

Dilutive average shares      342,129      332,054
    

  


 

For the three months ended March 31, 2004 and 2003, the following potentially dilutive financial instruments 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 during those periods: 2004—stock options of 1.8 million; 2003 —stock options of 19.3 million.

 

Note 14—Contingent Liabilities

 

State Street provides custody, accounting, daily pricing and administration; master trust and master custody; investment management; recordkeeping; foreign exchange and trading services; securities lending; cash management; wealth manager and hedge fund manager services; and information services 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 exist at March 31, 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. Management believes State Street is appropriately accrued for tax exposures. 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.

 

13


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 15—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:

 


(Dollars in millions)    March 31,
2004
   December 31,
2003

Trading:

             
Interest rate contracts:              
Swap agreements    $ 2,873    $ 3,154
Options and caps purchased      331      332
Options and caps written      650      656
Futures      38,693      40,003
Foreign exchange contracts:              
Forward, swap and spot      401,034      322,051
Options purchased      4,713      2,243
Options written      4,326      2,064

Balance Sheet Management:

             
Interest rate contracts:              
Swap agreements      3,431      3,964

 

In connection with its interest-rate risk management strategies, State Street has executed interest-rate swap agreements with a notional value of $2.1 billion at March 31, 2004, designated as fair value hedges to hedge the changes in the fair value of certain securities. For the three months ended March 31, 2004, State Street recognized net pre-tax losses of $3 million, 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 constitute a fully effective hedge. In addition, $1.2 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 $72 million at March 31, 2004. For the three months ended March 31, 2004, the Corporation’s overall weighted average interest rate for long-term debt was 5.80% on a contractual basis and 3.76% including the effects of derivative contracts.

 

Note 16—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:

 


(Dollars in millions)    March 31,
2004
   December 31,
2003

Indemnified securities on loan    $ 348,778    $ 266,055
Liquidity asset purchase agreements      16,824      16,540
Loan commitments      12,599      12,270
Standby letters of credit      5,126      4,545

 

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

 

14


Table of Contents

PART I.    ITEM 1.

FINANCIAL STATEMENTS (continued)

 

Notes to Consolidated Financial Statements—State Street Corporation (Unaudited)

 

Note 16—Commitments and Off-Balance Sheet Activities (continued)

 

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 $378.9 billion and $271.3 billion for indemnified securities on loan at March 31, 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 87% 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, special purpose entities (“SPEs”), as defined by FIN 46-R (revised), which are administered by State Street, issues asset-backed commercial paper (“ABCP”). At March 31, 2004 and December 31, 2003, State Street’s commitments under liquidity asset purchase agreements and lines of credit to these SPEs were $12.0 billion and $11.9 billion, respectively, and standby letters of credit were $653 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 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 6%, or $72 million at March 31, 2004. These trusts have a weighted average life of approximately 5.1 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 $1.2 billion at March 31, 2004, and December 31, 2003, none of which were utilized and are included in the preceding table.

 

15


Table of Contents

Independent Accountants’ Review Report

 

The Stockholders and Board of Directors

State Street Corporation

 

We have reviewed the accompanying consolidated statement of condition of State Street Corporation as of March 31, 2004, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the three months ended March 31, 2004 and 2003. These financial statements are the responsibility of the Corporation’s management.

 

We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States.

 

We have previously audited, in accordance with auditing standards generally accepted in the 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.

 

ERNST & YOUNG LLP

 

Boston, Massachusetts

April 12, 2004

 

16


Table of Contents

PART I.    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 MARCH 31, 2004 AND 2003

 

Condensed Income Statement—Reported Results

 


     Three Months Ended March 31,

 
(Dollars in millions, except per share data)    2004    2003    $ Change     % Change  

 

Fee Revenue:

                            
Servicing fees    $ 555    $ 438    $ 117     27 %
Management fees      147      125      22     17  
Securities lending      64      55      9     16  
Foreign exchange trading      118      72      46     63  
Brokerage fees      45      30      15     51  
Processing fees and other      84      70      14     21  
    

  

  


     
Total fee revenue      1,013      790      223     28  

Net Interest Revenue:

                            
Net interest revenue      203      204      (1 )    
Provision for loan losses                     
    

  

  


     
Net interest revenue after provision for loan losses      203      204      (1 )    
Gains on the sales of available-for-sale investment securities, net      3      26      (23 )   (89 )
    

  

  


     
Total Revenue      1,219      1,020      199     19  

Operating Expenses:

                            
Salaries and employee benefits      462      443      19     4  
Information systems and communications      139      130      9     7  
Transaction processing services      96      72      24     33  
Occupancy      90      71      19     26  
Merger and integration costs      18      37      (19 )   (51 )
Other      103      81      22     28  
    

  

  


     
Total operating expenses      908      834      74     9  
    

  

  


     
Income before income taxes      311      186      125     68  
Income tax expense      94      90      4     6  
    

  

  


     
Net Income    $ 217    $ 96    $ 121     125  
    

  

  


     

Earnings Per Share:

                            
Basic    $ .65    $ .29    $ .36     124  
Diluted      .63      .29      .34     117  

 

 

17


Table of Contents

PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

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, the results of the divested Private Asset Management (“PAM”) business and the impact of a state tax matter. Operating results include the results of the Global Securities Services (“GSS”) business for a full three months in the first quarter of 2004 and from the date of the acquisition, January 31, 2003, in the first quarter of 2003.

 

Supplemental Financial Information—Operating Basis Reconciliation—Three Months Ended March 31, 2004 and 2003

 


     Three Months Ended March 31,

     2004

   2003

(Dollars in millions, except per share data)   

Operating

Results

   Other    

Reported

Results

  

Operating

Results

   PAM(4)    Other    

Reported

Results


Fee Revenue:

                                                  

Servicing fees

   $ 555            $ 555    $ 438                   $ 438

Management fees

     147              147      108    $ 17              125

Securities lending

     64              64      55                   55

Foreign exchange trading

     118              118      72                   72

Brokerage fees

     45              45      30                   30

Processing fees and other

     84              84      69      1              70
    

          

  

  

          

Total fee revenue

     1,013              1,013      772      18              790

Net Interest Revenue:

                                                  

Net interest revenue

     214    $ (11 )(1)     203      217         $ (13 )(1)     204

Provision for loan losses

                                    
    

  


 

  

  

  


 

Net interest revenue after provision for loan losses

     214      (11 )     203      217           (13 )     204

Gains on the sales of available-for-sale investment securities, net

     3            3      26                 26
    

  


 

  

  

  


 

Total Revenue

     1,230      (11 )     1,219      1,015      18      (13 )     1,020

Operating Expenses:

                                                  

Salaries and employee benefits

     462            462      436      7            443

Information systems and communications

     139            139      130                 130

Transaction processing services

     96            96      72                 72

Occupancy

     90            90      70      1            71

Merger and integration costs

          18 (2)     18                37 (2)     37

Other

     103            103      77      4            81
    

  


 

  

  

  


 

Total operating expenses

     890      18       908      785      12      37       834
    

  


 

  

  

  


 

Income (loss) before income taxes

     340      (29 )     311      230      6      (50 )     186

Income tax expense (benefit)

     101      (7 )(3)     94      76      2      12 (5)     90

Taxable-equivalent adjustment

     11      (11 )(1)          13           (13 )(1)    
    

  


 

  

  

  


 

Net Income

   $ 228    $ (11 )   $ 217    $ 141    $ 4    $ (49 )   $ 96
    

  


 

  

  

  


 

Earnings Per Share—Diluted    $ .67    $ (.04 )   $ .63    $ .43    $ .01    $ (.15 )   $ .29

Reported results agree with the Corporation’s Consolidated Statement of Income

(1)   Taxable-equivalent adjustment not included in reported results
(2)   Merger and integration costs associated with the acquisition of the GSS business on January 31, 2003
(3)   Tax benefit associated with the merger and integration costs
(4)   Revenue and expenses of the Private Asset Management business divested October 31, 2003
(5)   Impact of a state tax matter ($25 million of expense), net of the tax benefit associated with merger and integration costs of $13 million

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

Supplement Financial Information—Operating (1) —Consolidated Statement of Income

 


     Three Months Ended March 31,

 
(Dollars in millions, except per share data)    2004    2003    $ Change     % Change  

 

Operating Fee Revenue:

                            
Servicing fees    $ 555    $ 438    $ 117     27 %
Management fees      147      108      39     36  
Securities lending      64      55      9     16  
Foreign exchange trading      118      72      46     63  
Brokerage fees      45      30      15     51  
Processing fees and other      84      69      15     21  
    

  

  


     
Total operating fee revenue      1,013      772      241     31  

Operating Net Interest Revenue:

                            
Net interest revenue      214      217      (3 )      
Provision for loan losses                       
    

  

  


     
Net interest revenue after provision for loan losses      214      217      (3 )   (1 )
Gains on the sales of available-for-sale investment securities, net      3      26      (23 )   (89 )
    

  

  


     
Total Operating Revenue      1,230      1,015      215     21  

Operating-Basis Operating Expenses:

                            
Salaries and employee benefits      462      436      26     6  
Information systems and communications      139      130      9     7  
Transaction processing services      96      72      24     33  
Occupancy      90      70      20     29  
Other      103      77      26     34  
    

  

  


     
Total operating-basis operating expenses      890      785      105     13  
    

  

  


     
Income before income taxes      340      230      110     48  
Income tax expense      101      76      25        
Taxable-equivalent adjustment      11      13      (2 )      
    

  

  


     
Net Operating Income    $ 228    $ 141    $ 87     63  
    

  

  


     
Operating Diluted Earnings Per Share    $ .67    $ .43    $ .24     56  

 
(1)   As defined and reconciled to reported results on an earlier schedule

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

Summary

 

State Street reported net income for the first quarter of 2004 of $.63 per share, reflecting net income of $217 million and total revenue of $1.2 billion. In the first quarter of 2003, State Street earned $.29 per share, reflecting net income of $96 million and total revenue of $1.0 billion. Total expenses in the first quarter of 2004 of $908 million are up $74 million compared to the year-ago quarter.

 

Results for the first quarter of 2004 include pre-tax merger and integration costs of $18 million, or $0.03 per diluted share due to the continuing integration of the Deutsche Bank Global Securities Services business (GSS), acquired in January of 2003. Results for the first quarter of 2003 included pre-tax merger and integration costs of $37 million, or $0.07 per diluted share, related to the GSS acquisition and an after-tax charge of $25 million, or $0.08 per diluted share, related to a tax matter with the Commonwealth of Massachusetts. First quarter 2003 results also include the operating results of the divested Private Asset Management (PAM) business.

 

Operating earnings per share for the first quarter of 2004 were $0.67, up 56% compared to operating earnings per share of $0.43 for the first quarter of 2003. Operating results for 2003 have been reduced from the previously reported $0.44 per share reflecting the impact of the divested Private Asset Management business. Operating revenue of $1.2 billion in the first quarter of 2004 was up 21% from the first quarter of 2003, primarily due to increases in servicing and management fees, foreign exchange, brokerage fees, and processing fees and other, slightly offset by lower securities gains. Operating expenses of $890 million in the first quarter of 2004 were up $105 million, or 13%, from the first quarter of 2003. This comparison reflects two months of recorded operating activity for the GSS business acquired on January 31, 2003, compared with three full months in 2004. Return on stockholders’ equity on an operating basis was 15.6% for the quarter

 

Total Revenue

 

In the first quarter of 2004, total reported revenue was $1.2 billion, up $199 million, compared to $1.0 billion a year ago. On an operating basis, total revenue was $1.2 billion compared to $1.0 billion in 2003, an increase of $215 million, reflecting an increase of $241 million in fee revenue, offset somewhat by a $23 million decline in sales of available-for-sale securities.

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

Fee Revenue

 

Fee revenue for the first quarter of 2004 was $1.0 billion on both a reported and operating basis. Reported fee revenue for 2003 was $790 million and included $18 million from the divested PAM business. On an operating basis, fee revenue increased $241 million from $772 million, reflecting increases in servicing, management, foreign exchange, brokerage and processing fees and other revenue.

 

Servicing fees are derived from custody, product- and participant-level accounting, daily pricing and administration; master trust and master custody; recordkeeping; performance, risk and compliance analytics; and wealth manager and hedge fund manager services. Servicing fees for the first quarter of 2004 were $555 million, up $117 million, or 27%, from servicing fees of $438 million a year earlier. The increase was primarily attributable to the extra month of servicing fee revenue generated by the GSS business, higher equity market valuations and new business from existing and new clients in 2004.

 

At March 31, 2004, total assets under custody were $9.4 trillion, up 19% from $7.9 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.

 


Mix of Assets Under Custody    March 31, 2004

    December 31, 2003

    March 31, 2003

 
(Dollars in trillions)    Assets   

Percentage

of Total

    Assets    Percentage
of Total
    Assets    Percentage
of Total
 

 
Equities    $ 3,681    39 %   $ 3,479    37 %   $ 2,647    33 %
Fixed income      2,749    29       2,636    28       2,292    29  
Short-term investments      1,226    13       1,176    13       1,032    13  
Acquired GSS      1,766    19       2,079    22       1,939    25  
    

        

        

      
Total    $ 9,422          $ 9,370          $ 7,910       
    

        

        

      

 

 

Management fees from investment management services, primarily delivered through State Street Global Advisors®, were $147 million, compared to $125 million a year ago. Fees from the PAM business added $17 million to 2003 management fees. On an operating basis, management fees were up $39 million, or 36%, from $108 million in 2003, reflecting an increase in average month-end equity valuations and continued new business success. Total assets under management were $1.2 trillion, up 58%, compared to $788 billion the previous year.

 

Securities lending revenue was $64 million in the first quarter of 2004, compared to $55 million in the first quarter of the previous year, an increase of 16%. The increase in securities lending revenue reflected a 47% increase in the volume of securities lent, partially offset by significantly narrower interest rate spreads.

 

Foreign exchange trading revenue was $118 million for the first quarter of 2004 compared to $72 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.

 

Brokerage fee revenue was $45 million in the first quarter, up 51% from $30 million in 2003 due to an increase in transition management for State Street’s clients and growth in electronic trade execution.

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

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 $84 million in the quarter compared to $70 million a year ago, or $69 million on an operating basis. The increase was primarily due to improved performance of the Corporation’s joint ventures.

 

Net Interest Revenue

 

Net interest revenue for the first quarter of 2004 was $203 million, flat to the first quarter of 2003. On an operating, tax-equivalent basis, net interest revenue was $214 million, down $3 million, or 1%, from $217 million in the first quarter of 2003. State Street’s loan portfolio includes leveraged leases, the income from which is included in interest income. Net interest revenue for the first quarter was reduced due to the recording of 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. This charge was partially offset by increased earnings resulting from an increase in the average balance sheet during the quarter. Excluding the reduction related to leveraged leases, net interest revenue would have increased by 8% from the prior year.

 


     Three Months Ended March 31,

 
     2004

    2003

 
(Dollars in millions)   

Average

Balance

   Rate(a)    

Average

Balance

   Rate(a)  

 
Interest-earning assets    $ 81,748    1.95 %   $ 69,705    2.39 %
Interest-bearing liabilities      72,948    1.00       61,456    1.27  
           

        

Excess of rate earned over rate paid           .95 %          1.12 %
           

        

Net interest margin           1.06 %          1.27 %
                            

 
(a)   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.

 

Net interest margin for the three months ended March 31, 2004 was 1.06%, a decline of 21 basis points from the first quarter of 2003. Rates earned in excess of rates paid decreased by 17 basis points year-over-year. These declines are primarily the result of a $19 million lease rebooking charge in the first quarter of 2004. Without this one-time charge, margin would have narrowed by 12 basis points to 1.15% and excess of rates earned over rates paid would have narrowed 8 basis points to 1.04%. Lower asset yields, as maturing assets were reinvested at lower market rates, were responsible for the remainder of the change.

 

Gains on the Sales of Available-for-Sale Securities

 

State Street realized securities gains of $3 million in the first quarter of 2004, compared with gains of $26 million in the first quarter of the prior year.

 

Operating Expenses

 

Operating expenses for the first quarter of 2004 were $908 million, up $74 million from $834 million a year ago. In 2003, the divested PAM business added $12 million to operating expenses. Excluding PAM and merger and integration costs, operating-basis operating expenses were $890 million, up $105 million, or 13%, from 2003. Approximately half of this increase was attributable to an extra, full month of expenses related to the GSS business. Higher incentive compensation and transaction processing expenses contributed to the increase, as well.

 

Salaries and employee benefits expense was $462 million in the first quarter of 2004, compared with $443 million in 2003 on a reported basis, or $436 million excluding PAM. The increase in salaries and employee

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

benefits expense is primarily attributable to the extra month of GSS-related expenses and higher incentive compensation expense due to improved performance in 2004. These increases were significantly offset by lower headcount, which declined from 21,900 at March 31, 2003, to 19,800 at the end of the first quarter of 2004.

 

Transaction processing services expense increased $24 million to $96 million due to substantially higher brokerage volumes.

 

Occupancy expense for the first quarter of 2004 was $90 million, up $19 million on a reported basis, or $20 million on an operating basis from the first quarter 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 $18 million for the quarter, down from $37 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 quarter of 2004 were $103 million, compared with $81 million a year earlier on a reported basis and $77 million a year earlier on an operating basis. State Street recorded a provision for securities processing losses of $17 million in the first quarter of 2004, resulting from unusually high losses during the quarter. This compares to $2 million in the first quarter of 2003. Increases in the costs of professional services and an additional month of GSS-related expenses also contributed to the increase. During the first quarter 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.

 

Income Taxes

 

State Street recorded tax expense of $94 million for the first quarter of 2004, compared to $90 million in the first quarter of 2003. Tax expense for the first quarter of 2004 included a cumulative benefit of $18 million resulting from a change in the effective state tax rate applied to 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 quarter of 2003 included a one-time $25 million after tax charge for a REIT-related tax matter later settled with the Massachusetts Department of Revenue.

 

The effective rate for the first quarter of 2004 was 30%, 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.

 

GSS ACQUISITION UPDATE

 

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 for a premium of $1.1 billion. The purchase price is subject to adjustments based upon performance of the acquired business for the year following the closing. State Street may make additional payments up to an estimated €360 million; however, State Street anticipates that the actual payment will be much less.

 

Excluding merger and integration costs, State Street’s first quarter of 2004 included $.02 per share of net income attributable to the GSS business compared with a loss of $.02 per share a year earlier. The GSS business contributed $160 million to revenue in the first quarter of 2004, net of financing costs, compared with $92 million in the prior

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

year, and added $138 million of expenses in 2004, compared with $92 million in the first quarter of 2003. This comparison reflects two months of recorded operating activity for the GSS business acquired on January 31, 2003, compared with three full months in the first quarter of 2004.

 

Merger and integration costs related to client conversions were $18 million for the first quarter of 2004. State Street’s estimates merger and integration costs of approximately $50 to $60 million for the full year 2004. To date, State Street has completed approximately 70% of the worldwide client conversions, including all clients in the Far East and substantially all clients in the U.S. The Corporation expects to be substantially complete in Europe by the end of 2004, with the exception of Germany, which is expected to be complete by the end of 2005.

 

LINES OF BUSINESS

 

State Street has two primary lines of business - Investment Servicing and Investment Management.

 

Investment Servicing includes custody, 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; wealth manager and hedge fund manager services; and performance, risk and compliance analytics to support institutional investors. State Street’s 50%-owned affiliates, Boston Financial Data Services, Inc. and the International Financial Data Services group of companies, 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 three months ended March 31, 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 State Street’s 50%-owned affiliate, CitiStreet LLC. Revenue from the Investment Management line of business comprised 15% of State Street’s total revenue for the three months ended March 31, 2004.

 

Business Divesture included the revenue and expenses related to the Private Asset Management operations sold in October 2003.

 

Other/One-Time charges for the first three months of 2004 and 2003 included merger and integration costs related to the acquisition of GSS of $18 million and $37 million, respectively.

 

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 included in the financial statements.

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 


     For the Three Months Ended March 31,

     Investment
Servicing


    Investment
Management


    Business
Divestiture


   Other/
One-Time


    Total

(Dollars in millions, except

where otherwise noted)

   2004     2003     2004     2003     2004    2003    2004     2003     2004    2003

Fee Revenue:

                                                                         

Servicing fees

   $ 555     $ 438                                                 $ 555    $ 438

Management fees

               $ 147     $ 108          $ 17                      147      125

Securities lending

     53       47       11       8                                 64      55

Foreign exchange trading

     118       72                                             118      72

Brokerage fees

     45       30                                             45      30

Processing fees and other

     70       64       14       5            1                      84      70
    


 


 


 


      

                  

  

Total fee revenue

     841       651       172       121            18                      1,013      790

Net interest revenue after provision for loan losses

     194       194       9       10                                 203      204

Gains on the sales of available-for-sale investment securities, net

     3       26                                             3      26
    


 


 


 


      

                  

  

Total Revenue

     1,038       871       181       131            18                      1,219      1,020

Operating Expenses

     755       669       135       116            12    $ 18     $ 37       908      834
    


 


 


 


      

  


 


 

  

Income (Loss) Before Income Taxes

   $ 283     $ 202     $ 46     $ 15          $ 6    $ (18 )   $ (37 )   $ 311    $ 186
    


 


 


 


      

  


 


 

  

Pre-tax margin

     27 %     23 %     25 %     12 %                                         
Average assets (billions)    $ 90.6     $ 75.8     $ 2.4     $ 1.8          $ .1                    $ 93.0    $ 77.7

 

Investment Servicing.    Total revenue for the three months ended March 31, 2004, increased $167 million to $1.038 billion, up 19% from the comparable period in 2003, driven by growth in fee revenue, somewhat offset by a decline in gains on sales of available-for-sale securities.

 

Growth in fee revenue of $190 million for the first quarter of 2004 to $841 million was primarily attributable to servicing fees, securities lending, foreign exchange trading and brokerage fee revenue. Servicing fees for the first quarter of 2004 were $555 million, up $117 million, or 27%, from servicing fees a year earlier due to the extra month of servicing fee revenue generated by the GSS business, higher equity market valuations and new business from existing and new clients in 2004. The increase in securities lending revenue reflected a 47% increase in the volume of securities lent, partially offset by significantly narrower interest rate spreads. Foreign exchange trading revenue was $118 million for the first quarter of 2004, an increase of $46 million from a year ago, attributable to significantly higher currency volatility, and higher volumes reflecting increased cross-border investment activities of State Street’s clients. Brokerage fee revenue was $45 million in the first quarter, up 51% from 2003 due to an increase in transition management for State Street’s clients and growth in electronic trade execution.

 

Net interest revenue after provision for loan losses for the first quarter of 2004 was $194 million, unchanged from the first quarter of 2003. Net interest revenue for the first quarter was reduced due to 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. This charge was offset by increased earnings resulting from an increase in the average balance sheet during the quarter.

 

Operating expenses for the first quarter of 2004 were $755 million, up $86 million from the prior year. The majority of the increase was attributable to an extra full month of expenses related to GSS business activity, as well as higher incentive compensation expense.

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

Investment Management.    Total revenue for the first quarter of 2004 was $181 million, up $50 million, from $131 million reported in the first quarter of 2003, representing a $51 million increase in fee revenue and a $1 million decline in net interest revenue after provision for loan losses.

 

Management fees from investment management services, delivered through State Street Global Advisors, were $147 million in the first quarter of 2004 compared to $108 million a year ago, reflecting an increase in average month-end equity valuations and continued new business success.

 

Operating expenses for the three months ended March 31, 2004, were $135 million, up from $116 million a year ago.

 

FINANCIAL GOALS AND FACTORS THAT MAY AFFECT THEM

 

State Street’s primary financial goal is sustainable real growth in operating earnings per share. The Corporation has two supporting goals, one for total operating revenue growth and one for operating return on common stockholders’ equity (ROE). The long-term revenue goal is a 12.5% real, or inflation adjusted, compound annual growth rate of revenue from 2000 through 2010. At present, this equates to approximately a 15% nominal compound annual growth rate. The return on stockholders’ equity goal is 13%-15% for 2004. The Corporation is revisiting this goal during 2004.

 

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

 

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PART I.    ITEM 2.

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RESULTS OF OPERATIONS (continued)

 

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, 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 large and well-capitalized new 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.

 

The Basel Committee on Banking Supervision is in the process of finalizing the New Basel Capital Accord (Basel II). The U.S. Banking and Thrift regulatory agencies have begun the process of U.S. implementation of Basel II through the joint issuance of an Advance Notice of Proposed Rulemaking (“ANPR”) and Draft Supervisory Guidance. After obtaining comments on the ANPR and Draft Guidance, the agencies are expected to release proposed rules for comment, and ultimately final rules. The Corporation cannot predict the final form of the Basel II accord or the related U.S. rules and their impact on the Corporation. However, changes to the risk-based capital guidelines as proposed may adversely affect the Corporation’s capital status.

 

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.

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

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 the Corporation’s 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 rates because interest-bearing liabilities reprice sooner than interest-earning assets. 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, 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. State Street Bank is near this limit; however, available alternatives exist for international expansion by the Corporation and State Street Bank.

 

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 of 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, will adversely affect future results of operations. A decline in the rate at which clients outsource functions such as their internal accounting activities, would also adversely affect results of operations.

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

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.

 

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 March 31, 2004, total gross loans were $5.0 billion. At quarter end, the allowance for loan losses was $36 million, down $25 million from a year ago due to a first quarter reclassification of reserves for off-balance

 

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PART I.    ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS (continued)

 

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 quarter ended March 31, 2004, no provision for loan losses was charged against income; there were no charge-offs and no recoveries. Non-performing assets at March 31, 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. State Street maintains a large portfolio of liquid assets. As of March 31, 2004, the Corporation’s defined liquid assets were $79.5 billion or 86% of total assets, the vast majority of which can be sold on the open market to meet liquidity needs. At March 31, 2004, State Street had defined short-term liabilities of $78.8 billion. State Street had $183 million in pre-tax net unrealized gains on available-for-sale investment securities at March 31, 2004.

 

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. 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 level 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 March 31, 2004, the Corporation’s Tier 1 risk-based capital ratio was 13.9% and State Street Bank’s Tier 1 risk-based capital ratio was 12.3%. These ratios are relatively flat from 14.0% for the Corporation and 12.4% for State Street Bank at year-end 2003. At March 31, 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 5.5% and 5.3%, respectively, at March 31, 2004, exceeding the regulatory minimum of 3% and the well-capitalized threshold of 5%. See Note 11 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 March 31, 2004, 8.3 million shares may be purchased under the stock purchase program. State Street employs a third-party broker-dealer to acquire shares for the Corporation’s stock purchase program on the open market.

 

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 March 31, 2004, the notional amount of these derivative instruments was $452.6 billion, of which $401.0 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:

 

Value at Risk for the three months ended March 31,

 


(Dollars in millions)    Average    Maximum    Minimum

2004:

                    
Foreign exchange products    $ 1.3    $ 3.5    $ .3
Interest rate products      2.4      3.0      1.5
2003:                     
Foreign exchange products    $ .9    $ 2.2    $ .4
Interest rate products      1.6      2.8      1.2

 

State Street compares actual daily profits and losses from trading activities to estimated one-day value at risk. During the first three 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.

 

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PART I.    ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

See information under the caption “Trading Activities: Foreign Exchange and Interest Rate Sensitivity” beginning on page 30.

 

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.

 

PART I.    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 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 March 31, 2004.

 

The Chief Executive Officer and Chief Financial Officer have also 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 March 31, 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

 

Securities industry practices and the mutual fund industry continue to be the subject of intense regulatory, governmental, and public scrutiny. The Corporation and its subsidiaries are broadly involved with the securities industry, including in particular the mutual fund industry. The Corporation has received various regulatory inquiries relating, among other things, to market timing and late trading, and continues to respond to the various requests.

 

In September 2003, the U.S. Securities and Exchange Commission (the “SEC”) disseminated letters throughout the industry requesting information about market timing and late trading activities. State Street responded to that request and since then has engaged in exchanges of requests and information with the SEC. Other regulatory agencies, including the U.S. Department of Labor (the “DOL”), have also distributed broad requests for information relating to market timing and late trading activities. In March 2004, State Street Corporation and some of its subsidiaries received subpoenas from the SEC seeking additional information. State Street continues to respond to the SEC and the requests received from the DOL.

 

ITEM 2.    CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

(a) In January 2003, in connection with its acquisition of the GSS business of Deutsche Bank AG, the Corporation issued $345 million, or 1.7 million units, of SPACES. SPACES are collateralized, forward purchase contract units for shares of Common Stock of the Corporation. Each of the SPACES has a stated amount of $200 and consists of PACES, a fixed-share purchase contract, and U.S. Treasury securities, and COVERS, a variable-share repurchase contract. SPACES are listed on the New York Stock Exchange under the symbol “SBZ”. Effective March 22, 2004, the Corporation 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 Purchase Contract Agreement dated as of January 21, 2003 relating to the units. The variable-share settlement rate has been fixed at 0.6949 shares per contract in accordance with a formula specified in the Purchase Contract Agreement. After the effective date, a holder of the 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.

 

(e) 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 anounced in 1995 and has been increased several times, most recently in December 2001. As of March 31, 2004, the number of shares purchased under the program aggregated 20,571,000, and authorization for the purchase of an additional 8,316,000 shares remained available for purchase under the program. Additionally, shares may be acquired by a consolidated trust for other deferred compensation plans, held by an external trustee, that are not part of the publicly-announced stock purchase program. These shares are purchased in open-market transactions by the trustee. There were no shares purchased by the trust in the quarter ended March 31, 2004. The following table discloses purchase of Common Stock by the Corporation and related information for the three months ended March 31, 2004:

 


(Shares in thousands)    Number
of Shares
Purchased
   Average
Price Per
Share
   Number of
Shares Purchased
Under Publicly-
Announced
Program
   Maximum Number
of Shares Yet to Be
Purchased Under
Program

January 1– January 31, 2004      4    $ 52.00      4    8,316
February 1– February 29, 2004               8,316
March 1– March 31, 2004               8,316
    
  

  
  
     4    $ 52.00    4    8,316
    
  

  
  

 

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ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

Registrant’s annual meeting of stockholders was held on April 21, 2004. At the meeting, the following nominees for Director were elected:

 


     Number of Shares

     For    Withheld

Kennett F. Burnes    271,892,286    3,553,448
David P. Gruber    263,754,882    11,690,852
Linda A. Hill    271,879,353    3,566,381
Charles R. LaMantia    261,788,548    13,657,186
Robert E. Weissman    269,434,516    6,011,218

 

The following directors continue in office: Tenley E. Albright, M.D., Truman S. Casner, Nader F. Darehshori, Arthur L. Goldstein, Ronald E. Logue, Richard P. Sergel, Ronald L. Skates, David A. Spina, Gregory L. Summe, and Diana Chapman Walsh.

 

Also at the meeting, the following action (which required the favorable vote of at least two-thirds of the outstanding shares — or at least 223,676,252 favorable votes — for adoption) was voted upon:

 


     Number of Shares

     For    Against    Abstain or
Not Voting
   Broker
Nonvotes

Vote to exempt the Board of Directors from Massachusetts General Laws, Chapter 156B, Section 50A(a)

   140,089,787    97,622,573    2,387,508    35,345,866

 

ITEM 6.    EXHIBITS AND REPORTS ON FORM 8-K

 

(a) Exhibits

 

The following exhibit is incorporated by reference:

 

Exhibit
Number


    
4    Amended and Restated Rights Agreement, dated as of September 15, 1988, as amended as of September 20, 1990, as amended and restated as of June 18, 1998, and as amended as of April 5, 2004, between State Street Corporation and BankBoston, N.A., as Rights Agent (filed with the Securities and Exchange Commission as Exhibit 99.1 to Registrant’s Current Report on Form 8-K dated April 5, 2004 and incorporated by reference)

 

The following exhibits are included herewith:

 

Exhibit
Number


        Page of this
Report


12    Ratio of earnings to fixed charges    38
15    Letter regarding unaudited interim financial information    39
31.1    Rule 13a-14(a)/15d-14(a) Certification    40
31.2    Rule 13a-14(a)/15d-14(a) Certification    41
32    Section 1350 Certifications    42

 

(b) Current Reports on Form 8-K

 

A current report on Form 8-K dated March 9, 2004, was filed, by the Registrant, on March 9, 2004, to the Securities and Exchange Commission reporting that government agencies have sought information from the

 

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Registrant and its subsidiaries in connection with investigations related to the mutual fund industry and market timing and late trading activities, and on March 5, 2004, the Registrant and some of its subsidiaries received subpoenas from the Securities and Exchange Commission seeking additional information.

 

A current report on Form 8-K dated March 22, 2004, was filed, by the Registrant, on March 29, 2004, to the Securities and Exchange Commission reporting that the Registrant has fixed the variable-share settlement rate of the variable-share repurchase contracts constituting part of the Registrant’s 6.75% SPACES or existing separately as Registrant’s 4.0% Separate COVERS, in accordance with the Purchase Contract Agreement.

 

A current report on Form 8-K dated April 5, 2004, was filed, by the Registrant, on April 5, 2004, to the Securities and Exchange Commission reporting that the Registrant has entered into an amendment to the Amended and Restated Rights Agreement, which eliminates the requirement that certain actions related to redemption may only be taken by Continuing Directors as defined in the Rights Agreement.

 

A current report on Form 8-K dated April 13, 2004, was furnished, by the Registrant, on April 13, 2004, with the Securities and Exchange Commission reporting results of operations and related financial information for its completed first quarter of 2004.

 

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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.

 

   

STATE STREET CORPORATION

Date: May 7, 2004

 

By:

 

/s/    EDWARD J. RESCH        


       

Edward J. Resch,

Executive Vice President

and Chief Financial Officer

 

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EXHIBIT INDEX

 

(filed herewith)

 

12    Ratio of earnings to fixed charges
15    Letter regarding unaudited interim financial information
31.1    Rule 13a-14(a)/15d-14(a) Certification
31.2    Rule 13a-14(a)/15d-14(a) Certification
32    Section 1350 Certifications

 

Pages 38-39 intentionally not included.