TEXT-S&P says State Street Corp ratings unaffected by Q2 results

July 17 - Standard & Poor's Ratings Services today said that its ratings on State Street Corp. (STT; A+/Negative/A-1) are not affected by the company's solid second-quarter earnings, which reflect flat fee revenue and lower compensation expenses than the first quarter of 2012. Positively, STT continues to exhibit good new business growth in its core asset servicing business. However, we recognize that, in coming quarters, possible volatile market valuations may continue to dampen asset servicing and asset management fees, and net interest revenue may be further hindered by very low interest rates. STT's ratings are also not affected by the company's announcement that it has agreed to acquire Goldman Sachs Administrative Services (GSAS), a hedge fund administration business, for $550 million in cash. The acquisition would add about $200 billion in servicing assets to STT's already industry-leading hedge fund administration business ($877 billion of assets under administration as of June 30, 2012). We believe this acquisition fits well into STT's business platform and growth strategy. However, we view the cash outlay unfavorably from a credit perspective, especially given STT's already aggressive, in our view, capital deployment for share repurchases. The company estimates this all-cash transaction would reduce its Basel 1 Tier 1 risk-based capital ratio by 75-80 basis points. STT's net income available to shareholders rose to $480 million in the second quarter from $417 million, sequentially, mainly reflecting the absence of first quarter's elevated compensation expenses. We estimate that the adjusted pretax operating margin in the quarter was approximately 27%, which is within our expectations for the ratings. Total operating revenue (including a small loss on Greek investment securities) was down about 1%, sequentially, as asset servicing fees were flat, trading services revenue was down, and securities lending revenue was seasonally higher. Assets under custody and administration of $22.4 trillion dipped 3%, while assets under management of $1.9 trillion declined 4% during the quarter, largely reflecting lower equity valuations, which net new business partly offset. Although still dampened by low interest rates, net interest revenue increased 4% sequentially, supported by some further growth in the company's securities portfolio and lower funding costs. The net interest margin (NIM) rose to 1.54% from 1.52% in the first quarter, but the company expects the NIM may narrow in the second half of 2012. Operating expenses declined 4%, sequentially, reflecting a sharp drop in compensation expenses from the first quarter's elevated levels. STT repurchased $480 million of its common shares in the quarter, and we expect the company will continue to be active in its $1.8 billion common stock buyback program announced in mid-March. We view this buyback program as large, and we consider the company's priority of returning capital to shareholders as a negative factor from a credit perspective. However, our rating assumes that the company will repurchase shares at a measured, quarterly pace and that its total payout will not exceed 80% of net income in 2012. STT estimated that its Basel III Tier 1 Common ratio, incorporating recent rules proposed by the Federal Reserve Bank, would be 9.8% as of June 30, 2012. This is significantly lower than the company's estimate of 12.7% as of June 30, using the original Basel III requirements. The negative outlook on STT reflects our negative outlook on the U.S. sovereign rating because we incorporate one notch of uplift into our ratings on STT based on our expectation for potential extraordinary U.S. government support. Otherwise, we view STT's fundamental trends as stable. We expect that STT's overall financial performance should remain satisfactory, with a pretax operating margin of mid-20%, although earnings performance may be subdued because of persistent low interest rates. Furthermore, our rating assumes that STT will increase and maintain its Standard & Poor's risk-adjusted capital (RAC) ratio to above 7% over approximately the next two years, despite its common share repurchases. We believe that capital deployment for the GSAS acquisition will slow this capital ratio growth, and we would view negatively additional significant cash-financed acquisitions. If STT's capital management actions lead us to expect that its RAC ratio will decline below 7% for a sustained period of time, we could lower the ratings.