4/15/2008: State Street's unrealized mark to market losses

Excerpt from State Street's Q108 conference call (starting at about 24 minutes in)

Ed Resch, CFO of State Street:

A lot has been said over the past few months and quarters regarding the extraordinary events impacting the fixed income markets. These are not ordinary times and these are not orderly markets. Despite the high credit quality of the investment portfolio, the illiquidity in the marketplace and resulting prices affecting fixed income securities have caused the unrealized pre-tax loss on our portfolio to increase to $3.2B at 3/31/2008, up from an unrealized pre-tax loss of $1.1B at 12/31/2007, and an unrealized pre-tax loss of $309M a year ago. We believe that these prices are not reflective of the underlying value of the securities. Several examples will help me illustrate that point.

Look at the element of the portfolio we hold in student loans, about $9.2B, the vast majority, about 90% of which is covered by a 97% Federal government guarantee. At 12/31/2007, these securities were trading at 98% of par. Today, they are trading at 92% of par. There has been no significant change in the credit quality of these securities, so what are the markets telling us? I think that the market is confirming that it is illiquid. In fact, there are few buyers or few sellers at this price.

Or look at the 18 subprime securities that the rating agencies put on credit watch at the end of January. They just recently reaffirmed the ratings on 17 of these, leaving only one on watch due to its downgrade of its insurance wrap provider. They are all rated AA, but are priced between 40% and 89% of par at March month end.

These are just two examples of the impact that the current market dislocations and sporadic forced selling have had on market prices for investment grade bonds. We continue to believe that our portfolio is not at risk of permanent impairment and is not currently other than temporarily impaired. We base this belief on the results of the extensive credit analysis we have performed and continue to perform on the portfolio and believe that we will recover the principal at maturity.

I would like to stop here and provide you with a deeper look into the securities within the portfolio. If you would turn to Slide 3 in the Investment Portfolio Slide Package, you can see some of the data I am presenting. First, 15 securities have been downgraded as of 3/31/2008. These 15 securities do not include those securities that were downgraded based on downgrades of the insurance wrap provider. Based on the total number [535] of securities downgraded by the rating agencies during the past two quarters, we believe the number of rating agency actions affecting our securities is very modest and is a testimony to the quality of the assets in our portfolio.

Lastly, I'll address the asset-backed securities that are collateralized by first-lien subprime mortgages, a portfolio which I have been commenting on since the second quarter of last year. This section of the portfolio has a $933M unrealized pre-tax loss at 3/31/2008, which is about 1/3 of the total unrealized pre-tax mark-to-market loss for the entire portfolio. If you turn to slides 4 and 5, first of all, the portfolio has performed as we have expected. Our portfolio of asset-backed securities collateralized by subprime mortgages is $5.9B as of 3/31/2008, down from $6.2B as of 12/31/2007. 70% of the portfolio is rated AAA and the remaining 30% is rated AA. 3 of the securities have been downgraded, again a very small number in light of the downgrades issued by the rating agencies over the last few quarters. We have a 41% average credit enhancement based on the structure itself, which gives us confidence that these securities will mature at par. You can see this credit enhancement grow over time with pay downs that we've received. Last March, the credit enhancement was 34%, which has increased to the 41% I mentioned as of 3/31/2008. This means that even if every mortgage backing an asset were to default, we would not lose one dollar until the recovery rate for those assets fell below 59%. And further we believe the assets are well-diversified by vintage, geography, and originator. As I just noted, the negative mark-to-market on this portion of the portfolio has increased to about $933M with no securities on credit watch. Since so many securities in this category have been downgraded industry-wide over the past two quarters, we have confidence that our credit process at State Street has served us well to date and that we expect these securities to mature at par.

However, during the quarter we recorded $11.5M in other than temporary impairment, which was one asset-backed security collateralized by HELOC's and wrapped by FGIC as the insurance provider. Based on our credit analysis of the underlying collateral, and our assessment of the wrap provider, we concluded that a portion of the fair value decline was attributable to credit, and therefore we wrote the security down to its current fair value.

If you review slides 6 through 8, you can also get some further detail about the monoline coverage we have on the portfolio, mostly in the municipal bond book. Note that our overall rating would decline only slightly, from 94% to 92%, if all the wraps were simultaneously removed. The last slide gives you a breakdown of the assets by wrap provider, where you can see that 99% of the coverages is due to the municipal bond investments, usually a very high performing asset class.

So, in conclusion to my remarks on the unrealized mark-to-market loss in the securities portfolio, why do we have such confidence in our portfolio when many others are writing down assets? We are very selective in the assets we buy and put these choices through a rigorous credit process. On an ongoing basis, we monitor the performance of these securities and have found them all to be performing well. Our investment portfolio consists of securities with significant levels of structural credit enhancement, which provides protection against difficult economic environments. I hope my remarks have given you some comfort in reviewing our portfolio so that you can understand the source of our confidence.