State Street Bank's Troubles

State Street Bank has now joined the ranks of US commercial banks experiencing problems from asset value declines.

I provided consulting to the bank's then-CEO, Marsh Carter, some years ago, in the company of my mentor and one-time boss, Gerald Weiss. The three of us knew each other well from our days at Chase Manhattan Bank, and Gerry was a more or less permanent, personal consultant to Carter when he ran State Street.

From the work I did for the company in 1997-98, I recall that the bank's primary competitive advantage was, and probably still is, its immense custody function. As a result of bidding a low price to service pension fund custody needs, the company knew where to locate quite a few securities, as well as became the institutional broker for trades from those customer accounts.

With this huge front end asset servicing business, State Street's other, downstream businesses could make money as a result of information about these securities. All perfectly legal.

Among the bank's least-related businesses was its own asset management group. The current CEO, Ron Logue, headed that group back when I consulted with the firm. So it's rather ironic that, now, the Wall Street Journal reported yesterday that Logue cited the asset management business as the source of the bank's current losses.

On Friday, it disclosed- unexpectedly- that it had some $9.1B of unrealized portfolio losses.

I haven't followed State Street very closely since Carter departed. He went on to become chairman of the NYSE in the wake of John Reed's departure. His successor, David Spina, was a somewhat myopic, cost-conscious operations executive who never understood that the key to State Street's long term ability to earn consistently superior returns was the investment in its ability to process more diverse and foreign-sourced assets, in support of its main customer base, US pension and other large asset funds.

I have no idea how it came to pass that Logue, an outsider to the bank's core functions, has eventually become CEO. But to read that State Street now has problems involving off-balance sheet conduits and other asset quality issues makes it sound like it began to operate more like Citigroup, and less like the less-risky, fee-based custody and processing bank it has historically been.

As the nearby price chart for State Street and the S&P500 Index shows, the company enjoyed a period of fairly consistent outperformance of the index from 1991 through about 1998. It was at that point that my consulting findings predicted that, if management failed to change some operational parameters, it would see a corresponding decline in its future total returns, relative to the S&P. Only a few days after my final presentation, the bank reported results which triggered a 10% drop in the price of the firm's equity in a single day.

Since that time, State Street's performance has been about the same as the index's. As I expected, Spina's cost focus eventually ended the firm's ability to continue benefiting from its massive market share. I would venture to guess, not having access to internal financial information, that State Street's market shares in key custody segments either eroded, or became less profitable.

Thus, it is understandable that they began to look to unrelated asset management units to make up the shortfall. But, in this area, the bank had no particular competitive advantage.

But in the last decade, it would have been fairly easy for even mediocre asset management by those units to offset the falling custody profitability and provide Logue with his ticket to the top job.

It is, in my opinion, yet another example of how failure to understand and manage a company's core businesses can result in a serious failure due to the attempt to maintain performance in the face of changing business realities. Either State Street's main business began to grow much more slowly, signaling an end to its natural period of consistent market outperformance, or they attempted to harvest the business prematurely. In either case, by using ever-riskier asset management to offset this decline, the once-conservatively managed bank has now joined so many other US commercial banks in requiring Federal money to stave off the effects of serious losses due to badly chosen business actions in the past few years.