http://online.wsj.com/article/BT-CO-...20-714624.html

* JANUARY 20, 2009, 4:35 P.M. ET

3rd UPDATE: State Street Tumbles, Pulls Down Bank Of New York

(Adds information on ratings downgrade by S&P and updates share prices.)

By Marshall Eckblad
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--State Street Corp.'s (STT) widening problems with more
than $23 billion in obscure off-balance-sheet assets sent the Boston bank's
shares tumbling Tuesday.

State Street's growing troubles with complicated assets known as
"conduits" - which depend heavily on the seized-up commercial debt markets -
also dragged down the shares of the other major custodial bank, Bank of New
York Mellon Corp. (BK), which has previously addressed issues with conduits.

Multiple analysts warned that State Street's problems could eventually lead
the firm to raise more capital, which would dilute existing shareholders.
State Street did not announce any such plans on Tuesday, even as it posted
sharply lower fourth-quarter earnings and said its earnings for 2009 will
likely be lower than previously forecast.

In after-hours trading, State Street were down 4.5%% to $14.22, adding to a
59% decline during the regular session. Bank of New York's shares were
recently up 0.5% to $19.09, after falling 17% during the regular session.

State Street and Bank of New York are both "custodial banks," which occupy a
once-sleepy corner of the finance world. Unlike most commercial banks, which
typically write heavy volumes of commercial and consumer loans, custodial
banks' central business is to hold securities on behalf of other investors.

But these banks also have smaller side businesses - like managing
money-market funds and sponsoring conduits - that have weighed down earnings
in recent quarters.

Both State Street and Bank of New York in September fought off a panic among
investors by insisting that they weren't being hit with the souring
investments that had plagued other banks. In October, when both banks
participated in the first round of government investments in banks, they
characterized the money as a vote of confidence, rather than indicating any
need for capital on their part.

State Street set off alarm bells on Friday, when it filed a document with
the Securities and Exchange Commission after the markets closed, warning
investors that its issues had grown more precarious.

Among State Street's problems are needing to support money-market vehicles
that have dropped below $1 a share in value, and investments that have
fallen in value.

Another serious, and somewhat esoteric, problem for State Street stems from
off-balance-sheet contracts called conduits. In these conduits, the bank
allows commercial clients to exchange various assets, like accounts
receivable or mortgage loans, for cash. In order to raise cash to make the
conduit payments, the bank typically issues debt from the conduit to other
investors, and then repays those investors as the client's cash receivables
or other assets pay off as scheduled.

As a result, the bank typically earned a fee for matching clients with the
debt purchasers, but did not invest in these assets itself.

Since most of that debt is short term in nature, and must be renewed every
month or so, State Street must find new investors to buy that debt, or even
front the capital itself, if no buyers show up.

Likewise, the conduits can hit the bank with tangible losses if they end up
paying debt investors higher interest rates than the assets held by the
conduits earn.

And finally, State Street could eventually be forced by complicated
accounting rules to bring the conduits onto its balance sheet, where it must
carry the associated securities at current market value. Since much
commercial debt and other securities have fallen steeply in value amid a
freezing of credit markets, State Street could immediately post heavy
unrealized losses should it bring the conduits onto its balance sheet.

Bank of New York holds about $4 billion in conduit-related assets in its
investment portfolio after it consolidated those assets onto its balance
sheet last year, posting a $180 million charge.

But State Street's option of consolidating the conduits it sponsors could
have more severe consequences.

If the bank converts the conduits into balance sheet assets, it will saddle
itself with billions in new assets, probably forcing it to raise capital to
support those assets.

The firm's tangible common equity ratio - which measures how much of a
bank's total assets the common shareholders actually own - would shrink to
levels where regulators typically demand that a bank raise new capital.

Gerard Cassidy, an analyst at RBC Capital Markets, said that if State Street
consolidated its conduits, its tangible common equity ratio would fall to
1.05%, from its third quarter level of 3.05%.

To boost that low ratio could require raising billions in new capital by
issuing shares, finding a buyer for all or part of its operations, or
accepting more capital from the federal government.

"I estimate that the consolidation could cause the company to seek $4.8
billion in new equity or sell 140 million new shares, which may not be
possible in this market," said Richard Bove, an analyst at Ladenburg
Thalmann & Co. Inc., in a note to investors.

Later Tuesday, Standard & Poor's Ratings Services downgraded State Street
and its units by a notch, including a cut to State Street's counterparty
credit rating to A+/A-1. The downgrade reflected more than $1.2 billion of
special charges over the past five quarters, unrealized losses in the
company's bond portfolio and off-balance-sheet conduits and new risks
regarding the valuation of collateral entering and exiting from cash
collateral managed for securities-lending participants. The outlook is
negative.

Earnings Erode

State Street posted dramatically lower earnings on Tuesday, adding to
investors' concern.

State Street Corp.'s fourth-quarter net income slid 71% on steps the asset
manager took to shore up some funds and restructuring charges. Moreover, the
firm said it expects flat results for 2009.

That forecast, which compares with 2008's $5.21 and the $4.71 expected for
2009 by analysts surveyed by Thomson Reuters, is below the company's
long-term goal of 10% to 15% growth.

Unrealized mark-to-market losses at State Street's investment portfolio more
than doubled during the quarter to $6.3 billion, which it blamed on the
ongoing market illiquidity. The figure dropped by $400 million as of Friday.

As part of the U.S. Treasury's capital purchase program, the Treasury bought
stakes in State Street and is investing $2 billion in the money manager.
State Street, which provides large financial institutions safekeeping for
stocks and assets, was also hired to serve as a custodian in the
government's efforts to revitalize the markets.

(Shirleen Dorman and Jay Miller contributed to this report.)

-By Marshall Eckblad, Dow Jones Newswires; 201-938-4306;