** **

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10–Q**

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**(Mark One)**

**ý**        QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the Quarterly period ended September 30, 2001**

**or**

**o**        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the Transition period from _____ to _____**

**0–26996****(Commission File Number)**

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**INVESTORS FINANCIAL SERVICES CORP.**

(Exact name of registrantas specified in its charter)

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| **Delaware**                                                      | **04–3279817**               |
|-------------------------------------------------------------------|-----------------------------------|
| (State or other  jurisdiction of   incorporation or organization) | (IRS Employer Identification No.) |
|                                                              |                              |
| **200  Clarendon Street,  P.O. Box 9130, Boston, MA**             | **02117–9130**               |
| (Address of principal executive offices)                          | (Zip Code)                        |

** **

| **(617) 937–6700**                                    |
|------------------------------------------------------------|
| (Registrant’s telephone  number, including area code) |

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ýNo o

Asof October 31, 2001 there were 31,903,481 shares of Common Stock outstanding.

 

 

 

**INVESTORS FINANCIALSERVICES CORP.**

**INDEX**
|           |                                                                                                                              |   |   |
|----------------|-----------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| **PART I.**    | **FINANCIAL INFORMATION**                                                                                                         |   |   |
|           |                                                                                                                              |   |   |
| Item  1.       | Condensed  Consolidated Financial Statements                                                                                      |   |   |
|           |                                                                                                                              |   |   |
|           | Condensed  Consolidated Balance Sheets  September  30, 2001 (unaudited) and December 31, 2000 (audited)                      |   |   |
|           |                                                                                                                              |   |   |
|           | Condensed  Consolidated Statements of Income and Comprehensive Income (unaudited) Nine  months ended September 30, 2001 and 2000  |   |   |
|           |                                                                                                                              |   |   |
|           | Condensed  Consolidated Statements of Income and Comprehensive Income (unaudited) Three  months ended September 30, 2001 and 2000 |   |   |
|           |                                                                                                                              |   |   |
|           | Condensed  Consolidated Statements of Stockholders’ Equity (unaudited) Nine months ended  September 30, 2001 and 2000        |   |   |
|           |                                                                                                                              |   |   |
|           | Condensed  Consolidated Statements of Cash Flows (unaudited) Nine months ended September  30, 2001 and 2000                       |   |   |
|           |                                                                                                                              |   |   |
|           | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                 |   |   |
|           |                                                                                                                              |   |   |
| Item  2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                       |   |   |
|           |                                                                                                                              |   |   |
| Item  3.       | Quantitative  and Qualitative Disclosure about Market Risk                                                                        |   |   |
|           |                                                                                                                              |   |   |
| **PART II.**   | **OTHER INFORMATION**                                                                                                             |   |   |
|           |                                                                                                                              |   |   |
| Item 6.        | Exhibits and  Reports on Form 8-K                                                                                                 |   |   |
|           |                                                                                                                              |   |   |
| **SIGNATURES** |                                                                                                                              |   |
|           |                                                                                                                              |   |   |

 

 

**PART I. FINANCIALINFORMATION**

**Item1.            Condensed ConsolidatedFinancial Statements**

**INVESTORS FINANCIAL SERVICES CORP.CONDENSED CONSOLIDATED BALANCESHEETSSeptember 30, 2001 and December 31, 2000(Dollars in thousands, except per share data)**

 
|                                                                                                                                                                                                                                |   | **September 30,  2001  (unaudited)** |       | **December 31,  2000** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                                                                |   |                                 | ** ** |                        | ** ** |
| **Assets**                                                                                                                                                                                                                          |   |                                 |       |                        |       |
| Cash and due  from banks                                                                                                                                                                                                            |   | $                                    | 17,846     |                        | $          | 30,489 |   |
| Federal funds  sold                                                                                                                                                                                                                 |   | 90,000                               |       | 450,000                     |       |
| Securities  available for sale                                                                                                                                                                                                      |   | 1,486,432                            |       | 772,333                     |       |
| Securities held  to maturity (approximate fair value of $3,245,655 and $2,287,602  at September 30, 2001 and  December 31, 2000, respectively)                                                                            |   | 3,207,988                            |       | 2,299,294                   |       |
| Non–marketable  equity securities                                                                                                                                                                                              |   | 50,000                               |       | 15,000                      |       |
| Loans, less  allowance for loan losses of $100 at September 30, 2001 and December 31,  2000                                                                                                                                    |   | 137,829                              |       | 129,269                     |       |
| Accrued interest  and fees receivable                                                                                                                                                                                               |   | 74,311                               |       | 48,003                      |       |
| Equipment and  leasehold improvements, less accumulated depreciation of $12,272 and $10,563  at September 30, 2001 and December 31, 2000, respectively                                                                         |   | 37,165                               |       | 15,086                      |       |
| Goodwill, net                                                                                                                                                                                                                       |   | 80,912                               |       | 34,094                      |       |
| Other assets                                                                                                                                                                                                                        |   | 42,567                               |       | 17,547                      |       |
| **Total Assets**                                                                                                                                                                                                                    |   | $                                    | 5,225,050  |                        | $          | 3,811,115 |   |
|                                                                                                                                                                                                                                |   |                                 |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                      |   |                                 |       |                        |       |
| **Liabilities:**                                                                                                                                                                                                                    |   |                                 |       |                        |       |
| Deposits:                                                                                                                                                                                                                           |   |                                 |       |                        |       |
| Demand                                                                                                                                                                                                                              |   | $                                    | 344,955    |                        | $          | 362,946 |   |
| Savings                                                                                                                                                                                                                             |   | 1,866,680                            |       | 1,903,938                   |       |
| Time                                                                                                                                                                                                                                |   | 90,000                               |       | 65,000                      |       |
| Total deposits                                                                                                                                                                                                                      |   | 2,301,635                            |       | 2,331,884                   |       |
|                                                                                                                                                                                                                                |   |                                 |       |                        |       |
| Securities sold  under repurchase agreements                                                                                                                                                                                        |   | 1,569,679                            |       | 1,251,725                   |       |
| Short-term and  other borrowings                                                                                                                                                                                                    |   | 915,546                              |       | 246                         |       |
| Other  liabilities                                                                                                                                                                                                                  |   | 78,341                               |       | 24,206                      |       |
| Total  liabilities                                                                                                                                                                                                                  |   | 4,865,201                            |       | 3,608,061                   |       |
|                                                                                                                                                                                                                                |   |                                 |       |                        |       |
| Commitments and  contingencies                                                                                                                                                                                                      |   | -                                    |       | -                           |       |
|                                                                                                                                                                                                                                |   |                                 |       |                        |       |
| Company–obligated,  mandatorily redeemable, preferred securities of subsidiary trust holding  solely junior subordinated deferrable interest debentures of the Company                                                         |   | 24,267                               |       | 24,246                      |       |
|                                                                                                                                                                                                                                |   |                                 |       |                        |       |
| **Stockholders’ Equity:**                                                                                                                                                                                                      |   |                                 |       |                        |       |
| Preferred stock,  par value $0.01 (shares authorized: 1,000,000; issued and outstanding: 0 at  September 30, 2001 and December 31, 2000)                                                                                       |   | -                                    |       | -                           |       |
| Common stock,  par value $0.01 (shares authorized: 100,000,000 at September 30, 2001 and  40,000,000 at December 31, 2000; issued and outstanding: 31,887,166 at  September 30, 2001 and 29,912,711 at December 31, 2000) |   | 319                                  |       | 299                         |       |
| Surplus                                                                                                                                                                                                                             |   | 217,962                              |       | 95,007                      |       |
| Deferred  compensation                                                                                                                                                                                                              |   | (475                                 | )          | (247                        | )          |
| Retained  earnings                                                                                                                                                                                                                  |   | 119,034                              |       | 85,188                      |       |
| Accumulated  other comprehensive loss, net                                                                                                                                                                                          |   | (1,258                               | )          | (1,439                      | )          |
| Treasury stock,  par value $0.01 (10,814 shares at September 30, 2001 and December 31,  2000)                                                                                                                                  |   | -                                    |       | -                           |       |
| Total  stockholders’ equity                                                                                                                                                                                                    |   | 335,582                              |       | 178,808                     |       |
| **Total Liabilities and Stockholders’  Equity**                                                                                                                                                                                |   | $                                    | 5,225,050  |                        | $          | 3,811,115 |   |

*See Notes to CondensedConsolidated Financial Statements.*

 

 

** **

**INVESTORSFINANCIAL SERVICES CORP.CONDENSED CONSOLIDATED STATEMENTSOF INCOME AND COMPREHENSIVE INCOME (unaudited)Nine Months Ended September 30, 2001 and 2000(Dollars in thousands, except per share data)**

 
|                                                                                                                                                |   | **September 30,  2001** |       | **September 30,**

**2000** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-----------------------------|------------|
| **Operating Revenue:**                                                                                                                              |   |                    | ** ** |                        | ** ** |
| Interest income:                                                                                                                                    |   |                    |       |                        |       |
| Federal funds  sold and securities purchased under resale agreements                                                                                |   | $                       | 1,611      |                        | $          | 2,037 |   |
| Investment  securities held to maturity and available for sale                                                                                      |   | 184,774                 |       | 120,878                     |       |
| Loans                                                                                                                                               |   | 4,279                   |       | 4,400                       |       |
| Total interest  income                                                                                                                              |   | 190,664                 |       | 127,315                     |       |
| Interest  expense:                                                                                                                                  |   |                    |       |                        |       |
| Deposits                                                                                                                                            |   | 53,147                  |       | 40,885                      |       |
| Short-term and  other borrowings                                                                                                                    |   | 60,075                  |       | 45,003                      |       |
| Total interest  expense                                                                                                                             |   | 113,222                 |       | 85,888                      |       |
| Net interest  income                                                                                                                                |   | 77,442                  |       | 41,427                      |       |
|                                                                                                                                                |   |                    |       |                        |       |
| Noninterest  income:                                                                                                                                |   |                    |       |                        |       |
| Asset servicing  fees                                                                                                                               |   | 173,107                 |       | 119,206                     |       |
| Other operating  income                                                                                                                             |   | 2,378                   |       | 1,560                       |       |
| Net operating  revenue                                                                                                                              |   | 252,927                 |       | 162,193                     |       |
|                                                                                                                                                |   |                    |       |                        |       |
| **Operating Expenses:**                                                                                                                             |   |                    |       |                        |       |
| Compensation and  benefits                                                                                                                          |   | 120,395                 |       | 76,360                      |       |
| Technology and  telecommunications                                                                                                                  |   | 27,157                  |       | 16,538                      |       |
| Transaction  processing services                                                                                                                    |   | 14,588                  |       | 7,447                       |       |
| Occupancy                                                                                                                                           |   | 12,649                  |       | 8,008                       |       |
| Depreciation and  amortization                                                                                                                      |   | 5,781                   |       | 3,367                       |       |
| Travel and sales  promotion                                                                                                                         |   | 4,064                   |       | 2,599                       |       |
| Professional  fees                                                                                                                                  |   | 2,787                   |       | 2,059                       |       |
| Amortization of  goodwill                                                                                                                           |   | 2,565                   |       | 1,201                       |       |
| Other operating  expenses                                                                                                                           |   | 9,647                   |       | 7,235                       |       |
| Total operating  expenses                                                                                                                           |   | 199,633                 |       | 124,814                     |       |
|                                                                                                                                                |   |                    |       |                        |       |
| **Income Before Income Taxes and  Minority Interest**                                                                                               |   | 53,294                  |       | 37,379                      |       |
|                                                                                                                                                |   |                    |       |                        |       |
| Provision for  income taxes                                                                                                                         |   | 16,384                  |       | 12,016                      |       |
| Minority  interest expense, net of income taxes                                                                                                     |   | 1,191                   |       | 1,191                       |       |
| **Net Income**                                                                                                                                      |   | $                       | 35,719     |                        | $          | 24,172 |   |
| **Basic Earnings Per Share**                                                                                                                        |   | $                       | 1.13       |                        | $          | 0.81 |   |
| **Diluted Earnings Per Share**                                                                                                                      |   | $                       | 1.09       |                        | $          | 0.78 |   |
|                                                                                                                                                |   |                    |       |                        |       |
| **Comprehensive Income:**                                                                                                                           |   |                    |       |                        |       |
| Net income                                                                                                                                          |   | $                       | 35,719     |                        | $          | 24,172 |   |
| Other comprehensive  income/(loss) net of tax of $97 and ($205) for the nine months ended September  30, 2001 and September 30, 2000, respectively: |   |                    |       |                        |       |
| Cumulative  effect of a change in accounting principle                                                                                              |   | (3,934                  | )          | -                           |       |
| Net unrealized  investment gain/(loss)                                                                                                              |   | 14,746                  |       | (438                        | )          |
| Net unrealized  derivative instrument loss                                                                                                          |   | (10,631                 | )          | -                           |       |
| Other comprehensive  income/(loss)                                                                                                                  |   | 181                     |       | (438                        | )          |
| Comprehensive  income                                                                                                                               |   | $                       | 35,900     |                        | $          | 23,734 |   |

*See Notes to CondensedConsolidated Financial Statements.*

** **

 

**INVESTORSFINANCIAL SERVICES CORP.CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited)Three Months Ended September 30, 2001 and 2000(Dollars in thousands, except per share data)**

 
|                                                                                                                                                          |   | **September 30,  2001** |       | **September 30,  2000** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------------|------------|
| **Operating Revenue:**                                                                                                                                        |   |                    | ** ** |                    | ** ** |
| Interest income:                                                                                                                                              |   |                    |       |                    |       |
| Federal funds  sold and securities purchased under resale agreements                                                                                          |   | $                       | 415        |                    | $          | 775 |   |
| Investment  securities held to maturity and available for sale                                                                                                |   | 64,200                  |       | 45,191                  |       |
| Loans                                                                                                                                                         |   | 1,431                   |       | 1,588                   |       |
| Total interest  income                                                                                                                                        |   | 66,046                  |       | 47,554                  |       |
| Interest  expense:                                                                                                                                            |   |                    |       |                    |       |
| Deposits                                                                                                                                                      |   | 16,417                  |       | 15,529                  |       |
| Short-term and  other borrowings                                                                                                                              |   | 20,601                  |       | 16,585                  |       |
| Total interest  expense                                                                                                                                       |   | 37,018                  |       | 32,114                  |       |
| Net interest  income                                                                                                                                          |   | 29,028                  |       | 15,440                  |       |
|                                                                                                                                                          |   |                    |       |                    |       |
| Noninterest  income:                                                                                                                                          |   |                    |       |                    |       |
| Asset servicing  fees                                                                                                                                         |   | 64,617                  |       | 40,051                  |       |
| Other operating  income                                                                                                                                       |   | 829                     |       | 757                     |       |
| Net operating  revenue                                                                                                                                        |   | 94,474                  |       | 56,248                  |       |
|                                                                                                                                                          |   |                    |       |                    |       |
| **Operating Expenses:**                                                                                                                                       |   |                    |       |                    |       |
| Compensation and  benefits                                                                                                                                    |   | 44,879                  |       | 25,949                  |       |
| Technology and  telecommunications                                                                                                                            |   | 8,660                   |       | 6,383                   |       |
| Transaction  processing services                                                                                                                              |   | 6,949                   |       | 2,434                   |       |
| Occupancy                                                                                                                                                     |   | 4,847                   |       | 2,901                   |       |
| Depreciation and  amortization                                                                                                                                |   | 2,558                   |       | 1,177                   |       |
| Travel and sales  promotion                                                                                                                                   |   | 1,670                   |       | 1,079                   |       |
| Amortization of  goodwill                                                                                                                                     |   | 992                     |       | 375                     |       |
| Professional  fees                                                                                                                                            |   | 892                     |       | 493                     |       |
| Other operating  expenses                                                                                                                                     |   | 3,161                   |       | 1,927                   |       |
| Total operating  expenses                                                                                                                                     |   | 74,608                  |       | 42,718                  |       |
|                                                                                                                                                          |   |                    |       |                    |       |
| **Income Before Income Taxes and Minority  Interest**                                                                                                         |   | 19,866                  |       | 13,530                  |       |
|                                                                                                                                                          |   |                    |       |                    |       |
| Provision for  income taxes                                                                                                                                   |   | 5,990                   |       | 4,348                   |       |
| Minority  interest expense, net of income taxes                                                                                                               |   | 397                     |       | 397                     |       |
| **Net Income**                                                                                                                                                |   | $                       | 13,479     |                    | $          | 8,785 |   |
| **Basic Earnings Per Share**                                                                                                                                  |   | $                       | 0.42       |                    | $          | 0.29 |   |
| **Diluted Earnings Per Share**                                                                                                                                |   | $                       | 0.41       |                    | $          | 0.28 |   |
|                                                                                                                                                          |   |                    |       |                    |       |
| **Comprehensive Income:**                                                                                                                                     |   |                    |       |                    |       |
| Net income                                                                                                                                                    |   | $                       | 13,479     |                    | $          | 8,785 |   |
| Other comprehensive  income/(loss) net of tax of $1,844 and ($171) for the three months ended  September 30, 2001 and September 30, 2000,  respectively: |   |                    |       |                    |       |
| Net unrealized  investment gain/(loss)                                                                                                                        |   | 12,427                  |       | (365                    | )          |
| Net unrealized  derivative instrument loss                                                                                                                    |   | (9,003                  | )          | -                       |       |
| Other  comprehensive income/(loss)                                                                                                                            |   | 3,424                   |       | (365                    | )          |
| Comprehensive  income                                                                                                                                         |   | $                       | 16,903     |                    | $          | 8,420 |   |

*See Notes to CondensedConsolidated Financial Statements.*

 

 

**INVESTORSFINANCIAL SERVICES CORP.CONDENSED CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY (unaudited)Nine Months Ended September 30, 2001 and 2000(Dollars in thousands, except per share data)**

** **
|                                                                                                       |   | **September 30,  2001** |       | **September 30,  2000** |       |
|------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------------|------------|
| **Common shares**                                                                                          |   |                    | ** ** |                    | ** ** |
| Balance, beginning of period                                                                               |   | 29,912,711              |       | 14,610,154              |       |
| Exercise of stock options                                                                                  |   | 329,322                 |       | 357,375                 |       |
| Common stock issuance                                                                                      |   | 1,645,133               |       | -                       |       |
| Stock dividend, two-for-one split                                                                          |   | -                       |       | 14,858,146              |       |
| Balance, end of period                                                                                     |   | 31,887,166              |       | 29,825,675              |       |
|                                                                                                       |   |                    |       |                    |       |
| **Treasury shares**                                                                                        |   |                    | ** ** |                    | ** ** |
| Balance, beginning of period                                                                               |   | 10,814                  |       | 10,814                  |       |
| Balance, end of period                                                                                     |   | 10,814                  |       | 10,814                  |       |
|                                                                                                       |   |                    |       |                    |       |
| **Common stock**                                                                                           |   |                    | ** ** |                    | ** ** |
| Balance, beginning of period                                                                               |   | $                       | 299        |                    | $          | 146 |   |
| Exercise of stock options                                                                                  |   | 4                       |       | 3                       |       |
| Common stock issuance                                                                                      |   | 16                      |       | -                       |       |
| Stock dividend, two-for one split                                                                          |   | -                       |       | 149                     |       |
| Balance, end of period                                                                                     |   | 319                     |       | 298                     |       |
|                                                                                                       |   |                    |       |                    |       |
| **Surplus**                                                                                                |   |                    |       |                    |       |
| Balance, beginning of period                                                                               |   | 95,007                  |       | 87,320                  |       |
| Exercise of stock options                                                                                  |   | 1,719                   |       | 2,606                   |       |
| Tax benefit from exercise of stock options                                                                 |   | 3,875                   |       | 2,499                   |       |
| Common stock issuance                                                                                      |   | 117,361                 |       | -                       |       |
| Balance, end of period                                                                                     |   | 217,962                 |       | 92,425                  |       |
|                                                                                                       |   |                    |       |                    |       |
| **Deferred compensation**                                                                                  |   |                    |       |                    |       |
| Balance, beginning of the period                                                                           |   | (247                    | )          | (689                    | )          |
| Common stock issuance                                                                                      |   | (335                    | )          | -                       |       |
| Exercise of stock options                                                                                  |   | (13                     | )          |                    |       |
| Amortization of deferred compensation                                                                      |   | 120                     |       | 383                     |       |
| Balance, end of period                                                                                     |   | (475                    | )          | (306                    | )          |
|                                                                                                       |   |                    |       |                    |       |
| **Retained earnings**                                                                                      |   |                    |       |                    |       |
| Balance, beginning of period                                                                               |   | 85,188                  |       | 53,542                  |       |
| Net income                                                                                                 |   | 35,719                  |       | 24,172                  |       |
| Stock dividend, two-for-one split                                                                          |   | -                       |       | (149                    | )          |
| Cash dividend, $0.06 and $0.045 per share  in the periods ending September 30, 2001 and 2000, respectively |   | (1,873                  | )          | (1,333                  | )          |
| Balance, end of period                                                                                     |   | 119,034                 |       | 76,232                  |       |
|                                                                                                       |   |                    |       |                    |       |
| **Accumulated other comprehensive income/(loss), net**                                                     |   |                    |       |                    |       |
| Balance, beginning of period                                                                               |   | (1,439                  | )          | (3,481                  | )          |
| Cumulative effect of a change in accounting  principle                                                     |   | (3,934                  | )          | -                       |       |
| Net unrealized investment gain/(loss)                                                                      |   | 14,746                  |       | (438                    | )          |
| Net unrealized derivative instrument loss                                                                  |   | (10,631                 | )          | -                       |       |
| Balance, end of period                                                                                     |   | (1,258                  | )          | (3,919                  | )          |
|                                                                                                       |   |                    |       |                    |       |
| **Treasury stock**                                                                                         |   |                    |       |                    |       |
| Balance, beginning of period                                                                               |   | -                       |       | -                       |       |
| Balance, end of period                                                                                     |   | -                       |       | -                       |       |
|                                                                                                       |   |                    |       |                    |       |
| **Total Stockholders’ Equity**                                                                        |   | $                       | 335,582    |                    | $          | 164,730 |   |

*See Notes to CondensedConsolidated Financial Statements.*

** **

** **

**INVESTORS FINANCIAL SERVICES CORP.CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS (unaudited)Nine Months Ended September 30, 2001 and 2000(Dollars in thousands)**

 
|                                                                               |   | **September 30,  2001** |    | **September 30,  2000** |   |
|------------------------------------------------------------------------------------|--------|-------------------------|---------|-------------------------|--------|
|                                                                               |   |                    |    |                    |   |
| **Cash Flows From Operating  Activities:**                                         |   |                    |    |                    |   |
| Net income                                                                         |   | $                       | 35,719  |                    | $      | 24,172 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |   |                    |    |                    |   |
| Depreciation and  amortization                                                     |   | 8,346                   |    | 4,568                   |   |
| Amortization of  deferred compensation                                             |   | 120                     |    | 383                     |   |
| Amortization of  premiums on securities, net of accretion of discounts             |   | (2                      | )       | 2,795                   |   |
| Changes in  assets and liabilities:                                                |   |                    |    |                    |   |
| Accrued interest  and fees receivable                                              |   | (26,308                 | )       | (7,600                  | )      |
| Other assets                                                                       |   | (3,899                  | )       | 2,845                   |   |
| Other  liabilities                                                                 |   | 14,162                  |    | 17,336                  |   |
| Total  adjustments                                                                 |   | (7,581                  | )       | 20,327                  |   |
| Net cash  provided by operating activities                                         |   | 28,138                  |    | 44,499                  |   |
|                                                                               |   |                    |    |                    |   |
| **Cash Flows From Investing  Activities:**                                         |   |                    |    |                    |   |
| Proceeds from  maturities of securities available for sale                         |   | 308,465                 |    | 59,406                  |   |
| Proceeds from  maturities of securities held to maturity                           |   | 747,100                 |    | 174,873                 |   |
| Purchases of  securities available for sale                                        |   | (597,293                | )       | (328,622                | )      |
| Purchases of  securities held to maturity                                          |   | (2,058,154              | )       | (598,041                | )      |
| Purchases of non–marketable  equity securities                                |   | (35,000                 | )       | -                       |   |
| Net decrease in  federal funds sold                                                |   | 360,000                 |    | 60,000                  |   |
| Net increase in  loans                                                             |   | (8,560                  | )       | (772                    | )      |
| Purchase of  businesses                                                            |   | (49,383                 | )       | -                       |   |
| Purchases of  fixed assets and leasehold improvements                              |   | (27,840                 | )       | (5,805                  | )      |
| Net cash used  for investing activities                                            |   | (1,360,665              | )       | (638,961                | )      |
|                                                                               |   |                    |    |                    |   |
| **Cash Flows From Financing  Activities:**                                         |   |                    |    |                    |   |
| Net  (decrease)/increase in demand deposits                                        |   | (17,991                 | )       | 2,943                   |   |
| Net  (decrease)/increase in time and savings deposits                              |   | (12,258                 | )       | 185,299                 |   |
| Net increase in  short–term and other borrowings                              |   | 1,233,254               |    | 384,211                 |   |
| Proceeds from exercise  of stock options                                           |   | 1,710                   |    | 2,609                   |   |
| Proceeds from  issuance of common stock                                            |   | 117,042                 |    | -                       |   |
| Cash dividends  to shareholders                                                    |   | (1,873                  | )       | (1,333                  | )      |
| Net cash  provided by financing activities                                         |   | 1,319,884               |    | 573,729                 |   |
|                                                                               |   |                    |    |                    |   |
| **Net Decrease In Cash And Due From  Banks**                                       |   | (12,643                 | )       | (20,733                 | )      |
| **Cash and Due From Banks, Beginning  of Period**                                  |   | 30,489                  |    | 37,624                  |   |
| **Cash and Due From Banks, End of  Period**                                        |   | $                       | 17,846  |                    | $      | 16,891 |   |
| **Supplemental Disclosure of Cash  Flow Information:**                             |   |                    |    |                    |   |
| Cash paid for  interest                                                            |   | $                       | 113,819 |                    | $      | 83,315 |   |
| Cash paid for  income taxes                                                        |   | $                       | 9,823   |                    | $      | 11,309 |   |

*See Notes to CondensedConsolidated Financial Statements.*

 

** **

 

**INVESTORS FINANCIALSERVICES CORP.**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS(Information as of and for the nine months and the three months ended September30, 2001 and 2000 is unaudited)**

 

**1.             Descriptionof Business**

 

Investors Financial Services Corp. (“IFSC”) provides asset servicingfor the financial services industry through its wholly-owned subsidiaries,Investors Bank & Trust Company (the “Bank”) and Investors Capital Services,Inc.  As used herein, the defined term“the Company” shall mean IFSC together with the Bank and its domestic andforeign subsidiaries.  The Companyprovides global custody, multicurrencyaccounting, mutual fund administration, securities lending, foreign exchange,cash management, performance measurement, institutional transfer agency andinvestment advisory services to a variety of financial asset managers,including mutual fund complexes, investment advisors, banks and insurancecompanies.  IFSC and the Bank aresubject to regulation by the Federal Reserve Board of Governors, the Office ofthe Commissioner of Banks of the Commonwealth of Massachusetts and the FederalDeposit Insurance Corporation.

On May 15, 2000, the Board of Directorsdeclared a two-for-one stock split in the form of a 100% stock dividend payableon June 15, 2000 to stockholders of record on May 31, 2000.  All share numbers have been restated toreflect the two-for-one stock split paid June 15, 2000, where applicable.

**2.             Interim Financial Statements**

The condensedconsolidated interim financial statements of the Company and subsidiaries as ofSeptember 30, 2001 and 2000 and for the nine–month periods andthree-month periods ended September 30, 2001 and 2000 have been prepared by theCompany, without audit, pursuant to the rules and regulations of the Securitiesand Exchange Commission.  Certaininformation and footnote disclosures normally included in annual financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted as permitted bysuch rules and regulations.  Alladjustments, consisting of normal recurring adjustments, necessary for theirfair presentation in conformity with accounting principles generally acceptedin the United States of America are included. Management believes that the disclosures are adequate to present fairlythe financial position, results of operations and cash flows at the dates andfor the periods presented. It is suggested that these interim financialstatements be read in conjunction with the financial statements and the notesthereto included in the Company’s latest annual report on Form 10–K.Results for interim periods are not necessarily indicative of those to beexpected for the full fiscal year. Certain amounts in the prior periods’financial statements have been reclassified to conform to the current periods’presentation.

Effective January 1,2001, the Company adopted SFAS No. 133, as amended and interpreted, whichestablished accounting and reporting standards for derivative instruments.  The Company uses derivative instruments tomanage exposures to interest rate risks. The Company routinely enters intointerest rate swap agreements in which the Company pays a fixed interest rateand receives a floating interest rate. These transactions are designed to hedge a portion of the Company’sliabilities in connection with securities sold under repurchase agreements.  By entering into apay-fixed/receive-floating interest rate swap, a portion of these liabilitiesis effectively converted to a fixed rate liability for the term of the interestrate swap agreement. Most of these derivatives have been designated as highlyeffective cash flow hedges, as determined in accordance with SFAS No. 133. Aninsignificant portion of the derivatives used to manage exposures to interestrate risks were not considered highly effective and, therefore, did not qualifyfor hedge accounting.

Hedge ineffectiveness,determined in accordance with SFAS No. 133, had an insignificant impact onearnings for the nine months ended September 30, 2001. No cash flow hedges werededesignated or discontinued for the nine months ended September 30, 2001.

Net interest incomeincluded net losses of $1.7 million and $0.5 million, net of tax, for the ninemonths and three months ended September 30, 2001, respectively, on interestrate swaps relating to SFAS No. 133.  Thenet loss consisted of a $0.1 million loss and a $0.1 million gain, net of tax,for the nine- and three-month periods, respectively, on changes in the fairvalue of derivative instruments not designated as hedging instruments.  There were also $1.6 million and $0.6million of derivative losses, net of tax, for the nine- and three-monthperiods, respectively, that resulted primarily from the reclassification oftransition adjustment-related derivative losses from Other Comprehensive Income(“OCI”) to net interest income in accordance with SFAS No. 133.  The Company estimates that $1.9 million, netof tax, of the remaining transition adjustment of net derivative lossesincluded in OCI will be reclassified into earnings within the next twelvemonths. The recognition in net interest income of the transition adjustmentderivative losses from OCI will be offset by derivative gains from changes inthe fair value liability of the interest rate swaps as they reach maturity.

** **

In June 2001, the FASBissued SFAS No. 141, “Business Combinations,” which supersedes APB Opinion No.16, “Business Combinations,” and FASB Statement No. 38, “Accounting forPreacquisiton Contingencies of Purchased Enterprises.”  SFAS No. 141 requires that all businesscombinations be accounted for by a single method--the purchase method.  This statement requires that intangibleassets that can be identified and named be recognized as assets apart fromgoodwill under certain criteria.  Thisstatement also requires disclosure of the primary reasons for a businesscombination and the allocation of the purchase price paid to the assetsacquired and liabilities assumed by major balance sheet caption.  When the amounts of goodwill and intangibleassets acquired are significant in relation to the purchase price paid,additional disclosures about those assets are required.  The provisions of SFAS No. 141 apply to allbusiness combinations initiated after June 30, 2001.  The Company is currently in the process of evaluating the effectof SFAS No. 141 on the consolidated financial statements.

In June 2001, the FASBissued SFAS No. 142, “Goodwill and Other Intangible Assets,” which supersedesAPB No. 17, “Intangible Assets.”  SFASNo. 142 addresses how intangible assets that are acquired individually or witha group of other assets (but not those acquired in a business combination)should be accounted for in financial statements upon their acquisition.  This statement also addresses how goodwilland other intangible assets should be accounted for after they have beeninitially recognized in the financial statements.  This statement affects the accounting of premiums, includesguidelines for the determination, measurement and testing of impairment, andrequires disclosure of information about goodwill and other intangible assetsin the years subsequent to their acquisition that was not previouslyrequired.  The provisions of SFAS No.142 are required to be applied starting with fiscal years beginning afterDecember 15, 2001.  The Company iscurrently in the process of evaluating the effect of SFAS No. 142 on theconsolidated financial statements.

In October 2001, the FASBissued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” which addresses financial accounting and reporting for the impairmentor disposal of long-lived assets.  WhileSFAS No. 144 supersedes FASB Statement No. 121, “Accounting for the Impairmentof Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” it retainsmany of the fundamental provisions of that Statement.  SFAS No. 144 also supersedes the accounting and reportingprovisions of APB No. 30, “Reporting the Results of Operations—Reporting theEffects of Disposal of a Segment of a Business, and Extraordinary, Unusual andInfrequently Occurring Events and Transactions,” for the disposal of a segmentof a business.  However, it retains therequirement in Opinion No. 30 to report separately discontinued operations andextends that reporting to a component of an entity that either has beendisposed of (by sale, abandonment, or in a distribution to owners) or isclassified as held for sale.  Theprovisions of SFAS No. 144 are required to be applied starting with fiscalyears beginning after December 15, 2001. The Company is currently in the process of evaluating the effect of SFASNo. 144 on the consolidated financial statements.

 

**3.             Loans**

Loans consist of demandloans to custody clients of the Company, including individuals, and not–for–profitinstitutions and loans to mutual fund clients. The loans to mutual fundsinclude lines of credit and advances pursuant to the terms of the custodyagreements between the Company and those mutual fund clients to facilitatesecurities transactions and redemptions. Generally, the loans are, or may be,in the event of default, collateralized with marketable securities held by theCompany as custodian. There were no impaired or nonperforming loans atSeptember 30, 2001 and December 31, 2000. In addition, there were no loan charge–offs or recoveries duringthe nine months ended September 30, 2001 and the year ended December 31, 2000.Loans are summarized as follows (Dollars in thousands):

 

|                            |   | **September 30,  2001** |    | **December 31,  2000** |   |
|---------------------------------|--------|-------------------------|---------|-----------------------------|--------|
| Loans to  individuals           |   | $                       | 87,796  |                        | $      | 42,997 |   |
| Loans to mutual  funds          |   | 50,069                  |    | 86,316                      |   |
| Loans to others                 |   | 64                      |    | 56                          |   |
|                            |   | 137,929                 |    | 129,369                     |   |
| Less allowance  for loan losses |   | (100                    | )       | (100                        | )      |
| Total                           |   | $                       | 137,829 |                        | $      | 129,269 |   |

The Company hadcommitments to lend of approximately $392.8 million and $222.4 million atSeptember 30, 2001 and December 31, 2000, respectively. The terms of thesecommitments are similar to the terms of outstanding loans.

 

**4.             Acquisitions**

Goodwill related to theCompany’s acquisitions is summarized as follows (Dollars in thousands):

 

|                           |   | **For the Nine  Months Ended  September 30, 2001** |   | **For the  Year Ended  December 31, 2000** |   |
|--------------------------------|--------|----------------------------------------------------|--------|-------------------------------------------------|--------|
| Goodwill,  beginning of period |   | $                                                  | 34,094 |                                            | $      | 39,776 |   |
| Plus purchase of  businesses   |   | 49,383                                             |   | -                                               |   |
| Plus contingent  payment       |   | -                                                  |   | 255                                             |   |
| Less termination  fees         |   | -                                                  |   | (4,362                                          | )      |
| Less  amortization             |   | (2,565                                             | )      | (1,575                                          | )      |
| Goodwill, end of  period       |   | $                                                  | 80,912 |                                            | $      | 34,094 |   |

 

On November 28, 2000, the Bank agreed topurchase the advisor custody unit of The Chase Manhattan Bank (“Chase”). Thetransaction was consummated on February 1, 2001.  This unit provides institutional custody services to individualaccounts, trusts, endowments and corporate accounts whose assets are managed bythird-party investment advisors.   OnMay 1, 2001, the Bank assumed the operations of the U.S. asset administrationunit of Barclays Global Investors, N.A. (“BGI”), a large internationalinstitutional investment manager.  Theunit, located in Sacramento, California, provides custody accounting and otheroperations functions for BGI’s clients. Both acquisitions were accounted for using the purchase method ofaccounting.

**5.             Deposits**

Time deposits atSeptember 30, 2001 and December 31, 2000 included noninterest-bearing amountsof approximately $90 million and $65 million, respectively.  All time deposits had a minimum balance of$100,000 and a maturity of less than three months at September 30, 2001 andDecember 31, 2000.

**6.             Short-term and other borrowings**

The components of short–termand other borrowings are as follows (Dollars in thousands):

 

|                                                  |   | **September 30,  2001** |    | **December 31,  2000** |   |
|-------------------------------------------------------|--------|-------------------------|---------|------------------------|--------|
|                                                  |   |                    |    |                   |   |
| Federal Home  Loan Bank of Boston long-term advances  |   | $                       | 350,000 |                   | $      | - |   |
| Federal Home  Loan Bank of Boston short-term advances |   | 325,000                 |    | -                      |   |
| Federal funds  purchased                              |   | 240,000                 |    | -                      |   |
| Treasury tax and  loan account                        |   | 546                     |    | 246                    |   |
| Total                                                 |   | $                       | 915,546 |                   | $      | 246 |   |

The Company has aborrowing arrangement with the Federal Home Loan Bank of Boston (“FHLBB”),which is utilized on an overnight and on a term basis to satisfy fundingrequirements.  The Company has utilizedboth short-term and long-term features of the term advances.  As of September 30, 2001, there were $350million of long-term term advances outstanding with interest rates ranging from4.64% to 5.17% and maturities ranging from September 2002 to February2005.  There were $325 million ofshort-term term advances outstanding at September 30, 2001 with interest ratesranging from 3.05% to 3.52%, maturing in October 2001.  There were no outstanding advances underthis arrangement at December 31, 2000.

The rate on theoutstanding balance of federal funds purchased from other banks at September30, 2001 was 3.15%. There were no outstanding balances of federal fundspurchased from other banks at December 31, 2000.

The Company receivesfederal tax deposits from clients as agent for the Federal Reserve Bank andaccumulates these deposits in the Treasury tax and loan account.  The Federal Reserve Bank charges the Companyinterest at the Federal funds rate on such deposits.  The interest rate on the outstanding balance was 2.76% atSeptember 30, 2001 and 6.29% at December 31, 2000.

**7.             Stockholders’ Equity**

 

At the Annual Meeting of Shareholders of theCompany held on April 18, 2000, shareholders approved an increase in thenumber of authorized shares of Common Stock from 20,000,000 to 40,000,000.  On May 2, 2000, the Company amended itsCertificate of Incorporation increasing the number of authorized shares ofCommon Stock to 40,000,000.

 

On May 15, 2000, the Board of Directors approved a two-for-onestock split in the form of a 100% stock dividend to shareholders of record onMay 31, 2000.  The dividend waspaid on June 15, 2000.  A total of14,858,146 shares of common stock were issued in connection with the stocksplit.  The par value of theseadditional shares was capitalized by a transfer from retained earnings tocommon stock.  The stock split did notcause any change in the $0.01 par value per share of the common stock or intotal stockholders' equity.

 

At the Annual Meeting of Shareholders of the Company held on April 17,2001, shareholders approved an increase in the number of authorized shares ofCommon Stock from 40,000,000 to 100,000,000. On April 25, 2001, the Companyamended its Certificate of Incorporation increasing the number of authorizedshares of Common Stock to 100,000,000. These shares are available for general corporate purposes as determinedby the Company's Board of Directors.  Asof September 30, 2001, the Company had authorized 1,000,000 shares of PreferredStock and 100,000,000 shares of Common Stock, all with a par value of $0.01 pershare.

 

The Company has three stock option plans: the Amended and Restated 1995Stock Plan, the Amended and Restated 1995 Non-Employee Director Stock OptionPlan, and the 1997 Employee Stock Purchase Plan.

At the Annual Meeting of Shareholders of the Company held on April 17,2001, shareholders approved the amendment and restatement of the Company’sAmended and Restated 1995 Stock Plan to increase the number of shares availablefor grant pursuant to the plan from 4,640,000 to 6,140,000.  Under the Plan, the Company may grantoptions to purchase up to a maximum of 6,140,000 shares of Common Stock tocertain employees, consultants, directors and officers.  The options may be awarded as incentivestock options (employees only), nonqualified stock options, stock awards oropportunities to make direct purchases of stock.  No options were granted to consultants during the nine monthsended September 30, 2001.  Of the6,140,000 shares of Common Stock authorized for issuance under the Plan atSeptember 30, 2001, 1,698,172 were available for grant as of that date.

 

The terms of the Amended and Restated 1995Non-Employee Director Stock Option Plan provide for the grant of options tonon-employee directors to purchase up to a maximum of 400,000 shares of CommonStock. Pursuant to the terms of the Plan, options to purchase 10,000 shares ofCommon Stock were awarded on November 8, 1995 to each director.  Any director elected or appointed after suchdate will receive an automatic initial grant of options to purchase 2,500shares upon becoming a director. Thereafter, each director will receive an automatic grant of options topurchase 2,500 shares effective upon each one-year anniversary of the date ofsuch director's original grant. Additionally, non-employee directors may elect to receive options toacquire shares of the Company's Common Stock in lieu of such director's cashretainer.  Any election is subject tocertain restrictions under the Amended and Restated 1995 Non-Employee DirectorStock Option Plan.  The number of sharesof stock underlying the option is equal to the quotient obtained by dividingthe cash retainer by the value of an option on the date of grant as determinedusing the Black-Scholes model.  Of the400,000 shares of Common Stock authorized for issuance under the plan, 82,718were available for grant at September 30, 2001.

 

The exerciseprice of options under the Amended and Restated 1995 Non-Employee DirectorStock Option Plan and the qualified incentive options under the Amended andRestated 1995 Stock Plan may not be less than the fair market value at the dateof the grant.  The exercise price of thenonqualified options under the Amended and Restated 1995 Stock Plan isdetermined by the compensation committee of the Board of Directors.  All options become exercisable as specifiedby the compensation committee at the date of the grant.

 

In November 1995, theCompany granted 456,000 shares of Common Stock to certain officers of theCompany under the Amended and Restated 1995 Stock Plan. These grants weresubject to the Company's right to repurchase the shares if the officers' employmentwith the Company terminated. The Company's right to repurchase the shareslapsed over a five-year period. On March 31, 1998, the Company repurchased4,000 unvested shares for $0.08 million under the terms of the Amended andRestated 1995 Stock Plan. By November 2000, all remaining sharesoutstanding under these grants had vested.

 

On May 29, 1998, theCompany granted 40,000 shares of Common Stock to an officer of InvestorsCapital Services, Inc. under the Amended and Restated 1995 StockPlan.  This grant is subject to theCompany's right to repurchase the shares if the officer's employment with theCompany terminates. The Company's right to repurchase the shares lapses in fiveequal annual installments beginning one year from the date of grant.

 

On February 13, 2001, theCompany granted 4,000 shares of Common Stock to former employees of the Chaseadvisor custody unit in connection with the acquisition of the unit under theAmended and Restated 1995 Stock Plan. This grant is subject to the Company’s right to repurchase the shares ifthe employees’ employment with the Company terminates.  The Company’s right to repurchase the shareslapses in five equal annual installments beginning one year from the date ofgrant.

 

On May 1, 2001, the Companygranted 29,000 nonqualified stock options to former employees of the U.S. assetadministration unit of BGI in connection with the assumption of the operationsof the unit.  The exerciseprice of the options is 10% of the fair market value of the Common Stock at theclose of market on the date of grant. The grants are exercisable immediately, but any shares acquired onexercise are subject to the Company’s right to repurchase the shares at theexercise price if the employees’ employment with the Company terminates.  TheCompany’s right to repurchase the shares lapses in five equal annualinstallments beginning one year from the date of grant.

 

The Company has recordeddeferred compensation of $0.5 million and $0.3 million at September30, 2001 and December 31, 2000, respectively, related to certain optionsgranted under the Amended and Restated 1995 Stock Plan.

 

Under the terms of the 1997 Employee StockPurchase Plan, the Company may issue up to 560,000 shares of Common Stockpursuant to the exercise of nontransferable options granted to participatingemployees. The 1997 Employee Stock Purchase Plan permits eligible employees topurchase up to 1,000 shares of Common Stock per payment period, subject tolimitations provided by Section 423(b) of the Internal Revenue Code, throughaccumulated payroll deductions. The purchases are made twice a year at a priceequal to the lesser of (i) 90% of the average market value of the CommonStock on the first business day of the payment period, or (ii) 90% of theaverage market value of the Common Stock on the last business day of thepayment period. The payment periods consist of two six-month periods,January 1 through June 30 and July 1 through December 31.

 

A summary of option activity under theAmended and Restated 1995 Non–Employee Director Stock Option Plan and theAmended and Restated 1995 Stock Plans is as follows:

 

|                                               |   | **Number of  Shares** |       | **Weighted–Average  Exercise Price** |       |
|----------------------------------------------------|--------|-----------------------|------------|-------------------------------------------|------------|
|                                               |   |                  | ** ** |                                      | ** ** |
| Outstanding at  December 31, 2000                  |   | 2,896,662             |       | $                                         | 27         |   |
| Granted                                            |   | 134,829               |       | 60                                        |       |
| Exercised                                          |   | (355,501              | )          | 10                                        |       |
| Canceled                                           |   | (18,400               | )          | 60                                        |       |
| Outstanding at  September 30, 2001                 |   | 2,657,590             |       | $                                         | 31         |   |
| Outstanding and  exercisable at September 30, 2001 |   | 1,420,259             |       |                                      |       |

 

|                                               |   | **Number of  Shares** |       | **Weighted–Average  Exercise Price** |       |
|----------------------------------------------------|--------|-----------------------|------------|-------------------------------------------|------------|
|                                               |   |                  | ** ** |                                      | ** ** |
| Outstanding at  December 31, 1999                  |   | 2,960,334             |       | $                                         | 13         |   |
| Granted                                            |   | 211,346               |       | 23                                        |       |
| Exercised                                          |   | (765,262              | )          | 8                                         |       |
| Canceled                                           |   | (53,850               | )          | 15                                        |       |
| Outstanding at  September 30, 2000                 |   | 2,352,568             |       | $                                         | 15         |   |
| Outstanding and  exercisable at September 30, 2000 |   | 1,123,958             |       |                                      |       |

A summary of activityunder the 1997 Employee Stock Purchase Plan is as follows (Number of shares):

 

|                                                        |   | **For the Nine**  |   | **For the**      |   |
|-------------------------------------------------------------|--------|-------------------|--------|------------------|--------|
|                                                        |   | **Months Ended**  |   | **Year Ended**   |   |
|                                                        |   | **September 30,** |   | **December 31,** |   |
|                                                        |   | **2001**          |   | **2000**         |   |
| Total shares  available under the Plan, beginning of period |   | 299,034           |   | 357,354          |   |
| Issued at June  30                                          |   | (20,988           | )      | (34,466          | )      |
| Issued at  December 31                                      |   | -                 |   | (23,854          | )      |
| Total shares  available under the Plan, end of period       |   | 278,046           |   | 299,034          |   |

For the six-month periodended June 30, 2001, the purchase price of the stock was $60.50, or 90% of theaverage market value of the Common Stock on the last business day of thepayment period ending June 30, 2001.

 

For the year endedDecember 31, 2000, the purchase price of the stock was $21.00 and $36.25, or90% of the average market value of the Common Stock on the first business dayof the payment periods ending June 30, 2000 and December 31, 2000,respectively.

*Earnings Per Share—*UnderSFAS No. 128, the Company is required to disclose a reconciliation of Basic EPSand Diluted EPS for the nine-month and three-month periods ended September 30,2001 and 2000 as follows (Dollars in thousands, except per share data):

 
|                                     |   | **For  the Nine Months Ended September 30,** |   | **For  the Quarter Ended September 30,** |   |
|------------------------------------------|--------|----------------------------------------------|--------|------------------------------------------|--------|
|                                     |   | **2001**                                     |   | **2000**                                 |   | **2001** |   | **2000** |   |
|                                     |   |                                         |   |                                     |   |   |   |   |   |
| Income  available to common stockholders |   | $                                            | 35,719 |                                     | $      | 24,172 |   | $ | 13,479 |   | $ | 8,785 |   |
|                                     |   |                                         |   |                                     |   |   |   |   |   |
| Basic  average shares                    |   | 31,562,851                                   |   | 29,653,926                               |   | 31,881,688 |   | 29,759,258 |   |
| Dilutive  effect of stock options        |   | 1,242,782                                    |   | 1,476,430                                |   | 1,182,237 |   | 1,666,503 |   |
| Diluted  average shares                  |   | 32,805,633                                   |   | 31,130,356                               |   | 33,063,925 |   | 31,425,761 |   |
|                                     |   |                                         |   |                                     |   |   |   |   |   |
| Earnings  per share                      |   |                                         |   |                                     |   |   |   |   |   |
| Basic                                    |   | $                                            | 1.13   |                                     | $      | 0.81 |   | $ | 0.42 |   | $ | 0.29 |   |
|                                     |   |                                         |   |                                     |   |   |   |   |   |
| Diluted                                  |   | $                                            | 1.09   |                                     | $      | 0.78 |   | $ | 0.41 |   | $ | 0.28 |   |

**8.             Off–Balance Sheet FinancialInstruments**

*Lines of Credit*—At September 30, 2001, theCompany had commitments to individuals and mutual funds under collateralizedopen lines of credit totaling $452 million, against which $59 million in loanswere drawn. The credit risk involved in issuing lines of credit is essentiallythe same as that involved in extending loan facilities. The Company does notanticipate any loss as a result of these lines of credit.

 

**9.             Commitments and Contingencies**

*Restrictions on Cash Balances*—The Companyis required to maintain certain average cash reserve balances. The reservebalance requirement with the Federal Reserve Bank (“FRB”) as of September 30,2001 was $9.1 million.  In addition,another cash balance in the amount of $13.4 million was pledged to secureclearings with a depository institution, Depository Trust Company, as ofSeptember 30, 2001.

*Lease Commitments*—Minimum future commitments on noncancelable operating leases at September 30,2001 were as follows (Dollars in thousands):

 

| **Fiscal Year Ending** |   | **Premises** |   | **Equipment** |   |
|----------------------------------|--------|--------------|--------|---------------|--------|
|                             |   |         |   |          |   |
| 2001                             |   | $            | 4,263  |          | $      | 1,236 |   |
| 2002                             |   | 17,285       |   | 3,987         |   |
| 2003                             |   | 16,990       |   | 2,294         |   |
| 2004                             |   | 16,712       |   | 612           |   |
| 2005 and beyond                  |   | 68,862       |   | 19            |   |
|                                  |        |              |        |               |        |  |  |

Total rent expense was$16.3 million and $10.8 million for the nine months ended September 30, 2001and 2000, respectively.

Effective January 1,2000, the Company renewed its five–year service agreement with ElectronicData Systems (“EDS”) to expire on December 31, 2005.  Under the terms of the agreement, the Company agreed to paycertain monthly service fees based on usage.  Service expense under this contract was $3.5 million for the ninemonths ended September 30, 2001 and $3.2 million for the nine months endedSeptember 30, 2000.

 

*Contingencies*—TheCompany provides global custody, multicurrency accounting, mutual fund administration,securities lending, foreign exchange, cash management, performance measurement,institutional transfer agency and investment advisory services to a variety offinancial asset managers, including mutual fund complexes, investment advisors,banks and insurance companies.  Assetsunder custody and management, held by the Company in a fiduciary capacity, arenot included in the consolidated balance sheets since such items are not assetsof the Company.  Management conductsregular reviews of its fiduciary responsibilities and considers the results inpreparing its consolidated financial statements.  In the opinion of management, there are no contingent liabilitiesat September 30, 2001 that are material to the consolidated financial positionor results of operations of the Company.

 

On January 16, 2001, Mopex, Inc. filed anaction entitled Mopex, Inc. v. Chicago Stock Exchange, Inc., et al.,Civil Action No. 01 C 0302 (the “Complaint”), in the United States DistrictCourt for the Northern District of Illinois. In the action, Mopex alleges that the Company and numerous otherentities, including Barclays Global Investors, State Street Bank and TrustCompany, and Merrill Lynch, Pierce, Fenner & Smith, Inc., infringe U.S.Patent No. 6,088,685, entitled, “Open End Mutual Fund Securitization Process,”assigned to Mopex.  In particular, Mopexalleges that the ’685 patent covers the creation and trading of certainsecurities, including the Barclays iShares exchange traded funds.  The Complaint seeks injunctive relief,damages, and enhanced remedies (including attorneys’ fees and trebledamages).  In a letter dated January 18,2001, Mopex stated that it desired to license the patent in suit “at afavorable royalty rate prior to substantial involvement with the Court.”  On April 3, 2001, the Company filed ananswer and counterclaim, denying any liability on Mopex’s claim and seeking adeclaratory judgment that the ’685 patent is invalid and not infringed.  On April 26, 2001, Mopex filed a reply tothe Company’s counterclaim, denying that the patent in suit is invalid and notinfringed.  The Company, which isindemnified by the iShares Trust for certain defense costs and damagesresulting from Mopex’s claim, believes the claim is without merit.

**10.          Regulatory Matters**

The Company and the Bankare subject to various regulatory capital requirements administered by thefederal banking agencies.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material adverse effect on the Company’s and the Bank’s results ofoperations and financial condition. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Bank’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accountingpractices.  The Company’s and the Bank’scapital amounts and classification are also subject to qualitative judgments bythe regulators about components, risk weightings, and other factors.

Quantitative measuresestablished by regulation to ensure capital adequacy require the Company andthe Bank to maintain minimum amounts and ratios (set forth in the table below)of total and Tier I capital (as defined in the regulations) to risk–weightedassets (as defined), and of Tier I capital (as defined) to average assets (asdefined). Management believes, as of September 30, 2001, that the Company andthe Bank meet all capital adequacy requirements to which they are subject.

 

As of September30, 2001, the most recent notification from the FDIC categorized the Companyand the Bank as well capitalized under the regulatory framework for promptcorrective action. To be categorized as well capitalized, the Company and theBank must maintain minimum total risk–based, Tier I risk–based, andTier I leverage ratios as set forth in the following table. There are noconditions or events since that notification that management believes havechanged the Company’s or the Bank’s category. The following table presents thecapital ratios for the Company and the Bank as of September 30, 2001 andDecember 31, 2000 (Dollars in thousands): 

 
|                                                        |   | **Actual** |       | **For Capital Adequacy  Purposes** |       | **To Be Well Capitalized  Under Prompt  Corrective Action  Provisions** |       |
|-------------------------------------------------------------|--------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
|                                                        |   | **Amount** |       | **Ratio**                          |       | **Amount**                                                              |       | **Ratio** |   | **Amount** |   | **Ratio** |   |
| **As of September 30, 2001:**                               |   |       | ** ** |                               | ** ** |                                                                    | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Total Capital   (to Risk Weighted Assets—the Company)  |   | $          | 280,295    |                               | 15.05      | %                                                                       | $          | 148,973 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital   (to Risk Weighted Assets—the Bank)     |   | $          | 277,323    |                               | 14.90      | %                                                                       | $          | 148,851 |   | 8.00 | % | $ | 186,064 |   | 10.00 | % |
| Tier I Capital   (to Risk Weighted Assets—the Company) |   | $          | 280,195    |                               | 15.05      | %                                                                       | $          | 74,486 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital   (to Risk Weighted Assets—the Bank)    |   | $          | 277,223    |                               | 14.90      | %                                                                       | $          | 74,426 |   | 4.00 | % | $ | 111,638 |   | 6.00 | % |
| Tier I Capital   (to Average Assets—the Company)       |   | $          | 280,195    |                               | 5.65       | %                                                                       | $          | 198,423 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital   (to Average Assets—the Bank)          |   | $          | 277,223    |                               | 5.59       | %                                                                       | $          | 198,351 |   | 4.00 | % | $ | 247,939 |   | 5.00 | % |
|                                                        |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| **As of December 31, 2000:**                                |   |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total Capital  (to Risk Weighted Assets—the Company)   |   | $          | 170,499    |                               | 13.39      | %                                                                       | $          | 101,847 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital  (to Risk Weighted Assets—the Bank)      |   | $          | 166,850    |                               | 13.12      | %                                                                       | $          | 101,735 |   | 8.00 | % | $ | 127,169 |   | 10.00 | % |
| Tier I Capital  (to Risk Weighted Assets—the Company)  |   | $          | 170,399    |                               | 13.38      | %                                                                       | $          | 50,923 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Risk Weighted Assets—the Bank)     |   | $          | 166,750    |                               | 13.11      | %                                                                       | $          | 50,867 |   | 4.00 | % | $ | 76,301 |   | 6.00 | % |
| Tier I Capital  (to Average Assets—the Company)        |   | $          | 170,399    |                               | 5.16       | %                                                                       | $          | 132,218 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Average Assets—the Bank)           |   | $          | 166,750    |                               | 5.05       | %                                                                       | $          | 132,172 |   | 4.00 | % | $ | 165,215 |   | 5.00 | % |

 

Under Massachusetts law, trustcompanies such as the Bank, like national banks, may pay dividends no moreoften than quarterly, and only out of “net profits” and to the extent that suchpayments will not impair the Bank’s capital stock and surplus account.Moreover, prior approval of the Commissioner of Banks of the Commonwealth ofMassachusetts is required if the total dividends for a calendar year wouldexceed net profits for that year combined with retained net profits for theprevious two years. These restrictions on the ability of the Bank to paydividends to the Company may restrict the ability of the Company to paydividends to its stockholders.

**11.          Segment Reporting**

The Company doesnot utilize segment information for internal reporting as management views theCompany as one segment. The following represents net operating revenue bygeographic area for the nine months and quarter ended September 30, 2001 and2000, and long–lived assets by geographic area as of September 30, 2001and December 31, 2000 (Dollars in thousands):

 
|                         |   | **Net  Operating Revenue**     |    | **Long-Lived  Assets**   |   |
|------------------------------|--------|--------------------------------|---------|--------------------------|--------|
|                         |   | **For  the Nine Months Ended** |    | **For  the Quarter**     |   |   |   |   |   |
| **Geographic  Information:** |   | **September  30,**             |    | **Ended  September 30,** |   | **September  30,  2001** |   | **December  31,  2000** |   |
| **2001**                     |   | **2000**                       |    | **2001**                 |   | **2000** |   |   | ** ** |
|                         |   |                           |    |                     |   |   |   |   |   |   |   |   |   |
| United  States               |   | $                              | 245,505 |                     | $      | 156,489 |   | $ | 91,784 |   | $ | 54,294 |   | $ | 117,635 |   | $ | 48,878 |   |
| Ireland                      |   | 5,788                          |    | 4,016                    |   | 2,151 |   | 1,410 |   | 424 |   | 247 |   |
| Canada                       |   | 1,570                          |    | 1,629                    |   | 518 |   | 523 |   | 18 |   | 55 |   |
| Cayman  Islands              |   | 64                             |    | 59                       |   | 21 |   | 21 |   | - |   | - |   |
|                         |   |                           |    |                     |   |   |   |   |   |   |   |   |   |
| Total                        |   | $                              | 252,927 |                     | $      | 162,193 |   | $ | 94,474 |   | $ | 56,248 |   | $ | 118,077 |   | $ | 49,180 |   |

BGI accounted for 12.22%and 17.16% of the Company’s consolidated net operating revenues for the ninemonths and the quarter ended September 30, 2001, respectively.

The following representsthe Company’s asset servicing fees component of operating revenue by serviceline for the nine months and quarter ended September 30, 2001 and 2000 (Dollarsin thousands):

 
|                                                      |   | **Asset Servicing Fees**                     |     |
|-----------------------------------------------------------|--------|----------------------------------------------|----------|
|                                                      |   | **For the Nine Months Ended  September 30,** |     | **For the Quarter Ended  September 30,** |   |
| **Asset servicing fees by service  line:**                |   |                                         | **2001** |   | **2000** |   | **2001** |   | **2000** | ** ** |
| Custody,  accounting, transfer agency, and administration |   | $                                            | 139,387  |   | $ | 94,208 |   | $ | 52,741 |   | $ | 32,187 |   |
| Foreign exchange                                          |   | 12,771                                       |     | 7,600 |   | 4,713 |   | 2,440 |   |
| Cash management                                           |   | 11,328                                       |     | 8,423 |   | 3,989 |   | 2,638 |   |
| Securities  lending                                       |   | 6,837                                        |     | 7,783 |   | 1,985 |   | 2,391 |   |
| Investment  advisory                                      |   | 2,784                                        |     | 1,192 |   | 1,189 |   | 395 |   |
|                                                      |   |                                         |     |   |   |   |   |   |   |
| Total                                                     |   | $                                            | 173,107  |   | $ | 119,206 |   | $ | 64,617 |   | $ | 40,051 |   |
|                                                           |        |                                              |          |  |  |  |  |  |  |  |  |  |  |  |

 

 

**Item 2.    Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Overview**

 

*You should read the following discussiontogether with our Condensed Consolidated Financial Statements**andrelated notes, which are included elsewhere in this Report.  The following discussion containsforward-looking statements that reflect plans, estimates and beliefs.  Our actual results could differ materiallyfrom those discussed in the forward-looking statements.*

 

                We provide a broad range of services to a variety of financial asset managers.  These services include our core services,global custody, multicurrency accounting and mutual fund administration, aswell as our value-added services, such as securities lending, foreign exchange,cash management, performance measurement, institutional transfer agency andinvestment advisory services.  AtSeptember 30, 2001, we provided services for approximately $767 billion innet assets, including approximately $71 billion of foreign assets.

 

                On May 15, 2000, our board of directors declared a two-for-onestock split in the form of a 100% stock dividend payable on June 15,2000.  All numbers in this Report havebeen restated to reflect the two-for-one stock split paid June 15, 2000,where applicable.

 

                On November 28, 2000, we agreed to purchase the advisorcustody unit of The Chase Manhattan Bank (“Chase”).  The transaction was consummated on February 1, 2001.  This unit provides institutional custodyservices to individual accounts, trusts, endowments and corporate accountswhose assets are managed by third-party investment advisors.  On May 1, 2001, we assumed the operations ofthe U.S. asset administration unit of Barclays Global Investors, N.A. (“BGI”),a large international institutional investment manager.  The unit, located in Sacramento, California,provides custody, accounting, administration and other operations functions forBGI’s clients.   Both acquisitions wereaccounted for using the purchase method of accounting.

 

**Revenue and Expense Overview**

 

                We derive our revenue from financial asset servicing.  Although interest income and noninterestincome are reported separately for financial statement presentation purposes,our clients view the pricing of our service offerings on a bundled basis.  In establishing a fee structure for a specificclient, management analyzes all expected revenue and related expenses, asopposed to separately analyzing fee income and interest income and relatedexpenses for each from the relationship. Accordingly, we believe net operating revenue (net interest income plusnoninterest income) and net income are the most meaningful measures of ourfinancial results. Net operating revenue increased 56% to $252.9 millionfor the nine months ended September 30, 2001 from the same period in 2000 andincreased 68% to $94.5 million for the three months ended September 30, 2001from the same period last year.

 

                Noninterest income consists primarily of fees for financial assetservicing and is principally derived from global custody, multicurrencyaccounting, mutual fund administration and institutional transfer agencyservices for financial asset managers and the assets they control. Our clientspay fees based on the volume of assets under custody, portfolio transactions,income collected and whether other value-added services such as foreignexchange, securities lending and performance measurement are needed.  Asset-based fees are usually charged on asliding scale and are subject to minimum fees. As such, when the assets in a portfolio under custody grow as a resultof changes in market values or cash inflows, our fees may be a smallerpercentage of those assets.  If thevalue of equity assets held by our clients were to increase or decrease by 10%,we estimate that this, by itself, would cause a corresponding change of approximately3% in our earnings per share.  If thevalue of fixed income assets held by our clients were to increase or decreaseby 10%, we estimate that this, by itself, would cause a corresponding change ofapproximately 3% in our earnings per share.

 

                Net interest income represents the difference between income generatedfrom interest-earning assets and expense on interest-bearing liabilities.  Interest-bearing liabilities are generatedby our clients who, in the course of their financial asset management, generatecash balances which they deposit on a short-term basis with us.  We invest these cash balances and remit aportion of the earnings on these investments to our clients.  Our share of earnings from these investmentsis viewed as part of the total package of compensation paid to us from ourclients for performing asset servicing.

 

 

                Operating expenses consist of costs incurred in support of our businessactivities.  As a service provider, ourlargest expenditures are staffing costs, including compensation andbenefits.  We also rely heavily ontechnological tools and services for processing, communicating and storingdata.  As a result, our technology andtelecommunication expense is also a large percentage of our operating expenses.

 

**Certain Factors That May Affect FutureResults**

 

                From time to time, information provided byus, statements made by our employees or information included in our filingswith the SEC (including this Form 10-Q) may contain statements which are nothistorical facts, so-called “forward-looking statements,” and which involverisks and uncertainties.  These statements relate to future events or ourfuture financial performance and are identified by words such as"may," "will," "could," "should,""expect," "plan," "intend," "seek,""anticipate," "believe," "estimate,""potential," or "continue" or other comparable terms or thenegative of those terms.  Forward-lookingstatements in this Form 10-Q include certain statements regarding liquidity,the timing and effect on earnings of derivative gains and losses, the effect onearnings of declines in equity values, and the effect of certain legal claimsagainst us.  Our actual future resultsmay differ significantly from those stated in any forward-lookingstatements.  Factors that may cause suchdifferences include, but are not limited to, the factors discussed below.  Each of these factors, and others, arediscussed from time to time in our filings with the SEC.

 

*The failure to properly manage our growthcould adversely affect the quality of our services and result in the loss ofclients.*

 

                We have been experiencing a period of rapid growth that has requiredthe dedication of significant management and other resources, including therecent assumption of the U.S. asset administration unit of BGI. Continued rapidgrowth could place a strain on our management and other resources.  To manage future growth effectively, we mustcontinue to invest in our operational, financial and other internal systems,and our human resources.  Also, we must continueto expand our office space at reasonable rates in a competitive real estatemarket.

 

*Our future results depend, in part, onsuccessful integration of pending and possible future acquisitions andoutsourcing transactions.*

 

                The integration of the BGI custody accounting unit presents us withchallenges and demands management attention that has to be diverted from othermatters.  Integration of acquisitionsand outsourcing transactions is complicated and frequently presents unforeseendifficulties and expenses which can affect whether and when a particularacquisition will be accretive to our earnings per share.  Any future acquisitions will present similarchallenges.

 

*We must hire and retain skilled personnel ina tight labor market in order to succeed.*

 

                Qualified personnel, in particular managers and other senior personnel,are in great demand throughout the financial services industry.  We could find it increasingly difficult tocontinue to attract and retain sufficient numbers of these highly skilledemployees.

 

*Our operating results are subject tofluctuations in interest rates and the securities markets.*

 

                We base some of our fees on the market value of the assets weprocess.  Accordingly, our operatingresults are subject to fluctuations in interest rates or the securities marketsas these fluctuations affect the market value of assets processed.  Fluctuations in interest rates or thesecurities markets can also lead to investors seeking alternatives to theinvestment offerings of our clients, which could result in a lesser amount ofassets processed and correspondingly lower fees.  Also, our net interest income is earned by investing depositors'funds and making loans.  Rapid changesin interest rates or changes in the relationship between different index ratescould adversely affect the market value of, or the earnings produced by, ourinvestment and loan portfolios.

 

 

*We face significant competition from otherfinancial services companies, which could negatively affect our operatingresults.*

 

                We are part of an extremely competitive asset servicing industry.  Many of our current and potentialcompetitors have longer operating histories, greater name recognition andsubstantially greater financial, marketing and other resources than we do.  These greater resources could, for example,allow our competitors to develop technology superior to our own. In addition,we face the risk that large mutual fund complexes may build in-house assetservicing capabilities and no longer outsource these services to us.  As a result, we may not be able to competeeffectively with current or future competitors.

 

*A material portion of our revenues arederived from our relationship with Barclays Global Investors, N.A.*

 

                As a result of our assumption of the U.S. asset administration unit ofBGI in 2001 and our ongoing relationship with BGI’s iShares and MasterInvestment Portfolios, BGI accounted for approximately 12.22% and 17.16% of ournet operating revenue during the nine months and the quarter ended September30, 2001, respectively.  We expect thatBGI will continue to account for a significant portion of our net operatingrevenue.  While we provide services toBGI under long-term contracts, loss of BGI’s business could cause our netoperating revenue to decline and could have a material adverse effect on ourquarterly and annual results.

 

*We may not be able to protect our proprietarytechnology.*

 

                Our proprietary technology is important toour business.  We rely on trade secret,copyright and trademark laws and confidentiality agreements with employees andthird parties to protect our proprietary technology, all of which offer onlylimited protection.  These intellectualproperty rights may be invalidated or our competitors may develop similartechnology independently.  Legalproceedings to enforce our intellectual property rights may be unsuccessful,and could also be expensive and divert management's attention.

 

*We may incur significant costs defendinginfringement claims.*

 

                We have been sued in federal court claiming that we and others areinfringing a patent allegedly covering the creation and trading of certainsecurities, including exchange traded funds. While we believe the claim is without merit, we cannot be sure that wewill prevail in the defense of this claim. Any patent litigation would be costly and could divert the attention ofmanagement.  If we were found toinfringe the patent, we would have to pay damages and would be ordered to ceaseany infringing activity or seek a license under the patent.  We cannot be sure that we will be able toobtain a license on a timely basis or on reasonable terms, if at all.  While we are indemnified against somedefense costs and damages related to this claim, we may incur significantexpenses defending the claim.  As a result,any determination of infringement could have a material adverse effect upon ourbusiness, financial condition and results of operations.  We may become subject to other infringementclaims in the future.

 

*Our quarterly and annual operating results mayfluctuate.*

 

                Our quarterly and annual operating results are difficult to predict andmay fluctuate from quarter to quarter and annually for several reasons,including:

 

•              Thetiming of commencement or termination of client engagements; and

 

•              Therate of net inflows and outflows of investor funds in the investment vehiclesoffered by our clients.

 

                Most of our expenses, like employee compensation and rent, arerelatively fixed.  As a result, anyshortfall in revenue relative to our expectations could significantly affectour operating results, which could adversely affect our stock price.

 

*We are subject to extensive federal and stateregulations that impose complex restraints on our business.*

 

                Federal and state laws and regulations applicable to financialinstitutions and their parent companies apply to us.  Our primary banking regulators are the Federal Reserve Board(“FRB”), the Federal Deposit Insurance Commission  (“FDIC”) and the Massachusetts Commissioner of Banks.  Virtually all aspects of our operations aresubject to specific requirements or restrictions and general regulatoryoversight including the following:

 

•              TheFRB and the FDIC maintain capital requirements that we must meet. Failure tomeet those requirements could lead to severe regulatory action or evenreceivership. We are currently considered to be "well capitalized;"

 

•              UnderMassachusetts law, the Bank may be restricted in its ability to pay dividendsto Investors Financial, which may in turn restrict our ability to pay dividendsto our stockholders; and

 

•              TheFRB and the FDIC are empowered to assess monetary penalties against, and toorder termination of activities by, companies or individuals who violate thelaw.

 

                Banking law restricts our ability to own the stock of certain companiesand also makes it more difficult for our company to be acquired.  Also, we have not elected financial holdingcompany status under the federal Gramm-Leach-Bliley Act of 1999.  This may place us at a competitivedisadvantage with respect to other organizations.

**Statement ofOperations**

*Comparison ofOperating Results for the Nine Months and the Quarter Ended September 30, 2001and 2000*

*Noninterest Income*

 

                Noninterest income was $175.5 million for thenine months ended September 30, 2001, up 45% from the same period in 2000, andwas $65.4 million for the quarter ended September 30, 2001, up 60% from thesame period in 2000.  Noninterest incomeconsists of the following items (Dollars in thousands):

 
|                     |   | **For the Nine Months Ended September 30,** |    | **For the Quarter Ended September 30,** |   |
|--------------------------|--------|---------------------------------------------|---------|-----------------------------------------|--------|
|                     |   | **2001**                                    |    | **2000**                                |   | **Change** |   | **2001** |   | **2000** |   | **Change** |   |
|                     |   |                                        |    |                                    |   |   |   |   |   |   |   |   |   |
| Asset servicing fees     |   | $                                           | 173,107 |                                    | $      | 119,206 |   | 45 | % | $ | 64,617 |   | $ | 40,051 |   | 61 | % |
| Other operating income   |   | 2,378                                       |    | 1,560                                   |   | 52 | % | 829 |   | 757 |   | 10 | % |
|                     |   |                                        |    |                                    |   |   |   |   |   |   |   |   |   |
| Total noninterest income |   | $                                           | 175,485 |                                    | $      | 120,766 |   | 45 | % | $ | 65,446 |   | $ | 40,808 |   | 60 | % |
|                     |   |                                        |    |                                    |   |   |   |   |   |   |   |   |   |

 

Assetservicing fees were $173.1 million for the nine months ended September 30,2001, up 45% from the same period in 2000. Asset servicing fees for the quarter ended September 30, 2001 increased61% from the same quarter in 2000 to $64.6 million and includes approximately$12.8 million relating to the asset administration operations assumed fromBGI.  The largest component of assetservicing fees is asset-based fees, which increased in both periods due to theincrease in assets processed.  Assetsprocessed is the total dollar value of financial assets on the reported datefor which we provide one or more of the following services: global custody,multicurrency accounting, mutual fund administration, securities lending,foreign exchange, cash management, performance measurement, and institutionaltransfer agency.   Total net assetsprocessed increased $464 billion from $303 billion at December 31, 2000 to $767billion at September 30, 2001, and decreased $73 billion from $840 billion atJune 30, 2001.  Changes in net assetsprocessed include several components(Dollars in billions):

 
|                                         |   | **For the Nine Months EndedSeptember  30, 2001** |   | **For the Quarter EndedSeptember 30, 2001** |   |
|----------------------------------------------|--------|--------------------------------------------------|--------|---------------------------------------------|--------|
|                                         |   |                                             |   |                                        |   |
| Assumed and acquired business  units         |   | $                                                | 542    |                                        | $      | - |   |
| Sales to existing clients                    |   | 20                                               |   | 7                                           |   |
| Sales to new clients                         |   | 6                                                |   | 3                                           |   |
| Fund flows and market  gain/loss             |   | (104                                             | )      | (83                                         | )      |
|                                         |   |                                             |   |                                        |   |
| Net increase/(decrease) in  assets processed |   | $                                                | 464    |                                        | $      | (73 | ) |

 

Another significant portion of the increase in asset servicing feesresulted from the success in marketing ancillary services, such as foreignexchange, cash management, and mutual fund advisory services.

 

 

                Otheroperating income consists of dividends received relating to the Federal HomeLoan Bank of Boston (“FHLBB”) stock investment, computer service fees andmiscellaneous fees for systems consulting services. The increase in otheroperating income resulted from the increase in FHLBB stock dividend income dueto an increase in the average investment in FHLBB stock during the nine monthsended and the quarter ended September 30, 2001, and increased income fromconsulting services performed for clients.

 

*Operating Expenses*

 

Total operating expenses were $199.6 million for the nine months endedSeptember 30, 2001, up 60% from the same period in 2000.  For the quarter ended September 30, 2001,total operating expenses were $74.6 million, up 75% from the same period in2000.  The components of operatingexpenses were as follows (Dollars in thousands):

 
|                               |   | **For the Nine Months Ended  September 30,** |    | **For the Quarter Ended September 30,** |   |
|------------------------------------|--------|---------------------------------------------------|---------|-----------------------------------------|--------|
|                               |   | **2001**                                          |    | **2000**                                |   | **Change** |   | **2001** |   | **2000** |   | **Change** |   |
|                               |   |                                              |    |                                    |   |   |   |   |   |   |   |   |   |
| Compensation                       |   | $                                                 | 120,395 |                                    | $      | 76,360 |   | 58 | % | $ | 44,879 |   | $ | 25,949 |   | 73 | % |
| Technology and  telecommunications |   | 27,157                                            |    | 16,538                                  |   | 64 | % | 8,660 |   | 6,383 |   | 36 | % |
| Transaction  processing services   |   | 14,588                                            |    | 7,447                                   |   | 96 | % | 6,949 |   | 2,434 |   | 185 | % |
| Occupancy                          |   | 12,649                                            |    | 8,008                                   |   | 58 | % | 4,847 |   | 2,901 |   | 67 | % |
| Depreciation  and amortization     |   | 5,781                                             |    | 3,367                                   |   | 72 | % | 2,558 |   | 1,177 |   | 117 | % |
| Travel and  sales promotion        |   | 4,064                                             |    | 2,599                                   |   | 56 | % | 1,670 |   | 1,079 |   | 55 | % |
| Professional  fees                 |   | 2,787                                             |    | 2,059                                   |   | 35 | % | 892 |   | 493 |   | 81 | % |
| Amortization  of goodwill          |   | 2,565                                             |    | 1,201                                   |   | 114 | % | 992 |   | 375 |   | 165 | % |
| Other  operating expenses          |   | 9,647                                             |    | 7,235                                   |   | 33 | % | 3,161 |   | 1,927 |   | 64 | % |
|                               |   |                                              |    |                                    |   |   |   |   |   |   |   |   |   |
| Total  operating expenses          |   | $                                                 | 199,633 |                                    | $      | 124,814 |   | 60 | % | $ | 74,608 |   | $ | 42,718 |   | 75 | % |
|                                    |        |                                                   |         |                                         |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

                Compensation and benefits expense was $120.4 million for the ninemonths ended September 30, 2001, up 58% from the same period in 2000, and was$44.9 million for the quarter ended September 30, 2001, up 73% from the sameperiod in 2000.  The average number ofemployees increased 37% to 2,202 during the nine months ended September 30,2001 from 1,602 for the same period last year. The average number of employees for the quarter ended September 30, 2001was 2,515, up 46% compared to 1,717 during the same period in 2000.  We increased the number of employees tosupport the expansion of client relationships and to service new businessacquisitions.  Approximately 129 and 298employees were added as part of the Chase acquisition and the BGI business unitassumption, respectively.  Benefits,including payroll taxes, group insurance plans, retirement plan contributionsand tuition reimbursement, increased $5.1 million for the nine monthsended September 30, 2001 and $2.0 million for the quarter ended September 30,2001, consistent with the increased headcount.

 

                Technology and telecommunications expense was $27.2 million forthe nine months ended September 30, 2001, up 64% from the same period in2000.  For the quarter ended September30, 2001, technology and telecommunications expense was $8.7 million, up 36%for the same period last year. Transitional services incurred earlier this year as a result of theChase acquisition agreement accounted for approximately $5.5 million of thenine-month increase.  Increasedhardware, software and telecommunications expenditures needed to support thegrowth in assets processed accounted for $3.5 million of the nine-monthperiod-to-period increase and $1.5 million of the quarter-to-quarterincrease.  Expenses related tooutsourced network monitoring and help desk service, along with mainframe dataprocessing, disaster recovery and other outsourced services accounted for$1.7 million of the nine-month period-to-period increase and $0.8 millionof the quarter-to-quarter increase.

 

                Transaction processing services expense was $14.6 million for the ninemonths ended September 30, 2001, up 96% from the same period in 2000 and was$6.9 million for the quarter ended September 30, 2001, up 185% compared to thesame period in 2000.  The increasesrelate primarily to increased subcustodian fees, driven by growth in assetsprocessed for clients.

 

                Occupancy expense was $12.6 million for the nine months endedSeptember 30, 2001, up 58% from the same period in 2000 and was $4.8 millionfor the quarter ended September 30, 2001, up 67% compared to the same period in2000.  These increases were primarilydue to increased rent resulting from the California offices assumed from BGIand the expansion of our office space in Boston, New York, and Dublin atcurrent market rental rates.

 

                Depreciation and amortization expense was $5.8 million for thenine months ended September 30, 2001, up 72% from the same period in 2000, andwas $2.6 million for the quarter ended September 30, 2001, up 117% compared tothe same period in 2000.  Theseincreases resulted from capitalized expenditures associated with the expansioninto additional office space and capitalized software.

 

                Travel and sales promotion expense was $4.1 million for the ninemonths ended September 30, 2001, up 56% from the same period in 2000.  For the quarter ended September 30, 2001,this expense was $1.7 million, up 55% compared to the same period in 2000.These increases were due to the increased level of business activity and theaddition of a California office this year. Travel and sales promotion expense consists of expenses incurred by thesales force, client management staff and other employees in connection withsales calls on potential clients, traveling to existing client sites, and toour offices in New York, California, and our foreign subsidiaries.

 

                Professional fees were $2.8 million for the nine months ended September30, 2001, up 35% from the same period in 2000.   Professional fees were $0.9 million for the quarter endedSeptember 30, 2001, up 81% compared to the same period in 2000.  The increases were due primarily to systemconversion consulting costs for the Advisor Custody unit acquired from Chaseand for legal services and other consulting services provided during bothperiods.

 

                Amortization of goodwill expense was $2.6 million for the ninemonths ended September 30, 2001, up 114% from the same period in 2000, and was$1.0 million for the quarter ended September 30, 2001, up 165% compared to thesame period in 2000.  The increases werethe result of the increase in goodwill from acquisition activities thisyear.  Please refer to the “Overview”section for a further discussion of acquisitions.

*NetInterest Income*

 

                Net interest income is affected by the volume and mix of assets andliabilities, and the movement and level of interest rates. The table belowpresents the changes in net interest income resulting from changes in thevolume of interest-earning assets or interest-bearing liabilities and changesin interest rates compared to the same periods in 2000. Changes attributed toboth volume and rate have been allocated based on the proportion of change ineach category (Dollars in thousands):

 
|                                |   | **For the Nine Months Ended  September 30, 2001** |   | **For the Quarter Ended   September 30, 2001** |       |
|-------------------------------------|--------|---------------------------------------------------|--------|------------------------------------------------|------------|
|                                |   | **Change  Due to  Volume**                        |   | **Change  Due to  Rate**                       | ** ** | **Net** | **    ** | **Change  Due to  Volume** | **    ** | **Change  Due to  Rate** | **    ** | **Net** | **    ** |
|                                |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| **Interest-earning  assets:**       |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| Federal funds  sold and other       |   | $                                                 | 99     |                                           | $          | (525 | ) | $ | (426 | ) | $ | 96 |   | $ | (456 | ) | $ | (360 | ) |
| Investment  securities              |   | 74,355                                            |   | (10,459                                        | )          | 63,896 |   | 27,931 |   | (8,922 | ) | 19,009 |   |
| Loans                               |   | (341                                              | )      | 220                                            |       | (121 | ) | 12 |   | (169 | ) | (157 | ) |
|                                |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| Total  interest-earning assets      |   | $                                                 | 74,113 |                                           | $          | (10,764 | ) | $ | 63,349 |   | $ | 28,039 |   | $ | (9,547 | ) | $ | 18,492 |   |
|                                |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| **Interest-bearing  liabilities:**  |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| Deposits                            |   | $                                                 | 18,789 |                                           | $          | (6,527 | ) | $ | 12,262 |   | $ | 6,463 |   | $ | (5,575 | ) | $ | 888 |   |
| Borrowings                          |   | 31,876                                            |   | (16,804                                        | )          | 15,072 |   | 13,766 |   | $ | (9,750 | ) | 4,016 |   |
|                                |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities |   | $                                                 | 50,665 |                                           | $          | (23,331 | ) | $ | 27,334 |   | $ | 20,229 |   | $ | (15,325 | ) | $ | 4,904 |   |
|                                |   |                                              |   |                                           |       |   |   |   |   |   |   |   |   |
| Change in net  interest income      |   | $                                                 | 23,448 |                                           | $          | 12,567 |   | $ | 36,015 |   | $ | 7,810 |   | $ | 5,778 |   | $ | 13,588 |   |

 

 

                Net interest income was $77.4 million for the nine months endedSeptember 30, 2001, up 87% from the same period in 2000.  Net interest income was $29.0 million forthe quarter ended September 30, 2001, up 88% from the same period in 2000.  The improvement in net interest income inboth periods primarily reflects the positive effect of balance sheet growthdriven by increased client repurchase agreements and other short-term andlong-term borrowings.  In addition, thedeclining interest rate environment this year has reduced our deposit andborrowing costs which have outpaced the re-pricing of our earning assets,primarily investment securities.  The net interest margin increased 33 basispoints and 26 basis points to 2.45% for the nine months and three months endedSeptember 30, 2001, respectively, compared to last year.

 

                Average interest-earning assets, primarily investment securities,increased $1.6 billion or 62% for the nine months ended September 30, 2001and increased $1.9 billion or 68% for the quarter ended September 30, 2001compared to the same periods last year. Funding for the asset growth for the nine-month period was provided byan increase in average borrowings, primarily client repurchase agreements andFHLBB advances, of $957 million and an increase in average client depositsof $606 million.  Funding for theasset growth for the three-month period was provided by an increase in averageborrowings of $1.3 billion and an increase in average client deposits of $596million.  The effect of changes involume of interest-earning assets and interest-bearing liabilities was anincrease in net interest income of approximately $23.4 million and $7.8 millionfor the nine months and three months ended September 30, 2001, respectively.

 

                Average yield on interest-earning assets was 6.02% for the nine monthsended September 30, 2001, down 48 basis points from the same period in 2000,and was 5.57% for the three months ended September 30, 2001, down 116 basispoints from the same period in 2000. The average rate paid on interest-bearing liabilities was 3.98% for thenine months ended September 30, 2001, down 114 basis points from the sameperiod in 2000. The average rate paid on interest-bearing liabilities for thequarter ended September 30, 2001 was 3.44%, down 197 basis points from the samequarter in 2000.  The effect on netinterest income due to changes in rates were increases of approximately$12.6 million and $5.8 million during the nine months and three monthsended September 30, 2001, respectively.

Effective January 1, 2001, we adopted SFAS No. 133, asamended and interpreted, which established accounting and reporting standardsfor derivative instruments.  We usederivative instruments to manage exposures to interest rate risks.  We routinely enter into interest rate swapagreements in which we pay a fixed interest rate and receive a floatinginterest rate.  These transactions aredesigned to hedge a portion of our liabilities in connection with securitiessold under repurchase agreements.  Byentering into a pay-fixed/receive-floating interest rate swap, a portion ofthese liabilities is effectively converted to a fixed rate liability for theterm of the interest rate swap agreement. Most of these derivatives have been designated as highly effective cashflow hedges, as determined in accordance with SFAS No. 133.  An insignificant portion of the derivativesused to manage exposures to interest rate risks were not considered highlyeffective and, therefore, did not qualify for hedge accounting.

Hedge ineffectiveness, determined in accordance withSFAS No. 133, had an insignificant impact on earnings for the nine months andquarter ended September 30, 2001. No cash flow hedges were dedesignated ordiscontinued for the nine months or quarter ended September 30, 2001.

Net interest income included net losses of $1.7million and $0.5 million, net of tax, for the nine months and three monthsended September 30, 2001, respectively, on interest rate swaps relating to SFASNo. 133.  The net loss consisted of a$0.1 million loss and a $0.1 million gain, net of tax, for the nine- andthree-month periods, respectively, on changes in the fair value of derivativeinstruments not designated as hedging instruments.  There were also $1.6 million and $0.6 million of derivativelosses, net of tax, for the nine- and three-month periods, respectively, thatresulted primarily from the reclassification of transition adjustment-relatedderivative losses from OCI to net interest income in accordance with SFAS No.133.  We estimate that $1.9 million, netof tax, of the remaining transition adjustment of net derivative lossesincluded in OCI will be reclassified into earnings within the next twelvemonths. The recognition in net interest income of the transition adjustmentderivative losses from OCI will be offset by derivative gains from changes inthe fair value liability of the interest rate swaps as they reach maturity.

 

*Income Taxes*

Taxesfor the nine months ended September 30, 2001 were $16.4 million, up 36% fromthe same period in 2000. Taxes for the quarter ended September 30, 2001 were$6.0 million, up 38% compared to the same period last year.  The increase in tax expense reflects thehigher level of pretax income during both the nine months and three monthsended September 30, 2001.  The effectivetax rate for the nine- and three-month periods ended September 30, 2001 were31% and 30%, respectively, down from 32% for both the nine- and three–monthperiods last year.   The decrease in theeffective tax rate reflects the increased investment in nontaxable municipalsecurities this year.

**Financial Condition**

*Investment Portfolio*

The following tablesummarizes our investment portfolio for the dates indicated (Dollars inthousands):

 
|                                 |   | **September 30,  2001** |       | **December 31,  2000** |       |
|--------------------------------------|--------|-------------------------|------------|------------------------|------------|
| **Securities available for sale:**   |   |                    |       |                   |       |
| Mortgage–backed securities      |   | $                       | 1,131,637  |                   | $          | 550,465 |   |
| Federal agency securities            |   | 41,012                  |       | 54,129                 |       |
| Corporate debt                       |   | 90,194                  |       | 45,504                 |       |
| State and political subdivisions     |   | 223,589                 |       | 122,235                |       |
| Total securities  available for sale |   | $                       | 1,486,432  |                   | $          | 772,333 |   |
|                                 |   |                    | ** ** |                   | ** ** |
|                                 |   |                    | ** ** |                   | ** ** |
| **Securities held  to maturity:**    |   |                    | ** ** |                   | ** ** |
| Mortgage–backed securities      |   | $                       | 2,716,659  |                   | $          | 1,891,286 |   |
| Federal agency securities            |   | 401,378                 |       | 320,824                |       |
| State and political subdivisions     |   | 82,442                  |       | 79,618                 |       |
| Foreign government securities        |   | 7,509                   |       | 7,566                  |       |
| Total securities held to maturity    |   | $                       | 3,207,988  |                   | $          | 2,299,294 |   |
|                                 |   |                    |       |                   |       |

 

Our investmentportfolio is used to invest depositors’ funds and provide a secondary source ofearnings for us.  In addition, we usethe investment portfolio to secure open positions at securities clearinginstitutions in connection with our custody services.  The portfolio is comprised of securities of state and politicalsubdivisions, mortgage-backed securities issued by the Federal NationalMortgage Association (“FNMA” or “Fannie Mae”) and the Federal Home LoanMortgage Corporation (“FHLMC” or “Freddie Mac”), and Federal agency callablebonds issued by FHLMC and the FHLBB, corporate debt securities, agency debt andagency preferred stock securities, and foreign government bonds issued by theCanadian provinces of Ontario and Manitoba.

 

                We invest in mortgage-backed securities,Federal agency callable bonds and corporate and agency debt to increase thetotal return of the investment portfolio. Mortgage-backed securities generally have a higher yield than U.S.Treasury securities due to credit and prepayment risk.  Credit risk results from the possibilitythat a loss may occur if a counterparty is unable to meet the terms of thecontract.  Prepayment risk results fromthe possibility that changes in interest rates may cause mortgage securities tobe paid off prior to their maturity dates. Federal agency callable bonds generally have a higher yield than U.S.Treasury securities due to credit and call risk.  Credit risk results from the possibility that the Federal agencyissuing the bonds may be unable to meet the terms of the bond.  Call risk results from the possibility thatfluctuating interest rates and other factors may result in the exercise of thecall option by the Federal agency. Credit risk related to mortgage-backed securities and Federal agency callablebonds is substantially reduced by payment guarantees and credit enhancements.

 

                We invest in municipal securities to generatestable, tax advantaged income. Municipal securities generally have lower stated yields than Federalagency and U.S. Treasury securities, but the after-tax yields arecomparable.  Municipal securities aresubject to credit risk.

    We invest in foreign government bonds inorder to generate foreign source income to maximize the use of the foreign taxcredit.  The foreign government bondsare denominated in U.S. dollars to avoid foreign currency risk.  These bonds are subject to credit risk.

 

Thebook value and weighted average yield of our securities available for sale atSeptember 30, 2001 by effective maturity, are reflected in the following table(Dollars in thousands):

 
|                                |   | **Years**   |   |
|-------------------------------------|--------|-------------|--------|
|                                |   | **Under 1** |   | **1 to 5** |   | **5 to 10** |   | **Over 10** |   |
|                                |   | **Amount**  |   | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   |
| Mortgage–backed securities     |   | $           | -      |   | - |   | $ | 1,121,873 |   | 6.49 | % | $ | 9,764 |   | 6.88 | % | $ | - |   | - |   |
| Federal agency securities           |   | -           |   | - |   | 31,012 |   | 5.64 | % | 10,000 |   | 5.65 | % | - |   | - |   |
| Corporate debt                      |   | -           |   | - |   | - |   | - |   | - |   | - |   | 90,194 |   | 3.26 | % |
| State and political subdivisions    |   | 2,608       |   | 4.73 | % | 34,300 |   | 4.73 | % | 137,698 |   | 4.73 | % | 48,983 |   | 4.73 | % |
| Total securities available for sale |   | $           | 2,608  |   | 4.73 | % | $ | 1,187,185 |   | 6.42 | % | $ | 157,462 |   | 4.92 | % | $ | 139,177 |   | 3.78 | % |

Thebook value and weighted average yield of our securities held to maturity atSeptember 30, 2001, by effective maturity, are reflected in the following table(Dollars in thousands):

 
|                              |   | **Years**   |    |
|-----------------------------------|--------|-------------|---------|
|                              |   | **Under 1** |    | **1 to 5** |   | **5 to 10** |   | **Over 10** |   |
|                              |   | **Amount**  |    | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   |
| Mortgage–backed  securities  |   | $           | 241,142 |   | 5.80 | % | $ | 2,097,959 |   | 6.06 | % | $ | 350,223 |   | 5.72 | % | $ | 27,335 |   | 5.00 | % |
| Federal agency securities         |   | 5,000       |    | 6.44 | % | 104,792 |   | 5.04 | % | 291,586 |   | 5.26 | % | - |   | - |   |
| State and political  subdivisions |   | -           |    | - |   | - |   | - |   | 4,127 |   | 5.45 | % | 78,315 |   | 5.45 | % |
| Foreign government  securities    |   | 7,509       |    | 6.84 | % | - |   | - |   | - |   | - |   | - |   | - |   |
| Total securities held to maturity |   | $           | 253,651 |   | 5.84 | % | $ | 2,202,751 |   | 6.01 | % | $ | 645,936 |   | 5.51 | % | $ | 105,650 |   | 5.33 | % |

*Loan Portfolio*

Thefollowing table summarizes our loan portfolio for the dates indicated (Dollarsin thousands):

 
|                             |   | **September 30,  2001** |       | **December 31,  2000** | ** ** |
|----------------------------------|--------|-------------------------|------------|------------------------|------------|
|                             |   |                    | ** ** |                   | ** ** |
| Loans to  individuals            |   | $                       | 87,796     |                   | $          | 42,997 |   |
| Loans to mutual  funds           |   | 50,069                  |       | 86,316                 |       |
| Loans to others                  |   | 64                      |       | 56                     |       |
|                             |   | 137,929                 |       | 129,369                |       |
| Less: allowance  for loan losses |   | (100                    | )          | (100                   | )          |
| Net loans                        |   | $                       | 137,829    |                   | $          | 129,269 |   |
|                             |   |                    |       |                   |       |
| Floating Rate                    |   | $                       | 137,903    |                   | $          | 129,337 |   |
| Fixed Rate                       |   | 26                      |       | 32                     |       |
|                             |   | $                       | 137,929    |                   | $          | 129,369 |   |

 

                We make loans to individually managed account customers and to mutualfunds and other pooled product clients. Virtually all loans to individually managed account customers arewritten on a demand basis, bear variable interest rates tied to the prime rateor LIBOR and are fully secured by liquid collateral, primarily freely tradablesecurities held in custody by us for the borrower.  Loans to mutual funds and other pooled product clients includeunsecured lines of credit that may, in the event of default, be collateralizedat our option by securities held in custody by us for those mutual funds.  Loans to individually managed accountcustomers, mutual funds and other pooled product clients also include advancesthat we make to certain clients pursuant to the terms of our custody agreementswith those clients to facilitate securities transactions and redemptions.

 

 

                At September 30, 2001, our only lending concentrations which exceeded10% of total loan balances, were the lines of credit to mutual fund clientsdiscussed above.  These loans were madein the ordinary course of business on the same terms and conditions prevailingat the time for comparable transactions.

 

                Our credit loss experience has been excellent.  There have been no loan charge-offs or adversecredit actions in our history.  It isour policy to place a loan on nonaccrual status when either principal orinterest becomes 60 days past due and the loan's collateral is notsufficient to cover both principal and accrued interest.  As of September 30, 2001, there were noloans on nonaccrual status, no loans greater than 90 days past due, and notroubled debt restructurings.  Althoughvirtually all of our loans are fully collateralized with freely tradablesecurities, management recognizes some credit risk inherent in the loanportfolio, and has recorded an allowance for loan losses of $0.1 millionat September 30, 2001.  This amount isnot allocated to any particular loan, but is intended to absorb any risk ofloss inherent in the loan portfolio. Management actively monitors the loanportfolio and the underlying collateral and regularly assesses the adequacy ofthe allowance for loan losses.

 

**MarketRisk**

 

                We engage in investment activities to serve clients' investment needsand contribute to overall corporate earnings. Interest-bearing liabilities are generated by our clients who, in thecourse of their financial asset management, maintain cash balances which theydeposit on a short-term basis with us. We invest these cash balances and remit a portion of the earnings onthese investments to our clients. In the conduct of these activities, we aresubject to market risk.  Market risk isthe risk of an adverse financial impact from changes in market prices and interestrates.  The level of risk we assume is afunction of our overall strategic objectives and liquidity needs, clientrequirements and market volatility.

 

                The active management of market risk is integral to ouroperations.  The objective of interestrate sensitivity management is to provide sustainable net interest revenueunder various economic conditions.  Wemanage the structure of interest-earning assets and interest-bearingliabilities by adjusting their mix, yield, maturity and/or repricing characteristics,based on market conditions.  Sinceclient deposits and repurchase agreements, our primary sources of funds, arepredominantly short term, we maintain a generally short-term structure for ourinterest-earning assets.  We also useinterest rate swap agreements to augment our management of interest rateexposure.  The purpose of theseagreements is to lengthen short-term variable-rate liabilities into longer-termfixed-rate liabilities.

 

                Our board of directors has set asset and liability management policiesthat define the overall framework for managing interest rate sensitivity,including accountabilities and controls over investment activities.  These policies delineate investment limitsand strategies that are appropriate, given our liquidity and regulatoryrequirements.  For example, we haveestablished a policy limit stating that projected net interest income over thenext 12 months will not be reduced by more than 10% given a change in interestrates of up to 200 basis points (+ or -) over 12 months.  Each quarter, our board of directors reviewsour investment position, including simulations of the effect of variousinterest rate scenarios on our capital. Due to current interest rate levels, the Company’s Board of Directorshas approved a temporary exception to the 10% limit.

 

                Our board of directors has delegated day-to-day responsibility foroversight of the Asset and Liability Management function to our Asset andLiability Committee (“ALCO”).  ALCO is asenior management committee consisting of the Chief Executive Officer, thePresident, the Chief Financial Officer and members of the Treasury function.ALCO meets twice monthly.  Our primarytool in managing interest rate sensitivity is an income simulation model. Keyassumptions in the simulation model include the timing of cash flows,maturities and repricing of financial instruments, changes in marketconditions, capital planning and deposit sensitivity.  The model assumes that the composition of our interest-sensitiveassets and liabilities existing at the beginning of a period will changeperiodically over the period being measured. The model also assumes that a particular change in interest rates isreflected uniformly across the yield curve regardless of the duration tomaturity or repricing of specific assets and liabilities.  These assumptions are inherently uncertain,and as a result, the model cannot precisely predict the effect of changes ininterest rates on our net interest income. Actual results may differ from simulated results due to the timing,magnitude and frequency of interest rate changes and changes in marketconditions and management strategies.

 

                Theresults of the income simulation model as of September 30, 2001 and 2000indicated that an upward shift of interest rates by 200 basis points wouldresult in a reduction in projectednet interest income of 3.79% and 9.12%, respectively.  A downward shift of 200 basis points would result in a decreasein projected net interest income of 10.35% at September 30, 2001, an exceptionto policy approved by the Company’s board, and an increase in projected netinterest income of 7.07% at September 30, 2000.

 

                We also use gap analysis as a secondary tool to manage our interestrate sensitivity.  Gap analysis involvesmeasurement of the difference in asset and liability repricing on a cumulativebasis within a specified time frame.  Apositive gap indicates that more interest-earning assets than interest-bearingliabilities mature in a time frame, and a negative gap indicates the opposite.  By seeking to minimize the amount of assetsand liabilities that could reprice in the same time frame, we attempt to reducethe risk of significant adverse effects on net interest income caused byinterest rate changes.  As shown in thetable below, at September 30, 2001, interest-bearing liabilities repricedfaster than interest-earning assets, as has been typical for us.  If all other variables remained constant, inthe short term, falling interest rates would lead to net interest income thatis higher than it would have been; rising rates would lead to lower netinterest income.  Other importantdeterminants of net interest income are rate levels, balance sheet growth andmix, and interest rate spreads.

 

Thefollowing table presents the repricing schedule of our interest-earning assetsand interest-bearing liabilities at September 30, 2001 (Dollars in thousands):

 
|                                                                                   |   | **Within Three  Months** |       | **Three to Six  Months** |       | **Six to Twelve  Months** |       | **One Year to  Five Years** |       | **Over Five  Years** |       | **Total** |       |
|----------------------------------------------------------------------------------------|--------|--------------------------|------------|--------------------------|------------|---------------------------|------------|-----------------------------|------------|----------------------|------------|-----------|------------|
|                                                                                   |   |                     | ** ** |                     | ** ** |                      | ** ** |                        | ** ** |                 | ** ** |      | ** ** |
| Interest–earning assets(1):                                                       |   |                     |       |                     |       |                      |       |                        |       |                 |       |      |       |
| Federal funds sold                                                                     |   | $                        | 90,000     |                     | $          | -                         |       | $                           | -          |                 | $          | -         |       | $ | - |   | $ | 90,000 |   |
| Investment securities (2)                                                              |   | 2,231,928                |       | 442,107                  |       | 627,723                   |       | 1,019,077                   |       | 373,585              |       | 4,694,420 |       |
| Loans—variable rate                                                               |   | 137,803                  |       | -                        |       | -                         |       | -                           |       | -                    |       | 137,803   |       |
| Loans—fixed rate                                                                  |   | 26                       |       | -                        |       | -                         |       | -                           |       | -                    |       | 26        |       |
| Total interest–earning assets                                                     |   | $                        | 2,459,757  |                     | $          | 442,107                   |       | $                           | 627,723    |                 | $          | 1,019,077 |       | $ | 373,585 |   | $ | 4,922,249 |   |
| Interest–bearing liabilities:                                                     |   |                     |       |                     |       |                      |       |                        |       |                 |       |      |       |
| Demand deposit accounts                                                                |   | $                        | 2,076      |                     | $          | -                         |       | $                           | -          |                 | $          | -         |       | $ | - |   | $ | 2,076 |   |
| Savings accounts                                                                       |   | 1,751,338                |       | -                        |       | -                         |       | 23,579                      |       | -                    |       | 1,774,917 |       |
| Interest rate contracts                                                                |   | (720,000                 | )          | 50,000                   |       | 110,000                   |       | 560,000                     |       | -                    |       | -         |       |
| Short-term and other borrowings                                                        |   | 2,135,225                |       | -                        |       | 50,000                    |       | 300,000                     |       | -                    |       | 2,485,225 |       |
| Total interest–bearing liabilities                                                |   | $                        | 3,168,639  |                     | $          | 50,000                    |       | $                           | 160,000    |                 | $          | 883,579   |       | $ | - |   | $ | 4,262,218 |   |
| Net interest-sensitivity gap during the period                                         |   | $                        | (708,882   | )                        | $          | 392,107                   |       | $                           | 467,723    |                 | $          | 135,498   |       | $ | 373,585 |   | $ | 660,031 |   |
| Cumulative gap                                                                         |   | $                        | (708,882   | )                        | $          | (316,775                  | )          | $                           | 150,948    |                 | $          | 286,446   |       | $ | 660,031 |   |   |   |
| Interest-sensitive assets as a percent of interest sensitive  liabilities (cumulative) |   | 77.63                    | %          | 90.16                    | %          | 104.47                    | %          | 106.72                      | %          | 115.49               | %          |      |       |
| Interest-sensitive assets as a percent of total assets (cumulative)                    |   | 47.08                    | %          | 55.54                    | %          | 67.55                     | %          | 87.05                       | %          | 94.20                | %          |      |       |
|                                                                                   |   |                     |       |                     |       |                      |       |                        |       |                 |       |      |       |
| Net interest-sensitivity gap as a percent of total assets                              |   | (13.57%                  | )          | 7.50                     | %          | 8.95                      | %          | 2.59                        | %          | 7.15                 | %          |      |       |
| Cumulative gap as a percent of total assets                                            |   | (13.57%                  | )          | (6.06%                   | )          | 2.89                      | %          | 5.48                        | %          | 12.63                | %          |      |       |

----

   (1)    Adjustable rate assets are included in the period in whichinterest rates are next scheduled to adjust rather than in the period in whichthey are due.  Fixed-rate loans areincluded in the period in which they are scheduled to be repaid.

   (2)    Mortgage–backed securities are included in the pricingcategory that corresponds with their effective maturity.

 

 

**Liquidity**

 

                Liquidity represents the ability of aninstitution to meet present and future financial obligations through either thesale or maturity of existing assets or the acquisition of additional fundsthrough liability management.  For afinancial institution such as us, these obligations arise from the withdrawalsof deposits and the payment of operating expenses.

 

                Our primary sources of liquidity include cash and cash equivalents,federal funds sold, new deposits, short-term borrowings, interest payments onsecurities held to maturity and available for sale, and fees collected fromasset administration clients.  As aresult of our management of liquid assets and the ability to generate liquiditythrough liability funds, management believes that we maintain overall liquiditysufficient to meet our depositors' needs, to satisfy our operating requirementsand to fund the payment of an anticipated annual cash dividend of $0.08 pershare for fiscal 2001 (approximately $2.6 million based upon 31,887,166shares outstanding as of September 30, 2001).

 

                Our ability to pay dividends on Common Stock may depend on the receiptof dividends from the Bank. Any dividend payments by the Bank are subject to certainrestrictions imposed by the Massachusetts Commissioner of Banks.  In addition, we may not pay dividends on ourCommon Stock if we are in default under certain agreements entered into inconnection with the sale of our Capital Securities.  The Capital Securities were issued by Investors Capital Trust I,a Delaware statutory business trust sponsored by us, and qualify as Tier Icapital under the capital guidelines of the Federal Reserve.

 

                We have informal borrowing arrangements with various counterparties.  Each counterparty has agreed to make fundsavailable to us at the Federal funds overnight rate.  The aggregate amount of these borrowing arrangements as ofSeptember 30, 2001 was $1.1 billion. Each bank may terminate its arrangement at any time and is under nocontractual obligation to provide us with requested funding.  Our borrowings under these arrangements aretypically on an overnight basis.  Wecannot be certain, however, that such funding will be available.  Lack of availability of liquid funds couldhave a material adverse impact on our operations.

 

                We also have master repurchase agreements in place with variouscounterparties, pursuant to which brokers have agreed to make funds availableto us at various rates in exchange for collateral consisting of marketablesecurities. The aggregate amount of these borrowing arrangements at September30, 2001 was $1.9 billion.

 

                We also have a borrowing arrangement with the FHLBB.  We may borrow amounts determined byprescribed collateral levels and the amount of FHLBB stock we hold.  We are required to hold FHLBB stock equal tono less than (i) 1% of our outstanding residential mortgage loan principal(including mortgage pool securities), (ii) 0.3% of total assets, or(iii) total advances from the FHLBB, divided by a leverage factor of20.  The aggregate amount of borrowingavailable to us under this arrangement at September 30, 2001 was $1.8 billion.

 

                Our cash flows are comprised of three primary classifications:  cash flows from operating activities, investingactivities, and financing activities. Net cash provided by operating activities was $28.1 million for the ninemonths ended September 30, 2001.  Netcash used for investing activities, consisting primarily of the excess ofpurchases of investment securities over proceeds from maturities of investmentsecurities and decreased federal funds sold, was $1.4 billion for the ninemonths ended September 30, 2001.  Netcash provided by financing activities, consisting primarily of increasedborrowings and proceeds from common stock issued, was $1.3 billion for the ninemonths ended September 30, 2001.

 

**Capital Resources**

 

                Historically, we have financed our operations principally throughinternally generated cash flows.  Weincur capital expenditures for furniture, fixtures and miscellaneous equipmentneeds.  We lease microcomputers throughoperating leases.  Capital expenditureshave been incurred and leases entered into on an as-required basis, primarilyto meet our growing operating needs and through business acquisitionactivities.  As a result, our capitalexpenditures were $27.8 million and $5.8 million for the nine months endedSeptember 30, 2001 and 2000, respectively. For the nine months ended September 30, 2001, capital expenditures werecomprised of approximately $15.1 million in fixed assets, $8.4 million incapitalized software and projects in process, and $4.3 million in leaseholdimprovements.

 

 

                Stockholders' equity at September 30, 2001 was $335.6 million, up88%, from December 31, 2000.  The ratioof stockholders' equity to assets increased to 6.4% at September 30, 2001 from4.7% at December 31, 2000.  The increasein stockholders’ equity is primarily the result of the February 1, 2001offering of 1,624,145 shares of Common Stock, which raised approximately $115.8million in capital.

 

                The FRB has adopted a system using internationally consistentrisk-based capital adequacy guidelines to evaluate the capital adequacy ofbanks and bank holding companies.  Underthe risk-based capital guidelines, different categories of assets are assigneddifferent risk weights, based generally upon the perceived credit risk of theasset.  These risk weights aremultiplied by corresponding asset balances to determine a "risk-weighted"asset base.  Some off-balance sheetitems are added to the risk-weighted asset base by converting them to a balancesheet equivalent and assigning them the appropriate risk weight.

 

                FRB and FDIC guidelines require that banking organizations have aminimum ratio of total capital to risk-adjusted assets and off-balance sheetitems of 8.0%.  Total capital is definedas the sum of "Tier I" and "Tier II" capitalelements, with at least half of the total capital required to beTier I.  Tier I capital includes,with certain restrictions, the sum of common stockholders' equity,noncumulative perpetual preferred stock, a limited amount of cumulativeperpetual preferred stock, and minority interests in consolidated subsidiaries,less certain intangible assets. Tier II capital includes, with certain limitations, subordinateddebt meeting certain requirements, intermediate-term preferred stock, certainhybrid capital instruments, certain forms of perpetual preferred stock, as wellas maturing capital instruments and general allowances for loan losses.

Thefollowing table summarizes our Tier I and total capital ratios at September 30,2001 (Dollars in thousands):

 

|                                            |   | **Amount** |       | **Ratio** |       |
|-------------------------------------------------|--------|------------|------------|-----------|------------|
|                                            |   |       | ** ** |      | ** ** |
| Tier I capital                                  |   | $          | 280,195    |      | 15.05      | % |
| Tier I capital  minimum requirement             |   | 74,486     |       | 4.00      | %          |
| Excess Tier I capital                           |   | $          | 205,709    |      | 11.05      | % |
| Total capital                                   |   | $          | 280,295    |      | 15.05      | % |
| Total capital  minimum requirement              |   | 148,973    |       | 8.00      | %          |
| Excess total  capital                           |   | $          | 131,322    |      | 7.05       | % |
| Risk adjusted  assets, net of intangible assets |   | $          | 1,862,160  |      |       |   |

The following tablesummarizes the Bank’s Tier I and total capital ratios at September 30, 2001(Dollars in thousands):

 

|                                            |   | **Amount** |       | **Ratio** |       |
|-------------------------------------------------|--------|------------|------------|-----------|------------|
|                                            |   |       | ** ** |      | ** ** |
| Tier I capital                                  |   | $          | 277,223    |      | 14.90      | % |
| Tier I capital  minimum requirement             |   | 74,426     |       | 4.00      | %          |
| Excess Tier I  capital                          |   | $          | 202,797    |      | 10.90      | % |
| Total capital                                   |   | $          | 277,323    |      | 14.90      | % |
| Total capital  minimum requirement              |   | 148,851    |       | 8.00      | %          |
| Excess total  capital                           |   | $          | 128,472    |      | 6.90       | % |
| Risk adjusted  assets, net of intangible assets |   | $          | 1,860,640  |      |       |   |

 

Inaddition to the risk–based capital guidelines, the FRB and the FDIC use a“Leverage Ratio” as an additional tool to evaluate capital adequacy.  The Leverage Ratio is defined to be acompany’s Tier I capital divided by its adjusted total average assets.  The Leverage Ratio adopted by the federalbanking agencies requires a ratio of 3.0% for top-rated banking institutionsnot experiencing a period of rapid growth. All other banking institutions will be expected to maintain a LeverageRatio of 4.0% to 5.0%.  The computationof the risk–based capital ratios and the Leverage Ratio requires that ourcapital and that of the Bank be reduced by most intangible assets.  Our Leverage Ratio at September 30, 2001 was5.65%, which is in excess of regulatory requirements.  The Bank’s Leverage Ratio at September 30, 2001 was 5.59%, whichis in excess of regulatory requirements.

Thefollowing tables present average balances, interest income and expense, andyields earned or paid on the major categories of assets and liabilities for theperiods indicated (Dollars in thousands):

 
|                                                                        |   | **Nine Months Ended September 30, 2001** |       | **Nine Months Ended September 30, 2000** |       |
|-----------------------------------------------------------------------------|--------|------------------------------------------|------------|------------------------------------------|------------|
|                                                                        |   | **Average Balance**                      |       | **Interest**                             |       | **Average  Yield/Cost** |   | **Average Balance** |   | **Interest** |   | **Average  Yield/Cost** |   |
| **Interest earning assets:**                                                |   |                                     | ** ** |                                     | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Federal funds sold and other                                                |   | $                                        | 46,850     |                                     | $          | 1,611 |   | 4.58 | % | $ | 44,591 |   | $ | 2,037 |   | 6.09 | % |
| Investment securities (1)                                                   |   | 4,062,126                                |       | 184,774                                  |       | 6.06 | % | 2,442,909 |   | 120,878 |   | 6.60 | % |
| Loans (2)                                                                   |   | 113,960                                  |       | 4,279                                    |       | 5.01 | % | 123,231 |   | 4,400 |   | 4.76 | % |
| Total interest-earning assets                                               |   | 4,222,936                                |       | 190,664                                  |       | 6.02 | % | 2,610,731 |   | 127,315 |   | 6.50 | % |
| Allowance for loan losses                                                   |   | (100                                     | )          |                                     |       |   |   | (100 | ) |   |   |   |   |
| Noninterest–earning assets                                             |   | 251,413                                  |       |                                     |       |   |   | 143,049 |   |   |   |   |   |
| Total assets                                                                |   | $                                        | 4,474,249  |                                     |       |   |   |   | $ | 2,753,680 |   |   |   |   |   |
| **Interest  bearing liabilities:**                                          |   |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Deposits:                                                                   |   |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Demand                                                                      |   | $                                        | 3,845      |                                     | $          | 56 |   | 1.94 | % | $ | 4,664 |   | $ | 70 |   | 2.00 | % |
| Savings                                                                     |   | 1,741,390                                |       | 53,078                                   |       | 4.06 | % | 1,130,979 |   | 40,271 |   | 4.75 | % |
| Time                                                                        |   | 319                                      |       | 13                                       |       | 5.43 | % | 11,830 |   | 544 |   | 6.13 | % |
| Short-term borrowings                                                       |   | 1,795,578                                |       | 50,731                                   |       | 3.77 | % | 1,087,027 |   | 45,003 |   | 5.52 | % |
| Other borrowings                                                            |   | 248,913                                  |       | 9,344                                    |       | 5.01 | % | - |   | - |   | - |   |
| Total interest-bearing liabilities                                          |   | 3,790,045                                |       | 113,222                                  |       | 3.98 | % | 2,234,500 |   | 85,888 |   | 5.12 | % |
| Noninterest-bearing liabilities                                             |   |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Demand deposits                                                             |   | 175,658                                  |       |                                     |       |   |   | 185,096 |   |   |   |   |   |
| Savings                                                                     |   | 66,715                                   |       |                                     |       |   |   | 53,333 |   |   |   |   |   |
| Noninterest-bearing time deposits                                           |   | 73,333                                   |       |                                     |       |   |   | 69,434 |   |   |   |   |   |
| Other liabilities                                                           |   | 49,104                                   |       |                                     |       |   |   | 35,708 |   |   |   |   |   |
| Total liabilities                                                           |   | 4,154,855                                |       |                                     |       |   |   | 2,578,071 |   |   |   |   |   |
| Trust preferred stock                                                       |   | 24,256                                   |       |                                     |       |   |   | 24,227 |   |   |   |   |   |
| Equity                                                                      |   | 295,138                                  |       |                                     |       |   |   | 151,382 |   |   |   |   |   |
| Total liabilities and equity                                                |   | $                                        | 4,474,249  |                                     |       |   |   |   | $ | 2,753,680 |   |   |   |   |   |
| Net interest income                                                         |   |                                     |       | $                                        | 77,442     |   |   |   |   |   | $ | 41,427 |   |   |   |
| Net interest margin (3)                                                     |   |                                     |       |                                     |       | 2.45 | % |   |   |   |   | 2.12 | % |
| Average interest rate spread (4)                                            |   |                                     |       |                                     |       | 2.04 | % |   |   |   |   | 1.38 | % |
| Ratio of interest–earning assets to interest–bearing  liabilities |   |                                     |       |                                     |       | 111.42 | % |   |   |   |   | 116.84 | % |

----

   (1)    Average yield/cost on available for sale securities is based onamortized cost.

   (2)    Average yield on loans includes accrual loan balances andnonaccrual loan balances, if any.

   (3)    Net interest income divided by total interest–earningassets.

   (4)    Yield on interest–earning assets less rate paid on interest–bearingliabilities.

**Item 3.    Quantitative and Qualitative Disclosureabout Market Risk**

Theinformation required by this item is contained in the “Market Risk” section inthe “Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” as part of this Report.

 

**PART II.  OTHER INFORMATION**

** **

**Item 6.   **Exhibits and Reports on Form 8-K.

** **

**(a)   OnJuly 12, 2001 and October 11, 2001, the Company filed current reports on Form8-K providing financial information pursuant to Regulation FD.**

** **

**(b)   Exhibits**

** **

**None.**

** **

** **

 

**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                           |   |   | **INVESTORS  FINANCIAL SERVICES CORP.**                                                |
|--------------------------------|--------|--------|----------------------------------------------------------------------------------------|
|                           |   |   |                                                                                   |
| Date:   November 13, 2001 |   | By:    | /s/ Kevin J. Sheehan                                                                   |
|                           |   |   | Kevin J. Sheehan   Chairman and Chief Executive Officer                                |
|                           |   |   |                                                                                   |
|                           |   |   |                                                                                   |
|                           |   | By:    | /s/ Karen C. Keenan                                                                    |
|                           |   |   | Karen C. Keenan  Chief Financial Officer  (Principal Financial and Accounting Officer) |