** **

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

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**FORM 10-Q**

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**(Mark One)**

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

**For the Quarterly period ended September 30, 2003**

**or**

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

**For the Transition period from              to              **

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

**INVESTORS FINANCIAL SERVICES CORP.**

(Exact name of registrantas specified in its charter)

 

| **Delaware**                             |   | **04-3279817**                    |
|------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of          |   | (IRS Employer Identification No.) |
| incorporation or organization)           |   |                              |
|                                     |   |                              |
| **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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule12b-2).  Yes ý  No o

 

Asof October 31, 2003 there were 65,295,258 shares of Common Stock outstanding.

 

 

 

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**INVESTORS FINANCIALSERVICES CORP.**

**INDEX**

** **
|           |                                                                                                                        |
|----------------|-----------------------------------------------------------------------------------------------------------------------------|
| **PART I.**    | **FINANCIAL  INFORMATION**                                                                                                  |
| Item 1.        | Unaudited Condensed  Consolidated Financial Statements                                                                      |
|           | Condensed  Consolidated Balance Sheets  September  30, 2003 and December 31, 2002                                      |
|           | Condensed  Consolidated Statements of Income and Comprehensive Income  Nine months ended September 30, 2003 and  2002  |
|           | Condensed  Consolidated Statements of Income and Comprehensive Income  Three months ended September 30, 2003 and  2002 |
|           | Condensed  Consolidated Statements of Stockholders’ Equity  Nine months ended September 30, 2003 and 2002         |
|           | Condensed  Consolidated Statements of Cash Flows   Nine months ended September 30, 2003 and 2002                       |
|           | Notes to Condensed  Consolidated Financial Statements                                                                       |
|           | Independent  Accountants’ Review Report                                                                                |
| Item  2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                 |
| Item  3.       | Quantitative  and Qualitative Disclosure about Market Risk                                                                  |
|           |                                                                                                                        |
| Item 4.        | Controls and  Procedures                                                                                                    |
|           |                                                                                                                        |
| **PART II.**   | **OTHER  INFORMATION**                                                                                                      |
| Item 1.        | Legal  Proceedings                                                                                                          |
| Item 6.        | Exhibits and  Reports on Form 8-K                                                                                           |
|           |                                                                                                                        |
| **SIGNATURES** |
|           |                                                                                                                        |

 

 

2

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**PART I. FINANCIAL INFORMATION**

**Item1.            Unaudited CondensedConsolidated Financial Statements**

**INVESTORSFINANCIAL SERVICES CORP.CONDENSED CONSOLIDATED BALANCE SHEETSSeptember 30, 2003 and December 31, 2002(Dollars in thousands, except share data)**

 
|                                                                                                                                                                                                                       |   | **September  30,** |       | **December  31,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|-------------------|------------|
|                                                                                                                                                                                                                       |   | **2003**           |       | **2002**          |       |
|                                                                                                                                                                                                                       |   |               | ** ** |              | ** ** |
| **Assets**                                                                                                                                                                                                                 |   |               |       |              |       |
| Cash and due from banks                                                                                                                                                                                                    |   | $                  | 41,494     |              | $          | 14,568 |   |
| Securities held to maturity (approximate fair value of $4,000,873 and  $3,460,754  at September 30, 2003 and  December 31, 2002, respectively)                                                                   |   | 3,995,519          |       | 3,438,689         |       |
| Securities available for sale                                                                                                                                                                                              |   | 3,964,129          |       | 3,272,465         |       |
| Nonmarketable equity securities                                                                                                                                                                                            |   | 50,000             |       | 50,000            |       |
| Loans, less allowance for loan losses of $100 at September 30, 2003  and December 31, 2002                                                                                                                            |   | 166,788            |       | 143,737           |       |
| Accrued interest and fees receivable                                                                                                                                                                                       |   | 68,567             |       | 67,261            |       |
| Equipment and leasehold improvements, less accumulated depreciation  of $40,931 and $25,402 at September 30, 2003 and December 31, 2002,  respectively                                                                |   | 78,125             |       | 74,869            |       |
| Goodwill, net                                                                                                                                                                                                              |   | 79,969             |       | 79,969            |       |
| Other assets                                                                                                                                                                                                               |   | 110,990            |       | 73,916            |       |
| **Total  Assets**                                                                                                                                                                                                          |   | $                  | 8,555,581  |              | $          | 7,215,474 |   |
|                                                                                                                                                                                                                       |   |               |       |              |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                              |   |               |       |              |       |
| **Liabilities:**                                                                                                                                                                                                           |   |               |       |              |       |
| Deposits:                                                                                                                                                                                                                  |   |               |       |              |       |
| Demand                                                                                                                                                                                                                     |   | $                  | 352,702    |              | $          | 384,461 |   |
| Savings                                                                                                                                                                                                                    |   | 3,507,061          |       | 2,858,457         |       |
| Time                                                                                                                                                                                                                       |   | 100,000            |       | 90,000            |       |
| Total deposits                                                                                                                                                                                                             |   | 3,959,763          |       | 3,332,918         |       |
|                                                                                                                                                                                                                       |   |               |       |              |       |
| Securities sold under repurchase agreements                                                                                                                                                                                |   | 3,348,458          |       | 2,301,974         |       |
| Short-term and other borrowings                                                                                                                                                                                            |   | 615,732            |       | 741,107           |       |
| Due to brokers for open trades payable                                                                                                                                                                                     |   | —             |       | 286,843           |       |
| Company-obligated, mandatorily redeemable, preferred securities of  subsidiary trust holding solely junior subordinated deferrable interest  debentures of the Company                                                     |   | 24,000             |       | —            |       |
| Other liabilities                                                                                                                                                                                                          |   | 99,447             |       | 85,676            |       |
| Total liabilities                                                                                                                                                                                                          |   | 8,047,400          |       | 6,748,518         |       |
|                                                                                                                                                                                                                       |   |               |       |              |       |
| Commitments and contingencies                                                                                                                                                                                              |   | —             |       | —            |       |
|                                                                                                                                                                                                                       |   |               |       |              |       |
| Company-obligated, mandatorily redeemable, preferred securities of  subsidiary trust holding solely junior subordinated deferrable interest  debentures of the Company                                                     |   | —             |       | 24,000            |       |
|                                                                                                                                                                                                                       |   |               |       |              |       |
| **Stockholders’  Equity:**                                                                                                                                                                                            |   |               |       |              |       |
| Preferred stock, par value $0.01 (shares authorized: 1,000,000;  issued and outstanding: none at September 30, 2003 and December 31,  2002)                                                                           |   | —             |       | —            |       |
| Common stock, par value $0.01 (shares authorized: 100,000,000 at  September 30, 2003 and December 31, 2002; issued and outstanding:  65,204,690 at September 30, 2003 and  64,775,042 at December 31, 2002) |   | 652                |       | 648               |       |
| Surplus                                                                                                                                                                                                                    |   | 238,099            |       | 233,337           |       |
| Deferred compensation                                                                                                                                                                                                      |   | (1,211             | )          | (1,599            | )          |
| Retained earnings                                                                                                                                                                                                          |   | 255,193            |       | 198,282           |       |
| Accumulated other comprehensive income, net                                                                                                                                                                                |   | 15,448             |       | 12,288            |       |
| Treasury stock, par value $0.01 (10,814 shares at September 30, 2003  and December 31, 2002)                                                                                                                          |   | —             |       | —            |       |
| Total stockholders’ equity                                                                                                                                                                                            |   | 508,181            |       | 442,956           |       |
| **Total  Liabilities and Stockholders’ Equity**                                                                                                                                                                       |   | $                  | 8,555,581  |              | $          | 7,215,474 |   |

*See Notes to UnauditedCondensed Consolidated Financial Statements.*

 

3

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**INVESTORSFINANCIAL SERVICES CORP.**CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME Nine Months Ended September 30, 2003 and 2002(Dollars in thousands, except per share data)

 
|                                                                                 |   | **September  30,** |       | **September  30,** |       |
|--------------------------------------------------------------------------------------|--------|--------------------|------------|--------------------|------------|
|                                                                                 |   | **2003**           |       | **2002**           |       |
| **Operating  Revenue:**                                                              |   |               | ** ** |               | ** ** |
| Interest income:                                                                     |   |               |       |               |       |
| Federal funds sold and securities purchased under resale agreements                  |   | $                  | 259        |               | $          | 680 |   |
| Investment securities held to maturity and available for sale                        |   | 176,995            |       | 181,394            |       |
| Loans                                                                                |   | 2,650              |       | 2,891              |       |
| Total interest income                                                                |   | 179,904            |       | 184,965            |       |
|                                                                                 |   |               |       |               |       |
| Interest expense:                                                                    |   |               |       |               |       |
| Deposits                                                                             |   | 28,698             |       | 31,777             |       |
| Short-term and other borrowings                                                      |   | 39,579             |       | 49,057             |       |
| Total interest expense                                                               |   | 68,277             |       | 80,834             |       |
| Net interest income                                                                  |   | 111,627            |       | 104,131            |       |
|                                                                                 |   |               |       |               |       |
| Noninterest income:                                                                  |   |               |       |               |       |
| Asset servicing fees                                                                 |   | 239,012            |       | 218,103            |       |
| Other operating income                                                               |   | 1,864              |       | 1,645              |       |
| Net operating revenue                                                                |   | 352,503            |       | 323,879            |       |
|                                                                                 |   |               |       |               |       |
| **Operating  Expenses:**                                                             |   |               |       |               |       |
| Compensation and benefits                                                            |   | 143,309            |       | 146,819            |       |
| Technology and telecommunications                                                    |   | 29,020             |       | 30,070             |       |
| Transaction processing services                                                      |   | 23,624             |       | 26,078             |       |
| Occupancy                                                                            |   | 21,820             |       | 18,247             |       |
| Depreciation and amortization                                                        |   | 20,233             |       | 11,179             |       |
| Professional fees                                                                    |   | 5,234              |       | 4,968              |       |
| Travel and sales promotion                                                           |   | 3,315              |       | 4,217              |       |
| Other operating expenses                                                             |   | 8,401              |       | 9,956              |       |
| Total operating expenses                                                             |   | 254,956            |       | 251,534            |       |
|                                                                                 |   |               |       |               |       |
| **Income  Before Income Taxes**                                                      |   | 97,547             |       | 72,345             |       |
|                                                                                 |   |               |       |               |       |
| Provision for income taxes   (Note 10)                                          |   | 37,711             |       | 21,704             |       |
|                                                                                 |   |               |       |               |       |
| **Net  Income**                                                                      |   | $                  | 59,836     |               | $          | 50,641 |   |
|                                                                                 |   |               |       |               |       |
| **Basic  Earnings Per Share**                                                        |   | $                  | 0.92       |               | $          | 0.79 |   |
|                                                                                 |   |               |       |               |       |
| **Diluted  Earnings Per Share**                                                      |   | $                  | 0.90       |               | $          | 0.76 |   |
|                                                                                 |   |               |       |               |       |
| **Comprehensive  Income:**                                                           |   |               |       |               |       |
| Net income                                                                           |   | $                  | 59,836     |               | $          | 50,641 |   |
| Other comprehensive income:                                                          |   |               |       |               |       |
| Net unrealized investment (loss) gain, net of tax of $(2,093) and  $16,962           |   | (4,466             | )          | 31,500             |       |
| Net unrealized derivative instrument gain (loss), net of tax of  $4,048 and $(6,176) |   | 7,518              |       | (11,469            | )          |
| Cumulative translation adjustment                                                    |   | 108                |       | —             |       |
| Other comprehensive income                                                           |   | 3,160              |       | 20,031             |       |
| Comprehensive income                                                                 |   | $                  | 62,996     |               | $          | 70,672 |   |

*See Notes to UnauditedCondensed Consolidated Financial Statements.*

** **

** **

**4**

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** **

**INVESTORSFINANCIAL SERVICES CORP.**CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME Three Months Ended September 30, 2003 and 2002(Dollars in thousands, except per share data)

** **
|                                                                                 |   | **September  30,** |       | **September  30,** |       |
|--------------------------------------------------------------------------------------|--------|--------------------|------------|--------------------|------------|
|                                                                                 |   | **2003**           |       | **2002**           |       |
| **Operating  Revenue:**                                                              |   |               | ** ** |               | ** ** |
| Interest income:                                                                     |   |               |       |               |       |
| Federal funds sold and securities purchased under resale agreements                  |   | $                  | 77         |               | $          | 473 |   |
| Investment securities held to maturity and available for sale                        |   | 57,401             |       | 62,378             |       |
| Loans                                                                                |   | 872                |       | 930                |       |
| Total interest income                                                                |   | 58,350             |       | 63,781             |       |
|                                                                                 |   |               |       |               |       |
| Interest expense:                                                                    |   |               |       |               |       |
| Deposits                                                                             |   | 10,467             |       | 10,750             |       |
| Short-term and other borrowings                                                      |   | 12,621             |       | 17,796             |       |
| Total interest expense                                                               |   | 23,088             |       | 28,546             |       |
| Net interest income                                                                  |   | 35,262             |       | 35,235             |       |
|                                                                                 |   |               |       |               |       |
| Noninterest income:                                                                  |   |               |       |               |       |
| Asset servicing fees                                                                 |   | 83,645             |       | 73,982             |       |
| Other operating income                                                               |   | 436                |       | 515                |       |
|                                                                                 |   |               |       |               |       |
| Net operating revenue                                                                |   | 119,343            |       | 109,732            |       |
|                                                                                 |   |               |       |               |       |
| **Operating  Expenses:**                                                             |   |               |       |               |       |
| Compensation and benefits                                                            |   | 42,574             |       | 47,951             |       |
| Technology and telecommunications                                                    |   | 10,170             |       | 10,004             |       |
| Transaction processing services                                                      |   | 7,285              |       | 8,764              |       |
| Occupancy                                                                            |   | 7,290              |       | 6,841              |       |
| Depreciation and amortization                                                        |   | 7,548              |       | 4,540              |       |
| Professional fees                                                                    |   | 1,493              |       | 1,752              |       |
| Travel and sales promotion                                                           |   | 1,247              |       | 1,463              |       |
| Other operating expenses                                                             |   | 3,191              |       | 3,747              |       |
| Total operating expenses                                                             |   | 80,798             |       | 85,062             |       |
|                                                                                 |   |               |       |               |       |
| **Income  Before Income Taxes**                                                      |   | 38,545             |       | 24,670             |       |
|                                                                                 |   |               |       |               |       |
| Provision for income taxes   (Note 10)                                          |   | 12,141             |       | 7,401              |       |
|                                                                                 |   |               |       |               |       |
| **Net  Income**                                                                      |   | $                  | 26,404     |               | $          | 17,269 |   |
|                                                                                 |   |               |       |               |       |
| **Basic  Earnings Per Share**                                                        |   | $                  | 0.41       |               | $          | 0.27 |   |
|                                                                                 |   |               |       |               |       |
| **Diluted  Earnings Per Share**                                                      |   | $                  | 0.40       |               | $          | 0.26 |   |
|                                                                                 |   |               |       |               |       |
| **Comprehensive  Income:**                                                           |   |               |       |               |       |
| Net income                                                                           |   | $                  | 26,404     |               | $          | 17,269 |   |
| Other comprehensive income:                                                          |   |               |       |               |       |
| Net unrealized investment (loss) gain, net of tax of $(5,879) and  $4,495            |   | (13,004            | )          | 8,347              |       |
| Net unrealized derivative instrument gain (loss), net of tax of  $2,747 and $(4,868) |   | 5,102              |       | (9,040             | )          |
| Cumulative translation adjustment                                                    |   | (137               | )          | —             |       |
| Other comprehensive (loss)                                                           |   | (8,039             | )          | (693               | )          |
| Comprehensive income                                                                 |   | $                  | 18,365     |               | $          | 16,576 |   |

** **

***See Notes to Unaudited Condensed Consolidated FinancialStatements.***

** **

** **

**5**

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** **

** **

**INVESTORSFINANCIAL SERVICES CORP.**CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYNine Months Ended September 30, 2003 and 2002(Dollars in thousands, except share data)

** **
|                                                                                                          |   | **September  30,** |       | **September  30,** |       |
|---------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|--------------------|------------|
|                                                                                                          |   | **2003**           |       | **2002**           |       |
| **Common shares**                                                                                             |   |               | ** ** |               | ** ** |
| Balance, beginning of period                                                                                  |   | 64,775,042         |       | 31,971,404         |       |
| Exercise of stock options                                                                                     |   | 359,042            |       | 381,880            |       |
| Common stock issuance                                                                                         |   | 70,606             |       | 61,193             |       |
| Stock dividend, two-for-one split                                                                             |   | —             |       | 32,168,922         |       |
| Balance, end of period                                                                                        |   | 65,204,690         |       | 64,583,399         |       |
|                                                                                                          |   |               |       |               |       |
| **Treasury  shares**                                                                                          |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | 10,814             |       | 10,814             |       |
| Balance, end of period                                                                                        |   | 10,814             |       | 10,814             |       |
|                                                                                                          |   |               |       |               |       |
| **Common  stock**                                                                                             |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | $                  | 648        |               | $          | 320 |   |
| Exercise of stock options                                                                                     |   | 4                  |       | 4                  |       |
| Stock dividend, two-for-one split                                                                             |   | —             |       | 322                |       |
| Balance, end of period                                                                                        |   | 652                |       | 646                |       |
|                                                                                                          |   |               |       |               |       |
| **Surplus**                                                                                                   |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | 233,337            |       | 222,440            |       |
| Exercise of stock options                                                                                     |   | 1,259              |       | 2,212              |       |
| Tax benefit from exercise of stock options                                                                    |   | 1,703              |       | 3,559              |       |
| Common stock issuance                                                                                         |   | 1,800              |       | 1,835              |       |
| Stock option issuance                                                                                         |   | —             |       | 78                 |       |
| Balance, end of period                                                                                        |   | 238,099            |       | 230,124            |       |
|                                                                                                          |   |               |       |               |       |
| **Deferred  compensation**                                                                                    |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | (1,599             | )          | (2,563             | )          |
| Amortization of deferred compensation                                                                         |   | 388                |       | 829                |       |
| Stock option issuance                                                                                         |   | —             |       | (78                | )          |
| Balance, end of period                                                                                        |   | (1,211             | )          | (1,812             | )          |
|                                                                                                          |   |               |       |               |       |
| **Retained  earnings**                                                                                        |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | 198,282            |       | 132,877            |       |
| Net income                                                                                                    |   | 59,836             |       | 50,641             |       |
| Stock dividend, two-for-one split                                                                             |   | —             |       | (322               | )          |
| Cash dividend, $0.0450 and $0.0375 per  share in the periods ending September 30, 2003 and 2002, respectively |   | (2,925             | )          | (2,412             | )          |
| Balance, end of period                                                                                        |   | 255,193            |       | 180,784            |       |
|                                                                                                          |   |               |       |               |       |
| **Accumulated  other comprehensive income (loss), net**                                                       |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | 12,288             |       | (10,296            | )          |
| Net unrealized investment (loss) gain                                                                         |   | (4,466             | )          | 31,500             |       |
| Net unrealized derivative instrument gain  (loss)                                                             |   | 7,172              |       | (13,575            | )          |
| Amortization of transition-related  adjustment                                                                |   | 346                |       | 2,106              |       |
| Effect of foreign currency translation                                                                        |   | 108                |       | —             |       |
| Balance, end of period                                                                                        |   | 15,448             |       | 9,735              |       |
|                                                                                                          |   |               |       |               |       |
| **Treasury  stock**                                                                                           |   |               |       |               |       |
| Balance, beginning of period                                                                                  |   | —             |       | —             |       |
| Balance, end of period                                                                                        |   | —             |       | —             |       |
|                                                                                                          |   |               |       |               |       |
| **Total  Stockholders’ Equity**                                                                          |   | $                  | 508,181    |               | $          | 419,477 |   |

** **

***See Notes to Unaudited Condensed Consolidated FinancialStatements.***

** **

**6**

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** **

**INVESTORSFINANCIAL SERVICES CORP.**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30, 2003 and 2002(Dollars in thousands)

 
|                                                                                               |   | **September  30,** |       | **September  30,** |       |
|----------------------------------------------------------------------------------------------------|--------|--------------------|------------|--------------------|------------|
|                                                                                               |   | **2003**           |       | **2002**           |       |
|                                                                                               |   |               | ** ** |               | ** ** |
| **Cash  Flows From Operating Activities:**                                                         |   |               |       |               |       |
| Net income                                                                                         |   | $                  | 59,836     |               | $          | 50,641 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities:                 |   |               |       |               |       |
| Depreciation and amortization                                                                      |   | 20,233             |       | 11,179             |       |
| Amortization of deferred compensation                                                              |   | 388                |       | 829                |       |
| Amortization of premiums on securities, net of accretion of discounts                              |   | 30,314             |       | 4,921              |       |
| Changes in assets and liabilities:                                                                 |   |               |       |               |       |
| Accrued interest and fees receivable                                                               |   | (1,306             | )          | (8,551             | )          |
| Other assets                                                                                       |   | (39,057            | )          | (19,913            | )          |
| Other liabilities                                                                                  |   | 25,070             |       | 34,133             |       |
| Net cash provided by operating activities                                                          |   | 95,478             |       | 73,239             |       |
|                                                                                               |   |               |       |               |       |
| **Cash  Flows From Investing Activities:**                                                         |   |               |       |               |       |
| Proceeds from maturities and paydowns of securities available for  sale                            |   | 1,266,417          |       | 411,825            |       |
| Proceeds from maturities and paydowns of securities held to maturity                               |   | 1,595,747          |       | 1,403,792          |       |
| Purchases of securities available for sale                                                         |   | (1,976,260         | )          | (1,467,910         | )          |
| Purchases of securities held to maturity                                                           |   | (2,169,308         | )          | (1,684,895         | )          |
| Net decrease in due to brokers for open trades payable                                             |   | (286,843           | )          | —             |       |
| Net increase in federal funds sold and securities purchased under  resale agreements               |   | —             |       | (120,000           | )          |
| Net (increase) decrease in loans                                                                   |   | (23,051            | )          | 93,115             |       |
| Purchases of fixed assets, capitalized software and leasehold  improvements                        |   | (23,454            | )          | (38,726            | )          |
| Net cash used for investing activities                                                             |   | (1,616,752         | )          | (1,402,799         | )          |
|                                                                                               |   |               |       |               |       |
| **Cash  Flows From Financing Activities:**                                                         |   |               |       |               |       |
| Net decrease in demand deposits                                                                    |   | (31,759            | )          | (131,283           | )          |
| Net increase in time and savings deposits                                                          |   | 658,604            |       | 629,224            |       |
| Net increase in securities sold under repurchase agreements                                        |   | 1,046,484          |       | 632,063            |       |
| Net (decrease) increase in short-term and other borrowings                                         |   | (125,375           | )          | 265,248            |       |
| Proceeds from exercise of stock options                                                            |   | 1,263              |       | 2,216              |       |
| Proceeds from issuance of common stock                                                             |   | 1,800              |       | 1,835              |       |
| Repurchase of Company-obligated, mandatorily redeemable, preferred  securities of subsidiary trust |   | —             |       | (1,000             | )          |
| Cash dividends to shareholders                                                                     |   | (2,925             | )          | (2,412             | )          |
| Net cash provided by financing activities                                                          |   | 1,548,092          |       | 1,395,891          |       |
|                                                                                               |   |               |       |               |       |
| **Effect of  foreign currency translation**                                                        |   | 108                |       | —             |       |
|                                                                                               |   |               |       |               |       |
| **Net  Increase In Cash And Due From Banks**                                                       |   | 26,926             |       | 66,331             |       |
|                                                                                               |   |               |       |               |       |
| **Cash and  Due From Banks, Beginning of Period**                                                  |   | 14,568             |       | 15,605             |       |
|                                                                                               |   |               |       |               |       |
| **Cash and  Due From Banks, End of Period**                                                        |   | $                  | 41,494     |               | $          | 81,936 |   |
|                                                                                               |   |               |       |               |       |
| **Supplemental  Disclosure of Cash Flow Information:**                                             |   |               |       |               |       |
| Cash paid for interest                                                                             |   | $                  | 67,687     |               | $          | 78,641 |   |
| Cash paid for income taxes                                                                         |   | $                  | 32,882     |               | $          | 22,789 |   |
|                                                                                               |   |               |       |               |       |

*See Notes to UnauditedCondensed Consolidated Financial Statements.*

** **

** **

**7**

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** **

** **

**INVESTORSFINANCIAL SERVICES CORP.**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Information is as of and for the nine months and the three months endedSeptember 30, 2003 and 2002)

 

**1.       Descriptionof Business**

 

Investors Financial Services Corp. (‘IFSC’) provides asset administrationservices for the financial services industry through its wholly-ownedsubsidiary, Investors Bank & Trust Company (the ‘Bank’).  As used herein, the defined term “theCompany” shall mean IFSC together with the Bank and its domestic and foreignsubsidiaries.  The Company provides coreservices and value-added services to avariety of financial asset managers, including mutual fund complexes,investment advisors, banks and insurance companies.  Core services include global custody, multicurrency accountingand mutual fund administration. Value-added services include securities lending, foreign exchange, cashmanagement, performance measurement, institutional transfer agency, investmentadvisory services, lines of credit and brokerage services.  The Company is subject to regulationby the Federal Reserve Board of Governors, the Office of the Commissioner ofBanks of the Commonwealth of Massachusetts, the Federal Deposit InsuranceCorporation and the National Association of Securities Dealers.

On April 23, 2002, the Board of Directors approved a two-for-one stocksplit in the form of a 100% stock dividend to stockholders of record as of May24, 2002.  All share numbers in thenotes to the unaudited condensed consolidated financial statements have been restatedto reflect the two-for-one stock split paid June 14, 2002, where applicable.

 

**2.       InterimFinancial Statements**

 

Theunaudited condensed consolidated interim financial statements of the Companyand subsidiaries as of September 30, 2003 and December 31, 2002, and for thenine-month and three-month periods ended September 30, 2003 and 2002 have beenprepared by the Company pursuant to the rules and regulations of the Securitiesand Exchange Commission.  Certain informationand footnote disclosures normally included in annual financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America (‘GAAP’) have been condensed or omitted as permittedby such rules and regulations.  Alladjustments, consisting of normal recurring adjustments, necessary for theirfair presentation in conformity with GAAP are included.  Management believes that the disclosures areadequate to present fairly the financial position, results of operations andcash flows at the dates and for the periods presented. It is suggested thatthese interim financial statements be read in conjunction with the financialstatements and the notes thereto included in the Company’s latest annual reporton Form 10-K. Results for interim periods are not necessarily indicativeof those to be expected for the full fiscal year. Certain amounts in priorfinancial statements have been reclassified to conform to the currentpresentation.

 

 

8

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**2.       InterimFinancial Statements (continued)**

 

***Employee Stock-Based Compensation*** ***—*** The Company measures compensation cost for stock-basedcompensation plans using the intrinsic value method. The intrinsic value methodmeasures compensation cost as the difference of the option exercise price andthe fair market value of the common stock on the measurement date, which isgenerally the date of grant.  Generally,options granted have an exercise price equivalent to the fair market value atthe measurement date.  Accordingly, nocompensation cost has been recorded.  Ifstock-based compensation were recognized using the fair value method, stockoptions would be valued at grant date using the Black-Scholes valuation modeland compensation costs would have decreased net income as indicated below(Dollars in thousands):

 
|                                                                                                                                         |   | **For the  Nine Months** |   | **For the  Three Months** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|---------------------------|--------|
|                                                                                                                                         |   | **Ended  September 30,** |   | **Ended  September 30,**  |   |
|                                                                                                                                         |   | **2003**                 |   | **2002**                  |   | **2003** |   | **2002** |   |
|                                                                                                                                         |   |                     |   |                      |   |   |   |   |   |
| Net income as reported                                                                                                                       |   | $                        | 59,836 |                      | $      | 50,641 |   | $ | 26,404 |   | $ | 17,269 |   |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards, net of related tax effects |   | (6,362                   | )      | (8,464                    | )      | (2,858 | ) | (2,652 | ) |
| Pro forma net income                                                                                                                         |   | $                        | 53,474 |                      | $      | 42,177 |   | $ | 23,546 |   | $ | 14,617 |   |
|                                                                                                                                         |   |                     |   |                      |   |   |   |   |   |
| Earnings per share:                                                                                                                          |   |                     |   |                      |   |   |   |   |   |
| Basic-as reported                                                                                                                            |   | $                        | 0.92   |                      | $      | 0.79 |   | $ | 0.41 |   | $ | 0.27 |   |
| Basic-pro forma                                                                                                                              |   | 0.82                     |   | 0.66                      |   | 0.36 |   | 0.23 |   |
|                                                                                                                                         |   |                     |   |                      |   |   |   |   |   |
| Diluted-as reported                                                                                                                          |   | $                        | 0.90   |                      | $      | 0.76 |   | $ | 0.40 |   | $ | 0.26 |   |
| Diluted-pro forma                                                                                                                            |   | 0.81                     |   | 0.63                      |   | 0.35 |   | 0.22 |   |

 

The fair value of eachoption grant was estimated on the date of grant using the Black-Scholesvaluation model with the following assumptions for the nine months endedSeptember 30, 2003 and 2002, respectively: an average assumed risk-freeinterest rate of 2.24% and 2.40%, an expected life of four years, an averageexpected volatility of 56.13% and 56.20%, and an average dividend yield of0.22%.

For the three months endedSeptember 30, 2003 and 2002, respectively, the following assumptions were usedin the Black-Scholes valuation model: an assumed risk-free interest rate of2.37% and 2.40%, an expected life of four years, an expected volatility of55.87% and 56.20%, and a dividend yield of 0.19% and 0.22%.

***New Accounting Principles*** — The Company has adoptedFASB Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.*  This Interpretation elaborates ondisclosures to be made by a guarantor about its obligations and requiresrecognition of a liability for the fair value of the obligation undertaken inissuing guarantees. On behalf of its clients, the Company lends securities tocreditworthy broker-dealers.  In certaincircumstances, the Company may indemnify its clients for the fair market valueof those securities against a failure of the borrower to return suchsecurities.  The Company requires theborrowers to provide collateral in an amount equal to, or in excess of, 102% ofthe fair market value of U.S. dollar denominated securities borrowed and 105%of the fair market value of non-U.S. dollar denominated securitiesborrowed.  The borrowed securities arerevalued daily to determine whether additional collateral is necessary.  As guarantor, the Company is required to recognize,at the inception of a guarantee, a liability for the fair value of theobligation undertaken in issuing the guarantee.  The Company measures the fair value of its indemnificationobligation by marking its securities lending portfolio to market on a dailybasis and comparing the value of the portfolio to the collateral holdingsposition.  The fair value of theindemnification obligation to be recorded would be the deficiency of collateralas compared to the value of the securities out on loan.  At September 30, 2003, the collateralreceived by the Company was in excess of the value of the securities that theCompany would be required to replace if the borrower defaulted and failed toreturn such securities.  Therefore, thefair value of the indemnification obligation was zero, and the Company hasrecorded no liability.

 

9

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**2.       InterimFinancial Statements (continued)**

 

InJanuary 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable InterestEntities, an Interpretation of Accounting Research Bulletin (ARB) 51.*  FIN 46 addresses consolidation by businessenterprises of variable interest entities (‘VIE’).  FIN 46 requires a VIE to be consolidated by a company if thatcompany is subject to a majority of the risk of loss from the VIE’s activitiesor entitled to receive a majority of the entity’s residual returns, orboth.  The provisions are effective forany new entities that are originated subsequent to January 31, 2003.  For entities that were originated prior toFebruary 1, 2003, the provisions of FIN 46 were to be effective July 31,2003.  In October 2003, the FASBdeferred the adoption of this Interpretation in its entirety. Accordingly, theCompany has delayed the implementation of the Interpretation and does notexpect it to have a material impact on the consolidated financial statements.

 

TheCompany has adopted SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections.*  Among its provisions, this Statementrescinds Statement No. 4, *Reporting Gains and Losses from Extinguishment ofDebt*, and an amendment of that Statement, Statement No. 64, *Extinguishmentsof Debt Made to Satisfy Sinking-Fund Requirements*, and eliminatesthe extraordinary item treatment of reporting gains and losses fromextinguishments of debt.  During thenine months ended September 30, 2003, the Company recorded an earlyextinguishment of $50 million of its Federal Home Loan Bank debt by replacingit with new debt.  The Companyrecognized a $1.1 million fee which has been classified in interestexpense.  The adoption of this Statementdid not have a material impact on the Company’s financial position or resultsof operations.

 

TheCompany has adopted SFAS No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*.  This Statementaddresses financial accounting and reporting for costs associated with exit ordisposal activities by requiring that a liability for a cost associated with anexit or disposal activity be recognized and measured initially at fair valueonly when the liability is incurred. The adoption of this Statement did not have a material impact on theCompany’s financial position or results of operations.

 

InApril 2003, the FASB issued SFAS No. 149, *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities*. SFAS No. 149 amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts and for hedging activitiesunder SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, resulting in more consistent reporting of contracts aseither derivatives or hybrid instruments. SFAS No. 149 is effective for contracts entered into or modified afterJune 30, 2003, and should be applied prospectively.  The Company has evaluated its financial accounting and reportingmethods for all derivative instruments and has found them to be consistent withSFAS No. 149.

 

TheCompany has adopted SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*effective July 1,2003.  SFAS No. 150 requires an issuerto classify financial instruments within its scope, including mandatorilyredeemable financial instruments, as a liability (or an asset in somecircumstances).  The Statement providesthat these instruments, commonly referred to as Capital Securities, must beclassified as liabilities in the statement of financial position and recordedat fair value upon issuance. Capital Securities in existence prior to theadoption of this standard that were originally issued at fair value arereclassified as a liability upon adoption of this standard and no further fairvalue measurements are required. Investors Capital Trust I (‘ICT1’), a Delawarestatutory business trust sponsored by the Company, issued Capital Securities in1997.  On November 7, 2003, themeasurement provisions relating to noncontrolling mandatorily redeemableinstruments were deferred.  Theclassification provisions as written remain in effect.  The adoption of this Statement resulted in areclassification of the ICT1 Capital Securities from mezzanine financing toliabilities in the financial statements. Interest payments on the ICT1 CapitalSecurities are classified as a component of interest expense.

 

 

10

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**3.       Securities**

 

Amortized cost amounts and fair values ofsecurities are summarized as follows as of September 30, 2003 (Dollars inthousands):

 
|                             |   | **Amortized** |      | **Unrealized** |   | **Unrealized** |   | **Fair**  |    |
|----------------------------------|--------|---------------|-----------|----------------|--------|----------------|--------|-----------|---------|
| **Held to Maturity**             |   | **Cost**      |      | **Gains**      |   | **(Losses)**   |   | **Value** |    |
|                             |   |          |      |           |   |           |   |      |    |
| Mortgage-backed securities       |   | $             | 2,022,608 |           | $      | 13,062         |   | $         | (3,586  | ) | $ | 2,032,084 |   |
| Federal agency securities        |   | 1,845,416     |      | 1,594          |   | (12,275        | )      | 1,834,735 |    |
| State and political subdivisions |   | 127,495       |      | 6,703          |   | (144           | )      | 134,054   |    |
|                             |   |          |      |           |   |           |   |      |    |
| Total                            |   | $             | 3,995,519 |           | $      | 21,359         |   | $         | (16,005 | ) | $ | 4,000,873 |   |

 
|                             |   | **Amortized** |      | **Unrealized** |   | **Unrealized** |   | **Fair**  |   |
|----------------------------------|--------|---------------|-----------|----------------|--------|----------------|--------|-----------|--------|
| **Available for Sale**           |   | **Cost**      |      | **Gains**      |   | **(Losses)**   |   | **Value** |   |
|                             |   |          |      |           |   |           |   |      |   |
| Mortgage-backed securities       |   | $             | 3,257,697 |           | $      | 27,412         |   | $         | (8,037 | ) | $ | 3,277,072 |   |
| State and political subdivisions |   | 333,483       |      | 23,215         |   | (81            | )      | 356,617   |   |
| Corporate debt                   |   | 178,518       |      | —         |   | (1,114         | )      | 177,404   |   |
| US Treasury securities           |   | 110,883       |      | 2,972          |   | —         |   | 113,855   |   |
| Federal agency securities        |   | 29,600        |      | 348            |   | —         |   | 29,948    |   |
| Foreign government securities    |   | 9,238         |      | —         |   | (5             | )      | 9,233     |   |
|                             |   |          |      |           |   |           |   |      |   |
| Total                            |   | $             | 3,919,419 |           | $      | 53,947         |   | $         | (9,237 | ) | $ | 3,964,129 |   |

 

Amortized cost amounts and fair values of securitiesare summarized as follows as of December 31, 2002 (Dollars in thousands):

 
|                             |   | **Amortized** |      | **Unrealized** |   | **Unrealized** |   | **Fair**  |   |
|----------------------------------|--------|---------------|-----------|----------------|--------|----------------|--------|-----------|--------|
| **Held to Maturity**             |   | **Cost**      |      | **Gains**      |   | **(Losses)**   |   | **Value** |   |
|                             |   |          |      |           |   |           |   |      |   |
| Mortgage-backed securities       |   | $             | 2,034,430 |           | $      | 19,702         |   | $         | (664   | ) | $ | 2,053,468 |   |
| Federal agency securities        |   | 1,287,238     |      | 2,520          |   | (4,999         | )      | 1,284,759 |   |
| State and political subdivisions |   | 117,021       |      | 5,566          |   | (60            | )      | 122,527   |   |
|                             |   |          |      |           |   |           |   |      |   |
| Total                            |   | $             | 3,438,689 |           | $      | 27,788         |   | $         | (5,723 | ) | $ | 3,460,754 |   |

 
|                             |   | **Amortized** |      | **Unrealized** |   | **Unrealized** |   | **Fair**  |   |
|----------------------------------|--------|---------------|-----------|----------------|--------|----------------|--------|-----------|--------|
| **Available for Sale**           |   | **Cost**      |      | **Gains**      |   | **(Losses)**   |   | **Value** |   |
|                             |   |          |      |           |   |           |   |      |   |
| Mortgage-backed securities       |   | $             | 2,723,703 |           | $      | 36,294         |   | $         | (204   | ) | $ | 2,759,793 |   |
| State and political subdivisions |   | 290,241       |      | 17,090         |   | (39            | )      | 307,292   |   |
| Corporate debt                   |   | 179,612       |      | 21             |   | (5,134         | )      | 174,499   |   |
| Federal agency securities        |   | 29,602        |      | 1,279          |   | —         |   | 30,881    |   |
|                             |   |          |      |           |   |           |   |      |   |
| Total                            |   | $             | 3,223,158 |           | $      | 54,684         |   | $         | (5,377 | ) | $ | 3,272,465 |   |

 

 

11

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**4.       Loans**

 

Loans consist of demandloans to custody clients of the Company, including individuals, not-for-profitinstitutions and mutual fund clients. The loans to mutual funds and otherpooled product clients include lines of credit and advances pursuant to theterms of the custody agreements between the Company and those mutual fundclients to facilitate securities transactions and redemptions. Generally, theloans are, or may be, in the event of default, collateralized with marketablesecurities held by the Company as custodian. There were no impaired ornonperforming loans at September 30, 2003 and December 31, 2002.  In addition, there were no loan charge-offsor recoveries during the nine months ended September 30, 2003 and the yearended December 31, 2002. Loans are summarized as follows (Dollars inthousands):

 
|                           |   | **September  30,  2003** |    | **December 31,  2002** |   |
|--------------------------------|--------|--------------------------|---------|-----------------------------|--------|
| Loans to individuals           |   | $                        | 85,330  |                        | $      | 76,263 |   |
| Loans to mutual funds          |   | 60,093                   |    | 49,372                      |   |
| Loans to others                |   | 21,465                   |    | 18,202                      |   |
|                           |   | 166,888                  |    | 143,837                     |   |
| Less allowance for loan losses |   | (100                     | )       | (100                        | )      |
| Total                          |   | $                        | 166,788 |                        | $      | 143,737 |   |

 

**5.       SecuritiesSold Under Repurchase Agreements**

 

The componentsof securities sold under repurchase agreements are as follows (Dollars inthousands): 
|                                    |   | **September  30,** |      | **December  31,** |   |
|-----------------------------------------|--------|--------------------|-----------|-------------------|--------|
|                                    |   | **2003**           |      | **2002**          |   |
|                                    |   |               |      |              |   |
| Repurchase agreements — short-term |   | $                  | 3,148,458 |              | $      | 2,151,974 |   |
| Repurchase agreements — long-term  |   | 200,000            |      | 150,000           |   |
| Total                                   |   | $                  | 3,348,458 |              | $      | 2,301,974 |   |

 

**6.       Short-termand Other Borrowings**

 

The componentsof short-term and other borrowings are as follows (Dollars in thousands):****
|                                                 |   | **September  30,** |    | **December  31,** |   |
|------------------------------------------------------|--------|--------------------|---------|-------------------|--------|
|                                                 |   | **2003**           |    | **2002**          |   |
|                                                 |   |               |    |              |   |
| Federal Home Loan Bank of Boston long-term advances  |   | $                  | 200,000 |              | $      | 250,000 |   |
| Federal Home Loan Bank of Boston short-term advances |   | 200,000            |    | —            |   |
| Federal Home Loan Bank of Boston overnight advances  |   | 100,000            |    | 360,000           |   |
| Federal funds purchased — short-term            |   | 60,000             |    | —            |   |
| Federal funds purchased — overnight             |   | 55,566             |    | 130,648           |   |
| Treasury, Tax and Loan account                       |   | 166                |    | 459               |   |
| Total                                                |   | $                  | 615,732 |              | $      | 741,107 |   |

The Company has aborrowing arrangement with the Federal Home Loan Bank of Boston (‘FHLBB’),which has been utilized on an overnight, short-term and long-term basis tosatisfy funding requirements.

 

 

12

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**7.       Stockholders’Equity**

 

TheCompany has three stock option plans: the Amended and Restated 1995 Stock Plan(‘Stock Plan’), the Amended and Restated 1995 Non-Employee Director StockOption Plan (‘Director Plan’), and the 1997 Employee Stock Purchase Plan.  There have been no amendments to these plansduring the nine months ended September 30, 2003.

 

Duringthe nine months ended September 30, 2003, the following activity occurred underthe Director Plan and the Stock Plan:

 
|                                           |   | **September  30, 2003** |   |
|------------------------------------------------|--------|-------------------------|--------|
|                                           |   |                    |   | **Weighted—** |   |
|                                           |   |                    |   | **Average** |   |
|                                           |   |                    |   | **Exercise** |   |
|                                           |   | **Shares**              |   | **Price** |   |
|                                           |   |                    |   |   |   |
| Outstanding at December 31, 2002               |   | 6,621,157               |   | $ |  22 |   |
| Granted                                        |   | 89,551                  |   | 25 |   |
| Exercised                                      |   | (439,852                | )      | 8 |   |
| Canceled                                       |   | (122,040                | )      | 31 |   |
| Outstanding at September 30, 2003              |   | 6,148,816               |   | $ |  23 |   |
|                                           |   |                    |   |   |   |
| Outstanding and exercisable September 30, 2003 |   | 4,169,532               |   |   |   |
|                                           |   |                    |   |   |   |

 

Asummary of the 1997 Employee Stock Purchase Plan is as follows:

 
|                                                       |   | **For the  Nine   Months Ended   September 30,   2003** |   | **For the   Year Ended   December 31,   2002** |   |
|------------------------------------------------------------|--------|---------------------------------------------------------|--------|------------------------------------------------|--------|
| Total shares available under the Plan, beginning of period |   | 356,875                                                 |   | 500,764                                        |   |
| Issued at June 30                                          |   | (70,606                                                 | )      | (61,193                                        | )      |
| Issued at December 31                                      |   | —                                                  |   | (82,696                                        | )      |
| Total shares available under the Plan, end of period       |   | 286,269                                                 |   | 356,875                                        |   |

For the six-month periodended June 30, 2003, the purchase price of the stock was $25.50, or 90% of themarket value of the Common Stock on the first business day of the paymentperiod ending June 30, 2003.

 

For the year endedDecember 31, 2002, the purchase price of the stock was $30.00 and $24.75, or90% of the market value of the Common Stock on the first business day of thepayment period ending June 30, 2002 and the last business day of the paymentperiod ending December 31, 2002, respectively.

** **

**13**

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** **

**7.         Stockholders’ Equity (continued)**

 

***Earnings Per Share****—*The reconciliation fromBasic to Diluted earnings per share (‘EPS’) is as follows (Dollars inthousands, except share data):

 
|                                        |   | **For the  Nine Months Ended** |   | **For the  Three Months Ended** |   |
|---------------------------------------------|--------|--------------------------------|--------|---------------------------------|--------|
|                                        |   | **September  30,**             |   | **September  30,**              |   |
|                                        |   | **2003**                       |   | **2002**                        |   | **2003** |   | **2002** |   |
|                                        |   |                           |   |                            |   |   |   |   |   |
| Income available to common stockholders     |   | $                              | 59,836 |                            | $      | 50,641 |   | $ | 26,404 |   | $ | 17,269 |   |
|                                        |   |                           |   |                            |   |   |   |   |   |
| Basic weighted average shares outstanding   |   | 65,029,004                     |   | 64,356,467                      |   | 65,169,758 |   | 64,547,952 |   |
| Dilutive effect of stock options            |   | 1,369,119                      |   | 2,065,632                       |   | 1,386,348 |   | 1,729,045 |   |
| Diluted weighted average shares outstanding |   | 66,398,123                     |   | 66,422,099                      |   | 66,556,106 |   | 66,276,997 |   |
|                                        |   |                           |   |                            |   |   |   |   |   |
| Earnings per share:                         |   |                           |   |                            |   |   |   |   |   |
| Basic                                       |   | $                              | 0.92   |                            | $      | 0.79 |   | $ | 0.41 |   | $ | 0.27 |   |
|                                        |   |                           |   |                            |   |   |   |   |   |
| Diluted                                     |   | $                              | 0.90   |                            | $      | 0.76 |   | $ | 0.40 |   | $ | 0.26 |   |

 

 

Therewere 3,544,283 and 3,482,925 option shares which were not considered dilutivefor purposes of earnings per share calculations for the nine-month andthree-month periods ended September 30, 2003, respectively.

**8.        Off-Balance Sheet Financial Instruments**

***Lines of Credit*****— At September 30, 2003,the Company had commitments to individuals and mutual funds undercollateralized open lines of credit totaling $860.1 million, against which$72.5 million in loans were drawn. The credit risk involved in issuing lines ofcredit is essentially the same as that involved in extending demand loans. TheCompany does not anticipate any loss as a result of these lines of credit.

***Securities Lending*****— On behalf of its clients,the Company lends securities to creditworthy broker-dealers.  In certain circumstances, the Company mayindemnify its clients for the fair market value of those securities against afailure of the borrower to return such securities.  The Company requires the borrowers to provide collateral in anamount equal to, or in excess of, 102% of the fair market value of U.S.dollar-denominated securities borrowed and 105% of the fair market value ofnon-U.S. dollar-denominated securities borrowed.  The borrowed securities are revalued daily to determine whetheradditional collateral is necessary.  Asguarantor, the Company is required to recognize, at the inception of aguarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee.  The Companymeasures the fair value of its indemnification obligation by marking itssecurities lending portfolio to market on a daily basis and comparing the valueof the portfolio to the collateral holdings position.  The fair value of the indemnification obligation to be recordedwould be the deficiency of collateral as compared to the value of thesecurities out on loan.

With respect to theindemnified securities lending portfolio, the cash and U.S. governmentsecurities held by the Company as collateral at September 30, 2003 totaled $4.3billion while the fair value of the portfolio totaled approximately $4.1billion.  Given that the collateral heldwas in excess of the value of the securities that the Company would be requiredto replace if the borrower defaulted and failed to return such securities, theCompany’s indemnification obligation was zero and no liability was recorded.

All securities loans arecategorized as overnight loans. The maximum potential amount of future paymentsthat the Company could be required to make would be equal to the market valueof the securities borrowed.  Since thesecurities loans are overcollateralized by 2% (for U.S. dollar-denominatedsecurities) to 5% (for non-U.S. dollar-denominated securities) of the fairmarket value of the loan made, the collateral held by the Company would be usedto satisfy the obligation.  In addition,each borrowing agreement includes “set-off”

** **

**14**

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** **

**8.        Off-Balance Sheet Financial Instruments (continued)**

 language that allows the Company to use anyexcess collateral on other loans to that borrower to cover any collateralshortfall of that borrower.  However,there is a potential risk that the collateral would not be sufficient to coversuch an obligation if the security on loan increased in value between the timethe borrower defaulted and the time the security is “bought-in.”  In such instances, the Company would“buy-in” the security using all available collateral and a loss would resultfrom the difference between the value of the security “bought-in” and the valueof the collateral held.  The Company hasnever experienced a broker default.

**9.        Derivative Financial Instruments**

 

***                             ******Foreign Exchange Contracts*** — Foreignexchange contracts involve an agreement to exchange the currency of one countryfor the currency of another country at an agreed-upon rate and settlementdate.  Foreign exchange contractsconsist of spot, forward and swap contracts. Spot contracts call for the exchange of one currency for another andusually settle in two business days. Forward contracts call for the exchange of one currency for another at adate beyond spot.  In a currency swap,the holder of a currency transacts simultaneously both a spot and a forwardtransaction in that currency for an equivalent amount of another currency toget temporary liquidity in the currency owned. Unrealized gains or losses resulting from purchases and sales of foreignexchange contracts are included within the respective other assets and otherliabilities categories on the Company’s consolidated balance sheet.  Unrealized gains in other assets were $9.2million and $4.4 million as of September 30, 2003 and December 31, 2002,respectively.  Unrealized losses inother liabilities were $8.8 million and $4.5 million as of September 30, 2003and December 31, 2002, respectively. These gains and losses were reduced by offsetting balances with the samecounterparty where a master netting agreement exists.  These contracts have not been designated as hedging instruments,therefore, all changes in fair value are included in asset servicing fees.  The notional values of the Company’s foreignexchange contracts as of September 30, 2003 and December 31, 2002 were $1.7billion and $0.7 billion, respectively.

 

***                             ******Interest-Rate Contracts*** - Interestrate contracts involve an agreement with a counterparty to exchange cash flowsbased on an underlying interest rate index. A swap agreement involves the exchange of a series of interest payments,either at a fixed or variable rate, based upon the notional amount without theexchange of the underlying principal amount. The Company’s exposure from theseinterest rate contracts results from the possibility that one party may defaulton its contractual obligation when the contracts are in a gain position. TheCompany has experienced no terminations by counterparties of interest rateswaps. Credit risk is limited to the positive fair value of the derivativefinancial instrument, which is significantly less than the notional value. Theeffect of these agreements was to lengthen short-term variable rate liabilitiesinto longer-term fixed rate liabilities. The contractual or notional amounts ofinterest rate swap agreements held by the Company were approximately $1.1billion and $1.0 billion at September 30, 2003 and December 31, 2002,respectively.  These contracts had nocost and the fair values were approximately $(21.8) million and $(33.1) millionat September 30, 2003 and December 31, 2002, respectively.  These fair values are included in the otherliabilities category on the Company’s consolidated balance sheet.  These instruments have been designated ascash flow hedges.  Changes in fair valueof effective portions are included as a component of other comprehensiveincome.  Changes in fair value ofineffective portions are included in net interest income.

 

                              ***Other -*** The Company also entersinto fixed price purchase contracts that are designed to hedge the variabilityof the consideration to be paid for the purchase of investment securities.  By entering into these contracts, theCompany is fixing the price to be paid at a future date for certain investmentsecurities. At September 30, 2003 and December 31, 2002, the Company had $759.0million and $432.6 million, respectively, of fixed price purchase contractsoutstanding to purchase investment securities. Changes in fair value of thesecash flow hedges are included as a component of other comprehensive income.

** **

**15**

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** **

**10.            Commitments and Contingencies**

** **

***Restrictions on Cash Balances***—The Company is required tomaintain certain average cash reserve balances. The average required reservebalance with the Federal Reserve Bank (‘FRB’) for the two-week period includingSeptember 30, 2003 was approximately $20.4 million.  In addition, the Company’s other assets category includesdeposits totaling approximately $21.0 million, which were pledged to secureclearings with depository institutions.

***Contingencies***—The Company provides a broad range ofservices to financial asset managers, such as mutual fund complexes, investmentadvisors, banks and insurance companies. Core services include global custody, multicurrency accounting andmutual fund administration.  Value-addedservices include securities lending,foreign exchange, cash management, performance measurement, institutionaltransfer agency, investment advisory services, lines of credit and brokerageservices.  Assets under custodyand management, held by the Company in a fiduciary capacity, are not includedin the consolidated balance sheets since such items are not assets of theCompany.  Management conducts regularreviews 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, 2003 that are material to the consolidated financial positionor results of operations of the Company.

InMarch 2003, a retroactive change in tax law disallowed a dividends receiveddeduction taken by the Bank on dividends it had received since 1999 from awholly-owned real estate investment trust. The Company’s income statement forthe nine-month period ended September 30, 2003 reflects a net charge of $7.2million, net of federal income tax benefit, representing the settled amountpaid to the Massachusetts Department of Revenue.

 

OnJanuary 31, 2003, the Company was named in a class action lawsuit alleging,among other things, violations of California wage and hour laws at  the Company’s Sacramento and Walnut Creekfacilities.  The lawsuit was filed inthe Superior Court of California, County of Sacramento. On July 23, 2003, theCompany reached an agreement in principle with representatives of theplaintiffs to settle the case. As currently agreed, the settlement will nothave a material impact on the Company’s business, financial condition orresults of operations.  In anticipationof this settlement and related costs, the Company accrued a liability ofapproximately $1.0 million in the second quarter of 2003.  The settlement is subject to preliminaryapproval by the court, proper administration of payments to the class membersand final approval by the court.

 

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**11.            Geographic Reporting**

The Company doesnot utilize segment information for internal reporting as management views theCompany as one segment. The following represents net operating revenue andlong-lived assets (including goodwill) by geographic area (Dollars in thousands):

 
|                        |   | **Net  Operating Revenue**     |    | **Long-Lived  Assets**          |   |
|-----------------------------|--------|--------------------------------|---------|---------------------------------|--------|
|                        |   | **For the  Nine Months Ended** |    | **For the  Three Months Ended** |   |   |   |   |   |
|                        |   | **September  30,**             |    | **September  30,**              |   | **September  30,** |   | **December  31,** |   |
| **Geographic Information:** |   | **2003**                       |    | **2002**                        |   | **2003** |   | **2002** |   | **2003** |   | **2002** |   |
|                        |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| United States               |   | $                              | 337,518 |                            | $      | 314,017 |   | $ | 113,594 |   | $ | 106,220 |   | $ | 150,929 |   | $ | 154,060 |   |
| Ireland                     |   | 13,424                         |    | 8,322                           |   | 5,033 |   | 3,046 |   | 7,131 |   | 773 |   |
| Canada                      |   | 1,505                          |    | 1,477                           |   | 698 |   | 445 |   | 34 |   | 5 |   |
| Cayman Islands              |   | 56                             |    | 63                              |   | 18 |   | 21 |   | — |   | — |   |
|                        |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Total                       |   | $                              | 352,503 |                            | $      | 323,879 |   | $ | 119,343 |   | $ | 109,732 |   | $ | 158,094 |   | $ | 154,838 |   |

 

Barclays GlobalInvestors, N.A. (‘BGI’) accounted for approximately 16% of the Company’sconsolidated net operating revenues for the nine-month periods ended September30, 2003 and 2002.  For the three-monthperiods ended September 30, 2003 and 2002, BGI accounted for approximately 17%of consolidated net operating revenues.

 

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INDEPENDENT ACCOUNTANTS’ REVIEW REPORT

 

To the Board of Directors and Stockholders of

Investors Financial Services Corp.

Boston, Massachusetts

 

We have reviewed the accompanying condensedconsolidated balance sheet of Investors Financial Services Corp. andsubsidiaries (the “Company”) as of September 30, 2003, and the relatedcondensed consolidated statements of income and comprehensive income for thethree-month and nine-month periods ended September 30, 2003 and 2002, and theconsolidated stockholders’ equity and cash flows for the nine-month periods endedSeptember 30, 2003 and 2002.  Theseinterim financial statements are the responsibility of the Company’smanagement.

 

We conducted our review in accordance withstandards established by the American Institute of Certified PublicAccountants.  A review of interimfinancial information consists principally of applying analytical proceduresand making inquiries of persons responsible for financial and accountingmatters.  It is substantially less inscope than an audit conducted in accordance with auditing standards generallyaccepted in the United States of America, the objective of which is theexpression of an opinion regarding the financial statements taken as awhole.  Accordingly, we do not expresssuch an opinion.

 

Based on our reviews, we are not aware of anymaterial modifications that should be made to such condensed consolidatedinterim financial statements for them to be in conformity with accountingprinciples generally accepted in the United States of America.

 

We have previously audited, in accordancewith auditing standards generally accepted in the United States of America, theconsolidated balance sheet of Investors Financial Services Corp. andsubsidiaries as of December 31, 2002, and the related consolidated statementsof income and comprehensive income, stockholders’ equity and cash flows for theyear then ended (not presented herein); and in our report dated February 14,2003, we expressed an unqualified opinion on those consolidated financialstatements.  In our opinion, theinformation set forth in the accompanying condensed consolidated balance sheetas of December 31, 2002 is fairly stated, in all material respects, in relationto the consolidated balance sheet from which it has been derived.

 

As discussed in Note 2 to the condensed consolidatedfinancial statements, the Company adopted Statement of Financial AccountingStandards No. 150, *Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity*.

 

DELOITTE & TOUCHE LLP

Boston, Massachusetts

# November 7, 2003

#  

 

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**Item 2.            Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

**Overview**

 

*You should read the following discussion togetherwith our Unaudited Condensed Consolidated Financial Statements**and relatedNotes to Unaudited Condensed Consolidated Financial Statements, which areincluded elsewhere in this Report.  Thefollowing discussion contains forward-looking statements that reflect plans,estimates and beliefs.  Our actualresults could differ materially from those discussed in the forward-lookingstatements.*

 

                Weprovide a broad range of services to a variety of financial assetmanagers.  These include our coreservices of global custody, multicurrency accounting and mutual fundadministration, as well as our value-added services, which are securitieslending, foreign exchange, cash management, performance measurement,institutional transfer agency, investment advisory services, lines of creditand brokerage services.  At September30, 2003, we provided services for approximately $956 billion in netassets, including approximately $138 billion of foreign net assets.

 

                On April 23,2002, the Board of Directors approved a two-for-one stock split in the form ofa 100% stock dividend payable to shareholders of record as of May 24,2002.  The dividend was paid on June 14,2002.

 

On January 31, 2003, we werenamed in a class action lawsuit alleging, among other things, violations ofCalifornia wage and hour laws at our Sacramento and Walnut Creek facilities.The lawsuit was filed in the Superior Court of California, County ofSacramento. On July 23, 2003, we reached agreement in principle withrepresentatives of the plaintiffs to settle the case.  As currently agreed, the settlement will not have a materialimpact on our business, financial condition or results of operations. Inanticipation of this settlement and related costs, we accrued a liability ofapproximately $1.0 million in the second quarter of 2003. The settlement issubject to preliminary approval by the court, proper administration of paymentsto the class members and final approval by the court.

 

                InMarch 2003, a retroactive change in tax law disallowed a dividends receiveddeduction taken by the Bank on dividends it had received since 1999 from awholly-owned real estate investment trust (‘REIT’). Our income statement forthe nine-month period ended September 30, 2003 reflects a net charge in theamount of $7.2 million, net of federal income tax benefit, representing thesettled amount paid to the Massachusetts Department of Revenue.

 

                OnJune 27, 2003, we and an individual employee of ours were named in a lawsuitalleging, among other things, that we breached an implied covenant of goodfaith and fair dealing in a subadvisory contract with Opus InvestmentManagement, Inc. (‘Opus’) and that our individual employee engaged in a breachof fiduciary duties and tortious interference with a contract.  Opus had been a subadviser to the MerrimacFunds, for which we act as investment adviser. Upon the expiration of Opus’ contract on June 1, 2003, the MerrimacFunds elected not to re-appoint Opus as subadviser.  The lawsuit was filed in Superior Court in Worcester,Massachusetts and seeks unspecified damages. We believe that the claims are without merit and intend to defend ourrights vigorously.  On September 22,2003, we filed a motion to dismiss all claims against us under thecomplaint.  We expect that the courtwill not rule on the motion to dismiss until the first quarter of 2004 at theearliest.

 

                OnJuly 31, 2003, we signed an outsourcing agreement to provide fund accounting,custody and related services for Barclays Global Investors Canada, Ltd.(‘BGICL’).  We expect to complete mostof the conversion of the $22 billion of BGICL assets to our systems by the endof 2003.

 

 

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**Revenue and Expense Overview**

 

                Wederive our revenue from providing financial asset administration services.  Although interest income and noninterestincome are reported separately for financial statement presentation purposes,our service offerings are priced on a bundled basis.  In establishing a fee structure for a specific client, managementanalyzes all expected revenue and related expenses.  Accordingly, we believe net operating revenue (net interestincome plus noninterest income) and net income are the most meaningful measuresof our financial results. Net operating revenue increased 9% to $352.5 millionfrom $323.9 million for the nine months ended September 30, 2003 and 2002,respectively.  Net operating revenueincreased 9% to $119.3 million from $109.7 million for the three months endedSeptember 30, 2003 and 2002, respectively. Net income increased 18% to $59.8 million for the nine months endedSeptember 30, 2003 from $50.6 million for the same period in 2002.  For the three months ended September 30,2003, net income was $26.4 million, up 53% from $17.3 million for the sameperiod in 2002.

 

    Net operatingincome for the nine months ended September 30, 2003 was $67.0 million, up 32%from $50.6 million for the same period in 2002.  Net operating income for the nine months ended September 30, 2003excludes the net $7.2 million charge, net of federal income tax benefit,relating to a retroactive change in Massachusetts tax law discussed throughoutthis report.  During 2003,the Company ceased taking the deduction for dividends paid by the REIT and theeffect of this action will increase the effective tax rate to approximately31.5% for the year. Management considersnet operating income to be a more useful depiction of our actual results ofoperations.

 

                Thefollowing table represents a reconciliation between earnings presented on theface of our Statement of Income and the non-GAAP measure of net operatingincome referenced in this section:

 

**GAAP Earnings**
|                       |   | **For the  Nine Months Ended** |   | **For the  Three Months Ended** |   |
|----------------------------|--------|--------------------------------|--------|---------------------------------|--------|
|                       |   | **September  30,**             |   | **September  30,**              |   |
|                       |   | **2003**                       |   | **2002**                        |   | **2003** |   | **2002** |   |
|                       |   |                           |   |                            |   |   |   |   |   |
| Income before taxes        |   | $                              | 97,547 |                            | $      | 72,345 |   | $ | 38,545 |   | $ | 24,670 |   |
| Provision for income taxes |   | 37,711                         |   | 21,704                          |   | 12,141 |   | 7,401 |   |
| Net income                 |   | $                              | 59,836 |                            | $      | 50,641 |   | $ | 26,404 |   | $ | 17,269 |   |
| Earnings per share:        |   |                           |   |                            |   |   |   |   |   |
| Basic                      |   | $                              | 0.92   |                            | $      | 0.79 |   | $ | 0.41 |   | $ | 0.27 |   |
|                       |   |                           |   |                            |   |   |   |   |   |
| Diluted                    |   | $                              | 0.90   |                            | $      | 0.76 |   | $ | 0.40 |   | $ | 0.26 |   |

 

**Operating Earnings**
|                       |   | **For the  Nine Months Ended** |   | **For the  Three Months Ended** |   |
|----------------------------|--------|--------------------------------|--------|---------------------------------|--------|
|                       |   | **September  30,**             |   | **September  30,**              |   |
|                       |   | **2003**                       |   | **2002**                        |   | **2003** |   | **2002** |   |
|                       |   |                           |   |                            |   |   |   |   |   |
| Income before taxes        |   | $                              | 97,547 |                            | $      | 72,345 |   | $ | 38,545 |   | $ | 24,670 |   |
| Provision for income taxes |   | 30,511                         | (1)    | 21,704                          |   | 12,141 |   | 7,401 |   |
| Net income                 |   | $                              | 67,036 |                            | $      | 50,641 |   | $ | 26,404 |   | $ | 17,269 |   |
| Earnings per share:        |   |                           |   |                            |   |   |   |   |   |
| Basic                      |   | $                              | 1.03   |                            | $      | 0.79 |   | $ | 0.41 |   | $ | 0.27 |   |
|                       |   |                           |   |                            |   |   |   |   |   |
| Diluted                    |   | $                              | 1.01   |                            | $      | 0.76 |   | $ | 0.40 |   | $ | 0.26 |   |

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(1)          Provision for the nine months ended September 30, 2003 excludes a taxcharge of $7.2 million, net of federal income tax benefit, related to aretroactive tax law change by the Commonwealth of Massachusetts disallowing a95% dividends received deduction on dividends that the Bank received from itswholly-owned REIT.  The effect of theexclusions is an increase of $0.11 per diluted share and basic share.

 

 

                Noninterestincome consists primarily of fees for financial asset servicing and isprincipally derived from global custody, multicurrency accounting, mutual fundadministration and institutional transfer agency services for financial assetmanagers and the assets they control. Our clients pay fees based on the volumeof assets processed, portfolio transactions, income collected and whether othervalue-added services such as foreign exchange, securities lending and 

 

 

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cash management are needed.  Asset-based fees are usually charged on a sliding scale and aresubject to minimum fees.  As such, whenthe assets in a portfolio under custody grow as a result of changes in marketvalues or cash inflows, our fees may be a smaller percentage of those assets.  Conversely, as asset values fall, ourrevenue decreases by the marginal rate charged on our sliding scale pricingmodel.  As a result, as asset valuesdecrease, fees will decrease, but at a smaller percentage than the asset valuedecrease.

 

                Netinterest income represents the difference between income from interest-earningassets and expense on interest-bearing liabilities. Our clients, in the courseof their financial asset management, maintain cash balances, which they candeposit with us on a short-term basis in interest-bearing accounts.  We either directly invest these cashbalances to earn interest income, or place these deposits in third-partyvehicles and remit a portion of the earnings on these investments to ourclients.  Our share of earnings fromthese investments is viewed as part of the total compensation that our clientspay us for servicing their assets.

 

                Operatingexpenses consist of costs incurred in support of our business activities.  As a service provider, our largestexpenditures are staffing costs, including compensation and benefits.  We rely heavily on technological tools andservices for processing, communicating and storing data.  As a result, our technology andtelecommunication expense is also a large percentage of our operating expenses.  We also rely on an established network ofglobal subcustodians in order to service our clients worldwide, which isreflected in our transaction processing service expense.

 

                Ifthe value of equity assets held by our clients were to increase or decrease by10%, we estimate that this, by itself, would currently cause a correspondingchange of approximately 3% in our earnings per share.  If the value of fixed income assets held by our clients were toincrease or decrease by 10%, we estimate that this, by itself, would currentlycause a corresponding change of approximately 2% in our earnings pershare.  In practice, earnings per sharedo not track precisely to the value of the equity markets because conditionspresent in a market increase or decrease may generate offsetting increases inother revenue items.  For example,market volatility often results in increased transaction fee revenue.  Also, market declines may result inincreased interest income and sweep fee income as clients move larger amountsof assets into cash management vehicles that we offer.  As a result, our earnings have remainedstrong despite steep declines in the broad equity markets in 2000, 2001 and2002.  However, there can be noassurance that these offsetting revenue increases will occur during any futuredownturn in the equity markets.

 

# **Critical AccountingPolicies**

 

Accounting policiesinvolving significant judgments and assumptions by management, which have, orcould have, a material impact on both the carrying value of certain assets andnet income, are considered critical accounting policies.  We consider the following to be our criticalaccounting policies: derivatives, valuation of goodwill, capitalized costs ofsoftware developed for internal use, other than temporary impairment ofsecurities, accounting for stock options, and revenue recognition.  There have been no significant changes inthe methods or assumptions used in the accounting policies that requiredmaterial estimates and assumptions during the nine months ended September 30,2003.  Senior management has discussedthese critical accounting policies with the audit committee and the auditors.

 

# *Derivatives*

 

We do not purchasederivative instruments for trading purposes. We use derivative instruments to manage exposures to interest raterisks.  We routinely enter into interestrate swap agreements in which we pay a fixed interest rate and receive afloating interest rate.  Thesetransactions are designed to hedge a portion of our floating rate liabilities.  By entering into apay-fixed/receive-floating interest rate swap, a portion of our floating rateliabilities are effectively converted to a fixed rate liability for the term ofthe interest rate swap agreement.  Thisassists us in matching our fixed rate assets with funding sources with similarmaturities, which is an integral component of our asset liabilitystrategy.  We also enter into fixedprice purchase contracts that are designed to hedge the variability of theconsideration to be paid for the purchase of investment securities.  By entering into these contracts, we are fixingthe price to be paid at a future date for certain investment securities.

 

All derivatives, whetherdesignated in hedging relationships or not, are required to be recorded on thebalance sheet at fair value.  If thederivative is designated as a fair value hedge, the change in the fair value ofthe derivative and the item being hedged will be recognized in earnings.  If the derivative is designated as a cashflow hedge, the effective portions of changes in the fair value of thederivative are recorded as a component of other 

 

 

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comprehensive income.  Ineffective portions of changes in the fairvalue of the derivatives are recognized in earnings.  For derivatives that do not qualify as hedges changes in fairvalue are recognized in earnings.

 

We measure the changes infair value of our hedge-designated interest rate swap derivatives against thechanges in expected cash flows of the underlying hedged transactions for eachreporting period.  This process involvesthe estimation of the expected future cash flows of hedged transactions.  Interest rate swaps are valued using anationally recognized swap valuation model. The LIBOR (London Interbank Offered Rate) curve in this model serves asthe basis for computing the market value of the swap portfolio.  If interest rates increase, the swaps wouldgain in value.  Conversely, if interestrates decrease there would be a corresponding decline in the market value ofthe swap portfolio.  Changes inconditions or the occurrence of unforeseen events could affect the timing ofthe recognition of changes in fair value of certain hedging derivatives.  The measurement of fair value is based uponmarket values; however, in the absence of quoted market values, measurementinvolves valuation estimates.  Theseestimates are based on methodologies deemed appropriate in thecircumstances.  However, the use ofalternative assumptions could have a significant effect on estimated fairvalues.

 

Weexperienced hedge ineffectiveness equivalent to $1.1 million for the ninemonths ended September 30, 2003, which is included in our interestexpense.  At September 30, 2003, thecontractual or notional amounts of our interest rate swap agreements wereapproximately $1.1 billion.  These derivativeshave a fair value of approximately $(21.8) million and are included in theother liabilities category of our consolidated balance sheet.  These swaps have been designated as cashflow hedges and changes in fair value are recognized in other comprehensiveincome.

AtSeptember 30, 2003, we had $759.0 million of fixed price purchase contractsoutstanding.  There was no associatedunrealized gain or loss for these purchase contracts.  These contracts to purchase investment securities are designatedas cash flow hedges and changes in fair value are recognized in othercomprehensive income.

We also enter intoforeign exchange contracts with clients and seek to enter into matchedpositions with another bank.  Thesecontracts are subject to market valuations of foreign currencies.  Gains and losses from such fluctuations arenetted and recorded as an adjustment to asset servicing fees.  Unrealized gains or losses resulting frompurchases and sales of foreign exchange contracts are included within the respectiveother assets and other liabilities categories on our consolidated balancesheet.  Unrealized gains in other assetswere $9.2 million and unrealized losses in other liabilities were $8.8 millionat September 30, 2003.  The foreignexchange contracts have been reduced by balances with the same counterpartywhere a master netting agreement exists. These contracts have not been designated as hedging instruments.  Therefore, all changes in fair value areincluded in asset servicing fees.

 

# *Valuation of goodwill*

 

For acquisitions accountedfor under the purchase method, we are required to record assets acquired andliabilities assumed at their fair value, which is an estimate determined by theuse of internal or other valuation techniques. These valuation estimates mayresult in goodwill and other intangible assets. Goodwill is subject to ongoingperiodic impairment tests and is evaluated using various fair value techniques.In evaluating the recorded goodwill for impairment, management must estimatethe fair value of the reporting units that have goodwill. We view the Companyas one segment and one reporting unit; therefore, the valuation of the fairvalue of our entity is evaluated at the consolidated level.  The valuation requires estimates of futureperformance and is susceptible to changes in the capital market environment.

 

*Capitalized costs of software developed for internaluse*

 

Costs of internallydeveloped software, such as those related to software licenses, programming,testing, configuration and integration, are capitalized and included inequipment and leasehold improvements. Assets are placed in service and depreciation and/or amortizationcommences when successful testing has been achieved.  Capitalized software costs are amortized over the estimateduseful life of a given project, which approximate three years.  These assets are reviewed on an ongoingbasis for compliance with accounting standards.  In addition, management periodically reviews capitalized costsfor impairment.  Significant judgment isexercised in these impairment reviews including the periodic evaluation of thecost/benefit analyses of software projects under development and in thedetermination of the remaining useful life of the completed projects.

 

 

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# *Other than temporary impairment*

 

On a quarterly basis, weevaluate our investment portfolio to determine whether there are any other thantemporary impairment valuation issues. This analysis is performed by comparing quoted market prices toamortized cost and evaluating each identified security whose market value isless than amortized cost for a sustained period of time. Our accounting policyrequires recognition of an other than temporary impairment charge on a securityif it is determined that we are unable to recover all amounts due under thecontractual obligations of the security. Management uses its best estimate regarding the estimated futurepayments on the contractual obligation by reviewing changes in security ratingsand evaluating the financial performance of the underlying issuer.

 

# *Accounting for stock options*

 

We measure compensation costfor stock-based plans using the intrinsic value method. The intrinsic valuemethod measures compensation cost as the difference between the exercise priceof options granted and the fair market value of our stock at the measurementdate, which is generally the date of grant. Generally, options granted have anexercise price equivalent to the fair market value at the measurement date.  Accordingly, no compensation cost has beenrecorded.  Alternatively, we couldchoose to record compensation expense using the fair value method.  The fair value method utilizes significantassumptions such as volatility, expected life of the option, risk-free interestrates as well as a dividend yield in a Black-Scholes valuation model tocalculate the amount of compensation expense. Under the fair value method, the compensation expense calculated isrecognized over the vesting period of the options.  The expected life of an option and the volatility of theunderlying stock determine a majority of the value of an option and itsultimate compensation cost.  As such,the longer the option life or the higher the volatility of the underlyingstock, the higher the value of the option and the higher the relatedcompensation cost to us.   If we hadrecognized compensation expense under the fair value method, compensationexpense relating to stock options would have been $6.4 million and $2.9 millionfor the nine months and three months ended September 30, 2003, respectively.

 

# *Revenue recognition*

 

We recognize revenue fromasset servicing and investment advisory services based on contractual termssigned by our clients.  Generally,revenue is accrued by multiplying average or month-end net assets by contractedrates.  Revenue is considered earneddaily as transactions are processed or services are provided and is accruedmonthly.   We recognize revenue from ourvalue-added services, such as foreign exchange, securities lending and cashmanagement services based on the specific type of transaction volume.  Value-added service revenue is earned dailyas transactions are processed or services are provided and is accrued monthly.  Revenue on interest-earning assets is recognizedbased on the effective yield of the financial instrument.  Revenue on interest-earning assets is earneddaily and accrued monthly.

 

Revenue recognition forasset servicing and value-added services involves the use of estimates andassumptions, including components that are calculated based on estimated assetvaluations and transaction volumes. While these estimates and assumptions could be considered complex, wehave the necessary internal controls and processes in place to ensure theaccuracy of revenue accruals. Historically, revenue recognized using these processes has fairlymatched revenue billed and collected. Our revenue recognition process is promptly validated by timelyinvoicing and cash collection from clients and counterparties.

 

 

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**CertainFactors That May Affect Future Results**

 

                Fromtime to time, information provided by us, statements made by our employees, orinformation included in our filings with the SEC (including this Form 10-Q) maycontain statements which are not historical facts, so-called “forward-lookingstatements,” and which involve risks and uncertainties.  Thesestatements relate to future events or our future financial performance and areidentified by words such as “may,” “will,” “could,” “should,” “expect,” “plan,”“intend,” “seek,” “anticipate,” “believe,” “estimate,” “potential,” or“continue” or other comparable terms or the negative of those terms.  Forward-looking statements in thisForm 10-Q include certain statements regarding liquidity, annual dividendpayments, interest rate conditions, interest rate sensitivity, loss exposure onlines of credit, the timing and effect on earnings of derivative gains andlosses, the effect on earnings of changes in equity values, timing of clientconversions and the effect of certain legal claims against us.  Our actual future results may differsignificantly from those stated in any forward-looking statements.  Factors that may cause such differencesinclude, 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.

 

*Our operating results are subject to fluctuations ininterest rates and the securities markets.*

 

                A significant portion of ourfees are based on the market value of the assets we process.  Accordingly, our operating results aresubject to fluctuations in interest rates and securities markets as thesefluctuations affect the market value of assets processed.  Current market conditions, including therecent volatility in the equity markets, can have a material effect on ourasset-based fees.  While reductions inasset servicing fees may be offset by increases in other sources of revenue, asustained downward movement of the broad equity markets will likely have anadverse impact on our earnings. Fluctuations in interest rates or the securities markets can also leadto investors seeking alternatives to the investment offerings of our clients,which could result in a lesser amount of assets processed and correspondinglylower fees.  Also, our net interestincome is earned by investing depositors’ funds and making loans.  Rapid changes in interest rates and/or therelationship between short-term and long-term interest rates could adverselyaffect the market value of, or the earnings produced by, our investment andloan portfolios, and thus could adversely affect our operating results.

 

*A material portion of our revenues is derived from ourrelationship with Barclays Global Investors, N.A. (‘BGI’) and related entities.*

 

                Asa result of our recent selection to service assets for Barclays GlobalInvestors Canada, Ltd., our assumption of the operations of the U.S. assetadministration unit of BGI in 2001 and our ongoing relationship with BGI’siShares and Master Investment Portfolios, BGI accounted for approximately 16%and 17% of our net operating revenue during the nine months and three monthsended September 30, 2003, respectively. We expect that BGI will continue to account for a significant portion ofour net operating revenue.  While weprovide services to BGI under long-term contracts, those contracts may beterminated for certain regulatory and fiduciary reasons.  The loss of BGI’s business would cause ournet operating revenue to decline and may have an adverse effect on ourquarterly and annual results.

 

*Wemay incur losses due to operational errors*

 

                Theservices that we provide require complex processes and interaction withnumerous third parties.  While wemaintain sophisticated computer systems and a comprehensive system of controls,and our operational history has been excellent, from time to time we may makeoperational errors for which we are responsible to our clients.  In addition, even though we maintainappropriate errors and omissions and other insurance policies, an operationalerror could result in significant liability to us and may have a materialadverse effect on our results of operations.

 

*We face significant competition from other financialservices companies, which could negatively affect our operating results.*

 

                Weare 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 

 

 

24

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capabilities and no longer outsource these services tous.  As a result, we may not be able tocompete effectively with current or future competitors, which could result in aloss of existing clients or difficulty in gaining new clients.

 

*We may incur significant costs defending legal claims.*

 

                Wehave been named in a lawsuit in Massachusetts state court alleging, among otherthings, violations of a covenant of good faith and fair dealing in a contract.While we believe this claim is without merit, we cannot be sure that we willprevail in the defense of this claim. Litigation is costly and could divert the attention of management.  We may become subject to other legal claimsin the future.

 

*Our future results depend, in part, on successfulintegration of pending and possible future acquisitions and outsourcingtransactions.*

 

                Integrationof acquisitions and outsourcing transactions is complicated and frequentlypresents unforeseen difficulties and expenses which can affect whether and whena particular acquisition or outsourcing transaction will be accretive to ourearnings per share.  Any futureacquisitions or outsourcing transactions will present similar challenges. Theseacquisitions or outsourcing transactions can also consume a significant amountof management’s time.

 

*The failure to properly manage our growth could adverselyaffect the quality of our services and result in the loss of clients.*

 

                Wehave been experiencing a period of rapid growth that has required thededication of significant management and other resources. 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.

 

*We must hire and retain skilled personnel in order tosucceed.*

 

                Qualifiedpersonnel, in particular managers and other senior personnel, are in greatdemand throughout the financial services industry, even in today’s slowereconomy.  We could find it increasinglydifficult to continue to attract and retain sufficient numbers of these highlyskilled employees, which could affect our ability to attract and retainclients.

 

*We may not be able to protect our proprietary technology.*

 

                Our proprietary technology is important to ourbusiness.  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.

 

*Our quarterly and annual operating results may fluctuate.*

 

                Ourquarterly and annual operating results are difficult to predict and mayfluctuate from quarter to quarter and annually for several reasons, including:

 

                                                •              The timing of commencement or termination of clientengagements;

 

                                                •              The rate of net inflows and outflows of investor fundsin the investment vehicles offered by our clients; and

 

                                                •              Rapid changes in interest rates and equity values.

 

                Mostof our expenses, like employee compensation and rent, are relativelyfixed.  As a result, any shortfall inrevenue relative to our expectations could significantly affect our operatingresults.

 

*We are subject to extensive federal and state regulationsthat impose complex restraints on our business.*

 

 

25

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                Federaland state laws and regulations applicable to financial institutions and theirparent companies apply to us.  Ourprimary regulators are the Federal Reserve Board (‘FRB’), the Federal DepositInsurance Corporation  (‘FDIC’), theMassachusetts Commissioner of Banks and the National Association of SecuritiesDealers (‘NASD’).  Virtually all aspectsof our operations are subject to specific requirements or restrictions andgeneral regulatory oversight including the following:

 

                                                •              The FRB and the FDIC maintain capital requirements thatwe must meet. Failure to meet those requirements could lead to severeregulatory action or even receivership. We are currently considered to be “wellcapitalized”;

 

                                                •              Under Massachusetts law, the Bank may be restricted inits ability to pay dividends to Investors Financial, which may in turn restrictour ability to pay dividends to our stockholders;

 

                                                •              The FRB and the FDIC are empowered to assess monetarypenalties against, and to order termination of activities by, companies orindividuals who violate the law; and

 

                                                •              The NASD maintains certain regulatory requirements thatour securities broker affiliate, Investors Securities Services, Inc. mustmeet.  Failure to meet thoserequirements could lead to severe regulatory action.

 

                Bankinglaw restricts our ability to own the stock of certain companies and also makesit more difficult for us to be acquired. Also, we have not elected financial holding company status under thefederal Gramm-Leach-Bliley Act of 1999. This may place us at a competitive disadvantage with respect to otherorganizations.

 

 

26

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**Results of Operations**

*Comparison of OperatingResults for the Nine Months and the Three Months Ended September 30, 2003 and2002*

 

*Net Operating Revenue*

 

                Thecomponents of net operating revenue are as follows (Dollars in thousands):

 
|                        |   | **For the  Nine Months Ended September 30,** |    | **For the Three  Months Ended September 30,** |   |
|-----------------------------|--------|----------------------------------------------|---------|-----------------------------------------------|--------|
|                        |   | **2003**                                     |    | **2002**                                      |   | **Change** |   | **2003** |   | **2002** |   | **Change** |   |
|                        |   |                                         |    |                                          |   |   |   |   |   |   |   |   |   |
| Net interest income         |   | $                                            | 111,627 |                                          | $      | 104,131 |   | 7 | % | $ | 35,262 |   | $ | 35,235 |   | 0 | % |
| Noninterest income          |   | 240,876                                      |    | 219,748                                       |   | 10 | % | 84,081 |   | 74,497 |   | 13 | % |
|                        |   |                                         |    |                                          |   |   |   |   |   |   |   |   |   |
| Total net operating revenue |   | $                                            | 352,503 |                                          | $      | 323,879 |   | 9 | % | $ | 119,343 |   | $ | 109,732 |   | 9 | % |

 

*NetInterest Income*

 

                Netinterest income is affected by the volume and mix of assets and liabilities,and the movement and level of interest rates. The table below presents thechange in net interest income resulting from change in the volume ofinterest-earning assets or interest-bearing liabilities and change in interestrates for the nine months and three months ended September 30, 2003 compared tothe same periods in 2002. Changes attributed to both volume and rate have beenallocated based on the proportion of change in each category (Dollars inthousands):

 
|                                                                |   | **For the  Nine Months Ended   September 30, 2003** |   | **For the  Three Months Ended   September 30, 2003** |   |
|---------------------------------------------------------------------|--------|-----------------------------------------------------|--------|------------------------------------------------------|--------|
|                                                                |   | **Change**                                          |   | **Change**                                           |   |   |   | **Change** |   | **Change** |   |   |   |
|                                                                |   | **Due to**                                          |   | **Due to**                                           |   |   |   | **Due to** |   | **Due to** |   |   |   |
|                                                                |   | **Volume**                                          |   | **Rate**                                             |   | **Net** |   | **Volume** |   | **Rate** |   | **Net** |   |
|                                                                |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| **Interest-earning assets:**                                        |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under resale agreements |   | $                                                   | (233   | )                                                    | $      | (188 | ) | $ | (421 | ) | $ | (246 | ) | $ | (150 | ) | $ | (396 | ) |
| Investment securities                                               |   | 49,758                                              |   | (54,157                                              | )      | (4,399 | ) | 17,039 |   | (22,016 | ) | (4,977 | ) |
| Loans                                                               |   | 251                                                 |   | (492                                                 | )      | (241 | ) | 63 |   | (121 | ) | (58 | ) |
|                                                                |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                       |   | $                                                   | 49,776 |                                                 | $      | (54,837 | ) | $ | (5,061 | ) | $ | 16,856 |   | $ | (22,287 | ) | $ | (5,431 | ) |
|                                                                |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                   |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| Deposits                                                            |   | $                                                   | 9,039  |                                                 | $      | (12,118 | ) | $ | (3,079 | ) | $ | 2,939 |   | $ | (3,222 | ) | $ | (283 | ) |
| Borrowings                                                          |   | 11,191                                              |   | (20,669                                              | )      | (9,478 | ) | 4,809 |   | (9,984 | ) | (5,175 | ) |
|                                                                |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities                                  |   | $                                                   | 20,230 |                                                 | $      | (32,787 | ) | $ | (12,557 | ) | $ | 7,748 |   | $ | (13,206 | ) | $ | (5,458 | ) |
|                                                                |   |                                                |   |                                                 |   |   |   |   |   |   |   |   |   |
| Change in net interest income                                       |   | $                                                   | 29,546 |                                                 | $      | (22,050 | ) | $ | 7,496 |   | $ | 9,108 |   | $ | (9,081 | ) | $ | 27 |   |
|                                                                     |        |                                                     |        |                                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

                Netinterest income was $111.6 million for the nine months ended September 30,2003, up 7% from the same period in 2002, due to a decrease in interest expensepaid on borrowings offset by a slight decrease in interest income earned oninvestments. We earned lower yields on assets, as maturing assets werereinvested at lower market rates. Interest expense declined due to the continued decline in the FederalFunds target rate, which is the primary index for our funding.  Repurchase agreements and client depositsare our primary sources of funding for the growth of interest-earning assets.

 

                Netinterest income was $35.3 million for the three months ended September 30,2003, flat compared to the same period in 2002.  Our net interest margin for this period was maintained due to theincrease in volume of our assets and liabilities keeping pace with the declinein the interest rate environment.

 

 

27

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                Asindicated in the net interest margin table below, the average yield on interest-earningassets was 3.29% for the nine months ended September 30, 2003, down 113 basispoints from the same period in 2002. The average rate paid on interest-bearingliabilities was 1.35% for the nine months ended September 30, 2003, down 78basis points from the same period in 2002. These decreases reflect the lowerinterest rate environment for the nine months ended September 30, 2003 comparedto the same period in 2002.  The averageFederal Funds target rate for the nine months ending September 30, 2003 was1.13% compared to an average rate of 1.75% for the same period in the prioryear.  The average Prime rate for thenine months ended September 30, 2003 was 4.15% compared to an average rate of4.75% for the comparative prior year period.

 

                Theaverage yield on interest-earning assets was 2.99% for the three months endedSeptember 30, 2003, down 126 basis points from the same period in 2002.  The average rate paid on interest-bearingliabilities was 1.28% for the three months ended September 30, 2003, down 82basis points from the same period in 2002. Again, these decreases reflect thelower rate environment for the three months ended September 30, 2003. Theeffect on net interest income due to changes in rates for the nine months andthree months ended September 30, 2003 was a decrease of $22.1 million and $9.1million, respectively.

 

                The net interest margindecreased 45 basis points to 2.04% and decreased 54 basis points to 1.81% forthe nine months and three months ended September 30, 2003, respectively,compared to the same periods last year. Our net interest margin compressed aswe continued to experience high volumes of prepayments which causes us toreinvest these cash flows in lower yielding assets.  In addition, the historical low level of interest rates limitsour ability to price our liabilities lower and remain competitive.  Overall, our asset yields have declined morerapidly than our funding costs.

 

 

28

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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, 2003** |      | **Nine  Months Ended September 30, 2002** |    |
|---------------------------------------------------------------------------|--------|-------------------------------------------|-----------|-------------------------------------------|---------|
|                                                                      |   | **Average**                               |      |                                      |    | **Average** |   | **Average** |   |   |   | **Average** |   |
|                                                                      |   | **Balance**                               |      | **Interest**                              |    | **Yield/Cost** |   | **Balance** |   | **Interest** |   | **Yield/Cost** |   |
|                                                                      |   |                                      |      |                                      |    |   |   |   |   |   |   |   |   |
| **Interest-earning assets:**                                              |   |                                      |      |                                      |    |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under resale  agreements |   | $                                         | 31,311    |                                      | $       | 259 |   | 1.10 | % | $ | 54,144 |   | $ | 680 |   | 1.67 | % |
| Investment securities(1)                                                  |   | 7,145,534                                 |      | 176,995                                   |    | 3.30 | % | 5,411,656 |   | 181,394 |   | 4.47 | % |
| Loans                                                                     |   | 120,955                                   |      | 2,650                                     |    | 2.92 | % | 110,747 |   | 2,891 |   | 3.48 | % |
| Total interest-earning assets                                             |   | 7,297,800                                 |      | 179,904                                   |    | 3.29 | % | 5,576,547 |   | 184,965 |   | 4.42 | % |
| Allowance for loan losses                                                 |   | (100                                      | )         |                                      |    |   |   | (100 | ) |   |   |   |   |
| Noninterest-earning assets                                                |   | 604,006                                   |      |                                      |    |   |   | 346,813 |   |   |   |   |   |
| Total assets                                                              |   | $                                         | 7,901,706 |                                      |    |   |   |   | $ | 5,923,260 |   |   |   |   |   |
|                                                                      |   |                                      |      |                                      |    |   |   |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                         |   |                                      |      |                                      |    |   |   |   |   |   |   |   |   |
| Deposits:                                                                 |   |                                      |      |                                      |    |   |   |   |   |   |   |   |   |
| Demand                                                                    |   | $                                         | —    |                                      | $       | — |   | — |   | $ | 1,100 |   | $ | 4 |   | 0.48 | % |
| Savings                                                                   |   | 2,413,323                                 |      | 28,697                                    |    | 1.59 | % | 1,797,890 |   | 31,749 |   | 2.35 | % |
| Time                                                                      |   | 231                                       |      | 1                                         |    | 0.58 | % | 1,862 |   | 24 |   | 1.72 | % |
| Securities sold under repurchase agreements                               |   | 3,281,576                                 |      | 22,385                                    |    | 0.91 | % | 2,379,131 |   | 23,888 |   | 1.34 | % |
| Trust preferred stock (2)                                                 |   | 24,000                                    |      | 1,758                                     |    | 9.77 | % | 24,889 |   | 1,852 |   | 9.92 | % |
| Other borrowings (3)                                                      |   | 1,022,343                                 |      | 15,436                                    |    | 2.01 | % | 865,927 |   | 23,317 |   | 3.59 | % |
| Total interest-bearing liabilities                                        |   | 6,741,473                                 |      | 68,277                                    |    | 1.35 | % | 5,070,799 |   | 80,834 |   | 2.13 | % |
| Noninterest-bearing liabilities:                                          |   |                                      |      |                                      |    |   |   |   |   |   |   |   |   |
| Demand deposits                                                           |   | 230,967                                   |      |                                      |    |   |   | 182,606 |   |   |   |   |   |
| Savings                                                                   |   | 132,880                                   |      |                                      |    |   |   | 120,666 |   |   |   |   |   |
| Noninterest-bearing time deposits                                         |   | 107,692                                   |      |                                      |    |   |   | 90,000 |   |   |   |   |   |
| Other liabilities                                                         |   | 216,574                                   |      |                                      |    |   |   | 75,971 |   |   |   |   |   |
| Total liabilities                                                         |   | 7,429,586                                 |      |                                      |    |   |   | 5,540,042 |   |   |   |   |   |
| Equity                                                                    |   | 472,120                                   |      |                                      |    |   |   | 383,218 |   |   |   |   |   |
| Total liabilities and equity                                              |   | $                                         | 7,901,706 |                                      |    |   |   |   | $ | 5,923,260 |   |   |   |   |   |
| Net interest income                                                       |   |                                      |      | $                                         | 111,627 |   |   |   |   |   | $ | 104,131 |   |   |   |
| Net interest margin (4)                                                   |   |                                      |      |                                      |    | 2.04 | % |   |   |   |   | 2.49 | % |
| Average interest rate spread (5)                                          |   |                                      |      |                                      |    | 1.94 | % |   |   |   |   | 2.29 | % |
| Ratio of interest-earning assets to interest-bearing liabilities          |   |                                      |      |                                      |    | 108.25 | % |   |   |   |   | 109.97 | % |

----

          (1)    Average yield/cost on available for salesecurities is based on amortized cost.

          (2)    Effective July 1, 2003, the Company adoptedprovisions of SFAS 150, which resulted in a reclassification of the trustpreferred stock from mezzanine financing to liabilities.

   (3)    Interest expenseincludes prepayment fees of $1.1 million and $5.0 million for 2003 and 2002,respectively.

   (4)    Net interest incomedivided by total interest-earning assets.

          (5)    Yield on interest-earning assets less ratepaid on interest-bearing liabilities.

 

 

29

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*NoninterestIncome*

 

                Noninterestincome was $240.9 million for the nine months ended September 30, 2003, up 10%from the same period in 2002, and was $84.1 million for the three months endedSeptember 30, 2003, up 13% from the same period in 2002.  Noninterest income consists of the followingitems (Dollars in thousands):

 
|                                   |   | **For the  Nine Months Ended** |    | **For the  Three Months Ended** |   |
|----------------------------------------|--------|--------------------------------|---------|---------------------------------|--------|
|                                   |   | **September  30, 2002**        |    | **September  30, 2002**         |   |
|                                   |   | **2003**                       |    | **2002**                        |   | **Change** |   | **2003** |   | **2002** |   | **Change** |   |
|                                   |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Core service fees:                     |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Custody, accounting and administration |   | $                              | 184,151 |                            | $      | 172,857 |   | 7 | % | $ | 65,314 |   | $ | 57,666 |   | 13 | % |
|                                   |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Ancillary service fees:                |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Foreign exchange                       |   | 25,984                         |    | 18,706                          |   | 39 | % | 9,161 |   | 7,669 |   | 19 | % |
| Cash management                        |   | 15,787                         |    | 12,362                          |   | 28 | % | 5,120 |   | 4,416 |   | 16 | % |
| Securities lending                     |   | 6,918                          |    | 8,605                           |   | (20 | )% | 2,076 |   | 2,362 |   | (12 | )% |
| Investment advisory                    |   | 5,235                          |    | 5,413                           |   | (3 | )% | 1,657 |   | 1,817 |   | (9 | )% |
| Other service fees                     |   | 937                            |    | 160                             |   | 486 | % | 317 |   | 52 |   | 510 | % |
| Total ancillary service fees           |   | 54,861                         |    | 45,246                          |   | 21 | % | 18,331 |   | 16,316 |   | 12 | % |
|                                   |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Total asset servicing fees             |   | 239,012                        |    | 218,103                         |   | 10 | % | 83,645 |   | 73,982 |   | 13 | % |
|                                   |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Other operating income                 |   | 1,864                          |    | 1,645                           |   | 13 | % | 436 |   | 515 |   | (15 | )% |
|                                   |   |                           |    |                            |   |   |   |   |   |   |   |   |   |
| Total noninterest income               |   | $                              | 240,876 |                            | $      | 219,748 |   | 10 | % | $ | 84,081 |   | $ | 74,497 |   | 13 | % |

 

Asset servicing fees for thenine months ended September 30, 2003 increased 10% to $239.0 million andincreased 13% to $83.6 million for the three months ended September 30, 2003from the same periods in 2002.  Thelargest components of asset servicing fees are custody, accounting andadministration, which are based in part on assets processed.  Assets processed is the total dollar valueof financial assets on the reported date for which we provide global custody ormulticurrency accounting.  Total netassets processed at September 30, 2003 increased $171 billion to $956 billioncompared to $785 billion at December 31, 2002, and increased $59 billion from$897 billion at June 30, 2003.  Thechange in net assets processed includes thefollowing components (Dollars in billions):

 
|                                    |   | **For the  Nine Months Ended** |   | **For the  Three Months Ended** |   |
|-----------------------------------------|--------|--------------------------------|--------|---------------------------------|--------|
|                                    |   | **September  30, 2003**        |   | **September  30, 2003**         |   |
| Further penetration of existing clients |   | $                              | 34     |                            | $      | 25 |   |
| New clients                             |   | 1                              |   | 1                               |   |
| Lost clients                            |   | (2                             | )      | —                          |   |
| Fund flows and market appreciation      |   | 138                            |   | 33                              |   |
| Net change in assets processed          |   | $                              | 171    |                            | $      | 59 |   |

 

Theincreases in asset servicing fees were driven by our ability to sell to new andexisting clients.  Additionally, thepositive capital market environment during the year has created several newbusiness opportunities including Barclays Global Investors Canada, Ltd.

 

Transaction-drivenincome includes our ancillary services, such as foreign exchange, cashmanagement and securities lending. Foreign exchange fees were $26.0 million forthe nine months ended September 30, 2003, up 39% from the same period in 2002,and were $9.2 million for the three months ended September 30, 2003, up 19%from the same period in 2002.  Theincreases in foreign exchange fees are attributable to further penetration ofexisting clients, the addition of new clients, higher transaction volumes andincreased volatility within the currencies traded by our clients.  Cash management fees, which consist of sweepfees, were $15.8 million for the nine months ended September 30, 2003, up 28%from the same period in 2002, and were $5.1 million for the three months endedSeptember 30, 2003, up 16% from the same period in 2002. These increases areprimarily due to increased client balances. Securities lending fees were $6.9 million for the nine months endedSeptember 30, 2003, down 20% from the same period in 2002, and were $2.1million for the three months ended September 30, 2003, down 12% from the sameperiod in 2002 due to a smaller lending book and narrower spreads.  Investment advisory service fees were $5.2million for the nine months ended September 30, 2003, flat compared to the sameperiod in 2002, and were $1.7 million for the three 

 

 

30

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months ended September30, 2003, down 9% compared to the same period in 2002 due to lower averageasset balances in the Merrimac Master Portfolio, an investment company forwhich we act as advisor.  Other servicesfees were $0.9 million for the nine months ended September 30, 2003, up 486%from the same period in 2002, and were $0.3 million for the three months endedSeptember 30, 2003, up 510% from the same period in 2002.  The increases were primarily attributed tocommission income earned from the Company’s broker-dealer subsidiary, whichbegan operations in late 2002.

 

                Other operating income consistsof dividends received relating to the Federal Home Loan Bank of Boston(‘FHLBB’) stock investment and miscellaneous fees for systems consultingservices.  For the nine months endedSeptember 30, 2003, other operating income increased 13% compared to the sameperiod last year due to client systems development projects.  For the three months ended September 30,2003, other operating income decreased 15% compared to the same period lastyear due primarily to a decrease of 70 basis points on the rate paid by theFHLBB on our stock investment.

 

*OperatingExpenses*

 

Totaloperating expenses were $255.0 million for the nine months ended September 30,2003, flat compared to the same period in 2002. For the three months endedSeptember 30, 2003, total operating expenses were $80.8 million, down 5% fromthe same period in 2002.  The componentsof operating expenses were as follows (Dollars in thousands):

 
|                              |   | **For the  Nine Months Ended September 30,** |    | **For the  Three Months Ended September 30,** |   |
|-----------------------------------|--------|----------------------------------------------|---------|-----------------------------------------------|--------|
|                              |   | **2003**                                     |    | **2002**                                      |   | **Change** |   | **2003** |   | **2002** |   | **Change** |   |
|                              |   |                                         |    |                                          |   |   |   |   |   |   |   |   |   |
| Compensation and benefits         |   | $                                            | 143,309 |                                          | $      | 146,819 |   | (2 | )% | $ | 42,574 |   | $ | 47,951 |   | (11 | )% |
| Technology and telecommunications |   | 29,020                                       |    | 30,070                                        |   | (3 | )% | 10,170 |   | 10,004 |   | 2 | % |
| Transaction processing services   |   | 23,624                                       |    | 26,078                                        |   | (9 | )% | 7,285 |   | 8,764 |   | (17 | )% |
| Occupancy                         |   | 21,820                                       |    | 18,247                                        |   | 20 | % | 7,290 |   | 6,841 |   | 7 | % |
| Depreciation and amortization     |   | 20,233                                       |    | 11,179                                        |   | 81 | % | 7,548 |   | 4,540 |   | 66 | % |
| Professional fees                 |   | 5,234                                        |    | 4,968                                         |   | 5 | % | 1,493 |   | 1,752 |   | (15 | )% |
| Travel and sales promotion        |   | 3,315                                        |    | 4,217                                         |   | (21 | )% | 1,247 |   | 1,463 |   | (15 | )% |
| Other operating expenses          |   | 8,401                                        |    | 9,956                                         |   | (16 | )% | 3,191 |   | 3,747 |   | (15 | )% |
|                              |   |                                         |    |                                          |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |   | $                                            | 254,956 |                                          | $      | 251,534 |   | 1 | % | $ | 80,798 |   | $ | 85,062 |   | (5 | )% |

 

                Compensationand benefits expense was $143.3 million for the nine months ended September 30,2003, flat compared to the same period last year.  Compensation and benefits expense was $42.6 million for thethree months ended September 30, 2003, down 11% compared to the same period in2002 due to lower headcount, lower incentive compensation and efficienciesgained through technology enhancements.

 

                Transactionprocessing services expense was $23.6 million for the nine months endedSeptember 30, 2003, down 9% from the same period in 2002, and was $7.3 millionfor the three months ended September 30, 2003, down 17% from the same period in2002.  These decreases were primarilythe result of the conversion of BGI to our subcustodian system in late 2002 andother efficiencies gained through the completion of the Chase conversion in2002.

 

                Occupancyexpense was $21.8 million for the nine months ended September 30, 2003, up 20%from the same period in 2002, and was $7.3 million for the three months endedSeptember 30, 2003, up 7% from the same period in 2002.  These increases were primarily due toincreased space in our Boston and Dublin offices to support the growth of ourbusiness.

 

                Depreciationand amortization expense was $20.2 million for the nine months ended September30, 2003, up 81% from the same period in 2002, and was $7.5 million for thethree months ended September 30, 2003, up 66% from the same period in 2002.These increases resulted from completion of capitalized software projects inlate 2002 and early 2003 and their placement into service.

 

                Otheroperating expenses, including travel and sales promotion, decreased due tostrict management of discretionary expenses and the completion of the BGIconversion in 2002.

 

 

31

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*Income Taxes*

 

 

Oureffective tax rate, exclusive of the $7.2 million charge relating to aretroactive change in Massachusetts tax law, was 31.3% for the nine monthsended September 30, 2003, compared to an effective rate of 30.0% for the sameperiod in the prior year.  The primaryreason for the increase in effective rate is due to the Company no longertaking the dividends received deduction for dividends paid by the REIT to theBank.  Tax expense for the nine monthsended September 30, 2003 was $37.7 million, up from $21.7 million for the sameperiod last year.  The increase is dueto the $7.2 million one-time charge relating to a retroactive change inMassachusetts tax law, along with an increase of income before tax ofapproximately $25.2 million.

 

 

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**Financial Condition**

*            Total assetsincreased $1.3 billion, or 19%, to $8.6 billion at September 30, 2003 from $7.2billion at December 31, 2002.  Assetgrowth is primarily attributable to increases in the held to maturity andavailable for sale investment portfolios, specifically mortgage-backed andfederal agency securities. Average interest-earning assets increased $1.7billion, or 31% and $1.8 billion, or 30% for the nine months and three monthsended September 30, 2003, respectively, compared to the same periods last year.  Funding for our asset growth was provided bya combination of an increase in average client balances of approximately $1.1billion and average external borrowings of approximately $0.6 billion for thenine months ended September 30, 2003.*

 

*Investment Portfolio*

 

Ourinvestment portfolio is used to invest depositors’ funds and is a component ofour asset processing business.  Inaddition, we use the investment portfolio to secure open positions atsecurities clearing institutions in connection with our custody services.

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

 
|                                                 |   | **September  30,** |      | **December  31,** |   |
|------------------------------------------------------|--------|--------------------|-----------|-------------------|--------|
|                                                 |   | **2003**           |      | **2002**          |   |
| **Securities held to maturity (at amortized cost):** |   |               |      |              |   |
| Mortgage-backed securities                           |   | $                  | 2,022,608 |              | $      | 2,034,430 |   |
| Federal agency securities                            |   | 1,845,416          |      | 1,287,238         |   |
| State and political subdivisions                     |   | 127,495            |      | 117,021           |   |
| Total securities held to maturity                    |   | $                  | 3,995,519 |              | $      | 3,438,689 |   |
|                                                 |   |               |      |              |   |
| **Securities available for sale (at fair value):**   |   |               |      |              |   |
| Mortgage-backed securities                           |   | $                  | 3,277,072 |              | $      | 2,759,793 |   |
| State and political subdivisions                     |   | 356,617            |      | 307,292           |   |
| Corporate debt                                       |   | 177,404            |      | 174,499           |   |
| US Treasury securities                               |   | 113,855            |      | —            |   |
| Federal agency securities                            |   | 29,948             |      | 30,881            |   |
| Foreign government securities                        |   | 9,233              |      | —            |   |
| Total securities available for sale                  |   | $                  | 3,964,129 |              | $      | 3,272,465 |   |

 

The overall increases inthe held to maturity and available for sale portfolios are attributable toinvesting excess cash and borrowed funds to effectively utilize the Bank’scapital.  Our held to maturity portfolioincreased $556.8 million, or 16%, to $4.0 billion at September 30, 2003 from$3.4 billion at December 31, 2002.  Aswe continue to grow our balance sheet, we purchase investment securities thatwill protect our net interest margin while maintaining an acceptable riskprofile.  The increase in the held tomaturity portfolio stems primarily from purchases of Federal agency securities,particularly those issued by the Small Business Administration (‘SBA’).  SBA securities provide an attractive yieldwith limited credit risk and prepayment risk in a rapidly changing interestrate environment.  The weighted averagelife of the SBA securities correspond with our overall asset liabilitystrategy.  SBA securities are variablerate securities indexed to the Prime rate and are purchased with an intent andability to hold to maturity.

 

                Ouravailable for sale portfolio increased $691.7 million, or 21%, to $4.0 billionat September 30, 2003 from $3.3 billion at December 31, 2002.  The increase in the available for saleportfolio is primarily due to an increase in mortgage-backed securities of$517.3 million, or 19%, and the addition of $113.9 million of U.S. Treasurysecurities.  In an effort to maintainour net interest margin, we have increased our position in mortgage-backedsecurities.  As interest rates arelikely to begin to rise, causing prepayments on existing mortgage-backedsecurities begin to slow, floating rate and hybrid mortgage-backed securitiesoffer a healthy effective yield and limited extension risk, which aligns withour asset liability strategy.  Refer tothe gap analysis under “Market Risk” below for additional details regarding thematching of our interest-earning assets and interest-bearing liabilities.

 

 

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We also invest in municipalsecurities to generate stable, tax advantaged income.  Municipal securities generally have lower stated yields thanFederal agency and U.S. Treasury securities, but the after-tax yields atcurrent tax rates are more favorable. Municipal securities are subject to credit risk.  However, all municipal securities that weinvest in are insured and are rated AAA.

The average balance ofour combined investment portfolio for the nine months ended September 30, 2003was $7.1 billion, with an average yield of approximately 3.30%, compared to anaverage balance of $5.4 billion and an average approximate yield of 4.47% forthe same period last year.  The averagebalance of our combined investment portfolio for the three months endedSeptember 30, 2003 was $7.6 billion, with an average yield of approximately3.01%, compared to an average balance of $5.8 billion and an averageapproximate yield of 4.32% for the same period last year.

*Loan Portfolio*

                Our loan portfolio increased $23.1 million, or 16%,to $166.8 million at September 30, 2003 from $143.7 million at December 31,2002. The overall increase in the loan portfolio is primarily attributable tothe increase in the volume of client overdrafts from December 31, 2002 toSeptember 30, 2003. The balance of client overdraft loans at September 30, 2003was $90.8 million compared to $73.0 million at December 31, 2002.  These extensions of credit are secured by freely tradable securities held in custody by usfor the borrower.

 

                Wemake loans to individually managed account customers and to mutual funds andother pooled product clients.  We offeroverdraft protection and lines of credit to our clients for the purpose offunding redemptions, covering overnight cash shortfalls, leveraging portfoliosand meeting other client borrowing needs. Virtually all loans to individuallymanaged account customers are written on a demand basis, bear variable interestrates tied to the prime rate or the Federal Funds rate and are fully secured byliquid collateral, primarily freely tradable securities held in custody by usfor the borrower.  Loans to mutual fundsand other pooled product clients include unsecured lines of credit that may, inthe event of default, be collateralized at our option by securities held incustody by us for those mutual funds. Loans to individually managed account customers, mutual funds and otherpooled product clients also include advances that we make to certain clientspursuant to the terms of our custody agreements with those clients tofacilitate securities transactions and redemptions.

 

                AtSeptember 30, 2003, our only lending concentrations that exceeded 10% of totalloan balances were the lines of credit to mutual fund clients discussedabove.  These loans were made in theordinary course of business on the same terms and conditions prevailing at thetime for comparable transactions.

 

                Ourcredit loss experience has been excellent. There have been no loan charge-offs in our history.  It is our policy to place a loan onnonaccrual status when either principal or interest becomes 60 days pastdue and the loan’s collateral is not sufficient to cover both principal andaccrued interest.  As of September 30,2003, there were no loans on nonaccrual status, no loans greater than90 days past due, and no troubled debt restructurings.  Although virtually all of our loans arefully collateralized with freely tradable securities, management recognizessome credit risk inherent in the loan portfolio, and has recorded an allowancefor loan losses of $0.1 million at September 30, 2003.  This amount is not allocated to anyparticular loan, but is intended to absorb any risk of loss inherent in the loanportfolio. Management actively monitors the loan portfolio and the underlyingcollateral and regularly assesses the adequacy of the allowance for loanlosses.

 

*Repurchase Agreements and Short-Term and Other Borrowings*

 

                Assetgrowth was funded in part by increased securities sold under repurchase agreements.  Repurchase agreements increased $1.0billion, or 45%, to $3.3 billion at September 30, 2003 from $2.3 billion atDecember 31, 2002.  We use repurchaseagreements, including client repurchase agreements, because they provide a morefavorable source of funding than other short-term borrowings in terms of thecost of these borrowings.  The averagebalance of securities sold under repurchase agreements for the nine monthsended September 30, 2003 was $3.3 billion with an average cost of approximately0.91%, compared to an average balance of $2.4 billion and an average cost ofapproximately 1.34% for the same period last year. The average balance ofsecurities sold under repurchase agreements for the three months endedSeptember 30, 2003 was $3.3 billion with an average cost of approximately 

 

 

34

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0.84%, compared to an average balance of $2.5billion and an average cost of approximately 1.38% for the same period lastyear.

 

                Short-term and other borrowingsdecreased $0.1 billion, or 17%, to $0.6 billion at September 30, 2003 from $0.7billion at December 31, 2002.  We useshort-term and other borrowings to offset variability of deposit flow.  The average balance of short-term and otherborrowings for the nine months ended September 30, 2003 was $1.0 billion withan average cost of approximately 2.01%, compared to an average balance of $0.9billion and an average cost of approximately 3.59% for the same period lastyear. The average balance of short-term and other borrowings for the threemonths ended September 30, 2003 was $1.3 billion with an average cost ofapproximately 1.57%, compared to an average balance of  $0.9 billion with an average cost of 3.67%for the same period last year.

 

                The average cost of borrowingfor the nine months ended September 30, 2003, included a second quarterprepayment fee of $1.1 million.  Thisfee was incurred to employ an asset-liability strategy in which we prepaid ahigh cost borrowing with a new borrowing at a lower rate and purchased assetswith a similar maturity to lock in spread. We employed the same strategy in 2002, in which the average cost for thethree and nine months ended September 30, 2002 included $2.2 million and $5.0million in prepayment fees, respectively.

 

**Market Risk**

 

                Weengage in investment activities to accommodate clients’ cash management needsand to contribute to overall corporate earnings.  Our clients, in the course of their financial asset management,maintain cash balances, which they can deposit with us on a short-term basis ininterest-bearing accounts.  We eitherdirectly invest these cash balances to earn interest income, or place thesedeposits in third-party vehicles and remit a portion of the earnings on theseinvestments to our clients after deducting a fee as our compensation for theinvestment. In the conduct of these activities, we are subject to marketrisk.  Market risk is the risk of anadverse financial impact from changes in market prices and interest rates.  The level of risk we assume is a function ofour overall strategic objectives and liquidity needs, client requirements andmarket volatility.

 

                Theactive management of market risk is integral to our operations.  The objective of interest rate sensitivitymanagement is to provide sustainable net interest revenue under variouseconomic conditions.  We manage thestructure of interest-earning assets and interest-bearing liabilities byadjusting their mix, yield, maturity and/or repricing characteristics, based onmarket conditions.  Since clientdeposits and repurchase agreements, our primary sources of funds, arepredominantly short term, we maintain a generally short-term structure for ourinterest-earning assets.  We also useterm borrowings and interest rate swap agreements to augment our management ofinterest rate exposure.  The effect ofthe swap agreements is to lengthen short-term variable-rate liabilities intolonger-term fixed-rate liabilities.

 

                OurBoard of Directors has set asset and liability management policies that definethe overall framework for managing interest rate sensitivity, includingaccountabilities and controls over investment activities.  These policies delineate investment limitsand strategies that are appropriate, given our liquidity and regulatory requirements.  For example, we have established a policylimit stating that projected net interest income over the next 12 months willnot be reduced by more than 10% given a change in interest rates of up to 200basis points (+ or -) over 12 months. Each quarter, our Board of Directors reviews our asset and liabilitypositions, including simulations of the effect of various interest ratescenarios on our capital.  Due tocurrent interest rate levels, the Company’s Board of Directors has approved atemporary exception to the 10% limit for decreases in interest rates.  The Board of Directors approved the policyexception because, with the Federal Funds target rate currently at 1.00%, a 200basis point further reduction would move rates into a negative position and istherefore not likely to occur.

 

                OurBoard of Directors has delegated day-to-day responsibility for oversight of theAsset and Liability Management function to our Asset and Liability Committee(‘ALCO’).  ALCO is a senior managementcommittee consisting of the Chief Executive Officer, the President, the ChiefFinancial Officer, the Chief Risk 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 

 

 

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changes in interest rates on our net interestincome.  Actual results may differ fromsimulated results due to the timing, magnitude and frequency of interest ratechanges and changes in market conditions and management strategies.

 

                Theresults of the income simulation model as of September 30, 2003 and 2002indicated that an upward shift of interest rates by 200 basis points wouldresult in a reduction in projected net interest income of 7.94% and 2.84%,respectively.  A downward shift of 200basis points would result in a decrease in projected net interest income of25.31% and 13.97% at September 30, 2003 and 2002, respectively.  As discussed above, a 200 basis pointreduction would move some rates into a negative position, which is not likelyto occur, therefore, those interest rates were lowered to zero for purposes ofthe income simulation model.

 

                Wealso use gap analysis as a secondary tool to manage our interest ratesensitivity.  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, 2003, interest-bearing liabilities repricedfaster than interest-earning assets in the short term, as has been typical forus.  Generally speaking, fallinginterest rates would lead to net interest income that is higher than it wouldhave been; rising rates would lead to lower net interest income.  However, at the current absolute level ofinterest rates, lower interest rates may also lead to lower net interest incomedue to a diminished ability to lower the rates paid on interest-bearingliabilities, including certain client funds, as rates approach zero.  Other important determinants of net interestincome are rate levels, balance sheet growth and mix, and interest ratespreads.

 

 

36

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Thefollowing table presents the repricing schedule of our interest-earning assetsand interest-bearing liabilities at September 30, 2003 (Dollars in thousands):

 
|                                                                                   |   | **Within  Three** |       | **Three to  Six** |       | **Six to  Twelve** |       | **One Year  to** |       | **Over Five** |       |      |       |
|----------------------------------------------------------------------------------------|--------|-------------------|------------|-------------------|------------|--------------------|------------|------------------|------------|---------------|------------|-----------|------------|
|                                                                                   |   | **Months**        |       | **Months**        |       | **Months**         |       | **Five Years**   |       | **Years**     |       | **Total** |       |
|                                                                                   |   |              | ** ** |              | ** ** |               | ** ** |             | ** ** |          | ** ** |      | ** ** |
| Interest-earning assets (1):                                                           |   |              |       |              |       |               |       |             |       |          |       |      |       |
| Investment securities (2)                                                              |   | $                 | 4,296,921  |              | $          | 619,044            |       | $                | 901,457    |          | $          | 1,762,140 |       | $ | 380,086 |   | $ | 7,959,648 |   |
| Loans—variable rate                                                               |   | 166,876           |       | —            |       | —             |       | —           |       | —        |       | 166,876   |       |
| Loans—fixed rate                                                                  |   | 12                |       | —            |       | —             |       | —           |       | —        |       | 12        |       |
| Total interest-earning assets                                                          |   | $                 | 4,463,809  |              | $          | 619,044            |       | $                | 901,457    |          | $          | 1,762,140 |       | $ | 380,086 |   | $ | 8,126,536 |   |
| Interest-bearing liabilities:                                                          |   |              |       |              |       |               |       |             |       |          |       |      |       |
| Savings accounts                                                                       |   | $                 | 3,436,955  |              | $          | —             |       | $                | —     |          | $          | 24,026    |       | $ | — |   | $ | 3,460,981 |   |
| Interest rate contracts                                                                |   | (1,000,000        | )          | 90,000            |       | 180,000            |       | 730,000          |       | —        |       | —    |       |
| Securities sold under repurchase agreements                                            |   | 3,148,458         |       | —            |       | —             |       | 200,000          |       | —        |       | 3,348,458 |       |
| Short-term and other borrowings                                                        |   | 415,732           |       | —            |       | —             |       | 200,000          |       | —        |       | 615,732   |       |
| Trust preferred stock                                                                  |   | —            |       | —            |       | —             |       | 24,000           |       | —        |       | 24,000    |       |
| Total interest-bearing liabilities                                                     |   | $                 | 6,001,145  |              | $          | 90,000             |       | $                | 180,000    |          | $          | 1,178,026 |       | $ | — |   | $ | 7,449,171 |   |
| Net interest-sensitivity gap during the period                                         |   | $                 | (1,537,336 | )                 | $          | 529,044            |       | $                | 721,457    |          | $          | 584,114   |       | $ | 380,086 |   | $ | 677,365 |   |
| Cumulative gap                                                                         |   | $                 | (1,537,336 | )                 | $          | (1,008,292         | )          | $                | (286,835   | )             | $          | 297,279   |       | $ | 677,365 |   |   |   |
| Interest-sensitive assets as a percent of interest sensitive  liabilities (cumulative) |   | 74.38             | %          | 83.45             | %          | 95.43              | %          | 103.99           | %          | 109.09        | %          |      |       |
| Interest-sensitive assets as a percent of total assets (cumulative)                    |   | 52.17             | %          | 59.41             | %          | 69.95              | %          | 90.54            | %          | 94.99         | %          |      |       |
|                                                                                   |   |              |       |              |       |               |       |             |       |          |       |      |       |
| Net interest-sensitivity gap as a percent of total assets                              |   | (17.97            | )%         | 6.18              | %          | 8.43               | %          | 6.83             | %          | 4.44          | %          |      |       |
| Cumulative gap as a percent of total assets                                            |   | (17.97            | )%         | (11.79            | )%         | (3.35              | )%         | 3.47             | %          | 7.92          | %          |      |       |

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

(2)            Mortgage-backedsecurities are included in the pricing category that corresponds with theearlier of their first repricing date or principal paydown schedule generatedfrom industry sourced prepayment projections.

 

 

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**Liquidity**

 

                Liquidity represents the ability of an institution tomeet present and future financial obligations through either the sale ormaturity of existing assets or the acquisition of additional funds through liabilitymanagement.  For a financial institutionsuch as ours, these obligations arise from the withdrawals of deposits and thepayment of operating expenses.

 

                Ourprimary sources of liquidity include cash and cash equivalents, Federal Fundssold, new deposits, securities sold under repurchase agreements, short-termborrowings, interest payments on securities held to maturity and available forsale, and fees collected from asset administration clients.  As a result of our management of liquidassets and the ability to generate liquidity through funding, managementbelieves that we maintain overall liquidity sufficient to meet our depositors’needs, to satisfy our operating requirements and to fund the payment of ananticipated annual cash dividend of $0.06 per share for 2003 (approximately$3.9 million based upon 65,204,690 shares outstanding as of September 30,2003).

 

                Ourability to pay dividends on Common Stock may depend on the receipt of dividendsfrom the Bank. Any dividend payments by the Bank are subject to certainrestrictions imposed by the Massachusetts Commissioner of Banks.  During all periods presented in this report,the Company did not require dividends from the Bank in order to fund theCompany’s own dividends.  In addition,we may not pay dividends on our Common Stock if we are in default under certainagreements entered into in connection with the sale of our CapitalSecurities.  The Capital Securities wereissued by Investors Capital Trust I, a Delaware statutory business trustsponsored by us, and qualify as Tier 1 capital under the capital guidelines ofthe Federal Reserve.

 

                Wehave 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, 2003 was $2.0 billion. Each bank may terminate its arrangement at any time and is under no contractualobligation to provide us with requested funding.  Our borrowings under these arrangements are typically on anovernight basis.  We cannot be certain,however, that such funding will be available. Lack of availability of liquid funds could have a material adverseimpact on our operations.

 

                Wealso have Master Repurchase Agreements in place with variouscounterparties.  Each broker has agreedto make funds available to us at various rates in exchange for collateralconsisting of marketable securities. The aggregate amount available under theseborrowing arrangements at September 30, 2003 was $3.5 billion.

 

                Wealso have a borrowing arrangement with the FHLBB.  We may borrow amounts determined by prescribed collateral levelsand the amount of FHLBB stock we hold. We are required to hold FHLBB stock equal to no less than (i) 1% ofour outstanding residential mortgage loan principal (including mortgage poolsecurities), (ii) 0.3% of total assets, or (iii) total advances fromthe FHLBB, divided by a leverage factor of 20. The aggregate amount of borrowing available to us under this arrangementat September 30, 2003 was $2.8 billion. The amount outstanding under this arrangement at September 30, 2003 was$0.5 billion.

 

 

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**Capital Resources**

 

                Historically,we have financed our operations principally through internally generated cashflows.  We incur capital expendituresfor furniture, fixtures, capitalized software and miscellaneous equipmentneeds.  Capital expenditures have beenincurred and operating leases entered into on an as-required basis, primarilyto meet our growing operating needs.  Asa result, our capital expenditures were $23.5 million and $38.7 millionfor the nine months ended September 30, 2003 and 2002, respectively.  For the nine months ended September 30,2003, capital expenditures were comprised of approximately $11.7 million incapitalized software and projects in process, $6.5 million in leaseholdimprovements and $5.3 million in fixed assets. For the nine months ended September 30, 2002, capital expenditures werecomprised of approximately $25.2 million in capitalized software and projectsin process and $11.0 million in fixed assets and $2.5 million in leaseholdimprovements.

 

                Stockholders’equity at September 30, 2003 was $508.2 million, up 15% from December 31, 2002,primarily due to current year net income. The ratio of stockholders’ equity to assets decreased to 5.9% atSeptember 30, 2003 from 6.1% at December 31, 2002, primarily due to assetgrowth in investment securities funded by increases in securities purchasedunder resale agreements and customer deposits.

 

                We are subject tovarious regulatory capital requirements administered by the federal bankingagencies.  Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial adverse effect on our results of operations and financialcondition.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, we mustmeet specific capital guidelines that involve quantitative measures of ourassets, liabilities, and certain off-balance sheet items as calculated underregulatory accounting practices.  Ourcapital amounts and classification are also subject to qualitative judgments byregulators about components, risk weightings, and other factors.

Quantitative measures established by regulation toensure capital adequacy require us to maintain minimum amounts and ratios (setforth in the table below) of Total and Tier 1 capital (as defined in theregulations) to risk-weighted assets (as defined), and of Tier 1 capital(as defined) to average assets (as defined). Management believes, as ofSeptember 30, 2003, that we meet all capital adequacy requirements to which weare subject.

 

 

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                Themost recent notification from the FDIC categorized us as “well capitalized”under the regulatory framework for prompt corrective action. To becategorized as well capitalized, we must maintain minimum Total risk-based,Tier 1 risk-based, and Tier 1 leverage ratios as set forth in thefollowing table. There are no conditions or events since that notification thatmanagement believes have changed our category. The following table presents thecapital ratios for Investors Financial and Investors Bank (Dollars inthousands):

** **

 
|                                                      |   | **Actual** |    | **For  Capital Adequacy Purposes** |   | **To Be Well  Capitalized   Under Prompt   Corrective Action   Provisions** |   |
|-----------------------------------------------------------|--------|------------|---------|------------------------------------|--------|-----------------------------------------------------------------------------|--------|
|                                                      |   | **Amount** |    | **Ratio**                          |   | **Amount**                                                                  |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| **As of September 30, 2003:**                             |   |       |    |                               |   |                                                                        |   |   |   |   |   |   |   |
| Total Capital (to Risk-Weighted Assets—the Company)  |   | $          | 436,865 |                               | 17.17  | %                                                                           | $      | 203,605 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital (to Risk-Weighted Assets—the Bank)     |   | $          | 433,098 |                               | 17.02  | %                                                                           | $      | 203,533 |   | 8.00 | % | $ | 254,416 |   | 10.00 | % |
| Tier 1 Capital (to Risk-Weighted Assets—the Company) |   | $          | 436,765 |                               | 17.16  | %                                                                           | $      | 101,802 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital (to Risk-Weighted Assets—the Bank)    |   | $          | 432,998 |                               | 17.02  | %                                                                           | $      | 101,766 |   | 4.00 | % | $ | 152,650 |   | 6.00 | % |
| Tier 1 Capital (to Average Assets—the Company)       |   | $          | 436,765 |                               | 5.28   | %                                                                           | $      | 331,165 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital (to Average Assets—the Bank)          |   | $          | 432,998 |                               | 5.23   | %                                                                           | $      | 330,921 |   | 4.00 | % | $ | 413,652 |   | 5.00 | % |
|                                                      |   |       |    |                               |   |                                                                        |   |   |   |   |   |   |   |
| **As of December 31, 2002:**                              |   |       |    |                               |   |                                                                        |   |   |   |   |   |   |   |
| Total Capital (to Risk-Weighted Assets—the Company)  |   | $          | 374,102 |                               | 15.51  | %                                                                           | $      | 192,915 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital (to Risk-Weighted Assets—the Bank)     |   | $          | 369,498 |                               | 15.32  | %                                                                           | $      | 192,915 |   | 8.00 | % | $ | 241,143 |   | 10.00 | % |
| Tier 1 Capital (to Risk-Weighted Assets—the Company) |   | $          | 374,002 |                               | 15.51  | %                                                                           | $      | 96,457 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital (to Risk-Weighted Assets—the Bank)    |   | $          | 369,398 |                               | 15.32  | %                                                                           | $      | 96,457 |   | 4.00 | % | $ | 144,686 |   | 6.00 | % |
| Tier 1 Capital (to Average Assets—the Company)       |   | $          | 374,002 |                               | 5.50   | %                                                                           | $      | 272,132 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital (to Average Assets—the Bank)          |   | $          | 369,398 |                               | 5.43   | %                                                                           | $      | 272,104 |   | 4.00 | % | $ | 340,130 |   | 5.00 | % |

UnderMassachusetts law, trust companies such as Investors Bank, like national banks,may pay dividends no more often than quarterly, and only out of “net profits”and to the extent that such payments will not impair Investors Bank’s capitalstock and surplus account. Moreover, prior approval of the Commissioner ofBanks of the Commonwealth of Massachusetts is required if the total dividendsfor a calendar year would exceed net profits for that year combined withretained net profits for the previous two years. These restrictions on theability of Investors Bank to pay dividends to us may restrict our ability topay dividends to our stockholders. Duringall periods presented in this report, the Company did not require dividendsfrom the Bank in order to fund the Company’s own dividends.

Theoperations of our securities broker affiliate, Investors Securities Services,Inc., are subject to federal and state securities laws, as well as the rules ofboth the Securities and Exchange Commission and the National Association ofSecurities Dealers, Inc.  Managementbelieves, as of September 30, 2003, that Investors Securities Services, Inc.met all regulatory requirements to which it is subject.

 

 

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**Item 3.            Quantitative and QualitativeDisclosure about 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.

 

**Item 4.            Controls and Procedures**

We evaluated the effectiveness of the design andoperation of our disclosure controls and procedures as of September 30,2003.  Our disclosure controls andprocedures are the controls and other procedures that we designed to ensurethat we record, process, summarize and report in a timely manner theinformation we must disclose in reports that we file or submit to the SEC.  Kevin J. Sheehan, our Chairman and ChiefExecutive Officer, and John N. Spinney, Jr., our Senior Vice President andChief Financial Officer, reviewed and participated in this evaluation.  Based on this evaluation, Messrs. Sheehanand Spinney concluded that, as of the date of the evaluation, our disclosurecontrols were effective.

As a result of the evaluation completed by us, and inwhich Messrs. Sheehan and Spinney participated, we have concluded that nochanges occurred during our fiscal quarter ended September 30, 2003 in ourinternal controls over financial reporting, which changes have materiallyaffected, or are reasonably likely to affect, our internal controls overfinancial reporting.

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**PART II.  OTHERINFORMATION**

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**Item 1. Legal Proceedings**

** **

On January 31, 2003, we werenamed in a class action lawsuit alleging, among other things, violations ofCalifornia wage and hour laws at our Sacramento and Walnut Creek facilities.The lawsuit was filed in the Superior Court of California, County ofSacramento. On July 23, 2003, we reached agreement in principle withrepresentatives of the plaintiffs to settle the case.  As currently agreed, the settlement will not have a materialimpact on our financial condition or results of operations.  The settlement is subject to preliminaryapproval by the court, proper administration of payments to the class membersand final approval by the court.  Inanticipation of this settlement and related costs, we accrued a liability ofapproximately $1.0 million in the second quarter of 2003.

 

On June 27, 2003, we and an individual employee of ours were named in alawsuit alleging, among other things, that we breached an implied covenant ofgood faith and fair dealing in a subadvisory contract with Opus InvestmentManagement, Inc. (‘Opus’) and that our individual employee engaged in a breachof fiduciary duties and tortious interference with a contract.  Opus had been a subadviser to the MerrimacFunds, for which we act as investment adviser. Upon the expiration of Opus’ contract on June 1, 2003, the MerrimacFunds elected not to re-appoint Opus as subadviser.  The lawsuit was filed in Superior Court in Worcester,Massachusetts and seeks unspecified damages. We believe that the claims are without merit and intend to defend ourrights vigorously.  On September 22,2003, we filed a motion to dismiss all claims against us under thecomplaint.  We expect that the courtwill not rule on our motion to dismiss until the first quarter of 2004 at theearliest.

 

 

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**Item 6. **Exhibits andReports on Form 8-K.

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**(a)**          Exhibits

** **
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                  |
|-----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **31.1**        |   | **Certification of Kevin J.  Sheehan, Chief Executive Officer**                                                                                                                                                                  |
|            |   |                                                                                                                                                                                                                             |
| **31.2**        |   | **Certification of John N. Spinney,  Jr., Chief Financial Officer**                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                             |
| **32.1**        |   | **Certification of Kevin J.  Sheehan, Chief Executive Officer, and John N. Spinney, Jr., Chief Financial  Officer, pursuant to 18 U.S.C. Section 1350, as adopted, pursuant to Section  906 of the Sarbanes-Oxley Act of 2002.** |

** **

**(b)**         A Form 8-K was furnished to the Securities and Exchange Commission onJuly 16, 2003 furnishing information pursuant to Items 9 (Regulation FD) and 12(Results of Operation and Financial Condition) relating to the press release ofInvestors Financial Services Corp. dated July 16, 2003 reporting Investors FinancialServices Corp.’s financial results for the fiscal quarter ended June 30,2003.  In addition, a Form 8-K wasfurnished to the Securities and Exchange Commission on September 19, 2003furnishing information pursuant to item 9 (Regulation FD).

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**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 12, 2003 |   | By:    | /s/ Kevin J. Sheehan                                                                                                        |
|                           |   |   | Kevin J. Sheehan   Chairman and Chief Executive Officer                                                                     |
|                           |   |   |                                                                                                                        |
|                           |   | By:    | /s/ John N. Spinney, Jr.                                                                                                    |
|                           |   |   | John N. Spinney, Jr.   Senior Vice President and Chief Financial Officer  (Principal Financial and Accounting Officer) |

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