**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10–Q**

 

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

** **

**For the Quarterly period ended March 31, 2002**

 

**or**

 

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

 

**For the Transition periodfrom        to        **

 

**0–26996**

**(CommissionFile Number)**

 

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**INVESTORS FINANCIAL SERVICES CORP.**

(Exact name of registrantas specified in its charter)

** **

| **Delaware**                                                   |   | **04-3279817**                    |
|----------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of incorporation or organization) |   | (IRS Employer Identification No.) |
|                                                           |   |                              |
| **200 Clarendon Street,**                                      |   |                              |
| **P.O. Box 9130, Boston, MA**                                  |   | **02117-9130**                    |
| (Address of principal executive offices)                       |   | (Zip Code)                        |
|                                                           |   |                              |
| **(617) 937-6700**                                             |
| (Registrant’s telephone number, including area code)      |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý No o

 

As of April 30, 2002there were 32,134,494 shares of Common Stock outstanding.

 

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**INVESTORS FINANCIAL SERVICES CORP.**

 

**INDEX**

 
|           |                                                                                                                          |
|----------------|-------------------------------------------------------------------------------------------------------------------------------|
| **PART I.**    | **FINANCIAL INFORMATION**                                                                                                     |
|           |                                                                                                                          |
| Item  1.       | Condensed  Consolidated Financial Statements                                                                                  |
|           |                                                                                                                          |
|           | Condensed  Consolidated Balance Sheets   March 31, 2002 (unaudited) and December 31, 2001 (audited)                           |
|           |                                                                                                                          |
|           | Condensed  Consolidated Statements of Income and Comprehensive Income (unaudited)  Three months ended March 31, 2002 and 2001 |
|           |                                                                                                                          |
|           | Condensed  Consolidated Statements of Stockholders’ Equity (unaudited)  Three months ended March 31, 2002 and 2001       |
|           |                                                                                                                          |
|           | Condensed  Consolidated Statements of Cash Flows (unaudited)  Three months ended March 31, 2002 and 2001                      |
|           |                                                                                                                          |
|           | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                             |
|           |                                                                                                                          |
| Item  2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                   |
|           |                                                                                                                          |
| Item  3.       | Quantitative  and Qualitative Disclosure about Market Risk                                                                    |
|           |                                                                                                                          |
| **PART II.**   | **OTHER INFORMATION**                                                                                                         |
|           |                                                                                                                          |
| Item 6.        | Exhibits  and Reports on Form 8-K                                                                                             |
|           |                                                                                                                          |
| **SIGNATURES** |                                                                                                                          |

 

2

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**PARTI. FINANCIAL INFORMATION**

 

**Item1.            Condensed ConsolidatedFinancial Statements**

 

**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**March**31, 2002 and December 31, 2001

**(Dollars in thousands, except per share data)**

 
|                                                                                                                                                                                                          |   | **March 31,  2002** |       | **December 31,  2001** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                                          |   | **(unaudited)**     | ** ** |                        | ** ** |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| **Assets**                                                                                                                                                                                                    |   |                |       |                        |       |
| Cash and due  from banks                                                                                                                                                                                      |   | $                   | 12,950     |                        | $          | 15,605 |   |
| Securities held  to maturity (approximate fair value of $3,317,938 and $3,157,209 at March 31,  2002 and December 31, 2001, respectively)                                                                |   | 3,306,255           |       | 3,135,784                   |       |
| Securities  available for sale                                                                                                                                                                                |   | 1,990,680           |       | 1,621,661                   |       |
| Non-marketable  equity securities                                                                                                                                                                             |   | 50,000              |       | 50,000                      |       |
| Loans, less  allowance for loan losses of $100 at March 31, 2002 and December 31,  2001                                                                                                                  |   | 135,177             |       | 232,113                     |       |
| Accrued interest  and fees receivable                                                                                                                                                                         |   | 63,865              |       | 59,751                      |       |
| Equipment and  leasehold improvements, less accumulated depreciation of $15,518 and $13,023  at March 31, 2002 and December 31, 2001, respectively                                                       |   | 49,379              |       | 42,618                      |       |
| Goodwill, net                                                                                                                                                                                                 |   | 79,969              |       | 79,969                      |       |
| Other assets                                                                                                                                                                                                  |   | 61,394              |       | 61,144                      |       |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| **Total Assets**                                                                                                                                                                                              |   | $                   | 5,749,669  |                        | $          | 5,298,645 |   |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                |   |                |       |                        |       |
| **Liabilities:**                                                                                                                                                                                              |   |                |       |                        |       |
| Deposits:                                                                                                                                                                                                     |   |                |       |                        |       |
| Demand                                                                                                                                                                                                        |   | $                   | 251,028    |                        | $          | 507,067 |   |
| Savings                                                                                                                                                                                                       |   | 1,824,007           |       | 1,681,810                   |       |
| Time                                                                                                                                                                                                          |   | 90,000              |       | 90,000                      |       |
| Total deposits                                                                                                                                                                                                |   | 2,165,035           |       | 2,278,877                   |       |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| Securities sold  under repurchase agreements                                                                                                                                                                  |   | 2,108,904           |       | 1,663,312                   |       |
| Short-term and  other borrowings                                                                                                                                                                              |   | 1,005,725           |       | 910,281                     |       |
| Other  liabilities                                                                                                                                                                                            |   | 82,647              |       | 79,123                      |       |
| Total  liabilities                                                                                                                                                                                            |   | 5,362,311           |       | 4,931,593                   |       |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| Commitments and  contingencies                                                                                                                                                                                |   | —              |       | —                      |       |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| Company-obligated,  mandatorily redeemable, preferred securities of subsidiary trust holding  solely junior subordinated deferrable interest debentures of the Company                                        |   | 24,281              |       | 24,274                      |       |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| **Stockholders’ Equity:**                                                                                                                                                                                |   |                |       |                        |       |
| Preferred stock,  par value $0.01 (shares authorized: 1,000,000; issued and outstanding: 0 at  March 31, 2002 and December 31, 2001)                                                                     |   | —              |       | —                      |       |
| Common stock,  par value $0.01 (shares authorized: 100,000,000 at March 31, 2002 and  December 31, 2001; issued and outstanding: 32,130,032 at March 31, 2002  and 31,971,404 at December 31, 2001) |   | 322                 |       | 320                         |       |
| Surplus                                                                                                                                                                                                       |   | 225,589             |       | 222,440                     |       |
| Deferred  compensation                                                                                                                                                                                        |   | (2,152              | )          | (2,563                      | )          |
| Retained  earnings                                                                                                                                                                                            |   | 148,130             |       | 132,877                     |       |
| Accumulated  other comprehensive loss, net                                                                                                                                                                    |   | (8,812              | )          | (10,296                     | )          |
| Treasury stock,  par value $0.01 (10,814 shares at March 31, 2002 and December 31, 2001)                                                                                                                 |   | —              |       | —                      |       |
| Total  stockholders’ equity                                                                                                                                                                              |   | 363,077             |       | 342,778                     |       |
|                                                                                                                                                                                                          |   |                |       |                        |       |
| **Total Liabilities and Stockholders’  Equity**                                                                                                                                                          |   | $                   | 5,749,669  |                        | $          | 5,298,645 |   |

* *

*See Notes toCondensed Consolidated Financial Statements.*

 

3

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**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME ANDCOMPREHENSIVE INCOME (unaudited)**

**Three**MonthsEnded March 31, 2002 and 2001

**(Dollars in thousands, except per share data)**

 
|                                                                                                                                  |   | **March 31,  2002** |       | **March 31,  2001** |       |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|---------------------|------------|
|                                                                                                                                  |   |                |       |                |       |
| **Operating Revenue:**                                                                                                                |   |                | ** ** |                | ** ** |
| Interest income:                                                                                                                      |   |                |       |                |       |
| Federal funds  sold and securities purchased under resale agreements                                                                  |   | $                   | 67         |                | $          | 929 |   |
| Investment  securities held to maturity and available for sale                                                                        |   | 57,560              |       | 57,021              |       |
| Loans                                                                                                                                 |   | 1,005               |       | 1,367               |       |
| Total interest  income                                                                                                                |   | 58,632              |       | 59,317              |       |
|                                                                                                                                  |   |                |       |                |       |
| Interest  expense:                                                                                                                    |   |                |       |                |       |
| Deposits                                                                                                                              |   | 10,594              |       | 19,430              |       |
| Short-term and  other borrowings                                                                                                      |   | 12,301              |       | 18,418              |       |
| Total interest  expense                                                                                                               |   | 22,895              |       | 37,848              |       |
|                                                                                                                                  |   |                |       |                |       |
| Net interest  income                                                                                                                  |   | 35,737              |       | 21,469              |       |
|                                                                                                                                  |   |                |       |                |       |
| Noninterest  income:                                                                                                                  |   |                |       |                |       |
| Asset servicing  fees                                                                                                                 |   | 67,214              |       | 48,432              |       |
| Other operating  income                                                                                                               |   | 584                 |       | 781                 |       |
|                                                                                                                                  |   |                |       |                |       |
| Net operating  revenue                                                                                                                |   | 103,535             |       | 70,682              |       |
|                                                                                                                                  |   |                |       |                |       |
| **Operating Expenses:**                                                                                                               |   |                |       |                |       |
| Compensation and  benefits                                                                                                            |   | 49,930              |       | 33,914              |       |
| Technology and  telecommunications                                                                                                    |   | 9,355               |       | 8,042               |       |
| Transaction  processing services                                                                                                      |   | 6,530               |       | 2,574               |       |
| Occupancy                                                                                                                             |   | 5,763               |       | 3,536               |       |
| Depreciation and  amortization                                                                                                        |   | 3,136               |       | 1,362               |       |
| Professional  fees                                                                                                                    |   | 1,472               |       | 745                 |       |
| Travel and sales  promotion                                                                                                           |   | 1,234               |       | 998                 |       |
| Amortization of  goodwill                                                                                                             |   | —              |       | 650                 |       |
| Other operating  expenses                                                                                                             |   | 2,569               |       | 3,032               |       |
| Total operating  expenses                                                                                                             |   | 79,989              |       | 54,853              |       |
|                                                                                                                                  |   |                |       |                |       |
| **Income Before Income Taxes and  Minority Interest**                                                                                 |   | 23,546              |       | 15,829              |       |
|                                                                                                                                  |   |                |       |                |       |
| Provision for  income taxes                                                                                                           |   | 7,094               |       | 5,084               |       |
| Minority  interest expense, net of income taxes                                                                                       |   | 397                 |       | 397                 |       |
|                                                                                                                                  |   |                |       |                |       |
| **Net Income**                                                                                                                        |   | $                   | 16,055     |                | $          | 10,348 |   |
|                                                                                                                                  |   |                |       |                |       |
| **Basic Earnings Per Share**                                                                                                          |   | $                   | 0.50       |                | $          | 0.33 |   |
|                                                                                                                                  |   |                |       |                |       |
| **Diluted Earnings Per Share**                                                                                                        |   | $                   | 0.48       |                | $          | 0.32 |   |
|                                                                                                                                  |   |                |       |                |       |
| **Comprehensive Income:**                                                                                                             |   |                |       |                |       |
| Net income                                                                                                                            |   | $                   | 16,055     |                | $          | 10,348 |   |
| Other comprehensive income/(loss)  net of tax of $799 and ($1,998) for the three  months ended March 31, 2002 and 2001, respectively: |   |                |       |                |       |
| Cumulative  effect of a change in accounting principle                                                                                |   | —              |       | (3,934              | )          |
| Net unrealized  investment (loss)/gain                                                                                                |   | (2,988              | )          | 3,782               |       |
| Net unrealized  derivative instrument gain/(loss)                                                                                     |   | 4,472               |       | (3,103              | )          |
| Other  comprehensive income/(loss)                                                                                                    |   | 1,484               |       | (3,255              | )          |
| Comprehensive  income                                                                                                                 |   | $                   | 17,539     |                | $          | 7,093 |   |

* *

*See Notes toCondensed Consolidated Financial Statements.*

 

4

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**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY (unaudited)**

**Three Months**EndedMarch 31, 2002 and 2001

**(Dollars in thousands, except per share data)**

** **
|                                                                                                   |   | **March 31,  2002** |    | **March 31,  2001** |   |
|--------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------|--------|
| **Common shares**                                                                                      |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | 31,971,404          |    | 29,912,711          |   |
| Exercise of stock options                                                                              |   | 158,628             |    | 176,320             |   |
| Common stock issuance                                                                                  |   | —              |    | 1,624,145           |   |
| Balance, end of period                                                                                 |   | 32,130,032          |    | 31,713,176          |   |
|                                                                                                   |   |                |    |                |   |
| **Treasury shares**                                                                                    |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | 10,814              |    | 10,814              |   |
| Balance, end of period                                                                                 |   | 10,814              |    | 10,814              |   |
|                                                                                                   |   |                |    |                |   |
| **Common stock**                                                                                       |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | $                   | 320     |                | $      | 299 |   |
| Exercise of stock options                                                                              |   | 2                   |    | 2                   |   |
| Common stock issuance                                                                                  |   | —              |    | 16                  |   |
| Balance, end of period                                                                                 |   | 322                 |    | 317                 |   |
|                                                                                                   |   |                |    |                |   |
| **Surplus**                                                                                            |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | 222,440             |    | 95,007              |   |
| Exercise of stock options                                                                              |   | 1,112               |    | 438                 |   |
| Tax benefit from exercise of stock options                                                             |   | 2,037               |    | 1,712               |   |
| Common stock issuance                                                                                  |   | —              |    | 116,164             |   |
| Balance, end of period                                                                                 |   | 225,589             |    | 213,321             |   |
|                                                                                                   |   |                |    |                |   |
| **Deferred compensation**                                                                              |   |                |    |                |   |
| Balance, beginning of the period                                                                       |   | (2,563              | )       | (247                | )      |
| Common stock issuance                                                                                  |   | —              |    | (335                | )      |
| Amortization of deferred compensation                                                                  |   | 411                 |    | 36                  |   |
| Balance, end of period                                                                                 |   | (2,152              | )       | (546                | )      |
|                                                                                                   |   |                |    |                |   |
| **Retained earnings**                                                                                  |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | 132,877             |    | 85,188              |   |
| Net income                                                                                             |   | 16,055              |    | 10,348              |   |
| Cash dividend, $0.025 and $0.02 per share  in the periods ending March 31, 2002 and 2001, respectively |   | (802                | )       | (599                | )      |
| Balance, end of period                                                                                 |   | 148,130             |    | 94,937              |   |
|                                                                                                   |   |                |    |                |   |
| **Accumulated other comprehensive income/(loss), net**                                                 |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | (10,296             | )       | (1,439              | )      |
| Cumulative effect of a change in accounting  principle                                                 |   | —              |    | (3,934              | )      |
| Net unrealized investment (loss)/gain                                                                  |   | (2,988              | )       | 3,782               |   |
| Net unrealized derivative instrument  gain/(loss)                                                      |   | 4,472               |    | (3,103              | )      |
| Balance, end of period                                                                                 |   | (8,812              | )       | (4,694              | )      |
|                                                                                                   |   |                |    |                |   |
| **Treasury stock**                                                                                     |   |                |    |                |   |
| Balance, beginning of period                                                                           |   | —              |    | —              |   |
| Balance, end of period                                                                                 |   | —              |    | —              |   |
|                                                                                                   |   |                |    |                |   |
| **Total Stockholders’ Equity**                                                                    |   | $                   | 363,077 |                | $      | 303,335 |   |

* *

*See Notes toCondensed Consolidated Financial Statements.*

 

5

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**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)**

**ThreeMonths Ended** March 31, 2002 and 2001

**(Dollars in thousands)**

 
|                                                                               |   | **March 31,  2002** |   | **March 31,  2001** |   |
|------------------------------------------------------------------------------------|--------|---------------------|--------|---------------------|--------|
|                                                                               |   |                |   |                |   |
| **Cash Flows From Operating  Activities:**                                         |   |                |   |                |   |
| Net income                                                                         |   | $                   | 16,055 |                | $      | 10,348 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |   |                |   |                |   |
| Depreciation and  amortization                                                     |   | 3,136               |   | 2,012               |   |
| Amortization of  deferred compensation                                             |   | 411                 |   | 36                  |   |
| Amortization of  premiums on securities, net of accretion of discounts             |   | 699                 |   | (313                | )      |
| Changes in  assets and liabilities:                                                |   |                |   |                |   |
| Accrued interest  and fees receivable                                              |   | (4,114              | )      | (13,176             | )      |
| Other assets                                                                       |   | 22,052              |   | (1,762              | )      |
| Other  liabilities                                                                 |   | (10,660             | )      | 18,495              |   |
| Total  adjustments                                                                 |   | 11,524              |   | 5,292               |   |
| Net cash  provided by operating activities                                         |   | 27,579              |   | 15,640              |   |
|                                                                               |   |                |   |                |   |
| **Cash Flows From Investing  Activities:**                                         |   |                |   |                |   |
| Proceeds from  maturities of securities available for sale                         |   | 125,033             |   | 87,812              |   |
| Proceeds from  maturities of securities held to maturity                           |   | 469,286             |   | 120,324             |   |
| Purchases of  securities available for sale                                        |   | (498,771            | )      | (269,526            | )      |
| Purchases of  securities held to maturity                                          |   | (640,334            | )      | (946,508            | )      |
| Purchases of  non-marketable equity securities                                     |   | —              |   | (8,000              | )      |
| Net decrease in  federal funds sold                                                |   | —              |   | 433,000             |   |
| Net decrease in  loans                                                             |   | 96,936              |   | 18,563              |   |
| Purchase of  businesses                                                            |   | —              |   | (33,008             | )      |
| Purchases of  fixed assets and leasehold improvements                              |   | (9,890              | )      | (3,048              | )      |
| Net cash used  for investing activities                                            |   | (457,740            | )      | (600,391            | )      |
|                                                                               |   |                |   |                |   |
| **Cash Flows From Financing  Activities:**                                         |   |                |   |                |   |
| Net decrease in  demand deposits                                                   |   | (256,039            | )      | (90,665             | )      |
| Net  increase/(decrease) in time and savings deposits                              |   | 142,197             |   | (167,433            | )      |
| Net increase in  short-term and other borrowings                                   |   | 541,036             |   | 721,834             |   |
| Proceeds from  exercise of stock options                                           |   | 1,114               |   | 440                 |   |
| Proceeds from  issuance of common stock                                            |   | —              |   | 115,845             |   |
| Cash dividends  to shareholders                                                    |   | (802                | )      | (599                | )      |
| Net cash  provided by financing activities                                         |   | 427,506             |   | 579,422             |   |
|                                                                               |   |                |   |                |   |
| **Net Decrease In Cash And Due From  Banks**                                       |   | (2,655              | )      | (5,329              | )      |
|                                                                               |   |                |   |                |   |
| **Cash and Due From Banks, Beginning  of Period**                                  |   | 15,605              |   | 30,489              |   |
|                                                                               |   |                |   |                |   |
| **Cash and Due From Banks, End of  Period**                                        |   | $                   | 12,950 |                | $      | 25,160 |   |
|                                                                               |   |                |   |                |   |
| **Supplemental Disclosure of Cash  Flow Information:**                             |   |                |   |                |   |
| Cash paid for  interest                                                            |   | $                   | 22,470 |                | $      | 37,626 |   |
| Cash paid for  income taxes                                                        |   | $                   | 5,941  |                | $      | 1,737 |   |

* *

*See Notes toCondensed Consolidated Financial Statements.*

 

6

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**INVESTORS FINANCIAL SERVICES CORP.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Information as of and for the three months endedMarch 31, 2002 and 2001 is unaudited)**

 

**1.             Descriptionof Business**

 

Investors Financial Services Corp. (‘IFSC’)provides asset servicing for the financial services industry through itswholly-owned subsidiaries, Investors Bank & Trust Company (the ‘Bank’) andInvestors Capital Services, Inc.  Asused herein, the defined term “the Company” shall mean IFSC together with theBank and its domestic and foreign subsidiaries.  The Company provides globalcustody, multicurrency accounting, mutual fund administration, securitieslending, foreign exchange, cash management, performance measurement,institutional transfer agency, investment advisory services and lines of creditto a variety of financial asset managers, including mutual fund complexes,investment advisors, banks and insurance companies.  IFSC and the Bank are subject to regulation by the FederalReserve Board of Governors, the Office of the Commissioner of Banks of theCommonwealth of Massachusetts and the Federal Deposit Insurance Corporation.

 

On February 1, 2001, theCompany completed the issuance and sale of 1,624,145 shares of Common Stock at$71.62 per share in a public offering. A portion of the proceeds was used to fund the acquisition of theoperations of the advisor custody unit of The Chase Manhattan Bank.  The remaining proceeds were used for theassumption of the U.S. asset administration unit of Barclays Global Investors,N.A. and working capital.

 

On April 23,2002, the Board of Directorsapproved a two-for-one stock split in the form of a 100% stock dividend payableon or about June 14, 2002 to stockholders of record as of May 24, 2002.

 

**2.             Interim Financial Statements**

 

The condensed consolidated interim financialstatements of the Company and subsidiaries as of March 31, 2002 and 2001 andfor the three-month periods ended March 31, 2002 and 2001 have been prepared bythe Company, without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnote disclosures normally included in annualfinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been condensed oromitted as permitted by such rules and regulations.  All adjustments, consisting of normal recurring adjustments,necessary for their fair presentation in conformity with accounting principlesgenerally accepted in the United States of America 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 the priorperiods’ financial statements have been reclassified to conform to the currentperiods’ presentation.

 

On January 1, 2001, the Company adopted SFASNo. 133, “Accounting for Derivative Instruments and Hedging Activities,” asamended and interpreted, whichestablished accounting and reporting standards for derivative instruments.  The Company also adopted SFAS No. 138,“Accounting for Certain Derivative Instruments and Certain Hedging Activities.”  All derivatives, whether designated inhedging relationships or not, are required to be recorded on the balance sheetat fair value.  If the derivative isdesignated as a fair value hedge, the change in the fair value of the derivativeand 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 in Other Comprehensive Income (‘OCI’).  Ineffective portions of changes, asdetermined in accordance with SFAS No. 133, in the fair value of the cash flowhedges are recognized in earnings.  Forderivatives that do not qualify as hedges, changes in their fair value arerecognized in earnings.  The adoption ofSFAS No. 133 on January 1, 2001, resulted in no cumulative effect-typeadjustment to net income.  However, theCompany recorded a reduction to OCI of $3.9 million, net of tax, and acorresponding liability for the fair value of the interest rate swaps.  The reduction to OCI and the recognition ofthe liability are primarily attributable to net unrealized losses on previouslydesignated cash flow hedges.  Inconjunction

 

7

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with the adoption, the Company elected toreclassify approximately $402 million of securities from held to maturity toavailable for sale, which further reduced OCI, net of tax, by approximately$1.4 million.

 

The Company uses derivative instruments to manage exposures to interest raterisks.  The Company routinely entersinto interest rate swap agreementsin which the Company pays a fixed interest rate and receives a floatinginterest rate.  These transactions aredesigned to hedge a portion of the Company’s liabilities in connection withsecurities sold under repurchase agreements.  By entering into a pay-fixed/receive-floating interest rate swap,a portion of these liabilities is effectively converted to a fixed rateliability for the term of the interest rate swap agreement.  Most of these derivatives have beendesignated as cash flow hedges.  Aninsignificant portion of the derivatives used to manage exposures to interestrate risks were not considered highly effective and, therefore, did not qualifyfor hedge accounting.

 

Hedge ineffectiveness, determined in accordance with SFAS No.133, had an insignificant impact on earnings for the three months ended March31, 2002. No cash flow hedges were dedesignated or discontinued for the threemonths ended March 31, 2002.

 

Net interest income included net gains of$0.2 million, net of tax, for the three months ended March 31, 2002 on interestrate swaps relating to SFAS No. 133. The net gain consisted of a $0.8 million gain, net of tax, for thethree-month period on changes in the fair value of derivative instruments notdesignated as hedging instruments. There were also $0.6 million of derivative losses, net of tax, for the three-month period, thatresulted primarily from the reclassification of transition adjustment-relatedderivative losses from OCI to net interest income in accordance with SFAS No.133.  The Company estimates that $1.3million, net of tax, of the remaining transition adjustment of net derivativelosses included in OCI will be reclassified into earnings within the nexttwelve months. The recognition in net interest income of the transitionadjustment derivative losses from OCI will be offset by derivative gains fromchanges in the fair value liability of the interest rate swaps as they reachmaturity.

 

In June 2001, the FASB issued SFAS No. 142,“Goodwill and Other Intangible Assets,” which supersedes APB No. 17,“Intangible Assets.”  SFAS No. 142 addresses how intangible assetsthat are acquired individually or with a group of other assets (but not thoseacquired in a business combination) should be accounted for in financialstatements upon their acquisition.  Thisstatement also addresses howgoodwill and other intangible assets should be accounted for after they havebeen initially recognized in the financial statements.  This statement affects the accounting ofpremiums, includes guidelines for the determination, measurement and testing ofimpairment, and requires disclosure of information about goodwill and otherintangible assets in the years subsequent to their acquisition that was notpreviously required.  On January 1,2002, the Company adopted SFAS No. 142 and ceased amortization of goodwill.

 

8

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**3.             Loans**

 

Loans consist of demand loans to custodyclients of the Company, including individuals and not-for-profit institutions,and loans to mutual fund clients. The loans to mutual funds and other pooledproduct clients include lines of credit and advances pursuant to the terms ofthe custody agreements between theCompany and those mutual fund clients to facilitate securities transactions andredemptions. Generally, the loans are, or may be, in the event of default,collateralized with marketable securities held by the Company as custodian.There were no impaired or nonperforming loans at March 31, 2002 and December31, 2001.  In addition, there were noloan charge-offs or recoveries during the three months ended March 31, 2002 andthe year ended December 31, 2001. Loans are summarized as follows (Dollars inthousands):

 
|                            |   | **March 31,  2002** |    | **December 31,  2001** |   |
|---------------------------------|--------|---------------------|---------|-----------------------------|--------|
| Loans to individuals            |   | $                   | 98,464  |                        | $      | 181,330 |   |
| Loans to mutual  funds          |   | 36,291              |    | 50,342                      |   |
| Loans to others                 |   | 522                 |    | 541                         |   |
|                            |   | 135,277             |    | 232,213                     |   |
| Less allowance  for loan losses |   | (100                | )       | (100                        | )      |
|                            |   |                |    |                        |   |
| Total                           |   | $                   | 135,177 |                        | $      | 232,113 |   |

 

The Company had commitments to lend of approximately$690 million and $390 million at March 31, 2002 and December 31, 2001, respectively. The terms of thesecommitments are similar to the terms of outstanding loans.

 

**4.             Acquisitions**

 

Goodwill relatedto the Company’s acquisitions is summarized as follows (Dollars in thousands):

 
|                           |   | **For the Three  Months Ended  March 31, 2002** |   | **For the  Year Ended  December 31, 2001** |   |
|--------------------------------|--------|-------------------------------------------------|--------|-------------------------------------------------|--------|
| Goodwill,  beginning of period |   | $                                               | 79,969 |                                            | $      | 34,094 |   |
| Plus purchase of  businesses   |   | —                                          |   | 49,434                                          |   |
| Less  amortization             |   | —                                          |   | (3,559                                          | )      |
|                           |   |                                            |   |                                            |   |
| Goodwill, end of  period       |   | $                                               | 79,969 |                                            | $      | 79,969 |   |

 

On February 1, 2001, the Company purchasedthe operations of the advisor custody unit of The Chase Manhattan Bank.  This unit provided institutional custodyservices to individual accounts holding approximately $27 billion in assets asof February 1, 2001.  These accountsconsist of individual accounts, trusts, endowments and corporate accounts whoseassets are managed by third-party investment advisors.  Pursuant tothe terms of the asset purchase agreement, the Company paid to Chase as ofclosing approximately $31.5 million of the total purchase price, plus another$39.8 million in exchange for the book value of loans to clients.  In the second quarter of 2002, the Companymay pay up to another $10.5 million contingent upon client retention.  Based upon current projections, which aresubject to change, the Company does not believe that it will be obligated topay any portion of the $10.5 million contingent payment.  The transaction was accounted for as apurchase.

 

On May 1, 2001, the Company assumed theoperations of the U.S. asset administration unit of Barclays Global Investors,N.A. (‘BGI’), a large international institutional investment manager.  The unit, located in Sacramento, California,provides custody accounting and other operations functions for BGI’sclients.  The transaction was accountedfor as a purchase.

 

No pro forma financial results of BGI arepresented as they were not material to the Company’s financial condition andoperating results for the periodspresented.

 

9

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On January 1, 2002, the Company adopted SFASNo. 142 and ceased amortization of goodwill. See “Interim Financial Statements” (Footnote 2) for a further discussionof this pronouncement.

 

**5.             Deposits**

 

Time deposits at March 31, 2002 and December31, 2001 included noninterest-bearing amounts of approximately $90million.  All time deposits had a minimum balance of $100,000and a maturity of less than three months at March 31, 2002 and December 31,2001.

 

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

 

The componentsof short–term and other borrowings are as follows (Dollars in thousands):

 
|                                                  |   | **March 31,  2002** |      | **December 31,  2001** |   |
|-------------------------------------------------------|--------|---------------------|-----------|------------------------|--------|
|                                                  |   |                |      |                   |   |
| Federal Home  Loan Bank of Boston long-term advances  |   | $                   | 300,000   |                   | $      | 300,000 |   |
| Federal Home  Loan Bank of Boston short-term advances |   | 250,000             |      | 100,000                |   |
| Federal Home  Loan Bank of Boston overnight advances  |   | 250,000             |      | 380,000                |   |
| Federal funds  purchased                              |   | 205,000             |      | 130,000                |   |
| Treasury, Tax  and Loan account                       |   | 725                 |      | 281                    |   |
|                                                  |   |                |      |                   |   |
| Total                                                 |   | $                   | 1,005,725 |                   | $      | 910,281 |   |

 

The Company has a borrowing arrangement withthe Federal Home Loan Bank of Boston (“FHLBB”), which is utilized on an overnight and on a term basis to satisfyfunding requirements.  The Company hasutilized both short-term and long-term features of the term advances.

 

As of March31, 2002 and December 31, 2001, there were $300 million of long-term termadvances outstanding with interest rates ranging from 3.59% to 5.17% andmaturities ranging from June 2003 to February 2005.

 

There wasone $250 million short-term term advance outstanding at March 31, 2002 with aninterest rate of 1.93% maturing in April 2002.   The interest rate on the $100 million short-term term advanceoutstanding at December 31, 2001 was 1.82% and matured in January 2002.  There were $250 million and $380 million ofoutstanding overnight advances at March 31, 2002 and December 31, 2001,respectively.

 

The rates on the outstanding balances offederal funds purchased from other banks at March 31, 2002 and December 31,2001 were 1.76% and 1.61%,respectively.

 

The Company receives federal tax depositsfrom clients as agent for the Federal Reserve Bank and accumulates thesedeposits in the Treasury, Tax and Loan account.  The Federal Reserve Bank charges the Company interest at theFederal Funds rate on such deposits.  The interest rate on the outstanding balancewas 1.46% at March 31, 2002 and 1.51% at December 31, 2001.

 

**7.             Stockholders’ Equity**

 

As of March 31, 2002, the Company hasauthorized 1,000,000 shares of Preferred Stock and 100,000,000 shares of CommonStock, all with a par value of $0.01 per share.

 

At the Annual Meeting of Stockholders of theCompany held on April 17, 2001, stockholders approved an increase in the numberof authorized shares of Common Stock from 40,000,000 to 100,000,000.  On April 25,2001, the Company amended its Certificate of Incorporation increasing the number ofauthorized shares of Common Stock to 100,000,000.  These shares are available for general corporate purposes as determinedby the Company’s Board of Directors.

 

10

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On April 23, 2002, the Board of Directorsapproved a two-for-one stock split in the form of a 100% stock dividend payableon or about June 14, 2002 to stockholdersof record as of May 24, 2002.

 

The Company has three stock option plans: theAmended and Restated 1995 Stock Plan (‘Stock Plan’), the Amended and Restated1995 Non-Employee Director Stock Option Plan (‘Director Plan’), and the 1997Employee Stock Purchase Plan.

 

At the Annual Meeting of Stockholders of theCompany held on April 17, 2001, stockholders approved the amendment and restatement of the Company’s Stock Plan toincrease the number of shares available for grant pursuant to the plan from4,640,000 to 6,140,000.  At the AnnualMeeting of Stockholders of the Company held on April 23, 2002, stockholdersapproved the amendment and restatement of the Company’s Stock Plan to increasethe number of shares available for grant pursuant to the plan from 6,140,000 to7,640,000. Of the 6,140,000 shares of Common Stock authorized for issuanceunder the Stock Plan at March 31, 2002, 841,691 were available for grant as ofthat date.  Under the Stock Plan, theCompany may grant options to purchase shares of Common Stock to certainemployees, consultants, directors and officers.  The options may be awarded as incentive stock options (employeesonly), nonqualified stock options, stock awards or opportunities to make directpurchases of stock.  No options weregranted to consultants during the three months ended March 31, 2002.

 

The terms of the Director Plan provide forthe grant of options to non-employee directors to purchase up to a maximum of400,000 shares of Common Stock. Of the 400,000 shares of Common Stock authorizedfor issuance under the plan, 84,590 were availablefor grant at March 31, 2002.

 

Pursuant to the terms of the Director Plan,options to purchase 10,000 shares of Common Stock were awarded onNovember 8, 1995 to each non-employee director then in office. Eachnon-employee director receives an automatic annual grant of options to purchasethe number of shares then specified by the Director Plan (initially 2,500), asdescribed below.  Additionally, any non-employee directormay elect to receive options to acquire shares of the Company’s Common Stock inlieu of such director’s cash retainer. Any such election is subject to certain restrictions under the DirectorPlan. The number of shares of stock underlying the option granted in lieu ofcash is equal to the quotient obtained by dividing the cash retainer by thefair market value of an option on the date of grant, which is based on theBlack-Scholes option-pricing model.

 

At the Annual Meeting of Stockholders of theCompany held on April 23, 2002, stockholders approved amendments to theDirector Plan providing that on the date of each Annual Meeting, each personwho is a member of the Board immediately after the Annual Meeting of theCompany and who is not an employee of the Company shall be automaticallygranted an option to purchase the number of shares called for by the DirectorPlan as of that date.  Formerly, eachnon-employee director received a grant of options upon their election orappointment and annually thereafter on their anniversary date.  The amendments also provide that the numberof shares granted to each non-employee director annually be adjusted for stocksplits and other capital changes. In addition, the amendments provide thatoptions granted under the Director Plan will vest in 36 equal monthlyinstallments beginning on the date of grant, rather than 48 equal monthlyinstallments, subject to certain restrictions. Finally, the amendments to theDirector Plan provide that in the event a non-employee director ceases to be amember of the Board by reason of his or her retirement, the Board may vote toaccelerate and fully vest all unvested options held by the retiringnon-employee director.

 

The exercise price of options under theAmended and Restated 1995 Non-Employee Director Stock Option Plan and theincentive options under the Amended and Restated 1995 Stock Plan may not beless than the fair market value at the date of the grant.  The exercise price of non-qualified optionsunder the Amended and Restated 1995 Stock Plan is determined by the compensation committee of the Board ofDirectors.  All options becomeexercisable as specified by the compensation committee at the date of thegrant.

 

On February 13, 2001, theCompany granted 4,000 shares of Common Stock under the Stock Plan to formeremployees of the Chase advisor custody unit. This grant is subject to the Company’s right to repurchase the shares ifthe employees’ employment with the Company terminates.  The Company’s right to repurchase the shareslapses in five equal annual installments beginning one year fromthe date of grant.

 

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On May 1, 2001, the Companygranted 29,000 nonqualified stock options under the Stock Plan to formeremployees of the U.S. asset administration unit of BGI in connection with theassumption of the operations of the unit.  The exercise price of the options is 10% ofthe fair market value of the Common Stock at the close of market on the date ofgrant.  The grants are exercisable immediately, but any sharesacquired on exercise are subject to the Company’s right to repurchase theshares at the exercise price if the employees’ employment with the Companyterminates.  The Company’s right to repurchase the shares lapses in five equal annualinstallments beginning one year from the date of grant.

 

On October 16, 2001, the Companygranted 5,000 nonqualified stock options to an officer of the Company under theStock Plan.  The grantsare exercisable immediately, but any shares acquired on exercise are subject tothe Company’s right to repurchase the shares at the exercise price if theofficer’s employment with the Company terminates.  The Company’s right torepurchase the shares lapses in five equal annual installments beginning oneyear from the date of grant.

 

The Company has recordeddeferred compensation of $2.2 million and $2.6 million at March 31,2002 and December 31, 2001, respectively, related to thegrants described in the above three paragraphs.

 

Under the terms of the 1997 Employee StockPurchase Plan, the Company may issue up to 560,000 shares of Common Stockpursuant to the exercise ofnontransferable options granted to participating employees. The 1997 EmployeeStock Purchase Plan permits eligible employees to purchase up to 1,000 sharesof Common Stock per payment period, subject to limitations provided bySection 423(b) of the Internal Revenue Code, through accumulated payrolldeductions. The purchases are made twice a year at a price equal to the lesserof (i) 90% of the average market value of the Common Stock on the firstbusiness day of the payment period, or (ii) 90% of the average marketvalue of the Common Stock on the last business day of the payment period. Thepayment periods consist of two six-month periods, January 1 through June 30and July 1 through December 31.

 

A summaryof option activity under the Amended and Restated 1995 Non–EmployeeDirector Stock Option Plan and the Amended and Restated 1995 Stock Plans is asfollows:

 
|                                           |   | **Number of  Shares** |   | **Weighted-Average  Exercise Price** |   |
|------------------------------------------------|--------|-----------------------|--------|--------------------------------------|--------|
| Outstanding at  December 31, 2001              |   | 3,460,805             |   | $                                    | 39     |   |
| Granted                                        |   | 32,735                |   | 71                                   |   |
| Exercised                                      |   | (178,493              | )      | 15                                   |   |
| Canceled                                       |   | (17,050               | )      | 63                                   |   |
|                                           |   |                  |   |                                 |   |
| Outstanding at  March 31, 2002                 |   | 3,297,997             |   | $                                    | 41     |   |
|                                           |   |                  |   |                                 |   |
| Outstanding and  exercisable at March 31, 2002 |   | 1,698,572             |   |                                 |   |

 
|                                           |   | **Number of  Shares** |   | **Weighted-Average  Exercise Price** |   |
|------------------------------------------------|--------|-----------------------|--------|--------------------------------------|--------|
|                                           |   |                  |   |                                 |   |
| Outstanding at  December 31, 2000              |   | 2,896,662             |   | $                                    | 27     |   |
| Granted                                        |   | 41,375                |   | 75                                   |   |
| Exercised                                      |   | (193,550              | )      | 9                                    |   |
| Canceled                                       |   | (1,800                | )      | 70                                   |   |
|                                           |   |                  |   |                                 |   |
| Outstanding at  March 31, 2001                 |   | 2,742,687             |   | $                                    | 29     |   |
|                                           |   |                  |   |                                 |   |
| Outstanding and  exercisable at March 31, 2001 |   | 1,319,257             |   |                                 |   |

 

12

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A summaryof activity under the 1997 Employee Stock Purchase Plan is as follows (Numberof shares):

 
|                                                        |   | **For the Three  Months Ended  March 31,  2002** |   | **For the  Year Ended  December 31,  2001** |   |
|-------------------------------------------------------------|--------|--------------------------------------------------|--------|---------------------------------------------|--------|
| Total shares  available under the Plan, beginning of period |   | 250,382                                          |   | 299,034                                     |   |
| Issued at June  30                                          |   | —                                           |   | (20,988                                     | )      |
| Issued at  December 31                                      |   | —                                           |   | (27,664                                     | )      |
|                                                        |   |                                             |   |                                        |   |
| Total shares  available under the Plan, end of period       |   | 250,382                                          |   | 250,382                                     |   |

 

For the year ended December 31, 2001, theexercise price of the stock was $60.50 and $59.75, or 90% of the average marketvalue of the Common Stock on the first business day of the payment periodsending June 30, 2001 and December 31, 2001, respectively.

 

***Earnings Per Share****—*Reconciliationfrom Basic EPS to Diluted EPS is as follows (Dollars in thousands, except pershare data):

 

|                                     |   | **For the  Three Months Ended  March 31,** |   |
|------------------------------------------|--------|--------------------------------------------|--------|
|                                     |   | **2002**                                   |   | **2001** |   |
| Income available  to common stockholders |   | $                                          | 16,055 |   | $ | 10,348 |   |
|                                     |   |                                       |   |   |   |
| Basic average  shares                    |   | 32,074,493                                 |   | 31,011,674 |   |
| Dilutive effect  of stock options        |   | 1,158,675                                  |   | 1,335,352 |   |
| Diluted average  shares                  |   | 33,233,168                                 |   | 32,347,026 |   |
|                                     |   |                                       |   |   |   |
| Earnings per  share                      |   |                                       |   |   |   |
| Basic                                    |   | $                                          | 0.50   |   | $ | 0.33 |   |
|                                     |   |                                       |   |   |   |
| Diluted                                  |   | $                                          | 0.48   |   | $ | 0.32 |   |

** **

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

 

*Lines of Credit*—At March 31, 2002, the Companyhad commitments to individuals and mutual funds under collateralized open linesof credit totaling $690 million, against which $59 million in loans were drawn.The credit risk involved in issuing lines of credit is essentially the same asthat involved in extending loan facilities. The Company does not anticipate anyloss as a result of these lines of credit.

 

On behalfof its clients, the Company lends its securities to creditworthy brokers andother institutions.  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 the securities borrowed.  The borrowed securities are revalued daily to determine ifadditional collateral is necessary.  TheCompany held, as collateral, cash and U.S. government securities totalingapproximately $2.4 billion and $2.1 billion for indemnified securities on loanat March 31, 2002 and December 31, 2001, respectively.

 

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**9.             Commitments and Contingencies**

 

*Restrictions on Cash Balances*—The Company isrequired to maintain certain average cash reserve balances. The reserve balancewith the Federal Reserve Bank (“FRB”) as of March 31, 2002 was approximately$20.3 million.  In addition, other cashbalances in the amount of approximately $12.6 million were pledged to secureclearings with a depository institution, Depository Trust Company, as of March31, 2002.

 

*Lease Commitments*— Minimum future commitmentson noncancelable operating leases at March 31, 2002 were as follows (Dollars inthousands):

 

| **Fiscal Year Ending** |   | **Premises** |    | **Equipment** |   | **Total** |   |
|----------------------------------|--------|--------------|---------|---------------|--------|-----------|--------|
|                             |   |         |    |          |   |      |   |
| 2002                             |   | $            | 13,922  |          | $      | 3,993     |   | $ | 17,915 |   |
| 2003                             |   | 17,319       |    | 3,697         |   | 21,016    |   |
| 2004                             |   | 16,727       |    | 1,901         |   | 18,628    |   |
| 2005                             |   | 16,801       |    | 153           |   | 16,954    |   |
| 2006 and beyond                  |   | 50,771       |    | —        |   | 50,771    |   |
| Total                            |   | $            | 115,540 |          | $      | 9,744     |   | $ | 125,284 |   |

 

Total rentexpense was $7.5 million and $4.8 million for the three months ended March 31,2002 and 2001, respectively.

 

Effective January1, 2000, the Company renewed its five–year service agreement withElectronic Data Systems (“EDS”), which now expires on December 31, 2005.  Under the terms of the agreement, theCompany agreed to pay certain monthly service fees based on usage.  Service expense under this contract was $1.7million and $1.1 million for the three months ended March 31, 2002 and 2001,respectively.

 

In 2001,the Company renewed its agreement with SEI Investments Company, which nowexpires on December 31, 2005.  Under theterms of the agreement, the Company agreed to pay certain monthly service feesbased upon usage.  Service expense underthis contract was $1.4 million and $0.8 million for the three months endedMarch 31, 2002 and 2001, respectively.

* *

*Contingencies*—The Company provides a broadrange of services to financial asset managers, such as mutual fund complexes,investment advisors, banks and insurance companies.  The core services include global custody, multicurrencyaccounting and mutual fund administration. The value-added services include securities lending, foreign exchangeand cash management.  Assets under custody and management, held bythe Company in a fiduciary capacity, are not included in the consolidatedbalance sheets since such items are not assets of the Company.  Management conducts regular reviews of itsfiduciary responsibilities and considers the results in preparing itsconsolidated financial statements.  Inthe opinion of management, there are no contingent liabilities at March 31,2002 that are material to the consolidated financial position or results ofoperations of the Company.

 

On January 16, 2001, Mopex,Inc. filed an action entitled Mopex, Inc. v. Chicago Stock Exchange, Inc.,et al., Civil Action No. 01 C 0302 (the “Complaint”), in the United StatesDistrict Court for the Northern District of Illinois.  In the action, Mopex alleges that the Company and numerous otherentities, including Barclays Global Investors, State Street Bank and TrustCompany, and Merrill Lynch, Pierce, Fenner & Smith, Inc., infringed U.S.Patent No. 6,088,685, entitled, “Open End Mutual Fund Securitization Process,”assigned to Mopex.  In particular, Mopexalleges that the ‘685 patent covers the creation and trading of certainsecurities, including the Barclays iShares exchange traded funds.  The Complaint seeks injunctive relief,damages, and enhanced remedies (including attorneys’ fees and trebledamages).  On April 3, 2001, the Companyfiled an answer and counterclaim, denying any liability on Mopex’s claim andseeking a declaratory judgment that the ‘685 patent is invalid and notinfringed by the Company’s activities. The Company, which is indemnified by the iShares Trust for certaindefense costs and damages resulting from Mopex’s claim, believes the claim iswithout merit.

 

While the Company does notoffer or sell the securities discussed in the complaint, it provides certaincustody, accounting or other administrative services for the Barclays iSharesfamily of exchange traded funds. Barclays is one of the defendants named in thecomplaint.  The Company cannot be surethat it will prevail in the defense of this claim.  Patent litigation can be costly and could divert the attention ofmanagement. If the Company was found

 

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to infringe the patent, itwould have to pay damages and would be ordered to cease any infringing activityor seek a license under the patent. The Company cannot be sure that it will beable to obtain a license on a timely basis or on reasonable terms, if at all.As a result, any determination of infringement could have a material adverseeffect upon its business, financial condition and results of operations.

 

In July 2000, two of theCompany’s Dublin subsidiaries, Investors Trust & Custodial Services(Ireland) Ltd. (ITC) and Investors Fund Services (Ireland) Ltd.(IFS), received a plenary summons in the High Court, Dublin, Ireland. Thesummons named ITC and IFS as defendants in an action brought by the FTFForexConcept Fund Plc (the “Fund”), a former client. The summons also named asdefendants FTF Forex Trading and Finance, S.A., the Fund’s investment manager, Ernst & Young, the Fund’sauditors, and Dresdner Bank-Kleinwort Benson (Suisse) S.A., a tradingcounterparty to the Fund. The Fund is an investment vehicle organized in Dublinto invest in foreign exchange contracts. A total of approximately$4.7 million had been invested in the Fund. Most of that money was lostprior to the Fund’s closing to subscriptions in June 1999.

 

In January 2001, ITC, IFSand the other defendants named in the plenary summons received a statement ofclaim by the Fund seeking unspecified damages allegedly arising from breach ofcontract, misrepresentation and breach of warranty, negligence and breach ofduty of care, and breach of fiduciary duty, among others. The Company continuesto investigate this matter. The Company has notified its insurers and intendsto defend itself vigorously. Based on its investigation through March 31, 2002, the Company’s managementdoes not expect this matter to have a material adverse effect on its results ofoperations and financial condition.

 

**10.          Regulatory Matters**

 

The Company and the Bank are subject tovarious regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certainmandatory and possibly additional discretionary actions by regulators that, ifundertaken, could have a direct material adverse effect on the Company’s andthe Bank’s results of operations and financial condition.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices.  The Company’s andthe Bank’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings, and other factors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require theCompany and the Bank to maintain minimum amounts and ratios (set forth in thetable below) of total and Tier I capital (as defined in the regulations) torisk–weighted assets (as defined), and of Tier I capital (as defined) toaverage assets (as defined). Management believes, as of March 31, 2002, thatthe Company and the Bank meet all capital adequacy requirements to which theyare subject.

** **

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As of March 31, 2002, the most recentnotification from the FDIC categorized the Company and the Bank as wellcapitalized under the regulatory framework for prompt corrective action. To becategorized as well capitalized, the Company and the Bank must maintain minimumtotal risk-based, Tier I risk-based, and Tier I leverage ratios as set forth inthe following table. There are no conditions or events since that notificationthat management believes have changed the Company’s or the Bank’s category. Thefollowing table presents the capital ratios for the Company and the Bank(Dollars in thousands):

 
|                                                       |   | **Actual** |       | **For  Capital  Adequacy Purposes** |       | **To Be Well  Capitalized  Under Prompt  Corrective Action  Provisions** |       |
|------------------------------------------------------------|--------|------------|------------|-------------------------------------|------------|--------------------------------------------------------------------------|------------|
|                                                       |   | **Amount** |       | **Ratio**                           |       | **Amount**                                                               |       | **Ratio** |   | **Amount** |   | **Ratio** | ** ** |
| **As of March 31,  2002:**                                 |   |       | ** ** |                                | ** ** |                                                                     | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Total Capital  (to Risk Weighted Assets—the Company)  |   | $          | 316,301    |                                | 17.80      | %                                                                        | $          | 142,121 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital  (to Risk Weighted Assets—the Bank)     |   | $          | 312,193    |                                | 17.58      | %                                                                        | $          | 142,092 |   | 8.00 | % | $ | 177,616 |   | 10.00 | % |
| Tier I Capital  (to Risk Weighted Assets—the Company) |   | $          | 316,201    |                                | 17.80      | %                                                                        | $          | 71,060 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Risk Weighted Assets—the Bank)    |   | $          | 312,093    |                                | 17.57      | %                                                                        | $          | 71,046 |   | 4.00 | % | $ | 106,569 |   | 6.00 | % |
| Tier I Capital  (to Average Assets—the Company)       |   | $          | 316,201    |                                | 5.92       | %                                                                        | $          | 213,541 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Average Assets—the Bank)          |   | $          | 312,093    |                                | 5.85       | %                                                                        | $          | 213,449 |   | 4.00 | % | $ | 266,812 |   | 5.00 | % |
|                                                       |   |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| **As of December  31, 2001:**                              |   |       | ** ** |                                | ** ** |                                                                     | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Total Capital  (to Risk Weighted Assets—the Company)  |   | $          | 297,479    |                                | 16.77      | %                                                                        | $          | 141,932 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital  (to Risk Weighted Assets—the Bank)     |   | $          | 293,706    |                                | 16.56      | %                                                                        | $          | 141,898 |   | 8.00 | % | $ | 177,373 |   | 10.00 | % |
| Tier I Capital  (to Risk Weighted Assets—the Company) |   | $          | 297,379    |                                | 16.76      | %                                                                        | $          | 70,966 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Risk Weighted Assets—the Bank)    |   | $          | 293,606    |                                | 16.55      | %                                                                        | $          | 70,949 |   | 4.00 | % | $ | 106,424 |   | 6.00 | % |
| Tier I Capital  (to Average Assets—the Company)       |   | $          | 297,379    |                                | 5.88       | %                                                                        | $          | 202,377 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Average Assets—the Bank)          |   | $          | 293,606    |                                | 5.80       | %                                                                        | $          | 202,334 |   | 4.00 | % | $ | 252,917 |   | 5.00 | % |

 

Under Massachusetts law, trust companies suchas the Bank, like national banks, may pay dividends no more often thanquarterly, and only out of “net profits” and to the extent that such paymentswill not impair the Bank’s capital stock and surplus account. Moreover, priorapproval of the Commissioner of Banks of the Commonwealth of Massachusetts isrequired if the total dividends for a calendar year would exceed net profitsfor that year combined with retained net profits for the previous two years.These restrictions on the ability of the Bank to pay dividends to the Companymay restrict the ability of the Company to pay dividends to its stockholders.

 

16

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**11           Segment Reporting**

** **

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

 
|                        |   | **Net  Operating Revenue**                |    | **Long-Lived  Assets** |   |
|-----------------------------|--------|-------------------------------------------|---------|------------------------|--------|
|                        |   | **For the  Three Months Ended March 31,** |    | **March 31,  2002**    |   | **December  31,  2001** |   |
| **Geographic Information:** |   | **2002**                                  |    | **2001**               |   |   |   |
|                        |   |                                      |    |                   |   |   |   |   |   |
| United States               |   | $                                         | 100,611 |                   | $      | 68,477 |   | $ | 129,013 |   | $ | 122,200 |   |
| Ireland                     |   | 2,403                                     |    | 1,667                  |   | 325 |   | 370 |   |
| Canada                      |   | 500                                       |    | 517                    |   | 10 |   | 17 |   |
| Cayman Islands              |   | 21                                        |    | 21                     |   | — |   | — |   |
|                        |   |                                      |    |                   |   |   |   |   |   |
| Total                       |   | $                                         | 103,535 |                   | $      | 70,682 |   | $ | 129,348 |   | $ | 122,587 |   |
|                             |        |                                           |         |                        |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

BGI accounted for 15.85% of the Company’sconsolidated net operating revenues for the three months ended March 31,2002.  Noone customer exceeded 10% of the Company’s consolidated net operating revenuesfor the three months ended March 31, 2001.

 

The followingrepresents the Company’s asset servicing fees by service line (Dollars inthousands):

 
|                                                      |   | **Asset  Servicing Fees**                  |   |
|-----------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                      |   | **For the  Three Months Ended  March 31,** |   |
| **Asset servicing fees by service line:**                 |   | **2002**                                   |   | **2001** |   |
| Custody,  accounting, transfer agency, and administration |   | $                                          | 53,808 |   | $ | 38,660 |   |
| Foreign exchange                                          |   | 4,856                                      |   | 3,957 |   |
| Cash management                                           |   | 4,194                                      |   | 3,060 |   |
| Securities  lending                                       |   | 2,638                                      |   | 2,196 |   |
| Investment  advisory                                      |   | 1,718                                      |   | 559 |   |
|                                                      |   |                                       |   |   |   |
| Total                                                     |   | $                                          | 67,214 |   | $ | 48,432 |   |

 

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**Item 2.            Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Overview**

 

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

 

We provide a broad range ofservices to a variety of financial asset managers.  These services include our core services, global custody,multicurrency accounting and mutual fund administration, as well as ourvalue-added services, such as securities lending, foreign exchange, cash management,performance measurement, institutional transfer agency, investment advisoryservices and lines of credit.  At March31, 2002, we provided services for approximately $831 billion in netassets, including approximately $84 billion of foreign net assets.

 

On January 1, 2001, we adoptedSFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,”and the corresponding amendments and SFAS No. 138, “Accounting for CertainDerivative Instruments and Certain Hedging Activities.”  On adoption of these new accountingstandards, we recorded a transition adjustment recognizing an after taxreduction in Other Comprehensive Income (“OCI”) of $3.9 million.  In conjunction with the adoption, we electedto reclassify approximately $402 million of securities from held to maturity toavailable for sale, which further reduced OCI, net of tax, by approximately$1.4 million.

 

On February 1, 2001, wecompleted the issuance and sale of 1,624,145 shares of Common Stock at $71.62per share in a public offering.  Aportion of the proceeds was used to fund the acquisition of the advisor custodyunit of the Chase Manhattan Bank.  Theremaining proceeds were used for the assumption of the operations of the U.S.asset administration unit of Barclays Global Investors, N.A. and for workingcapital.

 

On February 1, 2001, wepurchased the operations of the advisor custody unit of The ChaseManhattan Bank (“Chase”).    This unitprovided institutional custody services to individual accounts holdingapproximately $27 billion in assets as of February 1, 2001.  These accounts consist of individualaccounts, trusts, endowments and corporate accounts whose assets are managed bythird-party investment advisors. Pursuant to the terms of the asset purchase agreement, we paid to Chaseat the closing of the transaction approximately $31.5 million of the totalpurchase price, plus another $39.8 million in exchange for the book value ofloans to its clients.  In the secondquarter of 2002, we may pay up to another $10.5 million contingent upon clientretention.  Based upon currentprojections, which are subject to change, we do not believe that we will beobligated to pay any portion of the $10.5 million contingent payment.  The transaction was accounted for as apurchase.

 

On May 1, 2001, we assumed the operations ofthe U.S. asset administration unit of Barclays Global Investors, N.A. (“BGI”),a large international institutional investment manager.  The unit, located in Sacramento, California,provides custody, fund accounting and other operations functions for BGI’sclients.  The transaction was accountedfor as a purchase.

 

On April 23, 2002, the Board of Directorsapproved a two-for-one stock split in the form of a 100% stock dividend payableon or about June 14, 2002 to shareholders of record as of May 24, 2002.

 

**Revenue and Expense Overview**

 

We derive our revenue fromfinancial asset servicing.  Althoughinterest income and noninterest income are reported separately for financialstatement presentation purposes, our clients view the pricing of our serviceofferings on a bundled basis.  Inestablishing a fee structure for a specific client, management analyzes allexpected revenue and related expenses, as opposed to separately analyzing feeincome and interest income and related expenses for each from therelationship.  Accordingly, we believenet operating revenue (net interest income plus noninterest income) and netincome are the most meaningful measures of our financial results. Net operatingrevenue increased 46% to $103.5 million for the three months ended March31, 2002 from $70.7 million in 2001. Net income increased 55% to $16.1 million for the three months endedMarch 31, 2002 from $10.3 million in 2001.

 

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Noninterest income consistsprimarily of fees for financial asset servicing and is principally derived fromglobal custody, multicurrency accounting, mutual fund administration andinstitutional transfer agency services for financial asset managers and theassets they control. Our clients pay fees based on the volume of assets undercustody, portfolio transactions, income collected and whether other value-addedservices such as foreign exchange, securities lending and performancemeasurement are needed.  Asset-basedfees are usually charged on a sliding scale and are subject to minimumfees.  As such, when the assets in aportfolio under custody grow as a result of changes in market values or cashinflows, our fees may be a smaller percentage of those assets.  If the value of equity assets held by ourclients were to increase or decrease by 10%, we estimate that this, by itself,would currently cause a corresponding change of approximately 3% in ourearnings per share.  If the value offixed income assets held by our clients were to increase or decrease by 10%, weestimate that this, by itself, would currently cause a corresponding change ofapproximately 2% in our earnings per share.

 

Net interest income representsthe difference between income generated from interest-earning assets andexpense on interest-bearing liabilities. Interest-bearing liabilities are generated by our clients who, in thecourse of their financial asset management, generate cash balances which theydeposit on a short-term basis with us. We invest these cash balances and remit a portion of the earnings onthese investments to our clients.  Ourshare of earnings from these investments is viewed as part of the total packageof compensation paid to us from our clients for performing asset servicing.

 

Operating expenses consist ofcosts incurred in support of our business activities.  As a service provider, our largest expenditures are staffingcosts, including compensation and benefits. We also rely heavily on technological tools and services for processing,communicating and storing data.  As aresult, our technology and telecommunication expense is also a large percentageof our operating expenses.

 

**Significant Accounting Policies**

 

The consolidated financial statements areprepared in accordance with accounting principles generally accepted in theU.S., which require us to make estimates and assumptions.  We have identified the following accountingpolicies that, as a result of the complexities of the underlying accountingstandards and operations involved, could result in significant changes to ourconsolidated financial condition or results of operations under differentconditions or using different assumptions.

 

***Derivative Financial Instruments***  - We do not purchase derivative financial instruments for tradingpurposes.  Interest rate swap agreementsare matched with specific financial instruments reported on the consolidatedbalance sheet.    We use derivativeinstruments to manage exposures to interest rate risks.  We routinely enter into interest rate swapagreements in which we pay a fixed interest rate and receive a floatinginterest rate.  These transactions aredesigned to hedge a portion of our liabilities in connection with securitiessold under repurchase agreements.  Byentering into a pay-fixed/receive-floating interest rate swap, a portion ofthese liabilities is effectively converted to a fixed rate liability for theterm of the interest rate swap agreements.

 

On January 1, 2001, weadopted SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as amended and interpreted, which established accounting andreporting standards for derivative instruments.  We also adopted SFAS No. 138, “Accounting for Certain DerivativeInstruments and Certain Hedging Activities.” All derivatives, whether designated in hedging relationships or not, arerequired to be recorded on the balance sheet at fair value.  If the derivative is designated as a fairvalue hedge, the change in the fair value of the derivative and the item beinghedged will be recognized in earnings. If the derivative is designated as a cash flow hedge, the effectiveportions of changes in the fair value of the derivative are recorded inOCI.  Ineffective portions of changes,as determined in accordance with SFAS No. 133, in the fair value of the cashflow hedges are recognized in earnings. For derivatives that do not qualify as hedges, changes in their fairvalue are recognized in earnings.

 

Hedge accounting requiresthat we measure the changes in fair value of derivatives designated as hedgesas compared to changes in expected cash flows of the underlying hedgedtransactions for each reporting period. Changes in conditions or the occurrence of unforeseen events couldaffect the timing of the recognition of changes in fair value of certainhedging derivatives.  The measurement offair value is based upon market values, however, in the absence of quotedmarket values, measurement involves valuation estimates.  These estimates are based on

 

19

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methodologies deemed appropriate in thecircumstances.  However, the use ofalternative assumptions could have a significant effect on estimated fairvalue.

 

Hedge ineffectiveness, determined in accordance with SFAS No. 133, hadan insignificant impact on earnings for the three months ended March 31,2002.  No cash flow hedges werededesignated or discontinued for the three months ended March 31, 2002.

 

We enter into foreignexchange contracts with clients and attempt to enter into a matched positionwith another bank. These contracts are subject to market value fluctuations inforeign currencies.  Gains and lossesfrom such fluctuations are netted and recorded as an adjustment of assetservicing fees.  Unrealized gains(losses) resulting from purchases and sales of foreign exchange contracts areincluded within the respective other assets and other liabilities categories onour consolidated balance sheet.  Theforeign exchange contracts have been reduced by balances with the same counterpartywhere a master netting agreement exists.

*** ***

***New Accounting Principles*** –On January 1,2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” whichsupersedes APB No. 17, “Intangible Assets.” SFAS No. 142 addresses how intangible assets that are acquiredindividually or with a group of other assets (but not those acquired in abusiness combination) should be accounted for in financial statements upontheir acquisition.  This statement alsoaddresses how goodwill and other intangible assets should be accounted forafter they have been initially recognized in the financial statements.  This statement affects the accounting ofpremiums, includes guidelines for the determination, measurement and testing ofimpairment, and requires disclosure of information about goodwill and other intangibleassets in the years subsequent to their acquisition that was not previouslyrequired.  This Statement eliminates theamortization of goodwill, and requires that goodwill be reviewed at leastannually for impairment.  This Statementaffects all goodwill recognized on our consolidated balance sheet, regardlessof when the assets were initially recorded. Upon adoption of SFAS No. 142, we ceased amortization of goodwill.  Currently, we do not anticipate anyimpairment of goodwill for the fiscal year ending December 31, 2002.

 

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**Certain Factors That May Affect FutureResults**

 

From time totime, 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, the timing and effecton earnings of derivative gains and losses, the effect on earnings of declinesin equity values, 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.

 

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

 

We have been experiencing aperiod of rapid growth that has required the dedication of significantmanagement and other resources, including the assumption of the operations ofthe U.S. asset administration unit of BGI. Continued rapid growth could place astrain on our management and other resources. To manage future growth effectively, we must continue to invest in ouroperational, financial and other internal systems, and our humanresources.  Also, we must continue toexpand our office space at reasonable rates in a competitive real estatemarket.

 

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

 

The integration of the BGIasset administration unit presents us with challenges and demands managementattention that has to be diverted from other matters.  Integration of acquisitions and outsourcing transactions iscomplicated and frequently presents unforeseen difficulties and expenses whichcan affect whether and when a particular acquisition will be accretive to ourearnings per share.  Any futureacquisitions or outsourcing transactions will present similar challenges.

 

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

 

We base some of our fees on the market valueof the assets we process.  Accordingly,our operating results are subject to fluctuations in interest rates or thesecurities markets as these fluctuations affect the market value of assetsprocessed.  Fluctuations in interestrates or the securities markets can also lead to investors seeking alternativesto the investment offerings of our clients, which could result in a lesseramount of assets processed and correspondingly lower fees.  Also, our net interest income is earned byinvesting depositors’ funds and making loans. Rapid changes in interest rates or changes in the relationship betweendifferent index rates could adversely affect the market value of, or theearnings produced by, our investment and loan portfolios.

 

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

 

We are part of an extremelycompetitive asset servicing industry. Many of our current and potential competitors have longer operatinghistories, greater name recognition and substantially greater financial,marketing and other resources than we do. These greater resources could, for example, allow our competitors todevelop technology superior to our own. In addition, we face the risk thatlarge mutual fund complexes may build in-house asset servicing capabilities andno longer outsource these services to us. As a result, we may not be able to compete effectively with current orfuture competitors.

 

*A material portion of our revenues is derivedfrom our relationship with Barclays Global Investors, N.A.*

 

As a result of our assumptionof the operations of the U.S. asset administration unit of BGI in 2001 and ourongoing relationship with BGI’s iShares and Master Investment Portfolios, BGIaccounted for approximately 16% of our

 

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net operating revenue during the three monthsended March 31, 2002.  We expect thatBGI will continue to account for a significant portion of our net operatingrevenue.  While we provide services toBGI under long-term contracts, those contracts may be terminated for certainregulatory and fiduciary reasons.  Theloss of BGI’s business would cause our net operating revenue to decline andwould have a material adverse effect on our quarterly and annual results.

 

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

 

Our proprietary technology isimportant to our business.  We rely ontrade secret, copyright and trademark laws and confidentiality agreements withemployees and third parties to protect our proprietary technology, all of whichoffer only limited protection.  Theseintellectual property rights may be invalidated or our competitors may developsimilar technology independently.  Legalproceedings to enforce our intellectual property rights may be unsuccessful,and could also be expensive and divert management’s attention.

 

*We may incur significant costs defendinginfringement claims.*

 

We have been sued in federalcourt claiming that we and others are infringing a patent allegedly coveringthe creation and trading of certain securities, including exchange tradedfunds.  While we believe the claim iswithout merit, we cannot be sure that we will prevail in the defense of thisclaim.  Any patent litigation would becostly and could divert the attention of management.  If we were found to infringe the patent, we would have to paydamages and would be ordered to cease any infringing activity or seek a licenseunder the patent.  We cannot be surethat we will be able to obtain a license on a timely basis or on reasonableterms, if at all.  While we are indemnifiedagainst some defense costs and damages related to this claim, we may incursignificant expenses defending the claim. As a result, any determination of infringement could have a materialadverse effect upon our business, financial condition and results ofoperations.  We may become subject toother infringement claims in the future.

 

*We must hire and retain skilled personnel inorder to succeed.*

 

Qualified personnel, inparticular managers and other senior personnel, are in great demand throughoutthe financial services industry.  Wecould find it increasingly difficult to continue to attract and retainsufficient numbers of these highly skilled employees.

 

*Our quarterly and annual operating resultsmay fluctuate.*

 

Our quarterly and annualoperating results are difficult to predict and may fluctuate from quarter toquarter and annually for several reasons, including:

 

•              The timing of commencement ortermination of client engagements; and

 

•              The rate of net inflows andoutflows of investor funds in the investment vehicles offered by our clients.

 

Most of our expenses, likeemployee compensation and rent, are relatively fixed.  As a result, any shortfall in revenue relative to ourexpectations could significantly affect our operating results.

 

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

 

Federal and state laws andregulations applicable to financial institutions and their parent companiesapply to us.  Our primary bankingregulators are the Federal Reserve Board (“FRB”), the Federal Deposit InsuranceCommission  (“FDIC”) and theMassachusetts Commissioner of Banks. Virtually all aspects of our operations are subject to specificrequirements or restrictions and general regulatory oversight including thefollowing:

 

•                                          The FRB and the FDIC maintain capitalrequirements that we must meet. Failure to meet those requirements could leadto severe regulatory action or even receivership. We are currently consideredto be “well capitalized”;

 

•                                          Under Massachusetts law, the Bank may berestricted in its ability to pay dividends to Investors Financial, which may inturn restrict our ability to pay dividends to our stockholders; and

 

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•                                          The FRB and the FDIC are empowered to assessmonetary penalties against, and to order termination of activities by,companies or individuals who violate the law.

 

Banking law restricts ourability to own the stock of certain companies and also makes it more difficultfor us to be acquired.  Also, we havenot elected financial holding company status under the federalGramm-Leach-Bliley Act of 1999.  Thismay place us at a competitive disadvantage with respect to other organizations.

** **

**23**

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** **

**Statement of Operations**

* *

*Comparison of Operating Results for the Three MonthsEnded March 31, 2002 and 2001*

* *

*Noninterest Income*

 

Noninterestincome was $67.8 million for the three months ended March 31, 2002, up 38% fromthe same period in 2001.  Noninterestincome consists of the following items (Dollars in thousands):

 
|                     |   | **For the  Three Months Ended March 31,** |   |
|--------------------------|--------|-------------------------------------------|--------|
|                     |   | **2002**                                  |   | **2001** |   | **Change** |   |
|                     |   |                                      |   |   |   |   |   |
| Asset servicing fees     |   | $                                         | 67,214 |   | $ | 48,432 |   | 39 | % |
| Other operating income   |   | 584                                       |   | 781 |   | (25 | )% |
|                     |   |                                      |   |   |   |   |   |
| Total noninterest income |   | $                                         | 67,798 |   | $ | 49,213 |   | 38 | % |

 

Assetservicing fees for the three months ended March 31, 2002 increased 39% from thesame period in 2001 to $67.2 million and includes approximately $12.6 millionrelating to the asset administration operations assumed from BGI.  The largest component of asset servicingfees is asset-based fees, which increased due to the increase in assetsprocessed.  Assets processed is thetotal dollar value of financial assets on the reported date for which we provideone or more of the following services: global custody, multicurrencyaccounting, mutual fund administration, securities lending, foreign exchange,cash management, performance measurement, institutional transfer agency,investment advisory services and lines of credit.   Net assets processed increased $17 billion to $831 billion atMarch 31, 2002 from $814 billion at December 31, 2001.  This net increase includes the following components (Dollars in billions):

 

|                                     |   | **For the  Three Months Ended  March 31, 2002** |   |
|------------------------------------------|--------|-------------------------------------------------|--------|
|                                     |   |                                            |   |
| Further penetration of  existing clients |   | $                                               | 5      |   |
| Fund flows and market  gain/loss         |   | 12                                              |   |
|                                     |   |                                            |   |
| Net increase in assets  processed        |   | $                                               | 17     |   |

 

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

 

Otheroperating income consists of dividends received relating to the Federal HomeLoan Bank of Boston (“FHLBB”) stock investment and miscellaneous fees for systemsconsulting services. The decrease in other operating income resulted primarilyfrom the decrease in income from consulting services performed forclients.  This decrease was partiallyoffset by the increase in FHLBB stock dividend income resulting from anincrease in the average investment in FHLBB stock during the three months endedMarch 31, 2002.

 

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*Operating Expenses*

 

Total operating expenses were $80.0 million for the three months endedMarch 31, 2002, up 46% from the same period in 2001.  The components of operating expenses were as follows (Dollars inthousands):

 
|                               |   | **For the  Three Months Ended March 31,** |   |
|------------------------------------|--------|-------------------------------------------|--------|
|                               |   | **2002**                                  |   | **2001** |   | **Change** |   |
|                               |   |                                      |   |   |   |   |   |
| Compensation  and benefits         |   | $                                         | 49,930 |   | $ | 33,914 |   | 47 | % |
| Technology and  telecommunications |   | 9,355                                     |   | 8,042 |   | 16 | % |
| Transaction  processing services   |   | 6,530                                     |   | 2,574 |   | 154 | % |
| Occupancy                          |   | 5,763                                     |   | 3,536 |   | 63 | % |
| Depreciation  and amortization     |   | 3,136                                     |   | 1,362 |   | 130 | % |
| Professional  fees                 |   | 1,472                                     |   | 745 |   | 98 | % |
| Travel and  sales promotion        |   | 1,234                                     |   | 998 |   | 24 | % |
| Amortization  of goodwill          |   | —                                    |   | 650 |   | (100 | )% |
| Other  operating expenses          |   | 2,569                                     |   | 3,032 |   | (15 | )% |
|                               |   |                                      |   |   |   |   |   |
| Total  operating expenses          |   | $                                         | 79,989 |   | $ | 54,853 |   | 46 | % |

 

Compensation and benefits expense was $49.9 million for the threemonths ended March 31, 2002, up 47% from the same period in 2001.  The average number of employees increased41% to 2,600 during the three months ended March 31, 2002 from 1,843 for thesame period last year.  We increased thenumber of employees to support the expansion of client relationships and toservice new business acquisitions. Approximately 135 and 382 employees were added as part of the Chaseacquisition and the BGI business unit assumption, respectively.  In addition, compensation expense related toour management-incentive plans increased $4.7 million, consistent with higherearnings and additional incentive-eligible managers.  Benefits, including payroll taxes, group insurance plans,retirement plan contributions and tuition reimbursement, increased$2.9 million for the three months ended March 31, 2002, consistent withthe increased headcount.

 

Technology and telecommunications expense was $9.4 million for thethree months ended March 31, 2002, up 16% from the same period in 2001.Increased hardware, software, mainframe and trust processing andtelecommunications expenditures needed to support the growth in assetsprocessed accounted for $3.4 million of the increase and were offset byexpenses related to outsourced network monitoring, help desk and otheroutsourced services required in 2001, and not in 2002, due to the Chaseacquisition.  These amounts totaledapproximately $2.1 million in 2001.

 

Transaction processing services expense was $6.5 million for the threemonths ended March 31, 2002, up 154% from the same period in 2001.  The increase relates primarily to increasedsubcustodian fees, driven by growth in assets processed for clients, largely aresult of the BGI U.S. asset administration unit assumption in May 2001.

 

Occupancy expense was $5.8 million for the three months endedMarch 31, 2002, up 63% from the same period in 2001.  This increase was primarily due to increased space resulting fromthe California offices assumed from BGI and increased space in our Boston, NewYork, and Dublin offices.

 

Depreciation and amortization expense was $3.1 million for thethree months ended March 31, 2002, up 130% from the same period in 2001.  This increase resulted from capitalizedexpenditures associated with the expansion into additional office space andcapitalized software.

 

Professional fees were $1.5 million for the three months ended March31, 2002, up 98% from the same period in 2001. The increase was due primarily to accounting and other consultingservices provided during the period.

 

Travel and sales promotion expense was $1.2 million for the threemonths ended March 31, 2002, up 24% from the same period in 2001. The increasewas due to the increased level of business activity and the addition of aCalifornia office in May 2001.  Traveland sales promotion expense consists of expenses incurred by the sales force,client management staff and other employees in connection with sales calls onpotential clients, traveling to existing client sites, and to our offices inNew York, California and our foreign subsidiaries.

 

25

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Amortization of goodwill expense ended as of January 1, 2002, as aresult of the adoption of SFAS No. 142. Please refer to the “Significant Accounting Policies” section for a furtherdiscussion of this pronouncement.

 

*Net Interest Income*

 

Net interest income is affected by the volume and mix of assets andliabilities, and the movement and level of interest rates. The table belowpresents the changes in net interest income resulting from changes in thevolume of interest-earning assets or interest-bearing liabilities and changesin interest rates compared to the same period in 2001. Changes attributed toboth volume and rate have been allocated based on the proportion of change in eachcategory (Dollars in thousands):

 
|                                                                 |   | **For the  Three Months Ended  March 31, 2002** |   |
|----------------------------------------------------------------------|--------|------------------------------------------------------|--------|
|                                                                 |   | **Change  Due to  Volume**                           |   | **Change  Due to  Rate** |   | **Net** |   |
|                                                                 |   |                                                 |   |   |   |   |   |
| **Interest-earning  assets:**                                        |   |                                                 |   |   |   |   |   |
| Federal funds  sold and securities purchased under resale agreements |   | $                                                    | (444   | ) | $ | (418 | ) | $ | (862 | ) |
| Investment  securities                                               |   | 21,498                                               |   | (20,959 | ) | 539 |   |
| Loans                                                                |   | 4                                                    |   | (366 | ) | (362 | ) |
|                                                                 |   |                                                 |   |   |   |   |   |
| Total  interest-earning assets                                       |   | $                                                    | 21,058 |   | $ | (21,743 | ) | $ | (685 | ) |
|                                                                 |   |                                                 |   |   |   |   |   |
| **Interest-bearing  liabilities:**                                   |   |                                                 |   |   |   |   |   |
| Deposits                                                             |   | $                                                    | 1,497  |   | $ | (10,334 | ) | $ | (8,837 | ) |
| Borrowings                                                           |   | 11,097                                               |   | (17,213 | ) | (6,116 | ) |
|                                                                 |   |                                                 |   |   |   |   |   |
| Total  interest-bearing liabilities                                  |   | $                                                    | 12,594 |   | $ | (27,547 | ) | $ | (14,953 | ) |
|                                                                 |   |                                                 |   |   |   |   |   |
| Change in net  interest income                                       |   | $                                                    | 8,464  |   | $ | 5,804 |   | $ | 14,268 |   |

 

Net interest income was $35.7 million for the three months endedMarch 31, 2002, up 66% from the same period in 2001.  The improvement in net interest income primarily reflects thepositive effect of balance sheet growth driven by increased client deposits andborrowings and a more favorable interest rate environment.  The net interest margin increased 40 basispoints to 2.80% for the three months ended March 31, 2002 compared to lastyear.

 

Average interest-earning assets, primarily investment securities,increased $1.5 billion or 43% for the three months ended March 31, 2002compared to the same period last year. Funding for the asset growth for the three-month period was provided byan increase in average borrowings, primarily wholesale repurchase agreementsand FHLBB advances, of $1.3 billion and an increase in average clientdeposits of $270 million.  Theeffect of changes in volume of interest-earning assets and interest-bearingliabilities was an increase in net interest income of approximately$8.5 million for the three months ended March 31, 2002.

 

Average yield on interest-earning assets was 4.59% for the three monthsended March 31, 2002, down 204 basis points from the same period in 2001.  The average rate paid on interest-bearingliabilities was 2.00% for the three months ended March 31, 2002, down 277 basispoints from the same period in 2001. The decrease reflects the lower interest rate environment for the threemonths ended March 31, 2002 compared to the same period in 2001.  The effect on net interest income due tochanges in rates was an increase of approximately $5.8 million during thethree months ended March 31, 2002.

 

On January 1, 2001, weadopted SFAS No. 133, as amended and interpreted, which established accountingand reporting standards for derivative instruments.  All derivatives, whether designated in hedging relationships ornot, are required to be recorded on the balance sheet at fair value.  If the derivative is designated as a fairvalue hedge, the change in the fair value of the derivative and the item beinghedged will be recognized in earnings. If the derivative is designated as a cash flow hedge, the effectiveportions of changes in the fair value of the derivative are recorded inOCI.  Ineffective portions of changes,as determined in accordance with SFAS No. 133, in the fair value

 

26

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of the cash flow hedgesare recognized in earnings.  Forderivatives that do not qualify as hedges, changes in their fair value arerecognized in earnings.  The adoption ofSFAS No. 133 on January 1, 2001, resulted in no cumulative effect-typeadjustment to net income.  However, werecorded a reduction to OCI of $3.9 million, net of tax, and a correspondingliability for the fair value of the interest rate swaps.  The reduction to OCI and the recognition ofthe liability are primarily attributable to net unrealized losses on cash flowhedges as of initial adoption.  Inconjunction with the adoption, we elected to reclassify approximately $402 millionof securities from held to maturity to available for sale, which furtherreduced OCI, net of tax, by approximately $1.4 million.

 

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

 

Hedge ineffectiveness,determined in accordance with SFAS No. 133, had an insignificant impact onearnings for the three months ended March 31, 2002. No cash flow hedges werededesignated or discontinued for the three months ended March 31, 2002.

 

Net interest incomeincluded net gains of $0.2 million, net of tax, for the three months endedMarch 31, 2002, on interest rate swaps relating to SFAS No. 133.  The net gain consisted of a $0.8 milliongain, net of tax, for the three-month period, on changes in the fair value ofderivative instruments not designated as hedging instruments.  There were also $0.6 million of derivativelosses, net of tax, for the three-month period that resulted primarily from thereclassification of transition adjustment-related derivative losses from OCI tonet interest income in accordance with SFAS No. 133.  We estimate that $1.3 million, net of tax, of the remainingtransition adjustment of net derivative losses included in OCI will bereclassified into earnings within the next twelve months. The recognition innet interest income of the transition adjustment derivative losses from OCIwill be offset by derivative gains from changes in the fair value liability ofthe interest rate swaps as they reach maturity.

 

*Income Taxes*

* *

Taxes for the threemonths ended March 31, 2002 were $7.1 million, up 40% from the same period in2001.  The increase in tax expensereflects the higher level of pretax income during the three months ended March31, 2002.  The effective tax rate for thethree-month period ended March 31, 2002 was 30%, down from 32% for the three–monthperiod last year.   The decrease in theeffective tax rate reflects our increased investment in nontaxable municipalsecurities in 2002.

** **

**27**

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** **

**Financial Condition**

* *

*Investment Portfolio*

* *

The following table summarizes our investmentportfolio for the dates indicated (Dollars in thousands):

 
|                                 |   | **March 31,  2002** |       | **December  31,  2001** |       |
|--------------------------------------|--------|---------------------|------------|-------------------------|------------|
| **Securities held to maturity:**     |   |                |       |                    |       |
| Mortgage-backed  securities          |   | $                   | 2,595,032  |                    | $          | 2,585,287 |   |
| Federal agency  securities           |   | 612,034             |       | 456,108                 |       |
| State and  political subdivisions    |   | 99,189              |       | 91,888                  |       |
| Foreign  government securities       |   | —              |       | 2,501                   |       |
| Total securities  held to maturity   |   | $                   | 3,306,255  |                    | $          | 3,135,784 |   |
|                                 |   |                |       |                    |       |
|                                 |   |                |       |                    |       |
| **Securities  available for sale:**  |   |                | ** ** |                    | ** ** |
| Mortgage-backed  securities          |   | $                   | 1,565,118  |                    | $          | 1,228,841 |   |
| Federal agency  securities           |   | 30,574              |       | 30,848                  |       |
| Corporate debt                       |   | 133,598             |       | 120,505                 |       |
| State and  political subdivisions    |   | 261,390             |       | 241,467                 |       |
| Total securities  available for sale |   | $                   | 1,990,680  |                    | $          | 1,621,661 |   |

 

Our investmentportfolio is used to invest depositors’ funds and provide a secondary source ofearnings for us.  In addition, we usethe investment portfolio to secure open positions at securities clearinginstitutions in connection with our custody services.  The portfolio is comprised of securities of state and politicalsubdivisions (“municipal securities”), mortgage-backed securities issued by theFederal National Mortgage Association (“FNMA” or “Fannie Mae”) and the FederalHome Loan Mortgage Corporation (“FHLMC” or “Freddie Mac”), and Federal agencycallable bonds issued by FHLMC and the FHLBB, securities issued by the SmallBusiness Administration (“SBA”) and corporate debt securities.

 

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

 

We invest inmunicipal securities to generate stable, tax advantaged income.  Municipal securities generally have lowerstated yields than Federal agency and U.S. Treasury securities, but theafter-tax yields are comparable. Municipal securities are subject to credit risk, however, all municipalsecurities are AAA rated and are purchased with municipal bond insurance.

 

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The book valueand weighted average yield of our securities held to maturity at March 31, 2002are reflected in the following table (Dollars in thousands):

 
|                               |   | **Years to Maturity** |    |
|------------------------------------|--------|-----------------------|---------|
|                               |   | **Under 1**           |    | **1 to 5** |   | **5 to 10** |   | **Over 10** |   |
|                               |   | **Amount**            |    | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   |
| Mortgage-backed  securities        |   | $                     | 121,464 |   | 4.88 | % | $ | 1,905,313 |   | 4.85 | % | $ | 497,798 |   | 4.19 | % | $ | 70,457 |   | 3.89 | % |
| Federal agency  securities         |   | 5,000                 |    | 6.40 | % | 15,182 |   | 3.80 | % | 271,953 |   | 4.06 | % | 319,899 |   | 3.80 | % |
| State and  political subdivisions  |   | —                |    | — |   | 2,298 |   | 5.18 | % | 5,859 |   | 5.18 | % | 91,032 |   | 5.18 | % |
| Total securities  held to maturity |   | $                     | 126,464 |   | 4.94 | % | $ | 1,922,793 |   | 4.84 | % | $ | 775,610 |   | 4.15 | % | $ | 481,388 |   | 4.07 | % |

 

 

The carryingvalue and weighted average yield of our securities available for sale at March31, 2002 are reflected in the following table (Dollars in thousands):

 
|                                 |   | **Years to Maturity** |   |
|--------------------------------------|--------|-----------------------|--------|
|                                 |   | **Under 1**           |   | **1 to 5** |   | **5 to 10** |   | **Over 10** |   |
|                                 |   | **Amount**            |   | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   | **Amount** |   | **Yield** |   |
| Mortgage-backed  securities          |   | $                     | — |   | — |   | $ | 694,887 |   | 5.82 | % | $ | 16,666 |   | 7.11 | % | $ | 853,565 |   | 5.81 | % |
| Federal agency  securities           |   | —                |   | — |   | 30,574 |   | 5.64 | % | — |   | — |   | — |   | — |   |
| Corporate debt                       |   | —                |   | — |   | — |   | — |   | — |   | — |   | 133,598 |   | 2.94 | % |
| State and  political subdivisions    |   | 4,136                 |   | 4.67 | % | 35,798 |   | 4.67 | % | 180,476 |   | 4.67 | % | 40,980 |   | 4.67 | % |
| Total securities  available for sale |   | $                     | 4,136  |   | 4.67 | % | $ | 761,259 |   | 5.76 | % | $ | 197,142 |   | 4.88 | % | $ | 1,028,143 |   | 5.39 | % |

* *

*Loan Portfolio*

 

The followingtable summarizes our loan portfolio for the dates indicated (Dollars inthousands):

 
|                             |   | **March 31,   2002** |    | **December 31,   2001** |   |
|----------------------------------|--------|----------------------|---------|-------------------------|--------|
|                             |   |                 |    |                    |   |
| Loans to  individuals            |   | $                    | 98,464  |                    | $      | 181,330 |   |
| Loans to mutual  funds           |   | 36,291               |    | 50,342                  |   |
| Loans to others                  |   | 522                  |    | 541                     |   |
|                             |   | 135,277              |    | 232,213                 |   |
| Less: allowance  for loan losses |   | (100                 | )       | (100                    | )      |
| Net loans                        |   | $                    | 135,177 |                    | $      | 232,113 |   |
|                             |   |                 |    |                    |   |
| Floating Rate                    |   | $                    | 135,255 |                    | $      | 232,189 |   |
| Fixed Rate                       |   | 22                   |    | 24                      |   |
|                             |   |                 |    |                    |   |
|                             |   | $                    | 135,277 |                    | $      | 232,213 |   |

 

We make loans to individually managed account customers and to mutualfunds and other pooled product clients. Virtually all loans to individually managed account customers are written on a demand basis, bearvariable interest rates tied to the prime rate or the Federal Funds rate andare fully secured by liquid collateral, primarily freely tradable securitiesheld in custody by us for the borrower. Loans to mutual funds and other pooled product clients include unsecuredlines of credit that may, in the event of default, be collateralized at ouroption by securities held in custody by us for those mutual funds.  Loans to individually managed accountcustomers, mutual funds and other pooled product clients also include advancesthat we make to certain clients pursuant to the terms of our custody agreementswith those clients to facilitate securities transactions and redemptions.

 

At March 31, 2002, our only lending concentrations that exceeded 10% oftotal loan 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.

 

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Our credit loss experience has been excellent.  There have been no loan charge-offs oradverse credit actions in our history. It is our policy to place a loan on nonaccrual status when eitherprincipal or interest becomes 60 days past due and the loan’s collateralis not sufficient to cover both principal and accrued interest.  As of March 31, 2002, there were no loans onnonaccrual status, no loans greater than 90 days past due, and no troubleddebt restructurings.  Although virtuallyall of our loans are fully collateralized with freely tradable securities,management recognizes some credit risk inherent in the loan portfolio, and hasrecorded an allowance for loan losses of $0.1 million at March 31,2002.  This amount is not allocated toany particular loan, but is intended to absorb any risk of loss inherent in theloan portfolio. Management actively monitors the loan portfolio and theunderlying collateral and regularly assesses the adequacy of the allowance forloan losses.

 

**MarketRisk**

 

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

 

The active management of market risk is integral to ouroperations.  The objective of interestrate sensitivity management is to provide sustainable net interest revenueunder various economic conditions.  Wemanage the structure of interest-earning assets and interest-bearingliabilities by adjusting their mix, yield, maturity and/or repricingcharacteristics, based on market conditions. Since client deposits and repurchase agreements, our primary sources offunds, are predominantly short term, we maintain a generally short-termstructure for our interest-earning assets, including money-market assets andinvestments.  We also use termborrowings 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.

 

Our Board of Directors has set asset and liability management policiesthat define the overall framework for managing interest rate sensitivity,including accountabilities and controls over investment activities.  These policies delineate investment limitsand strategies that are appropriate, given our liquidity and regulatoryrequirements.  For example, we haveestablished a policy limit stating that projected net interest income over thenext 12 months will not be reduced by more than 10% given a change in interestrates of up to 200 basis points (+ or -) over 12 months.  Each quarter, our Board of Directors reviewsour asset and liability positions, including simulations of the effect ofvarious interest rate scenarios on our capital.  Due to current interest rate levels, the Company’s Board ofDirectors has approved a temporary exception to the 10% limit.  The Board of Directors approved the policyexception because, with the Federal Funds target rate currently at 1.75%, a 200basis point further reduction would move rates into a negative position and istherefore not likely to occur.

 

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

 

The results of the income simulation model as of March 31, 2002 and2001 indicated that an upward shift of interest rates by 200 basis points wouldresult in a reduction in projected net interest income of 5.39% and 7.00%,respectively.  A downward shift of 200basis points would result in a decrease in projected net interest income of11.73% 

 

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at March31, 2002, an exception to policy approved by the Board of Directors, and anincrease in projected net interest income of 1.70% at March 31, 2001.

 

We also use gap analysis as a secondary tool to manage our interestrate sensitivity.  Gap analysis involvesmeasurement of the difference in asset and liability repricing on a cumulativebasis within a specified time frame.  Apositive gap indicates that more interest-earning assets than interest-bearingliabilities mature in a time frame, and a negative gap indicates theopposite.  By seeking to minimize theamount of assets and liabilities that could reprice in the same time frame, weattempt to reduce the risk of significant adverse effects on net interestincome caused by interest rate changes. As shown in the table below, at March 31, 2002, interest-bearingliabilities repriced faster than interest-earning assets, 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 income due to adiminished ability to lower interest-bearing liabilities, including certainclient funds, as rates approach zero. Other important determinants of net interest income are rate levels,balance sheet growth and mix, and interest rate spreads.

 

The followingtable presents the repricing schedule of our interest-earning assets andinterest-bearing liabilities at March 31, 2002 (Dollars in thousands):

 
|                                                                                   |   | **Within Three  Months** |       | **Three to Six  Months** |   | **Six to Twelve  Months** |   | **One Year to  Five Years** |     | **Over Five  Years** |   | **Total** |   |
|----------------------------------------------------------------------------------------|--------|--------------------------|------------|--------------------------|--------|---------------------------|--------|-----------------------------|----------|----------------------|--------|-----------|--------|
|                                                                                   |   |                     |       |                     |   |                      |   |                        |     |                 |   |      |   |
| Interest-earning  assets(1):                                                           |   |                     |       |                     |   |                      |   |                        |     |                 |   |      |   |
| Investment  securities (2)                                                             |   | $                        | 2,445,481  |                     | $      | 420,863                   |   | $                           | 541,119  |                 | $      | 1,452,395 |   | $ | 437,077 |   | $ | 5,296,935 |   |
| Loans—variable  rate                                                              |   | 135,155                  |       | —                   |   | —                    |   | —                      |     | —               |   | 135,155   |   |
| Loans—fixed rate                                                                  |   | 22                       |       | —                   |   | —                    |   | —                      |     | —               |   | 22        |   |
| Total  interest-earning assets                                                         |   | $                        | 2,580,658  |                     | $      | 420,863                   |   | $                           | 541,119  |                 | $      | 1,452,395 |   | $ | 437,077 |   | $ | 5,432,112 |   |
| Interest-bearing  liabilities:                                                         |   |                     |       |                     |   |                      |   |                        |     |                 |   |      |   |
| Demand deposit  accounts                                                               |   | $                        | 2,334      |                     | $      | —                    |   | $                           | —   |                 | $      | —    |   | $ | — |   | $ | 2,334 |   |
| Savings accounts                                                                       |   | 1,751,925                |       | —                   |   | —                    |   | 20,687                      |     | —               |   | 1,772,612 |   |
| Interest rate  contracts                                                               |   | (810,000                 | )          | 60,000                   |   | 120,000                   |   | 630,000                     |     | —               |   | —    |   |
| Short-term and  other borrowings                                                       |   | 2,714,629                |       | —                   |   | —                    |   | 400,000                     |     | —               |   | 3,114,629 |   |
| Total  interest-bearing liabilities                                                    |   | $                        | 3,658,888  |                     | $      | 60,000                    |   | $                           | 120,000  |                 | $      | 1,050,687 |   | $ | — |   | $ | 4,889,575 |   |
| Net  interest-sensitivity gap during the period                                        |   | $                        | (1,078,230 | )                        | $      | 360,863                   |   | $                           | 421,119  |                 | $      | 401,708   |   | $ | 437,077 |   | $ | 542,537 |   |
| Cumulative gap                                                                         |   | $                        | (1,078,230 | )                        | $      | (717,367                  | )      | $                           | (296,248 | )                    | $      | 105,460   |   | $ | 542,537 |   |   |   |
| Interest-sensitive  assets as a percent of interest sensitive liabilities (cumulative) |   | 70.53                    | %          | 80.71                    | %      | 92.28                     | %      | 102.16                      | %        | 111.10               | %      |      |   |
| Interest-sensitive  assets as a percent of total assets (cumulative)                   |   | 44.88                    | %          | 52.20                    | %      | 61.61                     | %      | 86.88                       | %        | 94.48                | %      |      |   |
|                                                                                   |   |                     |       |                     |   |                      |   |                        |     |                 |   |      |   |
| Net  interest-sensitivity gap as a percent of total assets                             |   | (18.75                   | )%         | 6.28                     | %      | 7.32                      | %      | 6.99                        | %        | 7.60                 | %      |      |   |
| Cumulative gap  as a percent of total assets                                           |   | (18.75                   | )%         | (12.48                   | )%     | (5.15                     | )%     | 1.83                        | %        | 9.44                 | %      |      |   |

** **

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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-backed securities are included inthe pricing category that corresponds with their effective maturity.

 

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**Liquidity**

 

Liquidity represents theability of an institution to meet present and future financial obligationsthrough either the sale or maturity of existing assets or the acquisition ofadditional funds through liability management. For a financial institution such as ours, these obligations arise fromthe withdrawals of deposits and the payment of operating expenses.

 

Our primary sources ofliquidity include cash and cash equivalents, federal funds sold, new deposits,short-term borrowings, interest payments on securities held to maturity andavailable for sale, and fees collected from asset administration clients.  As a result of our management of liquidassets and the ability to generate liquidity through liability funds,management believes that we maintain overall liquidity sufficient to meet ourdepositors’ needs, to satisfy our operating requirements and to fund thepayment of an anticipated annual cash dividend of $0.10 per share for 2002(approximately $3.2 million based upon 32,130,032 shares outstanding as ofMarch 31, 2002).

 

Our ability to pay dividends onCommon Stock may depend on the receipt of dividends from the Bank. Any dividendpayments by the Bank are subject to certain restrictions imposed by theMassachusetts Commissioner of Banks.  Inaddition, we may not pay dividends on our Common Stock if we are in defaultunder certain agreements entered into in connection with the sale of ourCapital Securities.  The CapitalSecurities were issued by Investors Capital Trust I, a Delaware statutorybusiness trust sponsored by us, and qualify as Tier I capital under thecapital guidelines of the Federal Reserve.

 

We have informal borrowingarrangements with various counterparties. Each counterparty has agreed to make funds available to us at theFederal funds overnight rate.  The aggregateamount of these borrowing arrangements as of March 31, 2002 was$1.4 billion.  Each bank mayterminate its arrangement at any time and is under no contractual obligation toprovide us with requested funding.  Ourborrowings under these arrangements are typically on an overnight basis.  We cannot be certain, however, that suchfunding will be available.  Lack ofavailability of liquid funds could have a material adverse impact on ouroperations.

 

We also have Master RepurchaseAgreements in place with various counterparties.  Each broker has agreed to make funds available to us at variousrates in exchange for collateral consisting of marketable securities. Theaggregate amount of these borrowing arrangements at March 31, 2002 was$2.5 billion.

 

We also have a borrowingarrangement with the FHLBB.  We mayborrow amounts determined by prescribed collateral levels and the amount ofFHLBB stock we hold.  We are required tohold FHLBB stock equal to no less than (i) 1% of our outstandingresidential mortgage loan principal (including mortgage pool securities),(ii) 0.3% of total assets, or (iii) total advances from the FHLBB,divided by a leverage factor of 20.  Theaggregate amount of borrowing available to us under this arrangement at March31, 2002 was $1.9 billion.  The amountoutstanding under this arrangement at March 31, 2002 was $800 million.

 

Our cash flows are comprised ofthree primary classifications:  cashflows from operating activities, investing activities, and financingactivities.  Net cash provided by operatingactivities was $27.6 million for the three months ended March 31, 2002.  Net cash used for investing activities,consisting primarily of the excess of purchases of investment securities overproceeds from maturities of investment securities and decreased loans, was$457.7 million for the three months ended March 31, 2002.  Net cash provided by financing activities,consisting primarily of increased short-term and other borrowings, was $427.5million for the three months ended March 31, 2002.

 

**Capital Resources**

 

Historically, we have financedour operations principally through internally generated cash flows.  We incur capital expenditures for furniture,fixtures, capitalized software and miscellaneous equipment needs.  We lease microcomputers through operatingleases.  Capital expenditures have beenincurred and leases entered into on an as-required basis, primarily to meet ourgrowing operating needs.  As a result,our capital expenditures were $9.9 million and $3.0 million for the threemonths ended March 31, 2002 and 2001, respectively.  For the three months ended March 31, 2002, capital expenditureswere comprised of approximately $2.0 million in fixed assets and $7.9 millionin capitalized software and projects in process.

 

Stockholders’ equity at March31, 2002 was $363.1 million, up 6%, from December 31, 2001.  The ratio of stockholders’ equity to assetsdecreased to 6.3% at March 31, 2002 from 6.5% at December 31, 2001.

 

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The FRB has adopted a systemusing internationally consistent risk-based capital adequacy guidelines toevaluate the capital adequacy of banks and bank holding companies.  Under the risk-based capital guidelines,different categories of assets are assigned different risk weights, basedgenerally upon the perceived credit risk of the asset.  These risk weights are multiplied bycorresponding asset balances to determine a “risk-weighted” asset base.  Some off-balance sheet items are added tothe risk-weighted asset base by converting them to a balance sheet equivalentand assigning them the appropriate risk weight.

 

FRB and FDIC guidelines requirethat banking organizations have a minimum ratio of total capital torisk-adjusted assets and off-balance sheet items of 8.0%.  Total capital is defined as the sum of “Tier I”and “Tier II” capital elements, with at least half of the total capitalrequired to be Tier I.  Tier Icapital includes, with certain restrictions, the sum of common stockholders’equity, noncumulative perpetual preferred stock, a limited amount of cumulativeperpetual preferred stock, and minority interests in consolidated subsidiaries,less certain intangible assets. Tier II capital includes, with certain limitations, subordinateddebt meeting certain requirements, intermediate-term preferred stock, certainhybrid capital instruments, certain forms of perpetual preferred stock, as wellas maturing capital instruments and general allowances for loan losses.

 

The followingtable summarizes our Tier I and total capital ratios at March 31, 2002 (Dollarsin thousands):

 
|                                            |   | **Amount** |      | **Ratio** |   |
|-------------------------------------------------|--------|------------|-----------|-----------|--------|
|                                            |   |       |      |      |   |
| Tier I capital                                  |   | $          | 316,201   |      | 17.80  | % |
| Tier I capital  minimum requirement             |   | 71,060     |      | 4.00      | %      |
|                                            |   |       |      |      |   |
| Excess Tier I  capital                          |   | $          | 245,141   |      | 13.80  | % |
|                                            |   |       |      |      |   |
| Total capital                                   |   | $          | 316,301   |      | 17.80  | % |
| Total capital  minimum requirement              |   | 142,121    |      | 8.00      | %      |
|                                            |   |       |      |      |   |
| Excess total  capital                           |   | $          | 174,180   |      | 9.80   | % |
|                                            |   |       |      |      |   |
| Risk adjusted  assets, net of intangible assets |   | $          | 1,776,509 |      |   |   |

 

The following table summarizes InvestorsBank’s Tier I and total capital ratios at March 31, 2002 (Dollars inthousands):

 
|                                            |   | **Amount** |      | **Ratio** |   |
|-------------------------------------------------|--------|------------|-----------|-----------|--------|
|                                            |   |       |      |      |   |
| Tier I capital                                  |   | $          | 312,093   |      | 17.57  | % |
| Tier I capital  minimum requirement             |   | 71,046     |      | 4.00      | %      |
|                                            |   |       |      |      |   |
| Excess Tier I  capital                          |   | $          | 241,047   |      | 13.57  | % |
|                                            |   |       |      |      |   |
| Total capital                                   |   | $          | 312,193   |      | 17.58  | % |
| Total capital  minimum requirement              |   | 142,092    |      | 8.00      | %      |
|                                            |   |       |      |      |   |
| Excess total  capital                           |   | $          | 170,101   |      | 9.58   | % |
|                                            |   |       |      |      |   |
| Risk adjusted  assets, net of intangible assets |   | $          | 1,776,156 |      |   |   |

 

In addition to the risk–based capitalguidelines, the FRB and the FDIC use a “Leverage Ratio” as an additional toolto evaluate capital adequacy.  TheLeverage Ratio is defined to be a company’s Tier I capital divided by itsadjusted total average assets.  TheLeverage Ratio adopted by the federal banking agencies requires a ratio of 3.0%for top-rated banking institutions not experiencing a period of rapidgrowth.  All other banking institutionswill be expected to maintain a Leverage Ratio of 4.0% to 5.0%.  The computation of the risk–basedcapital ratios and the Leverage Ratio requires that our capital and that of theBank be reduced by most intangible assets. Our Leverage Ratio at March 31, 2002 was 5.92%, which is in excess ofregulatory requirements.  InvestorsBank’s Leverage Ratio at March 31, 2002 was 5.85%, which is in excess ofregulatory requirements.

 

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The following tables present averagebalances, interest income andexpense, and yields earned or paid on the major categories of assets andliabilities for the periods indicated (Dollars in thousands):

 
|                                                                 |   | **Three Months Ended March 31, 2002** |       | **Three Months Ended March 31, 2001** |       |
|----------------------------------------------------------------------|--------|---------------------------------------|------------|---------------------------------------|------------|
|                                                                 |   | **Average   Balance**                 |       | **Interest**                          |       | **Average   Yield/Cost** |   | **Average   Balance** |   | **Interest** |   | **Average   Yield/Cost** |   |
| **Interest earning  assets:**                                        |   |                                  | ** ** |                                  | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Federal funds  sold and securities purchased under resale agreements |   | $                                     | 15,733     |                                  | $          | 67 |   | 1.70 | % | $ | 63,678 |   | $ | 929 |   | 5.84 | % |
| Investment  securities (1)                                           |   | 4,978,413                             |       | 57,560                                |       | 4.62 | % | 3,402,910 |   | 57,021 |   | 6.70 | % |
| Loans (2)                                                            |   | 110,961                               |       | 1,005                                 |       | 3.62 | % | 110,615 |   | 1,367 |   | 4.94 | % |
| Total  interest-earning assets                                       |   | 5,105,107                             |       | 58,632                                |       | 4.59 | % | 3,577,203 |   | 59,317 |   | 6.63 | % |
| Allowance for  loan losses                                           |   | (100                                  | )          |                                  |       |   |   | (100 | ) |   |   |   |   |
| Noninterest-earning  assets                                          |   | 321,702                               |       |                                  |       |   |   | 178,625 |   |   |   |   |   |
|                                                                 |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Total assets                                                         |   | $                                     | 5,426,709  |                                  |       |   |   |   | $ | 3,755,728 |   |   |   |   |   |
|                                                                 |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| **Interest bearing liabilities:**                                    |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Deposits:                                                            |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Demand                                                               |   | $                                     | 1,934      |                                  | $          | 2 |   | 0.41 | % | $ | 3,561 |   | $ | 18 |   | 2.02 | % |
| Savings                                                              |   | 1,756,182                             |       | 10,568                                |       | 2.41 | % | 1,625,566 |   | 19,400 |   | 4.77 | % |
| Time                                                                 |   | 5,648                                 |       | 24                                    |       | 1.70 | % | 967 |   | 13 |   | 5.38 | % |
| Short-term  borrowings                                               |   | 2,424,851                             |       | 7,601                                 |       | 1.25 | % | 1,546,089 |   | 18,417 |   | 4.76 | % |
| Other borrowings                                                     |   | 396,667                               |       | 4,700                                 |       | 4.74 | % | — |   | — |   | — |   |
| Total  interest-bearing liabilities                                  |   | 4,585,282                             |       | 22,895                                |       | 2.00 | % | 3,176,183 |   | 37,848 |   | 4.77 | % |
| Noninterest-bearing  liabilities                                     |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Demand deposits                                                      |   | 230,090                               |       |                                  |       |   |   | 166,396 |   |   |   |   |   |
| Savings                                                              |   | 80,610                                |       |                                  |       |   |   | 32,988 |   |   |   |   |   |
| Noninterest-bearing  time deposits                                   |   | 90,000                                |       |                                  |       |   |   | 65,000 |   |   |   |   |   |
| Other  liabilities                                                   |   | 59,498                                |       |                                  |       |   |   | 42,610 |   |   |   |   |   |
| Total  liabilities                                                   |   | 5,045,480                             |       |                                  |       |   |   | 3,483,177 |   |   |   |   |   |
| Trust preferred  stock                                               |   | 24,277                                |       |                                  |       |   |   | 24,249 |   |   |   |   |   |
| Equity                                                               |   | 356,952                               |       |                                  |       |   |   | 248,302 |   |   |   |   |   |
|                                                                 |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Total  liabilities and equity                                        |   | $                                     | 5,426,709  |                                  |       |   |   |   | $ | 3,755,728 |   |   |   |   |   |
| Net interest  income                                                 |   |                                  |       | $                                     | 35,737     |   |   |   |   |   | $ | 21,469 |   |   |   |
|                                                                 |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Net interest  margin (3)                                             |   |                                  |       |                                  |       | 2.80 | % |   |   |   |   | 2.40 | % |
|                                                                 |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Average interest  rate  spread (4)                                   |   |                                  |       |                                  |       | 2.59 | % |   |   |   |   | 1.86 | % |
|                                                                 |   |                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Ratio of  interest-earning assets to interest-bearing liabilities    |   |                                  |       |                                  |       | 111.34 | % |   |   |   |   | 112.63 | % |

                        

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

                   (2)     Average yield on loans includes accrualloan balances.

                   (3)     Net interest income divided by totalinterest-earning assets.

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

** **

**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.

 

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**PART II.  OTHERINFORMATION**

** **

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

** **

(a)                  On January 22, 2002 the Company filed currentreports on Form 8-K providing financial information pursuant to Regulation FD.

** **

(b)                 Exhibits

** **
| **Exhibit  No.** |   | **Description**                                                        |
|------------------|--------|------------------------------------------------------------------------|
|             |   |                                                                   |
| **10.1**         |   | **Amended and Restated 1995 Stock Plan**                               |
| **10.2**         |   | **Amended and Restated 1995 Non-Employee Director Stock  Option Plan** |

** **

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                      |   | **INVESTORS  FINANCIAL SERVICES CORP.**                                                             |
|---------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                      |   |                                                                                                |
| Date:  May  13, 2002 | By:    | /s/ Kevin J. Sheehan                                                                                |
|                      |   | Kevin J. Sheehan   Chairman and Chief Executive Officer                                             |
|                      |   |                                                                                                |
|                      |   |                                                                                                |
|                      | By:    | /s/ John N. Spinney, Jr.                                                                            |
|                      |   | John N. Spinney, Jr.   Chief Financial Officer    (Principal Financial and Accounting Officer) |

 

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