**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 

**(MarkOne)**

** **

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

 

**For the Quarterly period ended June 30, 2002**

 

**or**

 

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

 

**For the Transition period from      to      **

 

**0-26996**

**(Commission File Number)**

 

----

 

| **INVESTORS FINANCIAL SERVICES CORP.**                          |
|-----------------------------------------------------------------|
| (Exact name of registrant as 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 bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý  No  o

 

As of July 31,2002 there were 64,524,158 shares of Common Stock outstanding.

 

 

----

 

**INVESTORS FINANCIAL SERVICES CORP.**

** **

**INDEX**

 
| **PART I.**    | **FINANCIAL INFORMATION**                                                                                                    |
|----------------|------------------------------------------------------------------------------------------------------------------------------|
|           |                                                                                                                         |
| Item 1.        | Condensed Consolidated Financial Statements                                                                                  |
|           |                                                                                                                         |
|           | Condensed Consolidated Balance Sheets  June 30, 2002 (unaudited) and December 31,  2001 (audited)                       |
|           |                                                                                                                         |
|           | Condensed Consolidated Statements of Income  and Comprehensive Income (unaudited)  Six months ended June 30, 2002 and 2001   |
|           |                                                                                                                         |
|           | Condensed Consolidated Statements of Income  and Comprehensive Income (unaudited)  Three months ended June 30, 2002 and 2001 |
|           |                                                                                                                         |
|           | Condensed Consolidated Statements of  Stockholders’ Equity (unaudited)  Six months ended June 30, 2002 and 2001         |
|           |                                                                                                                         |
|           | Condensed Consolidated Statements of Cash  Flows (unaudited)  Six months ended June 30, 2002 and 2001                        |
|           |                                                                                                                         |
|           | Notes to Condensed Consolidated Financial  Statements (unaudited)                                                            |
|           |                                                                                                                         |
|           | Independent Accountants’ Report                                                                                         |
|           |                                                                                                                         |
| 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 4.        | Submission of Matters to a Vote of Security  Holders                                                                         |
| Item 6.        | Exhibits and Reports on Form 8-K                                                                                             |
|           |                                                                                                                         |
| **SIGNATURES** |

 

2

----

 

**PARTI. FINANCIAL INFORMATION**

 

**Item 1.****    Condensed ConsolidatedFinancial Statements**

 

**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**June 30, 2002 and December 31, 2001**

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

 
|                                                                                                                                                                                                        |   | **June 30,  2002** |      | **December 31,  2001** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|-----------|-----------------------------|--------|
|                                                                                                                                                                                                        |   | **(unaudited)**    |      |                        |   |
| **Assets**                                                                                                                                                                                                  |   |               |      |                        |   |
| Cash and due from banks                                                                                                                                                                                     |   | $                  | 17,867    |                        | $      | 15,605 |   |
| Federal funds sold & securities  purchased under resale agreements                                                                                                                                      |   | 610,000            |      | —                      |   |
| Securities held to maturity (approximate  fair value of $3,419,424 and $3,157,209   at June 30, 2002 and December 31, 2001, respectively)                                                         |   | 3,384,777          |      | 3,135,784                   |   |
| Securities available for sale                                                                                                                                                                               |   | 2,256,884          |      | 1,621,661                   |   |
| Non-marketable equity securities                                                                                                                                                                            |   | 50,000             |      | 50,000                      |   |
| Loans, less allowance for loan losses of  $100 at June 30, 2002 and December 31, 2001                                                                                                                  |   | 125,849            |      | 232,113                     |   |
| Accrued interest and fees receivable                                                                                                                                                                        |   | 67,708             |      | 59,751                      |   |
| Equipment and leasehold improvements, less  accumulated depreciation of $18,161 and $13,023 at June 30, 2002 and  December 31, 2001, respectively                                                      |   | 59,212             |      | 42,618                      |   |
| Goodwill, net                                                                                                                                                                                               |   | 79,969             |      | 79,969                      |   |
| Other assets                                                                                                                                                                                                |   | 70,269             |      | 61,144                      |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| **Total Assets**                                                                                                                                                                                            |   | $                  | 6,722,535 |                        | $      | 5,298,645 |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                               |   |               |      |                        |   |
| **Liabilities:**                                                                                                                                                                                            |   |               |      |                        |   |
| Deposits:                                                                                                                                                                                                   |   |               |      |                        |   |
| Demand                                                                                                                                                                                                      |   | $                  | 825,507   |                        | $      | 507,067 |   |
| Savings                                                                                                                                                                                                     |   | 1,758,017          |      | 1,681,810                   |   |
| Time                                                                                                                                                                                                        |   | 90,000             |      | 90,000                      |   |
| Total deposits                                                                                                                                                                                              |   | 2,673,524          |      | 2,278,877                   |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| Securities sold under repurchase agreements                                                                                                                                                                 |   | 2,452,257          |      | 1,663,312                   |   |
| Short-term and other borrowings                                                                                                                                                                             |   | 1,055,218          |      | 910,281                     |   |
| Other liabilities                                                                                                                                                                                           |   | 114,984            |      | 79,123                      |   |
| Total liabilities                                                                                                                                                                                           |   | 6,295,983          |      | 4,931,593                   |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| Commitments and contingencies (See Note 9)                                                                                                                                                                  |   | —             |      | —                      |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| Company-obligated, mandatorily redeemable,  preferred securities of subsidiary trust holding solely junior subordinated  deferrable interest debentures of the Company                                      |   | 24,288             |      | 24,274                      |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| **Stockholders’ Equity:**                                                                                                                                                                              |   |               |      |                        |   |
| Preferred stock, par value $0.01 (shares  authorized: 1,000,000; issued and outstanding: 0 at June 30, 2002 and  December 31, 2001)                                                                    |   | —             |      | —                      |   |
| Common stock, par value $0.01 (shares  authorized: 100,000,000 at June 30, 2002 and December 31, 2001; issued  and outstanding: 64,472,732 at June 30, 2002 and 31,971,404 at  December 31, 2001) |   | 645                |      | 320                         |   |
| Surplus                                                                                                                                                                                                     |   | 228,867            |      | 222,440                     |   |
| Deferred compensation                                                                                                                                                                                       |   | (1,998             | )         | (2,563                      | )      |
| Retained earnings                                                                                                                                                                                           |   | 164,322            |      | 132,877                     |   |
| Accumulated other comprehensive  income/(loss), net                                                                                                                                                         |   | 10,428             |      | (10,296                     | )      |
| Treasury stock, par value $0.01 (10,814  shares at June 30, 2002 and December 31, 2001)                                                                                                                |   | —             |      | —                      |   |
| Total stockholders’ equity                                                                                                                                                                             |   | 402,264            |      | 342,778                     |   |
|                                                                                                                                                                                                        |   |               |      |                        |   |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                         |   | $                  | 6,722,535 |                        | $      | 5,298,645 |   |

 

*See Notes to Condensed Consolidated FinancialStatements.*

 

3

----

 

**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOMEAND COMPREHENSIVE INCOME (unaudited)**

**Six Months Ended June 30, 2002 and 2001**

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

 
|                                                                                                                                  |   | **June 30,  2002** |   | **June 30,  2001** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|
| **Operating Revenue:**                                                                                                                |   |               |   |               |   |
| Interest income:                                                                                                                      |   |               |   |               |   |
| Federal funds sold and securities purchased  under resale agreements                                                                  |   | $                  | 207    |               | $      | 1,196 |   |
| Investment securities held to maturity and  available for sale                                                                        |   | 119,016            |   | 120,574            |   |
| Loans                                                                                                                                 |   | 1,961              |   | 2,848              |   |
| Total interest income                                                                                                                 |   | 121,184            |   | 124,618            |   |
| Interest expense:                                                                                                                     |   |               |   |               |   |
| Deposits                                                                                                                              |   | 21,027             |   | 36,730             |   |
| Short-term and other borrowings                                                                                                       |   | 30,040             |   | 39,474             |   |
| Total interest expense                                                                                                                |   | 51,067             |   | 76,204             |   |
|                                                                                                                                  |   |               |   |               |   |
| Net interest income                                                                                                                   |   | 70,117             |   | 48,414             |   |
|                                                                                                                                  |   |               |   |               |   |
| Noninterest income:                                                                                                                   |   |               |   |               |   |
| Asset servicing fees                                                                                                                  |   | 139,801            |   | 108,490            |   |
| Other operating income                                                                                                                |   | 1,130              |   | 1,549              |   |
|                                                                                                                                  |   |               |   |               |   |
| Net operating revenue                                                                                                                 |   | 211,048            |   | 158,453            |   |
|                                                                                                                                  |   |               |   |               |   |
| **Operating Expenses:**                                                                                                               |   |               |   |               |   |
| Compensation and benefits                                                                                                             |   | 98,868             |   | 75,516             |   |
| Technology and telecommunications                                                                                                     |   | 18,836             |   | 18,497             |   |
| Transaction processing services                                                                                                       |   | 15,385             |   | 7,639              |   |
| Occupancy                                                                                                                             |   | 11,406             |   | 7,802              |   |
| Depreciation and amortization                                                                                                         |   | 6,639              |   | 3,223              |   |
| Professional fees                                                                                                                     |   | 2,795              |   | 1,895              |   |
| Travel and sales promotion                                                                                                            |   | 2,754              |   | 2,394              |   |
| Amortization of goodwill                                                                                                              |   | —             |   | 1,573              |   |
| Other operating expenses                                                                                                              |   | 5,469              |   | 6,486              |   |
| Total operating expenses                                                                                                              |   | 162,152            |   | 125,025            |   |
|                                                                                                                                  |   |               |   |               |   |
| **Income Before Income Taxes and Minority Interest**                                                                                  |   | 48,896             |   | 33,428             |   |
|                                                                                                                                  |   |               |   |               |   |
| Provision for income taxes                                                                                                            |   | 14,730             |   | 10,394             |   |
| Minority interest expense, net of income  taxes                                                                                       |   | 794                |   | 794                |   |
|                                                                                                                                  |   |               |   |               |   |
| **Net Income**                                                                                                                        |   | $                  | 33,372 |               | $      | 22,240 |   |
|                                                                                                                                  |   |               |   |               |   |
| **Basic Earnings Per Share**                                                                                                          |   | $                  | 0.52   |               | $      | 0.35 |   |
|                                                                                                                                  |   |               |   |               |   |
| **Diluted Earnings Per Share**                                                                                                        |   | $                  | 0.50   |               | $      | 0.34 |   |
|                                                                                                                                  |   |               |   |               |   |
| **Comprehensive Income:**                                                                                                             |   |               |   |               |   |
| Net income                                                                                                                            |   | $                  | 33,372 |               | $      | 22,240 |   |
| Other comprehensive income/(loss) net of  tax of $11,159 and ($1,746) for the six months ended June 30, 2002 and 2001,  respectively: |   |               |   |               |   |
| Cumulative effect of a change in accounting  principle                                                                                |   | —             |   | (3,934             | )      |
| Net unrealized investment gain                                                                                                        |   | 23,153             |   | 2,319              |   |
| Net unrealized derivative instrument loss                                                                                             |   | (2,429             | )      | (1,628             | )      |
| Other comprehensive income/(loss)                                                                                                     |   | 20,724             |   | (3,243             | )      |
| Comprehensive income                                                                                                                  |   | $                  | 54,096 |               | $      | 18,997 |   |

 

*See Notes to Condensed Consolidated FinancialStatements.*

 

4

----

 

**INVESTORS FINANCIAL SERVICES CORP.**

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

**Three Months Ended June 30, 2002 and 2001**

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

 
|                                                                                                                       |   | **June 30,  2002** |   | **June 30,  2001** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|
| **Operating Revenue:**                                                                                                     |   |               |   |               |   |
| Interest income:                                                                                                           |   |               |   |               |   |
| Federal funds sold and securities purchased  under resale agreements                                                       |   | $                  | 140    |               | $      | 267 |   |
| Investment securities held to maturity and  available for sale                                                             |   | 61,456             |   | 63,553             |   |
| Loans                                                                                                                      |   | 956                |   | 1,481              |   |
| Total interest income                                                                                                      |   | 62,552             |   | 65,301             |   |
| Interest expense:                                                                                                          |   |               |   |               |   |
| Deposits                                                                                                                   |   | 10,433             |   | 17,300             |   |
| Short-term and other borrowings                                                                                            |   | 17,739             |   | 21,056             |   |
| Total interest expense                                                                                                     |   | 28,172             |   | 38,356             |   |
|                                                                                                                       |   |               |   |               |   |
| Net interest income                                                                                                        |   | 34,380             |   | 26,945             |   |
|                                                                                                                       |   |               |   |               |   |
| Noninterest income:                                                                                                        |   |               |   |               |   |
| Asset servicing fees                                                                                                       |   | 72,587             |   | 60,058             |   |
| Other operating income                                                                                                     |   | 546                |   | 768                |   |
|                                                                                                                       |   |               |   |               |   |
| Net operating revenue                                                                                                      |   | 107,513            |   | 87,771             |   |
| **Operating Expenses:**                                                                                                    |   |               |   |               |   |
| Compensation and benefits                                                                                                  |   | 48,938             |   | 41,602             |   |
| Technology and telecommunications                                                                                          |   | 9,481              |   | 10,455             |   |
| Transaction processing services                                                                                            |   | 8,855              |   | 5,065              |   |
| Occupancy                                                                                                                  |   | 5,643              |   | 4,266              |   |
| Depreciation and amortization                                                                                              |   | 3,503              |   | 1,861              |   |
| Travel and sales promotion                                                                                                 |   | 1,520              |   | 1,396              |   |
| Professional fees                                                                                                          |   | 1,323              |   | 1,150              |   |
| Amortization of goodwill                                                                                                   |   | —             |   | 923                |   |
| Other operating expenses                                                                                                   |   | 2,900              |   | 3,454              |   |
| Total operating expenses                                                                                                   |   | 82,163             |   | 70,172             |   |
|                                                                                                                       |   |               |   |               |   |
| **Income Before Income Taxes and Minority Interest**                                                                       |   | 25,350             |   | 17,599             |   |
|                                                                                                                       |   |               |   |               |   |
| Provision for income taxes                                                                                                 |   | 7,636              |   | 5,310              |   |
| Minority interest expense, net of income  taxes                                                                            |   | 397                |   | 397                |   |
|                                                                                                                       |   |               |   |               |   |
| **Net Income**                                                                                                             |   | $                  | 17,317 |               | $      | 11,892 |   |
|                                                                                                                       |   |               |   |               |   |
| **Basic Earnings Per Share**                                                                                               |   | $                  | 0.27   |               | $      | 0.18 |   |
|                                                                                                                       |   |               |   |               |   |
| **Diluted Earnings Per Share**                                                                                             |   | $                  | 0.26   |               | $      | 0.18 |   |
|                                                                                                                       |   |               |   |               |   |
| **Comprehensive Income:**                                                                                                  |   |               |   |               |   |
| Net income                                                                                                                 |   | $                  | 17,317 |               | $      | 11,892 |   |
| Other comprehensive income net of tax of  $10,360 and $6 for the three months ended June 30, 2002 and 2001,  respectively: |   |               |   |               |   |
| Net unrealized investment gain/(loss)                                                                                      |   | 26,141             |   | (1,463             | )      |
| Net unrealized derivative instrument  (loss)/gain                                                                          |   | (6,901             | )      | 1,475              |   |
| Other comprehensive income                                                                                                 |   | 19,240             |   | 12                 |   |
| Comprehensive income                                                                                                       |   | $                  | 36,557 |               | $      | 11,904 |   |

 

*See Notes to Condensed Consolidated FinancialStatements.*

 

5

----

 

**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY (unaudited)**

**Six Months Ended June 30, 2002 and 2001**

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

 
|                                                                                                   |   | **June 30,  2002** |       | **June 30,  2001** |       |
|--------------------------------------------------------------------------------------------------------|--------|--------------------|------------|--------------------|------------|
| **Common shares**                                                                                      |   |               |       |               |       |
| Balance, beginning of period                                                                           |   | 31,971,404         |       | 29,912,711         |       |
| Exercise of stock options                                                                              |   | 271,213            |       | 311,445            |       |
| Common stock issuance                                                                                  |   | 61,193             |       | 1,645,133          |       |
| Restricted stock issuance                                                                              |   | —             |       | 4,000              |       |
| Stock dividend, two-for-one split                                                                      |   | 32,168,922         |       | —             |       |
| Balance, end of period                                                                                 |   | 64,472,732         |       | 31,873,289         |       |
|                                                                                                   |   |               |       |               |       |
| **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                                                                              |   | 3                  |       | 4                  |       |
| Common stock issuance                                                                                  |   | —             |       | 16                 |       |
| Stock dividend, two-for-one split                                                                      |   | 322                |       | —             |       |
| Balance, end of period                                                                                 |   | 645                |       | 319                |       |
|                                                                                                   |   |               |       |               |       |
| **Surplus**                                                                                            |   |               |       |               |       |
| Balance, beginning of period                                                                           |   | 222,440            |       | 95,007             |       |
| Exercise of stock options                                                                              |   | 1,861              |       | 1,548              |       |
| Tax benefit from exercise of stock options                                                             |   | 2,731              |       | 3,741              |       |
| Common stock issuance                                                                                  |   | 1,835              |       | 117,361            |       |
| Balance, end of period                                                                                 |   | 228,867            |       | 217,657            |       |
|                                                                                                   |   |               |       |               |       |
| **Deferred compensation**                                                                              |   |               |       |               |       |
| Balance, beginning of the period                                                                       |   | (2,563             | )          | (247               | )          |
| Common stock issuance                                                                                  |   | —             |       | (335               | )          |
| Amortization of deferred compensation                                                                  |   | 565                |       | 78                 |       |
| Balance, end of period                                                                                 |   | (1,998             | )          | (504               | )          |
|                                                                                                   |   |               |       |               |       |
| **Retained earnings**                                                                                  |   |               |       |               |       |
| Balance, beginning of period                                                                           |   | 132,877            |       | 85,188             |       |
| Net income                                                                                             |   | 33,372             |       | 22,240             |       |
| Stock dividend, two-for-one split                                                                      |   | (322               | )          | —             |       |
| Cash dividend, $0.025 and $0.020 per share  in the periods ending June 30, 2002 and 2001, respectively |   | (1,605             | )          | (1,235             | )          |
| Balance, end of period                                                                                 |   | 164,322            |       | 106,193            |       |
|                                                                                                   |   |               |       |               |       |
| **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 gain                                                                         |   | 23,153             |       | 2,319              |       |
| Net unrealized derivative instrument loss                                                              |   | (2,429             | )          | (1,628             | )          |
| Balance, end of period                                                                                 |   | 10,428             |       | (4,682             | )          |
|                                                                                                   |   |               |       |               |       |
| **Treasury stock**                                                                                     |   |               |       |               |       |
| Balance, beginning of period                                                                           |   | —             |       | —             |       |
| Balance, end of period                                                                                 |   | —             |       | —             |       |
|                                                                                                   |   |               |       |               |       |
| **Total Stockholders’ Equity**                                                                    |   | $                  | 402,264    |               | $          | 318,983 |   |

 

*See Notes to Condensed Consolidated FinancialStatements.*

 

6

----

 

**INVESTORS FINANCIAL SERVICES CORP.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS (unaudited)**

**Six Months Ended June 30, 2002 and 2001**

**(Dollars in thousands)**

 
|                                                                                            |   | **June 30,  2002** |   | **June 30,  2001** |   |
|-------------------------------------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|
| **Cash Flows From Operating Activities:**                                                       |   |               |   |               |   |
| Net income                                                                                      |   | $                  | 33,372 |               | $      | 22,240 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:              |   |               |   |               |   |
| Depreciation and amortization                                                                   |   | 6,639              |   | 4,796              |   |
| Amortization of deferred compensation                                                           |   | 565                |   | (257               | )      |
| Amortization of premiums on securities, net  of accretion of discounts                          |   | 2,284              |   | (224               | )      |
| Changes in assets and liabilities:                                                              |   |               |   |               |   |
| Accrued interest and fees receivable                                                            |   | (7,957             | )      | (25,404            | )      |
| Other assets                                                                                    |   | 33,430             |   | (12,383            | )      |
| Other liabilities                                                                               |   | (18,859            | )      | 13,464             |   |
| Total adjustments                                                                               |   | 16,102             |   | (20,008            | )      |
| Net cash provided by operating activities                                                       |   | 49,474             |   | 2,232              |   |
|                                                                                            |   |               |   |               |   |
| **Cash Flows From Investing Activities:**                                                       |   |               |   |               |   |
| Proceeds from maturities of securities  available for sale                                      |   | 246,365            |   | 197,874            |   |
| Proceeds from maturities of securities held  to maturity                                        |   | 874,839            |   | 412,237            |   |
| Purchases of securities available for sale                                                      |   | (846,149           | )      | (306,876           | )      |
| Purchases of securities held to maturity                                                        |   | (1,125,935         | )      | (1,591,570         | )      |
| Purchases of non-marketable equity  securities                                                  |   | —             |   | (35,000            | )      |
| Net (increase)/decrease in federal funds  sold and securities purchased under resale agreements |   | (610,000           | )      | 450,000            |   |
| Net decrease/(increase) in loans                                                                |   | 106,264            |   | (1,025             | )      |
| Purchase of businesses                                                                          |   | —             |   | (49,379            | )      |
| Purchases of fixed assets, capitalized  software and leasehold improvements                     |   | (23,219            | )      | (20,179            | )      |
| Net cash used for investing activities                                                          |   | (1,377,835         | )      | (943,918           | )      |
|                                                                                            |   |               |   |               |   |
| **Cash Flows From Financing Activities:**                                                       |   |               |   |               |   |
| Net increase/(decrease) in demand deposits                                                      |   | 318,440            |   | (248,112           | )      |
| Net increase in time and savings deposits                                                       |   | 76,207             |   | 231,472            |   |
| Net increase in short-term and other  borrowings                                                |   | 933,882            |   | 831,910            |   |
| Proceeds from exercise of stock options                                                         |   | 1,864              |   | 1,552              |   |
| Proceeds from issuance of common stock                                                          |   | 1,835              |   | 117,377            |   |
| Cash dividends to shareholders                                                                  |   | (1,605             | )      | (1,235             | )      |
| Net cash provided by financing activities                                                       |   | 1,330,623          |   | 932,964            |   |
|                                                                                            |   |               |   |               |   |
| **Net Increase / (Decrease) In Cash And Due From Banks**                                        |   | 2,262              |   | (8,722             | )      |
|                                                                                            |   |               |   |               |   |
| **Cash and Due From Banks, Beginning of Period**                                                |   | 15,605             |   | 30,489             |   |
|                                                                                            |   |               |   |               |   |
| **Cash and Due From Banks, End of Period**                                                      |   | $                  | 17,867 |               | $      | 21,767 |   |
|                                                                                            |   |               |   |               |   |
| **Supplemental Disclosure of Cash Flow Information:**                                           |   |               |   |               |   |
| Cash paid for interest                                                                          |   | $                  | 51,075 |               | $      | 77,577 |   |
| Cash paid for income taxes                                                                      |   | $                  | 14,962 |               | $      | 9,531 |   |

 

*See Notes to Condensed Consolidated FinancialStatements.*

 

7

----

 

**INVESTORS FINANCIAL SERVICES CORP.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Information as of and for the six months andthe three months ended June 30, 2002 and 2001 is unaudited)**

 

**1.****             Descriptionof Business**

 

InvestorsFinancial Services Corp. (‘IFSC’) provides asset servicing for the financialservices industry through its wholly-owned subsidiaries, Investors Bank &Trust Company (the ‘Bank’) and Investors Capital Services, Inc.  As used herein, the defined term “theCompany” shall mean IFSC together with the Bank and its domestic and foreignsubsidiaries.  The Company provides global custody, multicurrency accounting, mutualfund administration, securities lending, foreign exchange, cash management,performance measurement, institutional transfer agency, investment advisoryservices and lines of credit to a variety of financial asset managers,including mutual fund complexes, investment advisors, banks and insurancecompanies.  IFSC and the Bank aresubject to regulation by the Federal Reserve Board of Governors, the Office ofthe Commissioner of Banks of the Commonwealth of Massachusetts and the FederalDeposit Insurance Corporation.

 

On February 1, 2001, the Company completed the issuance and sale of1,624,145 shares of Common Stock at $71.62 per share in a public offering.  A portion of the proceeds was used to fundthe acquisition of the operations of the advisor custody unit of The ChaseManhattan Bank.  The remaining proceedswere used for the assumption of the U.S. asset administration unit of BarclaysGlobal Investors, N.A. and working capital.

 

On April 23,2002, the Board of Directors approved a two-for-one stock split in the form ofa 100% stock dividend to stockholders of record as of May 24, 2002.  All share numbers have been restated toreflect the two-for-one stock split paid June 14, 2002, where applicable.

 

**2.****             Interim FinancialStatements**

 

The condensedconsolidated interim financial statements of the Company and subsidiaries as ofJune 30, 2002 and 2001 and for the six-month periods and the three-monthperiods ended June 30, 2002 and 2001 have been prepared by the Company, withoutaudit, pursuant to the rules and regulations of the Securities and ExchangeCommission.  Certain information andfootnote disclosures normally included in annual financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates of America have been condensed or omitted as permitted by such rules andregulations.  All adjustments,consisting of normal recurring adjustments, necessary for their fairpresentation in conformity with accounting principles generally accepted in theUnited States of America are included. Management believes that the disclosures are adequate to present fairlythe financial position, results of operations and cash flows at the dates andfor the periods presented. It is suggested that these interim financialstatements be read in conjunction with the financial statements and the notesthereto included in the Company’s latest annual report on Form 10–K.Results for interim periods are not necessarily indicative of those to beexpected for the full fiscal year. Certain amounts in the prior periods’financial statements have been reclassified to conform to the current periods’presentation.

 

On January 1,2001, the Company adopted SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities,” as amended and interpreted, which establishedaccounting and reporting standards for derivative instruments.  The Company also adopted SFAS No. 138,“Accounting for Certain Derivative Instruments and Certain HedgingActivities.”  All derivatives, whetherdesignated in hedging relationships or not, are required to be recorded on thebalance sheet at fair value.  If thederivative is designated as a fair value hedge, the change in the fair value ofthe derivative and the item being hedged will be recognized in earnings.  If the derivative is designated as a cashflow hedge, the effective portions of changes in the fair value of the derivativeare recorded in Other Comprehensive Income (‘OCI’).  Ineffective portions of changes, as determined in accordance withSFAS No. 133, in the fair value of the cash flow hedges are recognized inearnings.  For derivatives that do notqualify as hedges, changes in their fair value are recognized in earnings.  The adoption of SFAS No. 133 on January 1,2001, resulted in no cumulative effect-type adjustment to net income.  However, the Company recorded a reduction toOCI of $3.9 million, net of tax, and a corresponding liability for the fairvalue of the interest rate swaps.  Thereduction to OCI and the recognition of the liability are primarilyattributable to net unrealized losses on previously designated cash flowhedges.  In conjunction

 

8

----

 

with theadoption, the Company elected to reclassify approximately $402 million ofsecurities from held to maturity to available for sale, which further reducedOCI, net of tax, by approximately $1.4 million.

 

The Companyuses derivative instruments to manage exposures to interest rate risks.  The Company routinely enters into interestrate swap agreements in which the Company pays a fixed interest rate andreceives a floating interest rate. These transactions are designed to hedge a portion of the Company’sliabilities in connection with securities sold under repurchaseagreements.  By entering into apay-fixed/receive-floating interest rate swap, a portion of these liabilitiesis effectively converted to a fixed rate liability for the term of the interestrate swap agreement.  Most of thesederivatives have been designated as cash flow hedges.  An insignificant portion of the derivatives used to manageexposures to interest rate risks were not considered highly effective and,therefore, did not qualify for hedge accounting.

 

Hedgeineffectiveness, determined in accordance with SFAS No. 133, had aninsignificant impact on earnings for the six months ended June 30, 2002. Nocash flow hedges were dedesignated or discontinued for the six months endedJune 30, 2002.

 

Net interestincome included net gains of $0.6 million and $0.4 million, net of tax, for thesix months and three months ended June 30, 2002, respectively, on interest rateswaps relating to SFAS No. 133.  The netgains were $1.7 million and $0.9 million, net of tax, for the six-month andthree-month periods, respectively, on changes in the fair value of derivativeinstruments designated as hedging instruments. There were also $1.1 million and $0.5 million of derivative losses, netof tax, for the six-month and three-month periods, respectively, that resultedprimarily from the reclassification of transition adjustment-related derivativelosses from OCI to net interest income in accordance with SFAS No. 133.  The Company estimates that $0.9 million, netof tax, of the remaining transition adjustment of net derivative lossesincluded in OCI will be reclassified into earnings within the next twelvemonths. The recognition in net interest income of the transition adjustmentderivative losses from OCI will be offset by derivative gains from changes inthe fair value liability of the interest rate swaps as they reach maturity.

 

In June 2001,the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets,” which supersedesAPB No. 17, “Intangible Assets.”  SFASNo. 142 addresses how intangible assets that are acquired individually or witha group of other assets (but not those acquired in a business combination)should be accounted for in financial statements upon their acquisition.  This statement also addresses how goodwilland other intangible assets should be accounted for after they have beeninitially recognized in the financial statements.  This statement affects the accounting of premiums, includesguidelines for the determination, measurement and testing of impairment, andrequires disclosure of information about goodwill and other intangible assetsin the years subsequent to their acquisition that was not previously required.  On January 1, 2002, the Company adopted SFASNo. 142 and ceased amortization of goodwill. As of June 30, 2002 there was no impairment of goodwill nor is anyimpairment anticipated for the fiscal year ending December 31, 2002.

 

9

----

 

**3.****             Loans**

** **

Loans consistof demand loans to custody clients of the Company, including individuals andnot–for–profit institutions, and loans to mutual fund clients. Theloans to mutual funds and other pooled product clients include lines of creditand advances pursuant to the terms of the 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 June 30, 2002 and December 31,2001.  In addition, there were no loancharge-offs or recoveries during the six months ended June 30, 2002 and theyear ended December 31, 2001. Loans are summarized as follows (Dollars inthousands):

 
|                           |   | **June 30,  2002** |    | **December 31,  2001** |   |
|--------------------------------|--------|--------------------|---------|-----------------------------|--------|
| Loans to individuals           |   | $                  | 83,200  |                        | $      | 181,330 |   |
| Loans to mutual funds          |   | 38,747             |    | 50,342                      |   |
| Loans to others                |   | 4,002              |    | 541                         |   |
|                           |   | 125,949            |    | 232,213                     |   |
| Less allowance for loan losses |   | (100               | )       | (100                        | )      |
| Total                          |   | $                  | 125,849 |                        | $      | 232,113 |   |

 

The Companyhad commitments to lend of approximately $669 million and $390 million at June30, 2002 and December 31, 2001, respectively. The terms of these commitmentsare similar to the terms of outstanding loans.

 

**4.****             Acquisitions**

 

Goodwillrelated to the Company’s acquisitions is summarized as follows (Dollars inthousands):

 
|                          |   | **For the  Six  Months Ended  June 30, 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 purchased the operations of the advisor custody unit of TheChase Manhattan Bank.  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 assetpurchase agreement, the Company paid to Chase as of closing approximately $31.5million of the total purchase price, plus another $39.8 million in exchange forthe book value of loans to clients. Under the terms of the asset purchase agreement, the Company is notobligated to make any further purchase price payments to Chase.  The transaction was accounted for as apurchase.

 

On May 1,2001, the Company assumed the operations of the U.S. asset administration unitof Barclays Global Investors, N.A. (‘BGI’), a large international institutionalinvestment manager.  The unit, locatedin Sacramento, California, provides custody accounting and other operationsfunctions for BGI’s clients.  Thetransaction was accounted for as a purchase.

 

No pro formafinancial results of Chase or BGI are presented as they were not material tothe Company’s financial condition and operating results for the periodspresented.

 

10

----

 

On January 1,2002, the Company adopted SFAS No. 142 and ceased amortization ofgoodwill.  See “Interim FinancialStatements” (Footnote 2) for a further discussion of this pronouncement.

 

**5.****             Deposits**

 

Time depositsat June 30, 2002 and December 31, 2001 included noninterest-bearing amounts of$90 million.  All time deposits had aminimum balance of $100,000 and a maturity of less than three months at June30, 2002 and December 31, 2001.

 

**6.****             Short-term and otherborrowings**

 

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

 
|                                                  |   | **June 30,  2002** |      | **December  31,  2001** |   |
|-------------------------------------------------------|--------|--------------------|-----------|-------------------------|--------|
| Federal Home Loan Bank of Boston short-term  advances |   | $                  | 400,000   |                    | $      | 100,000 |   |
| Federal funds purchased                               |   | 330,000            |      | 130,000                 |   |
| Federal Home Loan Bank of Boston long-term  advances  |   | 300,000            |      | 300,000                 |   |
| Federal funds purchased-term                          |   | 25,000             |      | —                  |   |
| Treasury, Tax and Loan account                        |   | 218                |      | 281                     |   |
| Federal Home Loan Bank of Boston overnight  advances  |   | —             |      | 380,000                 |   |
|                                                  |   |               |      |                    |   |
| Total                                                 |   | $                  | 1,055,218 |                    | $      | 910,281 |   |

 

The Companyhas a borrowing arrangement with the 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 June 30,2002 and December 31, 2001, there were $300 million of long-term term advancesoutstanding with interest rates ranging from 3.59% to 5.17%.  Maturities ranged from February 2004 to June2006 as of June 30, 2002 and ranged from June 2003 to February 2005 as ofDecember 31, 2001.

 

There were$400 million of short-term term advances outstanding at June 30, 2002 withinterest rates ranging from 1.79% to 1.80% maturing in July 2002.   The interest rate on the $100 millionshort-term term advance outstanding at December 31, 2001 was 1.82% and maturedin January 2002.  Outstanding overnightadvances were zero at June 30, 2002 and $380 million at December 31, 2001.

 

The rates onthe outstanding balances of federal funds purchased from other banks at June30, 2002 and December 31, 2001 were 2.00% and 1.61%, respectively.  The rate on federal funds purchased-term was1.80% at June 30, 2002.

 

The Companyreceives federal tax deposits from clients as agent for the Federal ReserveBank and accumulates these deposits in the Treasury, Tax and Loan account.  The Federal Reserve Bank charges the Companyinterest at the Federal Funds rate on such deposits.  The interest rate on the outstanding balance was 1.51% at June30, 2002 and December 31, 2001.

 

**7.****             Stockholders’ Equity**

 

As of June 30,2002, the Company has authorized 1,000,000 shares of Preferred Stock and100,000,000 shares of Common Stock, all with a par value of $0.01 per share.

 

At the AnnualMeeting of Stockholders of the Company held on April 17, 2001, stockholdersapproved an increase in the number of authorized shares of Common Stock from40,000,000 to 100,000,000.  On April 25, 2001, the Company amended its Certificate ofIncorporation increasing the number of authorized shares of

 

11

----

 

Common Stock to 100,000,000. These shares are available for general corporate purposes as determinedby the Company’s Board of Directors.

 

On April 23,2002, the Board of Directors approved a two-for-one stock split in the form ofa 100% stock dividend to shareholders of record on May 24, 2002.  The dividend was paid on June 14, 2002.  A total of 32,168,922 shares of common stockwere issued in connection with the stock split. The stock split did not resultin a change in the $0.01 par value per share of the common stock or in totalstockholders’ equity.

 

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

 

At the AnnualMeeting of Stockholders of the Company held on April 17, 2001, stockholdersapproved the amendment and restatement of the Company’s Stock Plan to increasethe number of shares available for grant pursuant to the plan from 4,640,000 to6,140,000.  At the Annual Meeting ofStockholders of the Company held on April 23, 2002, stockholders approved theamendment and restatement of the Company’s Stock Plan to increase the number ofshares available for grant pursuant to the plan from 6,140,000 to7,640,000.  Effective with the June 2002stock split, the number of shares available to grant increased to 15,280,000.  Of the 15,280,000 shares of Common Stockauthorized for issuance under the Stock Plan at June 30, 2002, 4,695,508 wereavailable for grant as of that date. Under the Stock Plan, the Company may grant options to purchase sharesof Common Stock to certain employees, consultants, directors and officers.  The options may be awarded as incentivestock options (employees only), nonqualified stock options, stock awards oropportunities to make direct purchases of stock.  No options were granted to consultants during the six months endedJune 30, 2002.

 

The terms ofthe Director Plan provide for the grant of options to non-employee directors topurchase up to a maximum of 400,000 shares of Common Stock. Effective with theJune 2002 stock split, the number of shares available to grant increased to800,000.  Of the 800,000 shares ofCommon Stock authorized for issuance under the plan, 138,572 were available forgrant at June 30, 2002.

 

Pursuant tothe terms of the Director Plan, options to purchase 20,000 shares of CommonStock were awarded on November 8, 1995 to each non-employee director thenin office. Each non-employee director receives an automatic annual grant ofoptions to purchase the number of shares then specified by the Director Plan(initially 2,500), as described below. Additionally, any non-employee director may elect to receive options toacquire shares of the Company’s Common Stock in lieu of such director’s cashretainer.  Any such election is subjectto certain restrictions under the Director Plan. The number of shares of stockunderlying the option granted in lieu of cash is equal to the quotient obtainedby dividing the cash retainer by the fair market value of an option on the dateof grant, which is based on the Black-Scholes option-pricing model.

 

At the AnnualMeeting of Stockholders of the Company held on April 23, 2002, stockholdersapproved amendments to the Director Plan providing that on the date of eachAnnual Meeting, each person who is a member of the Board immediately after theAnnual Meeting of the Company and who is not an employee of the Company shallbe automatically granted an option to purchase the number of shares called forby the Director Plan as of that date. Formerly, each non-employee director received a grant of options upontheir election or appointment and annually thereafter on their anniversarydate.  The amendments also provide thatthe number of shares granted to each non-employee director annually be adjustedfor stock splits and other capital changes. In addition, the amendments providethat options 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 exerciseprice of options under the Director Plan and the incentive options under theStock Plan may not be less than the fair market value at the date of thegrant.  The exercise price ofnon-qualified options under the Stock Plan is determined by the compensationcommittee of the Board of Directors. All options become exercisable as specified by the compensationcommittee at the date of the grant.

 

12

----

 

On February 13, 2001, the Company granted 8,000 shares of Common Stockunder the Stock Plan to former employees of the Chase advisor custodyunit.  This grant is subject to the Company’s right to repurchasethe shares if the employees’ employment with the Company terminates.  The Company’s right to repurchase the shareslapses in five equal annual installments beginning one year from the date ofgrant.

 

On May 1, 2001, the Company granted 58,000 nonqualified stock optionsunder the Stock Plan to former employees of the U.S. asset administration unitof BGI in connection with the assumption 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 exercisableimmediately, but any shares acquired on exercise are subject to the Company’sright to repurchase the shares at the exercise price if the employees’employment with the Company terminates. The Company’s right to repurchase theshares lapses in five equal annual installments beginning one year from thedate of grant.

 

On October 16, 2001, the Company granted 10,000 nonqualified stockoptions to an officer of the Company under the Stock Plan.  The grants are exercisable immediately, butany shares acquired on exercise are subject to the Company’s right torepurchase the shares at the exercise price if the officer’s employment withthe Company terminates.  The Company’s right to repurchase the shareslapses in five equal annual installments beginning one year from the date ofgrant.

 

The Company has recorded deferred compensation of $2.0 million and$2.6 million at June 30, 2002 and December 31, 2001, respectively,related to the grants described in the above three paragraphs.

 

Under theterms of the 1997 Employee Stock Purchase Plan, the Company may issue up to1,120,000 shares of Common Stock pursuant to the exercise of nontransferableoptions granted to participating employees. The 1997 Employee Stock PurchasePlan permits eligible employees to purchase up to 1,000 shares of Common Stockper payment period, subject to limitations provided by Section 423(b) of theInternal Revenue Code, through accumulated payroll deductions. The purchasesare made twice a year at a price equal to the lesser of (i) 90% of themarket value of the Common Stock on the first business day of the paymentperiod, or (ii) 90% of the market value of the Common Stock on the lastbusiness day of the payment period. The payment periods consist of twosix-month periods, January 1 through June 30 and July 1 throughDecember 31.

 

A summary ofoption activity under the Director Plan and the Stock Plan is as follows:

 
|                                          |   | **Number of  Shares** |   | **Weighted-Average  Exercise Price** |   |
|-----------------------------------------------|--------|-----------------------|--------|--------------------------------------|--------|
| Outstanding at December 31, 2001              |   | 6,921,610             |   | $                                    | 20     |   |
| Granted                                       |   | 168,433               |   | 37                                   |   |
| Exercised                                     |   | (519,316              | )      | 7                                    |   |
| Canceled                                      |   | (109,726              | )      | 28                                   |   |
|                                          |   |                  |   |                                 |   |
| Outstanding at June 30, 2002                  |   | 6,461,001             |   | $                                    | 21     |   |
|                                          |   |                  |   |                                 |   |
| Outstanding and exercisable at June 30,  2002 |   | 3,490,543             |   |                                 |   |

 
|                                          |   | **Number of  Shares** |   | **Weighted-Average  Exercise Price** |   |
|-----------------------------------------------|--------|-----------------------|--------|--------------------------------------|--------|
| Outstanding at December 31, 2000              |   | 5,793,324             |   | $                                    | 14     |   |
| Granted                                       |   | 268,714               |   | 30                                   |   |
| Exercised                                     |   | (682,752              | )      | 5                                    |   |
| Canceled                                      |   | (25,700               | )      | 30                                   |   |
|                                          |   |                  |   |                                 |   |
| Outstanding at June 30, 2001                  |   | 5,353,586             |   | $                                    | 15     |   |
|                                          |   |                  |   |                                 |   |
| Outstanding and exercisable at June 30,  2001 |   | 2,659,128             |   |                                 |   |

 

13

----

 

 

A summary ofactivity under the 1997 Employee Stock Purchase Plan is as follows (Number ofshares):

 
|                                                        |   | **For the  Six  Months Ended  June 30,  2002** |   | **For the  Year Ended  December 31,  2001** |   |
|-------------------------------------------------------------|--------|------------------------------------------------|--------|---------------------------------------------|--------|
| Total shares available under  the Plan, beginning of period |   | 500,764                                        |   | 598,068                                     |   |
| Issued at June 30                                           |   | (61,193                                        | )      | (41,976                                     | )      |
| Issued at December 31                                       |   | —                                         |   | (55,328                                     | )      |
|                                                        |   |                                           |   |                                        |   |
| Total shares available under the Plan, end  of period       |   | 439,571                                        |   | 500,764                                     |   |

 

For thesix-month period ended June 30, 2002, the purchase price of the stock was$30.00, or 90% of the market value of the Common Stock on the first business dayof the payment period ending June 30, 2002.

 

For the yearended December 31, 2001, the purchase price of the stock was $30.25 and$29.875, or 90% of the market value of the Common Stock on the first businessday of the payment periods ending 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  Six Months Ended  June 30,** |   | **For the  Three Months Ended  June 30,** |   |
|-----------------------------------------|--------|-----------------------------------------|--------|-------------------------------------------|--------|
|                                    |   | **2002**                                |   | **2001**                                  |   | **2002** |   | **2001** |   |
| Income available to common stockholders |   | $                                       | 33,372 |                                      | $      | 22,240 |   | $ | 17,317 |   | $ | 11,892 |   |
|                                    |   |                                    |   |                                      |   |   |   |   |   |
| Basic average shares                    |   | 64,249,041                              |   | 62,801,858                                |   | 64,312,901 |   | 63,574,862 |   |
| Dilutive effect of stock options        |   | 2,304,103                               |   | 2,552,634                                 |   | 2,279,235 |   | 2,455,092 |   |
| Diluted average shares                  |   | 66,553,144                              |   | 65,354,492                                |   | 66,592,136 |   | 66,029,954 |   |
|                                    |   |                                    |   |                                      |   |   |   |   |   |
| Earnings per share:                     |   |                                    |   |                                      |   |   |   |   |   |
| Basic                                   |   | $                                       | 0.52   |                                      | $      | 0.35 |   | $ | 0.27 |   | $ | 0.18 |   |
|                                    |   |                                    |   |                                      |   |   |   |   |   |
| Diluted                                 |   | $                                       | 0.50   |                                      | $      | 0.34 |   | $ | 0.26 |   | $ | 0.18 |   |

 

**8.****             Off–BalanceSheet Financial Instruments**

* *

*Lines of Credit*—AtJune 30, 2002, the Company had commitments to individuals and mutual fundsunder collateralized open lines of credit totaling $669 million, against which$66 million in loans were drawn. The credit risk involved in issuing lines ofcredit is essentially the same as that involved in extending loan facilities.The Company does not anticipate any loss as a result of these lines of credit.

 

On behalf ofits clients, the Company lends its securities to creditworthy brokers and otherinstitutions.  In certain circumstances,the Company may indemnify its clients for the fair market value of thosesecurities against a failure of the borrower to return such securities.  The Company requires the borrowers to providecollateral in an amount equal to or in excess of 102% of the fair market valueof domestic securities borrowed and 105% of the fair market value ofinternational securities borrowed.  Theborrowed securities are revalued daily to determine if additional collateral isnecessary.  The Company held, ascollateral, cash and U.S. government securities totaling approximately $2.7billion and $2.1 billion for indemnified securities on loan at June 30, 2002and December 31, 2001, respectively.

 

14

----

 

**9.****             Commitments andContingencies**

** **

*Restrictions on Cash Balances*—TheCompany is required to maintain certain average cash reserve balances. Thereserve balance with the Federal Reserve Bank (“FRB”) as of June 30, 2002 wasapproximately $14.0 million.  Inaddition, other cash balances in the amount of approximately $12.4 million werepledged to secure clearings with a depository institution, Depository TrustCompany, as of June 30, 2002.

* *

*Lease Commitments*—Minimum future commitments on noncancelable operating leases at June 30, 2002were as follows (Dollars in thousands):

 

| **Fiscal Year Ending** |   | **Premises** |    | **Equipment** |   | **Total** |   |
|----------------------------------|--------|--------------|---------|---------------|--------|-----------|--------|
| 2002                             |   | $            | 9,244   |          | $      | 2,728     |   | $ | 11,972 |   |
| 2003                             |   | 17,325       |    | 4,189         |   | 21,514    |   |
| 2004                             |   | 16,745       |    | 2,278         |   | 19,023    |   |
| 2005                             |   | 16,819       |    | 259           |   | 17,078    |   |
| 2006 and beyond                  |   | 50,790       |    | 31            |   | 50,821    |   |
| Total                            |   | $            | 110,923 |          | $      | 9,485     |   | $ | 120,408 |   |

 

Total rentexpense was $14.0 million and $10.3 million for the six months ended June 30,2002 and 2001, respectively.  Total rentexpense was $6.9 million and $5.1 million for the three months ended June 30,2002 and 2001, respectively.

 

EffectiveJanuary 1, 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 $3.4million and $2.1 million for the six months ended June 30, 2002 and 2001,respectively, and was $1.7 million and $1.1 million for the three months endedJune 30, 2002 and 2001, respectively.

 

In 2001, theCompany renewed its agreement with SEI Investments Company, which now expireson December 31, 2005.  Under the termsof the agreement, the Company agreed to pay certain monthly service fees basedupon usage.  Service expense under thiscontract was $2.7 million and $1.8 million for the six months ended June 30,2002 and 2001, respectively, and was $1.3 million and $0.9 million for thethree months ended June 30, 2002 and 2001, respectively.

* *

*Contingencies*—TheCompany provides a broad range of services to financial asset managers, such asmutual fund complexes, investment advisors, banks and insurance companies.  The core services include global custody,multicurrency accounting and mutual fund administration.  The value-added services include securitieslending, foreign exchange and cash management. Assets under custody and management, held by the Company in a fiduciarycapacity, are not included in the consolidated balance sheets since such itemsare not assets of the Company. Management conducts regular reviews of its fiduciary responsibilitiesand considers the results in preparing its consolidated financial statements.  In the opinion of management, there are nocontingent liabilities at June 30, 2002 that are material to the consolidatedfinancial position or results of operations of the Company.

 

In June 2002,the Bank received from the Commonwealth of Massachusetts Department of Revenue(‘DOR’) a Notice of Intent to Assess additional state excise taxes ofapproximately $5.5 million plus interest and penalties with respect to theBank’s tax years ended December 31, 1999 and December 31, 2000.

 

The DORcontends that dividend distributions to the Bank by Investors Funding Corp.(‘IFC’), a real estate investment trust 99.9% owned by the Bank, are fullytaxable in Massachusetts.  The Company,after consultation with its advisors, believes that the Massachusetts statutethat provides for a dividend received deduction equal to 95% of certaindividend distributions applies to the distributions made by IFC to theBank.  Accordingly, no provision hasbeen made in the Company’s financial statements for the amounts assessed or additionalamounts that might be assessed in the future.

 

The Companyhas been informed that the DOR has sent similar notices to numerous otherfinancial institutions in Massachusetts that reported a deduction for dividendsreceived from a real estate investment trust on their 1999 and 2000 Massachusettsfinancial institution excise tax return. Assessed amounts ultimately paid, if any,

 

15

----

 

would bedeductible expenses for federal income tax purposes.  The Company intends to appeal the assessment and to pursue allavailable means to defend its position vigorously.

 

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 theUnited States District Court for the Northern District of Illinois.  In the Complaint, Mopex alleges that theCompany and numerous other entities, including Barclays Global Investors, StateStreet Bank and Trust Company, and Merrill Lynch, Pierce, Fenner & Smith,Inc., infringed U.S. Patent No. 6,088,685, entitled, “Open End Mutual FundSecuritization Process,” assigned to Mopex. In particular, Mopex alleges that the ‘685 patent covers the creationand trading of certain securities, including the Barclays iShares exchangetraded funds.  The Complaint seeksinjunctive relief, damages, and enhanced remedies (including attorneys’ feesand treble damages).  On April 3, 2001,the Company filed an answer and counterclaim, denying any liability on Mopex’sclaim and seeking a declaratory judgment that the ‘685 patent is invalid andnot infringed 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 Companydoes not offer or sell the securities discussed in the Complaint, it providescertain custody, accounting or other administrative services for the BarclaysiShares family of exchange traded funds. Barclays is one of the defendantsnamed in the Complaint.  The Companycannot be sure that it will prevail in the defense of this claim.  Patent litigation can be costly and coulddivert the attention of management. If the Company was found to infringe thepatent, it would have to pay damages and would be ordered to cease anyinfringing activity or seek a license under the patent. The Company cannot besure that it will be able to obtain a license on a timely basis or onreasonable terms, if at all. As a result, any determination of infringementcould have a material adverse effect upon its business, financial condition andresults of operations.

 

In July 2000, two of the Company’s Dublin subsidiaries, InvestorsTrust & Custodial Services (Ireland) Ltd. (ITC) and InvestorsFund 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’s auditors, and Dresdner Bank-Kleinwort Benson(Suisse) S.A., a trading counterparty to the Fund. The Fund is an investmentvehicle organized in Dublin to invest in foreign exchange contracts. A total ofapproximately $4.7 million had been invested in the Fund. Most of thatmoney was lost prior to the Fund’s closing to subscriptions in June 1999.

 

In January 2001, ITC, IFS and the other defendants named in theplenary summons received a statement of claim by the Fund seeking unspecifieddamages allegedly arising from breach of contract, misrepresentation and breachof warranty, negligence and breach of duty of care, and breach of fiduciaryduty, among others. The Company continues to investigate this matter. TheCompany has notified its insurers and intends to defend itself vigorously.Based on its investigation through June 30, 2002, the Company’s management doesnot expect this matter to have a material adverse effect on its results of operationsand financial condition.

 

16

----

 

**10.****          Regulatory Matters**

 

The Companyand the Bank are subject to various regulatory capital requirementsadministered 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 otherfactors.

 

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 June 30, 2002, that theCompany and the Bank meet all capital adequacy requirements to which they aresubject.

 

17

----

 

As of June 30,2002, the most recent notification from the FDIC categorized the Company andthe Bank as well capitalized under the regulatory framework for promptcorrective action. To be categorized as well capitalized, the Company and theBank must maintain minimum Total risk–based, Tier I risk–based, andTier I leverage ratios as set forth in the following table. There are noconditions or events since that notification that management believes havechanged the Company’s or the Bank’s category. The following table presents thecapital ratios for the Company and the Bank (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 June 30, 2002:**                                   |   |       |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Total Capital  (to Risk Weighted Assets—the Company)  |   | $          | 336,256    |                                | 16.68      | %                                                                        | $          | 161,294 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital  (to Risk Weighted Assets—the Bank)     |   | $          | 330,718    |                                | 16.40      | %                                                                        | $          | 161,278 |   | 8.00 | % | $ | 201,598 |   | 10.00 | % |
| Tier I Capital  (to Risk Weighted Assets—the Company) |   | $          | 336,156    |                                | 16.67      | %                                                                        | $          | 80,647 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Risk Weighted Assets—the Bank)    |   | $          | 330,618    |                                | 16.40      | %                                                                        | $          | 80,639 |   | 4.00 | % | $ | 120,959 |   | 6.00 | % |
| Tier I Capital  (to Average Assets—the Company)       |   | $          | 336,156    |                                | 5.74       | %                                                                        | $          | 234,353 |   | 4.00 | % | N/A |   | N/A |   |
| Tier I Capital  (to Average Assets—the Bank)          |   | $          | 330,618    |                                | 5.64       | %                                                                        | $          | 234,320 |   | 4.00 | % | $ | 292,900 |   | 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 | % |

 

UnderMassachusetts law, trust companies such as the Bank, like national banks, maypay dividends no more often than quarterly, and only out of “net profits” andto the extent that such payments will not impair the Bank’s capital stock andsurplus account. Moreover, prior approval of the Commissioner of Banks of theCommonwealth of Massachusetts is required if the total dividends for a calendaryear would exceed net profits for that year combined with retained net profitsfor the previous two years. These restrictions on the ability of the Bank topay dividends to the Company may restrict the ability of the Company to paydividends to its stockholders.

 

18

----

 

**11.****          Segment Reporting**

 

The Companydoes not utilize segment information for internal reporting as management viewsthe Company 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  Six Months Ended** |    | **For the  Three Months Ended** |   |   |   |
|                        |   | **June 30,**                  |    | **June 30,**                    |   | **June 30,** |   | **December  31,** |   |
|                        |   | **2002**                      |    | **2001**                        |   | **2002** |   | **2001** |   | **2002** |   | **2001** |   |
| **Geographic Information:** |   |                          |    |                            |   |   |   |   |   |   |   |   |   |
| United States               |   | $                             | 204,758 |                            | $      | 153,721 |   | $ | 104,146 |   | $ | 85,245 |   | $ | 138,709 |   | $ | 122,200 |   |
| Ireland                     |   | 5,275                         |    | 3,637                           |   | 2,873 |   | 1,969 |   | 465 |   | 370 |   |
| Canada                      |   | 973                           |    | 1,052                           |   | 473 |   | 536 |   | 7 |   | 17 |   |
| Cayman Islands              |   | 42                            |    | 43                              |   | 21 |   | 21 |   | — |   | — |   |
|                        |   |                          |    |                            |   |   |   |   |   |   |   |   |   |
| Total                       |   | $                             | 211,048 |                            | $      | 158,453 |   | $ | 107,513 |   | $ | 87,771 |   | $ | 139,181 |   | $ | 122,587 |   |

 

BGI accountedfor 16.66% and 17.43% of the Company’s consolidated net operating revenues forthe six months and three months ended June 30, 2002, respectively.

 

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

 
|                                                      |   | **Asset  Servicing Fees**              |    |
|-----------------------------------------------------------|--------|----------------------------------------|---------|
|                                                      |   | **For the  Six Months Ended June 30,** |    | **For the  Three Months Ended June 30,** |   |
|                                                      |   | **2002**                               |    | **2001** |   | **2002** |   | **2001** |   |
| **Asset servicing fees by service line:**                 |   |                                   |    |   |   |   |   |   |   |
| Custody, accounting, transfer agency, and  administration |   | $                                      | 110,979 |   | $ | 86,646 |   | $ | 57,171 |   | $ | 47,986 |   |
| Foreign exchange                                          |   | 11,037                                 |    | 8,058 |   | 6,181 |   | 4,101 |   |
| Cash management                                           |   | 7,946                                  |    | 7,339 |   | 3,752 |   | 4,279 |   |
| Securities lending                                        |   | 6,243                                  |    | 4,852 |   | 3,605 |   | 2,656 |   |
| Investment advisory                                       |   | 3,596                                  |    | 1,595 |   | 1,878 |   | 1,036 |   |
|                                                      |   |                                   |    |   |   |   |   |   |   |
| Total                                                     |   | $                                      | 139,801 |   | $ | 108,490 |   | $ | 72,587 |   | $ | 60,058 |   |

 

19

----

 

INDEPENDENTACCOUNTANTS’ REPORT

 

To the Board of Directors andStockholders of

Investors Financial ServicesCorp.

Boston, Massachusetts

 

We have reviewed theaccompanying condensed consolidated balance sheet of Investors FinancialServices Corp. and subsidiaries as of June 30, 2002, the related condensedconsolidated statements of income and comprehensive income for the three-monthand six-month periods then ended, and the condensed consolidated statements ofstockholders’ equity and cash flows for the six-month period then ended.  These financial statements are theresponsibility of the Corporation’s management.

 

We conducted our review inaccordance with standards established by the American Institute of CertifiedPublic Accountants.  A review of interimfinancial information consists principally of applying analytical procedures tofinancial data and of making inquiries of persons responsible for financial andaccounting matters.  It is substantiallyless in scope than an audit conducted in accordance with auditing standardsgenerally accepted in the United States of America, the objective of which isthe expression of an opinion regarding the financial statements taken as awhole.  Accordingly, we do not expresssuch an opinion.

 

Based on our review, we are notaware of any material modifications that should be made to such condensedconsolidated financial statements for them to be in conformity with accountingprinciples generally accepted in the United States of America.

 

 

DELOITTE & TOUCHE LLP

 

Boston, Massachusetts

August 14, 2002

 

20

----

 

**Item2.****    Management’s Discussion andAnalysis 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 of services to a variety of financial assetmanagers.  These services include ourcore services, global custody, multicurrency accounting and mutual fundadministration, as well as our value-added services, such as securitieslending, foreign exchange, cash management, performance measurement,institutional transfer agency, investment advisory services and lines ofcredit.  At June 30, 2002, we providedservices for approximately $835 billion in net assets, includingapproximately $105 billion of foreign net assets.

 

On January 1, 2001, we adopted SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities,” and the corresponding amendments and SFASNo. 138, “Accounting for Certain Derivative 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, we completed the issuance and sale of 1,624,145shares of Common Stock at $71.62 per share in a public offering.  A portion of the proceeds was used to fundthe acquisition of the advisor custody unit of the Chase Manhattan Bank.  The remaining proceeds were used for theassumption of the operations of the U.S. asset administration unit of BarclaysGlobal Investors, N.A. and for working capital.

 

On February 1, 2001, we purchased the operations of theadvisor custody unit of The Chase Manhattan Bank (“Chase”).  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 to the terms of the asset purchaseagreement, we paid to Chase at the closing of the transaction approximately$31.5 million of the total purchase price, plus another $39.8 million inexchange for the book value of loans to its clients.  Under the terms of the assetpurchase agreement, we are not obligated to make any further purchase pricepayments to Chase.  Thetransaction was accounted for as a purchase.

 

On May 1,2001, we assumed the operations of the U.S. asset administration unit ofBarclays Global Investors, N.A. (“BGI”), a large international institutionalinvestment manager.  The unit, locatedin Sacramento, California, provides custody, fund accounting and otheroperations functions for BGI’s clients. The transaction was accounted for as a purchase.

 

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

 

In June 2002,we received from the Commonwealth of Massachusetts Department of Revenue aNotice of Intent to Assess additional state excise taxes of approximately $5.5million plus interest and penalties with respect to Investors Bank’s tax yearsended December 31, 1999 and December 31, 2000.

 

The Departmentof Revenue contends that dividend distributions to Investors Bank by InvestorsFunding Corp., a real estate investment trust 99.9% owned by Investors Bank,are fully taxable in Massachusetts. After consultation with our advisors, we believe that the Massachusettsstatute that provides for a dividend received deduction equal to 95% of certaindividend distributions applies to the distributions made by Investors Fundingto Investors Bank.  Accordingly, noprovision has been made in our financial statements for the amounts assessed oradditional amounts that might be assessed in the future.

 

21

----

 

We have beeninformed that the Department of Revenue has sent similar notices to numerousother financial institutions in Massachusetts that reported a deduction fordividends received from a real estate investment trust on their 1999 and 2000Massachusetts excise tax return. Assessed amounts ultimately paid, if any, would be deductible expensesfor federal income tax purposes.  Weintend to appeal the assessment and to pursue all available means to defend ourposition vigorously.

 

**Revenue and ExpenseOverview**

 

We derive our revenue from financial asset servicing.  Although interest income and noninterestincome are reported separately for financial statement presentation purposes,our clients view the pricing of our service offerings on a bundled basis.  In establishing a fee structure for aspecific client, management analyzes all expected revenue and related expenses,as opposed to separately analyzing fee income and interest income and relatedexpenses for each from the relationship. Accordingly, we believe net operating revenue (net interest income plusnoninterest income) and net income are the most meaningful measures of ourfinancial results. Net operating revenue increased 33% and 22% to$211.0 million and $107.5 million from $158.5 million and $87.8 millionfor the six months and three months ended June 30, 2002 and 2001,respectively.  Net income increased 50%and 46% to $33.4 million and $17.3 million from $22.2 million and $11.9 millionfor the six months and three months ended June 30, 2002 and 2001, respectively.

 

Noninterest income consists primarily of fees for financial assetservicing and is principally derived from global custody, multicurrencyaccounting, mutual fund administration and institutional transfer agencyservices for financial asset managers and the assets they control. Our 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 a portfoliounder custody grow as a result of changes in market values or cash inflows, ourfees may be a smaller percentage of those assets.

 

If the value of equity assets held by our clients were to increase ordecrease by 10%, we estimate that this, by itself, would currently cause a corresponding change of approximately 3% in our earnings pershare.  If the value of fixed incomeassets held by our clients were to increase or decrease by 10%, we estimatethat this, by itself, would currently cause a corresponding change ofapproximately 2% in our earnings per share. In practice, earnings per share do not track precisely to the value ofthe equity markets because conditions present in a market decline may generateoffsetting increases in other revenue items. For example, market volatility often results in increased transactionfee revenue.  Also, market declines mayresult in increased interest income and sweep fee income as clients move largeramounts of assets into cash management vehicles that we offer.  As a result, our earnings have remainedstrong despite the recent steep declines in the broad equity markets.  However, there can be no assurance thatthese offsetting revenue increases will continue.

 

Net interest incomerepresents the difference between income generated from interest-earning assetsand expense 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 of costs incurred in support of our businessactivities.  As a service provider, ourlargest expenditures are staffing costs, including compensation and benefits.  We also rely heavily on technological toolsand services for processing, communicating and storing data.  As a result,our technology and telecommunication expense is also a large percentage of ouroperating expenses.

 

**Significant Accounting Policies**

 

Theconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the U.S., which require us to make estimatesand assumptions.  We have identified thefollowing accounting policies that, as a result of the complexities of theunderlying accounting standards and operations involved, could result insignificant changes to our consolidated financial condition or results ofoperations under different conditions or using different assumptions.

 

22

----

 

***Derivative FinancialInstruments*** - 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, we adopted SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities,” as amended and interpreted, which established accountingand reporting 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 fair valuehedge, the change in the fair value of the derivative and the item being hedgedwill be recognized in earnings.  If thederivative is designated as a cash flow hedge, the effective portions ofchanges in the fair value of the derivative are recorded in 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.

 

Hedgeaccounting requires that we measure the changes in fair value of derivativesdesignated as hedges as compared to changes in expected cash flows of theunderlying hedged transactions for each reporting period.  Changes in conditions or the occurrence ofunforeseen events could affect the timing of the recognition of changes in fairvalue of certain hedging derivatives. The measurement of fair value is based upon market values, however, inthe absence of quoted market values, measurement involves valuationestimates.  These estimates are based onmethodologies deemed appropriate in the circumstances.  However, the use of alternative assumptionscould have a significant effect on estimated fair value.

 

Hedgeineffectiveness, determined in accordance with SFAS No. 133, had aninsignificant impact on earnings for the six months ended June 30, 2002.  No cash flow hedges were dedesignated ordiscontinued for the six months ended June 30, 2002.

 

We enter intoforeign exchange contracts with clients and attempt to enter into a matchedposition with another bank. These contracts are subject to market valuefluctuations in foreign currencies. Gains and losses from such fluctuations are netted and recorded as anadjustment of asset servicing fees. Unrealized gains (losses) resulting from purchases and sales of foreignexchange contracts are included within the respective other assets and otherliabilities categories on our consolidated balance sheet.  The foreign exchange contracts have beenreduced by balances with the same counterparty where a master netting agreementexists.

* *

***Stock-BasedCompensation*** — We account for stock-basedcompensation using the intrinsic value-based method of Accounting PrinciplesBoard (‘APB’) No. 25, “Accounting for Stock Issued to Employees,” as allowedunder SFAS No. 123, “Accounting for Stock-Based Compensation.”  Under APB No. 25, no compensation costs arerecognized because the option exercise price is equal to the fair market priceof the common stock on the date of the grant. If SFAS No. 123 were adopted, stock options would be valued at grantdate using the Black-Scholes valuation model and compensation costs would berecognized pro rata over the vesting period. The Black-Scholes option-pricingmodel uses assumptions including the expected life of an option, the expectedvolatility of the underlying stock and an assumed risk-free interest rate.

 

We reported a37% dilution in earnings per share for the fiscal year ended December 31, 2001using the following assumptions: an expected volatility of 57%, an expectedoption life of 10 years, an assumed risk-free interest rate of 5.16% and adividend yield of 0.12%.  During thequarter, we reexamined the actual expected life of our options and thevolatility of our stock, and determined our historical option life to be lessthan four years and the related volatility to be 55%.  Since SFAS No. 123 requires us to use an option life no less thanthe vesting period, a four-year life was chosen.  Based upon an expected option life of four years and the relatedvolatility of 55% over the same period, the dilution in earnings per share forthe year ended December 31, 2001 would have been 20% versus the 37% that waspreviously disclosed in our December 31, 2001 annual report on Form 10-K.

 

***Capitalized SoftwareCosts*** — Capitalized software costs are accountedfor under the method prescribed by AICPA Statement of Position 98-1,“Accounting for the Costs of Computer Software Developed or Obtained forInternal Use ,” (‘SOP 98-1’) and are included within the furniture, fixturesand equipment component.  Capitalizedsoftware costs are amortized over the estimated useful life, not to exceed 5years.  Our policy is to capitalizecosts relating to system development projects that provide significant functionalityenhancements.  Assets are placed inservice and depreciation and/or amortization commences when successful testinghas been achieved.  Please see the“Capital Resources” section of this Report regarding capitalized softwareexpenditures made during the six months ended June 30, 2002 and 2001.

 

23

----

 

***New AccountingPrinciples*** — On January 1, 2002, we adopted SFASNo. 142, “Goodwill and Other Intangible Assets,” which supersedes APB No. 17,“Intangible Assets.”  SFAS No. 142addresses how intangible assets that are acquired individually or with a groupof other assets (but not those acquired in a business combination) should beaccounted for in financial statements upon their acquisition.  This statement also addresses how goodwilland other intangible assets should be accounted for after they have beeninitially recognized in the financial statements.  This statement affects the accounting of premiums, includes guidelinesfor the determination, measurement and testing of impairment, and requiresdisclosure of information about goodwill and other intangible assets in theyears subsequent to their acquisition that was not previously required.  This Statement eliminates the amortizationof goodwill, and requires that goodwill be reviewed at least annually forimpairment.  This Statement affects allgoodwill recognized on our consolidated balance sheet, regardless of when theassets were initially recorded.  Uponadoption of SFAS No. 142, we ceased amortization of goodwill.  As of June 30, 2002 there was no impairmentof goodwill nor is any impairment anticipated for the fiscal year endingDecember 31, 2002.

 

24

----

 

**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, interest rateconditions, interest rate sensitivity, impairment of goodwill, the timing andeffect on earnings of derivative gains and losses, the effect on earnings ofdeclines in equity values, and the effect of certain legal claims againstus.  Our actual future results maydiffer significantly 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 toproperly manage our growth could adversely affect the quality of our servicesand result in the loss of clients.*

 

We have been experiencing a period of rapid growth that has requiredthe dedication of significant management and other resources, including theassumption of the operations of the U.S. asset administration unit of BGI.Continued rapid growth could place a strain on our management and otherresources.  To manage future growtheffectively, we must continue to invest in our operational, financial and otherinternal systems, and our human resources. Also, we must continue to expand our office space at reasonable rates ina competitive real estate market.

 

*Our future resultsdepend, in part, on successful integration of pending and possible futureacquisitions and outsourcing transactions.*

 

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

 

*Our operatingresults are subject to fluctuations in interest rates and the securitiesmarkets.*

 

We base someof our fees on the market value of the assets we process.  Accordingly, our operating results aresubject to fluctuations in interest rates or the securities markets as thesefluctuations affect the market value of assets processed.  Current market conditions, including therecent decline in equity markets, adversely affect our asset-based fees.  While reductions in these fees may be offsetby increases in other sources of revenue, continued downward movement of thebroad equity markets will have an adverse impact on our earnings.  Fluctuations in interest rates or thesecurities markets can also lead to investors seeking alternatives to theinvestment offerings of our clients, which could result in a lesser amount ofassets processed and correspondingly lower fees.  Also, our net interest income is earned by investing depositors’funds and making loans.  Rapid changesin interest rates or changes in the relationship between different index ratescould adversely affect the market value of, or the earnings produced by, ourinvestment and loan portfolios.

 

*We face significantcompetition from other financial services companies, which could negativelyaffect our operating results.*

 

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

 

25

----

 

*A material portionof our revenues is derived from our relationship with Barclays GlobalInvestors, N.A.*

 

As a result of our assumption of the operations of the U.S. assetadministration unit of Barclays Global Investors, N.A. (‘BGI’) in 2001 and ourongoing relationship with BGI’s iShares and Master Investment Portfolios, BGIaccounted for approximately 17% of our net operating revenue during the sixmonths and three months ended June 30, 2002. We expect that BGI will continue to account for a significant portion ofour net operating revenue.  While weprovide services to BGI under long-term contracts, those contracts may beterminated for certain regulatory and fiduciary reasons.  The loss ofBGI’s business would cause our net operating revenue to decline and would havea material adverse effect on our quarterly and annual results.

 

*We may not win ourappeal of the Massachusetts Department of Revenue Notice of Assessment.*

 

We receivedfrom the Commonwealth of Massachusetts Department of Revenue a Notice of Intentto Assess additional state excise taxes with respect to the years 1999 and2000.  After consultation with ouradvisors, we do not believe that we owe the additional excise tax.  The Company intends to appeal the assessmentand to pursue all available means to defend its position vigorously.  Legalproceedings to appeal and defend our position could be expensive and divertmanagement’s attention.  In addition, ifwe do not prevail, payment of the additional excise tax would have a materialadverse impact on our earnings for the period in which we pay the assessment.

 

*We may not be ableto protect our proprietary technology.*

 

Our proprietary technology is important to our business.  We rely on trade secret, copyright andtrademark laws and confidentiality agreements with employees and third partiesto protect our proprietary technology, all of which offer only limitedprotection.  These intellectual propertyrights may be invalidated or our competitors may develop similar technologyindependently.  Legal proceedings toenforce our intellectualproperty rights may be unsuccessful, and could also be expensive and divertmanagement’s attention.

 

*We may incursignificant costs defending infringement claims.*

 

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

 

*We must hire andretain skilled personnel in order to succeed.*

 

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

 

*Our quarterly andannual operating results may fluctuate.*

 

Our quarterly andannual operating results are difficult to predict and may fluctuate fromquarter to quarter and annually for several reasons, including:

 

•                                          The timing of commencement or termination ofclient engagements; and

 

•                                          The rate of net inflows and outflows of investorfunds in the investment vehicles offered by our clients.

 

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

 

26

----

 

*We are subject toextensive federal and state regulations that impose complex restraints on ourbusiness.*

 

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

 

•                                          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

 

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

 

27

----

 

**Statementof Operations**

 

*Comparison of Operating Results for the Six Months and the Three MonthsEnded June 30, 2002 and 2001*

* *

*Noninterest Income*

 

Noninterestincome was $140.9 million for the six months ended June 30, 2002, up 28% fromthe same period in 2001, and was $73.1 million for the three months ended June30, 2002, up 20% from the same period in 2001. Noninterest income consists of the following items (Dollars inthousands):

 
|                     |   | **For the  Six Months Ended June 30,** |    | **For the  Three Months Ended June 30,** |   |
|--------------------------|--------|----------------------------------------|---------|------------------------------------------|--------|
|                     |   | **2002**                               |    | **2001**                                 |   | **Change** |   | **2002** |   | **2001** |   | **Change** |   |
| Asset servicing fees     |   | $                                      | 139,801 |                                     | $      | 108,490 |   | 29 | % | $ | 72,587 |   | $ | 60,058 |   | 21 | % |
| Other operating income   |   | 1,130                                  |    | 1,549                                    |   | (27 | )% | 546 |   | 768 |   | (29 | )% |
|                     |   |                                   |    |                                     |   |   |   |   |   |   |   |   |   |
| Total noninterest income |   | $                                      | 140,931 |                                     | $      | 110,039 |   | 28 | % | $ | 73,133 |   | $ | 60,826 |   | 20 | % |

 

Assetservicing fees for the six months ended June 30, 2002 increased 29% to $139.8million from the same period in 2001, and were $72.6 million for the threemonths ended June 30, 2002, up 21% from the same period in 2001.  The change in asset servicing fees includesapproximately $19.7 million and $6.3 million relating to the assetadministration operations assumed from BGI for the six months and three monthsended June 30, 2002, respectively.  Thelargest component of asset servicing fees is asset-based fees, which increaseddue to the increase in assets processed. Assets processed is the total dollar value of financial assets on thereported date for which we provide one or more of the following services:global custody, multicurrency accounting, mutual fund administration,securities lending, foreign exchange, cash management, performance measurement,institutional transfer agency, investment advisory services and lines ofcredit.  Total net assets processedincreased $21 billion from $814 billion at December 31, 2001 to $835 billion atJune 30, 2002, and increased $4 billion from $831 billion at March 31, 2002.  Changes in net assets processed include the following components (Dollars inbillions):

 
|                                     |   | **For the Six Months Ended  June 30, 2002** |   | **For the Three Months Ended  June 30, 2002** |   |
|------------------------------------------|--------|---------------------------------------------|--------|-----------------------------------------------|--------|
| Sales to new clients                     |   | $                                           | 19     |                                          | $      | 19 |   |
| Further penetration of  existing clients |   | 16                                          |   | 11                                            |   |
| Fund flows and market loss               |   | (14                                         | )      | (26                                           | )      |
|                                     |   |                                        |   |                                          |   |
| Net increase in assets  processed        |   | $                                           | 21     |                                          | $      | 4 |   |

 

Another significant portion of the increase in asset servicing feesresulted from our success in marketing ancillary services, such as foreignexchange, securities lending, 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 forsystems consulting services. The decrease in other operating income for the sixmonths ended June 30, 2002  resultedprimarily from the decrease in income from consulting services performed forclients compared to the same period in 2001. The decrease in other operating income for the three months ended June30, 2002 was due to the decrease in FHLBB stock dividend income resulting froma decrease in the dividend rate paid on the FHLBB stock.  This decrease was offset by an increase inthe average investment in FHLBB stock during the three months ended June 30,2002 compared to the same period in 2001.

 

28

----

 

*Operating Expenses*

 

Totaloperating expenses were $162.2 million for the six months ended June 30, 2002,up 30% from the same period in 2001. For the three months ended June 30, 2002, total operating expenses were$82.2 million, up 17% from the same period in 2001.  The components of operating expenses were as follows (Dollars inthousands):

 
|                               |   | **For the Six Months Ended June 30,** |    | **For the Three Months Ended June 30,** |   |
|------------------------------------|--------|---------------------------------------|---------|-----------------------------------------|--------|
|                               |   | **2002**                              |    | **2001**                                |   | **Change** |   | **2002** |   | **2001** |   | **Change** |   |
|                               |   |                                  |    |                                    |   |   |   |   |   |   |   |   |   |
| Compensation and benefits          |   | $                                     | 98,868  |                                    | $      | 75,516 |   | 31 | % | $ | 48,938 |   | $ | 41,602 |   | 18 | % |
| Technology and  telecommunications |   | 18,836                                |    | 18,497                                  |   | 2 | % | 9,481 |   | 10,455 |   | (9 | )% |
| Transaction processing  services   |   | 15,385                                |    | 7,639                                   |   | 101 | % | 8,855 |   | 5,065 |   | 75 | % |
| Occupancy                          |   | 11,406                                |    | 7,802                                   |   | 46 | % | 5,643 |   | 4,266 |   | 32 | % |
| Depreciation and amortization      |   | 6,639                                 |    | 3,223                                   |   | 106 | % | 3,503 |   | 1,861 |   | 88 | % |
| Professional fees                  |   | 2,795                                 |    | 1,895                                   |   | 47 | % | 1,323 |   | 1,150 |   | 15 | % |
| Travel and sales promotion         |   | 2,754                                 |    | 2,394                                   |   | 15 | % | 1,520 |   | 1,396 |   | 9 | % |
| Amortization of goodwill           |   | —                                |    | 1,573                                   |   | (100 | )% | — |   | 923 |   | (100 | )% |
| Other operating expenses           |   | 5,469                                 |    | 6,486                                   |   | (16 | )% | 2,900 |   | 3,454 |   | (16 | )% |
|                               |   |                                  |    |                                    |   |   |   |   |   |   |   |   |   |
| Total operating expenses           |   | $                                     | 162,152 |                                    | $      | 125,025 |   | 30 | % | $ | 82,163 |   | $ | 70,172 |   | 17 | % |

 

Compensation and benefits expense was $98.9 million for the sixmonths ended June 30, 2002, up 31% from the same period in 2001, and was $48.9million for the three months ended June 30, 2002, up 18% from the same periodin 2001.  The average number of employeesincreased 28% to 2,623 during the six months ended June 30, 2002 from 2,045 forthe same period last year.  The averagenumber of employees for the three months ended June 30, 2002 was 2,647, up 19%compared to 2,216 during the same period in 2001.  We increased the number of employees to support the expansion ofclient relationships and to service new business acquisitions.  We added approximately 130 employees in connectionwith the Chase acquisition and approximately 370 employees in connection withthe BGI business unit assumption.  Inaddition, compensation expense related to our management-incentive plansincreased $4.9 million for the six months ended June 30, 2002 and $0.3 millionfor the three months ended June 30, 2002. The increases result from higher earnings and additionalincentive-eligible managers.  Benefits,including payroll taxes, group insurance plans, retirement plan contributionsand tuition reimbursement, increased $4.5 million for the six months endedJune 30, 2002, and $1.5 million for the three months ended June 30, 2002,consistent with the increased headcount.

 

Technology and telecommunications expense was $18.8 million forthe six months ended June 30, 2002, up 2% from the same period in 2001, and was$9.5 million for the three months ended June 30, 2002, down 9% from the sameperiod in 2001.  Increased hardware,software, mainframe and trust processing and telecommunications expendituresneeded to support the growth in assets processed accounted for $5.1 million and$2.1 million of the six- and three-month increases, respectively.  These were offset by decreased expenses of$4.8 million and $3.0 million for the six- and three-month periods,respectively, related to outsourced network monitoring, help desk and otheroutsourced services required in 2001, and not in 2002, primarily due to theChase acquisition.

 

Transaction processing services expense was $15.4 million for the sixmonths ended June 30, 2002, up 101% from the same period in 2001.  For the three months ended June 30, 2002,transaction processing services expense was $8.9 million, up 75% from the sameperiod last year.  The increase relatesprimarily to increased subcustodian fees, driven by increased volumes oftransactions and growth in assets processed for clients, largely a result ofthe BGI U.S. asset administration unit assumption in May 2001.

 

Occupancy expense was $11.4 million for the six months ended June30, 2002, up 46% from the same period in 2001 and was $5.6 million for thethree months ended June 30, 2002, up 32% compared to the same period in 2001.These increases were primarily due to increased space resulting from theCalifornia offices assumed from BGI and increased space in our Boston, NewYork, and Dublin offices.

 

Depreciation and amortization expense was $6.6 million for the sixmonths ended June 30, 2002, up 106% from the same period in 2001, and was $3.5million for the three months ended June 30, 2002, up 88% from the same 

 

29

----

 

period in2001.  These increases resulted fromcompletion of capitalized software projects and their placement into service.

 

Professional fees were $2.8 million for the six months ended June 30,2002, up 47% from the same period in 2001, and $1.3 million for the threemonths ended June 30, 2002, up 15% from the same period in 2001.  The increases were primarily due toincreased fees associated with the Merrimac Master Portfolio, an investmentcompany for which the Company acts as advisor. These fees are asset-based and the increases result from growth in thesize of the portfolio.  Also included inprofessional fees are increased accounting, legal and consulting servicesprovided during the periods.

 

Travel and sales promotion expense was $2.8 million for the sixmonths ended June 30, 2002, up 15% from the same period in 2001, and $1.5million for the three months ended June 30, 2002, up 9% from the same period in2001. These increases were due to the increased level of business activity andthe addition of a California office in May 2001.  Travel and sales promotion expense consists of expenses incurredby the sales force, client management staff and other employees in connectionwith sales calls on potential clients, traveling to existing client sites, toour offices in New York and California and to our foreign subsidiaries.

 

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 further discussion ofthis pronouncement.

 

Other operating expenses were $5.5 million and $2.9 million for the sixmonths and three months ended June 30, 2002, respectively, down 16% compared tothe same periods in 2001.  Otheroperating expenses include fees for recruiting, office supplies and postage,storage, temporary help, client accommodations and various regulatory feeassessments.  Recruiting and temporaryhelp expenses accounted for $0.3 million and $0.1 million of the six-month andthree-month period to period decreases. Client accommodations incurred for the six months and three months endedJune 30, 2002 decreased $1.1 million and $0.7 million, respectively, comparedto the same periods in 2001.  Growth inassets processed accounted for the remainder of the change in other operatingexpenses.

* *

*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 below presents the changes in net interest income resultingfrom changes in the volume of interest-earning assets or interest-bearingliabilities and changes in interest rates compared to the same periods in 2001.Changes attributed to both volume and rate have been allocated based on theproportion of change in each category (Dollars in thousands):

 
|                                                                 |   | **For the Six Months Ended June 30, 2002** |   | **For the Three Months Ended June 30, 2002** |   |
|----------------------------------------------------------------------|--------|--------------------------------------------|--------|----------------------------------------------|--------|
|                                                                 |   | **Change  Due to  Volume**                 |   | **Change  Due to  Rate**                     |   | **Net** |   | **Change  Due to  Volume** |   | **Change  Due to  Rate** |   | **Net** |   |
| **Interest-earning  assets:**                                        |   |                                       |   |                                         |   |   |   |   |   |   |   |   |   |
| Federal funds sold and  securities purchased under resale agreements |   | $                                          | (380   | )                                            | $      | (609 | ) | $ | (989 | ) | $ | 83 |   | $ | (210 | ) | $ | (127 | ) |
| Investment securities                                                |   | 37,851                                     |   | (39,409                                      | )      | (1,558 | ) | 16,563 |   | (18,660 | ) | (2,097 | ) |
| Loans                                                                |   | (66                                        | )      | (821                                         | )      | (887 | ) | (72 | ) | (453 | ) | (525 | ) |
|                                                                 |   |                                       |   |                                         |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                        |   | $                                          | 37,405 |                                         | $      | (40,839 | ) | $ | (3,434 | ) | $ | 16,574 |   | $ | (19,323 | ) | $ | (2,749 | ) |
|                                                                 |   |                                       |   |                                         |   |   |   |   |   |   |   |   |   |
| **Interest-earning  liabilities:**                                   |   |                                       |   |                                         |   |   |   |   |   |   |   |   |   |
| Deposits                                                             |   | $                                          | 577    |                                         | $      | (16,280 | ) | $ | (15,703 | ) | $ | (953 | ) | $ | (5,914 | ) | $ | (6,867 | ) |
| Borrowings                                                           |   | 19,976                                     |   | (29,410                                      | )      | (9,434 | ) | 8,236 |   | (11,553 | ) | (3,317 | ) |
|                                                                 |   |                                       |   |                                         |   |   |   |   |   |   |   |   |   |
| Total interest-bearing  Liabilities                                  |   | $                                          | 20,553 |                                         | $      | (45,690 | ) | $ | (25,137 | ) | $ | 7,283 |   | $ | (17,467 | ) | $ | (10,184 | ) |
|                                                                 |   |                                       |   |                                         |   |   |   |   |   |   |   |   |   |
| Change in net interest Income                                        |   | $                                          | 16,852 |                                         | $      | 4,851 |   | $ | 21,703 |   | $ | 9,291 |   | $ | (1,856 | ) | $ | 7,435 |   |

 

30

----

 

Net interest income was $70.1 million for the six months endedJune 30, 2002, up 45% from the same period in 2001.  Net interest income was $34.4 million for the three months endedJune 30, 2002, up 28% 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 17 basispoints to 2.62% for the six months ended June 30, 2002, compared to lastyear.  The net interest margin decreased3 basis points to 2.45% for the three months ended June 30, 2002, compared tothe same period last year, due to prepayment costs incurred in the secondquarter of 2002 associated with replacing borrowed funds at a more favorablerate.

 

Average interest-earning assets, primarily investment securities,increased $1.4 billion or 35% for the six months ended June 30, 2002 andincreased $1.3 billion or 29% for the three months ended June 30, 2002 comparedto the same periods last year.  Fundingfor the asset growth for the six-month period was provided by an increase in averageborrowings, primarily Federal funds purchased, client and wholesale repurchaseagreements and FHLBB advances, of $1.3 billion and an increase in averageclient deposits of $95 million. Funding for the asset growth for the three-month period was provided byan increase in average borrowings of $1.3 billion offset by a decrease inaverage client deposits of $78 million. The effect of changes in volume of interest-earning assets andinterest-bearing liabilities was an increase in net interest income ofapproximately $16.9 million and $9.3 million for the six months and threemonths ended June 30, 2002, respectively.

 

Average yield on interest-earning assets was 4.52% for the six monthsended June 30, 2002, down 177 basis points from the same period in 2001, andwas 4.46% for the three months ended June 30, 2002, down 156 basis points fromthe same period in 2001.  The averagerate paid on interest-bearing liabilities was 2.10% for the six months endedJune 30, 2002, down 222 basis points from the same period in 2001.  The average rate paid on interest-bearingliabilities was 2.20% for the three months ended June 30, 2002, down 174 basispoints from the same period in 2001.  Thedecreases reflect the lower interest rate environment for both the six months andthree months ended June 30, 2002 compared to the same periods in 2001.  The effect on net interest income due tochanges in rates was an increase of approximately $4.9 million and adecrease of $1.9 million for the six months and three months ended June 30,2002, respectively.

 

During the past 24 months, our net interest margin has been unusuallyfavorable.  While interest rates remainlow, the yield curve is flattening, meaning the difference between short-terminterest rates and long-term interest rates is decreasing.  In addition, with mortgage rates at historiclows, refinancing activities increase, resulting in prepayments of higheryielding mortgage-backed securities that we hold.  These factors, among others, may decrease our net interest marginto more traditional levels and reduce the unusually high growth rates in netinterest income that we have experienced during the last two years.

 

On January 1,2001, we adopted SFAS No. 133, as amended and interpreted, which establishedaccounting and reporting standards for derivative instruments.  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 thederivative and the item being hedged will be recognized in earnings.  If the derivative is designated as a cashflow hedge, the effective portions of changes in the fair value of thederivative are recorded 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, 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 $402million of securities from held to maturity to available for sale, whichfurther reduced OCI, net of tax, by approximately $1.4 million.

 

We usederivative instruments to manage exposures to interest rate risks.  We routinely enter into interest rate swapagreements in which we pay a fixed interest rate and receive a floatinginterest rate.  These transactions aredesigned to hedge a portion of our liabilities in connection with securitiessold under repurchase agreements.  Byentering into a pay-fixed/receive-floating interest rate swap, a portion ofthese liabilities is effectively converted to a fixed rate liability for theterm of the interest rate swap agreement. Most of these derivatives have been designated 

 

31

----

 

as highly effective cash flowhedges, 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.

 

Hedgeineffectiveness, determined in accordance with SFAS No. 133, had aninsignificant impact on earnings for the six months ended June 30, 2002. Nocash flow hedges were dedesignated or discontinued for the six months endedJune 30, 2002.

 

Net interestincome included net gains of $0.6 million and $0.4 million, net of tax, for thesix months and three months ended June 30, 2002, respectively, on interest rateswaps relating to SFAS No. 133.  The netgains were $1.7 million and $0.9 million, net of tax, for the six-month andthree-month periods, respectively, on changes in the fair value of derivativeinstruments designated as hedging instruments. There were also $1.1 million and $0.5 million of derivative losses, netof tax, for the six-month and three-month periods, respectively, that resultedprimarily from the reclassification of transition adjustment-related derivativelosses from OCI to net interest income in accordance with SFAS No. 133.  The Company estimates that $0.9 million, netof tax, of the remaining transition adjustment of net derivative lossesincluded in OCI will be reclassified into earnings within the next twelvemonths. The recognition in net interest income of the transition adjustmentderivative losses from OCI will be offset by derivative gains from changes inthe fair value liability of the interest rate swaps as they reach maturity.

 

*Income Taxes*

 

Taxes for thesix months ended June 30, 2002 were $14.7 million, up 42% from the same periodin 2001.  Taxes for the three monthsended June 30, 2002 were $7.6 million, up 44% from the same period in2001.  The increases in tax expensereflect the higher level of pretax income during both periods.  The effective tax rate for the six- andthree-month periods ended June 30, 2002 was 30%, down from 31% for thesix-month period last year, and consistent with 30% for the three–monthperiod last year.   The decrease in theeffective tax rate reflects our increased investment in nontaxable municipalsecurities in 2002.

 

32

----

 

**FinancialCondition**

 

*Investment Portfolio*

 

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

 
|                                |   | **June 30,  2002** |      | **December  31,  2001** |   |
|-------------------------------------|--------|--------------------|-----------|-------------------------|--------|
| **Securities held to maturity:**    |   |               |      |                    |   |
| Mortgage-backed securities          |   | $                  | 2,444,513 |                    | $      | 2,585,287 |   |
| Federal agency securities           |   | 834,763            |      | 456,108                 |   |
| State and political subdivisions    |   | 105,501            |      | 91,888                  |   |
| Foreign government securities       |   | —             |      | 2,501                   |   |
|                                |   |               |      |                    |   |
| Total securities held to maturity   |   | $                  | 3,384,777 |                    | $      | 3,135,784 |   |
|                                |   |               |      |                    |   |
| **Securities available for sale:**  |   |               |      |                    |   |
| Mortgage-backed securities          |   | $                  | 1,798,106 |                    | $      | 1,228,841 |   |
| Federal agency securities           |   | 30,741             |      | 30,848                  |   |
| Corporate debt                      |   | 159,085            |      | 120,505                 |   |
| State and political subdivisions    |   | 268,952            |      | 241,467                 |   |
|                                |   |               |      |                    |   |
| Total securities available for sale |   | $                  | 2,256,884 |                    | $      | 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 debt toincrease the total return of the investment portfolio.  Mortgage-backed securities generally have ahigher yield than U.S. Treasury securities due to credit and prepaymentrisk.  Credit risk results from thepossibility that a loss may occur if a counterparty is unable to meet the termsof the contract.  Prepayment risk resultsfrom the possibility that changes in interest rates may cause mortgage securitiesto be 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 or arebacked by government agency issued mortgages.

 

33

----

 

The book valueand weighted average yield of our securities held to maturity at June 30, 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        |   | $                      | 309,544 |   | 5.06 | % | $ | 1,618,734 |   | 4.48 | % | $ | 419,283 |   | 4.08 | % | $ | 96,952 |   | 3.92 | % |
| Federal agency securities         |   | 5,000                  |    | 6.30 | % | 14,981 |   | 3.83 | % | 418,081 |   | 3.83 | % | 396,701 |   | 3.83 | % |
| State and political subdivisions  |   | —                 |    | — |   | 2,326 |   | 5.14 | % | 5,889 |   | 5.14 | % | 97,286 |   | 5.14 | % |
| Total securities held to maturity |   | $                      | 314,544 |   | 5.08 | % | $ | 1,636,041 |   | 4.48 | % | $ | 843,253 |   | 3.96 | % | $ | 590,939 |   | 4.06 | % |

 

The carrying valueand weighted average yield of our securities available for sale at June 30,2002 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          |   | $                      | — |   | — |   | $ | 737,713 |   | 5.57 | % | $ | 63,936 |   | 5.86 | % | $ | 996,457 |   | 5.56 | % |
| Federal agency securities           |   | —                 |   | — |   | 30,741 |   | 5.64 | % | — |   | — |   | — |   | — |   |
| Corporate debt                      |   | —                 |   | — |   | — |   | — |   | — |   | — |   | 159,085 |   | 2.79 | % |
| State and political subdivisions    |   | 3,606                  |   | 4.68 | % | 35,710 |   | 4.68 | % | 187,501 |   | 4.68 | % | 42,135 |   | 4.68 | % |
| Total securities available for sale |   | $                      | 3,606  |   | 4.68 | % | $ | 804,164 |   | 5.53 | % | $ | 251,437 |   | 4.98 | % | $ | 1,197,677 |   | 5.16 | % |

 

*Loan Portfolio*

 

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

 
|                            |   | **June 30,  2002** |    | **December  31,  2001** |   |
|---------------------------------|--------|--------------------|---------|-------------------------|--------|
|                            |   |               |    |                    |   |
| Loans to individuals            |   | $                  | 83,200  |                    | $      | 181,330 |   |
| Loans to mutual funds           |   | 38,747             |    | 50,342                  |   |
| Loans to others                 |   | 4,002              |    | 541                     |   |
|                            |   | 125,949            |    | 232,213                 |   |
| Less: allowance for loan losses |   | (100               | )       | (100                    | )      |
|                            |   |               |    |                    |   |
| Net loans                       |   | $                  | 125,849 |                    | $      | 232,113 |   |
|                            |   |               |    |                    |   |
| Floating Rate                   |   | $                  | 125,929 |                    | $      | 232,189 |   |
| Fixed Rate                      |   | 20                 |    | 24                      |   |
|                            |   |               |    |                    |   |
|                            |   | $                  | 125,949 |                    | $      | 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 arewritten on a demand basis, bear variable interest rates tied to the prime rateor the Federal Funds rate and are fully secured by liquid collateral, primarilyfreely tradable securities held in custody by us for the borrower.  Loans to mutual funds and other pooledproduct clients include unsecured lines of credit that may, in the event ofdefault, be collateralized at our option by securities held in custody by usfor those mutual funds.  Loans toindividually managed account customers, mutual funds and other pooled productclients also include advances that we make to certain clients pursuant to theterms of our custody agreements with those clients to facilitate securitiestransactions and redemptions.

 

At June 30, 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.

 

34

----

 

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 June 30, 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 June 30,2002.  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.

 

**Market Risk**

 

We engage in investment activities to serve clients’ investment needsand contribute to overall corporate earnings. Interest-bearing liabilities are generated by our clients who, in thecourse of their financial asset management, maintain cash balances which theydeposit on a short-term basis with us. We invest these cash balances and remit a portion of the earnings onthese investments to our clients. In the conduct of these activities, we aresubject to market risk.  Market risk isthe risk of an adverse financial impact from changes in market prices andinterest rates.  The level of risk weassume is a function of our overall strategic objectives and liquidity needs,client requirements 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-bearing liabilities by adjusting their mix,yield, maturity and/or repricing characteristics, based on marketconditions.  Since client deposits andrepurchase agreements, our primary sources of funds, are predominantly shortterm, we maintain a generally short-term structure for our interest-earningassets, including money-market assets and investments.  We also use term borrowings and interestrate swap agreements to augment our management of interest rate exposure.  The effect of the swap agreements is tolengthen short-term variable-rate liabilities into longer-term fixed-rateliabilities.

 

Our Board of Directors has set asset and liability management policiesthat define the overall framework for managing interest rate sensitivity, including accountabilities andcontrols over investment activities. These policies delineate investment limits and strategies that areappropriate, given our liquidity and regulatory requirements.  For example, we have established a policylimit stating that projected net interest income over the next 12 months willnot be reduced by more than 10% given a change in interest rates of up to 200basis points (+ or -) over 12 months. Each quarter, our Board of Directors reviews our asset and liabilitypositions, including simulations of the effect of various interest ratescenarios on our capital.  Due tocurrent interest rate levels, the Company’s Board of Directors has approved atemporary exception to the 10% limit for decreases in interest rates.  The Board of Directors approved the policyexception because, with the Federal Funds target rate currently at 1.75%, 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, the President, the Chief Financial Officer and members of theTreasury function. ALCO meets twice monthly. Our primary tool in managing interest rate sensitivity is an incomesimulation model. Key assumptions in the simulation model include the timing ofcash flows, maturities and repricing of financial instruments, changes inmarket conditions, capital planning and deposit sensitivity.  The model assumes that the composition ofour interest-sensitive assets and liabilities existing at the beginning of aperiod will change periodically over the period being measured.  The model also assumes that a particularchange in interest rates is reflected uniformly across the yield curveregardless of the duration to maturity or repricing of specific assets andliabilities.  These assumptions areinherently uncertain, and as a result, the model cannot precisely predict theeffect of changes in interest rates on our net interest income.  Actual results may differ from simulatedresults due to the timing, magnitude and frequency of interest rate changes andchanges in market conditions and management strategies.

 

The results of the income simulation model as of June 30, 2002 and 2001indicated that an upward shift of interest rates by 200 basis points would result in a reduction in projected netinterest income of 4.56% and 5.44%, respectively.  A downward shift of 200 basis points would result in a decreasein projected net interest income of 14.34% 

 

35

----

 

at June30, 2002, an exception to policy approved by the Board of Directors, and adecrease in projected net interest income of 2.88% at June 30, 2001.

 

We also use gap analysis as a secondary tool to manage our interest ratesensitivity.  Gap analysis involvesmeasurement of the difference in asset and liability repricing on a cumulativebasis within a specified time frame.  Apositive gap indicates that more interest-earning assets than interest-bearingliabilities mature in a time frame, and a negative gap indicates 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 June 30, 2002, interest-bearingliabilities repriced faster than interest-earning assets, as has been typicalfor us.  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 June 30, 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)                                                              |   | $                        | 2,726,095 |                     | $      | 424,850                   |   | $                           | 588,747 |                 | $      | 1,503,928 |   | $ | 398,041 |   | $ | 5,641,661 |   |
| Federal funds sold and securities purchased  under repurchase agreements               |   | 610,000                  |      | —                   |   | —                    |   | —                      |    | —               |   | 610,000   |   |
| Loans—variable rate                                                               |   | 125,829                  |      | —                   |   | —                    |   | —                      |    | —               |   | 125,829   |   |
| Loans—fixed rate                                                                  |   | 20                       |      | —                   |   | —                    |   | —                      |    | —               |   | 20        |   |
| Total interest—earning assets                                                     |   | $                        | 3,461,944 |                     | $      | 424,850                   |   | $                           | 588,747 |                 | $      | 1,503,928 |   | $ | 398,041 |   | $ | 6,377,510 |   |
| Interest-bearing liabilities:                                                          |   |                     |      |                     |   |                      |   |                        |    |                 |   |      |   |
| Demand deposit accounts                                                                |   | $                        | —    |                     | $      | —                    |   | $                           | —  |                 | $      | —    |   | $ | — |   | $ | — |   |
| Savings accounts                                                                       |   | 1,661,322                |      | —                   |   | —                    |   | 28,976                      |    | —               |   | 1,690,298 |   |
| Interest rate contracts                                                                |   | (880,000                 | )         | 60,000                   |   | 120,000                   |   | 700,000                     |    | —               |   | —    |   |
| Short-term and other borrowings                                                        |   | 3,107,475                |      | —                   |   | —                    |   | 400,000                     |    | —               |   | 3,507,475 |   |
| Total interest-bearing liabilities                                                     |   | $                        | 3,888,797 |                     | $      | 60,000                    |   | $                           | 120,000 |                 | $      | 1,128,976 |   | $ | — |   | $ | 5,197,773 |   |
| Net interest-sensitivity gap during the  period                                        |   | $                        | (426,853  | )                        | $      | 364,850                   |   | $                           | 468,747 |                 | $      | 374,952   |   | $ | 398,041 |   | $ | 1,179,737 |   |
|                                                                                   |   |                     |      |                     |   |                      |   |                        |    |                 |   |      |   |
| Cumulative gap                                                                         |   | $                        | (426,853  | )                        | $      | (62,003                   | )      | $                           | 406,744 |                 | $      | 781,696   |   | $ | 1,179,737 |   |   |   |
| Interest-sensitive assets as a percent of  interest sensitive liabilities (cumulative) |   | 89.02                    | %         | 98.43                    | %      | 110.00                    | %      | 115.04                      | %       | 122.70               | %      |      |   |
| Interest-sensitive assets as a percent of  total assets (cumulative)                   |   | 51.50                    | %         | 57.82                    | %      | 66.58                     | %      | 88.95                       | %       | 94.87                | %      |      |   |
|                                                                                   |   |                     |      |                     |   |                      |   |                        |    |                 |   |      |   |
| Net interest-sensitivity gap as a percent  of total assets                             |   | (6.35                    | )%        | 5.43                     | %      | 6.97                      | %      | 5.58                        | %       | 5.92                 | %      |      |   |
| Cumulative gap as a percent of total assets                                            |   | (6.35                    | )%        | (0.92                    | )%     | 6.05                      | %      | 11.63                       | %       | 17.55                | %      |      |   |

 

----

(1)                    Adjustablerate assets are included in the period in which interest rates are nextscheduled to adjust rather than in the period in which they are due.  Fixed-rate loans are included in the periodin which they are scheduled to be repaid.

(2)                    Mortgage–backedsecurities are included in the pricing category that corresponds with theireffective maturity.

 

36

----

 

**Liquidity**

 

Liquidity represents the ability of an institution to meet present andfuture financial obligations through either the sale or maturity of existingassets or the acquisition of additional funds through liabilitymanagement.  For a financial institutionsuch as ours, these obligations arise from the withdrawals of deposits and thepayment of operating expenses.

 

Our primary sources of liquidity include cash and cash equivalents,federal funds sold, new deposits, short-term borrowings, interest payments onsecurities held to maturity and available for sale, and fees collected fromasset administration clients.  As aresult of our management ofliquid assets 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 $0.05 per share for 2002(approximately $3.2 million based upon 64,472,732 shares outstanding as ofJune 30, 2002).

 

Our ability to pay dividends on Common Stock may depend on the receiptof dividends from the Bank. Any dividend payments by the Bank are subject to certain restrictions imposed bythe Massachusetts Commissioner of Banks. In addition, we may not pay dividends on our Common Stock if we are indefault under certain agreements entered into in connection with the sale ofour Capital Securities.  The CapitalSecurities were issued by Investors Capital Trust I, a Delaware statutorybusiness trust sponsored by us, and qualify as Tier I capital under the capitalguidelines of the Federal Reserve.

 

We have informal borrowing arrangements with variouscounterparties.  Each counterparty hasagreed to make funds available to us at the Federal funds overnight rate.  The aggregate amount of these borrowingarrangements as of June 30, 2002 was $1.3 billion.  Each bank may terminate its arrangement atany time and is under no contractual obligation to provide us with requestedfunding.  Our borrowings under thesearrangements are typically on an overnight basis.  We cannot be certain, however, that such funding will beavailable.  Lack of availability ofliquid funds could have a material adverse impact on our operations.

 

We also have Master Repurchase Agreements in place with variouscounterparties.  Each broker has agreedto make funds available to us at various rates in exchange for collateralconsisting of marketable securities. The aggregate amount of these borrowingarrangements at June 30, 2002 was $2.5 billion.

 

We also have a borrowing arrangement with the FHLBB.  We may borrow amounts determined byprescribed collateral levels and the amount of FHLBB stock we hold.  We are required to hold FHLBB stock equal tono less than (i) 1% of our outstanding residential mortgage loan principal (including mortgage pool securities),(ii) 0.3% of total assets, or (iii) total advances from the FHLBB,divided by a leverage factor of 20.  Theaggregate amount of borrowing available to us under this arrangement at June30, 2002 was $1.9 billion.  The amountoutstanding under this arrangement at June 30, 2002 was $0.7 billion.

 

Our cash flows are comprised of three primary classifications:  cash flows from operating activities,investing activities, and financing activities.  Net cash provided by operating activities was $49.5 million forthe six months ended June 30, 2002.  Netcash used for investing activities for the six months ended June 30, 2002 was$1.4 billion, consisting primarily of the excess of purchases of investmentsecurities over proceeds from maturities of investment securities and increasedFederal funds sold and securities purchased under resale agreements.  Net cash provided by financing activities, consistingprimarily of increased short-term and other borrowings and demand deposits, was$1.3 billion for the six months ended June 30, 2002.

 

**Capital Resources**

 

Historically, we have financed our operations principally throughinternally generated cash flows.  Weincur capital expenditures for furniture, fixtures, capitalized software andmiscellaneous equipment needs.  We leasemicrocomputers through operating leases. Capital expenditures have been incurred and leases entered into on anas-required basis, primarily to meet our growing operating needs.  As a result, our capital expenditures were$23.2 million and $20.2 million for the six months ended June 30, 2002 and2001, respectively.  For the six monthsended June 30, 2002, capital expenditures were comprised of approximately $16.3million in capitalized software and projects in process, $6.6 million in fixedassets and $0.3 million in leasehold improvements.  For the six months ended June 30, 2001, capital expenditures werecomprised of approximately $10.7 million in fixed assets, $6.0 million incapitalized software and projects in process and $3.5 million in leaseholdimprovements.

 

37

----

 

Stockholders’ equity at June 30, 2002 was $402.3 million, up 17%,from December 31, 2001.  The ratio ofstockholders’ equity to assets decreased to 6.0% at June 30, 2002 from 6.5% atDecember 31, 2001.

 

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

 

FRB and FDIC guidelines require that banking organizations have aminimum ratio of total capital to risk-adjusted assets and off-balance sheetitems of 8.0%.  Total capital is definedas the sum of “Tier I” and “Tier II” capital elements, with at leasthalf of the total capital required to be Tier I.  Tier I capital includes, with certain restrictions, the sum ofcommon stockholders’ equity, noncumulative perpetual preferred stock, a limitedamount of cumulative perpetual preferred stock, and minority interests inconsolidated subsidiaries, less certain intangible assets.  Tier II capital includes, with certainlimitations, subordinated debt meeting certain requirements, intermediate-termpreferred stock, certain hybrid capital instruments, certain forms of perpetualpreferred stock, as well as maturing capital instruments and general allowancesfor loan losses.

 

The followingtable summarizes our Tier I and total capital ratios at June 30, 2002 (Dollarsin thousands):

 
|                                            |   | **Amount** |      | **Ratio** |   |
|-------------------------------------------------|--------|------------|-----------|-----------|--------|
|                                            |   |       |      |      |   |
| Tier I capital                                  |   | $          | 336,156   |      | 16.67  | % |
| Tier I capital minimum requirement              |   | 80,647     |      | 4.00      | %      |
|                                            |   |       |      |      |   |
| Excess Tier I capital                           |   | $          | 255,509   |      | 12.67  | % |
|                                            |   |       |      |      |   |
| Total capital                                   |   | $          | 336,256   |      | 16.68  | % |
| Total capital minimum requirement               |   | 161,294    |      | 8.00      | %      |
|                                            |   |       |      |      |   |
| Excess total capital                            |   | $          | 174,962   |      | 8.68   | % |
|                                            |   |       |      |      |   |
| Risk adjusted assets, net of intangible  assets |   | $          | 2,016,170 |      |   |   |

 

The followingtable summarizes Investors Bank’s Tier I and total capital ratios at June 30,2002 (Dollars in thousands):

 
|                                            |   | **Amount** |      | **Ratio** |   |
|-------------------------------------------------|--------|------------|-----------|-----------|--------|
|                                            |   |       |      |      |   |
| Tier I capital                                  |   | $          | 330,618   |      | 16.40  | % |
| Tier I capital minimum requirement              |   | 80,639     |      | 4.00      | %      |
|                                            |   |       |      |      |   |
| Excess Tier I capital                           |   | $          | 249,979   |      | 12.40  | % |
|                                            |   |       |      |      |   |
| Total capital                                   |   | $          | 330,718   |      | 16.40  | % |
| Total capital minimum requirement               |   | 161,278    |      | 8.00      | %      |
|                                            |   |       |      |      |   |
| Excess total capital                            |   | $          | 169,440   |      | 8.40   | % |
|                                            |   |       |      |      |   |
| Risk adjusted assets, net of intangible  assets |   | $          | 2,015,979 |      |   |   |

 

In addition tothe risk–based capital guidelines, the FRB and the FDIC use a “LeverageRatio” as an additional tool to evaluate capital adequacy.  The Leverage Ratio is defined to be acompany’s Tier I capital divided by its adjusted total average assets.  The Leverage Ratio adopted by the federalbanking agencies requires a ratio of 3.0% for top-rated banking institutionsnot experiencing a period of rapid growth. All other banking institutions will be expected to maintain a LeverageRatio of 4.0% to 5.0%.  The computationof the risk–based capital ratios and the Leverage Ratio requires that ourcapital and that of the Bank be reduced by most intangible assets.  Our Leverage Ratio at June 30, 2002 was5.74%, which is in excess of regulatory requirements.  Investors Bank’s Leverage Ratio at June 30, 2002 was 5.64%, whichis in excess of regulatory requirements.

 

38

----

 

The followingtables present average balances, interest income and expense, and yields earnedor paid on the major categories of assets and liabilities for the periodsindicated (Dollars in thousands):

 
|                                                                 |   | **Six Months  Ended June 30, 2002** |      | **Six Months  Ended June 30, 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 |   | $                                   | 24,652    |                                | $      | 207 |   | 1.68 | % | $ | 43,536 |   | $ | 1,196 |   | 5.49 | % |
| Investment securities (1)                                            |   | 5,229,213                           |      | 119,016                             |   | 4.55 | % | 3,805,830 |   | 120,574 |   | 6.34 | % |
| Loans (2)                                                            |   | 107,614                             |      | 1,961                               |   | 3.64 | % | 110,225 |   | 2,848 |   | 5.17 | % |
| Total interest-earning assets                                        |   | 5,361,479                           |      | 121,184                             |   | 4.52 | % | 3,959,591 |   | 124,618 |   | 6.29 | % |
| Allowance for loan losses                                            |   | (100                                | )         |                                |   |   |   | (100 | ) |   |   |   |   |
| Noninterest-earning assets                                           |   | 333,483                             |      |                                |   |   |   | 223,127 |   |   |   |   |   |
| Total assets                                                         |   | $                                   | 5,694,862 |                                |   |   |   |   | $ | 4,182,618 |   |   |   |   |   |
| **Interest bearing liabilities:**                                    |   |                                |      |                                |   |   |   |   |   |   |   |   |   |
| Deposits:                                                            |   |                                |      |                                |   |   |   |   |   |   |   |   |   |
| Demand                                                               |   | $                                   | 1,660     |                                | $      | 4 |   | 0.48 | % | $ | 3,974 |   | $ | 39 |   | 1.96 | % |
| Savings                                                              |   | 1,707,024                           |      | 20,999                              |   | 2.46 | % | 1,682,005 |   | 36,678 |   | 4.36 | % |
| Time                                                                 |   | 2,809                               |      | 24                                  |   | 1.71 | % | 481 |   | 13 |   | 5.41 | % |
| Short-term borrowings                                                |   | 2,748,225                           |      | 17,765                              |   | 1.29 | % | 1,643,685 |   | 34,566 |   | 4.21 | % |
| Other borrowings                                                     |   | 398,343                             |      | 12,275                              |   | 6.16 | % | 197,532 |   | 4,908 |   | 4.97 | % |
| Total interest-bearing liabilities                                   |   | 4,858,061                           |      | 51,067                              |   | 2.10 | % | 3,527,677 |   | 76,204 |   | 4.32 | % |
| Noninterest-bearing liabilities                                      |   |                                |      |                                |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                      |   | 201,633                             |      |                                |   |   |   | 176,483 |   |   |   |   |   |
| Savings                                                              |   | 83,032                              |      |                                |   |   |   | 63,286 |   |   |   |   |   |
| Noninterest-bearing time deposits                                    |   | 90,000                              |      |                                |   |   |   | 65,000 |   |   |   |   |   |
| Other liabilities                                                    |   | 65,092                              |      |                                |   |   |   | 46,459 |   |   |   |   |   |
| Total liabilities                                                    |   | 5,297,818                           |      |                                |   |   |   | 3,878,905 |   |   |   |   |   |
| Trust preferred stock                                                |   | 24,281                              |      |                                |   |   |   | 24,252 |   |   |   |   |   |
| Equity                                                               |   | 372,763                             |      |                                |   |   |   | 279,461 |   |   |   |   |   |
| Total liabilities and equity                                         |   | $                                   | 5,694,862 |                                |   |   |   |   | $ | 4,182,618 |   |   |   |   |   |
| Net interest income                                                  |   |                                |      | $                                   | 70,117 |   |   |   |   |   | $ | 48,414 |   |   |   |
| Net interest margin (3)                                              |   |                                |      |                                |   | 2.62 | % |   |   |   |   | 2.45 | % |
| Average interest rate spread (4)                                     |   |                                |      |                                |   | 2.42 | % |   |   |   |   | 1.97 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities    |   |                                |      |                                |   | 110.36 | % |   |   |   |   | 112.24 | % |

 

----

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

(2)    Average yield on loansincludes accrual loan balances.

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

(4)    Yield on interest-earningassets less rate paid on interest-bearing liabilities.

 

**Item3.****          Quantitative andQualitative Disclosure 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.

 

39

----

 

**PART II. OTHER INFORMATION**

 

**Item4.**  Submission of Matters to a Vote of SecurityHolders.

 

Our annual meeting of stockholders was held on Tuesday, April 23,2002.  A vote was proposed to:

 

•                          Elect each of Donald G. Friedl and Phyllis S.Swersky as a Class I director of the Company, to serve for a three-year termand until his and her successor is elected and qualified.

•                          To approve an amendment and restatement of theCompany’s Amended and Restated 1995 Stock Plan to increase the number ofauthorized shares available for grant pursuant to the plan.

•                          To approve an amendment and restatement of theCompany’s Amended and Restated 1995 Non-Employee Director Stock Option Plan.

•                          To ratify the selection of Deloitte &Touche LLP as our independent auditors for our fiscal year ending December 31,2002.

 

All proposals were approved. The voting results were as follows:

** **
|   |   |                                                                       |   | **Votes  For** |   | **Votes  Against** |   | **Votes  Withheld** |   | **Abstained** |   |
|--------|--------|----------------------------------------------------------------------------|--------|----------------|--------|--------------------|--------|---------------------|--------|---------------|--------|
| (1)    |   | Donald G. Friedl                                                           |   | 28,698,574     |   | N/A                |   | 292,676             |   | N/A           |   |
|   |   | Phyllis S. Swersky                                                         |   | 28,541,222     |   | N/A                |   | 450,028             |   | N/A           |   |
| (2)    |   | Amendment and  restatement of  the 1995 Stock Plan                    |   | 22,286,883     |   | 6,650,768          |   | N/A                 |   | 53,599        |   |
| (3)    |   | Amendment and restatement of 1995 Non-Employee Director Stock Option  Plan |   | 27,089,642     |   | 1,819,108          |   | N/A                 |   | 82,500        |   |
| (4)    |   | Deloitte & Touche LLP                                                  |   | 28,410,897     |   | 556,936            |   | N/A                 |   | 23,417        |   |

 

Proposals2 and 3 regarding the Amended and Restated 1995 Stock Plan and Amended and RestatedNon-Employee Director Stock Option Plan are discussed in more detail in Note 7to the Condensed Consolidated Financial Statements presented in this Report.

 

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

 

(a)                                  On April 15, 2002 and June 26, 2002, the Companyfiled current reports on Form 8-K providing financial information pursuant toRegulation FD.

 

(b)                                 Exhibits

None.

 

40

----

 

**SIGNATURES**

 

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

 
|                        |   | **INVESTORS FINANCIAL SERVICES CORP.**                                                                                 |
|-----------------------------|--------|------------------------------------------------------------------------------------------------------------------------|
|                        |   |                                                                                                                   |
| Date:  August 14, 2002 | By:    | /s/ Kevin J. Sheehan                                                                                                   |
|                        |   | Kevin J.  Sheehan  Chairman and Chief Executive Officer                                                                |
|                        |   |                                                                                                                   |
|                        |   |                                                                                                                   |
|                        | By:    | /s/ John N.  Spinney, Jr.                                                                                              |
|                        |   | John N.  Spinney, Jr.  Senior Vice President and Chief Financial Officer  (Principal Financial and Accounting Officer) |

 

41

----