The head of State Street Corp.'s investment unit stepped down yesterday as the company set aside $618 million to deal with growing problems with investments tied to subprime mortgages.
State Street of Boston, the world's largest institutional money manager, has faced questions since fall about investments in vehicles that grew risky as world credit markets dried up.
The full extent of the risks became clear yesterday as State Street said William W. Hunt had resigned as head of its Global Advisors business, replaced on an interim basis by James S. Phalen.
State Street also acknowledged it faces legal liabilities and disclosed the reserve, which it said will lead it to take a $279 million charge in the fourth quarter of 2007. Chief executive Ronald E. Logue said it set up the reserve after discussions with customers and part of a broader review of its strategies.
"The issue here is one of looking at new market realities and making sure that we have in place enhanced risk and compliance issues to deal with those realities," Logue said yesterday during a conference call with stock analysts.
During the call, one analyst suggested the size of State Street's charge meant the company was capitulating to lawsuits brought by customers such as Prudential Financial Inc., which al leged State Street made more aggressive investments with certain bond funds than allowed under contracts, causing significant losses. "We're not capitulating on anything," Logue responded, but said he couldn't get into much detail, and a spokeswoman later said Logue, Hunt, and Phalen were not available to be interviewed.
State Street also did not provide more detail about which funds faced problems. In a subpoena to the company in October, Secretary of State William F. Galvin sought more information about a range of bond funds meant to provide stable returns for institutional clients, including its Intermediate Bond Fund and Government Credit Bond Fund, both named in Prudential's lawsuit.
Many short-term, supposedly conservative investments such as bond funds and money-market funds have been hurt as borrowers have struggled to pay back high-interest subprime mortgages. These subprime mortgages were packaged with less risky mortgages and sold to funds seeking slightly higher rates of return for their investors. But as the subprime market has unraveled, institutions such as Bank of America Corp. and Wachovia Corp. have had to bail out some of their funds, cutting into profits. Chief executives forced out by the credit crunch include Citigroup Inc.'s Charles Prince, who left the top job in November.
Analysts mostly responded positively, however, to State Street's news, which was offset by its forecasts that earnings per share and returns on equity for 2007 would be higher than predictions it made in October, and that 2007 revenue would grow more than 30 percent over what it took in the previous year on strong results in other business lines. Shares in State Street rose $6.49, or 8.2 percent, to close at $85.37.
"In this environment, there are not too many financial companies that offer this level of attractiveness," Punk Ziegel & Co. analyst Richard Bove wrote yesterday in a note to clients in which he also raised his rating to "buy" from "market perform." Despite the issues that led to the charge, he wrote, State Street's earnings are gaining steam as it wins clients and capitalizes on acquisitions, such as its $4.2 billion purchase last year of a Boston rival, Investors Financial Services Corp.
"I think State Street came out front and center to say, 'We've got a problem; we've taken a sizable charge; we fired the people who got us into it,' " said RBC Capital Markets analyst Gerard Cassidy. "It's a bitter pill, and now they're moving on."
Hunt will receive roughly $14.1 million in cash and stock compensation and benefits under the terms of a severance agreement worked out on Wednesday, State Street said in a securities filing.
Hunt's departure is still a blow for State Street, whose Global Advisors unit has been an important earnings driver but also the location of many internal struggles over the years, including one in 2005 when leaders named Hunt to lead the unit in place of a pair of interim officials who ran it after the unexpected death of Timothy Harbert in 2004.
Global Advisors, which manages money for institutional clients, has $2 trillion in assets under management, up from $1.4 trillion at the end of 2005. Logue had made the unit's growth a priority.
It now seems that some of the money was drawn in by high returns based on aggressive bets that proved vulnerable as world credit markets began to seize up in the second half of last year. In October, Logue acknowledged he was disappointed in the poor performance of "a small number of fixed-income strategies" at Global Advisors, and the next month the company reported the departure of several executives, including Sean Flannery, its top North American investment officer.
According to a review State Street released yesterday, it managed $244 billion in fixed-income assets as of June 30, of which $36 billion was "actively managed," or invested at the discretion of company traders and executives. Of this, about $13.9 billion was invested in instruments backed by subprime mortgages.
This pool had fallen in value to $8.2 billion by September as managers struggled to cope with the subprime mess and some customers pulled out money, "which worsened the liquidity issues in certain instances," Logue said on the conference call.
The company, however, Logue said, will defend against claims such as those for losses tied solely to market changes, and he said it has taken steps to avoid similar problems in the future. Among other things, he said, the company has avoided any subprime investments in its money-market funds.
Ross Kerber can be reached at kerber@globe.com.
