A Nightmare on State Street

By PETER EAVIS Reality has already bitten. On the same day President Barack Obama took office, bank stocks experienced one of their worst-ever selloffs. State Street -- previously considered a safe bet because it doesn't have a large loan book that could experience high defaults -- more than halved in value. With uncanny clarity, its stumble frames many of the problems the Obama Treasury now has to address as it attempts to rebuild the financial sector. State Street's main revenue source is fees from services such as securities custody and asset management. But in Tuesday's fourth-quarter results, State Street reported higher paper losses on its $78.9 billion of bond holdings than analysts expected. Mark-to-market losses increased $3 billion in the fourth quarter to $6.3 billion. A Morgan Stanley analyst was expecting a $1 billion increase. Citigroup and J.P. Morgan Chase also reported large paper bond losses in the fourth quarter. These system-wide losses point to a serious problem for the new Treasury: a lack of appetite for certain types of bonds. Recent Federal Reserve policies aimed at bringing confidence and liquidity to credit markets have sparked rallies for certain bonds, such as mortgage-backed securities backed by Fannie Mae and Freddie Mac. But corporate bonds remain priced at distressed levels. As a result, President Obama's policy makers might step up the Fed's commitments to buy bonds. And to avoid selloffs in bonds excluded from Fed purchase commitments, the central bank could buy broad baskets of fixed-income securities. Such an initiative wouldn't come out of the blue. In a November speech, Richard Fisher, president of the Dallas Fed, said he wouldn't be surprised to see the Fed's balance sheet swell to $3 trillion by the end of 2008 as it bought assets and lent against them. It is currently at $2.09 trillion. But State Street's slide also concerns capital -- the other big problem. Indeed, State Street's capital numbers underscore the need for the government to introduce capital measures investors can trust. For instance, State Street's Tier 1 capital ratio is an industry-beating 20.5%. But investors are looking past this and calculating tangible common equity as a percentage of tangible assets, factoring in State Street's off-balance-sheet vehicles. Done that way, capital is a wafer-thin 1.05% of assets. Since this approach to capital now reigns for investors, the Obama team needs to find ways to raise it across the sector. The problem is that the equity markets are in no mood to buy the common stock required to achieve this. The government is the sole investor of size. But taking sizable common stakes in banks would leave the government owning them, and then restructuring their balance sheets to make them viable. Increased expectations of that outcome were no doubt behind Tuesday's bank-stock massacre. Write to Peter Eavis at peter.eavis@wsj.com