EX-13 16 dex13.htm 2008 ANNUAL REPORT TO STOCKHOLDERS 2008 Annual Report to Stockholders
Table of Contents

 

Exhibit 13

FINANCIAL REVIEW

 

20

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

60

Management’s Report on Internal Control Over Financial Reporting

 

61

Report of Independent Registered Public Accounting Firm with Respect to Internal Control over Financial Reporting

 

62

Consolidated Financial Statements

 

66

Notes to Consolidated Financial Statements

 

105

Report of Independent Registered Public Accounting Firm

 

106

Consolidated Financial Statistics

 

109

Senior Officers

 

110

Board of Directors

 

111

Corporate Information


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA

 

($ In Millions Except Per Share Information)   2008        2007        2006        2005        2004  
 

FOR THE YEAR ENDED DECEMBER 31

                                                   

Noninterest Income

                                                   

Trust, Investment and Other Servicing Fees

  $ 2,134.9        $ 2,077.6        $ 1,791.6        $ 1,559.4        $ 1,330.3  

Foreign Exchange Trading Income

    616.2          351.3          247.3          180.2          158.0  

Security Commissions and Trading Income

    77.0          67.6          62.7          55.2          50.5  

Treasury Management Fees

    72.8          65.3          65.4          71.2          88.1  

Gain on Visa Share Redemption

    167.9                                      

Other Operating Income

    186.9          95.3          83.0          85.2          78.0  

Investment Security Gains (Losses), net

    (56.3 )        6.5          1.4          .3          .2  
                                                     

Total Noninterest Income

    3,199.4          2,663.6          2,251.4          1,951.5          1,705.1  
                                                     

Net Interest Income

    1,079.1          845.4          744.7          673.7          566.9  

Provision for Credit Losses

    115.0          18.0          15.0          2.5          (15.0 )
                                                     

Income before Noninterest Expenses

    4,163.5          3,491.0          2,981.1          2,622.7          2,287.0  
                                                     

Noninterest Expenses

                                                   

Compensation

    1,133.1          1,038.2          876.6          774.2          661.7  

Employee Benefits

    223.4          234.9          217.6          190.4          161.5  

Outside Services

    413.8          386.2          316.2          268.0          228.0  

Equipment and Software Expense

    241.2          219.3          205.3          196.6          192.8  

Occupancy Expense

    166.1          156.5          145.4          133.7          121.5  

Visa Indemnification Charges

    (76.1 )        150.0                             

Other Operating Expenses

    786.3          245.1          195.8          172.0          166.2  
                                                     

Total Noninterest Expenses

    2,887.8          2,430.2          1,956.9          1,734.9          1,531.7  
                                                     

Income before Income Taxes

    1,275.7          1,060.8          1,024.2          887.8          755.3  

Provision for Income Taxes

    480.9          333.9          358.8          303.4          249.7  
                                                     

Net Income

  $ 794.8        $ 726.9        $ 665.4        $ 584.4        $ 505.6  

Net Income Applicable to Common Stock

  $ 782.8        $ 726.9        $ 665.4        $ 584.4        $ 505.6  
                                                     

Average Total Assets

  $ 73,029        $ 60,588        $ 53,106        $ 45,974        $ 41,300  
 

PER COMMON SHARE

                                                   

Net Income – Basic

  $ 3.53        $ 3.31        $ 3.06        $ 2.68        $ 2.30  

                    – Diluted

    3.47          3.24          3.00          2.64          2.27  

Cash Dividends Declared

    1.12          1.03          .94          .86          .78  

Book Value – End of Period (EOP)

    21.89          20.44          18.03          16.51          15.04  

Market Price – EOP

    52.14          76.58          60.69          51.82          48.58  
 

AT YEAR END

                                                   

Senior Notes

    1,053          654          445          272          200  

Long-Term Debt

    3,293          2,682          2,308          2,818          2,625  

Floating Rate Capital Debt

    277          277          276          276          276  
                                                     

Stockholders

    2,799          2,842          3,040          3,239          3,525  

Staff (full-time equivalent)

    12,200          10,900          9,700          9,000          8,000  
 

RATIOS

                                                   

Dividend Payout Ratio

    32.0 %        31.4 %        30.8 %        32.1 %        33.9 %

Return on Average Assets

    1.09          1.20          1.25          1.27          1.22  

Return on Average Common Equity

    15.98          17.46          17.57          17.01          16.07  

Tier 1 Capital to Risk-Weighted Assets – EOP

    13.1          9.7          9.8          9.7          11.0  

Total Capital to Risk-Weighted Assets – EOP

    15.4          11.9          11.9          12.3          13.3  

Risk-Adjusted Leverage Ratio

    8.5          6.8          6.7          7.1          7.6  

Average Stockholders’ Equity to Average Assets

    7.0          6.9          7.1          7.5          7.6  

 

OPERATING RESULTS – EXCLUDING VISA RELATED ADJUSTMENTS

 

($ In Millions Except Per Share Information)   2008        2007        2006        2005        2004  

Operating Earnings

  $ 641.3        $ 821.1        $ 665.4        $ 584.4        $ 505.6  
                                                     

Operating Earnings per Common Share – Basic

  $ 2.84        $ 3.73        $ 3.06        $ 2.68        $ 2.30  

                                                                  – Diluted

    2.79          3.66          3.00          2.64          2.27  
                                                     

Operating Return on Average Common Equity

    12.89 %        19.72 %        17.57 %        17.01 %        16.07 %

Operating results for 2008 and 2007 exclude adjustments relating to Visa Inc. (Visa). Excluded are Visa indemnification related charges totaling $150.0 million recorded in 2007, and benefits totaling $244.0 million recorded in 2008 in connection with Visa’s initial public offering. The 2008 benefits included a gain on the mandatory partial redemption of Northern Trust’s Visa shares totaling $167.9 million and a $76.1 million offset of the Visa indemnification related charges recorded in 2007. Visa related adjustments are discussed in further detail in Note 20 to the consolidated financial statements.

 

NORTHERN TRUST CORPORATION 2008 ANNUAL REPORT TO SHAREHOLDERS

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Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW OF CORPORATION

 

Focused Business Strategy

 

Northern Trust Corporation (Northern Trust or the Corporation) is a leading provider of global financial solutions for asset management, asset servicing, fiduciary, and banking needs of corporations, institutions, and affluent individuals. Northern Trust is focused on the management, custody, and servicing of client assets in two target market segments, successful individuals, families, and privately-held businesses through its Personal Financial Services (PFS) business unit and institutional investors worldwide through its Corporate and Institutional Services (C&IS) business unit. An important element of this strategy is to provide an array of asset management and related service solutions to PFS and C&IS clients which are provided by a third business unit, Northern Trust Global Investments (NTGI). In executing this strategy, Northern Trust emphasizes quality through a high level of service complemented by the effective use of technology. Operating and systems support for these business units is provided through the Operations and Technology (O&T) business unit.

 

Business Structure

 

Northern Trust is a financial holding company that is a leading provider of investment management, asset and fund administration, fiduciary, and banking solutions for corporations, institutions, and successful individuals, families, and privately-held businesses. The Corporation conducts business through various U.S. and non-U.S. subsidiaries, including The Northern Trust Company (Bank). The Corporation has a network of 85 offices in 18 U.S. states and has offices in 15 international locations outside the U.S.

Except where the context otherwise requires, the term “Northern Trust” refers to Northern Trust Corporation and its subsidiaries on a consolidated basis.

 

FINANCIAL OVERVIEW

 

Northern Trust Corporation reported net income of $794.8 million in 2008, as compared with net income of $726.9 million in 2007. Reported results in both 2008 and 2007 were impacted by various adjustments related to Visa, Inc. (Visa), as further described in Note 20 to the consolidated financial statements.

Northern Trust is providing operating earnings in order to present a clearer indication of the results and trends in our core businesses, absent adjustments related to Visa. A reconciliation of operating earnings to reported earnings prepared in accordance with U.S. generally accepted accounting principles (GAAP) is included in the table below.

 

    2008      2007
($ In Millions Except Per
Share Data)
  Amount      Per Share      Amount    Per Share

Reported Earnings

  $ 794.8      $ 3.47      $ 726.9    $ 3.24

Visa Indemnification Accrual (net of tax effects of $28.2 in 2008 and $55.8 in 2007)

    (47.9 )      (.21 )      94.2      .42

Visa Initial Public Offering (net of $62.3 tax effect)

    (105.6 )      (.47 )          
                                

Operating Earnings

  $ 641.3      $ 2.79      $ 821.1    $ 3.66

 

Excluding the impact of Visa related items, Northern Trust achieved operating earnings of $641.3 million in 2008, down 22% as compared with $821.1 million in operating earnings achieved in 2007. Operating net income per common share equaled $2.79 in 2008, down 24% from $3.66 per common share in 2007.

Northern Trust’s 2008 results were strong in the context of the extremely difficult market and economic conditions of the past year. Revenues, excluding Visa related items, equaled a record $4.16 billion on a fully taxable equivalent (FTE) basis, an increase of 16% from 2007. Trust, investment and other servicing fees, the largest component of consolidated revenues, totaled $2.13 billion, up 3% compared with the prior year, reflecting new business, partially offset by the effect of lower market valuations. Foreign exchange trading income and net interest income (FTE) both achieved record levels in 2008. Foreign exchange trading income increased 75% and totaled $616.2 million, reflecting strong client volumes and high levels of currency volatility throughout 2008. Net interest income (FTE) increased 24% and totaled $1.13 billion, primarily reflecting higher levels of average earning assets and an increase in the net interest margin from 1.70% in 2007 to 1.76% in 2008.

 

NORTHERN TRUST CORPORATION 2008 ANNUAL REPORT TO SHAREHOLDERS

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Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Noninterest expenses, excluding Visa related adjustments, equaled $2.96 billion and increased 30% when compared with 2007. Northern Trust’s results in 2008 were negatively impacted by the following client support related and other significant charges recorded during the year:

 

Client Support Related Charges

 

Ÿ  

Pre-tax charges totaling $314.1 million ($198.8 million after tax, or $.88 per common share) in connection with support provided to cash investment funds under capital support agreements.

Ÿ  

Pre-tax charges totaling $167.6 million ($106.1 million after tax, or $.47 per common share) in connection with actions taken to provide support for Northern Trust’s securities lending clients.

Ÿ  

A $54.6 million pre-tax charge ($34.5 million after tax, or $.15 per common share) related to the establishment of a program to purchase certain illiquid auction rate securities that were purchased by a limited number of Northern Trust clients.

 

Other Significant Charges

 

Ÿ  

A $38.9 million pre-tax charge ($100.2 million after tax, or $.44 per common share) reducing net interest income and increasing income taxes to revised estimates regarding the outcome of the Corporation’s tax position with respect to certain structured leasing transactions.

Ÿ  

A $61.3 million pre-tax charge ($38.8 million after tax, or $.17 per common share) to reflect the other-than-temporary impairment of six asset-backed securities held within Northern Trust’s balance sheet investment portfolio.

Ÿ  

A $19.2 million pre-tax charge ($13.0 million after tax, or $.06 per common share) associated with severance and benefits and other operating costs in connection with the previously announced plan to reduce staff expense levels and better position the company for improved profitability and continued global growth.

 

Partially offsetting these charges were reductions in performance-based compensation and defined contribution plan expense, primarily reflecting the impact of the above charges on full year performance.

The provision for credit losses increased significantly in 2008, totaling $115.0 million as compared with $18.0 million in 2007. The higher provision for credit losses reflects both loan growth and the weak economic environment. Loans and leases equaled $30.8 billion at year end, an increase of 21% when compared with $25.3 billion at the end of 2007. The credit quality of our loan portfolio continued to be strong, with nonperforming assets at year end equal to only $100.2 million, or 0.33% of total loans and other real estate owned.

Reflecting the difficult market and economic environment, Northern Trust achieved only one of its four long-term, across cycle, strategic financial targets, measured exclusive of Visa related items. In 2008, we achieved revenue growth of 16%, exceeding our goal of 8-10% revenue growth. Strategic financial targets that were not achieved in 2008 were:

Ÿ  

earnings per share growth goal of 10-12% (operating earnings per share declined 24%);

Ÿ  

return on common equity goal of 16-18% (return on common equity equaled 12.89%); and

Ÿ  

positive operating leverage goal (expense growth exceeded revenue growth).

Client assets under custody equaled $3.01 trillion at year end 2008, down 27% from $4.14 trillion one year earlier. Client assets under management equaled $558.8 billion, down 26% from $757.2 billion the prior year. The decline in client assets reflects the market environment in 2008, which saw a 38% decline in the S&P 500® index and a 45% decline in the international MSCI EAFE® (USD) index. Partially offsetting the impact of market depreciation in 2008 was new business won from both existing and new clients.

Northern Trust continues to maintain its strong capital position, exceeding “well capitalized” levels under federal bank regulatory capital requirements. At year end, total stockholders’ equity equaled $6.39 billion, an increase of 42% from $4.51 billion one year earlier. The increase reflects the issuance of senior preferred stock and a related warrant to the U.S. Department of the Treasury pursuant to the terms of its Capital Purchase Program and the retention of earnings, offset in part by the repurchase of common stock.

 

CONSOLIDATED RESULTS OF OPERATIONS

 

REVENUE

Northern Trust generates the majority of its revenues from noninterest income, primarily consisting of trust, investment and other servicing fees. Net interest income comprises the remainder of revenues and consists of interest income generated by earning assets, net of interest expense on deposits and borrowed funds.

Total revenue for 2008 was $4.33 billion on a fully taxable equivalent basis, up 21% from $3.57 billion in 2007, which in turn was up 17% from 2006 revenues of $3.06 billion. When adjusted to an FTE basis, yields on taxable, nontaxable, and partially taxable assets are comparable, although the adjustment to an FTE basis has no impact on net income. Noninterest income totaled $3.20 billion in 2008, up 19%

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

from $2.66 billion in 2007, and represented 74% of total taxable equivalent revenue in 2008. Noninterest income of $2.66 billion in 2007 was up 18% from $2.25 billion in 2006, and represented 75% of total taxable equivalent revenue in 2007.

Net interest income for 2008 was $1.08 billion, up 28% from $845.4 million in 2007, which was up 14% from $744.7 million in 2006.

The largest contributor to the current year growth in revenues and noninterest income was foreign exchange trading income, up 75% to $616.2 million compared with $351.3 million in 2007. The increase in net interest income in 2008 is primarily attributable to a $10.8 billion or 20% increase in average earning assets and an increase in the net interest margin to 1.76% from 1.70% in 2007. Trust, investment and other servicing fees, the largest component of noninterest income, increased 3% to $2.13 billion compared with 2007 fees of $2.08 billion, reflecting new business offset by lower market valuations. Additional information regarding Northern Trust’s revenues by type is provided below.

 

2008 TOTAL REVENUE OF $4.33 BILLION (FTE)

 

LOGO

 

Noninterest Income

 

The components of noninterest income, and a discussion of significant changes during 2008 and 2007, are provided below.

 

NONINTEREST INCOME

 

(In Millions)   2008      2007    2006

Trust, Investment and Other Servicing Fees

  $ 2,134.9      $ 2,077.6    $ 1,791.6

Foreign Exchange Trading Income

    616.2        351.3      247.3

Security Commissions and Trading Income

    77.0        67.6      62.7

Treasury Management Fees

    72.8        65.3      65.4

Gain on Visa Share Redemption

    167.9            

Other Operating Income

    186.9        95.3      83.0

Investment Security Gains (Losses), net

    (56.3 )      6.5      1.4
                       

Total Noninterest Income

  $ 3,199.4      $ 2,663.6    $ 2,251.4

 

2008 NONINTEREST INCOME

 

LOGO

 

Trust, Investment and Other Servicing Fees

Trust, investment and other servicing fees accounted for 49% of total taxable equivalent revenue in 2008. Trust, investment and other servicing fees for 2008 increased 3% to $2.13 billion from $2.08 billion in 2007. Over the past five years, trust, investment and other servicing fees have increased at a compound annual growth rate of 12.4%. For a more detailed discussion of trust, investment and other servicing fees, refer to the “Business Unit Reporting” section.

Trust, investment and other servicing fees are generally based on the market value of assets custodied, managed, and serviced; the volume of transactions; securities lending volume and spreads; and fees for other services rendered. Certain market value calculations are performed on a monthly or quarterly basis in arrears. Certain investment management fee arrangements also may provide for performance fees, based on client portfolio returns exceeding predetermined levels. Securities lending fees are also impacted by Northern Trust’s share of unrealized investment gains and losses in one investment fund, used in our securities lending activities, that is accounted for at fair value. Based on analysis of historical trends and current asset and product mix, management estimates that a 10% rise or fall in overall equity markets would cause a corresponding increase or decrease in Northern Trust’s trust, investment and other servicing fees of approximately 4% and in total revenues of approximately 2%.

 

NORTHERN TRUST CORPORATION 2008 ANNUAL REPORT TO SHAREHOLDERS

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following table presents selected average month-end, average quarter-end, and year-end equity market indices and the percentage changes year over year.

 

MARKET INDICES   AVERAGE OF MONTH-END   AVERAGE OF QUARTER-END   YEAR-END  
    2008      2007      CHANGE   2008      2007      CHANGE   2008      2007      CHANGE  

S&P 500 ®

  1,215      1,477      (18)%   1,168      1,475      (21)%   903      1,468      (38 )%

MSCI EAFE ® *

  1,777      2,230      (20)%   1,699      2,241      (24)%   1,237      2,253      (45 )%
                                                         

* In U.S. dollars.

                                                       

 

In addition, C&IS client relationships are generally priced to reflect earnings from activities such as foreign exchange trading and custody-related deposits that are not included in trust, investment and other servicing fees. Custody-related deposits maintained with bank subsidiaries and foreign branches are primarily interest-bearing and averaged $33.2 billion in 2008, $28.3 billion in 2007, and $20.7 billion in 2006. Total assets under custody at December 31, 2008, which form the primary basis of our trust, investment and other servicing fees, were $3.01 trillion, down 27% from $4.14 trillion a year ago, and included $1.42 trillion of global custody assets. Managed assets totaled $558.8 billion, down 26% from $757.2 billion at the end of 2007. The above are in comparison to the twelve month declines in the S&P 500® index of approximately 38% and the MSCI EAFE® index (USD) of approximately 45% noted above.

 

ASSETS UNDER CUSTODY                  DECEMBER 31            

PERCENT

CHANGE

   

FIVE-YEAR
COMPOUND
GROWTH

RATE

 
($ In Billions)   2008      2007      2006      2005      2004      2008/07    

Corporate & Institutional

  $ 2,719.2      $ 3,802.9      $ 3,263.5      $ 2,699.7      $ 2,345.1      (28 )%   7 %

Personal

    288.3        332.3        281.9        225.6        209.3      (13 )   9  
                                                          

Total Assets Under Custody

  $ 3,007.5      $ 4,135.2      $ 3,545.4      $ 2,925.3      $ 2,554.4      (27 )%   8 %

 

C&IS ASSETS UNDER CUSTODY ($ in Billions)

 

  

PFS ASSETS UNDER CUSTODY ($ in Billions)

 

LOGO    LOGO

 

ASSETS UNDER MANAGEMENT                  DECEMBER 31            

PERCENT

CHANGE

   

FIVE-YEAR
COMPOUND
GROWTH

RATE

 
($ In Billions)   2008      2007      2006      2005      2004      2008/07    

Corporate & Institutional

  $ 426.4      $ 608.9      $ 562.5      $ 500.7      $ 461.5      (30 )%   3 %

Personal

    132.4        148.3        134.7        117.2        110.4      (11 )   5  
                                                          

Total Managed Assets

  $ 558.8      $ 757.2      $ 697.2      $ 617.9      $ 571.9      (26 )%   3 %

 

C&IS ASSETS UNDER MANAGEMENT ($ in Billions)

 

  

PFS ASSETS UNDER MANAGEMENT ($ in Billions)

 

LOGO    LOGO

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Foreign Exchange Trading Income

Northern Trust provides foreign exchange services in the normal course of business as an integral part of its global custody services. Active management of currency positions, within conservative limits, also contributes to trading income. Foreign exchange trading income totaled a record $616.2 million in 2008 compared with $351.3 million in 2007. The increase reflects strong client volumes as well as exceptionally high currency volatility.

 

Security Commissions and Trading Income

Revenues from security commissions and trading income totaled $77.0 million in 2008, compared with $67.6 million in 2007. This income is primarily generated from securities brokerage services provided by Northern Trust Securities, Inc. (NTSI). The increase in 2008 primarily reflects increased revenue from core brokerage services.

 

Treasury Management Fees

The fee portion of treasury management revenues totaled $72.8 million in 2008, up 11% from the $65.3 million reported in 2007. The increase resulted from more clients electing to pay for services in fees rather than with compensating deposit balances.

 

Gain on Visa Share Redemption

A gain of $167.9 million was realized in connection with Visa Inc.’s (Visa) March 2008 initial public offering.

 

Other Operating Income

The components of other operating income were as follows:

 

(In Millions)   2008    2007      2006  

Loan Service Fees

  $ 30.0    $ 16.5      $ 17.1  

Banking Service Fees

    39.4      35.7        35.8  

Non-Trading Foreign Exchange Gains (Losses)

    36.1      2.1        (.6 )

Credit Default Swap Gains (Losses)

    35.4      4.8        (1.6 )

Loss on Sale of Non-U.S. Subsidiary

         (4.1 )       

Other Income

    46.0      40.3        32.3  
                         

Total Other Operating Income

  $ 186.9    $ 95.3      $ 83.0  

 

The increase in loan service fees from the prior year primarily reflects increased commercial loan-related commitment fees. The increase in non-trading foreign exchange gains primarily reflects the foreign exchange rate impact of translating non-U.S. dollar denominated assets and liabilities. Other income increased primarily as a result of higher custody-related deposit revenue.

 

Investment Security Gains (Losses)

Net investment security losses were $56.3 million in 2008 compared with gains of $6.5 million in 2007. Included in the 2008 losses is a $61.3 million charge recorded to adjust the book values of six asset-backed securities to their estimated fair values, as management determined the securities to be other-than-temporarily impaired. Gains of $4.9 million and $6.3 million were recorded in 2008 and 2007, respectively, from the sale of CME Group Inc. stock acquired from the demutualizations and subsequent merger of the Chicago Mercantile Exchange and the Chicago Board of Trade.


NONINTEREST INCOME — 2007 COMPARED WITH 2006

Trust, investment and other servicing fees for 2007 accounted for 78% of total noninterest income and 58% of total taxable equivalent revenue and increased 16% to $2.08 billion from $1.79 billion for 2006. The increase from 2006 reflects the benefits of strong growth in global fees, strong new business, and higher equity markets. Total assets under custody at December 31, 2007 were $4.14 trillion, up 17% from $3.55 trillion in 2006, and included $2.09 trillion of global custody assets. Managed assets totaled $757.2 billion, up 9% from $697.2 billion at the end of 2006.

Foreign exchange trading income totaled $351.3 million in 2007, a 42% increase compared with $247.3 million in 2006. The increase primarily reflects strong client volumes as well as higher currency volatility.

Revenues from security commissions and trading income totaled $67.6 million in 2007, compared with $62.7 million in 2006, with the increase reflecting higher income from derivative instruments not designated in hedging relationships, partially offset by decreased revenue from core brokerage services and transition management services.

Total other operating income of $95.3 million in 2007 increased 15% from the 2006 balance of $83.0 million. 2007 included increases in the other income component resulting primarily from higher custody-related deposit revenue. Net security gains were $6.5 million in 2007 compared with net gains of $1.4 million in 2006.

 

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Net Interest Income

 

An analysis of net interest income on an FTE basis, major balance sheet components impacting net interest income, and related ratios are provided below.

 

ANALYSIS OF NET INTEREST INCOME [FTE]

 

                       PERCENT CHANGE  
($ In Millions)   2008      2007     2006     2008/07     2007/06  

Interest Income

  $ 2,478.5      $ 2,784.2     $ 2,249.7     (11.0 )%   23.8 %

FTE Adjustment

    49.8        62.5       64.8     (20.3 )   (3.5 )
                                      

Interest Income – FTE

    2,528.3        2,846.7       2,314.5     (11.2 )   23.0  

Interest Expense

    1,399.4        1,938.8       1,505.0     (27.8 )   28.9  
                                      

Net Interest Income – FTE Adjusted

  $ 1,128.9      $ 907.9     $ 809.5     24.3 %   12.1 %
                                      

Net Interest Income – Unadjusted

  $ 1,079.1      $ 845.4     $ 744.7     27.6 %   13.5 %
                                      

AVERAGE BALANCE

                                    

Earning Assets

  $ 64,249.9      $ 53,426.4     $ 45,994.8     20.3 %   16.2 %

Interest-Related Funds

    55,173.9        45,722.7       40,410.0     20.7     13.1  

Net Noninterest-Related Funds

    9,076.0        7,703.7       5,584.8     17.8     37.9  
                                      
                       CHANGE IN PERCENTAGE  

AVERAGE RATE

                                    

Earning Assets

    3.94 %      5.33 %     5.03 %   (1.39 )   .30  

Interest-Related Funds

    2.54        4.24       3.72     (1.70 )   .52  

Interest Rate Spread

    1.40        1.09       1.31     .31     (.22 )

Total Source of Funds

    2.18        3.63       3.27     (1.45 )   .36  

Net Interest Margin

    1.76 %      1.70 %     1.76 %   .06     (.06 )
                                      

Refer to pages 106 and 107 for a detailed analysis of net interest income.

 

Net interest income is defined as the total of interest income and amortized fees on earning assets, less interest expense on deposits and borrowed funds, adjusted for the impact of interest related hedging activity. Earning assets, which consist of securities, loans, and money market assets, are financed by a large base of interest-bearing funds, including personal and institutional deposits, wholesale deposits, short-term borrowings, senior notes, and long-term debt. Earning assets are also funded by net noninterest-related funds. Net noninterest-related funds include demand deposits, the reserve for credit losses, and stockholders’ equity, reduced by nonearning assets including cash and due from banks, items in process of collection and buildings and equipment. Variations in the level and mix of earning assets, interest-bearing funds, and net noninterest-related funds, and their relative sensitivity to interest rate movements, are the dominant factors affecting net interest income. In addition, net interest income is impacted by the level of nonperforming assets and client use of compensating deposit balances to pay for services.

Net interest income for 2008 was $1.08 billion, up 28% from $845.4 million in 2007. When adjusted to an FTE basis, yields on taxable, nontaxable, and partially taxable assets are comparable, although the adjustment to an FTE basis has no impact on net income. Net interest income on an FTE basis for 2008 was $1.13 billion, an increase of 24% from $907.9 million in 2007. The increase in net interest income in 2008 is primarily the result of a $10.8 billion or 20% increase in average earning assets, primarily money market assets and loans, and an increase in the net interest margin. The net interest margin increased to 1.76% from 1.70% in the prior year, reflecting a widening of the spread between interest rates on short-term investments and on overnight funding sources, including the impact of Federal Reserve Bank rate reductions. The results for 2008 and 2007 were negatively impacted by leasing related adjustments that reduced net interest income by $38.9 million and $13.0 million, respectively. Excluding the impact of the leasing adjustments, the net interest margin would have been 1.82% and 1.72%, respectively.

Earning assets averaged $64.2 billion, up 20% from the $53.4 billion reported in 2007. The growth in average earning assets reflects a $6.4 billion increase in money market assets, a $4.6 billion increase in loans and a $172.4 million decrease in securities.

Loans averaged $27.4 billion, 20% higher than last year. The year-to-year comparison reflects a 39% increase in average commercial loans to $7.0 billion. Residential mortgages rose 9% to average $9.7 billion and personal loans

 

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increased 33% to $4.4 billion. Non-U.S. loans decreased 4% to $1.6 billion in 2008 from the prior year average of $1.7 billion. Money market assets averaged $24.6 billion in 2008, up 35% from 2007 levels. Securities averaged $12.3 billion in 2008, down 1% from 2007. Government sponsored agency securities averaged $8.7 billion in 2008, down 11% from $9.7 billion in the prior year.

The increase in average earning assets of $10.8 billion was funded primarily through growth in interest-bearing deposits. The deposit growth was primarily in non-U.S. office interest-bearing deposits, up $7.4 billion, and reflects increased global custody activity. Savings and money market deposits were up 11% and savings certificates increased 5%. Other interest-related funds averaged $8.7 billion, up $1.1 billion due primarily to higher levels of senior and subordinated debt, and Federal Home Loan Bank borrowings. Average net noninterest-related funds increased 18% and averaged $9.1 billion, due primarily to higher levels of noninterest-bearing deposits in both domestic and non-U.S. offices. Stockholders’ equity for the year averaged $5.1 billion, an increase of $942.0 million or 23% from 2007, principally due to the retention of earnings and the issuance of senior preferred stock and related warrant to the U.S. Department of the Treasury, offset in part by the repurchase of 1.1 million shares of the Corporation’s common stock at a total cost of $75.1 million ($66.68 average price per share).

For additional analysis of average balances and interest rate changes affecting net interest income, refer to the Average Statement of Condition with Analysis of Net Interest Income on pages 106 and 107.


NET INTEREST INCOME — 2007 COMPARED WITH 2006

The increase in net interest income in 2007 was primarily the result of a $7.4 billion or 16% increase in average earning assets, primarily money market assets and loans, offset in part by a reduction in the net interest margin. The net interest margin decrease to 1.70% from 1.76% in 2006 reflects the $13.0 million negative impact of the 2007 lease adjustment, a narrowing of the interest rate spread to 1.09% in 2007 compared to 1.31% in 2006, and the significant growth in global custody related deposits which were invested in lower-yielding short-term money market assets and securities.

Earning assets averaged $53.4 billion in 2007, up 16% from the $46.0 billion reported in 2006. The growth in average earning assets in 2007 reflected a $4.5 billion increase in money market assets, a $2.3 billion increase in loans, and a $656.3 million increase in securities.

Loans averaged $22.8 billion in 2007, 11% higher than in 2006. The year-to-year comparison reflects a 19% increase in average commercial loans to $5.0 billion. Residential mortgages rose 4% to average $8.9 billion and personal loans increased 11% to $3.3 billion. Non-U.S. loans increased 36% to $1.7 billion in 2007 from the 2006 average of $1.3 billion. Money market assets averaged $18.1 billion in 2007, up 33% from 2006 levels. Securities averaged $12.5 billion in 2007, up 6% resulting primarily from higher levels of asset-backed and government sponsored agency securities.

The increase in average earning assets of $7.4 billion in 2007 was funded primarily through growth in interest-bearing deposits. The deposit growth was concentrated in non-U.S. office interest-bearing deposits, up $6.7 billion resulting from increased global custody activity. Savings and money market deposits were up 6% and savings certificates increased 19%. Other interest-related funds averaged $7.6 billion, down $2.2 billion due primarily to lower levels of federal funds purchased, securities sold under agreements to repurchase, and other borrowed funds. Average net noninterest-related funds increased 38% and averaged $7.7 billion, due primarily to higher levels of noninterest-bearing deposits in non-U.S. offices and other liabilities. Stockholders’ equity for 2007 averaged $4.2 billion, an increase of $377.5 million or 10% from 2006, principally due to the retention of earnings, offset in part by the repurchase of over 3.2 million shares of the Corporation’s common stock at a total cost of $218.9 million ($67.10 average price per share).

 

Provision for Credit Losses

 

The provision for credit losses was $115.0 million in 2008 compared with an $18.0 million provision in 2007 and a $15.0 million provision in 2006. The current year provision reflects loan growth and weakness in the broader economic environment. For a fuller discussion of the reserve and provision for credit losses for 2008, 2007, and 2006, refer to pages 53 through 55.

 

Noninterest Expenses

 

Noninterest expenses for 2008 totaled $2.89 billion, up 19% from $2.43 billion in 2007. On an operating basis, which excludes the impact in 2008 and 2007 of the Visa indemnification related charges discussed below, noninterest expenses increased $683.7 million or 30%. The 2008 results were negatively impacted by the $536.3 million of client support related charges. The components of noninterest expenses and a discussion of significant changes in balances during 2008 and 2007 are provided below.

 

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NONINTEREST EXPENSES

 

(In Millions)   2008      2007    2006

Compensation

  $ 1,133.1      $ 1,038.2    $ 876.6

Employee Benefits

    223.4        234.9      217.6

Outside Services

    413.8        386.2      316.2

Equipment and Software
Expense

    241.2        219.3      205.3

Occupancy Expense

    166.1        156.5      145.4

Visa Indemnification Charges

    (76.1 )      150.0     

Other Operating Expenses

    786.3        245.1      195.8
                       

Total Noninterest Expenses

  $ 2,887.8      $ 2,430.2    $ 1,956.9

 

Compensation and Benefits

Compensation costs, which are the largest component of noninterest expenses, increased $94.9 million, or 9% from 2007, reflecting the impact of higher staff levels, annual salary increases, and the $17.0 million charge in connection with the plan to reduce staff expense levels. Partially offsetting this increase was a $36.4 million decrease in performance-based compensation. Staff on a full-time equivalent basis averaged 11,679 in 2008, up 14% compared with 10,273 in 2007. Increases in 2008 were due primarily to additional staff to support international growth. Staff on a full-time equivalent basis totaled 12,200 at December 31, 2008 compared with 10,900 at December 31, 2007.

Employee benefit costs for 2008 totaled $223.4 million, down $11.5 million or 5% from $234.9 million in 2007. The current year reflects lower defined benefit and defined contribution plan expenses, partially offset by higher expenses related to employment taxes and health care costs.

 

Outside Services

Outside services expense totaled $413.8 million in 2008, up 7% from $386.2 million in 2007. The increase reflects higher expenses for legal fees, and technical, consulting, and other outsourced services. Technical services includes expenses for services such as systems and application support, the provision of market and research data, and outsourced check processing and lockbox services.

 

Equipment and Software Expense

Equipment and software expense, comprised of depreciation and amortization, rental, and maintenance costs, totaled $241.2 million, up 10% from $219.3 million in 2007. The increase resulted from higher computer software expense.

 

Occupancy Expense

Net occupancy expense totaled $166.1 million, up 6% from $156.5 million in 2007. Occupancy expense for 2008 reflects higher levels of operating expense and building maintenance, partially offset by lower levels of rent expense.

 

Visa Indemnification Charges

The 2008 expenses reflect the $76.1 million offset to the Visa indemnification accruals and related charges established in the fourth quarter of 2007. Northern Trust, as a member bank of Visa U.S.A., Inc., recorded 2007 charges totaling $150 million related to our obligation to share in potential losses resulting from certain indemnified litigation involving Visa. These charges were partially offset in the first quarter of 2008 by Northern Trust’s proportionate share of a litigation escrow account established by Visa to fund the settlements of, or judgments in, the indemnified litigation. Visa indemnification charges are further discussed in Note 20 to the consolidated financial statements.

 

Other Operating Expenses

The components of other operating expenses were as follows:

 

(In Millions)   2008    2007    2006

Business Promotion

  $ 87.8    $ 77.0    $ 65.2

Other Intangibles Amortization

    17.8      20.9      22.4

Capital Support Agreements

    314.1          

Securities Lending Client Support

    167.6          

Auction Rate Securities Purchase Program

    54.6          

Other Expenses

    144.4      147.2      108.2
                     

Total Other Operating Expenses

  $ 786.3    $ 245.1    $ 195.8

 

The increase in business promotion for the current year primarily reflects expenses related to the sponsorship of the Northern Trust Open golf tournament. Included in the current year other expenses component of other operating expenses are higher charges related to account servicing activities and legal matters, offset by a $20.1 million currency translation related benefit associated with Lehman Brothers bankruptcy matters.


NONINTEREST EXPENSE — 2007 COMPARED WITH 2006

Noninterest expenses for 2007 totaled $2.43 billion, up 24% from $1.96 billion in 2006. Excluding the $150.0 million of Visa indemnification charges, noninterest expenses for 2007 increased 17%. Compensation and employee benefits of $1.27 billion in 2007 represented 52% of total noninterest expenses. The year-over-year increase was $178.9 million, or 16%, from $1.09 billion in 2006. Compensation costs in 2007 totaled $1.04 billion, reflecting the impact of higher staff levels, higher performance-based compensation, and annual salary increases. Staff on a full-time equivalent basis averaged 10,273 in 2007, up 10% compared with 9,312 in 2006 due primarily to additional staff to support international growth. Staff on a full-time equivalent basis totaled 10,900 at December 31, 2007 compared with 9,700 at December 31, 2006.

 

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Employee benefit costs for 2007 totaled $234.9 million, up $17.3 million or 8% from $217.6 million in 2006. The increase reflects higher expenses related to employment taxes and health care costs.

Outside services expense totaled $386.2 million in 2007, 22% higher than the $316.2 million in 2006. The increase reflects higher expenses for technical and consulting services, and volume-driven growth in global subcustody and investment manager sub-advisor expenses.

Equipment and software expense, comprised of depreciation and amortization, rental, and maintenance costs, totaled $219.3 million in 2007, which was 7% higher than the $205.3 million in 2006. The increase in 2007 resulted from higher computer software expense.

Occupancy expense totaled $156.5 million in 2007, up 8% from $145.4 million in 2006. Occupancy expense for 2007 reflects increased levels of building maintenance and operating expense, and increased rental costs.

Other operating expenses for 2007 excluding the $150.0 million of Visa indemnification charges totaled $245.1 million, up 25% from $195.8 million in 2006, reflecting significantly higher charges related to account servicing activities, higher business promotion and advertising, and increased hiring and employee relocation costs.

 

Provision for Income Taxes

 

The provision for income tax expense was $480.9 million in 2008 representing an effective rate of 37.7%. This compares with $333.9 million in income tax expense and an effective rate of 31.5% in 2007. The 2008 provision reflects an increase in pre-tax earnings and a $61.3 million increase related to revised estimates regarding the outcome of the Corporation’s tax position with respect to certain structured leasing transactions. The current year effective rate excluding the impact of client support, Visa indemnification, and leasing related charges was 32.8%. The effective tax rate in 2008 reflects a $47.8 million reduction in the tax provision resulting from management’s decision to indefinitely reinvest earnings of certain non-U.S. subsidiaries as compared with $18.4 million in 2007. The 2007 effective tax rate benefited from a reduction in net deferred tax liabilities resulting from new state tax legislation enacted during 2007.


PROVISION FOR INCOME TAXES — 2007 COMPARED WITH 2006

The provision for income tax expense of $333.9 million in 2007 representing an effective rate of 31.5%, compared with income tax expense of $358.8 million and an effective rate of 35.0% in 2006. The effective tax rate in 2007 reflects an $18.4 million reduction in the tax provision resulting from management’s decision to indefinitely reinvest 2007 earnings of certain non-U.S. subsidiaries and compares with $7.9 million in 2006. The 2007 effective tax rate also benefited from a lower state income tax provision due to a higher proportion of income generated in tax jurisdictions outside the U.S. and a reduction in net deferred tax liabilities resulting from new state tax legislation enacted during 2007. The 2006 provision includes $16.8 million related to leveraged leasing transactions.

 

BUSINESS UNIT REPORTING

 

Northern Trust, under the leadership of President and Chief Executive Officer Frederick H. Waddell, is organized around its two principal client-focused business units, C&IS and PFS. Investment management services and products are provided to the clients of these business units by NTGI. Operating and systems support is provided to each of the business units by O&T. Effective January 1, 2008, Mr. Waddell became Chief Executive Officer of Northern Trust and its chief operating decision maker, having final authority over resource allocation decisions and performance assessment. Prior to January 1, 2008, William A. Osborn, Chairman of the Corporation, served as Northern Trust’s Chief Executive Officer and was considered the chief operating decision maker.

Information regarding the financial performance of C&IS and PFS is presented in order to promote a greater understanding of their financial performance. The information, presented on an internal management-reporting basis, is derived from internal accounting systems that support Northern Trust’s strategic objectives and management structure. Management has developed accounting systems to allocate revenue and direct expenses related to each segment, and which incorporate processes for allocating assets, liabilities, and equity, and the applicable interest income and expense. Equity is allocated based on the proportion of economic capital associated with the business units.

Allocations of capital and certain corporate expenses may not be representative of levels that would be required if the segments were independent entities. The accounting policies used for management reporting are consistent with those described in Note 1 to the consolidated financial statements. Transfers of income and expense items are recorded at cost; there is no profit or loss on sales or transfers between business units. Northern Trust’s presentations are not necessarily consistent with similar information for other financial institutions.

 

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In 2008, Northern Trust transitioned to new management accounting systems. In connection with the implementation of the new systems, enhancements were made to certain management accounting methodologies used for business unit reporting. These enhancements include changes in the application of funds transfer pricing used in calculating net interest income and revisions to the methodologies for allocating revenue, expense, and capital. These changes had no impact on Northern Trust’s consolidated results of operation or financial condition. Prior year information on a comparable basis is not available and, as a result, year over year changes are not necessarily indicative of changes in business unit performance from the prior year.

 

 

In this transition year, internal management reporting is centered on business unit direct contribution, defined as revenues less provision for credit losses and direct expenses. Direct expenses are those incurred directly by each business unit and exclude expenses relating to product and operating support provided by NTGI, O&T, and other support service functions. For management reporting purposes, expenses associated with NTGI and O&T, the impact of long-term debt and holding company investments, and certain corporate operating expenses and nonrecurring items are not allocated to the business units and are presented as part of “Treasury and Other Support Services.” Although prior year information has not been restated, business unit direct expenses and direct contribution for the prior years have been provided in the tables below for comparative purposes.

 

CONSOLIDATED FINANCIAL INFORMATION

 

(In Millions)   2008        2007      2006

Noninterest Income

                         

Trust, Investment and Other Servicing Fees

  $ 2,134.9        $ 2,077.6      $ 1,791.6

Gain on Visa Share Redemption

    167.9                

Other

    896.6          586.0        459.8

Net Interest Income (FTE)*

    1,128.9          907.9        809.5
                           

Revenues (FTE)*

    4,328.3          3,571.5        3,060.9

Provision for Credit Losses

    115.0          18.0        15.0

Visa Indemnification Charges

    (76.1 )        150.0       

Direct Expenses

    2,963.9          2,280.2        1,956.9
                           

Total Direct Contribution*

    1,325.5          1,123.3        1,089.0
                           

Average Assets

  $ 73,028.5        $ 60,588.0      $ 53,105.9
                           

* Stated on an FTE basis. The consolidated figures include $49.8 million, $62.5 million, and $64.8 million of FTE adjustment for 2008, 2007, and 2006, respectively.

 

Corporate and Institutional Services

 

The C&IS business unit is a leading global provider of asset servicing, asset management, and related services to corporate and public retirement funds, foundations, endowments, fund managers, insurance companies, and government funds. C&IS also offers a full range of commercial banking services, placing special emphasis on developing and supporting institutional relationships in two target markets: large and mid-sized corporations and financial institutions. Asset servicing, asset management, and related services encompass a full range of state-of-the-art capabilities including: global master trust and custody, trade settlement, and reporting; fund administration; cash management; investment risk and performance analytical services; and investment operations outsourcing. Client relationships are managed through the Bank and the Bank’s and the Corporation’s subsidiaries, including support from international locations in North America, Europe, the Asia-Pacific region and the Middle East. Asset servicing relationships managed by C&IS often include investment management, securities lending, transition management, and commission recapture services provided through the NTGI business unit. C&IS also provides related foreign exchange services in the U.S., U.K., Guernsey, and Singapore.

 

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The following table summarizes the direct contribution of C&IS for the years ended December 31, 2008, 2007, and 2006 on a management-reporting basis.

 

CORPORATE AND INSTITUTIONAL SERVICES

DIRECT CONTRIBUTION

 

(In Millions)   2008      2007      2006

Noninterest Income

                       

Trust, Investment and Other Servicing Fees

  $ 1,225.9      $ 1,179.8      $ 1,012.4

Other

    804.6        462.8        346.7

Net Interest Income (FTE)

    571.1        423.2        330.0
                         

Revenues (FTE)

    2,601.6        2,065.8        1,689.1

Provision for Credit Losses

    25.2        4.5        9.1

Direct Expenses

    856.3        377.7        331.0
                         

Direct Contribution

  $ 1,720.1      $ 1,683.6      $ 1,349.0
                         

Average Assets

  $ 49,490.4      $ 41,510.2      $ 33,899.4

 

C&IS direct contribution increased 2% in 2008 and totaled $1.72 billion compared with $1.68 billion in 2007, which increased 25% from $1.35 billion in 2006. The increase in 2008 resulted primarily from record foreign exchange trading results, record net interest income, and a record level of trust, investment and other servicing fees. Partially offsetting these increases were client support related charges totaling $454.9 million. Direct contribution increased in 2007 primarily due to higher levels of trust, investment and other servicing fees, foreign exchange trading results, and a 28% increase in net interest income.

 

C&IS Trust, Investment and Other Servicing Fees

C&IS trust, investment and other servicing fees are attributable to four general product types: Custody and Fund Administration, Investment Management, Securities Lending, and Other Services. Custody and fund administration services are priced, in general, using asset values at the beginning of the quarter. There are, however, fees within custody and fund administration services that are not related to asset values, but instead are based on transaction volumes or account fees. Investment management fees are primarily based on market values throughout a period. Securities lending revenue is impacted by market values and the demand for securities to be lent, which drives volumes, and the interest rate spread earned on the investment of cash deposited by investment firms as collateral for securities they have borrowed. Securities lending fees also include Northern Trust’s share of unrealized gains and losses on one mark-to-market investment fund used in securities lending activities. The other services fee category in C&IS includes such products as benefit payment, performance analysis, electronic delivery, and other services. Revenues from these products are generally based on the volume of services provided or a fixed fee.

 

Trust, investment and other servicing fees in C&IS increased 4% in 2008 to $1.23 billion from $1.18 billion in 2007. Provided below are the components of trust, investment and other servicing fees and a breakdown of assets under custody and under management.

 

CORPORATE AND INSTITUTIONAL SERVICES

TRUST, INVESTMENT AND OTHER SERVICING FEES

 

(In Millions)   2008    2007    2006

Custody and Fund Administration

  $ 661.6    $ 615.2    $ 502.4

Investment Management

    277.4      290.6      256.3

Securities Lending

    221.4      207.1      191.5

Other Services

    65.5      66.9      62.2
                     

Total Trust, Investment and Other Servicing Fees

  $ 1,225.9    $ 1,179.8    $ 1,012.4

 

2008 C&IS FEES

LOGO

 

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CORPORATE AND INSTITUTIONAL SERVICES

ASSETS UNDER CUSTODY

 

    DECEMBER 31
(In Billions)   2008    2007    2006

North America

  $ 1,661.1    $ 2,166.1    $ 1,908.4

Europe, Middle East, and Africa

    801.7      1,139.3      955.2

Asia-Pacific Region

    146.2      228.0      152.0

Securities Lending

    110.2      269.5      247.9
                     

Total Assets Under Custody

  $ 2,719.2    $ 3,802.9    $ 3,263.5

 

2008 C&IS ASSETS UNDER CUSTODY

 

LOGO

 

CORPORATE AND INSTITUTIONAL SERVICES

ASSETS UNDER MANAGEMENT

 

    DECEMBER 31
(In Billions)   2008    2007    2006

North America

  $ 232.3    $ 281.3    $ 258.9

Europe, Middle East, and Africa

    52.8      35.1      36.1

Asia-Pacific Region

    31.1      23.0      19.6

Securities Lending

    110.2      269.5      247.9
                     

Total Assets Under Management

  $ 426.4    $ 608.9    $ 562.5

 

2008 C&IS ASSETS UNDER MANAGEMENT

 

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The increase in C&IS trust, investment and other servicing fees reflects new business, partially offset by lower market valuations. Custody and fund administration fees increased 8% to $661.6 million compared with $615.2 million a year ago, reflecting growth in global fees. Fees from investment management totaled $277.4 million compared with $290.6 million in the year-ago period. The 5% decrease in investment management fees primarily reflects lower market valuations. Securities lending fees increased 7% to $221.4 million compared with $207.1 million in 2007. The increase was primarily due to improved spreads on the investment of cash collateral, partially offset by decreased volumes and net unrealized asset valuation losses in one mark-to-market investment fund used in our securities lending activities which reduced fees by approximately $212.7 million in 2008 and approximately $93.8 million in 2007.

C&IS assets under custody totaled $2.72 trillion at December 31, 2008, 28% lower than $3.80 trillion at December 31, 2007. Managed assets totaled $426.4 billion and $608.9 billion at December 31, 2008 and 2007, respectively, and as of the current year-end were invested 37% in equity securities, 15% in fixed income securities and 48% in cash and other assets. Cash and other assets that have been deposited by investment firms as collateral for securities they have borrowed from custody clients are invested by Northern Trust and are included in assets under custody and under management. This collateral totaled $110.2 billion and $269.5 billion at December 31, 2008 and 2007, respectively, primarily reflecting lower market valuations and the impact of changes in the relative values of non-U.S. currencies to the U.S. dollar.

 

C&IS Other Noninterest Income

Other noninterest income in 2008 increased 74% from the prior year primarily due to a 76% increase in foreign exchange trading income, $35.4 million of valuation gains recorded on certain credit default swap contracts, a $34.3 million increase in non-trading foreign exchange gains primarily due to the translation of non-U.S. dollar denominated assets and liabilities, and higher levels of custody-related deposit revenue and commercial loan-related commitment fees. The increase in other noninterest income in 2007 compared with 2006 resulted from a 43% increase in foreign exchange trading income and higher levels of custody-related deposit revenue.

 

C&IS Net Interest Income

Net interest income increased 35% in 2008, resulting primarily from an $8.9 billion or 25% increase in average earning assets, primarily short-term money market assets and loans. The net interest margin was 1.27% in 2008 and 1.17% in 2007. The 28% increase in net interest income for 2007 from the previous year was also primarily due to an increase in short-term money market assets and loans.

 

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C&IS Provision for Credit Losses

The provision for credit losses was $25.2 million for 2008, compared with $4.5 million in 2007, and $9.1 million in 2006. The increase in the provision for credit losses from the prior year reflects growth in the commercial loan portfolio and weakness in the broader economic environment. The provision for credit losses in 2007 and 2006 primarily reflected overall growth in the commercial loan portfolio.

 

C&IS Direct Expenses

Direct expenses of C&IS increased 127% in 2008 and 14% in 2007. Included in the current year results are $454.9 million of client support related charges. Excluding the impact of these expenses, direct expenses were $401.4 million, up 6% from 2007. The growth in expenses for 2008 reflects the impact of higher staff levels, annual salary increases and other staff-related charges, and higher expenses related to account servicing activities, partially offset by a decrease in performance-based compensation, and lower expenses for technical and global subcustody services. The growth in expenses for 2007 reflects the impact of higher staff levels, annual salary increases, increased performance-based compensation, employee benefit charges and higher volume-driven growth in global subcustody expenses and consulting services.

 

Personal Financial Services

 

The PFS business unit provides personal trust, investment management, custody, and philanthropic services; financial consulting; guardianship and estate administration; qualified retirement plans; brokerage services; and private and business banking. PFS focuses on high net worth individuals and families, business owners, executives, professionals, retirees, and established privately-held businesses in its target markets. PFS also includes the Wealth Management Group, which provides customized products and services to meet the complex financial needs of individuals and family offices in the United States and throughout the world with assets typically exceeding $200 million. PFS services are delivered through a network of 85 offices in 18 U.S. states as well as offices in London and Guernsey.

 

The following table summarizes the direct contribution of PFS for the years ended December 31, 2008, 2007, and 2006 on a management-reporting basis.

 

PERSONAL FINANCIAL SERVICES

DIRECT CONTRIBUTION

 

(In Millions)   2008    2007    2006

Noninterest Income

                   

Trust, Investment and Other Servicing Fees

  $ 909.0    $ 897.8    $ 779.2

Other

    132.6      99.4      96.8

Net Interest Income (FTE)

    542.7      518.9      497.7
                     

Revenues (FTE)

    1,584.3      1,516.1      1,373.7

Provision for Credit Losses

    89.8      13.5      5.9

Direct Expenses

    623.5      514.6      487.0
                     

Direct Contribution

  $ 871.0    $ 988.0    $ 880.8
                     

Average Assets

  $ 22,868.7    $ 18,888.6    $ 17,482.0

 

PFS direct contribution totaled $871.0 million in 2008, a decrease of 12% from 2007, which in turn was 12% above the direct contribution achieved in 2006. The decline in direct contribution in 2008 resulted primarily from $81.4 million of client support related charges, and a $76.3 million increase in the provision for credit losses. Total revenues increased 4% to $1.58 billion from 2007 results reflecting record levels of trust, investment and other servicing fees and a 5% increase in net interest income. The increase in 2007 direct contribution is attributable primarily to higher trust, investment and other servicing fees and higher net interest income.

 

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PFS Trust, Investment and Other Servicing Fees

Provided below is a summary of trust, investment and other servicing fees and assets under custody and under management.

 

PERSONAL FINANCIAL SERVICES

TRUST, INVESTMENT AND OTHER SERVICING FEES

 

(In Millions)   2008    2007    2006

Illinois

  $ 301.6    $ 302.5    $ 260.6

Florida

    205.5      207.3      189.2

California

    90.7      92.2      82.8

Arizona

    47.8      47.9      42.5

Texas

    37.9      36.0      32.5

Other

    83.1      78.3      60.5

Wealth Management

    142.4      133.6      111.1
                     

Total Trust, Investment and Other Servicing Fees

  $ 909.0    $ 897.8    $ 779.2

 

2008 PFS FEES

 

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PERSONAL FINANCIAL SERVICES

ASSETS UNDER CUSTODY

 

    DECEMBER 31
(In Billions)   2008    2007    2006

Illinois

  $ 46.6    $ 54.2    $ 48.9

Florida

    28.6      34.7      31.3

California

    14.3      17.4      14.5

Arizona

    5.7      7.3      7.2

Texas

    6.1      6.6      5.9

Other

    18.6      17.1      14.5

Wealth Management

    168.4      195.0      159.6
                     

Total Assets Under Custody

  $ 288.3    $ 332.3    $ 281.9

 

2008 PFS ASSETS UNDER CUSTODY

 

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PERSONAL FINANCIAL SERVICES

ASSETS UNDER MANAGEMENT

 

    DECEMBER 31
(In Billions)   2008    2007    2006

Illinois

  $ 35.7    $ 41.3    $ 37.1

Florida

    23.3      27.9      25.8

California

    10.2      12.0      10.2

Arizona

    4.5      5.6      5.4

Texas

    4.5      4.7      4.1

Other

    25.2      26.9      24.6

Wealth Management

    29.0      29.9      27.5
                     

Total Assets Under Management

  $ 132.4    $ 148.3    $ 134.7

 

2008 PFS ASSETS UNDER MANAGEMENT

 

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Fees in the majority of locations in which PFS operates, and all mutual fund-related revenue, are accrued based on market values. PFS trust, investment and other servicing fees totaled a record $909.0 million for the year, up 1% from $897.8 million in 2007, which in turn was up 15% from $779.2 million in 2006. The current year performance was positively impacted by strong new business, offset in part by lower equity markets. The 2007 performance was positively impacted by new business and higher equity markets when compared with 2006.

At December 31, 2008, assets under custody in PFS totaled $288.3 billion, compared with $332.3 billion at December 31, 2007. Included in assets under custody are those for which Northern Trust has management responsibility. Managed assets totaled $132.4 billion at December 31, 2008, 11% lower than the previous year end, and were invested 31% in equity securities, 28% in fixed income securities and 41% in cash and other assets.

 

PFS Other Income

Other noninterest income for 2008 totaled $132.6 million compared with $99.4 million last year. The increase in noninterest income for 2008 was primarily driven by higher security commissions and trading income, commercial loan-related commitment fees, and treasury management fees. Noninterest income for 2007 was 3% higher than 2006.

 

PFS Net Interest Income

Net interest income of $542.7 million was 5% higher than the previous year. Average loan volume grew $3.6 billion or 20%, while the net interest margin decreased to 2.43% from 2.84% in 2007. The net interest margin reflects asset yields that have declined at a more accelerated pace than the related total funding sources, and the impact of changes to management accounting system methodologies relating to the application of funds transfer pricing and the allocation of capital. Net interest income for 2007 of $518.9 million was 4% higher than for 2006 resulting primarily from higher average loan volume, partially offset by a decrease in the net interest margin from 2.96% in 2006 to 2.84% in 2007.

 

PFS Provision for Credit Losses

The provision for credit losses was $89.8 million for 2008, compared with $13.5 million in 2007, and $5.9 million in 2006. The increase in the provision for credit losses from 2007 reflects growth in the commercial loan portfolio and weakness in the broader economic environment. The provision for credit losses in 2007 and 2006 primarily reflects growth in the loan portfolio and the migration of certain loans to higher risk credit ratings.

 

PFS Direct Expenses

Direct expenses of PFS increased 21% in 2008 and 6% in 2007. Included in the current year results are the client support related charges totaling $81.4 million, related to the auction rate securities purchase program and other client support related charges. Excluding the impact of these expenses, total direct expenses were $542.1 million, up $27.5 million or 5% from 2007. The remaining growth in noninterest expenses for 2008 reflects annual salary increases, higher charges related to account servicing activities and legal matters, and fees for legal services, partially offset by lower performance-based compensation, occupancy costs, and lower business promotion and advertising. The growth in expenses for 2007 reflects annual salary increases, higher performance-based compensation, and higher occupancy costs, partially offset by lower costs associated with business promotion and advertising.

 

Northern Trust Global Investments

 

NTGI, through various subsidiaries of the Corporation, provides a broad range of investment management and related services and other products to U.S. and non-U.S. clients, including clients of C&IS and PFS. Clients include institutional and individual separately managed accounts, bank common and collective funds, registered investment companies, non-U.S. collective investment funds, and unregistered private investment funds. NTGI offers both active and passive equity and fixed income portfolio management, as well as alternative asset classes (such as private equity and hedge funds of funds) and multi-manager products and services. NTGI’s activities also include brokerage, securities lending, transition management, and related services. NTGI’s business operates internationally and its revenues are fully allocated to C&IS and PFS.

At year-end 2008, Northern Trust managed $558.8 billion in assets for personal and institutional clients compared with $757.2 billion at year-end 2007. The decrease in assets is attributable to lower equity markets, partially offset by strong new business. Assets under management have grown at a five-year compound annual rate of 3%.

 

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NORTHERN TRUST GLOBAL INVESTMENTS

$558.8 BILLION ASSETS UNDER MANAGEMENT

 

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ASSET CLASSES

 

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CLIENT SEGMENTS

 

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MANAGEMENT STYLES

 

Operations and Technology

 

The O&T business unit supports all of Northern Trust’s business activities, including the processing and product management activities of C&IS, PFS, and NTGI. These activities are conducted principally in the operations and technology centers in Chicago, London, and Bangalore and fund administration centers in Ireland.

 

Corporate Financial Management Group

 

The Corporate Financial Management Group includes the Chief Financial Officer, Controller, Treasurer, Corporate Development, Financial Analysis & Internal Consulting, Investor Relations, and Strategic Sourcing functions. The Group is responsible for Northern Trust’s accounting and financial infrastructure and for managing the Corporation’s financial position.

 

Corporate Risk Management Group

 

The Corporate Risk Management Group includes the Credit Policy and other Corporate Risk Management functions. The Credit Policy function is described in the “Risk Management – Loans and Other Extensions of Credit” section. The Corporate Risk Management Group monitors, measures, and facilitates the management of risks across the businesses of the Corporation and its subsidiaries.

 

Treasury and Other Support Services

 

Treasury and Other Support Services includes expenses associated with NTGI and O&T product and operating support and expenses associated with the wholesale funding activities and the investment portfolios of the Corporation and the Bank. Treasury and Other Support Services also includes certain corporate-based expenses, executive level compensation, and nonrecurring items not allocated to the business units.

The following table summarizes the direct contribution of Treasury and Other Support Services for the years ended December 31, 2008, 2007, and 2006 on a management-reporting basis.

 

TREASURY AND OTHER SUPPORT SERVICES

DIRECT CONTRIBUTION

 

(In Millions)   2008      2007      2006  

Gain on Visa Share Redemption

  $ 167.9      $      $  

Other Noninterest Income

    (40.6 )      23.8        16.3  

Net Interest Income (Expense) (FTE)

    15.1        (34.2 )      (18.2 )
                           

Revenues (FTE)

    142.4        (10.4 )      (1.9 )

Visa Indemnification Charges

    (76.1 )      150.0         

Direct Expenses

    1,484.1        1,387.9        1,138.9  
                           

Direct Contribution

  $ (1,265.6 )    $ (1,548.3 )    $ (1,140.8 )
                           

Average Assets

  $ 669.4      $ 189.2      $ 1,724.5  

 

Treasury and Other Support Services other noninterest income was a negative $40.6 million compared with $23.8 million in the prior year. The current year was impacted by losses totaling $61.3 million recognized in connection with the write-down to estimated fair value of six asset-backed securities determined to be other-than-temporarily impaired. Net interest income for 2008 of $15.1 million, as compared with a negative $34.2 million in 2007 and a negative $18.2 million in 2006, benefited as a result of methodology changes under the new management accounting systems. The current year also includes the $76.1 million offset to the Visa indemnification accruals and related charges totaling $150.0

 

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million that were recorded in 2007. Direct expenses totaled $1.48 billion for 2008 compared with $1.39 billion in the prior year. Contributing to the current year increase in direct expenses are higher staff levels and annual salary increases, higher levels of consulting and other professional service fees, and increases in software related expense, partially offset by lower performance-based compensation. Expenses in 2007 increased due to higher levels of compensation, increases in consulting and other professional service fees, and higher costs associated with business promotion and advertising.

 

CRITICAL ACCOUNTING ESTIMATES

 

The use of estimates and assumptions is required in the preparation of financial statements in conformity with GAAP and actual results could differ from those estimates. The Securities and Exchange Commission has issued guidance relating to the disclosure of critical accounting estimates. Critical accounting estimates are those that require management to make subjective or complex judgments about the effect of matters that are inherently uncertain and may change in subsequent periods. Changes that may be required in the underlying assumptions or estimates in these areas could have a material impact on Northern Trust’s future financial condition and results of operations.

For Northern Trust, accounting estimates that are viewed as critical are those relating to reserving for credit losses, pension plan accounting, other than temporary impairment of investment securities, and accounting for structured leasing transactions. Management has discussed the development and selection of each critical accounting estimate with the Audit Committee of the Board of Directors.

 

Reserve for Credit Losses

 

The reserve for credit losses represents management’s estimate of probable losses that have occurred as of the date of the financial statements. The loan and lease portfolio and other credit exposures are regularly reviewed to evaluate the adequacy of the reserve for credit losses. In determining the level of the reserve, Northern Trust evaluates the adequacy of the reserve related to performing loans and lending-related commitments as well as loans and lending-related commitments that are deemed impaired.

The quarterly analysis of specific and inherent loss components and the control process maintained by Credit Policy and the lending staff, as described in the “Risk Management – Loans and Other Extensions of Credit” section, are the principal methods relied upon by management for the timely identification of, and adjustment for, changes in estimated credit loss levels. In addition to Northern Trust’s own experience, management also considers the experience of peer institutions and regulatory guidance. Control processes and analyses employed to evaluate the adequacy of the reserve for credit losses are reviewed on at least an annual basis and modified as considered appropriate. As discussed in more detail in the “Risk Management – Provision and Reserve for Credit Losses” section, effective in 2008, the methodology used by management to determine the appropriate level of the reserve was modified to better align loan loss reserves with the related credit risk.

Loans, leases and other extensions of credit deemed uncollectible are charged to the reserve. Subsequent recoveries, if any, are credited to the reserve. The provision for credit losses, which is charged to income, is the amount necessary to adjust the reserve to the level determined through the above process. Actual losses may vary from current estimates and the amount of the provision may be either greater than or less than actual net charge-offs.

Management’s estimates utilized in establishing an adequate reserve for credit losses are not dependent on any single assumption. Management evaluates numerous variables, many of which are interrelated or dependent on other assumptions and estimates, in determining reserve adequacy. Due to the inherent imprecision in accounting estimates, other estimates or assumptions could reasonably have been used in the current period and changes in estimates are reasonably likely to occur from period to period. However, management believes that the established reserve for credit losses appropriately addresses these uncertainties and is adequate to cover probable losses which have occurred as of the date of the financial statements.

The reserve for credit losses consists of the following components:

Specific Reserve: The amount of specific reserves is determined through an individual evaluation of loans and lending-related commitments considered impaired that is based on expected future cash flows, the value of collateral, and other factors that may impact the borrower’s ability to pay.

Inherent Reserve: The amount of inherent loss reserves is based primarily on reserve factors which incorporate management’s evaluation of historical charge-off experience and various qualitative factors such as management’s evaluation of economic and business conditions and changes in the character and size of the loan portfolio. Reserve factors are applied to loan and lease credit exposures aggregated by shared risk characteristics and are reviewed quarterly by

 

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Northern Trust’s Loan Loss Reserve Committee which includes representatives from Credit Policy, business unit management, and Corporate Financial Management.

 

Pension Plan Accounting

 

As summarized in Note 22 to the consolidated financial statements, Northern Trust maintains a noncontributory defined benefit pension plan covering substantially all U.S. employees (the Qualified Plan) and a noncontributory supplemental pension plan (the Nonqualified Plan). Certain European-based employees also participate in local defined benefit pension plans that have been closed to new employees in prior years. Measuring cost and reporting liabilities resulting from defined benefit pension plans requires the use of several assumptions regarding future interest rates, asset returns, compensation increases and other actuarial-based projections relating to the plans. Due to the long-term nature of this obligation and the estimates that are required to be made, the assumptions used in determining the periodic pension expense and the projected pension obligation are closely monitored and annually reviewed for adjustments that may be required. The Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards (SFAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS No. 158) requires that differences between the estimates and actual experience be recognized as other comprehensive income in the period in which they occur. The differences are amortized into net periodic pension expense from accumulated other comprehensive income over the future working lifetime of eligible participants. As a result, differences between the estimates made in the calculation of periodic pension expense and the projected pension obligation and actual experience affect stockholders’ equity in the period in which they occur but continue to be recognized as expense systematically and gradually over subsequent periods.

Northern Trust recognizes the significant impact that these pension-related assumptions have on the determination of the pension obligations and related expense and has established procedures for monitoring and setting these assumptions each year. These procedures include an annual review of actual demographic and investment experience with the pension plan’s actuaries. In addition to actual experience, adjustments to these assumptions consider observable yields on fixed income securities, known compensation trends and policies, as well as economic conditions and investment strategies that may impact the estimated long-term rate of return on plan assets.

In determining the pension expense for the U.S. plans in 2008, Northern Trust utilized a discount rate of 6.25% for both the Qualified Plan and the Nonqualified Plan. The rate of increase in the compensation level is based on a sliding scale that averaged 4.02%. The expected long-term rate of return on Qualified Plan assets was 8.25%.

In evaluating possible revisions to pension-related assumptions for the U.S. plans as of Northern Trust’s December 31, 2008 measurement date, the following events were considered:

Discount Rate: Northern Trust estimates the discount rate for its U.S. pension plans using the weighted average of market-observed yields for high quality fixed income securities with maturities that closely match the duration of the plans’ liabilities. The yield curve models referenced by Northern Trust in establishing the discount rate supported a rate between 5.93% and 6.85%, with an average decrease of 8 basis points over the prior year. As such, Northern Trust maintained the discount rate for the Qualified and Nonqualified plans at 6.25% for 2008.

Compensation Level: As compensation policies remained consistent with prior years, no changes were made to the compensation scale assumption, which was revised in 2007 based on a review of actual salary experience of eligible employees.

Rate of Return on Plan Assets: The expected return on plan assets is based on an estimate of the long-term rate of return on plan assets, which is determined using a building block approach that considers the current asset mix and estimates of return by asset class based on historical experience, giving proper consideration to diversification and rebalancing. Current market factors such as inflation and interest rates are also evaluated before long-term capital market assumptions are determined. Peer data and historical returns are reviewed to check for reasonability and appropriateness. As a result of these analyses, Northern Trust’s rate of return assumption for 2008 was decreased from 8.25% to 8.00% for 2008.

Mortality Table: In 2006, Northern Trust adopted the mortality table proposed by the U.S. Treasury for use in accordance with the provisions of the Pension Protection Act of 2006 (PPA) for both pre- and post-retirement mortality assumptions. This table is based on the RP2000 mortality table used by Northern Trust in 2005 but includes projections of expected future mortality. This same table was used in 2007 and in 2008.

In order to illustrate the sensitivity of these assumptions on the expected periodic pension expense in 2009 and the

 

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projected benefit obligation, the following table is presented to show the effect of increasing or decreasing each of these assumptions by 25 basis points.

 

(In Millions)   25 BASIS
POINT
INCREASE
     25 BASIS
POINT
DECREASE
 

Increase (Decrease) in 2009 Pension Expense

            

Discount Rate Change

  (3.9 )    4.1  

Compensation Level Change

  2.0      (1.9 )

Rate of Return on Asset Change

  (1.7 )    1.7  

Increase (Decrease) in Projected Benefit Obligation

            

Discount Rate Change

  (24.3 )    25.7  

Compensation Level Change

  7.5      (7.3 )

 

Pension Contributions: The PPA provided for an increase in the deduction limits specified by the Internal Revenue Code for contributions made by sponsors of defined benefit pension plans. This increase provided Northern Trust with the opportunity to make an additional $105.0 million contribution to the Qualified Plan, which was made in December 2006. No contributions were made in 2007. Northern Trust contributed another $110.0 million to the Qualified Plan in 2008. The investment return on these contributions decreases the U.S. pension expense. This benefit will be partially offset by the related forgone net interest income. The continuing effect of the PPA on Northern Trust’s annual contributions is not expected to be significant. The minimum required contribution is expected to be zero in 2009 and for several years thereafter. The maximum deductible contribution, which is based on a “Target Liability” under the provisions of the PPA, is estimated at $180.0 million in 2009.

As a result of the pension-related assumptions currently utilized, the contributions to the Qualified Plan, and other actuarial experiences of the qualified and nonqualified plans, the estimated U.S. pension expense is expected to increase by approximately $10.0 million in 2009 from 2008 expense of $20.4 million.

 

Other Than Temporary Impairment of Investment Securities

 

Under GAAP, companies are required to perform periodic reviews of securities with unrealized losses to determine whether the declines in value are considered other than temporary. If a review results in a determination that an impairment is other than temporary, the carrying value of the security is written down to fair value, and a loss is recognized through earnings in the period in which the determination was made. The application of significant judgment is required in determining whether impairment loss recognition is appropriate. Additionally, estimates as to the collectability of principal or interest are inherently subject to change in future periods. Different judgments or subsequent changes in estimates could result in materially different impairment loss recognition. The current economic and financial market conditions have negatively affected the liquidity and pricing of investment securities generally and asset-backed securities in particular, and have resulted in an increase in the likelihood and severity of other-than-temporary impairment charges.

Northern Trust conducts security impairment reviews quarterly to evaluate those securities within its investment portfolio that have indications of possible other-than-temporary impairment. Impairment losses are recognized when quantitative and qualitative factors indicate that it is probable that a contractual principal loss or interest shortfall will occur. For debt securities, cash flow analyses employing macroeconomic and security specific assumptions, are an important element in determining whether an other-than-temporary impairment has occurred. Other factors considered in an impairment review, which can vary by security as to their relative significance, include the length of time and extent to which a security’s market value has been below amortized cost; the financial condition and prospects of the issuer of the security; and Northern Trust’s intent and ability to retain the security until a recovery of fair value, which may be maturity. The Corporate Asset and Liability Policy Committee (ALCO) reviews the results of impairment analyses and concludes on whether other-than-temporary impairment exists.

Impairment reviews conducted in 2008 identified six asset-backed securities determined to be other-than-temporarily impaired and losses totaling $61.3 million were recorded to write the securities down to their estimated fair values. The remaining securities with unrealized losses within Northern Trust’s portfolio as of December 31, 2008 are not considered to be other-than-temporarily impaired. However, due to market and economic conditions, additional other-than-temporary impairments may occur in future periods.

 

Accounting for Structured Leasing Transactions

 

Through its leasing subsidiary, Norlease, Inc., Northern Trust acts as a lessor in leveraged lease transactions primarily for transportation equipment, including commercial aircraft and railroad equipment. Northern Trust’s net investment in leveraged leases is reported at the aggregate of lease payments receivable and estimated residual values, net of non-recourse debt and unearned income. Unearned income is required to be recognized in interest income in a manner that yields a level rate of return on the net investment. Determining the net investment in a leveraged lease and the interest income to be

 

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recognized requires management to make assumptions regarding the amount and timing of cash flows, estimates of residual values, and the impact of income tax regulations and rates. Changes in these assumptions in future periods could affect asset balances and related interest income.

As further described in Note 21 to the consolidated financial statements, FSP 13-2, adopted by Northern Trust on January 1, 2007, requires a recalculation of the allocation and rate of return of income from the inception of a leveraged lease if, during the lease term, the expected timing of the income tax cash flows generated by the leveraged lease is revised.

Northern Trust has entered into certain leveraged leasing transactions commonly referred to as Lease-In/Lease-Out (LILO) and Sale-In/Sale-Out (SILO) transactions. The IRS is challenging the amount and timing of tax deductions with respect to these types of transactions and proposing to assess related interest and penalties as part of its audit of federal tax returns filed from 1997-2000. The Corporation anticipates that the IRS will continue to disallow deductions relating to these leases and possibly include other lease transactions with similar characteristics as part of its audit of tax returns filed after 2000. The Corporation believes its tax treatment relating to these transactions is appropriate based on its interpretation of the tax regulations and legal precedents; a court or other judicial authority, however, could disagree. Accordingly, management’s estimates of future cash flows related to leveraged leasing transactions include assumptions about the eventual resolution of this matter, including the timing and amount of any potential payments. Due to the nature of this tax matter, it is difficult to estimate future cash flows with precision. On August 6, 2008, the IRS announced that settlements would be offered to taxpayers who participated in LILO and SILO transactions. Although Northern Trust elected not to participate in the IRS offer, the Corporation revised its estimates regarding the likely outcome of leveraged leasing tax positions in light of the terms of the settlement offer. As a result of the reallocation of lease income and increase in taxes over the life of certain of the leveraged leases under the revised assumptions, Northern Trust recorded $38.9 million in charges against interest income for the year ended December 31, 2008. The provision for taxes related to these adjustments, inclusive of interest and penalties, totaled $61.3 million. Management does not believe that subsequent changes that may be required in these assumptions would have a material effect on the consolidated financial position or liquidity of Northern Trust, although they could have a material effect on operating results for a particular period.

 

FAIR VALUE MEASUREMENTS

 

The preparation of financial statements in conformity with GAAP requires certain assets and liabilities to be reported at fair value. As of December 31, 2008, approximately 22% of Northern Trust’s consolidated total assets and approximately 4% of its total liabilities were carried on the balance sheet at fair value in accordance with these principles. As discussed more fully in Note 31 to the consolidated financial statements, FASB SFAS No. 157, “Fair Value Measurements”, (SFAS No. 157) requires entities to categorize financial assets and liabilities carried at fair value according to a three-level valuation hierarchy. The hierarchy gives the highest priority to quoted, active market prices for identical assets and liabilities (Level 1) and the lowest priority to valuation techniques that require significant management judgment because one or more of the significant inputs are unobservable in the market place (Level 3). Less than one percent of Northern Trust’s assets and liabilities carried at fair value are classified as Level 1 as Northern Trust typically does not hold equity securities or other instruments that would be actively traded on an exchange.

Approximately 97% of Northern Trust’s assets and 87% of its liabilities that are carried at fair value are valued using models in which all significant inputs are observable in active markets and are, therefore, categorized as Level 2. Investment securities classified as available for sale make up 81% of Level 2 assets with the remaining 19% primarily consisting of derivative financial instruments. Level 2 liabilities consist of derivative financial instruments.

Investment securities are principally valued by third party pricing vendors. Northern Trust has a well-established process to validate all prices received from pricing vendors. Prices are compared to separate independent sources such as non-binding broker quotes and other vendor price feeds to ensure the fair value determination is consistent with SFAS No. 157 and to ensure the proper classification of assets and liabilities in the fair value hierarchy.

As of December 31, 2008, all derivative assets and liabilities were classified in Level 2 and in excess of 95%, measured on a notional value basis, related to client-related and trading activities, predominantly consisting of foreign exchange contracts. Derivative instruments are valued internally using widely accepted models that incorporate inputs readily observable in actively quoted markets and do not require significant management judgment. Northern Trust evaluated the impact of counterparty credit risk and its own credit risk on the valuation of derivative instruments. Factors considered included the likelihood of default by us and our counterparties, the remaining maturities

 

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of the instruments, our net exposures after giving effect to master netting agreements, available collateral, and other credit enhancements in determining the appropriate fair value of our derivative instruments. The resulting valuation adjustments are not considered material.

As of December 31, 2008, the fair value of Northern Trust’s Level 3 assets and liabilities were $453.1 million and $418.3 million, respectively, and represented approximately 3% of assets and 13% of liabilities carried at fair value, respectively. Level 3 assets consist of auction rate securities purchased from Northern Trust clients in the fourth quarter of 2008. Since February 2008, the market for auction rate securities has had minimal activity as the majority of auctions have failed preventing holders from liquidating their investments. The lack of activity in the auction rate security market has resulted in a lack of observable market inputs to use in determining fair value. Therefore, Northern Trust incorporated its own assumptions about future cash flows and the appropriate discount rate adjusted for credit and liquidity factors. In developing these assumptions, Northern Trust incorporated the contractual terms of the securities, the type of collateral, any credit enhancements available, and relevant market data, where available. Level 3 liabilities principally include capital support agreements (Capital Support Agreements) with certain investment funds and investment asset pools for which Northern Trust acts as investment advisor. These agreements are valued using an option pricing model that includes prices for securities not actively traded in the marketplace as a significant input. Level 3 liabilities also include the net estimated liability for Visa related indemnifications and financial guarantees relating to standby letters of credit, the fair values of which are based on significant management judgment and relevant market data, where available.

While Northern Trust believes its valuation methods for its assets and liabilities carried at fair value are appropriate and consistent with other market participants, the use of different methodologies or assumptions, particularly as applied to Level 3 assets and liabilities, could have a material effect on the computation of their estimated fair values.

The provisions of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” were effective January 1, 2008. SFAS No. 159 gives entities the option, at specified election dates, to measure certain financial assets and liabilities at fair value. The election may be applied to financial assets and liabilities on an instrument by instrument basis, is irrevocable, and may only be applied to entire instruments. Northern Trust has not elected to apply SFAS No. 159 to any assets or liabilities.

 

IMPLEMENTATION OF ACCOUNTING STANDARDS

 

Information related to recent accounting pronouncements is contained in Note 2 to the consolidated financial statements.

 

CAPITAL EXPENDITURES

 

Proposed significant capital expenditures are reviewed and approved by Northern Trust’s senior management and, where appropriate, by the Board of Directors. This process is designed to assure that the major projects to which Northern Trust commits its resources produce benefits compatible with corporate strategic goals.

Capital expenditures in 2008 included ongoing enhancements to Northern Trust’s hardware and software capabilities and expansion or renovation of several existing offices. Capital expenditures for 2008 totaled $309.9 million, of which $205.7 million was for software, $54.6 million was for computer hardware and machinery, $42.0 million was for building and leasehold improvements, and $7.6 million was for furnishings. These capital expenditures are designed principally to support and enhance Northern Trust’s transaction processing, investment management, and asset servicing capabilities, as well as relationship management and client interaction. Additional capital expenditures planned for systems technology will result in future expenses for the depreciation of hardware and amortization of software. Depreciation on computer hardware and machinery and software amortization are charged to equipment and software expense. Depreciation on building and leasehold improvements and on furnishings is charged to occupancy expense and equipment expense, respectively.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

Assets Under Custody and Assets Under Management

 

Northern Trust, in the normal course of business, holds assets under custody, management and servicing in a fiduciary or agency capacity for its clients. In accordance with GAAP, these assets are not assets of Northern Trust and are not included in its consolidated balance sheet.

 

Financial Guarantees and Indemnifications

 

Northern Trust issues financial guarantees in the form of standby letters of credit to meet the liquidity and credit enhancement needs of its clients. Standby letters of credit obligate Northern Trust to meet certain financial obligations of its clients, if, under the contractual terms of the agreement,

 

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the clients are unable to do so. These instruments are primarily issued to support public and private financial commitments, including commercial paper, bond financing, initial margin requirements on futures exchanges and similar transactions.

Credit risk is the principal risk associated with these instruments. The contractual amounts of these instruments represent the credit risk should the instrument be fully drawn upon and the client default. To control the credit risk associated with issuing letters of credit, Northern Trust subjects such activities to the same credit quality and monitoring controls as its lending activities. Certain standby letters of credit have been secured with cash deposits or participated to others. Northern Trust is obligated to meet the entire financial obligation of these agreements and in certain cases is able to recover the amounts paid through recourse against cash deposits or other participants.

The following table shows the contractual amounts of standby letters of credit.

 

    DECEMBER 31
(In Millions)   2008    2007

Standby Letters of Credit:

            

Corporate

  $ 1,136.2    $ 1,095.0

Industrial Revenue

    2,080.7      1,102.0

Other

    808.1      684.8
              

Total Standby Letters of Credit*

  $ 4,025.0    $ 2,881.8

*These amounts include $340.1 million and $356.7 million of standby letters of credit secured by cash deposits or participated to others as of December 31, 2008 and 2007, respectively. The weighted average maturity of standby letters of credit was 25 months at December 31, 2008 and 23 months at December 31, 2007.

 

As part of the Corporation’s securities custody activities and at the direction of clients, Northern Trust lends securities owned by clients to borrowers who are reviewed and approved by the Senior Credit Committee. In connection with these activities, Northern Trust has issued certain indemnifications to clients against loss resulting from the bankruptcy of the borrower of securities. The borrower is required to fully collateralize securities received with cash, marketable securities, or irrevocable standby letters of credit. As securities are loaned, collateral is maintained at a minimum of 100 percent of the fair value of the securities plus accrued interest, with the collateral revalued on a daily basis. The amount of securities loaned as of December 31, 2008 and 2007 subject to indemnification was $82.7 billion and $179.8 billion, respectively. Because of the credit quality of the borrowers and the requirement to fully collateralize securities borrowed, management believes that the exposure to credit loss from this activity is not significant.

Northern Trust, as a member bank of Visa U.S.A., Inc., is obligated to share in potential losses resulting from certain indemnified litigation involving Visa. In the fourth quarter of 2007, Northern Trust recorded liabilities totaling $150.0 million in connection with the indemnifications. As anticipated, Visa placed a portion of the proceeds from its initial public offering into an escrow account to fund the settlements of, or judgments in, the indemnified litigation. Northern Trust recorded $76.1 million, its proportionate share of the escrow account balance, in the first quarter of 2008 as an offset to the indemnification liabilities and related charges recorded in the fourth quarter of 2007. Northern Trust’s net Visa related indemnification liability at December 31, 2008 and 2007 totaled $73.9 million and $150.0 million, respectively. The value of Northern Trust’s remaining Visa shares is expected to be more than adequate to offset any remaining indemnification liabilities related to Visa litigation. Visa indemnifications are further discussed in Note 20 to the consolidated financial statements.

 

Variable Interests

 

Variable Interest Entities (VIEs) are defined in FASB Interpretation, “Consolidation of Variable Interest Entities (revised December 2003)—an interpretation of ARB No. 51” (FIN 46-R) as entities which either have a total equity investment that is insufficient to permit the entity to finance its activities without additional subordinated financial support or whose equity investors lack the characteristics of a controlling financial interest. Investors that finance a VIE through debt or equity interests, or other counterparties that provide other forms of support, such as guarantees, subordinated fee arrangements, or certain types of derivative contracts, are variable interest holders in the entity and the variable interest holder, if any, that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both, is deemed to be the VIEs primary beneficiary and is required to consolidate the VIE.

In 1997, Northern Trust issued $150 million of Floating Rate Capital Securities, Series A, and $120 million of Floating Rate Capital Securities, Series B, through statutory business trusts wholly-owned by the Corporation (“NTC Capital I” and “NTC Capital II”, respectively). The sole assets of the trusts are Subordinated Debentures of Northern Trust Corporation that have the same interest rates and maturity dates as the corresponding distribution rates and redemption dates of the Floating Rate Capital Securities.

The outstanding principal amount of the Subordinated Debentures, net of discount, held by the trusts totaled $276.7

 

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million as of December 31, 2008. The book value of the Series A and Series B Securities totaled $268.4 million as of December 31, 2008. Both Series A and B Securities qualify as tier 1 capital for regulatory purposes. NTC Capital I and NTC Capital II are considered variable interest entities. However, as the Corporation has determined that it is not the primary beneficiary of the trusts, they are not consolidated by the Corporation.

Northern Trust acts as investment advisor to Registered Investment Companies, Undertakings for the Collective Investment of Transferable Securities and other unregistered short-term investment pools in which various clients of Northern Trust are investors. As discussed in further detail in Note 28 to the consolidated financial statements, although not obligated to do so, in 2008, Northern Trust entered into Capital Support Agreements with certain of these entities (Funds) whereby Northern Trust would be required to contribute capital to the Funds, not to exceed $550 million in the aggregate and for no consideration, should certain asset loss events occur. In the first quarter of 2009, Northern Trust extended the termination dates of the Capital Support Agreements through November 6, 2009 with all other significant terms, including the maximum contribution limits of $550 million in the aggregate, remaining unchanged. As of December 31, 2008, no capital contributions have been made under the agreements. Although not obligated to do so, Northern Trust also incurred a pre-tax charge of $167.6 million in connection with support provided to securities lending clients whose cash collateral was invested in five unregistered short-term investment collateral pools (Pools).

Under FIN 46-R and related interpretations, the above actions reflect Northern Trust’s implicit interest in the credit risk of the affected Funds and Pools, thus creating a significant variable interest in these entities. Northern Trust has determined, in accordance with FIN 46-R, that it is not the primary beneficiary of the Funds or the Pools and is, therefore, not required to consolidate them within its consolidated balance sheet.

Northern Trust has interests in other variable interest entities which are also not consolidated as Northern Trust is not considered the primary beneficiary of those entities. Northern Trust’s interests in those entities are not considered significant and do not have a material impact on its consolidated financial position or results of operations.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Liquidity Risk Management

 

The objectives of liquidity risk management are to ensure that Northern Trust can meet its cash flow requirements and capitalize on business opportunities on a timely and cost effective basis.

Northern Trust manages its liquidity on a global basis, utilizing regional management when appropriate. The Corporate Treasury department has the day-to-day responsibility for measuring and managing the liquidity risk within guidelines and limits established by the Corporate Asset and Liability Policy and Business Risk Committees. The management of liquidity is based on a framework that monitors the various sources and uses of liquidity, the alignment of their maturities and their level of stability. Liquidity is provided by a variety of sources, including client deposits (institutional and personal) from our C&IS and PFS businesses, wholesale funding from the capital markets, and unencumbered liquid assets that can be sold or pledged to secure additional funding. While management does not view the Federal Reserve’s discount window as a primary source of funds, the Bank can borrow from the discount window on a collateralized basis. Liquidity is used in a variety of activities, including client withdrawals, purchases of securities, and draws on unfunded commitments to extend credit. Certain of our client deposits are payable on demand, which could put pressure on our liquidity during periods of stress. During 2008, the financial markets experienced periods of stress that challenged overall market liquidity. Notably, our sources and uses of liquidity remained stable and we experienced growth in our client deposits.

During 2008, U.S. regulatory agencies took various actions in order to improve liquidity in the financial markets. One of those actions was the establishment by the Federal Deposit Insurance Corporation (FDIC) in October of 2008 of the Temporary Liquidity Guarantee Program (TLGP). This program provides a guarantee of certain newly issued senior unsecured debt issued by eligible entities, including the Bank, and guarantees of funds over $250,000 in non-interest bearing transaction deposit accounts held at FDIC insured banks. The debt guarantee is available, subject to certain limitations, for debt issued through June 30, 2009, and the deposit coverage extends through December 31, 2009. Northern Trust is able to issue debt under the TLGP of approximately $1.5 billion prior to June 30, 2009.

 

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Northern Trust maintains a liquid balance sheet with loans representing only 37% of total assets as of December 31, 2008. Further, at December 31, 2008, there were significant sources of liquidity within Northern Trust’s consolidated balance sheet in the form of cash and due from banks, securities available for sale, and money market assets, which in aggregate totaled $43.4 billion or 53% of total assets.

An important element of our liquidity management is our contingent liquidity plan which can be employed in the event of a liquidity crisis. The objective of the contingent liquidity plan is to ensure that we maintain our liquidity during periods of stress. This plan takes into consideration a variety of scenarios that could challenge our liquidity. These scenarios include specific and systemic events that can impact our on- and off-balance sheet sources and uses of liquidity.

The liquidity of the Corporation is managed separately from that of its banking subsidiaries. The Corporation’s uses of cash consist mainly of dividend payments to the Corporation’s stockholders, the payment of principal and interest to note holders, investments in its subsidiaries, purchases of its common stock, and acquisitions. The more significant uses of cash by the Corporation during 2008 were a $500.0 million investment in the Bank, $247.7 million of common dividends paid to stockholders, and $68.3 million for the repurchase of common stock.

The primary sources of cash for the Corporation are the issuance of equity (common and preferred), issuance of debt, dividend payments from its subsidiaries, and interest and dividends earned on investment securities and money market assets.

On November 14, 2008, in connection with the Corporation’s participation in the U.S. Department of the Treasury’s (U.S. Treasury) Troubled Asset Relief Program’s Capital Purchase Program (Capital Purchase Program), the Corporation issued preferred stock and a warrant for the purchase of the Corporation’s common stock to the U.S. Treasury for total proceeds of $1,576.0 million. Participation in this program puts additional cash flow requirements on the Corporation in future years in the form of preferred dividends. This program also contains certain restrictions, including limits on dividends and share repurchase programs. For additional detail, see Note 14 to the consolidated financial statements. Prior to the establishment of the Capital Purchase Program, the Corporation issued, on August 6, 2008, $400 million in senior debt to mature in 2013 with a coupon of 5.50%.

Bank subsidiary dividends are subject to certain restrictions, as discussed in further detail in Note 30 to the consolidated financial statements. Bank subsidiaries have the ability to pay dividends during 2009 equal to their 2009 eligible net profits plus $1,295.6 million. During 2008, the Corporation received $86.4 million in subsidiary dividends.

The Corporation’s liquidity, defined as the amount of marketable assets in excess of commercial paper, was strong at $1.24 billion at year-end 2008 and $386.0 million at year-end 2007. The cash flows of the Corporation are shown in Note 34 to the consolidated financial statements. The Corporation also has available a $150 million revolving line of credit.

A significant source of liquidity for both Northern Trust and the holding company is the ability to draw funding from capital markets globally. The availability and cost of these funds are influenced by our credit rating; as a result, a downgrade could have an adverse impact on our liquidity. The credit ratings of the Corporation and the Bank as of December 31, 2008, provided below, allow Northern Trust to access capital markets on favorable terms.

 

   

Standard &

Poor’s

   Moody’s    FitchRatings

Northern Trust Corporation:

             

Commercial Paper

  A-1+    P-1    F1+

Senior Debt

  AA-    A1    AA-

The Northern Trust Company:

             

Short-Term Deposit / Debt

  A-1+    P-1    F1+

Long-Term Deposit / Debt

  AA    Aa3    AA / AA-

Outlook

  Stable    Stable    Negative
               

 

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The following table shows Northern Trust’s contractual obligations at December 31, 2008.

 

CONTRACTUAL OBLIGATIONS

 

    PAYMENT DUE BY PERIOD
(In Millions)   TOTAL    ONE YEAR
AND LESS
   1-3 YEARS      4-5 YEARS    OVER 5
YEARS

Senior Notes*

  $ 1,052.6    $    $ 395.3      $ 657.3    $

Subordinated Debt*

    1,365.7      200.0      150.0        200.0      815.7

Federal Home Loan Bank Borrowings*

    1,917.7      180.0      629.6        872.0      236.1

Floating Rate Capital Debt*

    278.4                       278.4

Capital Lease Obligations**

    36.1      3.1      (30.6 )      16.0      47.6

Operating Leases**

    663.5      64.0      118.1        94.8      386.6

Purchase Obligations***

    319.7      90.5      149.2        78.0      2.0
                                     

Total Contractual Obligations

  $ 5,633.7    $ 537.6    $ 1,411.6      $ 1,918.1    $ 1,766.4

Note: Obligations as shown do not include deposit liabilities or interest requirements on funding sources.

* Refer to Notes 12 and 13 to the consolidated financial statements for further details.

** Refer to Note 9 to the consolidated financial statements for further details.

*** Purchase obligations consist primarily of ongoing operating costs related to outsourcing arrangements for certain cash management services and the support and maintenance of the Corporation’s technological requirements. Certain obligations are in the form of variable rate contracts and, in some instances, 2008 activity was used as a base to project future obligations.

 

Capital Management

 

One of management’s primary objectives is to maintain a strong capital position to merit and maintain the confidence of clients, the investing public, bank regulators and stockholders. A strong capital position helps Northern Trust take advantage of profitable investment opportunities and withstand unforeseen adverse developments.

Northern Trust manages its capital both on a total Corporation basis and, where appropriate, on a legal entity basis. The Corporate Treasury department has the day-to-day responsibility for measuring and managing capital levels within guidelines and limits established by the Corporate Asset and Liability Policy and Business Risk Committees. The management of capital will also involve regional management when appropriate. In establishing the guidelines and limits for capital, a variety of factors are taken into consideration, including the overall risk of the business, regulatory requirements, capital levels relative to our peers, and the impact on our credit ratings.

In 2008, capital levels were strengthened as average common equity increased 18% or $735.4 million reaching a record $4.89 billion at year-end. Total stockholders’ equity increased to $6.39 billion reflecting the issuance of senior preferred stock and related warrant to the U.S. Treasury pursuant to the terms of the Capital Purchase Program and the retention of earnings. The increase in common equity was accomplished while paying common dividends and purchasing shares under the Corporation’s share buyback program. The Corporation paid common dividends totaling $247.7 million in 2008 and, in October 2008, the Board of Directors maintained the quarterly dividend at $.28 per common share. The common dividend has increased 47% from its level five years ago. During 2008, the Corporation purchased 1.1 million of its own common shares at a cost of $75.1 million as part of the share buyback program. The buyback program is used for general corporate purposes, including management of the Corporation’s capital level. Under the share buyback program, the Corporation may purchase up to 7.6 million additional shares after December 31, 2008, subject to certain restrictions related to the Corporation’s Series B Preferred Stock as discussed in further detail in Note 14 to the consolidated financial statements.

 

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CAPITAL ADEQUACY   DECEMBER 31  
($ In Millions)   2008      2007  

TIER 1 CAPITAL

                

Common Stockholders’ Equity

  $ 4,888      $ 4,509  

Preferred Stock Series B

    1,501         

Floating Rate Capital Securities

    268        268  

Goodwill and Other Intangible Assets

    (462 )      (529 )

Pension and Other Postretirement Benefit Adjustments

    274        80  

Other

    234        31  
                  

Total Tier 1 Capital

    6,703        4,359  
                  

TIER 2 CAPITAL

                

Reserve for Credit Losses Assigned to Loans and Leases

    229        148  

Off-Balance Sheet Credit Loss Reserve

    22        12  

Reserves Against Identified Losses

    (24 )      (11 )

Long-Term Debt*

    939        830  
                  

Total Tier 2 Capital

    1,166        979  
                  

Total Risk-Based Capital

  $ 7,869      $ 5,338  
                  

Risk-Weighted Assets**

  $ 51,258      $ 44,852  
                  

Total Assets – End of Period (EOP)

  $ 82,054      $ 67,611  

Average Fourth Quarter Assets**

    78,903        64,255  

Total Loans – EOP

    30,755        25,340  
                  

RATIOS

                

Risk-Based Capital Ratios

                

Tier 1

    13.1 %      9.7 %

Total (Tier 1 and Tier 2)

    15.4        11.9  

Leverage

    8.5        6.8  
                  

COMMON STOCKHOLDERS’ EQUITY TO

                

Total Loans EOP

    15.89 %      17.8 %

Total Assets EOP

    5.96        6.7  

* Long-Term Debt that qualifies for risk-based capital amortizes for the purpose of inclusion in tier 2 capital during the five years before maturity.

** Assets have been adjusted for goodwill and other intangible assets, net unrealized (gain) loss on securities and excess reserve for credit losses that have been excluded from tier 1 and tier 2 capital, if any.

 

The 2008 capital levels reflect Northern Trust’s ongoing retention of earnings to allow for strategic expansion while maintaining a strong balance sheet. The Corporation’s capital supported risk-weighted asset growth of 14% in 2008 with all of its capital ratios well above the ratios that are a requirement for regulatory classification as “well-capitalized”. At December 31, 2008, the Corporation’s tier 1 capital was 13.1% and total capital was 15.4% of risk-weighted assets. The “well-capitalized” minimum ratios are 6.0% and 10.0%, respectively. The Corporation’s leverage ratio (tier 1 capital to fourth quarter average assets) of 8.5% is also well above the “well-capitalized” minimum requirement of 5.0%. In addition, each of the Corporation’s U.S. subsidiary banks had a ratio of at least 8.5% for tier 1 capital, 11.2% for total risk-based capital, and 6.4% for the leverage ratio.

The Corporation is subject to the framework for risk-based capital adequacy, sometimes referred to as Basel II, which was developed by the Basel Committee on Banking Supervision and has been endorsed by the central bank governors and heads of bank supervision of the G10 countries. In December 2007, the U.S. bank regulatory agencies published final rules, effective April 1, 2008, with respect to implementation of the Basel II framework, the latest agreed-version of which was released by the Basel Committee in November 2005.

Under the final Basel II rules, the Corporation is one of a small number of “core” banking organizations. As a result, the Corporation and its U.S. depository institution subsidiaries will be required to use the advanced approaches under Basel II for calculating risk-based capital related to credit risk and operational risk, instead of the methodology reflected in the regulations effective prior to adoption of Basel II. The new rules also require core banking organizations to have rigorous processes for assessing overall capital adequacy in relation to their total risk profiles, and to publicly disclose certain information about their risk profiles and capital adequacy.

In order to implement the new rules, a core banking organization such as the Corporation was required to (and the Corporation did) adopt an implementation plan by October 1, 2008 and must satisfactorily complete a four-quarter parallel

 

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run, in which it calculates capital requirements under both the new Basel II rules and regulations effective prior to the adoption of Basel II. The organization must then progress through three transitional periods of at least four quarters each, commencing no later than April 1, 2011. During these transitional periods, the maximum cumulative reduction in capital requirements from those under the regulations effective prior to adoption of Basel II may not exceed 5% for the first period, 10% for the second period and 15% for the third period. Supervisory approval is required to move through these transitional periods and out of the final transitional period. The agencies also have said they will publish a study after the end of the second transitional year that will examine the new framework for any deficiencies.

 

RISK MANAGEMENT

 

Overview

 

The Board of Directors’ Business Risk Committee provides oversight with respect to the following risks inherent in Northern Trust’s businesses: credit risk, market and liquidity risk, fiduciary risk, operational risk and the regulatory component of compliance risk. The Business Risk Committee has approved a Corporate Risk Appetite Statement articulating Northern Trust’s expectation that risk is consciously considered as part of strategic decisions and in day-to-day activities. Northern Trust’s business units are expected to manage business activities within the parameters set forth in the Corporate Risk Appetite Statement.

Risk tolerances are further detailed in separate credit, operational, market, fiduciary and compliance risk policies and appetite statements. Various corporate committees and oversight entities have been established to review and approve risk management strategies, standards, management practices and tolerance levels. These committees and entities monitor and provide periodic reporting to the Business Risk Committee on risk performance and effectiveness of risk management processes.

 

Asset Quality and Credit Risk Management

 

Securities Portfolio

 

Northern Trust maintains a high quality securities portfolio, with 90% of the total portfolio at December 31, 2008 composed of U.S. Treasury and government sponsored agency securities, Federal Home Loan Bank and Federal Reserve Bank stock, and triple-A rated asset-backed securities, auction rate securities and obligations of states and political subdivisions. The remaining portfolio was composed of asset- backed securities, obligations of states and political subdivisions, auction rate securities and other securities, of which 4% were rated double-A, 3% were rated below double-A, and 3% were not rated by Standard and Poor’s or Moody’s Investors Service. Asset-backed securities held at December 31, 2008 were predominantly floating rate, with average lives less than 5 years, and 85% were rated triple-A, 10% were rated double-A, and the remaining 5% rated below double-A. Asset-backed securities rated below double-A had a total amortized cost and fair value of $145.5 million and $76.1 million, respectively, and were comprised primarily of sub-prime and Alt-A residential mortgage-backed securities.

Auction rate securities were purchased in 2008 in connection with a program to purchase at par value certain illiquid auction rate securities held for clients under investment discretion or that were acquired by clients from Northern Trust’s affiliated broker/dealer. A $54.6 million charge was recorded within other operating expenses reflecting differences between the securities’ par values and estimated purchase date fair market values. At December 31, 2008, 96% of these securities were investment grade. The remaining 4% that were below investment grade had a total amortized cost and fair value of $5 million and $3 million, respectively.

Total unrealized losses within the investment securities portfolio at December 31, 2008 were $387.9 million as compared to $175.5 million at June 30, 2008 and $64.8 million at December 31, 2007. The $323.1 million increase in unrealized losses from the prior year end primarily reflects lower valuations of asset-backed securities due to the widening of credit spreads and deterioration in overall market conditions experienced in the second half of 2008. As discussed above in the “Critical Accounting Estimates – Other Than Temporary Impairment of Investment Securities” section, processes are in place to provide for the timely identification of other-than-temporary impairment. Losses totaling $61.3 million were recognized in 2008 in connection with the write-down to estimated fair value of six asset-backed securities determined to be other-than-temporarily impaired. The remaining securities with unrealized losses within Northern Trust’s portfolio as of December 31, 2008 are not considered to be other-than-temporarily impaired. However, due to market and economic conditions, additional other-than-temporary impairments may occur in future periods.

Northern Trust is an active participant in the repurchase agreement market. This market provides a relatively low cost alternative for short-term funding. Securities purchased under agreements to resell and securities sold under agreements to repurchase are recorded at the amounts at which the securities

 

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were acquired or sold plus accrued interest. To minimize any potential credit risk associated with these transactions, the fair value of the securities purchased or sold is continuously monitored, limits are set on exposure with counterparties, and the financial condition of counterparties is regularly assessed. It is Northern Trust’s policy to take possession of securities purchased under agreements to resell. Securities sold under agreements to repurchase are held by the counterparty until the repurchase.

 

Loans and Other Extensions of Credit

 

Credit risk is inherent in Northern Trust’s various lending activities. Northern Trust focuses its lending efforts on clients who are looking to establish a full range of financial services with Northern Trust. Credit risk is managed through the Credit Policy function, which is designed to assure adherence to a high level of credit standards. Credit Policy reports to the Corporation’s Head of Corporate Risk Management. Credit Policy provides a system of checks and balances for Northern Trust’s diverse credit-related activities by establishing and monitoring all credit-related policies and practices throughout Northern Trust and assuring their uniform application. These activities are designed to diversify credit exposure on an industry and client basis, thus lessening overall credit risk. These credit management activities also apply to Northern Trust’s use of derivative financial instruments, including foreign exchange contracts and interest risk management instruments.

Individual credit authority for commercial and other loans is limited to specified amounts and maturities. Credit decisions involving commitment exposure in excess of the specified individual limits are submitted to the appropriate Credit Approval Committee (Committee). Each Committee is chaired by the executive in charge of the area or their designee and has a Credit Policy officer as a voting participant. Each Committee’s credit approval authority is specified, based on commitment levels, credit ratings and maturities. Credits involving commitment exposure in excess of these limits require the approval of the Senior Credit Committee.

The Counterparty Risk Management Committee established by Credit Policy manages counterparty risk. This committee has sole credit authority for exposure to all non-U.S. banks, certain U.S. banks which Credit Policy deems to be counterparties and which do not have commercial credit relationships within the Corporation, and certain other exposures.

Under the auspices of Credit Policy, country exposure limits are reviewed and approved on a country-by-country basis.

As part of Northern Trust’s ongoing credit granting process Credit Policy assigns internal ratings to each client and credit before credit is extended, based on an assessment of creditworthiness. Credit Policy performs, at least annually, a review of selected significant credit exposures to identify, at an early stage, clients who might be facing financial difficulties. Internal credit ratings are also reviewed during this process. Credit ratings range from “1” for the strongest credits to “9” for the weakest credits; a “9” rated loan would normally represent a complete loss. Above average risk loans receive special attention by both lending officers and Credit Policy. This approach allows management to take remedial action in an effort to deal with potential problems.

An integral part of the Credit Policy function is a formal review of past due and potential problem loans to determine which credits, if any, need to be placed on nonaccrual status or charged off. As more fully described in the “Provision and Reserve For Credit Losses” section below, the provision for credit losses is reviewed quarterly to determine the amount necessary to maintain an adequate reserve for credit losses.

A further way in which credit risk is managed is by requiring collateral. Management’s assessment of the borrower’s creditworthiness determines whether collateral is obtained. The amount and type of collateral held varies but may include deposits held in financial institutions, U.S. Treasury securities, other marketable securities, income-producing commercial properties, accounts receivable, residential real estate, property, plant and equipment, and inventory. Collateral values are monitored on a regular basis to ensure that they are maintained at an appropriate level.

 

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The largest component of credit risk relates to the loan portfolio. In addition, credit risk is inherent in certain contractual obligations such as legally binding unfunded commitments to extend credit, commercial letters of credit, and standby letters of credit. These contractual obligations and arrangements are discussed in Note 27 to the consolidated financial statements and are presented in the tables that follow.

 

COMPOSITION OF LOAN PORTFOLIO   DECEMBER 31
(In Millions)   2008    2007    2006    2005    2004

U.S.

                                 

Residential Real Estate

  $ 10,381.4    $ 9,171.0    $ 8,674.4    $ 8,340.5    $ 8,095.3

Commercial

    8,253.6      5,556.4      4,679.1      3,545.3      3,217.9

Commercial Real Estate

    3,014.0      2,350.3      1,836.3      1,524.3      1,307.5

Personal

    4,766.7      3,850.8      3,415.8      2,961.3      2,927.2

Other

    1,404.2      969.1      979.2      797.8      609.7

Lease Financing

    1,143.8      1,168.4      1,291.6      1,194.1      1,221.8
                                   

Total U.S.

  $ 28,963.7    $ 23,066.0    $ 20,876.4    $ 18,363.3    $ 17,379.4

Non-U.S.

    1,791.7      2,274.1      1,733.3      1,605.2      563.3
                                   

Total Loans and Leases

  $ 30,755.4    $ 25,340.1    $ 22,609.7    $ 19,968.5    $ 17,942.7

 

SUMMARY OF OFF-BALANCE SHEET FINANCIAL INSTRUMENTS WITH CONTRACT

AMOUNTS THAT REPRESENT CREDIT RISK

  DECEMBER 31
(In Millions)   2008    2007

Unfunded Commitments to Extend Credit

            

One Year and Less

  $ 9,902.4    $ 6,327.6

Over One Year

    15,453.9      15,796.7
              

Total

  $ 25,356.3    $ 22,124.3
              

Standby Letters of Credit

    4,025.0      2,881.8

Commercial Letters of Credit

    36.7      35.9

Custody Securities Lent with Indemnification

    82,728.2      179,779.5

 

UNFUNDED COMMITMENTS TO EXTEND CREDIT AT DECEMBER 31, 2008

BY INDUSTRY SECTOR

 

(In Millions)   COMMITMENT EXPIRATION
Industry Sector  

TOTAL

COMMITMENTS

   ONE YEAR
AND LESS
   OVER ONE
YEAR
  

OUTSTANDING

LOANS

Finance and Insurance

  $ 2,461.7    $ 1,278.3    $ 1,183.4    $ 731.6

Holding Companies

    214.1      130.6      83.5      212.0

Manufacturing

    5,037.2      833.1      4,204.1      1,982.4

Mining

    183.2      37.0      146.2      96.8

Public Administration

    20.1      15.6      4.5      365.9

Retail Trade

    701.8      110.8      591.0      238.4

Security and Commodity Brokers

    84.1      35.0      49.1     

Services

    4,102.6      1,870.4      2,232.2      3,645.1

Transportation and Warehousing

    343.6      47.6      296.0      96.4

Utilities

    604.1      66.4      537.7      208.8

Wholesale Trade

    675.3      100.8      574.5      485.5

Other Commercial

    273.6      67.2      206.4      190.7
                            

Total Commercial*

  $ 14,701.4    $ 4,592.8    $ 10,108.6    $ 8,253.6

Residential Real Estate

    2,386.0      279.6      2,106.4      10,381.4

Commercial Real Estate

    613.3      186.9      426.4      3,014.0

Personal

    5,561.6      3,229.5      2,332.1      4,766.7

Other

    1,262.1      915.9      346.2      1,404.2

Lease Financing

                   1,143.8

Non-U.S.

    831.9      697.7      134.2      1,791.7
                            

Total

  $ 25,356.3    $ 9,902.4    $ 15,453.9    $ 30,755.4
                            

* Commercial industry sector information is presented on the basis of the North American Industry Classification System (NAICS).

 

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Although credit exposure is well diversified, there are certain groups of credits that meet the accounting definition of credit risk concentrations under FASB SFAS No. 107 “Disclosures about Fair Value of Financial Instruments”. According to this standard, group concentrations of credit risk exist if a number of borrowers or other counterparties are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The fact that a credit exposure falls into one of these groups does not necessarily indicate that the credit has a higher than normal degree of credit risk. These groups are: residential real estate, banks and bank holding companies, and commercial real estate.

 

Residential Real Estate

 

The residential real estate loan portfolio is primarily composed of mortgages to clients with whom Northern Trust is seeking to establish a comprehensive financial services relationship. At December 31, 2008, residential real estate loans totaled $10.4 billion or 36% of total U.S. loans at December 31, 2008, compared with $9.2 billion or 40% at December 31, 2007. All mortgages were underwritten utilizing Northern Trust’s stringent credit standards. Residential real estate loans consist of conventional home mortgages and equity credit lines, which generally require a loan to collateral value of no more than 75% to 80% at inception.

Of the total $10.4 billion in residential real estate loans, $3.9 billion were in the greater Chicago area, $2.8 billion were in Florida, and $1.0 billion were in Arizona, with the remainder distributed throughout the other geographic regions within the U.S. served by Northern Trust. Legally binding commitments to extend residential real estate credit, which are primarily equity credit lines, totaled $2.4 billion and $2.3 billion at December 31, 2008 and 2007, respectively.

 

Banks and Bank Holding Companies

 

On-balance sheet credit risk to banks and bank holding companies, both U.S. and non-U.S., consists primarily of short-term money market assets, which totaled $16.9 billion and $25.1 billion at December 31, 2008 and December 31, 2007, respectively, and noninterest-bearing demand balances maintained at correspondent banks, which totaled $2.6 billion and $3.7 billion at December 31, 2008 and December 31, 2007, respectively.

Credit risk associated with banks and bank holding companies is managed by committees within the Credit Policy function which approve and monitor U.S. and non-U.S bank exposures. Credit limits are also established by these committees through a review process that includes an internally prepared financial analysis, use of an internal rating system and consideration of external ratings from rating agencies. Northern Trust places deposits with banks that have high internal and external credit ratings and the average life to maturity of deposits with banks is maintained on a short-term basis in order to respond quickly to changing credit conditions.

Northern Trust also provides commercial financing to banks and bank holding companies with which it has a substantial business relationship. Northern Trust’s outstanding lending exposure to these entities, primarily U.S. bank holding companies located in the Greater Midwest, was not considered material to its consolidated financial position as of December 31, 2008 or 2007.

 

Commercial Real Estate

In managing its credit exposure, management has defined a commercial real estate loan as one where: (1) the borrower’s principal business activity is the acquisition or the development of real estate for commercial purposes; (2) the principal collateral is real estate held for commercial purposes, and loan repayment is expected to flow from the operation of the property; or (3) the loan repayment is expected to flow from the sale or refinance of real estate as a normal and ongoing part of the business. Unsecured lines of credit to firms or individuals engaged in commercial real estate endeavors are included without regard to the use of loan proceeds. The commercial real estate portfolio consists of interim loans and commercial mortgages.

Short-term interim loans provide financing for the initial phases of the acquisition or development of commercial real estate, with the intent that the borrower will refinance the loan through another financial institution or sell the project upon its completion. The interim loans are primarily in those markets where Northern Trust has a strong presence and a thorough knowledge of the local economy. The interim loans, which totaled $606.5 million and $511.5 million as of December 31, 2008 and 2007, respectively, are composed primarily of loans to developers that are highly experienced and well known to Northern Trust.

Commercial mortgage financing, which totaled $2.4 billion and $1.9 billion as of December 31, 2008 and 2007, respectively, is provided for the acquisition or refinancing of income producing properties. Cash flows from the properties generally are sufficient to amortize the loan. These loans average approximately $1 million each and are primarily located in the Illinois and Florida markets.

At December 31, 2008, legally binding commitments to extend credit and standby letters of credit to commercial real

 

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estate developers totaled $613.3 million and $63.4 million, respectively. At December 31, 2007, legally binding commitments were $620.9 million and standby letters of credit were $57.6 million.

 

Non-U.S. Outstandings

As used in this discussion, non-U.S. outstandings are cross-border outstandings as defined by the Securities and Exchange Commission. They consist of loans, acceptances, interest-bearing deposits with financial institutions, accrued interest and other monetary assets. Not included are letters of credit, loan commitments, and non-U.S. office local currency claims on residents funded by local currency liabilities. Non-U.S. outstandings related to a specific country are net of guarantees given by third parties resident outside the country and the value of tangible, liquid collateral held outside the country. However, transactions with branches of non-U.S. banks are included in these outstandings and are classified according to the country location of the non-U.S. banks’ head office.

Short-term interbank time deposits with non-U.S. banks represent the largest category of non-U.S. outstandings. Northern Trust actively participates in the interbank market with U.S. and non-U.S. banks. International commercial lending activities also include import and export financing for U.S.-based clients.

Northern Trust places deposits with non-U.S. counterparties that have high internal (Northern Trust) and external credit ratings. These non-U.S. banks are approved and monitored by Northern Trust’s Counterparty Risk Management Committee, which has credit authority for exposure to all non-U.S. banks and employs a review process that results in credit limits. This process includes financial analysis of the non-U.S. banks, use of an internal rating system and consideration of external ratings from rating agencies. Each counterparty is reviewed at least annually and potentially more frequently based on deteriorating credit fundamentals or general market conditions. Separate from the entity-specific review process, the average life to maturity of deposits with non-U.S. banks is deliberately maintained on a short-term basis in order to respond quickly to changing credit conditions. Additionally, the Committee performs a country-risk analysis and imposes limits to country exposure. The following table provides information on non-U.S. outstandings by country that exceed 1.00% of Northern Trust’s assets.

 

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NON-U.S. OUTSTANDINGS

 

(In Millions)   BANKS     

COMMERCIAL

AND OTHER

     TOTAL

At December 31, 2008

                       

United Kingdom

  $ 2,640      $ 63      $ 2,703

France

    2,455        1        2,456

Belgium

    1,382               1,382

Canada

    1,252        3        1,255

Netherlands

    1,025        95        1,120

Channel Islands & Isle of Man

    823        11        834
                         

At December 31, 2007

                       

France

  $ 2,982      $ 1      $ 2,983

United Kingdom

    2,693        109        2,802

Canada

    1,905        12        1,917

Netherlands

    1,527        188        1,715

Belgium

    1,540        8        1,548

Germany

    1,499        2        1,501

Australia

    1,316        19        1,335

Spain

    1,004        1        1,005

Switzerland

    967        4        971

Sweden

    877        3        880

Ireland

    522        309        831

Singapore

    779        2        781

Channel Islands & Isle of Man

    666        21        687
                         

At December 31, 2006

                       

France

  $ 3,187      $ 1      $ 3,188

United Kingdom

    2,176        52        2,228

Netherlands

    1,313        219        1,532

Ireland

    654        374        1,028

Hong Kong

    951               951

Belgium

    871        13        884

Germany

    791        3        794

Sweden

    727        2        729

Countries whose aggregate outstandings totaled between .75% and 1.00% of total assets were as follows: Ireland with aggregate outstandings of $773 million and Spain with aggregate outstandings of $752 million at December 31, 2008, Denmark with aggregate outstandings of $593 million at December 31, 2007, and Canada with aggregate outstandings of $489 million at December 31, 2006.

 

NONPERFORMING ASSETS   DECEMBER 31
(In Millions)   2008      2007      2006      2005      2004

Nonaccrual Loans

                                         

U.S.

                                         

Residential Real Estate

  $ 32.7      $ 5.8      $ 8.1      $ 5.0      $ 2.8

Commercial

    21.3        10.4        18.8        16.1        29.5

Commercial Real Estate

    35.8                             .1

Personal

    6.9        7.0        7.6        8.7        .5

Non-U.S.

                  1.2        1.2       
                                           

Total Nonaccrual Loans

    96.7        23.2        35.7        31.0        32.9

Other Real Estate Owned

    3.5        6.1        1.4        .1        .2
                                           

Total Nonperforming Assets

  $ 100.2      $ 29.3      $ 37.1      $ 31.1      $ 33.1
                                           

90 Day Past Due Loans Still Accruing

  $ 27.8      $ 8.6      $ 24.6      $ 29.9      $ 9.9

 

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Nonperforming Assets and 90 Day Past Due Loans

Nonperforming assets consist of nonaccrual loans and Other Real Estate Owned (OREO). OREO is comprised of commercial and residential properties acquired in partial or total satisfaction of problem loans. Past due loans are loans that are delinquent 90 days or more and still accruing interest. The level of 90 day past due loans at any reporting period can fluctuate widely based on the timing of cash collections, renegotiations and renewals.

Maintaining a low level of nonperforming assets is important to the ongoing success of a financial institution. In addition to the negative impact on both net interest income and credit losses, nonperforming assets also increase operating costs due to the expense associated with collection efforts. Northern Trust’s comprehensive credit review and approval process is a critical part of its ability to minimize nonperforming assets on a long-term basis.

The previous table presents the nonperforming assets and past due loans for the current and prior four years. Of the total loan portfolio of $30.8 billion at December 31, 2008, $96.7 million, or .31%, was nonaccrual, compared with $23.2 million, or .09%, at December 31, 2007.

Included in the portfolio of nonaccrual loans are those loans that meet the criteria of being “impaired.” A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. As of December 31, 2008, impaired loans, all of which have been classified as nonaccrual, totaled $85.6 million. These loans had $15.5 million of the reserve for credit losses allocated to them.

 

Provision and Reserve for Credit Losses

Changes in the reserve for credit losses were as follows:

 

(In Millions)   2008      2007      2006  

Balance at Beginning of Year

  $ 160.2      $ 151.0      $ 136.0  

Charge-Offs

    (25.7 )      (9.7 )      (1.8 )

Recoveries

    2.5        .9        1.6  
                           

Net Charge-Offs

    (23.2 )      (8.8 )      (.2 )

Provision for Credit Losses

    115.0        18.0        15.0  

Effect of Foreign Exchange Rates

    (.9 )             .2  
                           

Balance at End of Year

  $ 251.1      $ 160.2      $ 151.0  

 

The provision for credit losses is the charge to current earnings that is determined by management, through a disciplined credit review process, to be the amount needed to maintain a reserve that is sufficient to absorb probable credit losses that have been identified with specific borrower relationships (specific loss component) and for probable losses that are believed to be inherent in the loan and lease portfolios, unfunded commitments, and standby letters of credit (inherent loss component). The following table shows the specific portion of the reserve and the allocated portion of the inherent reserve and its components by loan category at December 31, 2008 and each of the prior four year-ends, and the unallocated portion of the reserve at each of the prior four year-ends.

 

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ALLOCATION OF THE RESERVE FOR CREDIT LOSSES

 

    DECEMBER 31  
    2008     2007     2006     2005     2004  
($ In Millions)   RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
    RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
    RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
    RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
    RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
 

Specific Reserve

  $ 23.5   %   $ 10.8   %   $ 19.6   %   $ 20.3   %   $ 24.0   %
                                                             

Allocated Inherent Reserve

                                                           

Residential Real Estate

    37.0   34       13.6   36       13.4   38       12.4   42       11.6   45  

Commercial

    114.7   27       64.1   22       55.0   21       48.3   18       49.9   18  

Commercial Real Estate

    43.8   10       28.4   9       21.5   8       17.7   7       17.1   7  

Personal

    19.7   15       6.2   15       5.9   15       6.1   15       5.5   16  

Other

    1.7   4         4         4         4         4  

Lease Financing

    3.3   4       3.6   5       3.7   6       3.9   6       4.5   7  

Non-U.S.

    7.4   6       7.4   9       6.6   8       2.9   8       1.6   3  
                                                             

Total Allocated Inherent Reserve

  $ 227.6   100 %   $ 123.3   100 %   $ 106.1   100 %   $ 91.3   100 %   $ 90.2   100 %
                                                             

Unallocated Inherent Reserve

            26.1         25.3         24.4         25.1    
                                                             

Total Reserve for Credit Losses

  $ 251.1   100 %   $ 160.2   100 %   $ 151.0   100 %   $ 136.0   100 %   $ 139.3   100 %
                                                             

Reserve Assigned to:

                                                           

Loans and Leases

  $ 229.1         $ 148.1         $ 140.4         $ 125.4         $ 130.7      

Unfunded Commitments and Standby Letters of Credit

    22.0           12.1           10.6           10.6           8.6      
                                                             

Total Reserve for Credit Losses

  $ 251.1         $ 160.2         $ 151.0         $ 136.0         $ 139.3      

 

Specific Component of the Reserve

The amount of specific reserves is determined through an individual evaluation of loans and lending-related commitments considered impaired based on expected future cash flows, collateral value, market value, and other factors that may impact the borrower’s ability to pay.

At December 31, 2008, the specific reserve component amounted to $23.5 million compared with $10.8 million at the end of 2007. The $12.7 million increase primarily reflects additional reserves provided for three credit exposures that are considered impaired, partially offset by principal repayments received and charge-offs.

The decrease in the specific loss component of the reserve from $19.6 million in 2006 to $10.8 million in 2007 reflects principal repayments received and charge-offs.

 

Inherent Component of the Reserve

The inherent component of the reserve addresses exposure relating to probable but unidentified credit-related losses. The amount of inherent loss reserves is based primarily on reserve factors which incorporate management’s evaluation of historical charge-off experience and various qualitative factors such as management’s evaluation of economic and business conditions and changes in the character and size of the loan portfolio. Effective in 2008, the methodology used to determine the qualitative element of the inherent reserve was modified to provide for the assignment of reserves to loan and lease credit exposures aggregated by shared risk characteristics to better align the reserves with the related credit risk. Previously, this element of the inherent reserve was associated with the credit portfolio as a whole and was referred to as the unallocated inherent reserve.

The historical charge-off experience for each loan category is based on data from the preceding four years. Qualitative factors reviewed by management include changes in asset quality metrics, changes in the nature and volume of the portfolio, changes in economic and business conditions, changes in collateral valuations, such as property values, and other pertinent information.

The inherent component of the reserve also covers the credit exposure associated with undrawn loan commitments and standby letters of credit. To estimate the reserve for credit losses on these instruments, management uses conversion rates to determine their balance sheet equivalent amount and assigns a reserve factor based on the methodology utilized for outstanding loans.

The inherent portion of the reserve increased $78.2 million to $227.6 million at December 31, 2008, compared with $149.4 million at December 31, 2007, which in turn increased $18.0 million from $131.4 million at December 31, 2006. The increase in this component of the reserve from the

 

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prior year is primarily attributable to loan growth and weakness in the broader economic environment. The increase during 2007 is primarily attributable to growth in the commercial loan portfolio.

 

Other Factors

The total amount of the two highest risk loan groupings, those rated “7” and “8” (based on Northern Trust’s internal rating scale, which closely parallels that of the banking regulators), increased $337.7 million to $401.0 million, of which $85.6 million was classified as impaired. This compares with $63.3 million last year-end when $19.4 million was classified as impaired. The increase in 2008 primarily reflects the migration of loans to higher risk ratings as a result continued weakness in the broader economic environment. There were no “9” rated loans reported at any time during the periods because loans are charged-off when they are so rated. At December 31, 2008, these highest risk loans represented 1.30% of outstanding loans.

 

Overall Reserve

In establishing the overall reserve level, management considers that 34% of the loan portfolio consists of lower risk residential mortgage loans. The evaluation of the factors above resulted in a reserve for credit losses of $251.1 million at December 31, 2008 compared with $160.2 million at the end of 2007. The reserve of $229.1 million assigned to loans and leases, as a percentage of total loans and leases, was .75% at December 31, 2008, compared with .58% at December 31, 2007. The increase in the reserve level reflects loan growth and weakness in the broader economic environment.

Reserves assigned to unfunded loan commitments and standby letters of credits totaled $22.0 million and $12.1 million at December 31, 2008 and December 31, 2007, respectively, and are included in other liabilities in the consolidated balance sheet.

 

Provision

The provision for credit losses was $115.0 million for 2008 and net charge-offs totaled $23.2 million. This compares with an $18.0 million provision for credit losses and net charge-offs of $8.8 million in 2007 and a $15.0 million provision for credit losses and net charge-offs of $.2 million in 2006.

 

Market Risk Management

 

Overview

To ensure adherence to Northern Trust’s interest rate and foreign exchange risk management policies, ALCO establishes and monitors guidelines to control the sensitivity of earnings to changes in interest rates and foreign currency exchange rates. The guidelines apply to both on- and off-balance sheet positions. The goal of the ALCO process is to maximize earnings while maintaining a high quality balance sheet and carefully controlling interest rate and foreign exchange risk.

 

Asset/Liability Management

Asset/liability management activities include lending, accepting and placing deposits, investing in securities, issuing debt, and hedging interest rate and foreign exchange risk with derivative financial instruments. The primary market risk associated with asset/liability management activities is interest rate risk and, to a lesser degree, foreign exchange risk.

 

Interest Rate Risk Management

Sensitivity of earnings to interest rate changes arises when yields on assets change in a different time period or in a different amount from that of interest costs on liabilities. To mitigate interest rate risk, the structure of the balance sheet is managed so that movements of interest rates on assets and liabilities (adjusted for off-balance sheet hedges) are highly correlated which allows Northern Trust’s interest-bearing assets and liabilities to contribute to earnings even in periods of volatile interest rates.

Northern Trust utilizes the following measurement techniques in the management of interest rate risk: simulation of earnings; simulation of the economic value of equity; and gap analysis. These three techniques are complementary and are used in concert to provide a comprehensive interest rate risk management capability.

Simulation of earnings is the primary tool used to measure the sensitivity of earnings to interest rate changes. Using modeling techniques, Northern Trust is able to measure the potential impact of different interest rate assumptions on pre-tax earnings. The model includes U.S. dollar-based on-balance sheet positions, as well as derivative financial instruments (principally interest rate swaps) that are used to manage interest rate risk.

Northern Trust used model simulations as of December 31, 2008 to measure its earnings sensitivity relative to management’s most likely interest rate forecast for the following year. Management’s most likely 2009 interest rate forecast reflects the current low level of market rates and has the current yield curve steepening by the end of the year. The interest sensitivity was tested by running alternative scenarios above and below the most likely interest rate forecast. The following table shows the estimated impact on 2009 pre-tax earnings of 100 and 200 basis point upward and downward movements in interest rates relative to management’s most

 

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likely interest rate forecast. Each of the movements in interest rates was assumed to have occurred gradually over a one-year period. The 100 basis point increase, for example, consisted of twelve consecutive monthly increases of 8.3 basis points. The following assumptions were also incorporated into the model simulations:

Ÿ  

the balance sheet size was assumed to remain constant over the one-year simulation horizon;

Ÿ  

maturing assets and liabilities were replaced on the balance sheet with the same terms;

Ÿ  

prepayments on mortgage loans were projected under each rate scenario using a third-party mortgage analytics system that incorporated market prepayment assumptions; and

Ÿ  

changes in the spreads between retail deposit rates and asset yields were estimated based on historical patterns and current competitive trends; and

Ÿ  

implied floors are assumed as interest rates approach zero in the declining rate scenarios, resulting in spread compression and lower net interest income.

 

INTEREST RATE RISK SIMULATION OF PRE-TAX

INCOME AS OF DECEMBER 31, 2008

 

(In Millions)  

ESTIMATED IMPACT ON
2009

PRE-TAX INCOME
INCREASE/(DECREASE)

 

INCREASE IN INTEREST RATES ABOVE

MANAGEMENT’S INTEREST RATE FORECAST

       

100 Basis Points

  $ 13.6  

200 Basis Points

    8.8  

DECREASE IN INTEREST RATES BELOW

MANAGEMENT’S INTEREST RATE FORECAST

       

100 Basis Points

  $ (46.1 )

200 Basis Points

    (69.2 )

 

The simulations of earnings do not incorporate any management actions that might moderate the negative consequences of actual interest rate deviations. For that reason and others, they do not reflect likely actual results but serve as conservative estimates of interest rate risk.

A second technique used to measure interest rate risk is simulation of the economic value of equity, which is defined as the present value of assets minus the present value of liabilities net of the value of instruments that are used to manage the interest rate risk of balance sheet items. This measurement of interest rate risk provides estimates of the potential future impact on the economic value of equity of various changes in interest rates. The potential effect of interest rate changes on economic equity is derived from the impact of such changes on the market values of assets, liabilities and off-balance sheet instruments. Northern Trust limits aggregate market risk, as measured in this fashion, to an acceptable level within the context of risk-return trade-offs.

The third technique that is used to measure interest rate risk is gap analysis. The calculation of the interest sensitivity gap measures the timing mismatches between assets and liabilities. This interest sensitivity gap is determined by subtracting the amount of liabilities from the volume of assets that reprice or mature in a particular time interval. A liability sensitive position results when more liabilities than assets reprice or mature within a given period. Under this scenario, as interest rates decline, increased net interest income will be generated. Conversely, an asset sensitive position results when more assets than liabilities reprice within a given period; in this instance, net interest income would benefit from an increasing interest rate environment. The economic impact of a liability or asset sensitive position depends on the magnitude of actual changes in interest rates relative to the current expectations of market price participants. Northern Trust utilizes interest rate risk gap analysis to measure and limit the interest rate risk of its assets and liabilities denominated in non-U.S. currencies.

A variety of actions may be used to implement risk management strategies including:

Ÿ  

purchases of securities;

Ÿ  

sales of securities that are classified as available for sale;

Ÿ  

sales of held for sale residential real estate loans;

Ÿ  

issuance of senior notes and subordinated notes;

Ÿ  

collateralized borrowings from the Federal Home Loan Bank;

Ÿ  

placing and taking Eurodollar time deposits; and

Ÿ  

hedging with various types of derivative financial instruments.

 

Northern Trust strives to use the most effective instruments for implementing its interest risk management strategies, considering the costs, liquidity, collateral and capital requirements of the various alternatives.

 

Foreign Exchange Risk Management

Northern Trust is exposed to non-trading foreign exchange risk as a result of its holdings of non-U.S. dollar denominated assets and liabilities, investment in non-U.S. subsidiaries, and other transactions in non-U.S. dollar currencies. To manage non-trading foreign exchange volatility and minimize the earnings impact of translation gains and losses, Northern Trust utilizes non-U.S. dollar denominated liabilities to fund non-U.S. dollar denominated net assets. If those currency offsets do not exist on the balance sheet, Northern Trust will use various foreign exchange derivative contracts to mitigate its currency exposure.

 

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Foreign Exchange Trading. Foreign exchange trading activities consist principally of providing foreign exchange services to clients. Most of these services are provided in connection with Northern Trust’s growing global custody business. However, in the normal course of business Northern Trust also engages in proprietary trading of non-U.S. currencies. The primary market risk associated with these activities is foreign exchange risk.

Foreign currency trading positions exist when aggregate obligations to purchase and sell a currency other than the U.S. dollar do not offset each other, or offset each other in different time periods. Northern Trust mitigates the risk related to its non-U.S. currency positions by establishing limits on the amounts and durations of its positions. The limits on overnight inventory positions are generally lower than the limits established for intra-day trading activity. All overnight positions are monitored by a risk management function, which is separate from the trading function, to ensure that the limits are not exceeded. Although position limits are important in controlling foreign exchange risk, they are not a substitute for the experience or judgment of Northern Trust’s senior management and its currency traders, who have extensive knowledge of the currency markets. Non-U.S. currency positions and strategies are adjusted as needed in response to changing market conditions.

As part of its risk management activities, Northern Trust regularly measures the risk of loss associated with non-U.S. currency positions using a value at risk model. This statistical model provides an estimate, based on a 99% confidence level, of the potential loss in earnings that may be incurred if an adverse one-day shift in non-U.S. currency exchange rates were to occur. The model, which is based on a variance/co-variance methodology, incorporates historical currency price data and historical correlations in price movement among the currencies. All non-U.S. currency trading positions are included in the model.

Northern Trust’s value at risk based on non-U.S. currency positions totaled $544 thousand and $916 thousand as of December 31, 2008 and 2007, respectively. Value at risk totals representing the average, high and low for 2008 were $548 thousand, $1.7 million and $132 thousand, respectively, with the average, high and low for 2007 being $309 thousand, $1.1 million and $44 thousand, respectively. These totals indicate the degree of risk inherent in non-U.S. currency dispositions as of year-end and during the year; however, it is not a prediction of an expected gain or loss. Actual future gains and losses will vary depending on market conditions and the size and duration of future non-U.S. currency positions. During 2008 and 2007, Northern Trust did not incur an actual trading loss in excess of the daily value at risk estimate.

 

Other Trading Activities. Market risk associated with other trading activities is negligible. Northern Trust is a party to various derivative financial instruments, most of which consist of interest rate swaps entered into to meet clients’ interest risk management needs. When Northern Trust enters into such swaps, its policy is to mitigate the resulting market risk with an offsetting swap or with futures contracts. Northern Trust carries in its trading portfolio a small inventory of securities that are held for sale to its clients. The interest rate risk associated with these securities is insignificant.

 

OPERATIONAL RISK MANAGEMENT

 

In providing its services, Northern Trust is exposed to operational risk which is the risk of loss from inadequate or failed internal processes, people, and systems or from external events. Northern Trust’s success depends, in part, upon maintaining its reputation as a well managed institution with shareholders, existing and prospective clients, creditors and regulators.

In order to maintain this reputation, Northern Trust seeks to minimize the frequency and severity of operational losses associated with compliance and fiduciary matters, product, process, and technology failures, and business continuity.

Operational risk is mitigated through a system of internal controls and risk management practices that are designed to keep operational risk at levels appropriate to the Northern Trust’s overall risk appetite and the inherent risk in the markets it operates. While operational risk controls are extensive, operational losses have occurred and there can be no assurance that such losses will not occur in the future.

The Operational Risk Committee of Northern Trust provides independent oversight and is responsible for setting the Corporate Operational Risk Management Policy and developing the operational risk management framework and programs that support the coordination of operational risk activities to identify, monitor, manage and report on operational risk.

The Corporate Operational Risk function is the focal point for the operational risk management framework and works closely with the business units to achieve the goal of assuring proactive management of operational risk within Northern Trust. To further limit operational risks, committee structures have been established to draft, enforce, and monitor adherence to corporate policies and established procedures. Each business unit is responsible for complying with corporate policies and external regulations applicable to the unit,

 

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and is responsible for establishing specific procedures to do so. Northern Trust’s internal auditors monitor the overall effectiveness of the system of internal controls on an ongoing basis.

 

FACTORS AFFECTING FUTURE RESULTS

 

This report contains statements that may be considered forward-looking, such as the statements relating to Northern Trust’s financial goals, dividend policy, expansion and business development plans, anticipated expense levels and projected profit improvements, business prospects and positioning with respect to market, demographic and pricing trends, strategic initiatives, re-engineering and outsourcing activities, new business results and outlook, changes in securities market prices, credit quality including reserve levels, planned capital expenditures and technology spending, anticipated tax benefits and expenses, and the effects of any extraordinary events and various other matters (including developments with respect to litigation, other contingent liabilities and obligations, and regulation involving Northern Trust and changes in accounting policies, standards and interpretations) on Northern Trust’s business and results.

Forward-looking statements are typically identified by words or phrases such as “believe”, “expect”, “anticipate”, “intend”, “estimate”, “may increase”, “may fluctuate”, “plan”, “goal”, “target”, “strategy”, and similar expressions or future or conditional verbs such as “may”, “will”, “should”, “would”, and “could.” Forward-looking statements are Northern Trust’s current estimates or expectations of future events or future results. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the health of the U.S. and international economies; changes in financial markets, including debt and equity markets, that impact the value, liquidity, or credit ratings of financial assets in general, or financial assets in particular investment funds, client portfolios, or securities lending collateral pools, including those funds, portfolios, collateral pools, and other financial assets with respect to which Northern Trust has taken, or may in the future take, actions to provide asset value stability or additional liquidity, such as entry into capital support agreements and other client support actions; the impact of recent upheaval in the financial markets, the effectiveness of domestic and international governmental actions taken in response, such as the U.S. Treasury’s Troubled Asset Relief Program and the FDIC’s Temporary Liquidity Guarantee Program, and the effect of such governmental actions on Northern Trust, its competitors and counterparties, financial markets generally and availability of credit specifically, and the U.S. and international economies; changes in foreign exchange trading client volumes, fluctuations and volatility in foreign currency exchange rates, and Northern Trust’s success in assessing and mitigating the risks arising from such changes, fluctuations and volatility; decline in the value of securities held in Northern Trust’s investment portfolio, particularly asset-backed securities, the liquidity and pricing of which may be negatively impacted by periods of economic turmoil and financial market disruptions, and difficulties in measuring the fair value of those securities; Northern Trust’s success in managing various risks inherent in its business, including credit risk, interest rate risk and liquidity risk, particularly during times of economic uncertainty and volatility in the credit and other markets; geopolitical risks and the risks of extraordinary events such as natural disasters, terrorist events, war and the U.S. government’s response to those events; the pace and extent of continued globalization of investment activity and growth in worldwide financial assets; regulatory and monetary policy developments; failure to obtain regulatory approvals when required; changes in tax laws, accounting requirements or interpretations and other legislation in the U.S. or other countries that could affect Northern Trust or its clients; changes in the nature and activities of Northern Trust’s competition, including increased consolidation within the financial services industry; Northern Trust’s success in maintaining existing business and continuing to generate new business in its existing markets; Northern Trust’s success in identifying and penetrating targeted markets, through acquisition, strategic alliance or otherwise; Northern Trust’s success in integrating recent and future acquisitions, strategic alliances, and preferred provider arrangements; Northern Trust’s success in addressing the complex needs of a global client base across multiple time zones and from multiple locations, and managing compliance with legal, tax, regulatory and other requirements in areas of faster growth in its businesses, especially in immature markets; Northern Trust’s ability to maintain a product mix that achieves acceptable margins; Northern Trust’s ability to continue to generate investment results that satisfy its clients and continue to develop its array of investment products; Northern Trust’s success in generating revenues in its securities lending business for itself and its clients, especially in periods of economic and financial market uncertainty; Northern Trust’s success in recruiting and retaining the necessary personnel to support business growth and expansion and maintain sufficient expertise to support increasingly complex products and services; Northern Trust’s ability, as products, methods of

 

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delivery, and client requirements change or become more complex, to continue to fund and accomplish innovation, improve risk management practices and controls, and address operating risks, including human errors or omissions, pricing or valuation of securities, fraud, systems performance or defects, systems interruptions, and breakdowns in processes or internal controls; Northern Trust’s success in controlling expenses particularly in a difficult economic environment; increased costs of compliance and other risks associated with changes in regulation and the current regulatory environment, including the requirements of the new Basel II capital regime and areas of increased regulatory emphasis and oversight such as the Bank Secrecy Act and Anti-Money Laundering Act; risks and uncertainties inherent in the litigation and regulatory process, including the adequacy of contingent liability, tax, and other reserves; and the risk of events that could harm Northern Trust’s reputation and so undermine the confidence of clients, counterparties, rating agencies, and stockholders.

Some of these and other risks and uncertainties that may affect future results are discussed in more detail in the section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” captioned “Risk Management” in the 2008 Annual Report to Shareholders (pages 47 – 58), in the section of the “Notes to Consolidated Financial Statements” in the 2008 Annual Report to Shareholders captioned “Note 25 – Contingent Liabilities” (page 91 and 92), in the sections of “Item 1 – Business” of the 2008 Annual Report on Form 10-K captioned “Government Monetary and Fiscal Polices,” “Competition” and “Regulation and Supervision” (pages 2 – 11), and in “Item 1A – Risk Factors” of the 2008 Annual Report on Form 10-K (pages 26 – 34). All forward-looking statements included in this report are based upon information presently available, and Northern Trust assumes no obligation to update any forward-looking statements.

 

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MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Management of Northern Trust Corporation (Northern Trust) is responsible for establishing and maintaining adequate internal control over financial reporting. This internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.

Management assessed Northern Trust’s internal control over financial reporting as of December 31, 2008. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2008, Northern Trust maintained effective internal control over financial reporting, including maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of Northern Trust, and policies and procedures that provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States and that receipts and expenditures of Northern Trust are being made only in accordance with authorizations of management and directors of Northern Trust. Additionally, KPMG LLP, the independent registered public accounting firm that audited Northern Trust’s consolidated financial statements as of, and for the year ended, December 31, 2008, included in this Annual Report, has issued an attestation report (included herein on page 61) on the effectiveness of Northern Trust’s internal control over financial reporting.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF NORTHERN TRUST CORPORATION:

 

We have audited Northern Trust Corporation’s internal control over financial reporting as of December 31, 2008, based on criteria established in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Northern Trust Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Report on Internal Control Over Financial Reporting”. Our responsibility is to express an opinion on Northern Trust Corporation’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Northern Trust Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Northern Trust Corporation and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2008, and our report dated February 27, 2009 expressed an unqualified opinion on those consolidated financial statements.

 

LOGO

 

CHICAGO, ILLINOIS

FEBRUARY 27, 2009

 

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CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED BALANCE SHEET

 

    DECEMBER 31  
($ In Millions Except Share Information)   2008      2007  

ASSETS

                

Cash and Due from Banks

  $ 2,648.2      $ 3,921.6  

Federal Funds Sold and Securities Purchased under Agreements to Resell

    169.0        3,790.7  

Time Deposits with Banks

    16,721.0        21,260.0  

Federal Reserve Deposits and Other Interest-Bearing

    9,403.8        21.5  

Securities

                

Available for Sale

    14,414.4        7,740.3  

Held to Maturity (Fair value – $1,156.1 in 2008 and $1,160.9 in 2007)

    1,154.1        1,144.8  

Trading Account

    2.3        3.1  
                  

Total Securities

    15,570.8        8,888.2  
                  

Loans and Leases

                

Commercial and Other

    20,374.0        16,169.1  

Residential Mortgages

    10,381.4        9,171.0  
                  

Total Loans and Leases (Net of unearned income – $539.5 in 2008 and $559.6 in 2007)

    30,755.4        25,340.1  
                  

Reserve for Credit Losses Assigned to Loans and Leases

    (229.1 )      (148.1 )

Buildings and Equipment

    506.6        491.9  

Customers’ Acceptance Liability

    .5        .5  

Client Security Settlement Receivables

    709.3        563.1  

Goodwill

    389.4        425.8  

Other Assets

    5,408.7        3,055.9  
                  

Total Assets

  $ 82,053.6      $ 67,611.2  
                  

LIABILITIES

                

Deposits

                

Demand and Other Noninterest-Bearing

  $ 11,823.6      $ 5,739.3  

Savings and Money Market

    9,079.2        7,533.9  

Savings Certificates

    2,606.8        2,028.0  

Other Time

    801.6        557.5  

Non-U.S. Offices – Noninterest-Bearing

    2,855.7        4,379.0  

– Interest-Bearing

    35,239.5        30,975.4  
                  

Total Deposits

    62,406.4        51,213.1  

Federal Funds Purchased

    1,783.5        1,465.8  

Securities Sold under Agreements to Repurchase

    1,529.1        1,763.6  

Other Borrowings

    736.7        2,108.5  

Senior Notes

    1,052.6        653.9  

Long-Term Debt

    3,293.4        2,682.4  

Floating Rate Capital Debt

    276.7        276.6  

Liability on Acceptances

    .5        .5  

Other Liabilities

    4,585.3        2,937.7  
                  

Total Liabilities

    75,664.2        63,102.1  
                  

STOCKHOLDERS’ EQUITY

                

Preferred Stock – Series B (Net of discount – $74.7)

    1,501.3         

Common Stock, $1.66  2/3 Par Value; Authorized 560,000,000 shares; Outstanding 223,263,132 shares in 2008 and 220,608,834 shares in 2007

    379.8        379.8  

Additional Paid-in Capital

    178.5        69.1  

Retained Earnings

    5,091.2        4,556.2  

Accumulated Other Comprehensive Income

    (494.9 )      (90.3 )

Treasury Stock (at cost – 4,658,392 shares in 2008 and 7,312,690 shares in 2007)

    (266.5 )      (405.7 )
                  

Total Stockholders’ Equity

    6,389.4        4,509.1  
                  

Total Liabilities and Stockholders’ Equity

  $ 82,053.6      $ 67,611.2  

See accompanying notes to consolidated financial statements on pages 66-104.

 

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CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED STATEMENT OF INCOME

 

    FOR THE YEAR ENDED DECEMBER 31
($ In Millions Except Per Share Information)   2008      2007      2006

Noninterest Income

                       

Trust, Investment and Other Servicing Fees

  $ 2,134.9      $ 2,077.6      $ 1,791.6

Foreign Exchange Trading Income

    616.2        351.3        247.3

Security Commissions and Trading Income

    77.0        67.6        62.7

Treasury Management Fees

    72.8        65.3        65.4

Gain on Visa Share Redemption

    167.9              

Other Operating Income

    186.9        95.3        83.0

Investment Security Gains (Losses), net

    (56.3 )      6.5        1.4
                         

Total Noninterest Income

    3,199.4        2,663.6        2,251.4
                         

Net Interest Income

                       

Interest Income

    2,478.5        2,784.2        2,249.7

Interest Expense

    1,399.4        1,938.8        1,505.0
                         

Net Interest Income

    1,079.1        845.4        744.7

Provision for Credit Losses

    115.0        18.0        15.0
                         

Net Interest Income after Provision for Credit Losses

    964.1        827.4        729.7
                         

Noninterest Expenses

                       

Compensation

    1,133.1        1,038.2        876.6

Employee Benefits

    223.4        234.9        217.6

Outside Services

    413.8        386.2        316.2

Equipment and Software Expense

    241.2        219.3        205.3

Occupancy Expense

    166.1        156.5        145.4

Visa Indemnification Charges

    (76.1 )      150.0       

Other Operating Expenses

    786.3        245.1        195.8
                         

Total Noninterest Expenses

    2,887.8        2,430.2        1,956.9
                         

Income before Income Taxes

    1,275.7        1,060.8        1,024.2

Provision for Income Taxes

    480.9        333.9        358.8
                         

Net Income

  $ 794.8      $ 726.9      $ 665.4
                         

Net Income Applicable to Common Stock

  $ 782.8      $ 726.9      $ 665.4
                         

Per Common Share

                       

Net Income – Basic

  $ 3.53      $ 3.31      $ 3.06

                   – Diluted

    3.47        3.24        3.00

Cash Dividends Declared

    1.12        1.03        .94
                         

Average Number of Common Shares Outstanding – Basic

    221,446,382        219,680,628        217,766,035

                                                                            – Diluted

    225,378,383        224,315,665        221,784,114
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME                        
    FOR THE YEAR ENDED DECEMBER 31
(In Millions)   2008      2007      2006

Net Income

  $ 794.8      $ 726.9      $ 665.4

Other Comprehensive Income (Loss) (net of tax and reclassifications)

                       

Net Unrealized Gains (Losses) on Securities Available for Sale

    (184.2 )      (33.2 )      9.7

Net Unrealized Gains (Losses) on Cash Flow Hedge Designations

    (17.7 )      (5.2 )      3.0

Foreign Currency Translation Adjustments

    (8.4 )      2.7        17.0

Pension and Other Postretirement Benefit Adjustments

    (194.3 )      94.0        14.2
                         

Other Comprehensive Income (Loss)

    (404.6 )      58.3        43.9
                         

Comprehensive Income

  $ 390.2      $ 785.2      $ 709.3

See accompanying notes to consolidated financial statements on pages 66-104.

 

NORTHERN TRUST CORPORATION 2008 ANNUAL REPORT TO SHAREHOLDERS

63


Table of Contents

CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

 

    FOR THE YEAR ENDED DECEMBER 31  
(In Millions)   2008      2007      2006  

PREFERRED STOCK

                         

Balance at January 1

  $      $      $  

Preferred Stock Issuance, Series B

    1,499.6                

Discount Accretion – Preferred Stock

    1.7                
                           

Balance at December 31

    1,501.3                
                           

COMMON STOCK

                         

Balance at January 1

    379.8        379.8        379.8  
                           

Balance at December 31

    379.8        379.8        379.8  
                           

ADDITIONAL PAID-IN CAPITAL

                         

Balance at January 1

    69.1        30.9         

Transferred from Common Stock Issuable – Stock Incentive Plans

                  55.5  

Transferred from Deferred Compensation

                  (29.5 )

Issuance of Warrant to Purchase Common Stock

    76.4                

Treasury Stock Transaction – Stock Options and Awards

    (46.1 )      (45.3 )      (43.9 )

Stock-Based Awards – Amortization

    44.1        38.4        27.5  

Stock-Based Awards – Tax Benefits

    35.0        45.1        21.3  
                           

Balance at December 31

    178.5        69.1        30.9  
                           

RETAINED EARNINGS

                         

Balance at January 1, as Previously Reported

    4,556.2        4,131.2        3,672.1  

Cumulative Effect of Applying FSP 13-2

           (73.4 )       

Change in Measurement Date of Postretirement Plans

    (7.4 )              
                           

Balance at January 1, as Adjusted

    4,548.8        4,057.8        3,672.1  

Net Income

    794.8        726.9        665.4  

Dividends Declared – Common Stock

    (250.7 )      (228.5 )      (206.3 )

Discount Accretion – Preferred Stock

    (1.7 )              
                           

Balance at December 31

    5,091.2        4,556.2        4,131.2  
                           

ACCUMULATED OTHER COMPREHENSIVE INCOME

                         

Balance at January 1

    (90.3 )      (148.6 )      (18.7 )

Other Comprehensive Income (Loss)

    (404.6 )      58.3        43.9  

Pension and Other Postretirement Benefit Adjustments

                  (173.8 )
                           

Balance at December 31

    (494.9 )      (90.3 )      (148.6 )
                           

COMMON STOCK ISSUABLE – STOCK INCENTIVE PLANS