Edward H. Gomez, Chief Financial Officer, commented: "While our businesses continue to be fundamentally sound and to build their client bases, the extremely difficult business environment and market conditions present an ongoing challenge. The principal driver for the current quarter's decline in earnings was poor performance by our outsourced securities portfolio. An unusual combination of market factors resulted in a year-over-year deterioration against benchmark earnings equal to $0.28 per share. We also continued to feel the effects of the persistent declines in equity markets and sustained low interest rates. These factors pressured both our revenue streams of fee income and interest earnings, as they adversely impacted fees based on the value of client assets and transaction-driven fees. They also suppressed margins on the reinvestment of free and low-interest bearing deposits. Nevertheless, our fee revenues continue to show strength, and we are pleased to report another quarter's growth by our largest business, Global Fund Services. This is a significant achievement in the current economic climate, and it demonstrates our sound positioning in our chosen markets."
Mr. Gomez continued: "With respect to our outsourced securities portfolio, you will recall that four years ago the Bank appointed a leading independent investment manager to manage a portion (currently about 13%) of our approximately $10 billion in total investable assets. The purpose for outsourcing was to improve diversification and enhance long-term returns by enabling us to invest in asset types for which we do not have in-house expertise. The outsourced portfolio is marked-to-market with changes in value immediately reflected in net income. This strategy has been successful from inception and has contributed to the Bank's earnings in line with expectations. In the current year, however, there has been increased volatility in portfolio earnings as a result of market turmoil and uncertainty about the future course of interest rates, and these conditions are expected to continue. We have therefore decided to reduce the size of the portfolio in order to improve earnings stability in this climate. This change will take place over the next several months."
Chief Executive Officer, Henry B. Smith, added: "We remain focused on the growth of our core businesses and we continue to see compelling opportunities in market niches that value our specialist skills. We are adding new clients and actively marketing our services in markets where we feel we have a clear competitive advantage. At the same time we are maintaining strict cost discipline throughout the organization in recognition of the difficult economic conditions. Despite these conditions, however, we are seeing ongoing demand for our products and services and steady growth in our largest business. We are therefore confidently growing our sales teams in key markets, and I continue to be enthusiastic about our positioning for future growth."
Quarter ended 30 September 2002 compared with Quarter ended 30 September 2001
Total core operating revenues were $102.4 million, compared with $110.2 million for the 2001 third quarter. The decline was the result of interest earnings pressures and, most significantly, reduced earnings on Bank of Bermuda's outsourced securities portfolio, which is accounted for on a marked-to-market basis. Non-interest income grew 6% to $66.6 million, from $62.9 million last year, and represented 65% of total core operating revenues.
Global Fund Services fees were $32.2 million, $2.9 million higher than a year ago. Nearly 60% of the increase was generated in the Far East, driven largely by a growing pension fund business.
In Europe, Global Fund Services fees were up $1.0 million, an increase of 11%, driven by growth in alternative fund business. North America also reported higher revenue.
Private Trust fees of $7.5 million were $0.3 million higher, as slight increases in various fee based services during the quarter offset the impact of weakness in client asset values. Investment Services fees were marginally higher than last year at $9.9 million, as increased management fees of $0.4 million were reduced by lower equity execution fees which fell by $0.3 million due to lower trading volumes. Assets in Bank of Bermuda's range of mutual funds totalled $6.4 billion, compared with $5.9 billion at 30 September 2001, with the increase driven by growth in the Corporate Money Fund, up $0.7 billion.
Foreign Exchange fees totalled $10.9 million, a 9.6% increase over the same quarter in 2001. Foreign exchange activity rose as clients adjusted their positions as a result of stock market volatility. Banking fees were $6.1 million in the quarter, down $0.6 million from a year ago.
Net interest income for the third quarter was $45.2 million down 5% from $47.8 million recorded during the same period in 2001. Average interest earning assets fell nearly 8% to $9.7 billion, mainly due to lower term liabilities. The net interest margin for the third quarter of 2002 was 1.85%, compared with 1.80% in the same period last year. This is largely the result of interest income on Bank of Bermuda's outsourced securities portfolio, which includes longer duration assets and was increased in size from an average of $517 million for the 2001 third quarter to $1,328 million for the 2002 third quarter. This portfolio generated a gross yield, before the effect of hedging instruments included as part of investment income, of 3.91%. Excluding the effects of gross interest earned on longer-duration instruments, Bank of Bermuda experienced ongoing margin compression reflecting lower returns on the reinvestment of free and low interest-bearing balances in the current low interest rate environment.
As at 30 September 2002, Bank of Bermuda's marked-to-market securities portfolio had a total net asset value of $1.3 billion, and gross interest earned for the third quarter was $13.1 million. Realised and unrealised losses on the marked-to-market portfolio totalled $12.9 million ($1.1 million in the 2001 third quarter). This portfolio is managed by a third party investment manager in accordance with strict duration and quality guidelines, and has an average credit quality of triple-A. The use of an independent investment manager enables Bank of Bermuda to improve asset diversification by investing in securities for which it does not have in-house expertise, notably mortgage products and asset-backed securities, which represented approximately 80% of the portfolio at 30 September 2002. These assets tend to be of longer-duration than the Bank's target level, and the overall portfolio duration is reduced accordingly using interest rate swaps and futures. Because the portfolio is marked-to-market, movements in fair value are recognised in earnings as they occur. With an upward sloping yield curve, this portfolio strategy results in a higher yield on the longer-duration assets, which is included in interest-earnings, being reduced by a loss on revaluation of the related hedging instruments, which is accounted for as an investment loss. The net investment loss due to hedging back to a shorter duration was $5.2 million for the current quarter. The remaining decline in value was driven by a combination of factors: firstly, a widening of spreads due to credit deterioration; secondly, higher mortgage prepayment spreads due to further interest rate declines, and, thirdly, the effect of yield curve positioning.
Investment and other income, excluding the marked-to-market portfolio, was a loss of $138 thousand for the 2002 third quarter, compared with income of $396 thousand a year ago. Realised gains on the available for sale portfolio totaled $2 million, compared with $2.5 million last year. In both periods, non-recurring items reduced this gain. In the current quarter, those items were a $2.5 million provision to reduce the book value of Bank of Bermuda's property in Cayman to its estimated realisable value and a $954 thousand write-down of an equity investment. These items were partly offset by a realised gain of $1.3 million on sale of an office building in one of Bank of Bermuda's overseas offices. These non-recurring items are not included in core operating results.
US GAAP operating expenses were $84 million, 2.2% higher than the year-ago quarter when expenses included $1.3 million relating to start-up costs of a cancelled business venture, which are excluded from core operating performance. On a core operating basis, expenses were up 3.9%, with the impact of increased salaries costs reduced by lower corporate, marketing and other expenses. Year-to-date expenses were $8.1 million, or 3.1%, lower that the prior year-to-date.
Net income for the quarter in accordance with U.S. GAAP, was $14.1 million, compared with $23.9 million in the 2001 third quarter. On a core operating basis, net income was $16.2 million in the current quarter and $27.3 million a year ago.