Bank of Bermuda's efforts to diversify their securities by outsourcing about 13 percent of their portfolio contributed to lower earnings, according to the banks third quarter earnings statement released yesterday.

Struggling equity markets and sustained low interest rates also pressured the bank's revenue streams of fee income and interest earnings, adversely impacting fees based on the value of client assets and transaction-driven fees, according to the bank.

Following the release, New York Stock Exchange listed Bank of Bermuda shares traded as low as $27.43 but fell $0.97 or 3.2 percent, closing at $29.23 while the Bermuda Stock Exchange traded shares fell $2 or 6.5 percent, closing at $29. The bank reported third quarter diluted earnings per share of $0.46 on a U.S. GAAP basis, compared with $0.76 in the year-ago quarter. On a core operating basis, diluted earnings per share were $0.53 for the current quarter and $0.87 a year-ago.

CFO Edward Gomez said: "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. As at 30 September, the bank'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).

The 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 bank said the use of an independent investment manager enables the bank 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 about 80 percent of the portfolio at 30 September of this year.

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. The bank also said 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 bank also said: "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, a higher rate of mortgage prepayment due to further interest rate declines, and, thirdly, the effect of yield curve positioning."

Mr. Gomez also said: "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 percent) 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."

CEO Henry Smith said: "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 organisation 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."

The bank will host an Internet broadcast of its third quarter earnings conference call today at 10 a.m. (EST) (11 a.m. Bermuda time), accessible on Bank of Bermuda's Investor Relations home page, at www.bankofbermuda.com