Jan. 3 (Bloomberg) -- State Street Corp., the world's largest money manager for institutions, ousted the head of its investment unit after setting aside $618 million to cover legal claims that it made inappropriate bets on subprime mortgages.

William Hunt, 45, chief executive officer of State Street Global Advisors for the past three years, was replaced on an interim basis by James Phalen, 57, the company said today in a statement. State Street, which faces at least three class-action investor lawsuits, rose 8.3 percent to a record in New York Stock Exchange composite trading after the company said 2007 operating profit exceeded analysts' estimates.

``This was a bitter pill they needed to swallow to get the litigation issues behind them,'' Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine, said in a telephone interview.

The collapse of the subprime market in July has forced money managers including Legg Mason Inc. and Bank of America Corp. to bail out funds and protect investors from losses. Banks including Citigroup Inc. and Merrill Lynch & Co. have written down $74 billion of securities backed by home loans to borrowers with poor credit histories.

State Street said the writedown cut fourth-quarter earnings by $279 million, or 71 cents a share, after taxes. Full-year net income was $3.42 to $3.45 a share, the company said in the statement. Operating profit, excluding the writedown and other expenses, was $4.54 to $4.57 a share, beating the average estimate of $4.19 a share of 18 analysts surveyed by Bloomberg.

Shares Rise

State Street rose $6.57 to $85.45 at 4 p.m. in NYSE trading after touching an all-time high of $86.46. The stock gained 27 percent in the past year, compared with the 13 percent increase by the Standard & Poor's Supercomposite Asset Management and Custody Bank Index.

Financial-company shares slumped in the past year as losses tied to the credit markets mounted. Baltimore-based Legg Mason declined 24 percent. Citigroup fell 45 percent and Merrill dropped 43 percent. Both companies are based in New York.

State Street, the third-biggest custodian of investor assets, said today that new business from foreign-exchange and securities servicing has grown because of increased market volatility. State Street oversees $15.1 trillion in custody assets for clients. State Street Chief Executive Officer Ronald Logue said the company increased revenue by at least 30 percent in 2007, beating his target of 20 percent to 22 percent.

`Earnings Power'

``The core earnings power continues to surprise to the upside, which should trump what is undoubtedly a disappointing charge,'' Ken Usdin, a New York-based analyst at Bank of America, wrote today in a note to clients.

Bank of New York Mellon Corp., the largest custody bank, rose 4.3 percent to $49.17, and Chicago-based Northern Trust Corp. gained 2.7 percent to $76.06 on speculation their fourth- quarter earnings would top estimates.

State Street, whose predecessor was founded in 1792, the same year the New York Stock Exchange opened, has more than tripled assets under management to $2 trillion over the past decade. It manages money for institutions including the California Public Employees' Retirement System, the largest U.S. public pension, and Massachusetts Pension Reserves Investment Management.

Returns on equity and bond funds managed by State Street Global Advisors averaged 18 percent on an asset-weighted basis in the first 11 months of 2007, according to Morningstar Inc. in Chicago. That compares with 10.1 percent for Bank of New York Mellon.

Still, some State Street bond funds were hurt as losses from subprime mortgages caused a freeze in the credit markets. The SSgA Yield Plus Fund tumbled 14 percent in the past year, ranking as the worst-performing fund in its category. The SSgA Bond Market Fund declined 7.3 percent.

Investor Lawsuits

State Street faces five lawsuits, including three class- action suits, filed by clients who accused the firm of breaching its fiduciary responsibilities as a fund manager. Each claims investment strategies sold as low risk led to substantial losses because of investments in mortgage-backed securities.

Hunt in November had removed fixed-income head Paul Greff, who was responsible for more than $200 billion of the unit's $2 trillion of assets. Hunt will get a severance payment valued at about $14.1 million, which includes a combination of cash and equity, according to a regulatory filing released today. He isn't entitled to a 2007 bonus.

Former CEOs

Hunt became head of State Street's investment unit in 2005, replacing Timothy Harbert, who passed away in August 2004. Harbert had taken over from Nicholas Lopardo, a hockey enthusiast who resigned in 2001 after a 14-year tenure with the company.

Phalen was the CEO of retirement-benefits provider CitiStreet, a joint venture between Citigroup and State Street, from 2000 to 2005. He returned to State Street in 2005 to lead the investment-servicing unit in North America. Last year, he was named to oversee investment servicing, investment research and trading internationally.

The company will defend itself against ``inappropriate claims'' stemming solely from changes in market conditions, Logue said in the statement.

On a conference call with investors, Logue said the reserve was built ``from the bottom up, customer-by-customer'' after assessing possible claims.

``We're just trying to put it behind us,'' he said.

Commercial Paper

State Street had $36 billion of actively managed fixed- income assets as of Sept. 30. Of that, $8.2 billion was in securities backed by mortgages made to the riskiest borrowers, down from $13.9 billion as of June 30.

State Street reduced its holdings of asset-backed commercial paper issued by conduits as credit markets have improved. State Street held $2 million in commercial paper as of Dec. 31, down from $222 million on Oct. 15.

Moody's Investors Service in New York today cut its outlook on State Street-related entities to ``negative,'' while leaving unchanged its Aa3 senior-debt rating. Fitch Ratings cut its outlook on State Street to ``negative'' and lowered the company's individual rating to B from A/B. Chicago-based Fitch left its other debt ratings unchanged.

To contact the reporters on this story: Sree Vidya Bhaktavatsalam in Boston at sbhaktavatsa@bloomberg.net; Christopher Condon in Boston at ccondon4@bloomberg.net

Last Updated: January 3, 2008 16:08 EST