Updated from 8:44 a.m. EST

State Street ( STT) surged nearly 8% after investors shrugged off the bank's announcement of a $279 million fourth-quarter charge and the departure of a top executive as subprime investment losses mount.

The Boston-based institutional investment giant says it will take an after-tax charge of $279 million, or 71 cents a share, to cover potential legal costs related to losses from its mortgage-backed investments. State Street plans to create a $618 million legal defense fund as a result of the investment losses. The company also says William Hunt, the CEO of State Street Global Advisors, has resigned and James Phalen has taken over as interim chief of the investment management arm.

"We have reviewed the actively managed fixed-income strategies at State Street Global Advisors that contained investments backed by subprime mortgages. Based on our review and discussions with certain customers who were invested in these strategies, we have established this reserve to address legal exposure and other costs relating to these strategies," State Street CEO Ron Logue said in a press release.

"State Street values its reputation as a trusted fiduciary to institutions around the world and recognizes the critical importance of preserving this reputation with its customers," Logue continued. "Some of our customers that were invested in the active fixed-income strategies have raised concerns that we intend to address. Nevertheless, we will continue to defend ourselves vigorously against inappropriate claims, including those that seek recovery of investment losses arising solely from changes in market conditions."

Despite the charge, shares of State Street were up $5.36 to $84.24 on Thursday, as investors looked past the subprime troubles to the company's longer term prospects.

Looking ahead, the financial shop says it expects 2007 adjusted earnings, excluding these charges, to be between $4.54 and $4.57 a share. That is above the $3.46 level in 2006 and well above the $4.19 pro forma profit analysts were expecting, according to Thomson Financial.

Analyst Richard Bove of Punk Ziegel raised his rating on State Street to buy from market perform, based on the fact that the company's positive earnings momentum, particularly in the fourth quarter, outweighed the litigation charge. He also significantly raised his 12-month price target by $26 to $108.

"State Street's new contract wins plus additional business from existing clients increased the servicing portfolio by an estimated $825 billion," Bove writes. "The trading operations, primarily foreign exchange activities for others, were apparently unusually strong. Other fee business was also strong."

"State Street sells a superior product. It is gaining market share in a growing market," Bove continued. "The company's recent acquisitions create an opportunity for positive operating leverage. In this environment there are not too many financial companies that offer this level of attractiveness."

Trust banks like State Street, Bank of New York Mellon ( BK) and Northern Trust ( NTRS) have relatively escaped the mortgage mayhem this year and have benefited from the recent volatility in the markets.

Shares of Northern Trust and Bank of New York Mellon each jumped roughly 4% on Thursday.

That said, State Street's news comes just a day after another mortgage lender, National City ( NCC), slashed jobs and its dividend as its home loan business deteriorates. The subprime meltdown and cooling real estate market has forced big cuts at lending giants like Countrywide ( CFC), Washington Mutual ( WM) and Wells Fargo ( WFC).

The subsequent erosion in portfolio values attached to mortgage-backed securities has also caused a rash of writedowns at investment firms like Citigroup ( C), Merrill Lynch ( MER) and Bear Stearns ( BSC), all of which have also sought outside investments to boost capital levels. Banks like WaMu and Nat City have looked to raise capital levels internally by cutting their dividends and undergoing various securities offerings to boost levels.

State Street executives said on a conference call Thursday morning that the company was considering raising new capital, according to Dow Jones. However, Logue said the firm isn't contemplating any issue of "significant size," Dow Jones said.

Fitch Ratings cut its rating outlook on State Street to negative from stable and downgraded both the holding company's and bank subsidiary's "Individual Rating" to B from A/B over "deficiencies in the control environment that allowed the potential exposure to develop." Individual Ratings, which are assigned only to banks, assess a bank's exposure to, appetite for, and management of risk, and thus represent our view on the likelihood that it would run into significant difficulties such that it would require support, according to Fitch's Web site.

Fitch also slapped a negative outlook on State Street over concerns about the "potential negative impact on business volume if customers lose confidence in State Street's risk control capabilities," it said. It affirmed the company's long- and short-term issuer default ratings and other debt ratings.

Moody's Investor Services also placed a negative outlook on State Street on similar concerns.

"The discrepancies between State Street's clients' investment directives and the firm's investment strategies that imply a lapse in controls and a risk governance failure at State Street Global Advisors," Moody's said. "The negative outlook also reflects the reputational vulnerability of the asset management franchise and any potential spillover into State Street's other businesses."

Standard & Poor's did not return a call seeking comment.

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