Back to GetFilings.com
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From ______ To ______
Commission File Number 0-850
[KEYCORP LOGO]
KEYCORP
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
OHIO 34-6542451
- ---------------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
127 PUBLIC SQUARE, CLEVELAND, OHIO 44114-1306
- ---------------------------------------- -------------------
(Address of principal executive offices) (Zip Code)
(216) 689-6300
----------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Shares with a par value of $1 each 420,834,010 Shares
- ----------------------------------------- ------------------------------
(Title of class) (Outstanding at July 31, 2003)
KEYCORP
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Page Number
-----------
Item 1. Financial Statements
Consolidated Balance Sheets --
June 30, 2003, December 31, 2002 and June 30, 2002 3
Consolidated Statements of Income --
Three and six months ended June 30, 2003 and 2002 4
Consolidated Statements of Changes in Shareholders' Equity --
Six months ended June 30, 2003 and 2002 5
Consolidated Statements of Cash Flow --
Six months ended June 30, 2003 and 2002 6
Notes to Consolidated Financial Statements 7
Independent Accountants' Review Report 31
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 32
Item 3. Quantitative and Qualitative Disclosure of Market Risk 66
Item 4. Controls and Procedures 66
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 66
Item 4. Submission of Matters to a Vote of Security Holders 66
Item 6. Exhibits and Reports on Form 8-K 67
Signature 69
Exhibits 70
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31, JUNE 30,
dollars in millions 2003 2002 2002
- --------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED) (UNAUDITED)
ASSETS
Cash and due from banks $ 3,249 $ 3,364 $ 2,929
Short-term investments 1,867 1,632 1,471
Securities available for sale 7,533 8,507 6,410
Investment securities (fair value: $107, $129 and $196) 99 120 186
Other investments 1,003 919 871
Loans, net of unearned income of $1,788, $1,776 and $1,746 63,214 62,457 63,881
Less: Allowance for loan losses 1,405 1,452 1,539
- ------------------------------------------------------------------------------------------------------------------------------
Net loans 61,809 61,005 62,342
Premises and equipment 606 644 659
Goodwill 1,142 1,142 1,105
Other intangible assets 31 35 26
Corporate-owned life insurance 2,470 2,414 2,359
Accrued income and other assets 5,670 5,420 4,419
- ------------------------------------------------------------------------------------------------------------------------------
Total assets $ 85,479 $85,202 $ 82,777
======== ======= ========
LIABILITIES
Deposits in domestic offices:
NOW and money market deposit accounts $ 17,900 $16,249 $ 13,184
Savings deposits 2,094 2,029 2,025
Certificates of deposit ($100,000 or more) 4,949 4,749 4,928
Other time deposits 11,231 11,946 12,995
- ------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing 36,174 34,973 33,132
Noninterest-bearing 11,375 10,630 9,095
Deposits in foreign office -- interest-bearing 2,320 3,743 2,578
- ------------------------------------------------------------------------------------------------------------------------------
Total deposits 49,869 49,346 44,805
Federal funds purchased and securities sold under repurchase agreements 3,766 3,862 5,110
Bank notes and other short-term borrowings 3,403 2,823 3,390
Accrued expense and other liabilities 5,760 5,471 4,742
Long-term debt 14,434 15,605 16,895
Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary
trusts holding solely subordinated debentures of KeyCorp (See Note 9) 1,258 1,260 1,244
- ------------------------------------------------------------------------------------------------------------------------------
Total liabilities 78,490 78,367 76,186
SHAREHOLDERS' EQUITY
Preferred stock, $1 par value; authorized 25,000,000 shares, none issued -- -- --
Common shares, $1 par value; authorized 1,400,000,000 shares;
issued 491,888,780 shares 492 492 492
Capital surplus 1,452 1,449 1,383
Retained earnings 6,633 6,448 6,214
Treasury stock, at cost (70,815,244, 67,945,135 and 65,537,753 shares) (1,667) (1,593) (1,530)
Accumulated other comprehensive income 79 39 32
- ------------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 6,989 6,835 6,591
- ------------------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 85,479 $85,202 $ 82,777
======== ======= ========
- ------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
3
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- --------------------------
dollars in millions, except per share amounts 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ 910 $ 989 $ 1,814 $ 1,974
Tax-exempt investment securities 1 3 3 6
Securities available for sale 96 96 197 185
Short-term investments 8 7 16 16
Other investments 7 7 13 13
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest income 1,022 1,102 2,043 2,194
INTEREST EXPENSE
Deposits 183 231 371 481
Federal funds purchased and securities sold under repurchase agreements 15 24 29 47
Bank notes and other short-term borrowings 15 20 33 47
Long-term debt, including capital securities 113 144 233 282
- ----------------------------------------------------------------------------------------------------------------------------------
Total interest expense 326 419 666 857
- ----------------------------------------------------------------------------------------------------------------------------------
NET INTEREST INCOME 696 683 1,377 1,337
Provision for loan losses 125 135 255 271
- ----------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 571 548 1,122 1,066
NONINTEREST INCOME
Trust and investment services income 131 158 263 316
Service charges on deposit accounts 91 104 183 204
Investment banking and capital markets income 53 47 87 96
Letter of credit and loan fees 40 29 71 57
Corporate-owned life insurance income 27 26 54 52
Electronic banking fees 22 20 41 38
Net securities gains 3 1 7 1
Other income 67 63 125 127
- ----------------------------------------------------------------------------------------------------------------------------------
Total noninterest income 434 448 831 891
NONINTEREST EXPENSE
Personnel 371 361 734 724
Net occupancy 56 56 115 113
Computer processing 44 48 88 102
Equipment 34 36 66 70
Marketing 33 30 58 56
Professional fees 32 21 57 42
Other expense 118 113 227 219
- ----------------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 688 665 1,345 1,326
INCOME BEFORE INCOME TAXES 317 331 608 631
Income taxes 92 85 166 145
- ----------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 225 $ 246 $ 442 $ 486
======== ======== ======== ========
Per common share:
Net income $ .53 $ .58 $ 1.04 $ 1.14
Net income-- assuming dilution .53 .57 1.03 1.13
Weighted average common shares outstanding (000) 423,882 426,092 424,575 425,477
Weighted average common shares and potential common
shares outstanding (000) 427,170 431,935 427,628 430,983
- ----------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
ACCUMULATED
TREASURY OTHER
COMMON CAPITAL RETAINED STOCK, COMPREHENSIVE COMPREHENSIVE
dollars in millions, except per share amounts SHARES SURPLUS EARNINGS AT COST INCOME (LOSS) INCOME(b)
- -----------------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2001 $ 492 $ 1,390 $ 5,856 $ (1,585) $ 2
Net income 486 $ 486
Other comprehensive income:
Net unrealized gains on securities available
for sale, net of income taxes of $9(a) 15 15
Net unrealized gains on derivative financial instruments,
net of income taxes of $5 9 9
Foreign currency translation adjustments 6 6
----
Total comprehensive income $516
====
Cash dividends declared on common shares ($.30 per share) (128)
Issuance of common shares:
Employee benefit and dividend reinvestment
plans--2,345,971 net shares (7) 55
- ---------------------------------------------------------------------------------------------------------------------
BALANCE AT JUNE 30, 2002 $ 492 $ 1,383 $ 6,214 $ (1,530) $ 32
====== ======= ======== ========= ====
- ---------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2002 $ 492 $ 1,449 $ 6,448 $ (1,593) $ 39
Net income 442 $442
Other comprehensive income (losses):
Net unrealized losses on securities available
for sale, net of income taxes of ($10)(a) (14) (14)
Net unrealized gains on derivative financial instruments,
net of income taxes of $22 37 37
Foreign currency translation adjustments 17 17
----
Total comprehensive income $482
====
Deferred compensation obligation 8
Cash dividends declared on common shares ($.61 per share) (257)
Issuance of common shares:
Employee benefit and dividend reinvestment
plans--2,150,646 net shares (5) 50
Repurchase of common shares - 5,000,000 shares (124)
- ---------------------------------------------------------------------------------------------------------------------
BALANCE AT JUNE 30, 2003 $ 492 $ 1,452 $ 6,633 $ (1,667) $ 79
====== ======= ======== ========= ====
- ---------------------------------------------------------------------------------------------------------------------
(a) Net of reclassification adjustments.
(b) For the three months ended June 30, 2003 and 2002, comprehensive income was
$262 million and $298 million, respectively.
See Notes to Consolidated Financial Statements (Unaudited).
5
CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)
SIX MONTHS ENDED JUNE 30,
--------------------------
in millions 2003 2002
- -------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $ 442 $ 486
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses 255 271
Depreciation expense and software amortization 99 116
Amortization of intangibles 6 5
Net securities gains (7) (1)
Net (gains) losses from principal investments (17) 1
Net gains from loan securitizations and sales (29) (9)
Deferred income taxes 22 63
Net (increase) decrease in mortgage loans held for sale (26) 68
Net increase in trading account assets (87) (155)
Net decrease in accrued restructuring charges (4) (19)
Other operating activities, net 372 (310)
- -------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 1,026 516
INVESTING ACTIVITIES
Cash used in acquisitions, net of cash acquired -- (15)
Net (increase) decrease in other short-term investments (148) 582
Purchases of securities available for sale (3,579) (2,803)
Proceeds from sales of securities available for sale 2,678 292
Proceeds from prepayments and maturities of securities available for sale 1,605 1,514
Purchases of investment securities (19) (14)
Proceeds from prepayments and maturities of investment securities 40 53
Purchases of other investments (195) (60)
Proceeds from sales of other investments 69 18
Proceeds from prepayments and maturities of other investments 70 22
Net increase in loans, excluding acquisitions, sales and divestitures (1,961) (1,849)
Purchases of loans (419) --
Proceeds from loan securitizations and sales 1,283 775
Purchases of premises and equipment (26) (44)
Proceeds from sales of premises and equipment 4 7
Proceeds from sales of other real esate owned 33 25
- -------------------------------------------------------------------------------------------------------------------
NET CASH USED IN INVESTING ACTIVITIES (565) (1,497)
FINANCING ACTIVITIES
Net increase in deposits 514 2
Net increase (decrease) in short-term borrowings 484 (784)
Net proceeds from issuance of long-term debt, including capital securities 2,324 3,943
Payments on long-term debt, including capital securities (3,543) (1,915)
Purchases of treasury shares (124) --
Net proceeds from issuance of common stock 26 28
Cash dividends paid (257) (255)
- -------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES (576) 1,019
- -------------------------------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS (115) 38
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,364 2,891
- -------------------------------------------------------------------------------------------------------------------
CASH AND DUE FROM BANKS AT END OF PERIOD $ 3,249 $ 2,929
======= =======
- -------------------------------------------------------------------------------------------------------------------
Additional disclosures relative to cash flow:
Interest paid $ 694 $ 825
Income taxes paid 108 159
Noncash items:
Transfer of investment securities to other investments -- $ 871
Transfer of investment securities to securities available for sale -- 61
- -------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The unaudited condensed consolidated interim financial statements include the
accounts of KeyCorp and its subsidiaries. All significant intercompany accounts
and transactions have been eliminated in consolidation.
As used in these Notes, KeyCorp refers solely to the parent company and Key
refers to the consolidated entity consisting of KeyCorp and its subsidiaries.
The Financial Accounting Standards Board ("FASB") issued Interpretation No. 46
in January 2003. The "Accounting Pronouncements Pending Adoption" section of
this note, on page 10, and Note 7 ("Variable Interest Entities"), which begins
on page 20, provide information on Interpretation No. 46. This interpretation
changes the method for determining when to consolidate an entity depending on
whether the entity is a voting interest entity or a variable interest entity. It
was effective immediately for entities created after January 31, 2003, and
applies to previously existing entities in quarters beginning after June 15,
2003.
Key currently evaluates whether to consolidate entities in which it invested
prior to February 1, 2003, based on the nature and amount of equity contributed
by third parties, the decision-making power granted to those parties and the
extent of their control over the entity's operating and financial policies.
Entities that Key controls, generally through majority ownership, are
consolidated and are considered subsidiaries.
Unconsolidated investments in entities in which Key has significant influence
over operating and financing decisions (usually defined as a voting or economic
interest of 20 to 50%) are accounted for by the equity method. Unconsolidated
investments in entities in which Key has a voting or economic interest of less
than 20% are generally carried at cost. Investments held by KeyCorp's
broker/dealer and investment company subsidiaries (principal investments) are
carried at estimated fair value.
Key uses special purpose entities ("SPEs"), including securitization trusts, in
the normal course of business for funding purposes. SPEs established by Key as
qualifying SPEs under the provisions of Statement of Financial Accounting
Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities," are not consolidated. Nonqualifying
SPEs established before February 1, 2003, are evaluated for consolidation by Key
based on the nature and amount of equity contributed by third parties, the risks
and rewards the parties assume and the control the respective parties exercise
over the SPE's activities. Securitization trusts sponsored by Key are not
consolidated since they are qualifying SPEs. Additional information on SFAS No.
140 is summarized in Note 1 ("Summary of Significant Accounting Policies") of
Key's 2002 Annual Report to Shareholders under the heading "Loan
Securitizations" on page 59.
Additionally, Key has determined that it is the primary beneficiary, as defined
in Interpretation No. 46, of an asset-backed commercial paper conduit for which
it is a referral agent, as currently structured. Therefore, Key plans to
consolidate the conduit in the third quarter in accordance with the
interpretation. Key and the conduit owner are currently in the process of
restructuring the conduit such that a third party unrelated to Key would become
the primary beneficiary during the third quarter and be required to consolidate
the conduit at that time. Additional information on the conduit is summarized in
Note 7 under the heading "Commercial paper conduits" and in Note 10 ("Contingent
Liabilities and Guarantees") under the heading "Guarantees" on page 26.
Management believes that the unaudited condensed consolidated interim financial
statements reflect all adjustments of a normal recurring nature and disclosures
that are necessary for a fair presentation of the results for the interim
periods presented. Some previously reported results have been reclassified to
conform to current reporting practices. The results of operations for the
interim periods are not necessarily indicative of the results of operations to
be expected for the full year. When you read these financial statements, you
should also look at the audited consolidated financial statements and related
notes included in Key's 2002 Annual Report to Shareholders.
7
STOCK-BASED COMPENSATION
Through December 31, 2002, Key accounted for stock options issued to employees
using the intrinsic value method. This method required that compensation expense
be recognized to the extent that the fair value of the stock exceeded the
exercise price of the option at the grant date. Key's employee stock options
generally have fixed terms and exercise prices that are equal to or greater than
the fair value of Key's common shares at the grant date, so Key generally had
not recognized compensation expense related to stock options.
Effective January 1, 2003, Key adopted the fair value method of accounting as
outlined in SFAS No. 123, "Accounting for Stock-Based Compensation." Additional
information pertaining to this accounting change is summarized under the heading
"Accounting Pronouncements Adopted in 2003" on page 9.
SFAS No. 123 requires companies like Key that have used the intrinsic value
method to account for employee stock options to provide pro forma disclosures of
the net income and earnings per share effect of accounting for stock options
using the fair value method. Management estimates the fair value of options
granted using the Black-Scholes option-pricing model. This model was originally
developed to estimate the fair value of exchange-traded equity options, which
(unlike employee stock options) have no vesting period or transferability
restrictions. As a result, the Black-Scholes model is not a perfect indicator of
the value of an employee stock option, but it is commonly used for this purpose.
The Black-Scholes model requires several assumptions, which management developed
and updates based on historical trends and current market observations. The
level of accuracy achieved in deriving the estimated fair value of options is
directly related to the accuracy of the underlying assumptions. The assumptions
for the three- and six-month periods ended June 30, 2003 and 2002, are shown in
the following table.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- --------------------------
2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------
Average option life 6.0 YEARS 5.0 years 6.0 YEARS 5.0 years
Future dividend yield 4.76% 4.36% 5.07% 4.86%
Share price volatility .293 .264 .293 .276
Weighted average risk-free interest rate 2.8% 3.5% 3.2% 4.0%
- ----------------------------------------------------------------------------------------------------------
The model assumes that the estimated fair value of an option is amortized over
the option's vesting period. The pro forma effect of applying the fair value
method of accounting to all forms of stock-based compensation (e.g., stock
options, stock purchase plans, restricted stock, etc.) for the three- and
six-month periods ended June 30, 2003 and 2002, is shown in the following table
and would, if recorded, have been included in personnel expense on the income
statement. The information presented may not be indicative of the effect in
future periods.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
in millions, except per share amounts 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------------
Net income, as reported $225 $246 $ 442 $ 486
Add: Stock-based employee compensation expense included
reported net income, net of related tax effects 2 1 4 2
Deduct: Total stock-based employee compensation expense determined under
fair value-based method for all awards, net of related tax effects 5 7 10 14
- -----------------------------------------------------------------------------------------------------------------------------------
Net income -- pro forma $222 $240 $ 436 $ 474
==== ==== ===== ======
Per common share:
Net income $.53 $.58 $1.04 $ 1.14
Net income -- pro forma .52 .57 1.03 1.11
Net income assuming dilution .53 .57 1.03 1.13
Net income assuming dilution -- pro forma .52 .56 1.02 1.10
- -----------------------------------------------------------------------------------------------------------------------------------
8
ACCOUNTING PRONOUNCEMENTS ADOPTED IN 2003
ACCOUNTING FOR AND DISCLOSURE OF GUARANTEES. In November 2002, the FASB issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others." This
interpretation requires a guarantor to recognize, at the inception of a
guarantee, a liability for the fair value of obligations undertaken. The
liability that must be recognized is specifically related to the obligation to
stand ready to perform over the term of the guarantee. The initial recognition
and measurement provisions of this guidance became effective on a prospective
basis for guarantees issued or modified on or after January 1, 2003.
For guarantees subject to the liability recognition provisions of this
interpretation for which Key receives a fee, the initial fair value stand ready
obligation is recognized at an amount equal to the fee. For guarantees for which
no fee is received, the fair value of the stand ready obligations is determined
using expected present value measurement techniques, unless observable
transactions for identical or similar guarantees are available. The subsequent
accounting for these stand ready obligations depends on the nature of the
underlying guarantees. Key accounts for its release from risk for a particular
guarantee either upon expiration or settlement, or by a systematic and rational
amortization method depending on the risk profile of the particular guarantee.
This new accounting guidance also expands the disclosures that a guarantor must
make about its obligations under certain guarantees. These disclosure
requirements took effect for financial statements of interim or annual periods
ending after October 15, 2002. The required disclosures for Key are provided in
Note 10 under the heading "Guarantees." The adoption of Interpretation No. 45
did not have any material effect on Key's financial condition or results of
operations.
COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES. In July 2002, the FASB issued
SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities." This new standard took effect for exit or disposal activities
(e.g., activities related to ceasing a line of business, relocating operations,
etc.) initiated after December 31, 2002. SFAS No. 146 substantially changes the
rules for recognizing costs, such as lease or other contract termination costs
and one-time employee termination benefits associated with exit or disposal
activities arising from corporate restructurings. Generally, these costs must be
recognized when incurred. Previously, those costs could be recognized earlier,
for example, when a company committed to an exit or disposal plan. Key adopted
SFAS No. 146 for restructuring activities initiated on or after January 1, 2003.
The adoption of SFAS No. 146 did not have any material effect on Key's financial
condition or results of operations.
ASSET RETIREMENT OBLIGATIONS. In August 2001, the FASB issued SFAS No. 143,
"Accounting for Asset Retirement Obligations." The new standard was effective
for fiscal years beginning after June 15, 2002. SFAS No. 143 addresses the
accounting for legal obligations associated with the retirement of tangible
long-lived assets and requires a liability to be recognized for the fair value
of these obligations in the period they are incurred. Related costs are
capitalized as part of the carrying amounts of the assets to be retired and are
amortized over the assets' useful lives. Key adopted SFAS No. 143 as of January
1, 2003. The adoption of this accounting guidance did not have any material
effect on Key's financial condition or results of operations.
ACCOUNTING FOR STOCK-BASED COMPENSATION. As discussed under the heading
"Stock-Based Compensation" on page 8, effective January 1, 2003, Key adopted the
fair value method of accounting as outlined in SFAS No. 123. Management is
applying the change in accounting prospectively (prospective method) to all
awards as permitted under the transition provisions in SFAS No. 148, "Accounting
for Stock-Based Compensation Transition and Disclosure," which was issued in
December 2002. SFAS No. 148 amends SFAS No. 123 to provide alternative methods
of transition for an entity that voluntarily changes to the fair value method of
accounting for stock compensation. These alternative methods include: (i) the
prospective method; (ii) the modified prospective method; and, (iii) the
retroactive restatement method. This accounting guidance also amends the
disclosure requirements of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of accounting for stock
compensation and the effect of the method used on reported financial results.
The required interim disclosures for Key are provided under the aforementioned
"Stock-Based Compensation" heading.
9
Based on the valuation and mid-year timing of option grants in 2003, management
estimates that the accounting change will reduce Key's diluted earnings per
common share by less than $.02 in 2003. The effect on Key's earnings per common
share in subsequent years will depend on the number and timing of options
granted and the assumptions used to estimate their fair value.
ACCOUNTING PRONOUNCEMENTS PENDING ADOPTION
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH
LIABILITIES AND EQUITY. In May 2003, the FASB issued SFAS No. 150, "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity," which establishes standards for how an issuer is to classify and
measure certain financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify certain financial instruments
that would previously have been classified as equity as liabilities (or as
assets in some circumstances). Specifically, SFAS No. 150 requires that
financial instruments issued in the form of shares that are mandatorily
redeemable; financial instruments that embody an obligation to repurchase the
issuer's equity shares or are indexed to such an obligation; or financial
instruments that embody an unconditional obligation or a conditional obligation
that can be settled in certain ways be classified as liabilities. This
accounting guidance is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003. The adoption of SFAS No. 150
is not expected to have any material effect on Key's financial condition or
results of operations.
AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. In
April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities," which amends and clarifies
financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts, and hedging activities
addressed under SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities." This accounting guidance amends SFAS No. 133 for decisions made by
the FASB as part of the Derivatives Implementation Group process and also amends
SFAS No. 133 to clarify the definition of a derivative. SFAS No. 149 is
effective generally for contracts entered into or modified after June 30, 2003,
and for hedging relationships designated after June 30, 2003. The adoption of
SFAS No. 149 is not expected to have any material effect on Key's financial
condition or results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES. In January 2003, the FASB issued
Interpretation No. 46, "Consolidation of Variable Interest Entities," which
significantly changes how Key and other companies determine when to consolidate
other entities. Under this guidance, entities are classified as either voting
interest entities or variable interest entities ("VIEs"). A voting interest
entity is evaluated for consolidation under existing accounting standards, which
focus on the equity owner with voting control, while a VIE is consolidated by
its primary beneficiary. The primary beneficiary is the party that holds
variable interests that expose it to a majority of the entity's expected losses
and/or residual returns. Variable interests include equity interests,
subordinated debt, derivative contracts, leases, service agreements, guarantees,
standby letters of credit, loan commitments and other instruments.
Interpretation No. 46 was effective immediately for entities created after
January 31, 2003, and applies to previously existing entities in quarters
beginning after June 15, 2003. It requires additional disclosures by primary
beneficiaries and other significant variable interest holders. See Note 7 for a
discussion of the actions that Key expects to take with respect to the adoption
of Interpretation No. 46. The most significant impact of this new guidance will
be on Key's balance sheet since consolidating or de-consolidating certain
entities will either increase, or change the classification of, assets and
liabilities and change leverage and capital ratios, as well as reported asset
concentrations. While the consolidation of previously unconsolidated entities or
the de-consolidation of previously consolidated entities under Interpretation
No. 46 will represent an accounting change, it will not affect Key's legal
rights or obligations to these entities. Additional information pertaining to
VIEs is summarized in Notes 7 and 10.
10
2. EARNINGS PER COMMON SHARE
Key calculates its basic and diluted earnings per common share as follows:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
dollars in millions, except per share amounts 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 225 $ 246 $ 442 $ 486
======== ======== ======== ========
- -----------------------------------------------------------------------------------------------------------------------------
WEIGHTED AVERAGE COMMON SHARES
Weighted average common shares outstanding (000) 423,882 426,092 424,575 425,477
Effect of dilutive common stock options (000) 3,288 5,843 3,053 5,506
- -----------------------------------------------------------------------------------------------------------------------------
Weighted average common shares and potential
common shares outstanding (000) 427,170 431,935 427,628 430,983
======== ======== ======== ========
- -----------------------------------------------------------------------------------------------------------------------------
EARNINGS PER COMMON SHARE
Net income per common share $ .53 $ .58 $ 1.04 $ 1.14
Net income per common share--assuming dilution .53 .57 1.03 1.13
- -----------------------------------------------------------------------------------------------------------------------------
3. ACQUISITIONS AND DIVESTITURE
Business acquisitions and divestitures either completed by Key during 2002 or
pending completion at June 30, 2003, are summarized below. There were no such
transactions completed during the first six months of 2003.
ACQUISITIONS
UNION BANKSHARES, LTD.
On December 12, 2002, Key purchased Union Bankshares, Ltd., the holding company
for Union Bank & Trust, a seven-branch bank headquartered in Denver, Colorado.
Key paid $22.63 per Union Bankshares common share for a total cash consideration
of $66 million. Goodwill of approximately $34 million and core deposit
intangibles of $13 million were recorded. Union Bankshares, Ltd. had assets of
$475 million at the date of acquisition. On January 17, 2003, Union Bank & Trust
was merged into Key Bank National Association ("KBNA").
CONNING ASSET MANAGEMENT
On June 28, 2002, Key purchased substantially all of the mortgage loan and real
estate business of Conning Asset Management, headquartered in Hartford,
Connecticut. Conning's mortgage loan and real estate business originates,
securitizes and services multi-family, retail, industrial and office property
mortgage loans on behalf of pension fund and life insurance company investors.
At the date of acquisition, the business had net assets of $17 million and
serviced approximately $4 billion in commercial mortgage loans through its St.
Louis office. In accordance with a confidentiality clause in the purchase
agreement, the terms, which are not material, have not been disclosed.
DIVESTITURE
401(k) RECORDKEEPING BUSINESS
On June 12, 2002, Key sold its 401(k) plan recordkeeping business. Key
recognized a gain of $3 million ($2 million after tax) on the transaction.
ACQUISITION PENDING AT JUNE 30, 2003
NEWBRIDGE PARTNERS LLC
On July 1, 2003, Key acquired NewBridge Partners LLC, a growth equity investment
management firm headquartered in New York City with managed assets of
approximately $2 billion. The terms of the transaction are not material and have
not been disclosed.
11
4. LINE OF BUSINESS RESULTS
CONSUMER BANKING
RETAIL BANKING provides individuals with branch-based deposit and investment
products, personal finance services and loans, including residential mortgages,
home equity and various types of installment loans.
SMALL BUSINESS provides businesses that have annual sales revenues of $10
million or less with deposit, investment and credit products, and business
advisory services.
CONSUMER FINANCE consists of two primary business units: Indirect Lending and
National Home Equity.
Indirect Lending offers automobile and marine loans to consumers through dealers
and finances inventory for automobile and marine dealers. This business unit
also provides education loans, insurance and interest-free payment plans for
students and their parents.
National Home Equity provides both prime and nonprime mortgage and home equity
loan products to individuals. These products originate outside of Key's retail
branch system. This business unit also works with mortgage brokers and home
improvement contractors to provide home equity and home improvement solutions.
CORPORATE AND INVESTMENT BANKING
CORPORATE BANKING provides a full array of products and services to large
corporations, middle-market companies, financial institutions and government
organizations. These products and services include: financing, treasury
management, investment banking, derivatives and foreign exchange, equity and
debt trading, and syndicated finance.
KEYBANK REAL ESTATE CAPITAL provides construction and interim lending, permanent
debt placements and servicing, and equity and investment banking services to
developers, brokers and owner-investors. This line of business deals exclusively
with nonowner-occupied properties (i.e., generally properties for which the
owner occupies less than 60% of the premises).
KEY EQUIPMENT FINANCE meets the equipment leasing needs of companies worldwide
and provides equipment manufacturers, distributors and resellers with financing
options for their clients. Lease financing receivables and related revenues are
assigned to other lines of business (primarily Corporate Banking) if those
businesses are principally responsible for maintaining the relationship with the
client.
INVESTMENT MANAGEMENT SERVICES
INVESTMENT MANAGEMENT SERVICES consists of two primary business units: Victory
Capital Management and McDonald Financial Group.
Victory Capital Management manages or gives advice regarding investment
portfolios for a national client base, including corporations, labor unions,
not-for-profit organizations, governments and individuals. These portfolios may
be managed in separate accounts, common funds or the Victory family of mutual
funds.
McDonald Financial Group offers financial, estate and retirement planning and
asset management services to assist high-net-worth clients with their banking,
brokerage, trust, portfolio management, insurance, charitable giving and related
needs. This unit also provides banking services to public sector institutions.
OTHER SEGMENTS
Other segments consists primarily of Treasury, Principal Investing and the net
effect of funds transfer pricing.
RECONCILING ITEMS
Total assets included under "Reconciling Items" represent primarily the
unallocated portion of nonearning assets of corporate support functions. Charges
related to the funding of these assets are part of net interest income and are
allocated to the business segments through noninterest expense. Reconciling
Items also
12
include certain items that are not allocated to the business segments
because they are not reflective of their normal operations.
The table that spans pages 14 and 15 shows selected financial data for each
major business group for the three- and six-month periods ended June 30, 2003
and 2002. This table is accompanied by additional supplementary information for
each of the lines of business that comprise these groups. The information was
derived from the internal financial reporting system that management uses to
monitor and manage Key's financial performance. Accounting principles generally
accepted in the United States guide financial accounting, but there is no
authoritative guidance for "management accounting"--the way management uses its
judgment and experience to make reporting decisions. Consequently, the line of
business results Key reports may not be comparable with line of business results
presented by other companies.
The selected financial data are based on internal accounting policies designed
to compile results on a consistent basis and in a manner that reflects the
underlying economics of the businesses. As such:
- - Net interest income is determined by assigning a standard cost for
funds used to assets or a standard credit for funds provided to
liabilities based on their maturity, prepayment and/or repricing
characteristics. The net effect of this funds transfer pricing is
included in the "Other Segments" columns.
- - Indirect expenses, such as computer servicing costs and corporate
overhead, are allocated based on assumptions of the extent to which
each line actually uses the services.
- - Key's consolidated provision for loan losses is allocated among the
lines of business based primarily on their actual net charge-offs,
adjusted periodically for loan growth and changes in risk profile. The
level of the consolidated provision is based on the methodology that
management uses to estimate Key's consolidated allowance for loan
losses. This methodology is described in Note 1 ("Summary of
Significant Accounting Policies") under the heading "Allowance for Loan
Losses" on page 58 of Key's 2002 Annual Report to Shareholders.
- - Income taxes are allocated based on the statutory federal income tax
rate of 35% (adjusted for tax-exempt interest income, income from
corporate-owned life insurance and tax credits associated with
investments in low-income housing projects) and a blended state income
tax rate (net of the federal income tax benefit) of 2.5%.
- - Capital is assigned based on management's assessment of economic risk
factors (primarily credit, operating and market risk).
Developing and applying the methodologies that management uses to allocate items
among Key's lines of business is a dynamic process. Accordingly, financial
results may be revised periodically to reflect accounting enhancements, changes
in the risk profile of a particular business or changes in Key's organization
structure. The financial data reported for all periods presented in the tables
reflect a number of changes, which occurred during the first half of 2003:
- - Key reorganized and renamed some of its business groups and lines of
business. Key's Capital Markets line of business moved from the
Investment Management Services group (formerly Key Capital Partners) to
the Corporate Banking line within the Corporate and Investment Banking
group (formerly Key Corporate Finance). Also within Corporate and
Investment Banking, Key changed the name of its National Commercial
Real Estate line of business to KeyBank Real Estate Capital, and
changed the name of its National Equipment Finance line of business to
Key Equipment Finance. In addition, Key consolidated the reporting of
its National Home Equity and Indirect Lending lines of business into
one line of business named Consumer Finance.
- - Methodologies used to allocate certain overhead and funding costs were
refined.
13
CORPORATE AND INVESTMENT
THREE MONTHS ENDED JUNE 30, CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES
-------------------- -------------------- --------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 459 $ 448 $ 261 $ 269 $ 61 $ 57
Noninterest income 122 125 124 112 126 164
- --------------------------------------------------------------------------------------------------------------------------
Total revenue (TE)(a) 581 573 385 381 187 221
Provision for loan losses 65 70 56 59 4 6
Depreciation and amortization expense 34 36 9 10 9 12
Other noninterest expense 322 295 173 159 150 154
- --------------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes (TE) 160 172 147 153 24 49
Allocated income taxes and TE adjustments 60 64 55 58 9 18
- --------------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 100 $ 108 $ 92 $ 95 $ 15 $ 31
======= ======= ======= ======= ======= =======
Percent of consolidated net income 44% 44% 41% 39% 7% 13%
Percent of total segments net income 44 45 41 40 7 13
- --------------------------------------------------------------------------------------------------------------------------
AVERAGE BALANCES
Loans $28,827 $27,926 $28,172 $29,668 $ 5,031 $ 4,892
Total assets(a) 31,251 30,268 32,566 32,966 6,022 5,874
Deposits 34,781 33,976 4,147 3,104 5,939 3,583
- --------------------------------------------------------------------------------------------------------------------------
OTHER FINANCIAL DATA
Net loan charge-offs $ 65 $ 70 $ 73 $ 127 $ 3 $ 6
Return on average allocated equity 18.21% 21.18% 11.05% 11.57% 9.94% 20.15%
Average full-time equivalent employees 8,447 8,488 2,269 2,247 2,842 3,182
- --------------------------------------------------------------------------------------------------------------------------
CORPORATE AND INVESTMENT
SIX MONTHS ENDED JUNE 30, CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES
-------------------- -------------------- --------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 904 $ 884 $ 520 $ 542 $ 120 $ 110
Noninterest income 235 242 234 233 259 324
- --------------------------------------------------------------------------------------------------------------------------
Total revenue (TE)(a) 1,139 1,126 754 775 379 434
Provision for loan losses 143 152 107 110 5 9
Depreciation and amortization expense 68 75 18 21 19 25
Other noninterest expense 619 592 332 317 298 311
- --------------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes (TE) 309 307 297 327 57 89
Allocated income taxes and TE adjustments 116 115 112 123 21 33
- --------------------------------------------------------------------------------------------------------------------------
Net income $ 193 $ 192 $ 185 $ 204 $ 36 $ 56
======= ======= ======= ======= ======= =======
Percent of consolidated net income 44% 39% 42% 42% 8% 12%
Percent of total segments net income 44 42 42 44 8 12
- --------------------------------------------------------------------------------------------------------------------------
AVERAGE BALANCES
Loans $28,628 $27,624 $28,281 $29,754 $ 4,994 $ 4,796
Total assets(a) 31,054 29,973 32,698 33,014 5,973 5,818
Deposits 34,572 34,142 4,093 3,120 5,579 3,627
- --------------------------------------------------------------------------------------------------------------------------
OTHER FINANCIAL DATA
Net loan charge-offs $ 143 $ 152 $ 152 $ 248 $ 7 $ 9
Return on average allocated equity 17.99% 19.00% 11.21% 12.57% 11.82% 18.36%
Average full-time equivalent employees 8,483 8,501 2,282 2,263 2,893 3,194
- --------------------------------------------------------------------------------------------------------------------------
(a) Substantially all revenue generated by Key's major business groups is
derived from clients resident in the United States. Substantially all
long-lived assets, including premises and equipment, capitalized software
and goodwill, held by Key's major business groups are located in the United
States.
TE = Taxable Equivalent, N/A = Not Applicable, N/M = Not Meaningful
14
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY
- ----------------------- ---------------------- ---------------------- ----------------------
2003 2002 2003 2002 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------
$ (39) $ (27) $ 742 $ 747 $ (32) $ (26) $ 710 $ 721
62 27 434 428 -- 20 434 448
- -------------------------------------------------------------------------------------------------------------
23 -- 1,176 1,175 (32) (6) 1,144 1,169
-- -- 125 135 -- -- 125 135
-- -- 52 58 -- -- 52 58
9 8 654 616 (18) (9) 636 607
- -------------------------------------------------------------------------------------------------------------
14 (8) 345 366 (14) 3 331 369
(5) (13) 119 127 (13) (4) 106 123
- -------------------------------------------------------------------------------------------------------------
$ 19 $ 5 $ 226 $ 239 $ (1) $ 7 $ 225 $ 246
======== ======== ======== ======== ======== ======== ======== ========
8% 2% 100% 98% --% 2% 100% 100%
8 2 100 100 N/A N/A N/A N/A
- -------------------------------------------------------------------------------------------------------------
$ 851 $ 1,312 $ 62,881 $ 63,798 $ 148 $ 130 $ 63,029 $ 63,928
13,293 10,657 83,132 79,765 1,580 1,795 84,712 81,560
3,699 3,918 48,566 44,581 (67) (77) 48,499 44,504
- -------------------------------------------------------------------------------------------------------------
-- -- $ 141 $ 203 -- -- $ 141 $ 203
20.32% 4.96% 13.90% 15.08% N/M N/M 12.98% 15.16%
34 31 13,592 13,948 6,407 6,955 19,999 20,903
- -------------------------------------------------------------------------------------------------------------
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY
- ----------------------- ---------------------- ----------------------- ----------------------
2003 2002 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------
$ (74) $ (61) $ 1,470 $ 1,475 $ (57) $ (52) $ 1,413 $ 1,423
96 60 824 859 7 32 831 891
- --------------------------------------------------------------------------------------------------------------
22 (1) 2,294 2,334 (50) (20) 2,244 2,314
-- -- 255 271 -- -- 255 271
-- -- 105 121 -- -- 105 121
16 14 1,265 1,234 (25) (29) 1,240 1,205
- --------------------------------------------------------------------------------------------------------------
6 (15) 669 708 (25) 9 644 717
(19) (26) 230 245 (28) (14) 202 231
- --------------------------------------------------------------------------------------------------------------
$ 25 $ 11 $ 439 $ 463 $ 3 $ 23 $ 442 $ 486
======== ======== ======== ======== ======== ======== ======== ========
5% 2% 99% 95% 1% 5% 100% 100%
6 2 100 100 N/A N/A N/A N/A
- --------------------------------------------------------------------------------------------------------------
$ 906 $ 1,378 $ 62,809 $ 63,552 $ 128 $ 157 $ 62,937 $ 63,709
13,046 10,626 82,771 79,431 1,544 1,786 84,315 81,217
3,454 3,432 47,698 44,321 (69) (83) 47,629 44,238
- --------------------------------------------------------------------------------------------------------------
-- -- $ 302 $ 409 -- -- $ 302 $ 409
13.55% 5.45% 13.67% 14.74% N/M N/M 12.94% 15.34%
35 31 13,693 13,989 6,529 7,002 20,222 20,991
- --------------------------------------------------------------------------------------------------------------
15
Supplementary information (Consumer Banking lines of business)
THREE MONTHS ENDED JUNE 30, RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE
-------------------- -------------------- --------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 334 $ 331 $ 97 $ 94 $ 150 $ 148
Provision for loan losses 15 14 17 15 33 41
Noninterest expense 216 205 47 43 93 83
Net income 64 70 21 23 15 15
Average loans 9,839 8,760 4,391 4,283 14,597 14,883
Average deposits 30,182 30,076 4,264 3,588 335 312
Net loan charge-offs 15 14 17 15 33 41
Return on average allocated equity 40.75% 49.69% 21.16% 28.04% 5.12% 5.23%
Average full-time equivalent employees 6,134 6,149 401 323 1,912 2,016
- -------------------------------------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE
-------------------- -------------------- --------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 655 $ 646 $ 191 $ 185 $ 293 $ 295
Provision for loan losses 31 32 35 29 77 91
Noninterest expense 419 409 89 86 179 172
Net income 128 128 42 44 23 20
Average loans 9,706 8,310 4,382 4,293 14,540 15,021
Average deposits 30,057 30,284 4,171 3,543 344 315
Net loan charge-offs 32 32 34 29 77 91
Return on average allocated equity 41.23% 46.76% 22.35% 27.39% 4.00% 3.47%
Average full-time equivalent employees 6,163 6,161 390 321 1,930 2,019
- --------------------------------------------------------------------------------------------------------------------------
Supplementary information (Corporate and Investment Banking lines of business)
THREE MONTHS ENDED JUNE 30, CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE
-------------------- --------------------------- ---------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 221 $ 238 $ 93 $ 83 $ 71 $ 60
Provision for loan losses 48 52 (1) -- 9 7
Noninterest expense 119 114 36 30 27 25
Net income 34 44 36 33 22 18
Average loans 14,002 16,273 7,406 7,711 6,764 5,684
Average deposits 3,421 2,556 712 538 14 10
Net loan charge-offs 65 120 (1) -- 9 7
Return on average allocated equity 6.86% 8.30% 16.97% 17.77% 17.68% 17.15%
Average full-time equivalent employees 1,001 1,105 655 522 613 620
- ---------------------------------------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE
-------------------- --------------------------- ---------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 442 $ 480 $ 173 $ 171 $ 139 $ 124
Provision for loan losses 89 86 3 3 15 21
Noninterest expense 230 232 68 59 52 47
Net income 76 101 64 68 45 35
Average loans 14,167 16,362 7,451 7,772 6,663 5,620
Average deposits 3,391 2,563 689 548 13 9
Net loan charge-offs 134 224 3 3 15 21
Return on average allocated equity 7.63% 9.71% 15.53% 18.09% 18.60% 16.84%
Average full-time equivalent employees 1,027 1,120 646 516 609 627
- --------------------------------------------------------------------------------------------------------------------------
16
5. SECURITIES
Key classifies its securities into four categories: trading, available for sale,
investment and other investments.
TRADING ACCOUNT SECURITIES. These are debt and equity securities that are
purchased and held by Key with the intent of selling them in the near term, and
certain interests retained in loan securitizations. All of these assets are
reported at fair value ($888 million at June 30, 2003, $801 million at December
31, 2002, and $752 million at June 30, 2002) and are included in "short-term
investments" on the balance sheet. Realized and unrealized gains and losses on
trading account securities are reported in "investment banking and capital
markets income" on the income statement.
SECURITIES AVAILABLE FOR SALE. These include securities that Key intends to hold
for an indefinite period of time and that may be sold in response to changes in
interest rates, prepayment risk, liquidity needs or other factors. Securities
available for sale are reported at fair value and include debt and marketable
equity securities with readily determinable fair values. Unrealized gains and
losses (net of income taxes) deemed temporary are recorded in shareholders'
equity as a component of "accumulated other comprehensive income (loss)."
Unrealized gains and losses on specific securities deemed to be "other than
temporary" are included in "net securities gains (losses)" on the income
statement. Also included in "net securities gains (losses)" are actual gains and
losses resulting from sales of specific securities.
When Key retains an interest in loans it securitizes, it bears risk that the
loans will be prepaid (which would reduce expected interest income) or not paid
at all. Key accounts for these retained interests (which include both
certificated and uncertificated interests) as debt securities, classifying them
as available for sale or as trading account assets.
"Other securities" held in the available for sale portfolio primarily are
marketable equity securities.
INVESTMENT SECURITIES. These are debt securities that Key has the intent and
ability to hold until maturity. Debt securities are carried at cost, adjusted
for amortization of premiums and accretion of discounts using the interest
method. This method produces a constant rate of return on the basis of the
adjusted carrying amount.
OTHER INVESTMENTS. Principal investments - investments in equity and mezzanine
instruments made by Key's Principal Investing unit - represent the majority of
other investments and are carried at fair value. They include direct and
indirect investments predominately in privately-held companies. Direct
investments are those made in a particular company, while indirect investments
are made through funds that include other investors. Changes in estimated fair
values and actual gains and losses on sales of principal investments are
included in "investment banking and capital markets income" on the income
statement.
In addition to principal investments, other investments include equity
securities that do not have readily determinable fair values. These securities
include certain real estate-related investments that are carried at estimated
fair value, as well as other types of securities that are generally carried at
cost. The carrying amount of the securities carried at cost is adjusted for
declines in value that are considered to be "other than temporary." These
adjustments are included in "net securities gains" on the income statement.
The amortized cost, unrealized gains and losses, and approximate fair value of
Key's investment securities and securities available for sale are presented in
the following tables. Gross "unrealized" gains and losses are represented by the
difference between the amortized cost and the fair values of securities on the
balance sheet as of the dates indicated. Accordingly, the amount of these gains
and losses may change in the future as market conditions improve or worsen.
17
JUNE 30, 2003
-------------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
in millions COST GAINS LOSSES VALUE
- ---------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES
States and political subdivisions $ 95 $ 8 -- $ 103
Other securities 4 -- -- 4
- ---------------------------------------------------------------------------------------------------------
Total investment securities $ 99 $ 8 -- $ 107
========== ========== ========== ==========
- ---------------------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 34 $ 1 -- $ 35
States and political subdivisions 25 1 -- 26
Collateralized mortgage obligations 6,552 61 $ 51 6,562
Other mortgage-backed securities 567 24 -- 591
Retained interests in securitizations 123 57 -- 180
Other securities 140 -- 1 139
- ---------------------------------------------------------------------------------------------------------
Total securities available for sale $ 7,441 $ 144 $ 52 $ 7,533
========== ========== ========== ==========
- ---------------------------------------------------------------------------------------------------------
DECEMBER 31, 2002
-------------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
in millions COST GAINS LOSSES VALUE
- ---------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES
States and political subdivisions $ 120 $ 9 -- $ 129
- ---------------------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 22 $ 1 -- $ 23
States and political subdivisions 35 -- -- 35
Collateralized mortgage obligations 7,143 129 $ 65 7,207
Other mortgage-backed securities 815 37 -- 852
Retained interests in securitizations 166 43 -- 209
Other securities 208 -- 27 181
- ---------------------------------------------------------------------------------------------------------
Total securities available for sale $ 8,389 $ 210 $ 92 $ 8,507
========== ========== ========== ==========
- ---------------------------------------------------------------------------------------------------------
JUNE 30, 2002
-------------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
in millions COST GAINS LOSSES VALUE
- ---------------------------------------------------------------------------------------------------------
INVESTMENT SECURITIES
States and political subdivisions $ 186 $ 10 -- $ 196
- ---------------------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 22 -- -- $ 22
States and political subdivisions 18 $ 1 -- 19
Collateralized mortgage obligations 5,092 99 $ 79 5,112
Other mortgage-backed securities 823 34 -- 857
Retained interests in securitizations 172 35 -- 207
Other securities 216 1 24 193
- ---------------------------------------------------------------------------------------------------------
Total securities available for sale $ 6,343 $ 170 $ 103 $ 6,410
========== ========== ========== ==========
- ---------------------------------------------------------------------------------------------------------
18
6. LOANS
Key's loans by category are summarized as follows:
JUNE 30, DECEMBER 31, JUNE 30,
in millions 2003 2002 2002
- -----------------------------------------------------------------------------------------------
Commercial, financial and agricultural $ 17,381 $ 17,425 $ 18,071
Commercial real estate:
Commercial mortgage 5,886 6,015 6,266
Construction 5,192 5,659 5,860
- -----------------------------------------------------------------------------------------------
Total commercial real estate loans 11,078 11,674 12,126
Commercial lease financing 8,009 7,513 7,216
- -----------------------------------------------------------------------------------------------
Total commercial loans 36,468 36,612 37,413
Real estate -- residential mortgage 1,754 1,968 2,117
Home equity 14,688 13,804 13,379
Consumer -- direct 2,170 2,161 2,185
Consumer -- indirect:
Automobile lease financing 528 873 1,386
Automobile loans 2,107 2,181 2,297
Marine 2,379 2,088 1,917
Other 595 667 912
- -----------------------------------------------------------------------------------------------
Total consumer -- indirect loans 5,609 5,809 6,512
- -----------------------------------------------------------------------------------------------
Total consumer loans 24,221 23,742 24,193
Loans held for sale:
Commercial, financial and agricultural -- 41 --
Real estate -- commercial mortgage 231 193 281
Real estate -- residential mortgage 45 57 19
Education 2,249 1,812 1,975
- -----------------------------------------------------------------------------------------------
Total loans held for sale 2,525 2,103 2,275
- -----------------------------------------------------------------------------------------------
Total loans $ 63,214 $ 62,457 $ 63,881
========== ========== ==========
- -----------------------------------------------------------------------------------------------
Key uses interest rate swaps to manage interest rate risk; these swaps modify
the repricing and maturity characteristics of certain loans. For more
information about such swaps at June 30, 2003, see Note 20 ("Derivatives and
Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to
Shareholders.
Changes in the allowance for loan losses are summarized as follows:
Three months ended June 30, Six months ended June 30,
--------------------------- -------------------------
in millions 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------
Balance at beginning of period $ 1,421 $ 1,607 $ 1,452 $ 1,677
Charge-offs (179) (236) (369) (469)
Recoveries 38 33 67 60
- ----------------------------------------------------------------------------------------------------
Net charge-offs (141) (203) (302) (409)
Provision for loan losses 125 135 255 271
- ----------------------------------------------------------------------------------------------------
Balance at end of period $ 1,405 $ 1,539 $ 1,405 $ 1,539
========== ========== ========== =======
- ----------------------------------------------------------------------------------------------------
19
7. VARIABLE INTEREST ENTITIES
A variable interest entity ("VIE") is a partnership, limited liability company,
trust or other legal entity that does not have sufficient equity to permit it to
finance its activities without additional subordinated financial support from
other parties, or whose investors lack one of three characteristics associated
with owning a controlling financial interest. Those characteristics include: (i)
the direct or indirect ability to make decisions about an entity's activities
through voting rights or similar rights; (ii) the obligation to absorb the
expected losses of an entity if they occur; and, (iii) the right to receive the
expected residual returns of the entity, if they occur.
Interpretation No. 46, "Consolidation of Variable Interest Entities," addresses
the consolidation of VIEs. This interpretation is summarized in Note 1 ("Basis
of Presentation"), under the heading "Accounting Pronouncements Pending
Adoption" on page 10. Under Interpretation No. 46, VIEs are consolidated by the
party who is exposed to a majority of the VIE's expected losses and/or residual
returns (i.e., the primary beneficiary).
Transferors of assets to qualifying special purpose entities meeting the
requirements of SFAS 140, "Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities," are exempt from the scope of
Interpretation No. 46. As a result, Key's securitization trusts are exempt from
consolidation under this interpretation.
Key has determined that it is the primary beneficiary of the following VIEs and
will, therefore, consolidate them when Interpretation No. 46 is adopted in the
third quarter of 2003.
COMMERCIAL PAPER CONDUITS. Key, among others, refers third party assets and
borrowers and provides liquidity and credit enhancement to an unconsolidated
asset-backed commercial paper conduit. The conduit had assets of $291 million at
June 30, 2003. Key has determined that it is the primary beneficiary of the
conduit, as currently structured. Therefore, Key plans to consolidate the
conduit in July 2003. At June 30, 2003, Key's maximum exposure to loss from its
interests in the conduit totaled $60 million, which represents the committed
credit enhancement facility.
Key and the conduit owner are currently working on restructuring the conduit.
Under this restructuring plan, capital notes will be issued to an unrelated
third party investor who will absorb the majority of the expected losses of the
conduit, if they occur. The issuance of capital notes by the conduit constitutes
a material change in the contractual arrangements among parties involved and is
a trigger event under Interpretation No. 46, which requires a reassessment of
this entity. The capital note investor is expected to be considered the primary
beneficiary of the conduit following the restructuring and, therefore, is
expected to consolidate it. Key and the conduit owner are currently discussing
and reviewing the restructuring plans with their respective independent
accountants and attorneys, and restructuring documents are being drafted. Key
anticipates that the restructuring will be completed during August 2003, at
which time the conduit will be de-consolidated by Key.
Additionally, Key holds a subordinated note in and provides referral services
and liquidity support to one program within another asset-backed commercial
paper conduit. Key has determined that this program does not qualify for
evaluation for consolidation separately from the entire conduit. Accordingly,
and because the assets in the program are being liquidated rapidly, Key no
longer believes that it has a significant interest in this conduit.
Additional information pertaining to Key's involvement with conduits is
summarized in Note 10 ("Contingent Liabilities and Guarantees") under the
heading "Guarantees" on page 26 and under the heading "Other Off-Balance Sheet
Risk" on page 28.
LOW-INCOME HOUSING TAX CREDIT ("LIHTC") GUARANTEED FUNDS. Key Affordable Housing
Corporation ("KAHC") forms limited partnerships (funds) that invest in LIHTC
projects. Interests in these funds are offered to qualified investors, who pay a
fee to KAHC for a guaranteed return. Key also earns syndication and asset
management fees from these funds. At June 30, 2003, the guaranteed funds had
unamortized
20
equity of $651 million. Guaranteed funds formed during the quarter ended June
30, 2003, did not have any material effect on Key's financial condition or
results of operations. Additional information on return guaranty agreements with
LIHTC investors is summarized in Note 10 under the heading "Guarantees."
Key's maximum exposure to loss from its relationships with guaranteed LIHTC
funds was $815 million at June 30, 2003, which represents undiscounted future
payments due to investors for the return on and of their investments. KAHC has
established a reserve in the amount of $34 million at June 30, 2003, which
management believes will be sufficient to absorb future estimated losses under
the guarantees.
As required by Interpretation No. 46, assets, liabilities and noncontrolling
interests of newly consolidated entities will initially be recorded at their
carrying amounts. If determining the carrying amounts is impractical, fair
values at the date Interpretation No. 46 first applies may be used. Any
difference between the net assets added to Key's balance sheet and the amount of
any previously recognized interest in the newly consolidated entities will be
recognized as a cumulative effect of an accounting change. The consolidation of
the commercial paper conduit and guaranteed LIHTC funds is not expected to have
any material effect on Key's financial condition or results of operations.
Key has also determined that it is not the primary beneficiary of the following
group of currently consolidated VIEs and, accordingly, will de-consolidate them
upon adoption of Interpretation No. 46 in the third quarter of 2003.
BUSINESS TRUSTS ISSUING MANDATORILY REDEEMABLE PREFERRED CAPITAL SECURITIES. Key
owns the common stock of six fully-consolidated subsidiary business trusts,
which have issued corporation-obligated mandatorily redeemable preferred capital
securities to third party investors. The trusts' only assets, which totaled $1.1
billion at June 30, 2003, are debentures issued by Key, which were acquired by
the trusts using proceeds from the issuance of the preferred securities and
common stock. Upon de-consolidation, Key will include the debentures in
"long-term debt" and Key's equity interest in the business trusts will be
included in "accrued income and other assets" on the balance sheet. For
regulatory reporting purposes, the Federal Reserve Board has advised that such
preferred securities will continue to constitute Tier 1 capital until further
notice. Additional information on the trusts is summarized in Note 9 ("Capital
Securities") starting on page 23.
In addition, Key has significant interests in the following VIE groups.
"Significant interests" has been defined by Key as subordinated interests in
VIEs that expose Key to a portion of the VIEs' expected losses or residual
returns, if they occur.
LIHTC NONGUARANTEED FUNDS. KAHC sells investments in certain unconsolidated
LIHTC funds without guaranteeing a return to the investors and earns syndication
and asset management fees for services provided to these nonguaranteed funds.
Key has determined these funds to be VIEs in which Key has significant
interests, but for which it is not the primary beneficiary. At June 30, 2003,
assets of nonguaranteed LIHTC funds were estimated to be $366 million. Key's
maximum exposure to loss from its involvement with these funds is minimal.
Nonguaranteed funds formed during the quarter ended June 30, 2003, did not have
any material effect on Key's financial condition or results of operations.
LIHTC INVESTMENTS. Key makes investments directly in LIHTC projects through the
Retail Banking line of business. As a limited partner in these unconsolidated
projects, Key is allocated tax credits and deductions associated with the
underlying properties. Key is evaluating the impact of applying Interpretation
No. 46 to these projects and has not yet completed its analysis. At June 30,
2003, estimated assets of the LIHTC projects totaled $863 million. Key's maximum
exposure to loss from its involvement with these LIHTC projects is the
unamortized investment balance of $296 million at June 30, 2003, plus $39
million of tax credits claimed, but subject to recapture. During the quarter
ended June 30, 2003, Key did not obtain any significant interests in LIHTC
projects created after January 31, 2003.
COMMERCIAL AND RESIDENTIAL REAL ESTATE INVESTMENTS. Through the KeyBank Real
Estate Capital line of business, Key makes mezzanine investments in
construction, acquisition and rehabilitation projects that have been determined
to be VIEs. Key receives underwriting, asset management and other fees from
these VIEs and for certain projects, may also provide the senior financing. It
is reasonably possible that, as primary beneficiary, Key will consolidate such
VIEs that have estimated assets of $78 million at June 30, 2003.
21
Key's investments in VIEs for which it is not reasonably possible that Key will
be determined to be the primary beneficiary totaled $41 million at June 30,
2003. Key's maximum exposure to loss from its involvement with these real estate
projects was $245 million at June 30, 2003, which represents the carrying amount
of its investments in and loans to the projects.
During the quarter ended June 30, 2003, Key made mezzanine investments of $21
million in VIEs created after January 31, 2003, and was determined to be the
primary beneficiary for a limited number of these VIEs, which did not have any
material effect on Key's financial condition or results of operations. Key's
maximum exposure to loss from its involvement with these VIEs is equal to $55
million at June 30, 2003, representing the amount invested in and lent to these
projects.
PRINCIPAL INVESTMENTS. Key's Principal Investing unit makes direct investments
in equity and mezzanine instruments offered by individual companies, some of
which have been determined to be VIEs. It is reasonably possible that, as
primary beneficiary, Key will consolidate VIEs that have estimated assets of
$154 million at June 30, 2003. Key's investments in VIEs for which it is not
reasonably possible that Key will be determined to be the primary beneficiary
totaled $45 million at June 30, 2003. Key's maximum exposure to loss from its
involvement with these VIEs was $84 million at June 30, 2003, which represents
the carrying amount of these investments.
During the quarter ended June 30, 2003, Key did not obtain any significant
interests in VIEs created after January 31, 2003, nor were any principal
investments made in VIEs created after January 31, 2003, for which Key was
determined to be the primary beneficiary.
LEVERAGED LEASES. The Key Equipment Finance line of business uses VIEs,
typically grantor and business trusts, in conducting leveraged lease financing
transactions. The VIEs facilitate the transfer of ownership of assets, reduce
financing costs, and reduce the level of risk for lenders and investors. VIEs
used to conduct these financings are consolidated by Key. As of June 30, 2003,
Key's investment in leveraged leases totaled $2.6 billion. Interpretation No.
46 will not change Key's accounting for these transactions.
During the quarter ended June 30, 2003, Key created one new leveraged lease VIE,
which involves $175 million in equipment. Key's maximum exposure to loss from
its involvement with this VIE is limited to its equity investment of $45
million.
22
8. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS
Impaired loans, which account for the largest portion of Key's nonperforming
assets, totaled $498 million at June 30, 2003, compared with $610 million at
December 31, 2002, and $671 million at June 30, 2002. Impaired loans averaged
$526 million for the second quarter of 2003 and $678 million for the second
quarter of 2002.
Key's nonperforming assets were as follows:
JUNE 30, DECEMBER 31, JUNE 30,
in millions 2003 2002 2002
- --------------------------------------------------------------------------------------------------------------------
Impaired loans $ 498 $ 610 $ 671
Other nonaccrual loans 339 333 286
- --------------------------------------------------------------------------------------------------------------------
Total nonperforming loans 837 943 957
Other real estate owned ("OREO") 60 48 40
Allowance for OREO losses (3) (3) (2)
- --------------------------------------------------------------------------------------------------------------------
OREO, net of allowance 57 45 38
Other nonperforming assets 3 5 --
- --------------------------------------------------------------------------------------------------------------------
Total nonperforming assets $ 897 $ 993 $ 995
====== ====== ======
- --------------------------------------------------------------------------------------------------------------------
At June 30, 2003, Key did not have any significant commitments to lend
additional funds to borrowers with loans on nonperforming status.
When expected cash flows or collateral values do not justify the carrying amount
of an impaired loan, the loan is assigned a specific allowance. Management
calculates the extent of the impairment, which is the carrying amount of the
loan less the estimated present value of future cash flows and the fair value of
any existing collateral. The amount that management deems uncollectible (the
impaired amount) is charged against the allowance for loan losses. Even when
collateral value or other sources of repayment appear sufficient, if management
remains uncertain about whether the loan will be repaid in full, an appropriate
amount is specifically allocated in the allowance for loan losses. At June 30,
2003, Key had $302 million of impaired loans with a specifically allocated
allowance for loan losses of $109 million, and $196 million of impaired loans
that were carried at their estimated fair value without a specifically allocated
allowance. At December 31, 2002, impaired loans included $377 million of loans
with a specifically allocated allowance of $179 million, and $233 million that
were carried at their estimated fair value without a specifically allocated
allowance.
Key does not perform a loan-specific impairment valuation for smaller-balance,
homogeneous, nonaccrual loans (shown in the preceding table as "Other nonaccrual
loans"). These typically are consumer loans, including residential mortgages,
home equity loans and various types of installment loans. Management applies
historical loss experience rates to these loan portfolios, adjusted to reflect
emerging credit trends and other factors, and then allocates a portion of the
allowance for loan losses to each loan type.
9. CAPITAL SECURITIES
KeyCorp has six fully-consolidated subsidiary business trusts that have issued
corporation-obligated mandatorily redeemable preferred capital securities
("capital securities"). These securities are carried as liabilities on Key's
balance sheet. The securities provide an attractive source of funds since they
constitute Tier I capital for regulatory reporting purposes, but have the same
tax advantages as debt for federal income tax purposes. To the extent the trusts
have funds available to make payments, as guarantor, KeyCorp unconditionally
guarantees payment of:
- - required distributions on the capital securities;
- - the redemption price when a capital security is redeemed; and
- - amounts due if a trust is liquidated or terminated.
23
KeyCorp owns the outstanding common stock of each of the trusts. The trusts used
the proceeds from the issuance of their capital securities and common stock to
buy debentures issued by KeyCorp. These debentures are the trusts' only assets;
the interest payments from the debentures finance the distributions paid on the
capital securities. Key's financial statements do not reflect the debentures or
the related effects on the income statement because they are eliminated in
consolidation.
Under Interpretation No. 46, Key has determined that these business trusts are
VIEs for which it is not the primary beneficiary. Therefore, effective July 1,
2003, these trusts will be de-consolidated. Additional information regarding
Interpretation No. 46 and these business trusts is summarized in Note 1 ("Basis
of Presentation"), which begins on page 7, and in Note 7 ("Variable Interest
Entities") under the heading "Business trusts issuing mandatorily redeemable
preferred capital securities" on page 21.
The capital securities, common stock and related debentures are summarized as
follows:
PRINCIPAL INTEREST RATE MATURITY
CAPITAL AMOUNT OF OF CAPITAL OF CAPITAL
SECURITIES, COMMON DEBENTURES, SECURITIES AND SECURITIES AND
dollars in millions NET OF DISCOUNT(a) SECURITIES NET OF DISCOUNT(b) DEBENTURES(c) DEBENTURES
- ----------------------------------------------------------------------------------------------------------------------------------
June 30, 2003
KeyCorp Institutional Capital A $ 415 $ 11 $ 361 7.826% 2026
KeyCorp Institutional Capital B 178 4 154 8.250 2026
KeyCorp Capital I 230 8 238 2.030 2028
KeyCorp Capital II 190 8 165 6.875 2029
KeyCorp Capital III 235 8 187 7.750 2029
Union Bankshares Capital Trust I 10 1 11 9.000 2028
- ----------------------------------------------------------------------------------------------------------------------------------
Total $1,258 $ 40 $1,116 6.678% --
====== ==== ======
- ----------------------------------------------------------------------------------------------------------------------------------
December 31, 2002 $1,260 $ 40 $1,136 6.779% --
====== ==== ======
- ----------------------------------------------------------------------------------------------------------------------------------
June 30, 2002 $1,244 $ 39 $1,195 6.749% --
====== ==== ======
- ----------------------------------------------------------------------------------------------------------------------------------
(a) The capital securities must be redeemed when the related debentures mature,
or earlier if provided in the governing indenture. Each issue of capital
securities carries an interest rate identical to that of the related
debenture. The capital securities constitute minority interests in the
equity accounts of KeyCorp's consolidated subsidiaries and, therefore,
qualify as Tier 1 capital under Federal Reserve Board guidelines. Included
in certain capital securities at June 30, 2003, December 31, 2002 and June
30, 2002, are basis adjustments of $182 million, $164 million and $88
million, respectively, related to fair value hedges. See Note 20
("Derivatives and Hedging Activities"), which begins on page 84 of Key's
2002 Annual Report to Shareholders, for an explanation of fair value hedges.
(b) KeyCorp has the right to redeem its debentures: (i) in whole or in part, on
or after December 1, 2006 (for debentures owned by Capital A), December 15,
2006 (for debentures owned by Capital B), July 1, 2008 (for debentures owned
by Capital I), March 18, 1999 (for debentures owned by Capital II), July 16,
1999 (for debentures owned by Capital III), and December 17, 2003 (for
debentures owned by Union Bankshares Capital Trust I); and, (ii) in whole at
any time within 90 days after and during the continuation of a "tax event"
or a "capital treatment event" (as defined in the applicable offering
circular). If the debentures purchased by Capital A or Capital B are
redeemed before they mature, the redemption price will be the principal
amount, plus a premium, plus any accrued but unpaid interest. If the
debentures purchased by Capital I or Union Bankshares Capital Trust I are
redeemed before they mature, the redemption price will be the principal
amount, plus any accrued but unpaid interest. If the debentures purchased by
Capital II or Capital III are redeemed before they mature, the redemption
price will be the greater of: (a) the principal amount, plus any accrued but
unpaid interest or (b) the sum of the present values of principal and
interest payments discounted at the Treasury Rate (as defined in the
applicable offering circular), plus 20 basis points (25 basis points for
Capital III), plus any accrued but unpaid interest. When debentures are
redeemed in response to tax or capital treatment events, the redemption
price generally is slightly more favorable to Key.
(c) The interest rates for Capital A, Capital B, Capital II, Capital III and
Union Bankshares Capital Trust I are fixed. Capital I has a floating
interest rate equal to three-month LIBOR plus 74 basis points; it reprices
quarterly. The rates shown as the total at June 30, 2003, December 31, 2002
and June 30, 2002, are weighted average rates.
During the first half of 2003, the subsidiary business trusts repurchased $20
million of their outstanding capital securities and KeyCorp repurchased a like
amount of the related debentures. Management intends to replace certain
repurchased capital securities with capital securities that yield a lower cost.
Accordingly, $175 million of new capital securities were issued on July 21,
2003.
24
10. CONTINGENT LIABILITIES AND GUARANTEES
LEGAL PROCEEDINGS
RESIDUAL VALUE INSURANCE LITIGATION. Key Bank USA, National Association ("Key
Bank USA") obtained two insurance policies from Reliance Insurance Company
("Reliance") insuring the residual value of certain automobiles leased through
Key Bank USA. The two policies ("the Policies"), the "4011 Policy" and the "4019
Policy," together covered leases entered into during the period from January 1,
1997 to January 1, 2001.
The 4019 Policy contains an endorsement stating that Swiss Reinsurance America
Corporation ("Swiss Re") will assume and reinsure 100% of Reliance's obligations
under the 4019 Policy in the event Reliance Group Holdings' ("Reliance's
parent") so-called "claims-paying ability" were to fall below investment grade.
Key Bank USA also entered into an agreement with Swiss Re and Reliance whereby
Swiss Re agreed to issue to Key Bank USA an insurance policy on the same terms
and conditions as the 4011 Policy in the event the financial condition of
Reliance Group Holdings fell below a certain level. Around May 2000, the
conditions under both the 4019 Policy and the Swiss Re agreement were triggered.
The 4011 Policy was canceled and replaced as of May 1, 2000, by a policy issued
by North American Specialty Insurance Company (a subsidiary or affiliate of
Swiss Re) ("the NAS Policy"). Tri-Arc Financial Services, Inc. ("Tri-Arc") acted
as agent for Reliance, Swiss Re and NAS. Since February 2000, Key Bank USA has
been filing claims under the Policies, but none of these claims has been paid.
In July 2000, Key Bank USA filed a claim for arbitration against Reliance, Swiss
Re, NAS and Tri-Arc seeking, among other things, a declaration of the scope of
coverage under the Policies and for damages. On January 8, 2001, Reliance filed
an action (litigation) against Key Bank USA in Federal District Court in Ohio
seeking rescission or reformation of the Policies because they allegedly do not
reflect the intent of the parties with respect to the scope of coverage and how
and when claims were to be paid. Key filed an answer and counterclaim against
Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, declaratory
relief as to the scope of coverage under the Policies, damages for breach of
contract and failure to act in good faith, and punitive damages. The parties
agreed to proceed with this court action and to dismiss the arbitration without
prejudice.
On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order placing
Reliance in a court supervised "rehabilitation" and purporting to stay all
litigation against Reliance. On July 23, 2001, the Federal District Court in
Ohio stayed the litigation to allow the rehabilitator to complete her task. On
October 3, 2001, the Court in Pennsylvania entered an order placing Reliance
into liquidation and canceling all Reliance insurance policies as of November 2,
2001. On November 20, 2001, the Federal District Court in Ohio entered an order
that, among other things, required Reliance to report to the Court on the
progress of the liquidation. On January 15, 2002, Reliance filed a status report
requesting the continuance of the stay for an indefinite period. On February 20,
2002, Key Bank USA filed a Motion for Partial Lifting of the July 23, 2001, Stay
in which it asked the Court to allow the case to proceed against the parties
other than Reliance. The Court granted Key Bank USA's motion on May 17, 2002. As
of February 19, 2003, all claims against Tri-Arc were dismissed through a
combination of court action and voluntary dismissal by Key Bank USA.
Management believes that Key Bank USA has valid insurance coverage or claims for
damages relating to the residual value of automobiles leased through Key Bank
USA during the four-year period ending January 1, 2001. With respect to each
individual lease, however, it is not until the lease expires and the vehicle is
sold that Key Bank USA can determine the existence and amount of any actual loss
(i.e., the difference between the residual value provided for in the lease
agreement and the vehicle's actual market value at lease expiration). Key Bank
USA's actual total losses for which it will file claims will depend to a large
measure upon the viability of, and pricing within, the market for used cars
throughout the lease run-off period, which extends through 2006. The market for
used cars varies.
25
Accordingly, the total expected loss on the portfolio for which Key Bank USA
will file claims cannot be determined with certainty at this time. Claims filed
by Key Bank USA through June 30, 2003, total approximately $315 million, and
management currently estimates that approximately $53 million of additional
claims may be filed through year-end 2006 bringing the total aggregate amount of
actual and potential claims to $368 million. As discussed previously, a number
of factors could affect Key Bank USA's actual loss experience, which may be
higher or lower than management's current estimates.
Key is filing insurance claims for the entire amount of its losses and is
recording as a receivable on its balance sheet a portion of the amount of the
insurance claims as and when they are filed. Management believes the amount
being recorded as a receivable due from the insurance carriers is appropriate to
reflect the collectibility risk associated with the insurance litigation;
however, litigation is inherently not without risk, and any actual recovery from
the litigation may be more or less than the receivable. While management does
not expect an adverse decision, if a court were to make an adverse final
determination, such result would cause Key to record a material one-time expense
during the period when such determination is made. An adverse determination
would not have a material effect on Key's financial condition, but could have a
material adverse effect on Key's results of operations in the quarter it occurs.
OTHER LITIGATION. In the ordinary course of business, Key is subject to legal
actions that involve claims for substantial monetary relief. Based on
information presently known to management, management does not believe there is
any legal action to which KeyCorp or any of its subsidiaries is a party, or
involving any of their properties, that, individually or in the aggregate, could
reasonably be expected to have a material adverse effect on Key's financial
condition or annual results of operations.
GUARANTEES
Key is a guarantor in various agreements with third parties. In accordance with
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others," certain
guarantees issued or modified on or after January 1, 2003, require the
recognition of a liability on Key's balance sheet for the "stand ready"
obligation associated with such guarantees. The accounting for guarantees
existing at December 31, 2002, was not revised. Additional information
pertaining to Interpretation No. 45 is summarized in Note 1 ("Basis of
Presentation") under the heading "Accounting Pronouncements Adopted in 2003" on
page 9. The following table shows the types of guarantees (as defined by
Interpretation No. 45) that Key had outstanding at June 30, 2003.
MAXIMUM POTENTIAL
UNDISCOUNTED LIABILITY
in millions FUTURE PAYMENTS RECORDED
- -----------------------------------------------------------------------------------------------------------------
Financial Guarantees:
Standby letters of credit $5,418 $ 9
Credit enhancement for asset-backed commercial paper conduit 60 --
Recourse agreement with FNMA 296 4
Return guaranty agreement with LIHTC investors 815 34
Default guarantees 11 --
Written interest rate caps(a) 42 16
- -----------------------------------------------------------------------------------------------------------------
Total $6,642 $ 63
====== =====
- -----------------------------------------------------------------------------------------------------------------
(a) As of June 30, 2003, the weighted average interest rate of written interest
rate caps was 1.3%. Maximum potential undiscounted future payments were
calculated assuming a 10% interest rate.
STANDBY LETTERS OF CREDIT. These instruments obligate Key to pay a third-party
beneficiary when a customer fails to repay an outstanding loan or debt
instrument, or fails to perform some contractual nonfinancial obligation.
Standby letters of credit are issued by many of Key's lines of business to
address clients' financing needs. If amounts are drawn under standby letters of
credit, such amounts are treated as loans; they bear interest (generally at
variable rates) and pose the same credit risk to Key as a loan. At June 30,
2003, Key's standby letters of credit had a remaining weighted average life of
approximately 2 years, with remaining actual lives ranging from less than 1 year
to as many as 17 years.
26
CREDIT ENHANCEMENT FOR ASSET-BACKED COMMERCIAL PAPER CONDUIT. Key provides
credit enhancement in the form of a committed facility to ensure the continuing
operations of an asset-backed commercial paper conduit, which is owned by a
third party and administered by an unaffiliated financial institution. The
commitment to provide credit enhancement extends until September 26, 2003, and
specifies that in the event of default by certain borrowers whose loans are held
by the conduit, Key will provide financial relief to the conduit in an amount
that is based on defined criteria that consider the level of credit risk
involved and other factors.
At June 30, 2003, Key's funding requirement under the credit enhancement
facility totaled $60 million. However, there were no drawdowns under the
facility during the six-month period ended June 30, 2003. Key has no recourse or
other collateral available to offset any amounts that may be funded under this
credit enhancement facility. Key's commitments to provide credit enhancement to
the conduit are periodically evaluated by management. No changes to Key's
funding requirement under the credit enhancement facility are expected to occur
as a result of the restructuring of the conduit discussed in Note 7 ("Variable
Interest Entities") under the heading "Commercial paper conduits" on page 20.
RECOURSE AGREEMENT WITH FEDERAL NATIONAL MORTGAGE ASSOCIATION. KBNA participates
as a lender in the Federal National Mortgage Association ("FNMA") Delegated
Underwriting and Servicing ("DUS") program. As a condition to FNMA's delegation
of responsibility for originating, underwriting and servicing mortgages, KBNA
has agreed to assume a limited portion of the risk of loss during the remaining
term on each commercial mortgage loan sold to FNMA. Accordingly, a reserve for
such potential losses has been established and is maintained in an amount
estimated by management to approximate the fair value of the liability
undertaken by KBNA. At June 30, 2003, the outstanding commercial mortgage loans
in this program had a weighted average remaining term of 10 years and the unpaid
principal balance outstanding of loans sold by KBNA as a participant in this
program was approximately $1.5 billion. The maximum potential amount of
undiscounted future payments that may be required under this program is equal to
20% of the principal balance of loans outstanding at June 30, 2003. If payment
is required under this program, Key would have an interest in the collateral
underlying the commercial mortgage loan on which the loss occurred.
RETURN GUARANTEE AGREEMENT WITH LOW-INCOME HOUSING TAX CREDIT ("LIHTC")
INVESTORS. Key Affordable Housing Corporation ("KAHC"), a subsidiary of KBNA,
offers limited partnership interests to qualified investors. Unconsolidated
partnerships formed by KAHC invest in low-income residential rental properties
that qualify for federal LIHTCs under Section 42 of the Internal Revenue Code.
In certain partnerships, investors pay a fee to KAHC for a guaranteed return
that is dependent on the financial performance of the property and the
property's ability to maintain its LIHTC status throughout the fifteen-year
compliance period. If these two conditions are not achieved, Key is obligated to
make any necessary payments to investors to provide the guaranteed return. KAHC
has the ability to affect changes in the management of the properties to improve
performance. However, other than the underlying income stream from the
properties, no recourse or collateral would be available to offset the guarantee
obligation. These guarantees have expiration dates that extend through 2018. Key
meets its obligations pertaining to the guaranteed returns generally through the
distribution of tax credits and deductions associated with the specific
properties.
As shown in the preceding table, KAHC had established a reserve in the amount of
$34 million at June 30, 2003, which management believes will be sufficient to
cover estimated future obligations under the guarantees. In accordance with
Interpretation No. 45, for any return guarantee agreements entered into or
modified with LIHTC investors on or after January 1, 2003, the amount of all
fees received in consideration for the guarantee has been recognized as the fair
value stand ready obligation.
VARIOUS TYPES OF DEFAULT GUARANTEES. Some lines of business provide or
participate in guarantees that obligate Key to perform if the debtor fails to
pay all or a portion of the subject indebtedness and/or related interest. These
guarantees are generally undertaken when Key is supporting or protecting its
underlying investment or where the risk profile of the debtor should provide an
investment return. The terms of these default guarantees range from less than 1
year to as many as 19 years. Although no collateral is held, Key would have
recourse against the debtors for any payments made under these default
guarantees.
27
WRITTEN INTEREST RATE CAPS. In the ordinary course of business, Key writes
interest rate caps for commercial loan clients that have variable rate loans
with Key. These caps are purchased by clients to limit their exposure to
interest rate increases and at June 30, 2003, had a weighted average life of
approximately 7.6 years.
Key is obligated to pay the interest rate counterparty if the applicable
benchmark interest rate exceeds a specified level (known as the "strike rate").
These instruments are accounted for as derivatives with the fair value liability
recorded in "other liabilities" on the balance sheet. Key's potential amount of
future payments under these obligations is mitigated by the fact that the
company enters into offsetting positions with third parties.
OTHER OFF-BALANCE SHEET RISK
Other off-balance sheet risk stems from financial instruments that do not meet
the definition of a guarantee as specified in Interpretation No. 45 and from
other relationships.
LIQUIDITY FACILITIES THAT SUPPORT ASSET-BACKED COMMERCIAL PAPER CONDUITS. Key
provides liquidity to all or a portion of two separate asset-backed commercial
paper conduits that are owned by third parties and administered by unaffiliated
financial institutions. These liquidity facilities obligate Key through February
15, 2005, to provide funding if such is required as a result of a disruption in
credit markets or other factors.
Key provides liquidity to the conduits in the form of committed facilities of
$1.2 billion. The amount available to be drawn on these facilities was $547
million at June 30, 2003. However, there were no drawdowns under either of the
committed facilities at that time. Of the $1.2 billion of liquidity facility
commitments, $92 million is associated with a conduit program that is in the
process of being liquidated. Therefore, Key's commitment will decrease as the
assets in this conduit program decrease. The remainder of the liquidity facility
commitments relate to the asset-backed commercial paper conduit discussed in
Note 1 on page 7.
Key's commitments to provide liquidity are periodically evaluated by management.
No changes to the committed liquidity facilities are expected to occur as a
result of the restructuring of the conduit, discussed in Note 7.
INDEMNIFICATIONS PROVIDED IN THE ORDINARY COURSE OF BUSINESS. Key provides
certain indemnifications primarily through representations and warranties in
contracts that are entered into in the ordinary course of business in connection
with purchases and sales of businesses, loan sales and other ongoing activities.
Management's past experience with these indemnifications has been that the
amounts paid, if any, have not had a significant effect on Key's financial
condition or results of operations.
INTERCOMPANY GUARANTEES. KeyCorp and primarily KBNA are parties to various
guarantees that are undertaken to facilitate the ongoing business activities of
other Key affiliates. These business activities encompass debt issuance, certain
lease and insurance obligations, investments and securities, and certain leasing
transactions involving clients.
RELATIONSHIP WITH MASTERCARD INTERNATIONAL INC. AND VISA U.S.A. INC. KBNA and
Key Bank USA are members of MasterCard International Inc. ("MasterCard") and
Visa U.S.A. Inc. ("Visa"). MasterCard's charter documents and bylaws state that
MasterCard may assess its members for certain liabilities that it incurs,
including litigation liabilities. Visa's charter documents state that Visa may
fix fees payable by members in connection with Visa's operations. We understand
that descriptions of significant pending lawsuits and MasterCard's and Visa's
positions regarding the potential impact of those lawsuits on members are set
forth on MasterCard's and Visa's respective websites, as well as in MasterCard's
public filings with the Securities and Exchange Commission. Key is not a party
to any significant litigation by third parties against MasterCard or Visa.
In June 2003, MasterCard and Visa agreed, independently, to settle a
class-action lawsuit that was brought against them by Wal-Mart Stores Inc. and
many other retailers. The lawsuit alleged that MasterCard and Visa violated
federal antitrust laws by conspiring to monopolize the debit card services
market and by requiring merchants that accept certain of their debit and credit
card services to also accept their higher
28
priced "off-line," signature-verified debit card services. According to
published reports, under the terms of the settlements, which are subject to
court approval, beginning August 1, 2003, MasterCard and Visa have agreed to pay
a total of approximately $3 billion, over a 10-year period, to merchants who
claim to have been harmed by their actions and to lower the fees they charge
merchants for their "off-line" signature-verified debit card services. Also, as
of January 1, 2004, such merchants will no longer be required to accept
MasterCard or Visa debit card services when they accept MasterCard or Visa
credit card services. Accordingly, management believes that the settlements will
result in the reduction of fees earned by KBNA and Key Bank USA from off-line
debit card transactions. Management estimates that the impact of the settlement
on Key will be a reduction to pre-tax net income of less than $10 million for
the balance of 2003 and less than $25 million in 2004. This estimate is subject
to change once management completes its evaluation of alternative actions that
may be available to it in response to the settlements, and has had an
opportunity to observe any changes in the marketplace for card services that
occur in response to the settlements. It is management's understanding that
certain retailers have opted-out of the class-action settlement and that
additional suits have been filed against MasterCard and Visa seeking additional
damage recovery. Management is unable at this time to estimate the possible
impact of any such actions.
11. DERIVATIVES AND HEDGING ACTIVITIES
Key, mainly through its lead bank, KBNA, is party to various derivative
instruments. These instruments are used for asset and liability management and
trading purposes. Generally, these instruments help Key meet clients' financing
needs and manage exposure to "market risk"--the possibility that economic value
or net interest income will be adversely affected by changes in interest rates
or other economic factors. However, like other financial instruments, these
derivatives contain an element of "credit risk"--the possibility that Key will
incur a loss because a counterparty fails to meet its contractual obligations.
The primary derivatives that Key uses are interest rate swaps, caps and futures,
and foreign exchange forward contracts. All foreign exchange forward contracts
and interest rate swaps and caps held are over-the-counter instruments.
At June 30, 2003, Key had $954 million of derivative assets and $146 million of
derivative liabilities on its balance sheet that arose from derivatives that
were being used for hedging purposes. As of the same date, derivative assets and
liabilities classified as trading derivatives totaled $1.7 billion and $1.6
billion, respectively. Derivative assets and liabilities are recorded at fair
value in "accrued income and other assets" and "accrued expense and other
liabilities," respectively, on the balance sheet.
Key uses a fair value hedging strategy to modify its exposure to interest rate
risk and a cash flow hedging strategy to reduce the potential adverse impact of
interest rate increases on future interest expense. For more information about
these asset and liability management strategies used to modify Key's exposure to
interest rate risk, see Note 20 ("Derivatives and Hedging Activities"), which
begins on page 84 of Key's 2002 Annual Report to Shareholders.
The change in "accumulated other comprehensive income (loss)" resulting from
cash flow hedges is as follows:
RECLASSIFICATION
DECEMBER 31, 2003 OF GAINS TO JUNE 30,
in millions 2002 HEDGING ACTIVITY NET INCOME 2003
- --------------------------------------------------------------------------------------------------------------------------
Accumulated other comprehensive income
(loss) resulting from cash flow hedges $ 6 $ 39 $ (2) $ 43
- ------------------------------------------------------------------------------------------------------------------------
Key expects to reclassify an estimated $52 million of net gains on derivative
instruments from "accumulated other comprehensive income (loss)" to earnings
during the next twelve months. Reclassifications will coincide with the income
statement impact of the hedged item through the payment of variable-rate
interest on debt, the receipt of variable-rate interest on commercial loans and
the sale or securitization of commercial real estate loans.
29
TRADING PORTFOLIO
Key's trading portfolio includes:
- - interest rate swap contracts entered into to accommodate the needs of
clients;
- - positions with third parties that are intended to offset or mitigate
the interest rate risk of client positions;
- - foreign exchange forward contracts entered into to accommodate the
needs of clients; and
- - proprietary trading positions in financial assets and liabilities.
The fair values of these trading portfolio items are included in "accrued income
and other assets" or "accrued expense and other liabilities" on the balance
sheet. Adjustments to the fair values are included in "investment banking and
capital markets income" on the income statement. Additional information
pertaining to Key's trading portfolio is summarized in Note 20 ("Derivatives and
Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to
Shareholders.
The following table shows trading income recognized on interest rate swaps and
foreign exchange forward contracts.
SIX MONTHS ENDED JUNE 30,
-------------------------
in millions 2003 2002
- --------------------------------------------------------------------
Interest rate swap contracts $ 4 $ 5
Foreign exchange forward contracts 15 18
- -------------------------------------------------------------------
COUNTERPARTY CREDIT RISK
Swaps and caps present credit risk because the counterparty may not meet the
terms of the contract. This risk is measured as the expected positive
replacement value of contracts. To mitigate credit risk, Key deals exclusively
with counterparties that have high credit ratings.
Key uses two additional precautions to manage exposure to credit risk on swap
contracts. First, Key generally enters into bilateral collateral and master
netting arrangements. These agreements include legal rights of setoff that
provide for the net settlement of the related contracts with the same
counterparty in the event of default. Second, Credit Administration monitors
credit risk exposure to the counterparty on each interest rate swap to determine
appropriate limits on Key's total credit exposure and whether it is advisable to
demand collateral.
At June 30, 2003, Key was party to interest rate swaps and caps with 55
different counterparties. Among these were swaps and caps entered into to offset
the risk of client exposure. Key had aggregate credit exposure of $147 million
(net of collateral of $574 million) on these instruments to 32 of the
counterparties. The largest credit exposure to an individual counterparty
amounted to approximately $27 million.
30
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
SHAREHOLDERS AND BOARD OF DIRECTORS
KEYCORP
We have reviewed the unaudited condensed consolidated balance sheets of KeyCorp
and subsidiaries ("Key") as of June 30, 2003 and 2002, and the related condensed
consolidated statements of income for the three- and six-month periods then
ended, and the condensed consolidated statements of changes in shareholders'
equity and cash flow for the six-month periods ended June 30, 2003 and 2002.
These financial statements are the responsibility of Key's management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data, and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with auditing standards generally accepted in the United States,
which will be performed for the full year with the objective of expressing an
opinion regarding the financial statements taken as a whole. Accordingly, we do
not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to the condensed consolidated financial statements referred to above for
them to be in conformity with accounting principles generally accepted in the
United States.
We have previously audited, in accordance with auditing standards generally
accepted in the United States, the consolidated balance sheet of Key as of
December 31, 2002, and the related consolidated statements of income, changes in
shareholders' equity, and cash flow for the year then ended (not presented
herein) and in our report dated January 13, 2003, we expressed an unqualified
opinion on those consolidated financial statements. In our opinion, the
information set forth in the accompanying condensed consolidated balance sheet
as of December 31, 2002, is fairly stated, in all material respects, in relation
to the consolidated balance sheet from which it has been derived.
/s/ Ernst & Young LLP
Cleveland, Ohio
July 18, 2003
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
This section generally reviews the financial condition and results of operations
of KeyCorp and its subsidiaries for the quarterly and year-to-date periods ended
June 30, 2003 and 2002. Some tables may cover more periods to comply with
disclosure requirements or to illustrate trends in greater depth. When you read
this discussion, you should also refer to the consolidated financial statements
and related notes that appear on pages 3 through 30.
SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES
Key's business is dynamic and complex. Consequently, management must exercise
judgment in choosing and applying accounting policies and methodologies in many
areas. These choices are important; not only are they necessary to comply with
accounting principles generally accepted in the United States, they also reflect
management's view of the most appropriate manner in which to record and report
Key's overall financial performance. All accounting policies are important, and
all policies described in Note 1 ("Summary of Significant Accounting Policies"),
which begins on page 57 of Key's 2002 Annual Report to Shareholders, should be
reviewed for a greater understanding of how Key's financial performance is
recorded and reported.
In management's opinion, some accounting policies are more likely than others to
have a significant effect on Key's financial results and to expose those results
to potentially greater volatility. These policies apply to areas of relatively
greater business importance or require management to make assumptions and
estimates that affect amounts reported in the financial statements. Because
these assumptions and estimates are based on current circumstances, they may
change over time or prove to be inaccurate based on actual experience. For Key,
areas that rely heavily on the use of assumptions and estimates include
accounting for the allowance for loan losses, loan securitizations, contingent
liabilities and guarantees, principal investments, goodwill, and pension and
other postretirement obligations. A brief discussion of each of these areas
appears below.
ALLOWANCE FOR LOAN LOSSES. Management determines probable losses inherent in
Key's loan portfolio (which represents by far the largest category of assets on
Key's balance sheet) and establishes an allowance that is sufficient to absorb
those losses by considering factors including historical loss rates, expected
cash flows and estimated collateral values. In assessing these factors,
management benefits from a lengthy organizational history and experience with
credit decisions and related outcomes. Nonetheless, if management's underlying
assumptions prove to be inaccurate, the allowance for loan losses would have to
be adjusted. Our accounting policy related to the allowance is disclosed in Note
1 under the heading "Allowance for Loan Losses" on page 58 of the Annual Report.
LOAN SECURITIZATIONS. Key securitizes certain types of loans and accounts for
such transactions as sales when the criteria set forth in SFAS No. 140,
"Accounting for Transfers and Servicing of Financial Assets and Extinguishment
of Liabilities," are met. If future events were to preclude accounting for such
transactions as sales, the loans would have to be placed back on Key's balance
sheet. This could have a potentially adverse effect on Key's capital ratios and
other unfavorable financial implications. In addition, determining the gain or
loss resulting from securitization transactions and the subsequent carrying
amount of retained interests is dependent on underlying assumptions made by
management, the most significant of which are described in Note 8 ("Loan
Securitizations and Variable Interest Entities"), which begins on page 70 of the
Annual Report. The use of alternative ranges of possible outcomes for these
assumptions would change the amount of the initial gain or loss recognized. It
could also result in changes in the carrying amount of retained interests, with
related effects on results of operations. Our accounting policy related to loan
securitizations is disclosed in Note 1 under the heading "Loan Securitizations"
on page 59 of the Annual Report.
32
CONTINGENT LIABILITIES AND GUARANTEES. Contingent liabilities arising from
litigation, guarantees in various agreements with third parties in which Key is
a guarantor and the potential effects of these items on Key's results of
operations, are summarized in Note 10 ("Contingent Liabilities and Guarantees"),
which begins on page 25.
Since Key records a liability for only the fair value of the obligation to stand
ready to perform over the term of a guarantee, the risk exists that potential
future payments that would be made by Key in the event of a default by a third
party could exceed the liability recorded on Key's balance sheet. See Note 10
for a comparison of the liability recorded and the maximum potential
undiscounted future payments for the various types of guarantees that Key had
outstanding at June 30, 2003.
In the normal course of business, Key is routinely subject to examinations and
challenges from tax authorities regarding the amount of taxes due in connection
with investments and business activities. Currently, the Internal Revenue
Service is challenging Key's tax treatment of certain leveraged lease
investments. This and other challenges by tax authorities may result in
adjustments to the timing or amount of Key's taxable income or deductions or the
allocation of income among tax jurisdictions. Management believes these
challenges will be resolved without having any material effect on Key's
financial condition or results of operations.
VALUATION METHODOLOGIES. Valuation methodologies employed by management often
involve a significant degree of judgment, particularly when there are no
observable liquid markets for the items being valued. The outcome of valuations
performed by management have a direct bearing on the carrying amounts of certain
assets and liabilities, such as principal investments, goodwill, and pension and
other postretirement benefit obligations. To determine the values of these
assets and liabilities, as well as the extent to which related assets may be
impaired, management makes assumptions and estimates related to discount rates,
asset returns, repayment rates and other factors. The use of different discount
rates or other valuation assumptions could produce significantly different
results, which could have material positive or negative effects on Key's results
of operations.
The valuation methodology management uses for principal investments is
summarized in Note 21 ("Fair Value Disclosures of Financial Instruments") on
page 86 of the Annual Report and the methodology used in the testing for
goodwill impairment is summarized in Note 1 under the heading "Goodwill and
Other Intangible Assets" on page 59 of the Annual Report. The primary
assumptions used in determining Key's pension and other postretirement benefit
obligations and related expenses are presented in Note 16 ("Employee Benefits"),
which begins on page 78 of the Annual Report.
When a potential asset impairment is identified through testing, observable
changes in liquid markets or other means, management must also exercise judgment
in determining the nature of the potential impairment (i.e., whether the
impairment is temporary or other than temporary) in order to apply the
appropriate accounting treatment. For example, unrealized losses on securities
available for sale that are deemed temporary are recorded in shareholders'
equity, whereas those deemed "other than temporary" are recorded in earnings.
REVENUE RECOGNITION
Corporate improprieties related to revenue recognition have received a great
deal of attention by regulatory authorities and the news media. Although all
companies face the risk of intentional or unintentional misstatements, such
misstatements are less likely in the financial services industry because most of
the revenue (i.e., interest accruals) recorded is driven by nondiscretionary
formulas based on written contracts, such as loan agreements.
TERMINOLOGY
This report contains some shortened names and industry-specific terms. We want
to explain some of these terms at the outset so you can better understand the
discussion that follows.
- - KEYCORP refers solely to the parent holding company.
33
- - KBNA refers to Key's lead bank, KeyBank National Association.
- - KEY refers to the consolidated entity consisting of KeyCorp and its
subsidiaries.
- - A KEYCENTER is one of Key's full-service retail banking facilities or
branches.
- - Key engages in CAPITAL MARKETS ACTIVITIES. These activities encompass a
variety of products and services. Among other things, we trade
securities as a dealer, enter into derivative contracts (both to
accommodate clients' financing needs and for proprietary trading
purposes), and conduct transactions in foreign currencies (both to
accommodate clients' needs and to benefit from fluctuations in exchange
rates).
- - All earnings per share data included in this discussion are presented
on a DILUTED basis, which takes into account all common shares
outstanding as well as potential common shares that could result from
the exercise of outstanding stock options. Some of the financial
information tables also include BASIC earnings per share, which takes
into account only common shares outstanding.
- - For regulatory purposes, capital is divided into two classes. Federal
regulations prescribe that at least one-half of a bank or bank holding
company's TOTAL RISK-BASED CAPITAL must qualify as TIER 1. Both total
and Tier 1 capital serve as bases for several measures of capital
adequacy, which is an important indicator of financial stability and
condition. You will find a more detailed explanation of total and Tier
1 capital and how they are calculated in the section entitled
"Capital," which begins on page 63.
- - When we want to draw your attention to a particular item in Key's Notes
to Consolidated Financial Statements, we refer to NOTE ___, giving the
particular number, name and starting page number.
FORWARD-LOOKING STATEMENTS
This report may contain "forward-looking statements" about issues like
anticipated earnings, anticipated levels of net loan charge-offs and
nonperforming assets, anticipated improvement in profitability and
competitiveness and long-term goals. These statements usually can be identified
by the use of forward-looking language such as "our goal," "our objective," "our
plan," "will likely result," "will be," "are expected to," "as planned," "is
anticipated," "intends to," "is projected," or similar words. Forward-looking
statements by their nature are subject to assumptions, risks and uncertainties.
For a variety of reasons, including the following, actual results could differ
materially from those contained in or implied by the forward-looking statements.
- - Interest rates could change more quickly or more significantly than we
expect, which may have an adverse effect on our financial results.
- - If the economy or segments of the economy fail to recover, or decline
further, the demand for new loans and the ability of borrowers to repay
outstanding loans may decline.
- - The stock and bond markets could suffer additional declines or
disruptions, which may have adverse effects on our financial condition
and that of our borrowers, and on our ability to raise money by issuing
new securities.
- - It could take us longer than we anticipate to implement strategic
initiatives designed to increase revenues or manage expenses; we may be
unable to implement certain initiatives; or the initiatives may be
unsuccessful.
- - Acquisitions and dispositions of assets, business units or affiliates
could adversely affect us in ways that management has not anticipated.
- - We may become subject to new legal obligations, or the resolution of
pending litigation may have an adverse effect on our financial results.
34
- - Terrorist activities or military actions could further disrupt the
economy and the general business climate, which may have an adverse
effect on our financial results or condition and that of our borrowers.
- - We may become subject to new accounting, tax, or regulatory practices
or requirements.
HIGHLIGHTS OF KEY'S PERFORMANCE
FINANCIAL PERFORMANCE
The primary measures of Key's financial performance for the second quarter and
first six months of 2003 and 2002 are summarized below.
- - Net income for the second quarter of 2003 was $225 million, or $.53 per
common share, compared with net income of $217 million, or $.51 per
share, for the previous quarter and net income of $246 million, or $.57
per share, for the second quarter of 2002. For the first six months of
2003, Key's net income was $442 million, or $1.03 per common share,
compared with net income of $486 million, or $1.13 per share for the
comparable period last year.
- - Key's return on average equity was 12.98% for the second quarter of
2003. This result compares with a return of 12.91% for the prior
quarter and a return of 15.16% for the year-ago quarter. For the first
six months of 2003, Key's return on average equity was 12.94%, compared
with a return of 15.34% for the first six months of 2002.
- - Key's second quarter 2003 return on average total assets was 1.07%.
This result compares with a return of 1.05% for the previous quarter
and a return of 1.21% for the second quarter of 2002. For the first six
months of 2003, Key's return on average total assets was 1.06%,
compared with a return of 1.21% for the comparable period in 2002.
Key's improved performance relative to the first quarter of 2003 reflected
several positive trends:
- - Revenue grew by $52 million, driven by increases in both net interest
income and noninterest income.
- - Average core deposits grew by an annualized 9% and were up 12% from the
same period last year.
- - Asset quality continued to improve as the level of Key's nonperforming
loans declined for the third consecutive quarter and net loan
charge-offs fell to their lowest level since the first quarter of 2001.
During the same period, the soft economy continued to adversely affect our
earnings, especially in our commercial and market-sensitive businesses. The weak
demand for commercial loans has placed pressure on the net interest margin and
this pressure is expected to continue as a result of the Federal Reserve Board's
June 2003 reduction in interest rates. Although Key's second quarter results
benefited from higher principal investing gains, the level of income generated
by most of our other market-sensitive businesses was essentially unchanged from
the first quarter of 2003 and down from the second quarter of last year.
Over the remainder of the year, we expect improvement in our business
fundamentals and modest earnings growth. We will continue to focus on expense
management and to take advantage of opportunities, such as our recent
acquisition of Newbridge Partners, a growth equity investment management firm
based in New York City, to ensure that we are well positioned for the
anticipated economic rebound. Newbridge will add almost $2 billion to our
managed assets, expand our product base and allow us to further leverage our
distribution capabilities. For the full year, we are comfortable with the
analysts' consensus estimate for earnings per share of $2.13.
The primary reasons that Key's revenue and expense components changed from those
of the three-and six-month periods ended June 30, 2002, are reviewed in greater
detail throughout the remainder of this discussion.
35
Figure 1 on page 37 summarizes Key's financial performance for each of the past
five quarters and the first six months of 2003 and 2002.
LONG-TERM GOALS
Our long-term goals are to achieve an annual return on average equity in the
range of 16% to 18% and to grow earnings per common share at an annual rate of
7% to 8%.
CORPORATE STRATEGY
Our strategy for achieving our long-term goals comprises the following five
primary elements:
- - FOCUS ON OUR CORE BUSINESSES. We intend to focus on businesses that
enable us to build relationships with our clients. We will focus on our
"footprint" businesses (i.e., those businesses conducted primarily
within the twelve states in which we have retail bank branches) that
serve individuals, small businesses and middle market companies. In
addition, we intend to focus nationwide on our commercial real estate
lending, asset management, home equity lending and equipment leasing
businesses. These are businesses in which we believe we possess
resources of the scale necessary to compete nationally.
- - PUT OUR CLIENTS FIRST. We will work to deepen our relationships with
our existing clients, and to build relationships with new clients,
including those who have the potential to purchase multiple products
and services or to generate repeat business. One way in which we are
pursuing this goal is by emphasizing deposit growth across all of our
lines of business.
We also want to ensure that our clients are receiving a distinctive
level of service, so we are putting considerable effort into enhancing
our service quality.
- - ENHANCE OUR BUSINESS. We will strive for continuous improvement. We
will continue to focus on increasing revenues, controlling expenses and
better serving our clients. In addition, we will continue to leverage
technology to reduce costs and to enhance service quality. Over time,
we also intend to diversify our revenue mix by emphasizing the growth
of fee income while investing in higher-growth and higher-return
businesses.
- - CULTIVATE A WORKFORCE THAT DEMONSTRATES KEY'S VALUES AND WORKS TOGETHER
FOR A COMMON PURPOSE. Key intends to achieve this by:
--paying for performance, but only if achieved in ways that are
consistent with Key's values;
--attracting, developing and retaining a quality, high-performing and
inclusive workforce;
--developing leadership at all levels in the company; and
--creating a positive, stimulating and entrepreneurial work
environment.
- - ENHANCE PERFORMANCE MEASUREMENT. We will continue to refine and to rely
upon performance measurement mechanisms that help us ensure that we are
maximizing returns for our shareholders, that those returns are
appropriate considering the inherent levels of risk involved and that
our incentive compensation plans are commensurate with the
contributions made to our profitability.
36
FIGURE 1. SELECTED FINANCIAL DATA
2003 2002 SIX MONTHS ENDED JUNE 30,
------------------- ------------------------------ -------------------------
dollars in millions, except per share amounts SECOND FIRST FOURTH THIRD SECOND 2003 2002
- --------------------------------------------------------------------------------------------------------------------------------
FOR THE PERIOD
Interest income $ 1,022 $ 1,021 $ 1,077 $ 1,095 $ 1,102 $ 2,043 $ 2,194
Interest expense 326 340 365 395 419 666 857
Net interest income 696 681 712 700 683 1,377 1,337
Provision for loan losses 125 130 147 135 135 255 271
Noninterest income 434 397 446 432 448 831 891
Noninterest expense 688 657 668 659 665 1,345 1,326
Income before income taxes 317 291 343 338 331 608 631
Net income 225 217 245 245 246 442 486
- --------------------------------------------------------------------------------------------------------------------------------
PER COMMON SHARE
Net income $ .53 $ .51 $ .58 $ .57 $ .58 $ 1.04 $ 1.14
Net income - assuming dilution .53 .51 .57 .57 .57 1.03 1.13
Cash dividends paid .305 .305 .30 .30 .30 .61 .60
Book value at period end 16.60 16.32 16.12 15.66 15.46 12.94 15.46
Market price:
High 27.42 27.11 26.75 27.35 29.40 27.42 29.40
Low 22.56 22.31 21.25 20.96 25.95 22.31 22.92
Close 25.27 22.56 25.14 24.97 27.30 25.27 27.30
Weighted average common shares (000) 423,882 425,275 424,578 426,274 426,092 424,575 425,477
Weighted average common shares and
potential common shares (000) 427,170 428,090 429,531 431,326 431,935 427,628 430,983
- --------------------------------------------------------------------------------------------------------------------------------
AT PERIOD END
Loans $ 63,214 $ 62,719 $ 62,457 $ 62,951 $ 63,881 $ 63,214 $ 63,881
Earning assets 73,716 75,113 73,635 72,548 72,820 73,716 72,820
Total assets 85,479 86,490 85,202 83,518 82,778 85,479 82,778
Deposits 49,869 50,455 49,346 44,610 44,805 49,869 44,805
Long-term debt 14,434 16,269 15,605 16,276 16,895 14,434 16,895
Shareholders' equity 6,989 6,898 6,835 6,654 6,592 6,989 6,592
- --------------------------------------------------------------------------------------------------------------------------------
PERFORMANCE RATIOS
Return on average total assets 1.07% 1.05% 1.17% 1.19% 1.21% 1.06% 1.21%
Return on average equity 12.98 12.91 14.46 14.74 15.16 12.94 15.34
Net interest margin (taxable equivalent) 3.85 3.86 3.98 3.99 3.98 3.86 3.96
- --------------------------------------------------------------------------------------------------------------------------------
CAPITAL RATIOS AT PERIOD END
Equity to assets 8.18% 7.98% 8.02% 7.97% 7.96% 8.18% 7.96%
Tangible equity to tangible assets 6.90 6.71 6.73 6.71 6.69 6.90 6.69
Tier 1 risk-based capital 8.02 8.22 8.09 8.34 8.23 8.02 8.23
Total risk-based capital 12.26 12.62 12.51 12.69 12.29 12.26 12.29
Leverage 8.12 8.12 8.15 8.15 8.14 8.12 8.14
- --------------------------------------------------------------------------------------------------------------------------------
OTHER DATA
Average full-time equivalent employees 19,999 20,447 20,485 20,802 20,903 20,222 20,991
KeyCenters 903 911 910 903 905 903 905
- --------------------------------------------------------------------------------------------------------------------------------
37
LINE OF BUSINESS RESULTS
This section summarizes the financial performance and related strategic
developments of each of Key's three major business groups: Consumer Banking,
Corporate and Investment Banking and Investment Management Services. To better
understand this discussion, see Note 4 ("Line of Business Results"), which
begins on page 12. Note 4 includes a brief description of the products and
services offered by each of the three major business groups, more detailed
financial information pertaining to the groups and their respective lines of
business and brief descriptions of "Other Segments" and "Reconciling Items"
presented in Figure 2.
Figure 2 summarizes the contribution made by each major business group to Key's
taxable-equivalent revenue and net income for the three- and six-month periods
ended June 30, 2003 and 2002.
FIGURE 2. MAJOR BUSINESS GROUPS - TAXABLE-EQUIVALENT REVENUE AND NET INCOME
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE
--------------------------- ------------------ ------------------------- -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
REVENUE (TAXABLE EQUIVALENT)
Consumer Banking $ 581 $ 573 $ 8 1.4 % $ 1,139 $ 1,126 $ 13 1.2%
Corporate and Investment Banking 385 381 4 1.0 754 775 (21) (2.7)
Investment Management Services 187 221 (34) (15.4) 379 434 (55) (12.7)
Other Segments 23 -- 23 N/M 22 (1) 23 N/M
- ----------------------------------------------------------------------------------------------------------------------------------
Total segments 1,176 1,175 1 .1 2,294 2,334 (40) (1.7)
Reconciling items (32) (6) (26) (433.3) (50) (20) (30) (150.0)
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 1,144 $ 1,169 $ (25) (2.1)% $ 2,244 $ 2,314 $ (70) (3.0)%
======= ======= ======= ======= ======= ======
NET INCOME (LOSS)
Consumer Banking $ 100 $ 108 $ (8) (7.4)% $ 193 $ 192 $ 1 .5%
Corporate and Investment Banking 92 95 (3) (3.2) 185 204 (19) (9.3)
Investment Management Services 15 31 (16) (51.6) 36 56 (20) (35.7)
Other Segments 19 5 14 280.0 25 11 14 127.3
- ----------------------------------------------------------------------------------------------------------------------------------
Total segments 226 239 (13) (5.4) 439 463 (24) (5.2)
Reconciling items (1) 7 (8) N/M 3 23 (20) (87.0)
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 225 $ 246 $ (21) (8.5)% $ 442 $ 486 $ (44) (9.1)%
======= ======= ======= ======= ======= ======
- ----------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
CONSUMER BANKING
As shown in Figure 3, net income for Consumer Banking was $100 million for the
second quarter of 2003, representing an $8 million decrease from the year-ago
quarter. The decline was attributable to a reduction in noninterest income and a
higher level of noninterest expense. These negative changes were partially
offset by an increase in taxable-equivalent net interest income and a lower
provision for loan losses.
Taxable-equivalent net interest income grew by $11 million, or 2%, from the
second quarter of 2002, due largely to an improved interest rate spread on
earning assets, a 3% increase in average loans outstanding, primarily in the
home equity and commercial portfolios, and a higher level of core deposits.
These positive results were offset in part by a decline in yield-related loan
fees, reflecting our efforts to exit the automobile leasing business.
Noninterest income decreased by $3 million, or 2%, due primarily to a $10
million reduction in service charges on deposit accounts generated by the Retail
Banking line of business. The decrease in deposit service charges reflects lower
overdraft fees, as well as the introduction of free checking products during the
second half of 2002. The overall reduction in noninterest income was moderated,
however, by increases in mortgage loan processing fees and net gains from loan
sales, both in the National Home Equity unit.
38
Noninterest expense rose by $25 million, or 8%, from the second quarter of 2002.
Increases in personnel expense, professional fees and various indirect charges
accounted for the increase.
The provision for loan losses decreased by $5 million, or 7%, reflecting a lower
level of net charge-offs in the Indirect Lending unit. This improvement was
largely the result of Key's decision in 2001 to exit the automobile leasing
business and to scale back indirect prime automobile lending to footprint
markets.
FIGURE 3. CONSUMER BANKING
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE
--------------------------- ------------------ ------------------------- -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 459 $ 448 $ 11 2.5% $ 904 $ 884 $ 20 2.3%
Noninterest income 122 125 (3) (2.4) 235 242 (7) (2.9)
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue (TE) 581 573 8 1.4 1,139 1,126 13 1.2
Provision for loan losses 65 70 (5) (7.1) 143 152 (9) (5.9)
Noninterest expense 356 331 25 7.6 687 667 20 3.0
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes (TE) 160 172 (12) (7.0) 309 307 2 .7
Allocated income taxes and TE
adjustments 60 64 (4) (6.3) 116 115 1 .9
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $ 100 $ 108 $ (8) (7.4)% $ 193 $ 192 $ 1 .5%
======= ======= ======= ======= ======= =======
Percent of consolidated net
income 44% 44% N/A N/A 44% 39% N/A N/A
AVERAGE BALANCES
Loans $28,827 $27,926 $ 901 3.2% $28,628 $27,624 $ 1,004 3.6%
Total assets 31,251 30,268 983 3.2 31,054 29,973 1,081 3.6
Deposits 34,781 33,976 805 2.4 34,572 34,142 430 1.3
- -----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE
ADDITIONAL CONSUMER BANKING DATA --------------------------- ------------------ ------------------------- -----------------
dollars in billions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
AVERAGE DEPOSITS OUTSTANDING
Noninterest-bearing $ 5,421 $ 5,057 $ 364 7.2% $ 5,360 $ 5,005 $ 355 7.1%
Money market deposit accounts and
other savings 15,178 12,869 2,309 17.9 14,863 12,889 1,974 15.3
Time 14,182 16,050 (1,868) (11.6) 14,349 16,248 (1,899) (11.7)
- -----------------------------------------------------------------------------------------------------------------------------------
Total deposits $34,781 $33,976 $ 805 2.4% $34,572 $34,142 $ 430 1.3%
======= ======= ======= ======= ======= =======
- -----------------------------------------------------------------------------------------------------------------------------------
HOME EQUITY LOANS
RETAIL BANKING AND SMALL BUSINESS
Average balance $ 8.0 $ 6.9
Average loan-to-value ratio 72% 73%
Percent first lien positions 56 47
NATIONAL HOME EQUITY
Average balance $ 5.1 $ 4.9
Average loan-to-value ratio 75% 76%
Percent first lien positions 81 83
- ----------------------------------------------------------------
OTHER DATA
On-line clients / percent
penetration 665,781 / 35% 489,632 / 28%
KeyCenters 903 905
Automated teller machines 2,159 2,284
- ----------------------------------------------------------------
CORPORATE AND INVESTMENT BANKING
As shown in Figure 4, net income for Corporate and Investment Banking was $92
million for the second quarter of 2003, down from $95 million for the same
period last year. A reduction in taxable-equivalent net interest income and
higher noninterest expense accounted for the decrease. These negative changes
were offset by an increase in noninterest income and a lower provision for loan
losses.
Taxable-equivalent net interest income decreased by $8 million, or 3%, from the
second quarter of 2002 due primarily to a less favorable interest rate spread on
deposits and other funding sources, as well as a decline in average loans
outstanding. The adverse effect of these factors was partially offset by the
positive effect of deposit growth.
39
Noninterest income increased by $12 million, or 11%, due primarily to increases
in non-yield-related loan fees and net gains from loan sales in the KeyBank Real
Estate Capital line of business. In addition, results benefited from higher net
gains from the residual values of leased equipment in Key Equipment Finance.
These positive changes were partially offset by lower income from investment
banking and capital markets activities, mainly in the Corporate Banking line.
Noninterest expense increased by $13 million, or 8%, due primarily to increases
in the cost of employee benefits, business and franchise taxes, and various
indirect charges.
FIGURE 4. CORPORATE AND INVESTMENT BANKING
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE
--------------------------- ------------------ ------------------------- -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 261 $ 269 $ (8) (3.0)% $ 520 $ 542 $ (22) (4.1)%
Noninterest income 124 112 12 10.7 234 233 1 .4
- -----------------------------------------------------------------------------------------------------------------------------------
Total revenue (TE) 385 381 4 1.0 754 775 (21) (2.7)
Provision for loan losses 56 59 (3) (5.1) 107 110 (3) (2.7)
Noninterest expense 182 169 13 7.7 350 338 12 3.6
- -----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes (TE) 147 153 (6) (3.9) 297 327 (30) (9.2)
Allocated income taxes and TE
adjustments 55 58 (3) (5.2) 112 123 (11) (8.9)
- -----------------------------------------------------------------------------------------------------------------------------------
Net income $ 92 $ 95 $ (3) (3.2)% $ 185 $ 204 $ (19) (9.3)%
======= ======= ======= ======= ======= =======
Percent of consolidated net
income 41% 39% N/A N/A 42% 42% N/A N/A
AVERAGE BALANCES
Loans $28,172 $29,668 $(1,496) (5.0)% $28,281 $29,754 $(1,473) (5.0)%
Total assets 32,566 32,966 (400) (1.2) 32,698 33,014 (316) (1.0)
Deposits 4,147 3,104 1,043 33.6 4,093 3,120 973 31.2
- -----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
INVESTMENT MANAGEMENT SERVICES
As shown in Figure 5, net income for Investment Management Services was $15
million for the second quarter of 2003, down from $31 million in the second
quarter of last year. The decrease was attributable to a significant reduction
in noninterest income. This reduction was partially offset by an increase in
taxable-equivalent net interest income and decreases in both noninterest expense
and the provision for loan losses.
Taxable-equivalent net interest income increased by $4 million, or 7%, from the
second quarter of 2002. The growth was due primarily to an improved interest
rate spread on earning assets, combined with strong growth in average deposits.
Noninterest income decreased by $38 million, or 23%, as market-sensitive
businesses continue to be adversely affected by the weak economy. The reduction
was due primarily to an aggregate decline of $29 million in trust and investment
services income in the McDonald Financial Group and in Victory Capital
Management. This decline was largely attributable to a decrease over the past
year in the market value of assets under management, as well as reduced revenue
resulting from the June 2002 sale of Key's 401(k) plan recordkeeping business.
Funds that clients elected to move from money market funds under management to
FDIC insured deposit accounts with Key also contributed to the decline.
Noninterest expense decreased by $7 million, or 4%, due primarily to lower
variable compensation expense associated with revenue generation.
40
FIGURE 5. INVESTMENT MANAGEMENT SERVICES
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE
--------------------------- ------------------ ------------------------- ----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ----------------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 61 $ 57 $ 4 7.0% $ 120 $ 110 $ 10 9.1%
Noninterest income 126 164 (38) (23.2) 259 324 (65) (20.1)
- ----------------------------------------------------------------------------------------------------------------------------------
Total revenue (TE) 187 221 (34) (15.4) 379 434 (55) (12.7)
Provision for loan losses 4 6 (2) (33.3) 5 9 (4) (44.4)
Noninterest expense 159 166 (7) (4.2) 317 336 (19) (5.7)
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes (TE) 24 49 (25) (51.0) 57 89 (32) (36.0)
Allocated income taxes and TE
adjustments 9 18 (9) (50.0) 21 33 (12) (36.4)
- ----------------------------------------------------------------------------------------------------------------------------------
Net income $ 15 $ 31 $ (16) (51.6)% $ 36 $ 56 $ (20) (35.7)%
======= ======= ======= ======= ======= =======
Percent of consolidated net
income 7% 13% N/A N/A 8% 12% N/A N/A
AVERAGE BALANCES
Loans $ 5,031 $ 4,892 $ 139 2.8 % $ 4,994 $ 4,796 $ 198 4.1%
Total assets 6,022 5,874 148 2.5 5,973 5,818 155 2.7
Deposits 5,939 3,583 2,356 65.8 5,579 3,627 1,952 53.8
- ----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
ADDITIONAL INVESTMENT MANAGEMENT SERVICES DATA
JUNE 30, DECEMBER 31, JUNE 30,
dollars in billions 2003 2002 2002
- -------------------------------------------------------------------------------------------------------
Assets under management $ 63.3 $ 61.7 $ 70.7
Nonmanaged and brokerage assets 61.5 65.0 72.0
- -------------------------------------------------------------------------------------------------------
OTHER SEGMENTS
Other segments consist primarily of Treasury, Principal Investing and the net
effect of funds transfer pricing. These segments generated net income of $19
million for the second quarter of 2003, compared with net income of $5 million
for the same period last year. The improvement reflects net gains of $20 million
($12 million after tax) from principal investing in the second quarter of 2003,
compared with net losses of less than $2 million for the year-ago quarter.
41
RESULTS OF OPERATIONS
NET INTEREST INCOME
Key's principal source of earnings is net interest income, which includes
interest paid to Key on earning assets such as loans and securities, as well as
loan-related fee income; less interest expense paid on deposits and borrowings.
There are several factors that affect net interest income, including:
- - the volume, pricing, mix and maturity of earning assets and
interest-bearing liabilities;
- - the use of derivative instruments to manage interest rate risk;
- - market interest rate fluctuations; and
- - asset quality.
To make it easier to compare results among several periods and the yields on
various types of earning assets, we present net interest income in this
discussion on a "taxable-equivalent basis." In other words, if we earn $100 of
tax-exempt income, we present those earnings at a higher amount (specifically,
$154) that--if taxed at the statutory federal income tax rate of 35%--would
yield $100. Figure 7, which spans pages 44 and 45, shows the various components
of Key's balance sheet that affect interest income and expense, and their
respective yields or rates over the past five quarters. This figure also
reconciles taxable-equivalent net interest income for each of those quarters to
net interest income reported under generally accepted accounting principles
("GAAP").
Taxable-equivalent net interest income for the second quarter of 2003 was $710
million, compared with $721 million a year ago. This decrease reflects the
negative effect of a lower net interest margin, which decreased 13 basis points
to 3.85%. The net interest margin is an indicator of the profitability of the
earning asset portfolio and is calculated by dividing net interest income by
average earning assets. During the same period, average earning assets grew by
2% to $73.9 billion.
The combination of a soft economy and significant growth in core deposits
affected the net interest margin, as well as the size and composition of Key's
earning assets portfolio. Over the past twelve months, core deposit growth has
exceeded net loan growth. The excess funds have been either invested in
securities or used to reduce wholesale funding. Although these actions improved
Key's liquidity, the weak demand for commercial loans has placed pressure on the
net interest margin. This pressure is expected to continue as a result of the
Federal Reserve Board's most recent cut in interest rates in June 2003.
NET INTEREST MARGIN. Key's net interest margin decreased over the past twelve
months, primarily because:
- - competitive market conditions precluded us from passing on the full
amount of the Federal Reserve Board's reductions in interest rates to
clients' deposit accounts;
- - we have experienced a higher level of loan refinancings and prepayments
as a result of the low interest rate environment; and
- - we invested more heavily in securities available for sale since
opportunities to originate loans, which typically have higher interest
rate spreads, have been adversely affected by the weak economy.
INTEREST EARNING ASSETS. Average earning assets for the second quarter of 2003
totaled $73.9 billion, which was $1.4 billion, or 2%, higher than the second
quarter 2002 level. This growth came principally from home equity lending and
the securities available-for-sale portfolio. During the same period, soft loan
demand resulting from the general economic slowdown contributed to a decline in
average commercial loans outstanding.
42
Over the past twelve months, the growth and composition of Key's loan portfolio
has been affected by the following actions:
- - During the first quarter of 2003, we acquired a $311 million commercial
lease financing portfolio and a $71 million commercial loan portfolio
from a Canadian financial institution. The acquisition of these
portfolios further diversifies our asset base and is expected to result
in additional equipment financing opportunities.
- - During the second quarter of 2001, management announced that Key would
exit the automobile leasing business, de-emphasize indirect prime
automobile lending and discontinue certain credit-only commercial
relationships. As of June 30, 2003, these portfolios, in the aggregate,
have declined by approximately $4.0 billion since the date of the
announcement and by approximately $1.6 billion since June 30, 2002.
- - We sold commercial mortgage loans of $661 million during the first six
months of 2003 and $1.4 billion during 2002. Since some of these loans
have been sold with limited recourse, Key established a loss reserve of
an amount estimated by management to be appropriate to reflect the
recourse risk. More information about the related recourse agreement is
provided in Note 10 ("Contingent Liabilities and Guarantees") under the
section entitled "Recourse agreement with Federal National Mortgage
Association" on page 27. Our business of originating and servicing
commercial mortgage loans has grown in part as a result of acquiring
Conning Asset Management in the second quarter of 2002 and both Newport
Mortgage Company, L.P. and National Realty Funding L.C. in 2000.
- - We sold other loans totaling $619 million during the first half of 2003
and $1.9 billion during 2002. These sales included education loans of
$156 million during the first six months of 2003 and $1.1 billion ($750
million through securitizations) during 2002.
Figure 6 shows how the changes in yields or rates and average balances from the
prior year affected net interest income. The section entitled "Financial
Condition," which begins on page 52, contains more discussion about changes in
earning assets and funding sources.
FIGURE 6. COMPONENTS OF NET INTEREST INCOME CHANGES
FROM THREE MONTHS ENDED JUNE 30, 2002 FROM SIX MONTHS ENDED JUNE 30, 2002
TO THREE MONTHS ENDED JUNE 30, 2003 TO SIX MONTHS ENDED JUNE 30, 2003
------------------------------------- ------------------------------------
AVERAGE YIELD/ NET AVERAGE YIELD/ NET
in millions VOLUME RATE CHANGE VOLUME RATE CHANGE
- ------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ (14) $ (90) $ (104) $ (25) $ (184) $ (209)
Tax-exempt investment securities (2) 1 (1) (4) - (4)
Securities available for sale 31 (30) 1 65 (53) 12
Short-term investments - - - (2) 2 -
Other investments 1 (1) - 2 (2) -
- ------------------------------------------------------------------------------------------------------------------------------
Total interest income (taxable equivalent) 16 (120) (104) 36 (237) (201)
INTEREST EXPENSE
NOW and money market deposit accounts 10 2 12 19 4 23
Certificates of deposit ($100,000 or more) (1) (8) (9) 1 (20) (19)
Other time deposits (15) (32) (47) (32) (75) (107)
Deposits in foreign office (1) (3) (4) (2) (5) (7)
- ------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits (7) (41) (48) (14) (96) (110)
Federal funds purchased and securities sold
under repurchase agreements (2) (7) (9) (5) (13) (18)
Bank notes and other short-term borrowings (4) (1) (5) (12) (2) (14)
Long-term debt, including capital securities (7) (24) (31) 2 (51) (49)
- ------------------------------------------------------------------------------------------------------------------------------
Total interest expense (20) (73) (93) (29) (162) (191)
- ------------------------------------------------------------------------------------------------------------------------------
Net interest income (taxable equivalent) $ 36 $ (47) $ (11) $ 65 $ (75) $ (10)
======= ====== ====== ======= ====== ======
- ------------------------------------------------------------------------------------------------------------------------------
The change in interest not due solely to volume or rate has been allocated in
proportion to the absolute dollar amounts of the change in each.
43
FIGURE 7. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
SECOND QUARTER 2003 FIRST QUARTER 2003
---------------------------- -----------------------------
AVERAGE YIELD/ AVERAGE YIELD/
dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE
- -------------------------------------------------------------------------------------------------------------------
ASSETS
Loans(a,b)
Commercial, financial and agricultural $17,391 $ 218 5.01% $17,221 $ 206 4.86%
Real estate -- commercial mortgage 5,932 80 5.38 6,034 82 5.49
Real estate -- construction 5,331 68 5.14 5,683 72 5.16
Commercial lease financing 7,883 119 6.05 7,790 123 6.30
- ------------------------------------------------------------------------------------------------------------------
Total commercial loans 36,537 485 5.32 36,728 483 5.31
Real estate -- residential 1,803 30 6.54 1,904 32 6.66
Home equity 14,433 219 6.09 14,005 217 6.29
Consumer - direct 2,135 40 7.44 2,129 40 7.68
Consumer - indirect lease financing 601 14 9.40 772 18 9.40
Consumer - indirect other 5,002 105 8.43 4,917 107 8.74
- ------------------------------------------------------------------------------------------------------------------
Total consumer loans 23,974 408 6.82 23,727 414 7.05
Loans held for sale 2,518 29 4.70 2,390 28 4.70
- ------------------------------------------------------------------------------------------------------------------
Total loans 63,029 922 5.86 62,845 925 5.95
Taxable investment securities 5 -- 5.44 2 -- 8.43
Tax-exempt investment securities(a) 110 3 9.46 125 3 8.89
- ------------------------------------------------------------------------------------------------------------------
Total investment securities 115 3 9.27 127 3 8.88
Securities available for sale(a,c) 8,321 97 4.68 7,790 101 5.21
Short-term investments 1,484 8 2.12 1,706 8 1.87
Other investments(c) 985 6 2.47 956 6 2.46
- ------------------------------------------------------------------------------------------------------------------
Total earning assets 73,934 1,036 5.61 73,424 1,043 5.73
Allowance for loan losses (1,409) (1,438)
Accrued income and other assets 12,187 11,928
- ------------------------------------------------------------------------------------------------------------------
$84,712 $83,914
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
NOW and money market deposit accounts $17,740 41 .93 $16,747 42 1.03
Savings deposits 2,084 3 .54 2,043 3 .60
Certificates of deposit ($100,000 or more)(d) 4,743 47 3.98 4,654 48 4.20
Other time deposits 11,434 84 2.96 11,799 90 3.09
Deposits in foreign office 2,445 8 1.25 1,719 5 1.24
- ------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 38,446 183 1.91 36,962 188 2.07
Federal funds purchased and securities
sold under repurchase agreements 5,075 15 1.19 4,800 14 1.19
Bank notes and other short-term borrowings(d) 2,351 15 2.58 2,801 18 2.65
Long-term debt, including capital securities(d) 16,309 113 2.90 17,279 120 2.90
- ------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities 62,181 326 2.13 61,842 340 2.25
Noninterest-bearing deposits 10,053 9,788
Accrued expense and other liabilities 5,526 5,465
Common shareholders' equity 6,952 6,819
- ------------------------------------------------------------------------------------------------------------------
$84,712 $83,914
======= =======
Interest rate spread (TE) 3.48% 3.48%
- ------------------------------------------------------------------------------------------------------------------
Net interest income (TE) and net interest
margin (TE) 710 3.85% 703 3.86%
==== ====
TE adjustment(a) 14 22
- ------------------------------------------------------------------------------------------------------------------
Net interest income, GAAP basis $ 696 $ 681
====== ======
Capital securities $ 1,266 $ 18 $ 1,254 $ 18
- ------------------------------------------------------------------------------------------------------------------
(a) Interest income on tax-exempt securities and loans has been adjusted to
a taxable-equivalent basis using the statutory federal income tax rate
of 35%.
(b) For purposes of these computations, nonaccrual loans are included in
average loan balances.
(c) Yield is calculated on the basis of amortized cost.
(d) Rate calculation excludes basis adjustments related to fair value
hedges. See Note 20 ("Derivatives and Hedging Activities"), which
begins on page 84 of Key's Annual Report to Shareholders, for an
explanation of fair value hedges.
TE = Taxable Equivalent
GAAP = Generally Accepted Accounting Principles
44
FIGURE 7. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
(CONTINUED)
FOURTH QUARTER 2002 THIRD QUARTER 2002 SECOND QUARTER 2002
- ---------------------------- ----------------------------- -----------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE
- ----------------------------------------------------------------------------------------------------
$17,362 $ 220 5.01% $17,485 $ 225 5.11% $18,213 $ 232 5.11%
6,168 88 5.66 6,207 93 5.92 6,414 95 5.94
5,856 78 5.27 5,822 79 5.37 5,870 79 5.40
7,356 112 6.13 7,215 121 6.72 7,206 126 6.96
- ---------------------------------------------------------------------------------------------------
36,742 498 5.39 36,729 518 5.60 37,703 532 5.65
2,029 33 6.72 2,089 37 7.00 2,148 38 7.04
13,649 226 6.55 13,505 222 6.52 13,072 229 7.03
2,153 44 8.17 2,172 46 8.32 2,210 46 8.37
1,001 24 9.42 1,264 28 8.98 1,514 33 8.84
5,117 116 9.05 5,143 117 9.13 5,131 118 9.19
- ---------------------------------------------------------------------------------------------------
23,949 443 7.36 24,173 450 7.41 24,075 464 7.73
1,986 26 5.28 2,584 35 5.48 2,150 30 5.58
- ---------------------------------------------------------------------------------------------------
62,677 967 6.14 63,486 1,003 6.29 63,928 1,026 6.43
1 -- 8.85 1 -- 8.45 1 -- 8.17
132 3 9.32 166 4 8.76 205 4 8.31
- ---------------------------------------------------------------------------------------------------
133 3 9.31 167 4 8.75 206 4 8.31
7,598 106 5.60 6,424 98 6.11 6,014 96 6.40
1,240 7 2.12 1,151 6 2.28 1,561 8 1.97
906 6 2.39 855 6 2.46 870 6 3.14
- ---------------------------------------------------------------------------------------------------
72,554 1,089 5.97 72,083 1,117 6.17 72,579 1,140 6.30
(1,471) (1,509) (1,579)
11,652 11,361 10,560
- ---------------------------------------------------------------------------------------------------
$82,735 $81,935 $81,560
======= ======= =======
$15,131 40 1.03 $13,293 30 .91 $13,232 29 .88
1,981 4 .63 2,002 3 .67 2,014 3 .67
4,741 51 4.29 4,886 54 4.45 4,816 56 4.69
12,213 101 3.29 12,713 115 3.57 13,085 131 4.02
1,974 6 1.43 2,593 12 1.76 2,638 12 1.76
- ---------------------------------------------------------------------------------------------------
36,040 202 2.22 35,487 214 2.40 35,785 231 2.59
5,502 20 1.44 5,483 23 1.69 5,541 24 1.71
2,192 14 2.53 2,581 18 2.73 2,995 20 2.73
17,040 129 3.09 17,455 140 3.25 17,230 144 3.37
- ---------------------------------------------------------------------------------------------------
60,774 365 2.40 61,006 395 2.59 61,551 419 2.73
9,926 9,177 8,719
5,314 5,159 4,783
6,721 6,593 6,507
- ---------------------------------------------------------------------------------------------------
$82,735 $81,935 $81,560
======= ======= =======
3.57% 3.58% 3.57%
- ---------------------------------------------------------------------------------------------------
724 3.98% 722 3.99% 721 3.98%
==== ==== =====
12 22 38
- ---------------------------------------------------------------------------------------------------
$ 712 $ 700 $ 683
====== ===== =====
$ 1,233 $ 18 $ 1,249 $ 19 $ 1,236 $ 20
- ---------------------------------------------------------------------------------------------------
45
MARKET RISK MANAGEMENT
The values of some financial instruments vary not only with changes in market
interest rates, but also with changes in foreign exchange rates, factors
influencing valuations in the equity securities markets, and other market-driven
rates or prices. For example, the value of a fixed-rate bond will decline if
market interest rates increase. As a result, the bond will become a less
attractive investment to the holder. Similarly, the value of the U.S. dollar
regularly fluctuates in relation to other currencies. The exposure that
instruments tied to such external factors present is called "market risk." Most
of Key's market risk is derived from interest rate fluctuations.
INTEREST RATE RISK MANAGEMENT
Key's Asset/Liability Management Policy Committee has developed a program to
measure and manage interest rate risk. This committee is also responsible for
approving Key's asset/liability management policies, overseeing the formulation
and implementation of strategies to improve balance sheet positioning and
earnings, and reviewing Key's interest rate sensitivity exposure.
FACTORS CONTRIBUTING TO INTEREST RATE EXPOSURE. Key uses interest rate exposure
models to quantify the potential impact on earnings and economic value of equity
arising from a variety of possible future interest rate scenarios. The many
interest rate scenarios modeled estimate the level of Key's interest rate
exposure arising from option risk, basis risk and gap risk. Each of these types
of risk is defined in the discussion of market risk management, which begins on
page 30 of Key's 2002 Annual Report to Shareholders.
MEASUREMENT OF SHORT-TERM INTEREST RATE EXPOSURE. Key uses a net interest income
simulation model to measure interest rate risk over a short time frame. These
simulations estimate the impact that various changes in the overall level of
interest rates over one- and two-year time horizons would have on net interest
income. The results help Key develop strategies for managing exposure to
interest rate risk.
Like any forecasting technique, interest rate simulation modeling is based on a
large number of assumptions and judgments. In this case, the assumptions relate
primarily to loan and deposit growth, asset and liability prepayments, interest
rates, and on- and off-balance sheet management strategies. Management believes
that, both individually and in the aggregate, the assumptions Key makes are
reasonable. Nevertheless, the simulation modeling process produces only a
sophisticated estimate, not a precise calculation of exposure.
Key's guidelines for risk management call for preventive measures to be taken if
the simulation modeling demonstrates that a gradual 200 basis point increase or
decrease in short-term rates over the next twelve months would adversely affect
net interest income over the same period by more than 2%. Key is operating
within these guidelines. Since short-term interest rates were relatively low at
June 30, 2003, management modified Key's standard rate scenario of a gradual
decrease of 200 basis points over twelve months to a gradual decrease of 25
basis points over the next two months and no change over the following ten
months. As of June 30, 2003, based on the results of our simulation model, and
assuming that management does not take action to alter the outcome, Key would
expect net interest income to decrease by approximately 1.13% over the next
twelve months if short-term interest rates gradually increase by 200 basis
points. Conversely, if short-term interest rates gradually decrease by 25 basis
points, net interest income would be expected to increase by approximately .11%
over the next twelve months.
MEASUREMENT OF LONG-TERM INTEREST RATE EXPOSURE. Key uses an economic value of
equity model to complement short-term interest rate risk analysis. The benefit
of this model is that it measures exposure to interest rate changes over time
frames longer than two years. The economic value of Key's equity is determined
by aggregating the present value of projected future cash flows for asset,
liability and derivative positions based on the current yield curve. However,
economic value does not represent the fair values of asset, liability and
derivative positions since it does not consider factors like credit risk and
liquidity.
Key's guidelines for risk management call for preventive measures to be taken if
an immediate 200 basis point increase or decrease in interest rates is estimated
to reduce the economic value of equity by more than 15%. Key is operating within
these guidelines. Certain short-term interest rates were limited to reductions
of less than 200 basis points since interest rates cannot decrease below zero in
Key's economic value of equity model.
46
MANAGEMENT OF INTEREST RATE EXPOSURE. Management uses the results of short-term
and long-term interest rate exposure models to formulate strategies to improve
balance sheet positioning, earnings, or both, within the bounds of Key's
interest rate risk, liquidity and capital guidelines. We manage interest rate
risk by using portfolio swaps and caps, which modify the repricing or maturity
characteristics of some of our assets and liabilities. The decision to use these
instruments rather than securities, debt or other on-balance sheet alternatives
depends on many factors, including the mix and cost of funding sources,
liquidity and capital requirements, and interest rate implications. A brief
description of interest rate swaps and caps is included in the discussion of
market risk management, which begins on page 30 of Key's 2002 Annual Report to
Shareholders. For more information about how Key uses interest rate swaps and
caps to manage its balance sheet, see Note 11 ("Derivatives and Hedging
Activities"), which begins on page 29.
Over the past year, we have invested more heavily in collateralized mortgage
obligations as opportunities to originate loans have been adversely affected by
the weak economy, while our core deposits have grown significantly. These
securities, the majority of which have relatively short average lives, have been
used in conjunction with swaps and caps to manage our interest rate risk
position.
TRADING PORTFOLIO RISK MANAGEMENT
Key's trading portfolio is described in Note 11.
Management uses a value at risk ("VAR") model to estimate the potential adverse
effect of changes in interest and foreign exchange rates, and equity prices on
the fair value of Key's trading portfolio. Using statistical methods, this model
estimates the maximum potential one-day loss with 95% probability. At June 30,
2003, Key's aggregate daily VAR was $1.4 million, compared with $1.8 million at
June 30, 2002. Aggregate daily VAR averaged $1.2 million for the first six
months of 2003, compared with an average of $1.6 million for the same period
last year. VAR modeling augments other controls that Key uses to mitigate the
market risk exposure of the trading portfolio. These controls include loss and
portfolio size limits that are based on market liquidity and the level of
activity and volatility of trading products.
47
NONINTEREST INCOME
Noninterest income for the second quarter of 2003 was $434 million, down $14
million, or 3%, from the same period last year. For the first six months of the
year, noninterest income was $831 million, representing a decrease of $60
million, or 7%, from the first six months of 2002.
As shown in Figure 8, the reduction in noninterest income for both the quarterly
and year-to-date periods was due primarily to lower income from trust and
investment services, and service charges on deposit accounts. These negative
changes were offset in part by increases in non-yield-related loan fees and net
gains from loan sales.
FIGURE 8. NONINTEREST INCOME
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, CHANGE JUNE 30, CHANGE
------------------ -------------------- ------------------ -------------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
Trust and investment services income $131 $158 $ (27) (17.1)% $263 $316 $ (53) (16.8)%
Service charges on deposit accounts 91 104 (13) (12.5) 183 204 (21) (10.3)
Investment banking and capital markets income 53 47 6 12.8 87 96 (9) (9.4)
Letter of credit and loan fees 40 29 11 37.9 71 57 14 24.6
Corporate-owned life insurance income 27 26 1 3.8 54 52 2 3.8
Electronic banking fees 22 20 2 10.0 41 38 3 7.9
Net securities gains 3 1 2 200.0 7 1 6 600.0
Other income:
Insurance income 13 15 (2) (13.3) 26 28 (2) (7.1)
Net gains from loan securitizations and
sales 14 3 11 366.7 29 9 20 222.2
Loan securitization servicing fees 2 2 -- -- 4 5 (1) (20.0)
Credit card fees 3 2 1 50.0 6 4 2 50.0
Miscellaneous income 35 41 (6) (14.6) 60 81 (21) (25.9)
- --------------------------------------------------------------------------------------------------------------------------------
Total other income 67 63 4 6.3 125 127 (2) (1.6)
- --------------------------------------------------------------------------------------------------------------------------------
Total noninterest income $434 $448 $ (14) (3.1)% $831 $891 $ (60) (6.7)%
==== ==== ====== ==== ==== ======
- --------------------------------------------------------------------------------------------------------------------------------
The discussion that follows provides additional information, such as the
composition of certain components of Key's noninterest income and the factors
that caused them to change from the prior year.
TRUST AND INVESTMENT SERVICES INCOME. Trust and investment services provide
Key's largest source of noninterest income. Its primary components are shown in
Figure 9. A significant portion of this income is based on the value of assets
under management. Thus, over the past twelve months, the level of revenue
derived from these services has been adversely affected by declines in the
equity markets.
FIGURE 9. TRUST AND INVESTMENT SERVICES INCOME
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, CHANGE JUNE 30, CHANGE
------------------ -------------------- ------------------ -------------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
Personal asset management and custody fees $ 36 $ 41 $ (5) (12.2)% $ 71 $ 81 $ (10) (12.3)%
Institutional asset management and custody fees 9 20 (11) (55.0) 20 40 (20) (50.0)
Bond services 9 10 (1) (10.0) 19 20 (1) (5.0)
Brokerage commission income 48 50 (2) (4.0) 95 101 (6) (5.9)
All other fees 29 37 (8) (21.6) 58 74 (16) (21.6)
- --------------------------------------------------------------------------------------------------------------------------------
Total trust and investment services income $131 $158 $ (27) (17.1)% $263 $316 $ (53) (16.8)%
==== ==== ===== ==== ==== =====
- --------------------------------------------------------------------------------------------------------------------------------
At June 30, 2003, Key's bank, trust and registered investment advisory
subsidiaries had assets under management of $63.3 billion, compared with $70.7
billion at June 30, 2002. These assets are managed on behalf of both
institutions and individuals through a variety of equity, fixed income and money
market accounts. The composition of Key's assets under management is shown in
Figure 10. The 10% decrease in the value of assets under management over the
past twelve months reflects a decline in the market value of those assets as
well as net asset outflows of approximately $4 billion. The June 2002 sale of
Key's 401(k) plan recordkeeping business, which accounted for most of the net
asset outflows, accounted for $14 million of the decrease in income from trust
and investment services from the second quarter of 2002 and $22 million of the
decrease from the first six months of 2002.
48
FIGURE 10. ASSETS UNDER MANAGEMENT
2003 2002
------------------ -----------------------------
in millions SECOND FIRST FOURTH THIRD SECOND
- ---------------------------------------------------------------------------------------------------------
Assets under management by investment type:
Equity $26,931 $25,415 $27,224 $25,422 $31,064
Fixed income 17,121 16,310 16,133 17,588 18,905
Money market 19,250 19,073 18,337 19,364 20,756
- ---------------------------------------------------------------------------------------------------------
Total $63,302 $60,798 $61,694 $62,374 $70,725
======= ======= ======= ======= =======
Proprietary mutual funds included in assets under
management:
Equity $ 2,604 $ 2,236 $ 2,878 $ 2,965 $ 3,709
Fixed income 1,144 1,125 1,215 1,377 1,262
Money market 10,362 10,762 11,457 12,129 12,568
- ---------------------------------------------------------------------------------------------------------
Total $14,110 $14,123 $15,550 $16,471 $17,539
======= ======= ======= ======= =======
- ---------------------------------------------------------------------------------------------------------
SERVICE CHARGES ON DEPOSIT ACCOUNTS. Service charges on deposit accounts have
declined in each of the past five quarters due primarily to lower overdraft and
maintenance fees. The decrease in maintenance fees is attributable to free
checking products, which were introduced in the third quarter of 2002 and rolled
out to all of Key's markets by the end of the year.
INVESTMENT BANKING AND CAPITAL MARKETS INCOME. As shown in Figure 11, the
year-to-date decrease in investment banking and capital markets income resulted
from declines in three of its four major revenue sources, reflecting the adverse
effects of a soft economy.
Key's principal investing income is susceptible to volatility since it is
derived from investments in small to medium-sized businesses, many of which are
in relatively early stages of economic development and strategy implementation.
Principal investments consist of direct and indirect investments in
predominantly privately-held companies and are carried on the balance sheet at
fair value ($717 million at June 30, 2003, and $652 million at June 30, 2002).
Thus, the net gains and losses presented in Figure 11 stem from changes in
estimated fair values, as well as actual gains and losses on sales of principal
investments.
FIGURE 11. INVESTMENT BANKING AND CAPITAL MARKETS INCOME
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, CHANGE JUNE 30, CHANGE
------------------ ---------------- ---------------- ----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
Dealer trading and derivatives income $ 3 $ 7 $ (4) (57.1)% $ 11 $ 24 $ (13) (54.2)%
Investment banking income 22 34 (12) (35.3) 44 55 (11) (20.0)
Net gains (losses) from principal investing 20 (2) 22 N/M 17 (1) 18 N/M
Foreign exchange income 8 8 -- -- 15 18 (3) (16.7)
- ---------------------------------------------------------------------------------------------------------------------------------
Total investment banking and capital markets income $ 53 $ 47 $ 6 12.8 % $ 87 $ 96 $ (9) (9.4)%
==== ==== ===== ==== ==== =====
- ---------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
LETTER OF CREDIT AND LOAN FEES. As shown in Figure 8, letter of credit and loan
fees were up from the prior year on both a quarterly and year-to-date basis due
primarily to higher syndication fees and agency origination fees generated
during the second quarter of 2003 by the KeyBank Real Estate Capital line of
business.
OTHER INCOME. Compared with the prior year, other income was affected by
offsetting items as shown in Figure 8. Increases in net gains from loan
securitizations and sales were offset in part by higher net losses from the
sales of residual values of leased equipment included in miscellaneous income.
These losses were up $4 million from the second quarter of 2002 and $15 million
from the first half of last year.
49
NONINTEREST EXPENSE
Noninterest expense for the second quarter of 2003 was $688 million, up $23
million, or 4%, from the same period last year. For the first six months of the
year, noninterest expense was $1.3 billion, representing an increase of only $19
million, or 1%, from the first six months of 2002.
As shown in Figure 12, increases in professional fees and personnel expense
drove the increase in noninterest expense for both the quarterly and
year-to-date periods. The aggregate increase in these expense components for the
year-to-date period was substantially offset, however, by a reduction in
computer processing expense.
FIGURE 12. NONINTEREST EXPENSE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, CHANGE JUNE 30, CHANGE
------------------ ---------------- ----------------- ----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ---------------------------------------------------------------------------------------------------------------------------
Personnel $ 371 $ 361 $ 10 2.8 % $ 734 $ 724 $ 10 1.4 %
Net occupancy 56 56 -- -- 115 113 2 1.8
Computer processing 44 48 (4) (8.3) 88 102 (14) (13.7)
Equipment 34 36 (2) (5.6) 66 70 (4) (5.7)
Marketing 33 30 3 10.0 58 56 2 3.6
Professional fees 32 21 11 52.4 57 42 15 35.7
Other expense:
Postage and delivery 13 14 (1) (7.1) 28 29 (1) (3.4)
Telecommunications 8 9 (1) (11.1) 16 17 (1) (5.9)
Equity- and gross receipts-based taxes 5 7 (2) (28.6) 10 13 (3) (23.1)
OREO expense, net 4 2 2 100.0 5 3 2 66.7
Miscellaneous expense 88 81 7 8.6 168 157 11 7.0
- -------------------------------------------------------------------------------------------------------------------------
Total other expense 118 113 5 4.4 227 219 8 3.7
- -------------------------------------------------------------------------------------------------------------------------
Total noninterest expense $ 688 $ 665 $ 23 3.5 % $ 1,345 $ 1,326 $ 19 1.4%
======= ======== ===== ======= ======= =====
Average full-time equivalent employees 19,999 20,903 (904) (4.3)% 20,222 20,991 (769) (3.7)%
- -------------------------------------------------------------------------------------------------------------------------
The discussion that follows explains the composition of certain components of
Key's noninterest expense and the factors that caused them to change from the
prior year.
PERSONNEL. Personnel expense, the largest category of Key's noninterest expense,
rose by a modest $10 million, or 1%, from the first six months of 2002. This
result reflected a rise in employee benefit costs (primarily pension costs),
offset in part by lower incentive compensation accruals.
The level of Key's personnel expense continues to reflect the benefits derived
from a competitiveness initiative completed last year, as well as the continuous
improvement efforts that have evolved from it. We will continue to evaluate
staffing levels and to make appropriate changes when they can be accomplished
without negatively affecting either customer service or our ability to grow
higher return businesses. For the second quarter of 2003, the number of average
full-time equivalent employees was 19,999, compared with 20,447 for the first
quarter of 2003 and 20,903 for the year-ago quarter. Figure 13 shows the major
components of Key's personnel expense.
Effective January 1, 2003, Key adopted the fair value method of accounting as
outlined in SFAS No. 123, "Accounting for Stock-Based Compensation."
Compensation expense related to stock option grants totaled less than $1 million
in the first half of 2003 and is included in incentive compensation in Figure
13. Additional information pertaining to this accounting change is included in
Note 1 ("Basis of Presentation") under the headings "Stock-Based Compensation"
on page 8 and "Accounting Pronouncements Adopted in 2003" on page 9.
FIGURE 13. PERSONNEL EXPENSE
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, CHANGE JUNE 30, CHANGE
------------------ ---------------- ---------------- ----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ----------------------------------------------------------------------------------------------------------------
Salaries $ 220 $ 215 $ 5 2.3 % $ 445 $ 431 $ 14 3.2%
Employee benefits 64 55 9 16.4 136 118 18 15.3
Incentive compensation 87 91 (4) (4.4) 153 175 (22) (12.6)
- --------------------------------------------------------------------------------------------------------------
Total personnel expense $ 371 $ 361 $ 10 2.8 % $ 734 $ 724 $ 10 1.4%
===== ===== ===== ===== ===== ====
- --------------------------------------------------------------------------------------------------------------
50
COMPUTER PROCESSING. The decrease in computer processing expense for both the
quarterly and year-to-date periods was due primarily to a lower level of
computer software amortization. This reduction is attributable to a decline in
the number of capitalized software projects.
PROFESSIONAL FEES. The increase in professional fees for both the quarterly and
year-to-date periods reflects additional costs incurred to enhance Key's sales
management systems.
INCOME TAXES
The provision for income taxes was $92 million for the second quarter of 2003,
compared with $85 million for the comparable period in 2002. The effective tax
rate, which is the provision for income taxes as a percentage of income before
income taxes, was 29.0% for the second quarter of 2003, compared with 25.7% for
the second quarter of 2002. For the first six months of 2003, the provision for
income taxes was $166 million, compared with $145 million for the first half of
2002. The effective tax rates for these periods were 27.3% and 23.0%,
respectively.
As discussed below, the management of residual values of certain leases has been
transferred to a foreign subsidiary in a lower tax jurisdiction. The increase in
the effective tax rate for both the quarterly and year-to-date periods was due
primarily to the fact that a smaller number of such leases were transferred in
the current year, compared with the first six months of 2002. These rate
increases were moderated in the current year, however, by tax-exempt income from
corporate-owned life insurance and credits associated with investments in
low-income housing projects, both of which represented a higher percentage of
income before income taxes compared with the three- and six-month periods ended
June 30, 2002.
The effective tax rates for both the current and prior year are substantially
below Key's combined statutory federal and state rate of 37.5% (37% in 2002)
primarily because portions of our equipment leasing portfolio became subject to
a lower income tax rate in the latter half of 2001. Responsibility for the
management of portions of Key's leasing portfolio was transferred to a foreign
subsidiary in a lower tax jurisdiction. Since Key intends to permanently
reinvest the earnings of this subsidiary, no deferred income taxes have been
recorded on those earnings in accordance with SFAS No. 109, "Accounting for
Income Taxes." Other factors that account for the difference between the
effective and statutory tax rates in the current and prior year include tax
deductions associated with dividends paid to Key's 401(k) savings plan, income
from investments in tax-advantaged assets (such as tax-exempt securities and
corporate-owned life insurance) and credits associated with investments in
low-income housing projects.
51
FINANCIAL CONDITION
LOANS
At June 30, 2003, total loans outstanding were $63.2 billion, compared with
$62.5 billion at the end of 2002 and $63.9 billion a year ago. Among the factors
that contributed to the decrease in our loans from one year ago are:
- - Loan sales completed to improve the profitability of the overall
portfolio or to accommodate our funding needs;
- - Weak loan demand due to the sluggish economy; and
- - Our decision to exit the automobile leasing business, de-emphasize
indirect prime automobile lending and discontinue certain credit-only
commercial relationships.
Over the past several years, we have used alternative funding sources like loan
sales and securitizations to allow us to continue to capitalize on our loan
origination capabilities. In addition, Key has completed acquisitions that have
improved our ability to generate and securitize new loans, especially in the
area of commercial real estate. These acquisitions include the purchase of
Conning Asset Management in June 2002, and both Newport Mortgage Company, L.P.
and National Realty Funding L.C. in 2000.
COMMERCIAL LOAN PORTFOLIO. Commercial loans outstanding decreased by $945
million, or 3%, from one year ago. Over the past year, growth in equipment lease
financing receivables was more than offset by a net decline in all other
commercial portfolios, reflecting continued weakness in the economy and our
decision to discontinue many credit-only relationships in the leveraged
financing and nationally syndicated lending businesses.
One of the largest segments of Key's commercial loan portfolio is commercial
real estate loans. At June 30, 2003, Key's commercial real estate portfolio
included mortgage loans of $5.9 billion and construction loans of $5.2 billion.
The average size of a mortgage loan was $.5 million and the largest mortgage
loan had a balance of $51 million. The average size of a construction loan was
$3 million. The largest construction loan commitment was $47 million, of which
$32 million was outstanding.
Key conducts its commercial real estate lending business through two primary
sources: a 12-state banking franchise and KeyBank Real Estate Capital, a
national line of business that cultivates relationships both within and beyond
the branch system. This line of business deals exclusively with
nonowner-occupied properties (i.e., generally properties in which the owner
occupies less than 60% of the premises) and accounted for approximately 53% of
Key's total average commercial real estate loans during the second quarter of
2003. At June 30, 2003, less than 2% of Key's nonowner-occupied portfolio was
either nonperforming or delinquent in payments. Our commercial real estate
business as a whole focuses on larger real estate developers and, as shown in
Figure 14, is diversified by both industry type and geography.
52
FIGURE 14. COMMERCIAL REAL ESTATE LOANS
GEOGRAPHIC REGION
JUNE 30, 2003 ------------------------------------- TOTAL PERCENT OF
dollars in millions EAST MIDWEST CENTRAL WEST AMOUNT TOTAL
- ----------------------------------------------------------------------------------------------------------------------
Nonowner-occupied:
Multi-family properties $ 595 $ 523 $ 642 $ 703 $ 2,463 22.2%
Retail properties 273 434 110 224 1,041 9.4
Office buildings 159 109 157 235 660 6.0
Residential properties 97 56 140 484 777 7.0
Warehouses 49 129 99 148 425 3.8
Manufacturing facilities 15 32 7 11 65 .6
Hotels/Motels 6 3 1 9 19 .2
Other 107 275 50 126 558 5.0
- --------------------------------------------------------------------------------------------------------------------
1,301 1,561 1,206 1,940 6,008 54.2
Owner-occupied 634 2,355 602 1,479 5,070 45.8
- --------------------------------------------------------------------------------------------------------------------
Total $ 1,935 $ 3,916 $ 1,808 $3,419 $11,078 100.0%
======= ======= ======= ====== ======= ======
- --------------------------------------------------------------------------------------------------------------------
Nonowner-occupied:
Nonperforming loans $ 4 $ 4 $ 1 $ 8 $ 17 N/M
Accruing loans past due 90 days or more 2 6 -- -- 8 N/M
Accruing loans past due 30 through 89 days 24 13 -- 29 66 N/M
- --------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
CONSUMER LOAN PORTFOLIO. The level of consumer loans outstanding at June 30,
2003, was essentially unchanged from that reported a year ago. Our home equity
portfolio increased by $1.3 billion, largely as a result of our focused efforts
to grow this business, facilitated by a period of lower interest rates. The
growth of the home equity portfolio was substantially offset by declines of
$858 million in automobile lease financing receivables and $363 million in
residential real estate mortgage loans. The decline in automobile lease
financing receivables reflects our decision to exit the automobile leasing
business.
Excluding loan sales and acquisitions, consumer loans would have increased by
$676 million, or 3%, during the past twelve months.
The home equity portfolio is by far the largest segment of Key's consumer loan
portfolio. Key's home equity portfolio is derived primarily from our Retail
Banking line of business (53% of the home equity portfolio at June 30, 2003) and
the National Home Equity unit within our Consumer Finance line of business.
The National Home Equity unit has two components: Champion Mortgage Company, a
home equity finance company, and Key Home Equity Services, which purchases
individual loans from an extensive network of correspondents and agents. Prior
to the third quarter of 2002, Key Home Equity Services also purchased loans
through bulk portfolio acquisitions from home equity loan companies. The average
loan-to-value ratio at origination for a loan generated by the National Home
Equity unit is 75%. First lien positions comprised 81% of the portfolio for this
unit at June 30, 2003.
Figure 15 summarizes Key's home equity loan portfolio at the end of each of the
last five quarters, as well as certain asset quality statistics and the yields
achieved on the portfolio as a whole.
53
FIGURE 15. HOME EQUITY LOANS
2003 2002
----------------------- -------------------------------------
dollars in millions SECOND FIRST FOURTH THIRD SECOND
- --------------------------------------------------------------------------------------------------------------------------
SOURCES OF LOANS OUTSTANDING AT PERIOD END
Retail Banking (KeyCenters) $ 7,795 $ 7,445 $ 7,212 $ 7,068 $ 6,833
McDonald Financial Group & other sources 1,775 1,700 1,655 1,612 1,548
Champion Mortgage Company 2,461 2,332 2,210 2,109 2,153
Key Home Equity Services division 2,657 2,667 2,727 2,727 2,845
- --------------------------------------------------------------------------------------------------------------------------
National Home Equity unit 5,118 4,999 4,937 4,836 4,998
- --------------------------------------------------------------------------------------------------------------------------
Total $14,688 $14,144 $13,804 $13,516 $13,379
======= ======= ======= ======= =======
- --------------------------------------------------------------------------------------------------------------------------
Nonperforming loans at period end $ 152 $ 154 $ 146 $ 124 $ 107
Net charge-offs for the period 13 13 13 12 13
Yield for the period 6.09% 6.29% 6.55% 6.52% 7.03%
- --------------------------------------------------------------------------------------------------------------------------
SALES, SECURITIZATIONS AND DIVESTITURES. During the past twelve months, Key sold
$1.6 billion of commercial real estate loans, $1.0 billion of education loans
($750 million through a securitization), $508 million of home equity loans and
$688 million of other types of loans. Since 1999, Key has securitized only
education loans.
Among the factors that Key considers in determining which loans to securitize
are:
- - whether the characteristics of a specific loan portfolio make it
conducive to securitization;
- - the relative cost of funds;
- - the level of credit risk; and
- - capital requirements.
Figure 16 summarizes Key's loan sales (including securitizations) for the first
six months of 2003 and all of 2002.
FIGURE 16. LOANS SOLD AND DIVESTED
COMMERCIAL COMMERCIAL RESIDENTIAL HOME CONSUMER
in millions COMMERCIAL REAL ESTATE LEASE FINANCING REAL ESTATE EQUITY --INDIRECT EDUCATION TOTAL
- -------------------------------------------------------------------------------------------------------------------------
2003
Second quarter $ 67 $ 408 -- $184 $ 83 -- $ 60 $ 802
First quarter 52 253 -- 4 73 -- 96 478
- --------------------------------------------------------------------------------------------------------------------------
Total $119 $ 661 -- $188 $156 -- $ 156 $1,280
==== ====== === ==== ==== ==== ====== ======
2002
Fourth quarter $ 93 $ 603 -- $ 65 $110 $177 $ 100 $1,148
Third quarter 18 352 -- 25 242 3 784 1,424
Second quarter 31 159 $18 20 24 -- 70 322
First quarter -- 319 -- -- 9 -- 116 444
- --------------------------------------------------------------------------------------------------------------------------
Total $142 $1,433 $18 $110 $385 $180 $1,070 $3,338
==== ====== === ==== ==== ==== ====== ======
- --------------------------------------------------------------------------------------------------------------------------
Figure 17 shows loans that are either administered or serviced by Key, but not
recorded on the balance sheet. Included are loans that have been both
securitized and sold, or simply sold outright. In the event of default, Key is
subject to recourse with respect to approximately $296 million of the $27.1
billion of loans administered or serviced at June 30, 2003.
54
Key derives income from two sources when we sell or securitize loans but retain
the right to administer or service them. We earn noninterest income (recorded as
"other income") from servicing or administering the loans, and we earn interest
income from any securitized assets retained. Conning Asset Management and
National Realty Funding L.C. service the commercial real estate loans shown in
Figure 17; however, other financial institutions originated most of these loans.
FIGURE 17. LOANS ADMINISTERED OR SERVICED
JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, JUNE 30,
in millions 2003 2003 2002 2002 2002
- ----------------------------------------------------------------------------------------------------------
Education loans $ 4,161 $ 4,381 $ 4,605 $ 4,756 $ 4,095
Automobile loans 29 40 54 69 87
Home equity loans 334 389 456 519 596
Commercial real estate loans 22,428 20,508 19,508 17,002 16,483
Commercial loans 142 130 123 110 103
- ---------------------------------------------------------------------------------------------------------
Total $27,094 $25,448 $24,746 $22,456 $21,364
======= ======= ======= ======= =======
- ---------------------------------------------------------------------------------------------------------
SECURITIES
At June 30, 2003, the securities portfolio totaled $8.6 billion and included
$7.5 billion of securities available for sale, $99 million of investment
securities and $1.0 billion of other investments (primarily principal
investments). In comparison, the total portfolio at December 31, 2002, was $9.5
billion, including $8.5 billion of securities available for sale, $120 million
of investment securities and $919 million of other investments. The weighted
average maturity of the total portfolio was 2.3 years at June 30, 2003, compared
with 3.0 years at December 31, 2002.
The size and composition of Key's securities portfolio are dependent largely on
our needs for liquidity and the extent to which we are required or elect to hold
these assets as collateral to secure public and trust deposits. Although debt
securities are generally used for this purpose, other assets, such as securities
purchased under resale agreements, may be used temporarily when they provide
more favorable yields.
SECURITIES AVAILABLE FOR SALE. The majority of Key's securities available for
sale portfolio consists of collateralized mortgage obligations that provide a
source of interest income and serve as collateral in connection with pledging
requirements. A collateralized mortgage obligation (sometimes called a "CMO") is
a debt security that is secured by a pool of mortgages, mortgage-backed
securities, U.S. government securities, corporate debt obligations or other
bonds. At June 30, 2003, Key had $7.2 billion invested in collateralized
mortgage obligations and other mortgage-backed securities in the
available-for-sale portfolio, compared with $8.1 billion at December 31, 2002,
and $6.0 billion at June 30, 2002. Over the past twelve months, Key has invested
more heavily in these securities as opportunities to originate loans (Key's
preferred earning asset) have been adversely affected by the weak economy.
Substantially all of these securities were issued or backed by federal agencies.
The CMO securities held by Key are shorter-maturity class bonds that were
structured to have more predictable cash flows than other longer-term class
bonds during periods of changing interest rates. During the second quarter of
2003, Key reduced the level of its CMOs by approximately $750 million, primarily
through sales undertaken to manage prepayment risk. The securities sold were
backed by higher coupon mortgages and had very short expected average lives.
Figure 18 shows the composition, yields and remaining maturities of Key's
securities available for sale. For more information about retained interests in
securitizations and gross unrealized gains and losses by type of security, see
Note 5 ("Securities"), which begins on page 17.
55
FIGURE 18. SECURITIES AVAILABLE FOR SALE
OTHER
U.S. TREASURY, STATES AND COLLATERALIZED MORTGAGE-
AGENCIES AND POLITICAL MORTGAGE BACKED
dollars in millions CORPORATIONS SUBDIVISIONS OBLIGATIONS(a) SECURITIES(a)
- ----------------------------------------------------------------------------------------------
JUNE 30, 2003
Remaining maturity:
One year or less $ 1 $ 1 $ 1,174 $ 45
After one through five years 28 5 5,063 535
After five through ten years 2 8 227 3
After ten years 4 12 98 8
- ---------------------------------------------------------------------------------------------
Fair value $ 35 $ 26 $ 6,562 $ 591
Amortized cost 34 25 6,552 567
Weighted average yield 2.60% 6.91% 4.51% 5.98%
Weighted average maturity 4.1 YEARS 10.5 YEARS 2.1 YEARS 1.7 YEARS
- ---------------------------------------------------------------------------------------------
DECEMBER 31, 2002
Fair value $ 23 $ 35 $ 7,207 $ 852
Amortized cost 22 35 7,143 815
- ---------------------------------------------------------------------------------------------
JUNE 30, 2002
Fair value $ 22 $ 19 $ 5,112 $ 857
Amortized cost 22 18 5,092 823
- ---------------------------------------------------------------------------------------------
RETAINED WEIGHTED
INTERESTS IN OTHER AVERAGE
dollars in millions SECURITIZATIONS(a) SECURITIES TOTAL YIELD(b)
- --------------------------------------------------------------------------------------------------
JUNE 30, 2003
Remaining maturity:
One year or less $ 24 -- $ 1,245 4.60%
After one through five years 156 $ 3 5,790 4.83
After five through ten years -- 4 244 8.78
After ten years -- 132(c) 254 8.94
- -----------------------------------------------------------------------------------------------
Fair value $ 180 $ 139 $ 7,533 --
Amortized cost 123 140 7,441 5.01%
Weighted average yield 27.55% 3.29%(b) 5.01% --
Weighted average maturity 2.6 YEARS 10.0 YEARS 2.3 YEARS --
- -----------------------------------------------------------------------------------------------
DECEMBER 31, 2002
Fair value $ 209 $ 181 $ 8,507 --
Amortized cost 166 208 8,389 5.76%
- -----------------------------------------------------------------------------------------------
JUNE 30, 2002
Fair value $ 207 $ 193 $ 6,410 --
Amortized cost 172 216 6,343 6.57%
- -----------------------------------------------------------------------------------------------
(a) Maturity is based upon expected average lives rather than contractual
terms.
(b) Weighted average yields are calculated based on amortized cost and exclude
equity securities of $131 million that have no stated yield. Such yields
have been adjusted to a taxable-equivalent basis using the statutory
federal income tax rate of 35%.
(c) Includes primarily marketable equity securities with no stated maturity.
INVESTMENT SECURITIES. Securities issued by states and political subdivisions
account for the majority of Key's investment securities. Figure 19 shows the
composition, yields and remaining maturities of these securities.
FIGURE 19. INVESTMENT SECURITIES
STATES AND WEIGHTED
POLITICAL OTHER AVERAGE
dollars in millions SUBDIVISIONS SECURITIES TOTAL YIELD(a)
- ------------------------------------------------------------------------------------------------------
JUNE 30, 2003
Remaining maturity:
One year or less $ 25 -- $ 25 9.98%
After one through five years 54 $ 4 58 9.02
After five through ten years 15 -- 15 8.17
After ten years 1 -- 1 11.22
- ---------------------------------------------------------------------------------------------------
Amortized cost $ 95 $ 4 $ 99 9.14%
Fair value 103 4 107 --
Weighted average maturity 2.8 YEARS 4.5 YEARS 2.9 YEARS --
- ---------------------------------------------------------------------------------------------------
DECEMBER 31, 2002
Amortized cost $ 120 -- $ 120 9.43%
Fair value 129 -- 129 --
- ---------------------------------------------------------------------------------------------------
JUNE 30, 2002
Amortized cost $ 186 -- $ 186 8.59%
Fair value 196 -- 196 --
- ---------------------------------------------------------------------------------------------------
(a) Weighted average yields are calculated based on amortized cost. Such
yields have been adjusted to a taxable-equivalent basis using the
statutory federal income tax rate of 35%.
56
OTHER INVESTMENTS. Principal investments - investments in equity and mezzanine
instruments made by Key's Principal Investing unit -- are carried at fair value,
which aggregated $717 million at June 30, 2003. Of this amount, $2 million
represents net unrealized gains. Principal investments represent approximately
71% of other investments and include direct and indirect investments
predominately in privately-held companies. Direct investments are those made in
a particular company, while indirect investments are made through funds that
include other investors.
In addition to principal investments, other investments include securities that
do not have readily determinable fair values. These securities include certain
real estate-related investments. Neither these securities nor principal
investments have stated maturities.
ASSET QUALITY
Key has a multi-faceted program to manage asset quality. Our professionals:
- - evaluate and monitor credit quality and risk in credit-related assets;
- - develop commercial and consumer credit policies and systems;
- - monitor compliance with internal underwriting standards;
- - establish credit-related concentration limits; and
- - review the adequacy of the allowance for loan losses.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses at June 30, 2003, was
$1.4 billion, or 2.22% of loans. This compares with $1.5 billion, or 2.41% of
loans, at June 30, 2002. The allowance includes $109 million that was
specifically allocated for impaired loans of $302 million at June 30, 2003,
compared with $144 million that was allocated for impaired loans of $312 million
a year ago. For more information about impaired loans, see Note 8 ("Impaired
Loans and Other Nonperforming Assets") on page 23. At June 30, 2003, the
allowance for loan losses was 167.86% of nonperforming loans, representing the
highest level of nonperforming loan coverage by the allowance since the 2001
year end. This compares with a ratio of 160.82% at June 30, 2002.
Management estimates the appropriate level of the allowance for loan losses on a
quarterly (and at times more frequent) basis. The methodology used is described
in Note 1 ("Summary of Significant Accounting Policies") under the heading
"Allowance for Loan Losses" on page 58 of Key's 2002 Annual Report to
Shareholders. Briefly, management assigns a specific allowance to an impaired
loan when the carrying amount of the loan exceeds the estimated present value of
related future cash flows and the fair value of any existing collateral. The
allowance for loan losses arising from nonimpaired loans is determined by
applying historical loss rates to existing loans with similar risk
characteristics and by exercising judgment to assess the impact of factors such
as changes in economic conditions, credit policies or underwriting standards,
and the level of credit risk associated with specific industries and markets.
The aggregate balance of the allowance for loan losses at June 30, 2003,
represents management's best estimate of the losses inherent in the loan
portfolio at that date.
The allowance specifically allocated for Key's impaired loans decreased by $35
million, or 24%, over the past twelve months, reflecting Key's continued efforts
to resolve problem credits, combined with stabilizing credit quality trends in
certain portfolios. During the same period, the allowance allocated for
nonimpaired loans decreased by $99 million, or 7%, due largely to stabilizing
credit quality trends in certain portfolios.
The level of watch credits in most commercial portfolios decreased from year-ago
levels. Watch credits are loans with the potential for further deterioration in
quality due to the debtor's current financial condition and related ability to
perform in accordance with the terms of the loan. The commercial loan portfolios
with the most significant decreases in watch credits were large corporate and
media. Other portfolios, including middle market, showed more modest
improvement. These changes reflect the fluctuations that occur in loan
portfolios from time to time, underscoring the benefits of Key's strategy to
limit the concentration of credit risk in any single portfolio.
57
NET LOAN CHARGE-OFFS. Net loan charge-offs for the second quarter of 2003
totaled $141 million, or .90% of average loans, representing the lowest level of
net charge-offs since the first quarter of 2001. These results compare with net
charge-offs of $203 million, or 1.27% of average loans, for the same period last
year. The composition of Key's loan charge-offs and recoveries by type of loan
is shown in Figure 20. The decrease in net charge-offs from the year-ago quarter
occurred primarily in the middle market and healthcare segments of the
commercial loan portfolio.
Included in second quarter 2003 net charge-offs are $17 million of losses
charged to the now depleted portion of Key's allowance for loan losses that had
been segregated in connection with management's decision to discontinue many
credit-only relationships in the leveraged financing and nationally syndicated
lending businesses and to facilitate sales of distressed loans in other
portfolios. Considering the progress that has been made in exiting the
commitments related to these two portfolios, management believes that it is no
longer necessary to segregate the run-off portfolio for reporting purposes.
FIGURE 20. SUMMARY OF LOAN LOSS EXPERIENCE
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
----------------------------- ---------------------------
dollars in millions 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------
Average loans outstanding during the period $ 63,029 $ 63,928 $ 62,937 $ 63,709
- ---------------------------------------------------------------------------------------------------------------
Allowance for loan losses at beginning of period $ 1,421 $ 1,607 $ 1,452 $ 1,677
Loans charged off:
Commercial, financial and agricultural 77 114 164 211
Real estate--commercial mortgage 14 13 25 48
Real estate--construction -- 12 4 12
- ---------------------------------------------------------------------------------------------------------------
Total commercial real estate loans(a) 14 25 29 60
Commercial lease financing 19 18 31 38
- ---------------------------------------------------------------------------------------------------------------
Total commercial loans 110 157 224 309
Real estate--residential mortgage 1 2 3 3
Home equity 15 15 29 29
Consumer--direct 13 13 25 27
Consumer--indirect lease financing 4 6 9 13
Consumer--indirect other 36 43 79 88
- ---------------------------------------------------------------------------------------------------------------
Total consumer loans 69 79 145 160
- ---------------------------------------------------------------------------------------------------------------
179 236 369 469
Recoveries:
Commercial, financial and agricultural 10 9 16 19
Real estate -- commercial mortgage 3 2 8 3
Real estate -- construction -- -- 3 --
- ---------------------------------------------------------------------------------------------------------------
Total commercial real estate loans(a) 3 2 11 3
Commercial lease financing 4 3 5 4
- ---------------------------------------------------------------------------------------------------------------
Total commercial loans 17 14 32 26
Real estate--residential mortgage 1 -- 1 1
Home equity 2 2 3 2
Consumer--direct 2 2 4 4
Consumer--indirect lease financing 2 2 3 4
Consumer--indirect other 14 13 24 23
- ---------------------------------------------------------------------------------------------------------------
Total consumer loans 21 19 35 34
- ---------------------------------------------------------------------------------------------------------------
38 33 67 60
- ---------------------------------------------------------------------------------------------------------------
Net loans charged off (141) (203) (302) (409)
Provision for loan losses 125 135 255 271
- ---------------------------------------------------------------------------------------------------------------
Allowance for loan losses at end of period $ 1,405 $ 1,539 $ 1,405 $ 1,539
======== ======== ======== ========
- ---------------------------------------------------------------------------------------------------------------
Net loan charge-offs to average loans .90% 1.27% .97% 1.29%
Allowance for loan losses to period-end loans 2.22 2.41 2.22 2.41
Allowance for loan losses to nonperforming loans 167.86 160.82 167.86 160.82
- ---------------------------------------------------------------------------------------------------------------
(a) See Figure 14 on page 53 and the accompanying discussion on page 52 for
more information related to Key's commercial real estate portfolio.
NONPERFORMING ASSETS. Figure 21 shows the composition of Key's nonperforming
assets, which have declined in each of the past three quarters. These assets
totaled $897 million at June 30, 2003, and represented 1.42% of loans, other
real estate owned (known as "OREO") and other nonperforming assets, compared
with $993 million, or 1.59%, at December 31, 2002, and $995 million, or 1.56%,
at June 30, 2002.
58
FIGURE 21. SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS
JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, JUNE 30,
dollars in millions 2003 2003 2002 2002 2002
- -----------------------------------------------------------------------------------------------------------------------
Commercial, financial and agricultural $ 361 $ 381 $ 448 $ 484 $ 471
Real estate -- commercial mortgage 143 165 157 149 179
Real estate -- construction 22 37 50 79 61
- -----------------------------------------------------------------------------------------------------------------------
Total commercial real estate loans(a) 165 202 207 228 240
Commercial lease financing 92 91 69 88 76
- -----------------------------------------------------------------------------------------------------------------------
Total commercial loans 618 674 724 800 787
Real estate -- residential mortgage 38 39 36 34 34
Home equity 152 154 146 124 107
Consumer--direct 13 13 13 6 6
Consumer--indirect lease financing 4 5 5 6 7
Consumer--indirect other 12 19 19 17 16
- -----------------------------------------------------------------------------------------------------------------------
Total consumer loans 219 230 219 187 170
- -----------------------------------------------------------------------------------------------------------------------
Total nonperforming loans 837 904 943 987 957
OREO 60 62 48 30 40
Allowance for OREO losses (3) (3) (3) (2) (2)
- -----------------------------------------------------------------------------------------------------------------------
OREO, net of allowance 57 59 45 28 38
Other nonperforming assets 3 5 5 2 --
- -----------------------------------------------------------------------------------------------------------------------
Total nonperforming assets $ 897 $ 968 $ 993 $ 1,017 $ 995
======= ======= ======= ======= =======
- -----------------------------------------------------------------------------------------------------------------------
Accruing loans past due 90 days or more $ 172 $ 207 $ 198 $ 208 $ 186
Accruing loans past due 30 through 89 days 731 721 790 787 780
- -----------------------------------------------------------------------------------------------------------------------
Nonperforming loans to period-end loans 1.32% 1.44% 1.51% 1.57% 1.50%
Nonperforming assets to period-end loans
plus OREO and other nonperforming assets 1.42 1.54 1.59 1.61 1.56
- -----------------------------------------------------------------------------------------------------------------------
(a) See Figure 14 on page 53 and the accompanying discussion on page 52 for
more information related to Key's commercial real estate portfolio.
The reduction in nonperforming loans during the second quarter was attributable
largely to decreases in the structured finance and healthcare portfolios.
Structured finance refers to a type of lending characterized by a high degree of
leverage in the borrower's financial condition and a relatively low level of
tangible loan collateral.
The economic slowdown can be expected to continue to impact Key's loan portfolio
in general. At June 30, 2003, two segments of the commercial, financial and
agricultural portfolio (loans to middle market clients and loans underwritten as
structured finance credits) accounted for $255 million and $72 million,
respectively, of Key's nonperforming loans. Although these two segments
comprised only 14% of Key's total loans, they accounted for 39% of total
nonperforming loans.
At June 30, 2003, our 20 largest nonperforming loans totaled $248 million,
representing 30% of total loans on nonperforming status.
Information pertaining to the credit exposure by industry classification
inherent in the largest sector of Key's loan portfolio, commercial, financial
and agricultural loans, is presented in Figure 22. Within the transportation
category, Key had approximately $255 million of exposure to the commercial
passenger airline industry at June 30, 2003. The types of activity that caused
the change in Key's nonperforming loans during the last five quarters are
represented in Figure 23.
59
FIGURE 22. COMMERCIAL, FINANCIAL AND AGRICULTURAL LOANS
NONPERFORMING LOANS
-------------------------
JUNE 30, 2003 TOTAL LOANS % OF LOANS
dollars in millions COMMITMENTS OUTSTANDING AMOUNT OUTSTANDING
- -------------------------------------------------------------------------------------------------
Industry classification:
Manufacturing $ 9,082 $ 3,683 $ 130 3.5%
Services 6,287 2,529 65 2.6
Financial services 5,806 959 2 .2
Retail trade 4,309 808 19 2.4
Property management 3,053 2,875 5 .2
Wholesale trade 2,686 1,248 25 2.0
Public utilities 1,792 499 -- --
Building contractors 1,385 692 39 5.6
Communications 1,340 451 12 2.7
Agriculture/forestry/fishing 1,051 677 23 3.4
Transportation 804 452 19 4.2
Public administration 748 244 -- --
Insurance 886 130 -- --
Mining 407 166 -- --
Individuals 179 121 1 .8
Other 2,025 1,847 21 1.1
- ----------------------------------------------------------------------------------------------
Total $41,840 $17,381 $ 361 2.1%
======= ======= =======
- ----------------------------------------------------------------------------------------------
FIGURE 23. SUMMARY OF CHANGES IN NONPERFORMING LOANS
2003 2002
----------------------- ----------------------------
in millions SECOND FIRST FOURTH THIRD SECOND
- ------------------------------------------------------------------------------------------------------
Balance at beginning of period $ 904 $ 943 $ 987 $ 957 $ 973
Loans placed on nonaccrual status 168 237 339 281 254
Charge-offs (141) (161) (186) (185) (203)
Loans sold (42) (23) (36) (25) (18)
Payments (26) (58) (149) (41) (49)
Transfers to OREO (1) (19) -- -- --
Loans returned to accrual status (25) (15) (13) -- --
Acquisition -- -- 1 -- --
- -----------------------------------------------------------------------------------------------------
Balance at end of period $ 837 $ 904 $ 943 $ 987 $ 957
===== ===== ===== ===== =====
- -----------------------------------------------------------------------------------------------------
60
DEPOSITS AND OTHER SOURCES OF FUNDS
"Core deposits" -- domestic deposits other than certificates of deposit of
$100,000 or more -- are Key's primary source of funding. During the second
quarter of 2003, core deposits averaged $41.3 billion, and represented 56% of
the funds Key used to support earning assets, compared with $37.1 billion and
51% during the same quarter in 2002. The composition of Key's deposits is shown
in Figure 7, which spans pages 44 and 45.
The increase in the level of Key's core deposits over the past twelve months was
due primarily to higher levels of NOW and money market deposit accounts as well
as noninterest-bearing deposits. The growth of these deposits reflected client
preferences for investments that provide high levels of liquidity in a low
interest rate environment. Also contributing to the significant growth in
noninterest-bearing deposits were our intensified cross-selling efforts and the
introduction of new products, including free checking. A more aggressive pricing
structure implemented in mid 2002 supported the growth in savings deposits.
During the same period, time deposits decreased by 13% in part because, like our
competitors, Key reduced the rates paid for them, as the Federal Reserve Board
reduced interest rates in general.
Purchased funds, comprising large certificates of deposit, deposits in the
foreign branch and short-term borrowings, averaged $14.6 billion during the
second quarter of 2003, compared with $16.0 billion during the year-ago quarter.
Each of these funding sources has declined over the past twelve months. This is
attributable in part to reduced funding needs resulting from core deposit
growth, loan sales, slow demand for loans and our decision to scale back or
discontinue certain types of lending.
Key continues to consider loan sales and securitizations as funding alternatives
when market conditions are favorable.
LIQUIDITY
"Liquidity" measures whether an entity has sufficient cash flow to meet its
financial obligations when due. Key has sufficient liquidity when it can meet
its obligations to depositors, borrowers and creditors at a reasonable cost, on
a timely basis, and without adverse consequences. KeyCorp has sufficient
liquidity when it can pay dividends to shareholders, service its debt, and
support customary corporate operations and activities, including acquisitions,
at a reasonable cost, in a timely manner and without adverse consequences.
LIQUIDITY RISK. There are both direct and indirect circumstances that could
adversely affect Key's liquidity or materially affect the cost of funds. For
example, events unrelated to Key, such as terrorism or war, natural disasters,
political events, or the default or bankruptcy of a major corporation, mutual
fund or hedge fund can have market-wide consequences. An example of a direct
(but hypothetical) event would be a significant downgrade in Key's public credit
rating by a rating agency due to a deterioration in asset quality, a large
charge to earnings, a significant merger or acquisition or other events.
Similarly, market speculation or rumors about Key or the banking industry in
general may cause normal funding sources to withdraw credit until further
information becomes available.
LIQUIDITY FOR KEY. Key's Funding and Investment Management Group monitors the
overall mix of funding sources with the objective of maintaining an appropriate
mix in light of the structure of the asset portfolios. We use several tools to
maintain sufficient liquidity.
- - We maintain portfolios of short-term money market investments and
securities available for sale, substantially all of which could be
converted to cash quickly at a small expense.
- - Key's portfolio of investment securities generates prepayments (often
at a premium) and payments at maturity.
- - We try to structure the maturities of our loans so we receive a
relatively consistent stream of payments from borrowers.
61
- - We have the ability to access the securitization markets for a variety
of loan types.
- - Our 903 full-service KeyCenters in 12 states generate a sizable volume
of core deposits. We monitor deposit flows and use alternative pricing
structures to attract deposits when necessary. For more information
about core deposits, see the previous section entitled "Deposits and
other sources of funds."
- - Key has access to various sources of money market funding (such as
federal funds purchased, securities sold under repurchase agreements,
and bank notes) and also can borrow from the Federal Reserve Bank to
meet short-term liquidity requirements. Key did not have any borrowings
from the Federal Reserve Bank outstanding at June 30, 2003.
The Consolidated Statements of Cash Flow on page 6 summarize Key's sources and
uses of cash by type of activity for the six-month periods ended June 30, 2003
and 2002. As shown in these statements, Key's largest cash flows relate to both
investing and financing activities. Over the past two years, the primary sources
of cash from investing activities have been loan securitizations and sales and
the sales, prepayments and maturities of securities available for sale.
Investing activities that have required the greatest use of cash include lending
and the purchases of new securities.
Over the past two years, the primary source of cash from financing activities
has been the issuance of long-term debt. However, in 2002, deposits were also a
significant source of cash. In each of the past two years, major outlays of cash
have been made to repay debt issued in prior periods. During 2002, cash was also
used to reduce the level of short-term borrowings.
LIQUIDITY FOR KEYCORP. KeyCorp meets its liquidity requirements principally
through regular dividends from affiliate banks. Federal banking law limits the
amount of capital distributions that banks can make to their holding companies
without obtaining prior regulatory approval. A national bank's dividend paying
capacity is affected by several factors, including the amount of its net profits
(as defined by statute) for the two previous calendar years, and net profits for
the current year up to the date of dividend declaration. Due to this constraint,
and the restructuring charges taken by KBNA and Key Bank USA in 2001, as of
January 1, 2003, neither bank could pay dividends or make other capital
distributions to KeyCorp without prior regulatory approval.
In February 2003, KBNA obtained regulatory approval to make capital
distributions to KeyCorp of up to $365 million in the aggregate in the first and
second quarters. As of June 30, 2003, the entire amount had been distributed.
Key Bank USA restored its dividend paying capacity during the first quarter and
KBNA restored its dividend paying capacity during the second quarter. As of June
30, 2003, the affiliate banks had an additional $86 million available to pay
dividends to KeyCorp without prior regulatory approval.
At June 30, 2003, KeyCorp had approximately $914 million of cash or short-term
investments available to pay dividends on its common shares, to service its debt
and to finance its corporate operations.
ADDITIONAL SOURCES OF LIQUIDITY. Management has implemented several programs
that enable Key and KeyCorp to raise money in the public and private markets
when necessary. The proceeds from all of these programs can be used for general
corporate purposes, including acquisitions. Each of the programs is replaced or
extended from time to time as needed.
BANK NOTE PROGRAM. During the first half of 2003, Key's affiliate banks raised
$1.4 billion under Key's bank note program. Of the notes issued during the year,
$975 million have original maturities in excess of one year and are included in
long-term debt. The remaining notes have original maturities of one year or less
and are included in short-term borrowings. Key's current bank note program
provides for the issuance of both long- and short-term debt of up to $20.0
billion ($19.0 billion by KBNA and $1.0 billion by Key Bank USA). At June 30,
2003, $16.8 billion was available for future issuance under this program.
EURO NOTE PROGRAM. Under Key's euro note program, KeyCorp, KBNA and Key Bank USA
may issue both long- and short-term debt of up to $10.0 billion in the
aggregate. The notes are offered exclusively to non-U.S. investors and can be
denominated in U.S. dollars and many foreign currencies. There were $197
62
million of borrowings issued under this program during the first half of 2003.
At June 30, 2003, $4.0 billion was available for future issuance.
KEYCORP MEDIUM-TERM NOTE PROGRAM AND OTHER SECURITIES. KeyCorp may issue, under
a registration statement filed with the Securities and Exchange Commission, up
to $2.2 billion of securities, which could include long- or short-term debt, or
equity securities. Of the amount registered, $1.0 billion has been allocated for
the issuance of medium-term notes. At June 30, 2003, unused capacity under
KeyCorp's universal shelf registration statement totaled $1.5 billion, including
$275 million allocated for the issuance of medium-term notes.
COMMERCIAL PAPER AND REVOLVING CREDIT. KeyCorp has a commercial paper program
and a revolving credit agreement with an unaffiliated financial institution that
provide funding availability of up to $500 million and $400 million,
respectively. As of June 30, 2003, there were no borrowings outstanding under
either the commercial paper program or the revolving credit agreement.
Key also has a commercial paper program with unaffiliated Canadian financial
institutions that provides funding availability of up to $1.0 billion in
Canadian currency or the equivalent in U.S. currency. As of June 30, 2003,
borrowings outstanding under this commercial paper program totaled $789 million
in Canadian currency and $26 million in U.S. currency (equivalent to $35 million
in Canadian currency).
Key has favorable debt ratings as shown in Figure 24 below. As long as those
debt ratings are maintained, management believes that, under normal conditions
in the capital markets, future offerings of securities by KeyCorp or its
affiliate banks would be marketable to investors at a competitive cost.
FIGURE 24. DEBT RATINGS
SENIOR SUBORDINATED
SHORT-TERM LONG-TERM LONG-TERM CAPITAL
JUNE 30, 2003 BORROWINGS DEBT DEBT SECURITIES
- ------------------------------------------------------------------------------------------------------------------------------
KEYCORP
Standard & Poor's A-2 A- BBB+ BBB
Moody's P-1 A2 A3 Baa1
Fitch F1 A A- A
KBNA
Standard & Poor's A-1 A A- N/A
Moody's P-1 A1 A2 N/A
Fitch F1 A A- N/A
KEY NOVA SCOTIA FUNDING COMPANY ("KNSF")
Dominion Bond Rating Service(a) R-1 (middle) N/A N/A N/A
- ------------------------------------------------------------------------------------------------------------------------------
(a) Reflects the guarantee by KBNA of KNSF's issuance of Canadian commercial
paper.
N/A = Not Applicable
CAPITAL
SHAREHOLDERS' EQUITY. Total shareholders' equity at June 30, 2003, was $7.0
billion, up $154 million from the balance at December 31, 2002. Growth in
retained earnings, net unrealized gains on derivative financial instruments and
the issuance of common shares out of the treasury stock account in connection
with employee stock purchase, 401(k), dividend reinvestment and stock option
programs contributed to the increase. Other factors contributing to the change
in shareholders' equity during the first half of 2003 are shown in the
Consolidated Statements of Changes in Shareholders' Equity presented on page 5.
SHARE REPURCHASES. In September 2000, the Board of Directors authorized the
repurchase of up to 25,000,000 common shares, including 3,647,200 shares
remaining at the time from an earlier repurchase program. These shares may be
repurchased in the open market or through negotiated transactions. During
63
the first half of 2003, Key repurchased a total of 5,000,000 of its common
shares at an average price per share of $24.70. At June 30, 2003, a remaining
balance of 8,764,670 shares may be repurchased under the September 2000
authorization.
At June 30, 2003, Key had 70,815,244 treasury shares. Management may reissue
those shares over time to support the employee stock purchase, 401(k), stock
option, deferred compensation and dividend reinvestment plans, and for other
corporate purposes. During the first half of 2003, Key reissued 2,150,646
treasury shares for employee benefit and dividend reinvestment plans.
CAPITAL ADEQUACY. Capital adequacy is an important indicator of financial
stability and performance. Overall, Key's capital position remains strong: the
ratio of total shareholders' equity to total assets was 8.18% at June 30, 2003,
and 7.96% at June 30, 2002.
Banking industry regulators prescribe minimum capital ratios for bank holding
companies and their banking subsidiaries. Note 14 ("Shareholders' Equity"),
which begins on page 76 of Key's 2002 Annual Report to Shareholders, explains
the implications of failing to meet specific capital requirements imposed by the
banking regulators. Risk-based capital guidelines require a minimum level of
capital as a percent of "risk-weighted assets," which is total assets plus
certain off-balance sheet items, both adjusted for predefined credit risk
factors. Currently, banks and bank holding companies must maintain, at a
minimum, Tier 1 capital as a percent of risk-weighted assets of 4.00%, and total
capital as a percent of risk-weighted assets of 8.00%. As of June 30, 2003,
Key's Tier 1 capital ratio was 8.02%, and its total capital ratio was 12.26%.
Another indicator of capital adequacy, the leverage ratio, is defined as Tier 1
capital as a percentage of average quarterly tangible assets. Leverage ratio
requirements vary with the condition of the financial institution. Bank holding
companies that either have the highest supervisory rating or have implemented
the Federal Reserve's risk-adjusted measure for market risk--as KeyCorp
has--must maintain a minimum leverage ratio of 3.00%. All other bank holding
companies must maintain a minimum ratio of 4.00%. As of June 30, 2003, Key had a
leverage ratio of 8.12%.
Federal bank regulators group FDIC-insured depository institutions into five
categories, ranging from "critically undercapitalized" to "well capitalized."
Both of Key's affiliate banks qualified as "well capitalized" at June 30, 2003,
since each exceeded the prescribed thresholds of 10.00% for total capital, 6.00%
for Tier 1 capital and 5.00% for the leverage ratio. If these provisions applied
to bank holding companies, Key would also qualify as "well capitalized" at June
30, 2003. The FDIC-defined capital categories serve a limited supervisory
function. Investors should not treat them as a representation of the overall
financial condition or prospects of Key or its affiliate banks.
Figure 25 presents the details of Key's regulatory capital position at June 30,
2003, December 31, 2002 and June 30, 2002.
64
FIGURE 25. CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS
JUNE 30, DECEMBER 31, JUNE 30,
dollars in millions 2003 2002 2002
- ----------------------------------------------------------------------------------------
TIER 1 CAPITAL
Common shareholders' equity(a) $ 6,885 $ 6,738 $ 6,527
Qualifying capital securities 1,076 1,096 1,156
Less: Goodwill 1,142 1,142 1,105
Other assets(b) 62 60 49
- ----------------------------------------------------------------------------------------
Total Tier 1 capital 6,757 6,632 6,529
- ----------------------------------------------------------------------------------------
TIER 2 CAPITAL
Allowable portion of allowance for loan losses 1,077 986 987
Qualifying long-term debt 2,491 2,639 2,233
- ----------------------------------------------------------------------------------------
Total Tier 2 capital 3,568 3,625 3,220
- ----------------------------------------------------------------------------------------
Total risk-based capital $ 10,325 $ 10,257 $ 9,749
========= ========= =========
RISK-WEIGHTED ASSETS
Risk-weighted assets on balance sheet $ 67,752 $ 67,051 $ 68,273
Risk-weighted off-balance sheet exposure 18,031 16,595 12,611
Less: Goodwill 1,142 1,142 1,105
Other assets(b) 327 251 248
Plus: Market risk-equivalent assets 223 192 312
- ----------------------------------------------------------------------------------------
Gross risk-weighted assets 84,537 82,445 79,843
Less: Excess allowance for loan losses 328 466 552
- ----------------------------------------------------------------------------------------
Net risk-weighted assets $ 84,209 $ 81,979 $ 79,291
========= ========= =========
AVERAGE QUARTERLY TOTAL ASSETS $ 84,712 $ 82,735 $ 81,560
========= ========= =========
CAPITAL RATIOS
Tier 1 risk-based capital ratio 8.02% 8.09% 8.23%
Total risk-based capital ratio 12.26 12.51 12.29
Leverage ratio(c) 8.12 8.15 8.14
- ----------------------------------------------------------------------------------------
(a) Common shareholders' equity does not include net unrealized gains or losses
on securities (except for net unrealized losses on marketable equity
securities) nor net gains or losses on cash flow hedges.
(b) "Other assets" deducted from Tier 1 capital consists of intangible assets
(excluding goodwill) recorded after February 19, 1992, deductible portions
of purchased mortgage servicing rights and deductible portions of
nonfinancial equity investments.
"Other assets" deducted from risk-weighted assets consists of intangible
assets (excluding goodwill) recorded after February 19, 1992, deductible
portions of purchased mortgage servicing rights and nonfinancial equity
investments.
(c) This ratio is Tier 1 capital divided by average quarterly total assets less
goodwill and the nonqualifying intangible assets described in footnote (b).
65
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
The information presented in the Market Risk Management section of the
Management's Discussion and Analysis of Financial Condition and Results of
Operations, which begins on page 32, is incorporated herein by reference.
ITEM 4. CONTROLS AND PROCEDURES
As a bank holding company, KeyCorp is subject to the internal control reporting
requirements of the Federal Deposit Insurance Corporation Improvement Act, which
became effective in 1993 ("FDICIA"). FDICIA requirements include an annual
assessment by our Chief Executive Officer and Chief Financial Officer of the
effectiveness of our internal controls over financial reporting, which generally
includes those controls relating to the preparation of our financial statements
in conformity with accounting principles generally accepted in the United
States. In addition, under FDICIA, our independent auditors have annually
examined and attested to, without qualification, management's assertions
regarding the effectiveness of our internal controls. Accordingly, we have had
an established process of maintaining and evaluating our internal controls over
financial reporting.
In connection with recent legislation and regulations, our management has also
focused its attention on our "disclosure controls and procedures," which, as
defined by the SEC, are generally those controls and procedures designed to
ensure that financial and nonfinancial information required to be disclosed in
KeyCorp's reports filed with the SEC is recorded, processed, summarized and
reported within the time periods specified in the SEC's rules and forms and that
such information is accumulated and communicated to KeyCorp's management,
including our Chief Executive Officer and Chief Financial Officer, as
appropriate, to allow timely decisions regarding required disclosure. In light
of the requirements imposed by the recently adopted SEC regulations, we engaged
in a process of reviewing our disclosure controls and procedures. As a result of
our review, and although we believe that our pre-existing disclosure controls
and procedures were effective in enabling us to comply with our disclosure
obligations, we implemented enhancements, which included establishing a
disclosure committee and generally formalizing and documenting disclosure
controls and procedures that we already had in place.
During the quarterly period covered by this report, KeyCorp carried out an
evaluation, under the supervision and with the participation of KeyCorp's
management, including our Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of KeyCorp's disclosure
controls and procedures. Based upon that evaluation, KeyCorp's Chief Executive
Officer and Chief Financial Officer concluded that the design and operation of
these disclosure controls and procedures were effective, in all material
respects, as of the end of the period covered by this report.
In conjunction with its normal on-going risk management and risk review process,
and consistent with the requirements of recently adopted SEC regulations,
management has undertaken a further comprehensive evaluation of its internal
control over financial reporting that may result in additional future
refinements to our existing internal control over financial reporting framework.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information presented in Note 10 ("Contingent Liabilities and Guarantees"),
which begins on page 25 of the Notes to Consolidated Financial Statements, is
incorporated herein by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the 2003 Annual Meeting of Shareholders of KeyCorp held on May 22, 2003, five
directors were elected for three-year terms expiring in 2006, and shareholders
adopted resolutions to approve the KeyCorp Amended and Restated Discounted Stock
Purchase Plan, to approve the KeyCorp Deferred Equity Allocation Plan, and to
approve the KeyCorp Directors' Deferred Share Plan, and to ratify the
appointment
66
by the Audit Committee of the Board of Directors of Ernst & Young LLP as
independent auditors for KeyCorp for the fiscal year ending December 31, 2003.
Director nominees for terms expiring in 2006 were: William G. Bares, Dr. Carol
A. Cartwright, Henry S. Hemingway, Steven A. Minter, and Thomas C. Stevens.
Directors whose term in office as a director continued after the Annual Meeting
of Shareholders were: Cecil D. Andrus, Edward P. Campbell, Alexander M. Cutler,
Charles R. Hogan, Dr. Shirley A. Jackson, Douglas J. McGregor, Eduardo R.
Menasce, Henry L. Meyer III, Bill R. Sanford, Dennis W. Sullivan, and Peter G.
Ten Eyck, II.
The vote on each issue was as follows:
For Against Abstain
---------------------------------------
Election of Directors
William G. Bares 356,995,210 * 11,868,726
Dr. Carol A. Cartwright 356,562,057 * 12,301,878
Henry S. Hemingway 356,572,407 * 12,291,527
Steven A. Minter 356,352,942 * 12,510,993
Thomas C. Stevens 357,134,371 * 11,729,564
Approval of the KeyCorp Amended 344,259,226 19,921,227 4,683,481
and Restated Discounted Stock
Purchase Plan
Approval of the KeyCorp Deferred 320,216,837 43,114,699 5,532,398
Equity Allocation Plan
Approval of the KeyCorp Directors' 314,910,264 47,891,386 6,062,283
Deferred Share Plan
Ratification of Ernst & Young 274,019,655 91,398,687 3,445,593
as independent auditors of
KeyCorp
* Proxies provide that shareholders may either cast a vote for, or abstain from
voting for, directors.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
15 Acknowledgment Letter of Independent Auditors.
31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
(b) REPORTS ON FORM 8-K
April 17, 2003 - Item 7. Financial Statements and Exhibits and Item 9.
Regulation FD Disclosure and Information Furnished under Item 12
(Disclosure of Results of Operations and Financial Condition).
Reporting that on April 17, 2003, the Registrant issued a press release
announcing its
67
earnings results for the three-month period ended March 31, 2003, and
providing a slide presentation reviewed in the related conference
call/webcast.
No other reports on Form 8-K were filed during the three-month period
ended June 30, 2003.
INFORMATION AVAILABLE ON WEBSITE
KeyCorp makes available free of charge on its website, WWW.KEY.COM, its annual
report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K
and amendments to these reports as soon as reasonably practicable after KeyCorp
electronically files such material with, or furnishes it to, the SEC.
68
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
KEYCORP
--------------------------------
(Registrant)
Date: August 11, 2003 /s/ Lee Irving
--------------------------------
By: Lee Irving
Executive Vice President
and Chief Accounting Officer
69