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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 September 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]
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(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
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(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 419,143,413 Shares
- ----------------------------------------- ---------------------------------
(Title of class) (Outstanding at October 31, 2003)
KEYCORP
TABLE OF CONTENTS
Page Number
-----------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets --
September 30, 2003, December 31, 2002 and September 30, 2002 3
Consolidated Statements of Income --
Three and nine months ended September 30, 2003 and 2002 4
Consolidated Statements of Changes in Shareholders' Equity --
Nine months ended September 30, 2003 and 2002 5
Consolidated Statements of Cash Flow --
Nine months ended September 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 6. Exhibits and Reports on Form 8-K 67
Signature 68
Exhibits 69
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30,
dollars in millions 2003 2002 2002
- ----------------------------------------------------------------------------------------------------------------------------------
(UNAUDITED) (UNAUDITED)
ASSETS
Cash and due from banks $ 2,398 $ 3,364 $ 3,039
Short-term investments 1,776 1,632 1,190
Securities available for sale 7,550 8,507 7,409
Investment securities (fair value: $113, $129 and $158) 106 120 148
Other investments 1,103 919 848
Loans, net of unearned income of $1,928, $1,776 and $1,808 62,723 62,457 62,951
Less: Allowance for loan losses 1,405 1,452 1,489
- ---------------------------------------------------------------------------------------------------------------------------------
Net loans 61,318 61,005 61,462
Premises and equipment 614 644 651
Goodwill 1,154 1,142 1,105
Other intangible assets 41 35 23
Corporate-owned life insurance 2,483 2,414 2,384
Accrued income and other assets 5,917 5,420 5,257
- ---------------------------------------------------------------------------------------------------------------------------------
Total assets $ 84,460 $ 85,202 $ 83,516
======== ======== ========
LIABILITIES
Deposits in domestic offices:
NOW and money market deposit accounts $ 18,389 $ 16,249 $ 14,094
Savings deposits 2,079 2,029 1,987
Certificates of deposit ($100,000 or more) 4,887 4,749 4,807
Other time deposits 11,034 11,946 12,413
- ---------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing 36,389 34,973 33,301
Noninterest-bearing 10,947 10,630 10,063
Deposits in foreign office-- interest-bearing 1,403 3,743 1,246
- ---------------------------------------------------------------------------------------------------------------------------------
Total deposits 48,739 49,346 44,610
Federal funds purchased and securities sold under repurchase agreements 4,804 3,862 6,350
Bank notes and other short-term borrowings 2,707 2,823 2,908
Accrued expense and other liabilities 5,891 5,471 5,438
Long-term debt 15,342 15,605 16,276
Corporation-obligated mandatorily redeemable preferred capital securities of
subsidiary trusts holding solely subordinated debentures of KeyCorp (See Note 9) -- 1,260 1,282
- ---------------------------------------------------------------------------------------------------------------------------------
Total liabilities 77,483 78,367 76,864
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 1,454 1,449 1,382
Retained earnings 6,732 6,448 6,330
Treasury stock, at cost (72,622,333, 67,945,135 and 67,024,459 shares) (1,718) (1,593) (1,569)
Accumulated other comprehensive income 17 39 17
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Total shareholders' equity 6,977 6,835 6,652
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Total liabilities and shareholders' equity $ 84,460 $ 85,202 $ 83,516
======== ======== ========
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See Notes to Consolidated Financial Statements (Unaudited).
3
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- --------------------
dollars in millions, except per share amounts 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ 880 $ 983 $ 2,694 $ 2,957
Tax-exempt investment securities 2 2 5 8
Securities available for sale 77 97 274 282
Short-term investments 6 7 22 23
Other investments 6 6 19 19
- -------------------------------------------------------------------------------------------------------------------------------
Total interest income 971 1,095 3,014 3,289
INTEREST EXPENSE
Deposits 168 214 539 695
Federal funds purchased and securities sold under repurchase agreements 12 23 41 70
Bank notes and other short-term borrowings 13 18 46 65
Long-term debt, including capital securities 101 140 334 422
- -------------------------------------------------------------------------------------------------------------------------------
Total interest expense 294 395 960 1,252
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NET INTEREST INCOME 677 700 2,054 2,037
Provision for loan losses 123 135 378 406
- -------------------------------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses 554 565 1,676 1,631
NONINTEREST INCOME
Trust and investment services income 139 151 402 467
Service charges on deposit accounts 93 102 276 306
Investment banking and capital markets income 52 34 139 130
Letter of credit and loan fees 42 36 113 93
Corporate-owned life insurance income 27 25 81 77
Electronic banking fees 20 21 61 59
Net securities gains 2 -- 9 1
Other income 88 63 213 190
- -------------------------------------------------------------------------------------------------------------------------------
Total noninterest income 463 432 1,294 1,323
NONINTEREST EXPENSE
Personnel 380 358 1,114 1,082
Net occupancy 56 57 171 170
Computer processing 43 45 131 147
Equipment 35 33 101 103
Marketing 30 33 88 89
Professional fees 30 21 87 63
Other expense 125 112 352 331
- -------------------------------------------------------------------------------------------------------------------------------
Total noninterest expense 699 659 2,044 1,985
INCOME BEFORE INCOME TAXES 318 338 926 969
Income taxes 91 93 257 238
- -------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 227 $ 245 $ 669 $ 731
======== ======== ======== ========
Per common share:
Net income $ .54 $ .57 $ 1.58 $ 1.72
Net income -- assuming dilution .53 .57 1.57 1.69
Weighted average common shares outstanding (000) 421,971 426,274 423,697 425,746
Weighted average common shares and potential common
shares outstanding (000) 425,669 431,326 426,968 431,098
- -------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
COMMON SHARES COMMON CAPITAL RETAINED
dollars in millions, except per share amounts OUTSTANDING (000) SHARES SURPLUS EARNINGS
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2001 424,005 $ 492 $ 1,390 $ 5,856
Net income 731
Other comprehensive income (losses):
Net unrealized gains on securities available
for sale, net of income taxes of $10(a)
Net unrealized losses on derivative financial instruments,
net of income taxes of ($7)
Foreign currency translation adjustments
Total comprehensive income
Cash dividends declared on common shares ($.60 per share) (257)
Issuance of common shares under employee benefit
and dividend reinvestment plans 2,639 (8)
Repurchase of common shares (1,780)
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE AT SEPTEMBER 30, 2002 424,864 $ 492 $ 1,382 $ 6,330
======= ====== ======= ========
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2002 423,944 $ 492 $ 1,449 $ 6,448
Net income 669
Other comprehensive income (losses):
Net unrealized losses on securities available
for sale, net of income taxes of ($35)(a)
Net unrealized gains on derivative financial instruments,
net of income taxes of $10
Foreign currency translation adjustments
Total comprehensive income
Deferred compensation obligation 8
Cash dividends declared on common shares ($.915 per share) (385)
Issuance of common shares under employee benefit
and dividend reinvestment plans 2,822 (3)
Repurchase of common shares (7,500)
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE AT SEPTEMBER 30, 2003 419,266 $ 492 $ 1,454 $ 6,732
======= ====== ======= ========
- -------------------------------------------------------------------------------------------------------------------------------
ACCUMULATED
TREASURY OTHER
STOCK, COMPREHENSIVE COMPREHENSIVE
dollars in millions, except per share amounts AT COST INCOME (LOSS) INCOME(b)
- ---------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2001 $ (1,585) $ 2
Net income $ 731
Other comprehensive income (losses):
Net unrealized gains on securities available
for sale, net of income taxes of $10(a) 15 15
Net unrealized losses on derivative financial instruments,
net of income taxes of ($7) (10) (10)
Foreign currency translation adjustments 10 10
-----
Total comprehensive income $ 746
=====
Cash dividends declared on common shares ($.60 per share)
Issuance of common shares under employee benefit
and dividend reinvestment plans 62
Repurchase of common shares (46)
- -----------------------------------------------------------------------------------------------------
BALANCE AT SEPTEMBER 30, 2002 $ (1,569) $ 17
======== =========
- -----------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2002 $ (1,593) $ 39
Net income $ 669
Other comprehensive income (losses):
Net unrealized losses on securities available
for sale, net of income taxes of ($35)(a) (56) (56)
Net unrealized gains on derivative financial instruments,
net of income taxes of $10 15 15
Foreign currency translation adjustments 19 19
-----
Total comprehensive income $ 647
=====
Deferred compensation obligation
Cash dividends declared on common shares ($.915 per share)
Issuance of common shares under employee benefit
and dividend reinvestment plans 66
Repurchase of common shares (191)
- -----------------------------------------------------------------------------------------------------
BALANCE AT SEPTEMBER 30, 2003 $ (1,718) $ 17
======== =========
- -----------------------------------------------------------------------------------------------------
(a) Net of reclassification adjustments.
(b) For the three months ended September 30, 2003 and 2002, comprehensive income
was $165 million and $230 million, respectively.
See Notes to Consolidated Financial Statements (Unaudited).
5
CONSOLIDATED STATEMENTS OF CASH FLOW(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
in millions 2003 2002
- -------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $ 669 $ 731
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses 378 406
Depreciation expense and software amortization 148 169
Amortization of intangibles 10 8
Net securities gains (9) (1)
Net (gains) losses from principal investing (32) 1
Net gains from loan securitizations and sales (68) (34)
Deferred income taxes 13 64
Net (increase) decrease in mortgage loans held for sale (19) 10
Net increase in trading account assets (241) (153)
Net decrease in accrued restructuring charges (8) (27)
Other operating activities, net (95) (214)
- -------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 746 960
INVESTING ACTIVITIES
Cash used in acquisitions, net of cash acquired (17) (15)
Net decrease in other short-term investments 97 861
Purchases of securities available for sale (5,547) (4,965)
Proceeds from sales of securities available for sale 3,271 1,004
Proceeds from prepayments and maturities of securities available for sale 2,962 1,928
Purchases of investment securities (19) (18)
Proceeds from prepayments and maturities of investment securities 45 72
Purchases of other investments (254) (67)
Proceeds from sales of other investments 64 37
Proceeds from prepayments and maturities of other investments 122 29
Net increase in loans, excluding acquisitions, sales and divestitures (3,859) (2,448)
Purchases of loans (453) --
Proceeds from loan securitizations and sales 3,716 2,224
Purchases of premises and equipment (73) (68)
Proceeds from sales of premises and equipment 11 8
Proceeds from sales of other real estate owned 47 32
- -------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 113 (1,386)
FINANCING ACTIVITIES
Net decrease in deposits (599) (229)
Net increase (decrease) in short-term borrowings 826 (26)
Net proceeds from issuance of long-term debt, including capital securities 2,723 4,467
Payments on long-term debt, including capital securities (4,236) (3,241)
Purchases of treasury shares (191) (46)
Net proceeds from issuance of common stock 37 32
Cash dividends paid (385) (383)
- -------------------------------------------------------------------------------------------------------------------
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES (1,825) 574
- -------------------------------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS (966) 148
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,364 2,891
- -------------------------------------------------------------------------------------------------------------------
CASH AND DUE FROM BANKS AT END OF PERIOD $ 2,398 $ 3,039
========= ========
- -------------------------------------------------------------------------------------------------------------------
Additional disclosures relative to cash flow:
Interest paid $ 989 $ 1,199
Income taxes paid 186 131
Noncash items:
Transfer of investment securities to other investments -- $ 848
Transfer of investment securities to securities available for sale -- 60
Net transfer of loans to other real estate owned $ 75 27
- -------------------------------------------------------------------------------------------------------------------
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,
"Consolidation of Variable Interest Entities," in January 2003. This accounting
guidance significantly changes how companies determine whether they must
consolidate an entity depending on whether the entity is a voting rights entity
or a variable interest entity ("VIE"). Interpretation No. 46 was effective
immediately for entities created after January 31, 2003, and was effective
originally for previously existing entities in the first interim or annual
period beginning after June 15, 2003. In October 2003, the FASB issued final
guidance that deferred the effective date of Interpretation No. 46 for entities
created before February 1, 2003, to no later than the first interim or annual
period ending after December 15, 2003. As permitted, Key elected to early-adopt
Interpretation No. 46 for such entities effective July 1, 2003. The "Accounting
Pronouncements Adopted in 2003" section of this note, which begins on page 9,
and Note 7 ("Variable Interest Entities"), which begins on page 20, provide
further information on Interpretation No. 46.
In accordance with the new guidance, Key considers a voting rights entity to be
a subsidiary and consolidates it if Key has a controlling financial interest in
the entity. VIEs are consolidated by Key if it is exposed to the majority of the
VIE's expected losses and/or residual returns (i.e., Key is considered to be the
primary beneficiary). Variable interests include equity interests, subordinated
debt, derivative contracts, leases, service agreements, guarantees, standby
letters of credit, loan commitments and other instruments.
Unconsolidated investments in voting rights entities or VIEs 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 using the equity
method. Unconsolidated investments in voting rights entities or VIEs 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 (primarily principal investments) are carried at estimated fair
value.
Prior to the adoption of Interpretation No. 46, KeyCorp generally determined
whether consolidation of an entity was appropriate 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 controlled, generally through majority ownership,
were consolidated and were considered subsidiaries.
Qualifying special purpose entities, including securitization trusts,
established by Key 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. 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.
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 outlined in Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees." This method requires that
compensation expense be recognized to the extent that the fair value of the
stock exceeds 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
pertaining to options issued during the three- and nine-month periods ended
September 30, 2003 and 2002, are shown in the following table.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ------------------------
2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------
Average option life 5.0 YEARS 5.0 years 5.0 YEARS 5.0 years
Future dividend yield 4.76 % 4.87 % 4.76 % 4.86 %
Share price volatility .280 .276 .280 .276
Weighted average risk-free interest rate 2.9 % 2.5 % 2.9 % 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
nine-month periods ended September 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- -------------------
in millions, except per share amounts 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------------
Net income, as reported $ 227 $ 245 $ 669 $ 731
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects 5 1 9 3
Deduct: Total stock-based employee compensation expense determined under
fair value-based method for all awards, net of related tax effects 8 7 18 20
- ----------------------------------------------------------------------------------------------------------------------------------
Net income - pro forma $ 224 $ 239 $ 660 $ 714
======= ======= ======= ======
Per common share:
Net income $ .54 $ .57 $ 1.58 $ 1.72
Net income - pro forma .53 .56 1.56 1.68
Net income assuming dilution .53 .57 1.57 1.69
Net income assuming dilution - pro forma .53 .55 1.55 1.66
- ----------------------------------------------------------------------------------------------------------------------------------
8
ACCOUNTING PRONOUNCEMENTS ADOPTED IN 2003
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 classifies and measures
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
was effective for financial instruments entered into or modified after May 31,
2003, and otherwise became effective for Key on July 1, 2003. In November 2003,
the FASB indefinitely deferred the effective date of the measurement and
recognition provisions of SFAS No. 150 for mandatorily redeemable noncontrolling
interests associated with finite-lived subsidiaries. Additional information on
this deferral is summarized in Note 7 under the heading "Low-Income Housing Tax
Credit ("LIHTC") guaranteed funds." The application of SFAS No. 150 to all other
financial instruments did not 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 generally
became effective for contracts entered into or modified after June 30, 2003, and
for hedging relationships designated after June 30, 2003. The adoption of this
accounting guidance did not have any material effect on Key's financial
condition or results of operations.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES. As disclosed previously on page 7
of this note, in January 2003, the FASB issued Interpretation No. 46,
"Consolidation of Variable Interest Entities," which significantly changes how
Key and other companies determine whether they must consolidate an entity.
Key's July 1, 2003, adoption of the new guidance primarily affected Key's
balance sheet; consolidating previously unconsolidated VIEs increased, and in
some cases changed the classification of, assets and liabilities. As of
September 30, 2003, the adoption of Interpretation No. 46 resulted in an $847
million increase to Key's assets, with no material effect on Key's results of
operations. While the consolidation of previously unconsolidated entities or the
de-consolidation of previously consolidated entities under Interpretation No. 46
represents an accounting change, it does not affect Key's legal rights or
obligations to these entities. Interpretation No. 46 also requires additional
disclosures by primary beneficiaries and other significant variable interest
holders. See Note 7 for more detailed information pertaining to Key's adoption
of Interpretation No. 46 and its involvement with VIEs. Additional information
pertaining to VIEs is summarized in Note 10 ("Contingent Liabilities and
Guarantees"), which begins on page 25.
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
9
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" on page 26. The adoption of
Interpretation No. 45 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.
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.
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.
10
2. EARNINGS PER COMMON SHARE
Key calculates its basic and diluted earnings per common share as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-----------------------------------------
dollars in millions, except per share amounts 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------
NET INCOME $ 227 $ 245 $ 669 $ 731
======== ======== ======== ========
- --------------------------------------------------------------------------------------------
WEIGHTED AVERAGE COMMON SHARES
Weighted average common shares outstanding (000) 421,971 426,274 423,697 425,746
Effect of dilutive common stock options (000) 3,698 5,052 3,271 5,352
- --------------------------------------------------------------------------------------------
Weighted average common shares and potential
common shares outstanding (000) 425,669 431,326 426,968 431,098
======== ======== ======== ========
- --------------------------------------------------------------------------------------------
EARNINGS PER COMMON SHARE
Net income per common share $ .54 $ .57 $ 1.58 $ 1.72
Net income per common share -- assuming dilution .53 .57 1.57 1.69
- --------------------------------------------------------------------------------------------
3. ACQUISITIONS AND DIVESTITURE
Business acquisitions and divestitures that Key completed during 2002 and the
first nine months of 2003 are summarized below.
ACQUISITIONS
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 $1.8
billion at the date of acquisition. The terms of the transaction are not
material and have not been disclosed.
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) PLAN 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.
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 nine-month periods ended September 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 that occurred during the first nine months 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
CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES
THREE MONTHS ENDED SEPTEMBER 30, --------------------- ----------------------- -----------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 475 $ 441 $ 258 $ 268 $ 65 $ 56
Noninterest income 141 136 125 111 143 150
- -----------------------------------------------------------------------------------------------------------------------
Total revenue (TE)(a) 616 577 383 379 208 206
Provision for loan losses 70 69 48 64 5 2
Depreciation and amortization expense 32 34 10 11 11 11
Other noninterest expense 323 303 171 158 150 151
- -----------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes (TE) 191 171 154 146 42 42
Allocated income taxes and TE adjustments 71 64 58 55 16 16
- -----------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 120 $ 107 $ 96 $ 91 $ 26 $ 26
======== ======== ======== ======== ======== ========
Percent of consolidated net income 53 % 44 % 42 % 37 % 11 % 11 %
Percent of total segments net income 52 45 41 38 11 11
- -----------------------------------------------------------------------------------------------------------------------
AVERAGE BALANCES
Loans $ 29,100 $ 28,243 $ 27,784 $ 29,123 $ 5,100 $ 4,826
Total assets(a) 31,516 30,593 32,469 32,749 6,311 5,782
Deposits 34,999 33,580 4,621 3,384 6,382 3,695
- -----------------------------------------------------------------------------------------------------------------------
OTHER FINANCIAL DATA
Net loan charge-offs $ 70 $ 70 $ 48 $ 113 $ 5 $ 2
Return on average allocated equity 21.08 % 20.22 % 11.36 % 11.08 % 16.72 % 16.77 %
Average full-time equivalent employees 8,508 8,439 2,475 2,461 2,791 3,119
- -----------------------------------------------------------------------------------------------------------------------
CORPORATE AND INVESTMENT
CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES
NINE MONTHS ENDED SEPTEMBER 30, ----------------------- ----------------------- -----------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 1,379 $ 1,327 $ 778 $ 808 $ 184 $ 166
Noninterest income 377 378 359 344 402 474
- -----------------------------------------------------------------------------------------------------------------------
Total revenue (TE)(a) 1,756 1,705 1,137 1,152 586 640
Provision for loan losses 213 222 155 173 10 11
Depreciation and amortization expense 96 105 30 34 32 38
Other noninterest expense 942 901 500 473 443 461
- -----------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes (TE) 505 477 452 472 101 130
Allocated income taxes and TE adjustments 189 179 169 176 38 48
- -----------------------------------------------------------------------------------------------------------------------
Net income (loss) $ 316 $ 298 $ 283 $ 296 $ 63 $ 82
======== ======== ======== ======== ======== ========
Percent of consolidated net income 47 % 41 % 42 % 41 % 10 % 11 %
Percent of total segments net income 47 43 42 42 9 12
- -----------------------------------------------------------------------------------------------------------------------
AVERAGE BALANCES
Loans $ 28,819 $ 27,889 $ 28,082 $ 29,486 $ 5,030 $ 4,806
Total assets(a) 31,228 30,223 32,605 32,882 6,088 5,807
Deposits 34,714 33,950 4,272 3,216 5,850 3,649
- -----------------------------------------------------------------------------------------------------------------------
OTHER FINANCIAL DATA
Net loan charge-offs $ 213 $ 223 $ 200 $ 360 $ 12 $ 11
Return on average allocated equity 18.97 % 19.17 % 11.28 % 12.14 % 13.67 % 17.97 %
Average full-time equivalent employees 8,494 8,482 2,456 2,436 2,872 3,185
- -----------------------------------------------------------------------------------------------------------------------
(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
- ---------------------------------------------------------------------------------------------------------
$ (76) $ (20) $ 722 $ 745 $ (32) $ (23) $ 690 $ 722
51 32 460 429 3 3 463 432
- ---------------------------------------------------------------------------------------------------------
(25) 12 1,182 1,174 (29) (20) 1,153 1,154
-- -- 123 135 -- -- 123 135
-- -- 53 56 -- -- 53 56
9 6 653 618 (7) (15) 646 603
- ---------------------------------------------------------------------------------------------------------
(34) 6 353 365 (22) (5) 331 360
(24) (8) 121 127 (17) (12) 104 115
- ---------------------------------------------------------------------------------------------------------
$ (10) $ 14 $ 232 $ 238 $ (5) $ 7 $ 227 $ 245
======== ======== ======== ======== ======== ======== ======== ========
(4) % 5 % 102 % 97 % (2) % 3 % 100 % 100 %
(4) 6 100 100 N/A N/A N/A N/A
- ---------------------------------------------------------------------------------------------------------
$ 947 $ 1,209 $ 62,931 $ 63,401 $ 147 $ 85 $ 63,078 $ 63,486
12,707 11,195 83,003 80,319 1,719 1,616 84,722 81,935
2,834 4,076 48,836 44,735 (137) (71) 48,699 44,664
- ---------------------------------------------------------------------------------------------------------
-- -- $ 123 $ 185 -- -- $ 123 $ 185
(10.17) % 13.45 % 13.90 % 14.79 % N/M N/M 13.06 % 14.74 %
35 34 13,809 14,053 6,250 6,749 20,059 20,802
- ---------------------------------------------------------------------------------------------------------
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY
- ------------------------ ----------------------- ------------------------ -----------------------
2003 2002 2003 2002 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------
$ (149) $ (80) $ 2,192 $ 2,221 $ (89) $ (76) $ 2,103 $ 2,145
147 92 1,285 1,288 9 35 1,294 1,323
- ---------------------------------------------------------------------------------------------------------
(2) 12 3,477 3,509 (80) (41) 3,397 3,468
-- -- 378 406 -- -- 378 406
-- -- 158 177 -- -- 158 177
25 19 1,910 1,854 (24) (46) 1,886 1,808
- ---------------------------------------------------------------------------------------------------------
(27) (7) 1,031 1,072 (56) 5 975 1,077
(42) (32) 354 371 (48) (25) 306 346
- ---------------------------------------------------------------------------------------------------------
$ 15 $ 25 $ 677 $ 701 $ (8) $ 30 $ 669 $ 731
======== ======== ======== ======== ======== ======== ======== ========
2 % 3 % 101 % 96 % (1) % 4 % 100 % 100 %
2 3 100 100 N/A N/A N/A N/A
- ---------------------------------------------------------------------------------------------------------
$ 920 $ 1,321 $ 62,851 $ 63,502 $ 134 $ 132 $ 62,985 $ 63,634
12,951 10,818 82,872 79,730 1,593 1,729 84,465 81,459
3,245 3,649 48,081 44,464 (92) (82) 47,989 44,382
- ---------------------------------------------------------------------------------------------------------
-- -- $ 425 $ 594 -- -- $ 425 $ 594
5.25 % 8.21 % 13.76 % 14.75 % N/M N/M 12.98 % 15.13 %
35 32 13,857 14,135 6,317 6,792 20,174 20,927
- ---------------------------------------------------------------------------------------------------------
15
Supplementary information (Consumer Banking lines of business)
RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE
THREE MONTHS ENDED SEPTEMBER 30, --------------------- --------------------- ---------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 342 $ 337 $ 102 $ 98 $ 172 $ 142
Provision for loan losses 14 16 17 16 39 37
Noninterest expense 212 207 49 46 94 84
Net income 73 71 23 23 24 13
Average loans 10,194 9,122 4,406 4,343 14,500 14,778
Average deposits 30,051 29,448 4,564 3,799 384 333
Net loan charge-offs 14 17 17 16 39 37
Return on average allocated equity 45.25 % 48.48 % 21.94 % 24.08 % 7.91 % 4.53 %
Average full-time equivalent employees 6,203 6,154 404 327 1,901 1,958
- --------------------------------------------------------------------------------------------------------------
RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE
NINE MONTHS ENDED SEPTEMBER 30, -------------------- -------------------- --------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 997 $ 983 $ 295 $ 286 $ 464 $ 436
Provision for loan losses 46 49 51 44 116 129
Noninterest expense 625 613 141 136 272 257
Net income 204 201 64 66 48 31
Average loans 9,870 8,584 4,421 4,366 14,528 14,939
Average deposits 30,054 30,001 4,303 3,628 357 321
Net loan charge-offs 46 50 51 44 116 129
Return on average allocated equity 42.88 % 47.99 % 21.02 % 23.91 % 5.42 % 3.61 %
Average full-time equivalent employees 6,175 6,157 397 325 1,922 2,000
- ---------------------------------------------------------------------------------------------------------
Supplementary information (Corporate and Investment Banking lines of business)
CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE
THREE MONTHS ENDED SEPTEMBER 30, -------------------- --------------------------- ---------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 224 $ 230 $ 93 $ 93 $ 66 $ 56
Provision for loan losses 42 50 1 2 5 12
Noninterest expense 119 114 37 33 25 22
Net income 40 42 34 36 22 13
Average loans 13,653 15,355 7,303 7,832 6,828 5,936
Average deposits 3,777 2,785 830 590 14 9
Net loan charge-offs 42 99 1 2 5 12
Return on average allocated equity 8.11 % 8.12 % 15.21 % 18.74 % 17.08 % 11.67 %
Average full-time equivalent employees 1,184 1,263 671 592 620 606
- ---------------------------------------------------------------------------------------------------------------------
CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE
NINE MONTHS ENDED SEPTEMBER 30, ----------------- --------------------------- ---------------------
dollars in millions 2003 2002 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------------
Total revenue (taxable equivalent) $ 664 $ 708 $ 267 $ 264 $ 206 $ 180
Provision for loan losses 129 134 4 5 22 34
Noninterest expense 349 345 105 93 76 69
Net income 117 143 99 104 67 49
Average loans 13,941 15,914 7,401 7,782 6,740 5,790
Average deposits 3,522 2,644 737 562 13 10
Net loan charge-offs 174 321 4 5 22 34
Return on average allocated equity 7.84 % 9.21 % 15.41 % 18.42 % 17.84 % 15.27 %
Average full-time equivalent employees 1,189 1,274 654 541 613 621
- ----------------------------------------------------------------------------------------------------------------------
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 ($1.0 billion at September 30, 2003, $801 million at
December 31, 2002, and $750 million at September 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 ($729 million at September 30,
2003, $677 million at December 31, 2002, and $631 million at September 30,
2002). 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
SEPTEMBER 30, 2003
---------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
in millions COST GAINS LOSSES VALUE
- ---------------------------------------------------------------------------------------------
INVESTMENT SECURITIES
States and political subdivisions $ 91 $ 7 -- $ 98
Other securities 15 -- -- 15
- ----------------------------------------------------------------------------------------------
Total investment securities $ 106 $ 7 -- $ 113
========= ====== ======= =======
- ---------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 59 -- -- $ 59
States and political subdivisions 24 $ 1 -- 25
Collateralized mortgage obligations 6,545 52 $ 115 6,482
Other mortgage-backed securities 575 22 1 596
Retained interests in securitizations 120 64 -- 184
Other securities 200 4 -- 204
- ---------------------------------------------------------------------------------------------
Total securities available for sale $ 7,523 $ 143 $ 116 $ 7,550
========= ====== ======= =======
- ---------------------------------------------------------------------------------------------
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
========= ====== ======= =======
- ---------------------------------------------------------------------------------------------
SEPTEMBER 30, 2002
---------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
in millions COST GAINS LOSSES VALUE
- ---------------------------------------------------------------------------------------------
INVESTMENT SECURITIES
States and political subdivisions $ 148 $ 10 -- $ 158
- ---------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 20 $ 1 -- $ 21
States and political subdivisions 17 1 -- 18
Collateralized mortgage obligations 6,156 98 $ 60 6,194
Other mortgage-backed securities 748 35 -- 783
Retained interests in securitizations 182 35 -- 217
Other securities 216 -- 40 176
- ---------------------------------------------------------------------------------------------
Total securities available for sale $ 7,339 $ 170 $ 100 $ 7,409
========= ====== ======= =======
- ---------------------------------------------------------------------------------------------
18
6. LOANS
Key's loans by category are summarized as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30,
in millions 2003 2002 2002
- ---------------------------------------------------------------------------------------------
Commercial, financial and agricultural $ 17,118 $ 17,425 $ 17,419
Commercial real estate:
Commercial mortgage 5,822 6,015 6,237
Construction 5,236 5,659 5,845
- -------------------------------------------------------------------------------------------
Total commercial real estate loans 11,058 11,674 12,082
Commercial lease financing 8,123 7,513 7,369
- -------------------------------------------------------------------------------------------
Total commercial loans 36,299 36,612 36,870
Real estate--residential mortgage 1,665 1,968 2,098
Home equity 14,879 13,804 13,516
Consumer--direct 2,154 2,161 2,167
Consumer--indirect:
Automobile lease financing 400 873 1,137
Automobile loans 2,093 2,181 2,256
Marine 2,489 2,088 2,047
Other 561 667 870
- -------------------------------------------------------------------------------------------
Total consumer--indirect loans 5,543 5,809 6,310
- -------------------------------------------------------------------------------------------
Total consumer loans 24,241 23,742 24,091
Loans held for sale:
Commercial, financial and agricultural -- 41 --
Real estate--commercial mortgage 210 193 309
Real estate--residential mortgage 59 57 49
Education 1,914 1,812 1,632
- -------------------------------------------------------------------------------------------
Total loans held for sale 2,183 2,103 1,990
- -------------------------------------------------------------------------------------------
Total loans $ 62,723 $ 62,457 $ 62,951
=========== ========== ==========
- -------------------------------------------------------------------------------------------
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, 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ --------------------
in millions 2003 2002 2003 2002
- ----------------------------------------------------------------------------
Balance at beginning of period $ 1,405 $ 1,539 $ 1,452 $ 1,677
Charge-offs (159) (211) (528) (680)
Recoveries 36 26 103 86
- ---------------------------------------------------------------------------
Net charge-offs (123) (185) (425) (594)
Provision for loan losses 123 135 378 406
- ---------------------------------------------------------------------------
Balance at end of period $ 1,405 $ 1,489 $ 1,405 $ 1,489
======= ======= ======= =======
- ---------------------------------------------------------------------------
19
7. VARIABLE INTEREST ENTITIES
A 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 are: (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 Adopted in 2003"
on page 9. 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.
Effective July 1, 2003, Key adopted Interpretation No. 46. As of September 30,
2003, the consolidation or de-consolidation of VIEs in accordance with the
implementation of Interpretation No. 46 increased Key's assets by $847 million
and had no material effect on Key's results of operations for the third quarter
of 2003. As required, assets, liabilities and noncontrolling interests of newly
consolidated entities were initially recorded at their carrying amounts.
Key's involvement with VIEs, including those consolidated and de-consolidated
and those in which Key holds a significant interest, are described below.
"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.
COMMERCIAL PAPER CONDUIT. Key, among others, refers third party assets and
borrowers and provides liquidity and credit enhancement to an asset-backed
commercial paper conduit. Key determined that it is the primary beneficiary of
this conduit and consolidated it effective July 1, 2003. At September 30, 2003,
the conduit had assets of $276 million, of which $200 million are recorded in
"loans" and $72 million are recorded in "securities available for sale" on the
balance sheet. These assets serve as collateral for the conduit's obligations to
commercial paper holders. The commercial paper holders have no recourse to Key's
general credit other than through Key's committed credit enhancement facility of
$60 million.
Additional information pertaining to Key's involvement with the conduit 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
operating partnerships. 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. Key determined that it
is the primary beneficiary of these funds and consolidated them effective July
1, 2003. The funds' assets are primarily investments in LIHTC operating
partnerships, which totaled $470 million at September 30, 2003. These
investments are recorded in "accrued income and other assets" on the balance
sheet and serve as collateral for the funds' limited obligations. No new
guaranteed funds were formed during the quarter ended September 30, 2003, and in
October management elected to discontinue new projects under this program.
Additional information on return guaranty agreements with LIHTC investors is
summarized in Note 10 under the heading "Guarantees."
Under the terms of its partnership agreement, each guaranteed fund is required
to be dissolved by a certain date. Therefore, in accordance with SFAS No. 150,
the noncontrolling interests associated with these funds are mandatorily
redeemable instruments and are recorded in "accrued expense and other
liabilities" on the balance sheet. In November 2003, the FASB indefinitely
deferred the measurement and recognition provisions of SFAS No. 150 for
mandatorily redeemable noncontrolling interests associated with finite-lived
subsidiaries. Key currently accounts for these noncontrolling interests as
minority interests, and adjusts the financial statements each period for the
investors' share of fund profits and losses. At September 30, 2003, the
settlement value of these noncontrolling interests was estimated to be between
$631 million and $785 million, while the recorded value, including reserves,
totaled $455 million. Additional information on SFAS No. 150 is summarized in
Note 1 under the heading "Accounting Pronouncements Adopted in 2003."
20
LIHTC NONGUARANTEED FUNDS. KAHC sells investments in certain LIHTC funds without
guaranteeing a return to the investors and earns syndication and asset
management fees for services provided to these nonguaranteed funds. Key
determined that it is the primary beneficiary of those nonguaranteed funds that
do not have a majority investor and consolidated them effective July 1, 2003.
The funds' assets are primarily investments in LIHTC operating partnerships,
which totaled $78 million at September 30, 2003. These investments are recorded
in "accrued income and other assets" on the balance sheet and serve as
collateral for the funds' limited obligations. The investors have no recourse to
Key's general credit.
Key has determined that all other nonguaranteed funds in which it has invested
are VIEs in which Key has significant interests, but for which it is not the
primary beneficiary. Therefore, these funds remain unconsolidated. At September
30, 2003, assets of these unconsolidated nonguaranteed funds were estimated to
be $255 million. Key's maximum exposure to loss from its involvement with these
funds is minimal. Nonguaranteed funds formed in the third quarter of 2003 did
not have any material effect on Key's financial condition or results of
operations. In October 2003, management elected to discontinue new projects
under this program.
BUSINESS TRUSTS ISSUING MANDATORILY REDEEMABLE PREFERRED CAPITAL SECURITIES. Key
owns the common stock of seven business trusts that have issued
corporation-obligated mandatorily redeemable preferred capital securities to
third party investors. The trusts' only assets, which totaled $1.3 billion at
September 30, 2003, are debentures issued by Key that were acquired by the
trusts using proceeds from the issuance of preferred securities and common
stock. Prior to July 1, 2003, Key consolidated these trusts. Upon adoption of
Interpretation No. 46, Key determined that it is not the primary beneficiary of
these trusts and de-consolidated them effective July 1, 2003. Key recorded the
debentures in "long-term debt" and its equity interest in the business trusts 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 Issued by
Unconsolidated Subsidiaries"), which begins on page 23.
LIHTC INVESTMENTS. For more than ten years, Key has made investments directly in
LIHTC operating partnerships through the Retail Banking line of business. As a
limited partner in these operating partnerships, Key is allocated tax credits
and deductions associated with the underlying properties. Key has determined
that the operating partnerships are VIEs in which Key has significant interests,
but for which it is not the primary beneficiary. Therefore, these operating
partnerships remain unconsolidated. At September 30, 2003, assets of these
unconsolidated LIHTC operating partnerships totaled approximately $900 million.
Key's maximum exposure to loss from its involvement with these partnerships is
the unamortized investment balance of $290 million at September 30, 2003, plus
$47 million of tax credits claimed, but subject to recapture. During the third
quarter of 2003, Key obtained no significant interests in LIHTC operating
partnerships.
COMMERCIAL AND RESIDENTIAL REAL ESTATE INVESTMENTS AND PRINCIPAL INVESTMENTS.
Through the KeyBank Real Estate Capital line of business, Key makes mezzanine
investments in construction, acquisition and rehabilitation projects that Key
has determined to be VIEs. Key receives underwriting and other fees from these
VIEs and, for certain projects, may also provide the senior financing. Key's
Principal Investing unit makes direct investments in equity and mezzanine
instruments offered by individual companies, some of which Key has determined to
be VIEs.
These investments are held by nonregistered investment companies subject to the
provisions of the AICPA Audit and Accounting Guide, "Audits of Investment
Companies" ("Audit Guide"). In October 2003, the FASB issued final guidance that
defers the effective date of Interpretation No. 46 for such nonregistered
investment companies until the AICPA finalizes its Statement of Position on the
clarification of the scope of the Audit Guide. As a result, Key is not currently
applying the accounting or disclosure provisions of Interpretation No. 46 to its
real estate mezzanine and principal investments, which remain unconsolidated.
21
8. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS
Impaired loans, which account for the largest portion of Key's nonperforming
assets, totaled $459 million at September 30, 2003, compared with $610 million
at December 31, 2002, and $645 million at September 30, 2002. Impaired loans
averaged $479 million for the third quarter of 2003 and $658 million for the
third quarter of 2002.
Key's nonperforming assets were as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30,
in millions 2003 2002 2002
- -----------------------------------------------------------------------------------
Impaired loans $ 459 $ 610 $ 645
Other nonaccrual loans 336 333 342
- -----------------------------------------------------------------------------------
Total nonperforming loans 795 943 987
Other real estate owned ("OREO") 69 48 30
Allowance for OREO losses (4) (3) (2)
- -----------------------------------------------------------------------------------
OREO, net of allowance 65 45 28
Other nonperforming assets 2 5 2
- -----------------------------------------------------------------------------------
Total nonperforming assets $ 862 $ 993 $ 1,017
====== ======= ========
- -----------------------------------------------------------------------------------
At September 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 September
30, 2003, Key had $286 million of impaired loans with a specifically allocated
allowance for loan losses of $93 million, and $173 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.
22
9. CAPITAL SECURITIES ISSUED BY UNCONSOLIDATED SUBSIDIARIES
Prior to July 1, 2003, KeyCorp fully consolidated six subsidiary business trusts
that issued corporation-obligated mandatorily redeemable preferred capital
securities ("capital securities"). These securities were carried as liabilities
on Key's balance sheet prior to July 1, 2003. In July 2003, KeyCorp Capital V,
KeyCorp's seventh business trust, issued its preferred capital securities.
KeyCorp owns the outstanding common stock of each of these trusts, which 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. Prior to July 1, 2003, Key's financial statements did not
reflect the debentures or the related effects on the income statement because
they were eliminated in consolidation.
Under Interpretation No. 46, Key determined that these business trusts are VIEs
for which it is not the primary beneficiary. Therefore, effective July 1, 2003,
the trusts were de-consolidated and are accounted for using the equity method.
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 characteristics of the business trusts and capital securities have not
changed with the de-consolidation of the trusts. The capital securities provide
an attractive source of funds since they constitute Tier 1 capital for
regulatory reporting purposes, but have the same tax advantages as debt for
federal income tax purposes. Although the Federal Reserve Board has indicated
that it will continue to treat capital securities as Tier 1 capital until
further notice, management believes that the change in accounting treatment for
capital securities (i.e., de-consolidation) could possibly move the Federal
Reserve Board to propose changes in the capital treatment of such securities in
the future. Because no specific proposal to this effect has been published,
however, management is unable to determine how such change could affect Key.
To the extent the trusts have funds available to make payments, as guarantor,
KeyCorp continues to unconditionally guarantee 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.
During the first nine months of 2003, the business trusts repurchased $30
million of their outstanding capital securities and KeyCorp repurchased a like
amount of the related debentures. On July 21, 2003, $175 million of lower cost
securities were issued by the Capital V trust.
23
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) STOCK NET OF DISCOUNT(b) DEBENTURES(c) DEBENTURES
- ----------------------------------------------------------------------------------------------------------------------
September 30, 2003
KeyCorp Institutional Capital A $ 402 $ 11 $ 361 7.826 % 2026
KeyCorp Institutional Capital B 173 4 154 8.250 2026
KeyCorp Capital I 210 8 218 1.854 2028
KeyCorp Capital II 177 8 165 6.875 2029
KeyCorp Capital III 232 8 197 7.750 2029
KeyCorp Capital V 175 5 180 5.875 2033
Union Bankshares Capital Trust I 10 1 11 9.000 2028
- ----------------------------------------------------------------------------------------------------------------------
Total $ 1,379 $ 45 $ 1,286 6.596 % --
========== ====== =========
- ----------------------------------------------------------------------------------------------------------------------
December 31, 2002 $ 1,260 $ 40 $ 1,136 6.779 % --
========== ====== =========
- ----------------------------------------------------------------------------------------------------------------------
September 30, 2002 $ 1,282 $ 39 $ 1,159 6.784 % --
========== ====== =========
- ----------------------------------------------------------------------------------------------------------------------
(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. Prior to July 1, 2003, the capital securities constituted
minority interests in the equity accounts of KeyCorp's consolidated
subsidiaries. Effective July 1, 2003, the business trusts that issued the
capital securities were de-consolidated. However, until further notice from
the Federal Reserve Board, the capital securities continue to qualify as
Tier 1 capital under Federal Reserve Board guidelines. Included in certain
capital securities at September 30, 2003, December 31, 2002 and September
30, 2002, are basis adjustments of $138 million, $164 million and $162
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), July 21, 2008 (for
debentures owned by Capital V), 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, Capital V, 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,
Capital V, 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 September 30, 2003,
December 31, 2002 and September 30, 2002, are weighted average rates.
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 September 30, 2003, total approximately $330 million,
and management currently estimates that approximately $57 million of additional
claims may be filed through year-end 2006 bringing the total aggregate amount of
actual and potential claims to $387 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 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 September 30, 2003.
MAXIMUM POTENTIAL
UNDISCOUNTED LIABILITY
in millions FUTURE PAYMENTS RECORDED
- -----------------------------------------------------------------------------------------------
Financial Guarantees:
Standby letters of credit $ 5,915 $ 24
Credit enhancement for asset-backed commercial paper conduit 60 --
Recourse agreement with FNMA 524 4
Return guaranty agreement with LIHTC investors 785 34
Default guarantees 9 --
Written interest rate caps(a) 72 18
- ----------------------------------------------------------------------------------------------
Total $ 7,365 $ 80
========== =======
- ----------------------------------------------------------------------------------------------
(a) As of September 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 September 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 16 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 25, 2004, 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. Key consolidated the conduit upon adoption of
Interpretation No. 46 on July 1, 2003.
At September 30, 2003, Key's funding requirement under the credit enhancement
facility totaled $60 million. However, there were no drawdowns under the
facility during the nine-month period ended September 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.
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 September 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 $1.6 billion. The maximum potential amount of
undiscounted future payments that may be required under this program is equal to
one-third of the principal balance of loans outstanding at September 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. 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. Key
consolidated these partnerships upon adoption of Interpretation No. 46 on July
1, 2003. Additional information regarding Interpretation No. 46 and these
partnerships is summarized in Note 1 and Note 7 ("Variable Interest Entities"),
which begins on page 20. 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 established a reserve in the amount of $34
million at September 30, 2003, which management believes will be sufficient to
cover estimated future obligations under the guarantees. The maximum exposure to
loss reflected in the preceding table represents undiscounted future payments
due to investors for the return on and of their investments. 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 in the
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 18 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 September 30, 2003, had a weighted average life
of approximately 5 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 "accrued expense and 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 FACILITY THAT SUPPORTS ASSET-BACKED COMMERCIAL PAPER CONDUIT. Key
provides liquidity to an asset-backed commercial paper conduit that is owned by
a third party and administered by an unaffiliated financial institution. See
further discussion of the conduit in Note 7. This liquidity facility obligates
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 this conduit in the form of a committed facility of $1.1 billion.
The amount available to be drawn was $435 million at September 30, 2003.
However, there were no drawdowns under this committed facility at that time.
Key's commitment to provide liquidity is periodically evaluated by management.
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 loan sales and other ongoing activities, as well as in connection with
purchases and sales of businesses. 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 Incorporated ("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 priced "off-line," signature-verified
debit card services. Under the terms of the proposed settlements, which remain
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
28
Key will be a reduction to pre-tax net income of less than $5 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 September 30, 2003, Key had $788 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 $1.4
billion and $1.3 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 SEPTEMBER 30,
in millions 2002 HEDGING ACTIVITY NET INCOME 2003
- --------------------------------------------------------------------------------------------------------------------
Accumulated other comprehensive income
(loss) resulting from cash flow hedges $ 6 $ 34 $ (19) $ 21
- --------------------------------------------------------------------------------------------------------------------
Key expects to reclassify an estimated $26 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.
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.
29
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.
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------
in millions 2003 2002
- -------------------------------------------------------
Interest rate swap contracts $ 6 $ 8
Foreign exchange forward contracts 25 26
- -------------------------------------------------------
COUNTERPARTY CREDIT RISK
Swaps and caps present credit risk because the counterparty, which may be a bank
or a broker/dealer, 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 means 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 September 30, 2003, Key was party to interest rate swaps and caps with 59
different counterparties. Among these were swaps and caps entered into to offset
the risk of client exposure. Key had aggregate exposure of $200 million (net of
collateral of $472 million) on these instruments to 34 of the counterparties.
The largest exposure to an individual counterparty amounted to approximately $62
million. Key has established a reserve in the amount of $12 million at September
30, 2003, which management believes will be sufficient to cover estimated future
losses on the trading portfolio in the event of default.
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 September 30, 2003 and 2002, and the related
condensed consolidated statements of income for the three- and nine-month
periods then ended, and the condensed consolidated statements of changes in
shareholders' equity and cash flow for the nine-month periods ended September
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
October 14, 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
September 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 September 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, Key's
management believes that 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.
33
- - KEYCORP refers solely to the parent holding company.
- - 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 third quarter and
first nine months of 2003 and 2002 are summarized below.
- - Net income for the third quarter of 2003 was $227 million, or $.53 per
common share, compared with net income of $225 million, or $.53 per share,
for the previous quarter and net income of $245 million, or $.57 per share,
for the third quarter of 2002. For the first nine months of 2003, Key's net
income was $669 million, or $1.57 per common share, compared with net
income of $731 million, or $1.69 per share for the comparable period last
year.
- - Key's return on average equity was 13.06% for the third quarter of 2003.
This result compares with a return of 12.98% for the prior quarter and a
return of 14.74% for the year-ago quarter. For the first nine months of
2003, Key's return on average equity was 12.98%, compared with a return of
15.13% for the first nine months of 2002.
- - Key's third quarter 2003 return on average total assets was 1.06%. This
result compares with a return of 1.07% for the previous quarter and a
return of 1.19% for the third quarter of 2002. For the first nine months of
2003, Key's return on average total assets was 1.06%, compared with a
return of 1.20% for the comparable period in 2002.
Key's third quarter results reflected several improved performance trends
relative to the second quarter:
- - Noninterest income grew by $29 million, driven by higher net gains from
loan securitizations and sales and an increase in income from trust and
investment services.
- - Average core deposits grew by an annualized 8% and were up 13% from the
same period last year.
- - Asset quality continued to improve as the level of Key's nonperforming
loans declined for the fourth consecutive quarter. Both nonperforming loans
and net loan charge-offs reached their lowest levels since the first
quarter of 2001.
However, the third quarter also presented a difficult environment for net
interest income, which declined by $19 million. A 12 basis point reduction in
the net interest margin drove the decrease and was attributable to a number of
factors, including the effects of a soft economy, significant prepayments of
higher rate consumer loans and mortgage backed securities which began to slow
late in the third quarter, and narrower deposit spreads resulting from declining
interest rates. During the same period, the level of Key's average earning
assets was essentially unchanged as continued growth in home equity loans was
offset by declines in the levels of both commercial loans and securities.
During the third quarter, earnings were also moderated by an $11 million
increase in noninterest expense, due primarily to higher incentive compensation
accruals and the expensing of stock options granted in July 2003. In future
periods, we will continue to evaluate staffing levels and to make appropriate
expense-reducing changes when they can be accomplished without negatively
affecting either customer service or our ability to grow higher return
businesses.
We believe Key is well positioned to reap benefits as economic activity begins
to improve. We expect that smaller and medium-size businesses, in which Key
holds a position of strength in the marketplace, will be among the first to seek
additional funding as the economy continues to improve. Considering recent
trends, we expect Key's earnings for the fourth quarter to be in the range of
$.52 to $.55 per share.
35
The primary reasons that Key's revenue and expense components changed from those
of the three-and nine-month periods ended September 30, 2002, are reviewed in
greater detail throughout the remainder of the Management's Discussion and
Analysis section.
Figure 1 on page 37 summarizes Key's financial performance for each of the past
five quarters and the first nine 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 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
NINE MONTHS ENDED
2003 2002 SEPTEMBER 30,
-------------------------------- -------------------- --------------------
dollars in millions, except per share amounts THIRD SECOND FIRST FOURTH THIRD 2003 2002
- --------------------------------------------------------------------------------------------------------------------------------
FOR THE PERIOD
Interest income $ 971 $ 1,022 $ 1,021 $ 1,077 $ 1,095 $ 3,014 $ 3,289
Interest expense 294 326 340 365 395 960 1,252
Net interest income 677 696 681 712 700 2,054 2,037
Provision for loan losses 123 125 130 147 135 378 406
Noninterest income 463 434 397 446 432 1,294 1,323
Noninterest expense 699 688 657 668 659 2,044 1,985
Income before income taxes 318 317 291 343 338 926 969
Net income 227 225 217 245 245 669 731
- --------------------------------------------------------------------------------------------------------------------------------
PER COMMON SHARE
Net income $ .54 $ .53 $ .51 $ .58 $ .57 $ 1.58 $ 1.72
Net income -- assuming dilution .53 .53 .51 .57 .57 1.57 1.69
Cash dividends paid .305 .305 .305 .30 .30 .915 .90
Book value at period end 16.64 16.60 16.32 16.12 15.66 16.64 15.66
Market price:
High 27.88 27.42 27.11 26.75 27.35 27.88 29.40
Low 24.86 22.56 22.31 21.25 20.96 22.31 20.96
Close 25.57 25.27 22.56 25.14 24.97 25.57 24.97
Weighted average common shares (000) 421,971 423,882 425,275 424,578 426,274 423,697 425,746
Weighted average common shares and
potential common shares (000) 425,669 427,170 428,090 429,531 431,326 426,968 431,098
- --------------------------------------------------------------------------------------------------------------------------------
AT PERIOD END
Loans $ 62,723 $ 63,214 $ 62,719 $ 62,457 $ 62,951 $ 62,723 $ 62,951
Earning assets 73,258 73,716 75,113 73,635 72,546 73,258 72,546
Total assets 84,460 85,479 86,490 85,202 83,516 84,460 83,516
Deposits 48,739 49,869 50,455 49,346 44,610 48,739 44,610
Long-term debt 15,342 14,434 16,269 15,605 16,276 15,342 16,276
Shareholders' equity 6,977 6,989 6,898 6,835 6,652 6,977 6,652
- --------------------------------------------------------------------------------------------------------------------------------
PERFORMANCE RATIOS
Return on average total assets 1.06% 1.07% 1.05% 1.17% 1.19% 1.06% 1.20%
Return on average equity 13.06 12.98 12.91 14.46 14.74 12.98 15.13
Net interest margin (taxable equivalent) 3.73 3.85 3.86 3.98 3.99 3.81 3.97
- --------------------------------------------------------------------------------------------------------------------------------
CAPITAL RATIOS AT PERIOD END
Equity to assets 8.26% 8.18% 7.98% 8.02% 7.97% 8.26% 7.97%
Tangible equity to tangible assets 6.94 6.90 6.71 6.73 6.71 6.94 6.71
Tier 1 risk-based capital 8.21 8.02 8.22 8.09 8.34 8.21 8.34
Total risk-based capital 12.46 12.26 12.62 12.51 12.69 12.46 12.69
Leverage 8.36 8.12 8.12 8.15 8.15 8.36 8.15
- --------------------------------------------------------------------------------------------------------------------------------
OTHER DATA
Average full-time equivalent employees 20,059 19,999 20,447 20,485 20,802 20,174 20,927
KeyCenters 900 903 911 910 903 900 903
- --------------------------------------------------------------------------------------------------------------------------------
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 nine-month periods
ended September 30, 2003 and 2002.
FIGURE 2. MAJOR BUSINESS GROUPS - TAXABLE-EQUIVALENT REVENUE AND NET INCOME
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ------------------ ----------------- -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ----------------------------------------------------------------------------------------------------------------------
Revenue (taxable equivalent)
Consumer Banking $ 616 $ 577 $ 39 6.8% $1,756 $ 1,705 $ 51 3.0%
Corporate and Investment Banking 383 379 4 1.1 1,137 1,152 (15) (1.3)
Investment Management Services 208 206 2 1.0 586 640 (54) (8.4)
Other Segments (25) 12 (37) N/M (2) 12 (14) N/M
- ----------------------------------------------------------------------------------------------------------------------
Total segments 1,182 1,174 8 .7 3,477 3,509 (32) (.9)
Reconciling items (29) (20) (9) (45.0) (80) (41) (39) (95.1)
- ----------------------------------------------------------------------------------------------------------------------
Total $ 1,153 $ 1,154 $ (1) (.1)% $3,397 $ 3,468 $ (71) (2.0)%
======= ======= ======= ====== ======= =======
Net income (loss)
Consumer Banking $ 120 $ 107 $ 13 12.1% $ 316 $ 298 $ 18 6.0%
Corporate and Investment Banking 96 91 5 5.5 283 296 (13) (4.4)
Investment Management Services 26 26 -- -- 63 82 (19) (23.2)
Other Segments (10) 14 (24) N/M 15 25 (10) (40.0)
- ----------------------------------------------------------------------------------------------------------------------
Total segments 232 238 (6) (2.5) 677 701 (24) (3.4)
Reconciling items (5) 7 (12) N/M (8) 30 (38) N/M
- ----------------------------------------------------------------------------------------------------------------------
Total $ 227 $ 245 $ (18) (7.3)% $ 669 $ 731 $ (62) (8.5)%
======= ======= ======= ====== ======= =======
- ----------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
38
CONSUMER BANKING
As shown in Figure 3, net income for Consumer Banking was $120 million for the
third quarter of 2003, representing a $13 million increase from the year-ago
quarter. The increase was due primarily to growth in both taxable-equivalent net
interest income and noninterest income, offset in part by a higher level of
noninterest expense.
Taxable-equivalent net interest income grew by $34 million, or 8%, from the
third 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 average core
deposits. The positive effect of these factors was offset in part by the adverse
effect of a less favorable interest rate spread on deposits.
Noninterest income increased by $5 million, or 4%, due to a reduction in losses
incurred on the residual values of leased vehicles and an increase in net gains
from the annual securitization and sale of education loans, both in the Indirect
Lending unit. These improvements were substantially offset by a 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.
Noninterest expense rose by $18 million, or 5%, from the third quarter of 2002.
Most of the increase was attributable to personnel expense, costs associated
with other real estate owned and various indirect charges.
FIGURE 3. CONSUMER BANKING
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ----------------- ------------------ -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 475 $ 441 $ 34 7.7% $ 1,379 $ 1,327 $ 52 3.9%
Noninterest income 141 136 5 3.7 377 378 (1) (.3)
- ----------------------------------------------------------------------------------------------------------------------------------
Total revenue (TE) 616 577 39 6.8 1,756 1,705 51 3.0
Provision for loan losses 70 69 1 1.4 213 222 (9) (4.1)
Noninterest expense 355 337 18 5.3 1,038 1,006 32 3.2
- ----------------------------------------------------------------------------------------------------------------------------------
Income before income taxes (TE) 191 171 20 11.7 505 477 28 5.9
Allocated income taxes and TE adjustments 71 64 7 10.9 189 179 10 5.6
- ----------------------------------------------------------------------------------------------------------------------------------
Net income $ 120 $ 107 $ 13 12.1% $ 316 $ 298 $ 18 6.0%
======= ======= ======= ======= ======= =======
Percent of consolidated net income 53% 44% N/A N/A 47% 41% N/A N/A
AVERAGE BALANCES
Loans $29,100 $28,243 $ 857 3.0% $28,819 $27,889 $ 930 3.3%
Total assets 31,516 30,593 923 3.0 31,228 30,223 1,005 3.3
Deposits 34,999 33,580 1,419 4.2 34,714 33,950 764 2.3
- ----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
ADDITIONAL CONSUMER BANKING DATA THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
----------------------- ---------------- ----------------- -----------------
dollars in billions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ----------------------------------------------------------------------------------------------------------------------------------
AVERAGE DEPOSITS OUTSTANDING
Noninterest-bearing $ 5,704 $ 5,184 $ 520 10.0% $ 5,477 $ 5,065 $ 412 8.1%
Money market deposit accounts and other
savings 15,576 12,819 2,757 21.5 15,100 12,863 2,237 17.4
Time 13,719 15,577 (1,858) (11.9) 14,137 16,022 (1,885) (11.8)
- ---------------------------------------------------------------------------------------------------------------------------------
Total deposits $34,999 $33,580 $ 1,419 4.2% $34,714 $33,950 $ 764 2.3%
=========== ======= ======= ======= ======= =======
- ----------------------------------------------------------------------------------------------------------------------------------
HOME EQUITY LOANS
Retail Banking and Small Business
Average balance $ 8.3 $ 7.3
Average loan-to-value ratio 72% 72%
Percent first lien positions 58 49
National Home Equity
Average balance $ 5.2 $ 5.0
Average loan-to-value ratio 74% 77%
Percent first lien positions 82 77
- -------------------------------------------------------------------
OTHER DATA
On-line clients / household penetration 722,172/37% 534,385/30%
KeyCenters 900 903
Automated teller machines 2,158 2,249
- -------------------------------------------------------------------
39
CORPORATE AND INVESTMENT BANKING
As shown in Figure 4, net income for Corporate and Investment Banking was $96
million for the third quarter of 2003, up from $91 million for the same period
last year. Significantly higher noninterest income and a substantial reduction
in the provision for loan losses were partially offset by a decrease in
taxable-equivalent net interest income and higher noninterest expense.
Taxable-equivalent net interest income decreased by $10 million, or 4%, from the
third quarter of 2002 due primarily to less favorable interest rate spreads on
deposits and other funding sources. Declines in average loans outstanding and
yield-related loan fees also contributed to the decrease. The adverse effect of
these factors was partially offset by the positive effects of core deposit
growth and a more favorable interest rate spread on earning assets.
Noninterest income increased by $14 million, or 13%, due largely to an increase
in non-yield-related loan fees and higher net gains from loan sales in the
KeyBank Real Estate Capital line of business.
Noninterest expense rose by $12 million, or 7%, reflecting increases in
personnel expense, professional fees and various indirect charges.
The provision for loan losses decreased by $16 million, or 25%, as a result of
improved asset quality in both the Corporate Banking and Key Equipment Finance
lines.
FIGURE 4. CORPORATE AND INVESTMENT BANKING
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ------------------ ------------------ ------------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 258 $ 268 $ (10) (3.7)% $ 778 $ 808 $ (30) (3.7)%
Noninterest income 125 111 14 12.6 359 344 15 4.4
- --------------------------------------------------------------------------------------------------------------------------------
Total revenue (TE) 383 379 4 1.1 1,137 1,152 (15) (1.3)
Provision for loan losses 48 64 (16) (25.0) 155 173 (18) (10.4)
Noninterest expense 181 169 12 7.1 530 507 23 4.5
- --------------------------------------------------------------------------------------------------------------------------------
Income before income taxes (TE) 154 146 8 5.5 452 472 (20) (4.2)
Allocated income taxes and TE adjustments 58 55 3 5.5 169 176 (7) (4.0)
- --------------------------------------------------------------------------------------------------------------------------------
Net income $ 96 $ 91 $ 5 5.5% $ 283 $ 296 $ (13) (4.4)%
======= ======= ======= ======= ======= =======
Percent of consolidated net income 42% 37% N/A N/A 42% 41% N/A N/A
AVERAGE BALANCES
Loans $27,784 $29,123 $(1,339) (4.6% $28,082 $29,486 $(1,404) (4.8)%
Total assets 32,469 32,749 (280) (.9) 32,605 32,882 (277) (.8)
Deposits 4,621 3,384 1,237 36.6 4,272 3,216 1,056 32.8
- --------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
40
INVESTMENT MANAGEMENT SERVICES
As shown in Figure 5, net income for Investment Management Services was $26
million for the third quarter of 2003, unchanged from the third quarter of last
year. Growth in taxable-equivalent net interest income was offset by a decrease
in noninterest income and a higher provision for loan losses. Noninterest
expense was essentially unchanged.
Taxable-equivalent net interest income increased by $9 million, or 16%, from the
third quarter of 2002. The increase was due primarily to strong growth in both
average loans and core deposits. The positive effect of this growth was offset
in part by the adverse effect of a less favorable interest rate spread on
deposits.
Noninterest income decreased by $7 million, or 5%, due to a $9 million decrease
in trust and investment services income. The decline was due largely to the June
2002 sale of Key's 401(k) plan recordkeeping business.
The provision for loan losses rose by $3 million, reflecting a higher level of
net charge-offs in the McDonald Financial Group.
On July 1, 2003, Key acquired NewBridge Partners LLC. This company was merged
into Key's Investment Management Services Group and accounted for $1.4 billion
of Key's $65.0 billion of assets under management at September 30, 2003. The
acquisition did not have any material effect on Investment Management Services'
results of operations for the third quarter of 2003.
FIGURE 5. INVESTMENT MANAGEMENT SERVICES
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ------------------ ------------------ -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -----------------------------------------------------------------------------------------------------------------------------------
SUMMARY OF OPERATIONS
Net interest income (TE) $ 65 $ 56 $ 9 16.1% $ 184 $ 166 $ 18 10.8%
Noninterest income 143 150 (7) (4.7) 402 474 (72) (15.2)
- ---------------------------------------------------------------------------------------------------------------------------------
Total revenue (TE) 208 206 2 1.0 586 640 (54) (8.4)
Provision for loan losses 5 2 3 150.0 10 11 (1) (9.1)
Noninterest expense 161 162 (1) (.6) 475 499 (24) (4.8)
- ---------------------------------------------------------------------------------------------------------------------------------
Income before income taxes (TE) 42 42 -- -- 101 130 (29) (22.3)
Allocated income taxes and TE adjustments 16 16 -- -- 38 48 (10) (20.8)
- ---------------------------------------------------------------------------------------------------------------------------------
Net income $ 26 $ 26 -- --% $ 63 $ 82 $ (19) (23.2)%
======= ======= ======= ======= ======= =======
Percent of consolidated net income 11% 11% N/A N/A 10% 11% N/A N/A
AVERAGE BALANCES
Loans $ 5,100 $ 4,826 $ 274 5.7% $ 5,030 $ 4,806 $ 224 4.7%
Total assets 6,311 5,782 529 9.1 6,088 5,807 281 4.8
Deposits 6,382 3,695 2,687 72.7 5,850 3,649 2,201 60.3
- ---------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
ADDITIONAL INVESTMENT MANAGEMENT SERVICES DATA SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30,
dollars in billions 2003 2002 2002
- -------------------------------------------------------------------------------------------------------
Assets under management $65.0 $61.7 $62.4
Nonmanaged and brokerage assets 63.4 65.0 67.2
- -------------------------------------------------------------------------------------------------------
OTHER SEGMENTS
Other segments consist primarily of Treasury, Principal Investing and the net
effect of funds transfer pricing. These segments generated a net loss of $10
million for the third quarter of 2003, compared with net income of $14 million
for the same period last year. The change in results from the third quarter of
2002 was due primarily to the net effect of funds transfer pricing and includes
the effect of loan and security sales and prepayments.
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 6, 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 accounting principles generally accepted in
the United States ("GAAP").
Taxable-equivalent net interest income for the third quarter of 2003 was $690
million, compared with $722 million a year ago. This decrease reflects the
negative effect of a lower net interest margin, which decreased 26 basis points
to 3.73%. 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 $73.6 billion.
The combination of a soft economy and significant growth in core deposits have
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 and the Federal Reserve
Board's reduction in interest rates in June 2003 placed downward pressure on
third quarter net interest income. Management anticipates that Key's margin will
remain near the current level over the remainder of the year.
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 exceptionally high levels of prepayments on both
investment and consumer loan portfolios 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 third quarter of 2003
totaled $73.6 billion, which was $1.5 billion, or 2%, higher than the third
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. Average consumer loans, other than home
equity loans, also declined during this period, primarily as a result of
management's efforts to scale back or exit certain types of indirect lending.
42
Over the past twelve months, the growth and composition of Key's loan portfolio
has been affected by the following actions:
- - During the third quarter of 2003, Key consolidated an asset-backed
commercial paper conduit as a result of adopting Interpretation No. 46.
This consolidation added approximately $200 million to Key's commercial
loan portfolio. More information about Interpretation No. 46 is
provided in Note 7 ("Variable Interest Entities"), which begins on page
20.
- - 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 diversified 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 September 30, 2003, these portfolios, in the
aggregate, have declined by approximately $4.3 billion since the date
of the announcement and by approximately $1.4 billion since September
30, 2002.
- - We sold commercial mortgage loans of $1.1 billion during the first nine
months of 2003 and $1.4 billion during all of 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 education loans of $1.1 billion ($835 million through
securitizations) during the first nine months of 2003 and $1.1 billion
($750 million through securitizations) during all of 2002. Key has used
the securitization market for education loans as a cost effective means
of diversifying its funding sources.
- - We sold other loans (primarily home equity and residential mortgage
loans) totaling $1.5 billion during the first nine months of 2003 and
$835 million during all of 2002.
Figure 7 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.
43
FIGURE 6. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
THIRD QUARTER 2003 SECOND QUARTER 2003
--------------------------- --------------------------
AVERAGE YIELD/ AVERAGE YIELD/
dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE
- -----------------------------------------------------------------------------------------------------------
ASSETS
Loans(a,b)
Commercial, financial and agricultural $ 17,188 $ 202 4.65 % $ 17,391 $ 218 5.01 %
Real estate - commercial mortgage 5,859 77 5.21 5,932 80 5.38
Real estate construction 5,196 66 5.05 5,331 68 5.14
Commercial lease financing 7,995 118 5.91 7,883 119 6.05
- ---------------------------------------------------------------------------------------------------------
Total commercial loans 36,238 463 5.07 36,537 485 5.32
Real estate - residential 1,707 28 6.43 1,803 30 6.54
Home equity 14,862 218 5.80 14,433 219 6.09
Consumer - direct 2,162 39 7.19 2,135 40 7.44
Consumer - indirect lease financing 460 11 9.60 601 14 9.40
Consumer - indirect other 5,123 105 8.23 5,002 105 8.43
- ---------------------------------------------------------------------------------------------------------
Total consumer loans 24,314 401 6.55 23,974 408 6.82
Loans held for sale 2,526 29 4.53 2,518 29 4.70
- ---------------------------------------------------------------------------------------------------------
Total loans 63,078 893 5.62 63,029 922 5.86
Taxable investment securities 14 -- 4.46 5 -- 5.44
Tax-exempt investment securities(a) 91 2 9.76 110 3 9.46
- ---------------------------------------------------------------------------------------------------------
Total investment securities 105 2 9.07 115 3 9.27
Securities available for sale(a,c) 7,877 77 3.91 8,321 97 4.68
Short-term investments 1,531 6 1.70 1,484 8 2.12
Other investments(c) 1,032 6 2.68 985 6 2.47
- ---------------------------------------------------------------------------------------------------------
Total earning assets 73,623 984 5.32 73,934 1,036 5.61
Allowance for loan losses (1,396) (1,409)
Accrued income and other assets 12,495 12,187
- ---------------------------------------------------------------------------------------------------------
$ 84,722 $ 84,712
======== =========
LIABILITIES AND SHAREHOLDERS' EQUITY
NOW and money market deposit accounts $ 18,381 35 .75 $ 17,740 41 .93
Savings deposits 2,092 2 .48 2,084 3 .54
Certificates of deposit ($100,000 or more)(d) 4,898 46 3.78 4,743 47 3.98
Other time deposits 11,073 81 2.89 11,434 84 2.96
Deposits in foreign office 1,627 4 1.04 2,445 8 1.25
- ---------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 38,071 168 1.76 38,446 183 1.91
Federal funds purchased and securities
sold under repurchase agreements 5,133 12 .93 5,075 15 1.19
Bank notes and other short-term borrowings(d) 2,559 13 2.05 2,351 15 2.58
Long-term debt, including capital securities(d) 15,421 101 2.68 16,309 113 2.90
- ---------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities 61,184 294 1.93 62,181 326 2.13
Noninterest-bearing deposits 10,628 10,053
Accrued expense and other liabilities 6,016 5,526
Common shareholders' equity 6,894 6,952
- ---------------------------------------------------------------------------------------------------------
$ 84,722 $ 84,712
======== =========
Interest rate spread (TE) 3.39 % 3.48 %
- ---------------------------------------------------------------------------------------------------------
Net interest income (TE) and net
interest margin (TE) 690 3.73 % 710 3.85 %
==== ====
TE adjustment(a) 13 14
- ---------------------------------------------------------------------------------------------------------
Net interest income, GAAP basis $ 677 $ 696
======= ======
Capital securities -- -- $ 1,266 $ 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 = Accounting Principles Generally Accepted in the United States
44
FIGURE 6. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
(CONTINUED)
FIRST QUARTER 2003 FOURTH QUARTER 2002 THIRD QUARTER 2002
- -------------------------- ------------------------- ------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE
- ----------------------------------------------------------------------------------------
$17,221 $ 206 4.86 % $17,362 $ 220 5.01 % $17,485 $ 225 5.11 %
6,034 82 5.49 6,168 88 5.66 6,207 93 5.92
5,683 72 5.16 5,856 78 5.27 5,822 79 5.37
7,790 123 6.30 7,356 112 6.13 7,215 121 6.72
- ---------------------------------------------------------------------------------------
36,728 483 5.31 36,742 498 5.39 36,729 518 5.60
1,904 32 6.66 2,029 33 6.72 2,089 37 7.00
14,005 217 6.29 13,649 226 6.55 13,505 222 6.52
2,129 40 7.68 2,153 44 8.17 2,172 46 8.32
772 18 9.40 1,001 24 9.42 1,264 28 8.98
4,917 107 8.74 5,117 116 9.05 5,143 117 9.13
- ---------------------------------------------------------------------------------------
23,727 414 7.05 23,949 443 7.36 24,173 450 7.41
2,390 28 4.70 1,986 26 5.28 2,584 35 5.48
- ---------------------------------------------------------------------------------------
62,845 925 5.95 62,677 967 6.14 63,486 1,003 6.29
2 -- 8.43 1 -- 8.85 1 -- 8.45
125 3 8.89 132 3 9.32 166 4 8.76
- ---------------------------------------------------------------------------------------
127 3 8.88 133 3 9.31 167 4 8.75
7,790 101 5.21 7,598 106 5.60 6,424 97 6.11
1,706 8 1.87 1,240 7 2.12 1,151 7 2.28
956 6 2.46 906 6 2.39 855 6 2.46
- ---------------------------------------------------------------------------------------
73,424 1,043 5.73 72,554 1,089 5.97 72,083 1,117 6.17
(1,438) (1,471) (1,509)
11,928 11,652 11,361
- ---------------------------------------------------------------------------------------
$83,914 $82,735 $81,935
======= ======= =======
$16,747 42 1.03 $15,131 40 1.03 $13,293 30 .91
2,043 3 .60 1,981 4 .63 2,002 3 .67
4,654 48 4.20 4,741 51 4.29 4,886 54 4.45
11,799 90 3.09 12,213 101 3.29 12,713 115 3.57
1,719 5 1.24 1,974 6 1.43 2,593 12 1.76
- ---------------------------------------------------------------------------------------
36,962 188 2.07 36,040 202 2.22 35,487 214 2.40
4,800 14 1.19 5,502 20 1.44 5,483 23 1.69
2,801 18 2.65 2,192 14 2.53 2,581 18 2.73
17,279 120 2.90 17,040 129 3.09 17,455 140 3.25
- ---------------------------------------------------------------------------------------
61,842 340 2.25 60,774 365 2.40 61,006 395 2.59
9,788 9,926 9,177
5,465 5,314 5,159
6,819 6,721 6,593
- ---------------------------------------------------------------------------------------
$83,914 $82,735 $81,935
======= ======= =======
3.48 % 3.57 % 3.58 %
- ----------------------------------------------------------------------------------------
703 3.86 % 724 3.98 % 722 3.99 %
==== ==== ====
22 12 22
- ----------------------------------------------------------------------------------------
$ 681 $ 712 $ 700
====== ======== ========
$ 1,254 $ 18 $ 1,233 $ 18 $1,249 $ 19
- ----------------------------------------------------------------------------------------
45
FIGURE 7. COMPONENTS OF NET INTEREST INCOME CHANGES
FROM THREE MONTHS ENDED SEPTEMBER 30, 2002
TO THREE MONTHS ENDED SEPTEMBER 30, 2003
------------------------------------------
AVERAGE YIELD/ NET
in millions VOLUME RATE CHANGE
- --------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ (6) $(104) $ (110)
Tax-exempt investment securities (2) -- (2)
Securities available for sale 19 (40) (21)
Short-term investments 2 (2) --
Other investments 1 (1) --
- ----------------------------------------------------------------------------------------
Total interest income (taxable equivalent) 14 (147) (133)
INTEREST EXPENSE
NOW and money market deposit accounts 10 (5) 5
Savings deposits -- (1) (1)
Certificates of deposit ($100,000 or more) -- (8) (8)
Other time deposits (14) (20) (34)
Deposits in foreign office (4) (4) (8)
- ----------------------------------------------------------------------------------------
Total interest-bearing deposits (8) (38) (46)
Federal funds purchased and securities sold
under repurchase agreements (1) (10) (11)
Bank notes and other short-term borrowings -- (5) (5)
Long-term debt, including capital securities (15) (24) (39)
- ----------------------------------------------------------------------------------------
Total interest expense (24) (77) (101)
- ----------------------------------------------------------------------------------------
Net interest income (taxable equivalent) $ 38 $ (70) $(32)
===== ===== ====
- ----------------------------------------------------------------------------------------
FROM NINE MONTHS ENDED SEPTEMBER 30, 2002
TO NINE MONTHS ENDED SEPTEMBER 30, 2003
-----------------------------------------
AVERAGE YIELD/ NET
in millions VOLUME RATE CHANGE
- --------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ (31) $ (290) $ (321)
Tax-exempt investment securities (6) 2 (4)
Securities available for sale 82 (90) (8)
Short-term investments -- (1) (1)
Other investments 3 (3) --
- --------------------------------------------------------------------------------------------
Total interest income (taxable equivalent) 48 (382) (334)
INTEREST EXPENSE
NOW and money market deposit accounts 29 (2) 27
Savings deposits -- (2) (2)
Certificates of deposit ($100,000 or more) 1 (27) (26)
Other time deposits (45) (95) (140)
Deposits in foreign office (6) (9) (15)
- --------------------------------------------------------------------------------------------
Total interest-bearing deposits (21) (135) (156)
Federal funds purchased and securities sold
under repurchase agreements (6) (23) (29)
Bank notes and other short-term borrowings (12) (7) (19)
Long-term debt, including capital securities (15) (73) (88)
- --------------------------------------------------------------------------------------------
Total interest expense (54) (238) (292)
- --------------------------------------------------------------------------------------------
Net interest income (taxable equivalent) $ 102 $(144) $ (42)
====== ===== =======
- --------------------------------------------------------------------------------------------
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.
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
September 30, 2003,
46
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 September
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 1.22% 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 .20% 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.
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 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 September
30, 2003, Key's aggregate daily VAR was $1.3 million, compared with $1.1 million
at September 30, 2002. Aggregate daily VAR averaged $1.2 million for the first
nine months of 2003, compared with an average of $1.4 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 third quarter of 2003 was $463 million, up $31
million, or 7%, from the same period last year. For the first nine months of the
year, noninterest income was $1.3 billion, representing a decrease of $29
million, or 2%, from the first nine months of 2002.
As shown in Figure 8, the growth in noninterest income from the year-ago quarter
was due primarily to a $16 million increase in net gains from principal
investing included in "investment banking and capital markets income," higher
net gains from loan securitizations and sales and an $11 million decrease in net
losses incurred on the residual values of leased vehicles included in
"miscellaneous income." These positive changes were offset in part by lower
income from trust and investment services and from service charges on deposit
accounts.
For the year-to-date period, decreases in income from trust and investment
services and from service charges on deposit accounts more than offset an
increase in net gains from loan sales and securitizations and the growth in
non-yield-related loan fees.
FIGURE 8. NONINTEREST INCOME
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ---------------- ----------------- -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- -------------------------------------------------------------------------------------------------------------------------------
Trust and investment services income $139 $151 $(12) (7.9)% $ 402 $ 467 $(65) (13.9)%
Service charges on deposit accounts 93 102 (9) (8.8) 276 306 (30) (9.8)
Investment banking and capital markets income 52 34 18 52.9 139 130 9 6.9
Letter of credit and loan fees 42 36 6 16.7 113 93 20 21.5
Corporate-owned life insurance income 27 25 2 8.0 81 77 4 5.2
Electronic banking fees 20 21 (1) (4.8) 61 59 2 3.4
Net securities gains 2 -- 2 N/M 9 1 8 800.0
Other income:
Insurance income 12 14 (2) (14.3) 38 42 (4) (9.5)
Net gains from loan securitizations and sales 39 25 14 56.0 68 34 34 100.0
Loan securitization servicing fees 2 2 -- -- 6 7 (1) (14.3)
Credit card fees 2 2 -- -- 8 6 2 33.3
Miscellaneous income 33 20 13 65.0 93 101 (8) (7.9)
- ------------------------------------------------------------------------------------------------------------------------------
Total other income 88 63 25 39.7 213 190 23 12.1
- ------------------------------------------------------------------------------------------------------------------------------
Total noninterest income $463 $432 $31 7.2 % $1,294 $1,323 $(29) (2.2)%
==== ==== ====== ====== ====== ======
- -------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
The discussion that follows explains 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. The decrease in trust and investment services income relative to the
prior year is attributable largely to the June 2002 sale of Key's 401(k) plan
recordkeeping business. The divestiture of this business accounted for $10
million of the decrease in income from the third quarter of 2002 and $29 million
of the decrease from the first nine months of last year.
FIGURE 9. TRUST AND INVESTMENT SERVICES INCOME
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ---------------- ----------------- ----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ---------------------------------------------------------------------------------------------------------------------------
Personal asset management and custody fees $ 39 $ 38 $1 2.6 % $111 $120 $(9) (7.5)%
Institutional asset management and custody fees 10 20 (10) (50.0) 29 60 (31) (51.7)
Bond services 10 9 1 11.1 29 29 -- --
Brokerage commission income 47 48 (1) (2.1) 141 149 (8) (5.4)
All other fees 33 36 (3) (8.3) 92 109 (17) (15.6)
- -------------------------------------------------------------------------------------------------------------------------
Total trust and investment services income $139 $151 $(12) (7.9)% $402 $467 $(65) (13.9)%
==== ==== ====== ==== ==== ======
- -------------------------------------------------------------------------------------------------------------------------
A significant portion of Key's trust and investment services income is based on
the value of assets under management. Thus, declines in the equity and fixed
income markets that occurred during 2002 and the first half of 2003 also
contributed to the year-to-date decrease in revenue compared with that reported
for the first nine months of 2002. Income from trust and investment services for
the third quarter of 2003 rose by
48
$8 million from the prior quarter due largely to the recent improvement in the
financial markets and a modest boost from the acquisition of NewBridge Partners.
At September 30, 2003, Key's bank, trust and registered investment advisory
subsidiaries had assets under management of $65.0 billion, compared with $62.4
billion at September 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 4% increase in the value of assets under management over the past
twelve months was due primarily to an increase in the market value of those
assets. During the same period, net asset inflows accounted for a small amount
of the increase in assets under management, due largely to the July 2003
acquisition of NewBridge Partners.
FIGURE 10. ASSETS UNDER MANAGEMENT
2003 2002
------------------------------ --------------------
in millions THIRD SECOND FIRST FOURTH THIRD
- ----------------------------------------------------------------------------------------------------------------------------
Assets under management by investment type:
Equity $28,839 $26,931 $25,415 $27,224 $25,422
Fixed income 17,300 17,121 16,310 16,133 17,588
Money market 18,901 19,250 19,073 18,337 19,364
- ----------------------------------------------------------------------------------------------------------------------------
Total $65,040 $63,302 $60,798 $61,694 $62,374
------- ------- ------- ------- -------
Proprietary mutual funds included in assets under management:
Equity $2,777 $2,604 $2,236 $2,878 $2,965
Fixed income 1,087 1,144 1,125 1,215 1,377
Money market 10,205 10,362 10,762 11,457 12,129
- ----------------------------------------------------------------------------------------------------------------------------
Total $14,069 $14,110 $14,123 $15,550 $16,471
======= ======= ======= ======= =======
- ----------------------------------------------------------------------------------------------------------------------------
SERVICE CHARGES ON DEPOSIT ACCOUNTS. The reduction in service charges for both
the quarterly and year-to-date periods was 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, improved
results from principal investing activities drove the increase from the prior
year in investment banking and capital markets income for both the quarterly and
year-to-date periods.
Key's principal investing income is susceptible to volatility since it is
derived from investments in small to medium-sized businesses, some 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 ($729 million at September 30, 2003, and $631 million at September
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 NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ----------------- ----------------- ------------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ----------------------------------------------------------------------------------------------------------------------------------
Dealer trading and derivatives income $ 3 $ 3 -- -- $ 15 $ 27 $ (12) (44.4)%
Investment banking income 23 23 -- -- 67 78 (11) (14.1)
Net gains (losses) from principal investing 16 -- $ 16 N/M 32 (1) 33 N/M
Foreign exchange income 10 8 2 25.0% 25 26 (1) (3.8)
- ---------------------------------------------------------------------------------------------------------------------------------
Total investment banking and capital markets
income $ 52 $ 34 $ 18 52.9% $ 139 $130 $ 9 6.9 %
==== ==== ====== ===== ==== ======
- ----------------------------------------------------------------------------------------------------------------------------------
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 agency origination, servicing and syndication fees generated
by the KeyBank Real Estate Capital line of business. These improved results
49
were due in part to the acquisition of Conning Asset Management in June 2002.
Higher fees from letter of credit activities also contributed to the increases.
OTHER INCOME. The increase in other income for both the quarterly and
year-to-date periods was due largely to higher net gains from loan
securitizations and sales as shown in Figure 8. In addition, the increase in
other income for the third quarter compared with the same period last year
reflects an $11 million decrease in net losses incurred on the residual values
of leased vehicles included in "miscellaneous income."
NONINTEREST EXPENSE
Noninterest expense for the third quarter of 2003 was $699 million, up $40
million, or 6%, from the same period last year. For the first nine months of the
year, noninterest expense was $2.0 billion, representing an increase of $59
million, or 3%, from the first nine months of 2002.
As shown in Figure 12, increases in personnel expense and professional fees
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 NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------- ----------------- ----------------- -----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ----------------------------------------------------------------------------------------------------------------------------------
Personnel $ 380 $ 358 $ 22 6.1 % $ 1,114 $ 1,082 $ 32 3.0%
Net occupancy 56 57 (1) (1.8) 171 170 1 .6
Computer processing 43 45 (2) (4.4) 131 147 (16) (10.9)
Equipment 35 33 2 6.1 101 103 (2) (1.9)
Marketing 30 33 (3) (9.1) 88 89 (1) (1.1)
Professional fees 30 21 9 42.9 87 63 24 38.1
Other expense:
Postage and delivery 15 15 -- -- 43 44 (1) (2.3)
Telecommunications 8 9 (1) (11.1) 24 26 (2) (7.7)
Equity- and gross receipts-based taxes 5 7 (2) (28.6) 15 20 (5) (25.0)
OREO expense, net 5 1 4 400.0 10 4 6 150.0
Miscellaneous expense 92 80 12 15.0 260 237 23 9.7
- ---------------------------------------------------------------------------------------------------------------------------------
Total other expense 125 112 13 11.6 352 331 21 6.3
- ---------------------------------------------------------------------------------------------------------------------------------
Total noninterest expense $ 699 $ 659 $ 40 6.1 % $ 2,044 $ 1,985 $ 59 3.0%
====== ====== ====== ======= ======= ======
Average full-time equivalent employees 20,059 20,802 (743) (3.6)% 20,174 20,927 (753) (3.6)%
- ---------------------------------------------------------------------------------------------------------------------------------
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. As shown in Figure 13, personnel expense, the largest category of
Key's noninterest expense, rose by $32 million, or 3%, from the first nine
months of 2002. This increase resulted from higher salaries expense, a rise in
employee benefit costs (primarily pension costs), and an increase in stock
options expense, offset in part by lower incentive compensation accruals.
Effective January 1, 2003, Key adopted the fair value method of accounting for
stock option expense as outlined in SFAS No. 123, "Accounting for Stock-Based
Compensation." 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.
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 third quarter of 2003, the number of average
full-time equivalent employees was 20,059, compared with 19,999 for the second
quarter of 2003 and 20,802 for the year-ago quarter.
50
FIGURE 13. PERSONNEL EXPENSE
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE
------------------ ----------------- ------------------ ----------------
dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT
- ---------------------------------------------------------------------------------------------------------------------
Salaries $215 $218 $ (3) (1.4)% $ 656 $ 647 $ 9 1.4%
Employee benefits 63 53 10 18.9 198 171 27 15.8
Incentive compensation 94 85 9 10.6 245 259 (14) (5.4)
Stock-based compensation 8 2 6 300.0 15 5 10 200.0
- --------------------------------------------------------------------------------------------------------------------
Total personnel expense $380 $358 $ 22 6.1% $1,114 $1,082 $ 32 3.0%
==== ==== ==== ====== ====== ====
- --------------------------------------------------------------------------------------------------------------------
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 and for outside legal services.
INCOME TAXES
The provision for income taxes was $91 million for the third quarter of 2003,
compared with $93 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 28.6% for the third quarter of 2003, compared with 27.5% for
the third quarter of 2002. For the first nine months of 2003, the provision for
income taxes was $257 million, compared with $238 million for the first nine
months of 2002. The effective tax rates for these periods were 27.8% and 24.6%,
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 nine 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 nine-month periods ended
September 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 September 30, 2003, total loans outstanding were $62.7 billion, compared with
$62.5 billion at the end of 2002 and $63.0 billion a year ago. The composition
of Key's loan portfolio at each of these dates is presented in Note 6 ("Loans")
on page 19. 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 $571
million, or 2%, 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.
Commercial real estate loans comprise one of the largest segments of Key's
commercial loan portfolio. At September 30, 2003, Key's commercial real estate
portfolio included mortgage loans of $5.8 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 $45 million. The average size of a construction
loan was $7 million. The largest construction loan commitment was $49 million,
of which $38 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 52% of
Key's total average commercial real estate loans during the third quarter of
2003. 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
SEPTEMBER 30, 2003 --------------------------------------------- TOTAL PERCENT OF
dollars in millions EAST MIDWEST CENTRAL WEST AMOUNT TOTAL
- -----------------------------------------------------------------------------------------------------------------------------------
Nonowner-occupied:
Multi-family properties $ 619 $ 550 $ 676 $ 683 $ 2,528 23.0%
Retail properties 225 469 106 233 1,033 9.3
Office buildings 135 91 174 223 623 5.6
Residential properties 116 59 140 505 820 7.4
Warehouses 39 126 104 136 405 3.7
Manufacturing facilities 15 14 7 13 49 .4
Hotels/Motels 6 9 1 8 24 .2
Other 112 299 58 162 631 5.7
- -----------------------------------------------------------------------------------------------------------------------------------
1,267 1,617 1,266 1,963 6,113 55.3
Owner-occupied 667 2,190 608 1,480 4,945 44.7
- -----------------------------------------------------------------------------------------------------------------------------------
Total $1,934 $3,807 $1,874 $3,443 $11,058 100.0%
====== ====== ====== ====== ======= =====
- -----------------------------------------------------------------------------------------------------------------------------------
Nonowner-occupied:
Nonperforming loans -- $ 18 $ 3 $ 15 $ 36 N/M
Accruing loans past due 90 days or more $ 2 16 -- 3 21 N/M
Accruing loans past due 30 through 89 days 21 8 -- 8 37 N/M
- -----------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
CONSUMER LOAN PORTFOLIO. Consumer loans outstanding increased by $150 million,
or 1%, from one year ago. Our home equity portfolio increased by $1.4 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 $737 million in automobile lease financing
receivables and $433 million in residential real estate mortgage loans. The
decline in automobile lease financing receivables reflects our decision to exit
the automobile leasing business. Residential real estate loans declined since
most of the new loans originated by Key over the past twelve months were
originated for sale, and low interest rates led to significant mortgage
prepayment activity.
Excluding loan sales and acquisitions, consumer loans would have increased by
$1.1 billion, or 5%, 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 (54% of the home equity portfolio at September 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.
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 yields on
the portfolio as a whole.
53
FIGURE 15. HOME EQUITY LOANS
2003 2002
------------------------------------- ----------------------
dollars in millions THIRD SECOND FIRST FOURTH THIRD
- ------------------------------------------------------------------------------------------------------------------------
SOURCES OF LOANS OUTSTANDING AT PERIOD END
Retail Banking (KeyCenters) and Small Business $ 8,324 $ 8,152 $ 7,788 $ 7,549 $ 7,395
McDonald Financial Group and other sources 1,455 1,418 1,357 1,318 1,285
Champion Mortgage Company 2,747 2,461 2,332 2,210 2,109
Key Home Equity Services division 2,353 2,657 2,667 2,727 2,727
- ------------------------------------------------------------------------------------------------------------------------
National Home Equity unit 5,100 5,118 4,999 4,937 4,836
- ------------------------------------------------------------------------------------------------------------------------
Total $14,879 $14,688 $14,144 $13,804 $13,516
======= ======= ======= ======= =======
- ------------------------------------------------------------------------------------------------------------------------
Nonperforming loans at period end $ 151 $ 152 $ 154 $ 146 $ 124
Net charge-offs for the period 14 13 13 13 12
Yield for the period 5.80% 6.09% 6.29% 6.55% 6.52%
- ------------------------------------------------------------------------------------------------------------------------
SALES, SECURITIZATIONS AND DIVESTITURES. During the past twelve months, Key sold
$1.7 billion of commercial real estate loans, $1.2 billion of education loans
($835 million through a securitization), $829 million of home equity loans, $607
million of residential real estate loans, and $509 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
nine 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
- --------------
Third quarter $120 $ 423 -- $211 $473 -- $ 895 $2,122
Second quarter 67 408 -- 184 134 -- 85 878
First quarter 52 253 -- 147 112 -- 109 673
- -------------------------------------------------------------------------------------------------------------------------
Total $239 $1,084 -- $542 $719 -- $1,089 $3,673
==== ====== === ==== ==== ==== ====== ======
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 $524 million of the $29.6
billion of loans administered or serviced at September 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 and from the investment of funds
generated by escrow deposits. 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
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30,
in millions 2003 2003 2003 2002 2002
- --------------------------------------------------------------------------------------------------------------------------
Education loans $ 4,750 $ 4,161 $ 4,381 $ 4,605 $ 4,756
Automobile loans -- 29 40 54 69
Home equity loans 283 334 389 456 519
Commercial real estate loans 24,379 22,428 20,508 19,508 17,002
Commercial loans 153 142 130 123 110
- --------------------------------------------------------------------------------------------------------------------------
Total $29,565 $27,094 $25,448 $24,746 $22,456
======= ======= ======= ======= =======
- --------------------------------------------------------------------------------------------------------------------------
SECURITIES
At September 30, 2003, the securities portfolio totaled $8.8 billion and
included $7.6 billion of securities available for sale, $106 million of
investment securities and $1.1 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 3.4 years at September 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 September 30, 2003, Key had $7.1 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 $7.0 billion at September 30, 2002. 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. However, 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. Substantially all of Key's mortgage-backed securities
are issued or backed by federal agencies. The CMO securities held by Key are
shorter-maturity class bonds that are structured to have more predictable cash
flows than other longer-term class bonds during periods of rising interest
rates.
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)
- --------------------------------------------------------------------------------------------
SEPTEMBER 30, 2003
Remaining maturity:
One year or less $ 26 $ 1 $ 36 $ 112
After one through five years 28 5 6,136 358
After five through ten years 2 7 224 115
After ten years 3 12 86 11
- --------------------------------------------------------------------------------------------
Fair value $ 59 $ 25 $6,482 $ 596
Amortized cost 59 24 6,545 575
Weighted average yield 2.10% 6.98% 4.25% 5.46%
Weighted average maturity 2.1 YEARS 10.6 YEARS 3.4 YEARS 2.7 YEARS
- --------------------------------------------------------------------------------------------
DECEMBER 31, 2002
Fair value $ 23 $ 35 $7,207 $ 852
Amortized cost 22 35 7,143 815
- --------------------------------------------------------------------------------------------
SEPTEMBER 30, 2002
Fair value $ 21 $ 18 $6,194 $ 783
Amortized cost 20 17 6,156 748
- --------------------------------------------------------------------------------------------
RETAINED WEIGHTED
INTERESTS IN OTHER AVERAGE
dollars in millions SECURITIZATIONS(a) SECURITIES TOTAL YIELD(b)
- --------------------------------------------------------------------------------------------
SEPTEMBER 30, 2003
Remaining maturity:
One year or less -- $ 13 $ 188 4.04%
After one through five years $ 167 185(c) 6,879 4.58
After five through ten years -- -- 348 7.57
After ten years 17 6 135 9.32
- ---------------------------------------------------------------------------------------
Fair value $ 184 $204 $ 7,550 --
Amortized cost 120 200 7,523 4.77%
Weighted average yield 35.67% 1.47(b)% 4.77% --
Weighted average maturity 4.3 YEARS 3.7 YEARS 3.4 YEARS --
- ---------------------------------------------------------------------------------------
DECEMBER 31, 2002
Fair value $ 209 $ 181 $ 8,507 --
Amortized cost 166 208 8,389 5.76%
- ---------------------------------------------------------------------------------------
SEPTEMBER 30, 2002
Fair value $ 217 $ 176 $ 7,409 --
Amortized cost 182 216 7,339 5.95%
- ---------------------------------------------------------------------------------------
(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 $114 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)
- ------------------------------------------------------------------------------------------
SEPTEMBER 30, 2003
Remaining maturity:
One year or less $ 24 $ 2 $ 26 9.65%
After one through five years 56 8 64 8.61
After five through ten years 10 5 15 6.73
After ten years 1 -- 1 11.30
- ------------------------------------------------------------------------------------------
Amortized cost $ 91 $15 $106 8.57%
Fair value 98 15 113 --
Weighted average maturity 2.5 YEARS 3.9 YEARS 2.7 YEARS --
- ------------------------------------------------------------------------------------------
DECEMBER 31, 2002
Amortized cost $120 -- $120 9.43%
Fair value 129 -- 129 --
- ------------------------------------------------------------------------------------------
SEPTEMBER 30, 2002
Amortized cost $148 -- $148 9.33%
Fair value 158 -- 158 --
- ------------------------------------------------------------------------------------------
(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 $729 million at September 30, 2003. Of this amount, $16 million
represents net unrealized gains. Principal investments represent approximately
66% 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 September 30, 2003,
was $1.4 billion, or 2.24% of loans. This compares with $1.5 billion, or 2.37%
of loans, at September 30, 2002. The allowance includes $93 million that was
specifically allocated for impaired loans of $286 million at September 30, 2003,
compared with $200 million that was allocated for impaired loans of $414 million
a year ago. For more information about impaired loans, see Note 8 ("Impaired
Loans and Other Nonperforming Assets") on page 22. At September 30, 2003, the
allowance for loan losses was 176.73% of nonperforming loans, representing the
highest level of nonperforming loan coverage by the allowance since December 31,
2001. This compares with a ratio of 150.86% at September 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 September 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 $107
million, or 54%, over the past twelve months, reflecting Key's continued efforts
to resolve problem credits, combined with stabilizing credit quality trends in
certain portfolios.
The level of watch credits in the commercial portfolio has decreased in each of
the last three quarters. Watch credits are loans with the potential for further
deterioration in quality due to the debtor's current financial condition and
related inability to perform in accordance with the terms of the loan. The
commercial loan portfolios with the most significant decreases in watch credits
were commercial real estate, structured finance and media. 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. 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 third quarter of 2003 totaled
$123 million, or .77% 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 $185 million, or 1.16% 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 structured finance and media segments of the
commercial loan portfolio.
FIGURE 20. SUMMARY OF LOAN LOSS EXPERIENCE
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- ------------------
dollars in millions 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------
Average loans outstanding during the period $63,078 $63,486 $62,985 $63,634
- ------------------------------------------------------------------------------------------------------------------------
Allowance for loan losses at beginning of period $ 1,405 $ 1,539 $ 1,452 $ 1,677
Loans charged off:
Commercial, financial and agricultural 61 110 225 321
Real estate -- commercial mortgage 11 11 36 59
Real estate -- construction 1 5 5 17
- ------------------------------------------------------------------------------------------------------------------------
Total commercial real estate loans(a) 12 16 41 76
Commercial lease financing 14 18 45 56
- ------------------------------------------------------------------------------------------------------------------------
Total commercial loans 87 144 311 453
Real estate -- residential mortgage 2 1 5 4
Home equity 15 13 44 42
Consumer -- direct 12 11 37 38
Consumer -- indirect lease financing 3 6 12 19
Consumer -- indirect other 40 36 119 124
- ------------------------------------------------------------------------------------------------------------------------
Total consumer loans 72 67 217 227
- ------------------------------------------------------------------------------------------------------------------------
159 211 528 680
Recoveries:
Commercial, financial and agricultural 11 6 27 25
Real estate -- commercial mortgage 2 -- 10 3
Real estate -- construction -- 2 3 2
- ------------------------------------------------------------------------------------------------------------------------
Total commercial real estate loans(a) 2 2 13 5
Commercial lease financing 6 2 11 6
- ------------------------------------------------------------------------------------------------------------------------
Total commercial loans 19 10 51 36
Real estate -- residential mortgage -- -- 1 1
Home equity 1 1 4 3
Consumer -- direct 3 2 7 6
Consumer -- indirect lease financing 2 2 5 6
Consumer -- indirect other 11 11 35 34
- ------------------------------------------------------------------------------------------------------------------------
Total consumer loans 17 16 52 50
- ------------------------------------------------------------------------------------------------------------------------
36 26 103 86
- ------------------------------------------------------------------------------------------------------------------------
Net loans charged off (123) (185) (425) (594)
Provision for loan losses 123 135 378 406
- ------------------------------------------------------------------------------------------------------------------------
Allowance for loan losses at end of period $ 1,405 $ 1,489 $ 1,405 $ 1,489
======= ======= ======= =======
- ------------------------------------------------------------------------------------------------------------------------
Net loan charge-offs to average loans .77% 1.16% .90% 1.25%
Allowance for loan losses to period-end loans 2.24 2.37 2.24 2.37
Allowance for loan losses to nonperforming loans 176.73 150.86 176.73 150.86
- ------------------------------------------------------------------------------------------------------------------------
(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.
58
NONPERFORMING ASSETS. Figure 21 shows the composition of Key's nonperforming
assets, which have declined for four consecutive quarters. These assets totaled
$862 million at September 30, 2003, and represented 1.37% 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 $1.0 billion, or 1.61%, at
September 30, 2002.
FIGURE 21. SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30,
dollars in millions 2003 2003 2003 2002 2002
- -------------------------------------------------------------------------------------------------------------------------------
Commercial, financial and agricultural $ 345 $ 361 $ 381 $ 448 $ 484
Real estate--commercial mortgage 89 143 165 157 149
Real estate--construction 38 22 37 50 79
- -------------------------------------------------------------------------------------------------------------------------------
Total commercial real estate loans(a) 127 165 202 207 228
Commercial lease financing 108 92 91 69 88
- -------------------------------------------------------------------------------------------------------------------------------
Total commercial loans 580 618 674 724 800
Real estate--residential mortgage 36 38 39 36 34
Home equity 151 152 154 146 124
Consumer--direct 12 13 13 13 6
Consumer--indirect lease financing 3 4 5 5 6
Consumer--indirect other 13 12 19 19 17
- -------------------------------------------------------------------------------------------------------------------------------
Total consumer loans 215 219 230 219 187
- -------------------------------------------------------------------------------------------------------------------------------
Total nonperforming loans 795 837 904 943 987
OREO 69 60 62 48 30
Allowance for OREO losses (4) (3) (3) (3) (2)
- -------------------------------------------------------------------------------------------------------------------------------
OREO, net of allowance 65 57 59 45 28
Other nonperforming assets 2 3 5 5 2
- -------------------------------------------------------------------------------------------------------------------------------
Total nonperforming assets $ 862 $ 897 $ 968 $ 993 $ 1,017
===== ===== ===== ===== =======
- -------------------------------------------------------------------------------------------------------------------------------
Accruing loans past due 90 days or more $ 165 $ 172 $ 207 $ 198 $ 208
Accruing loans past due 30 through 89 days 710 731 721 790 787
- -------------------------------------------------------------------------------------------------------------------------------
Nonperforming loans to period-end loans 1.27% 1.32% 1.44% 1.51% 1.57%
Nonperforming assets to period-end loans
plus OREO and other nonperforming assets 1.37 1.42 1.54 1.59 1.61
- -------------------------------------------------------------------------------------------------------------------------------
(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 third quarter was attributable
largely to decreases in the healthcare, middle market and structured finance
portfolios. At September 30, 2003, our 20 largest nonperforming loans totaled
$267 million, representing 34% 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. 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
----------------------
SEPTEMBER 30, 2003 TOTAL LOANS % OF LOANS
dollars in millions COMMITMENTS OUTSTANDING AMOUNT OUTSTANDING
- ------------------------------------------------------------------------------------------
Industry classification:
Manufacturing $ 9,450 $ 3,381 $140 4.1%
Services 6,525 2,503 69 2.8
Financial services 5,606 977 1 .1
Retail trade 4,550 2,539 16 .6
Property management 3,099 1,162 4 .3
Wholesale trade 2,717 1,268 17 1.3
Public utilities 2,024 375 2 .5
Building contractors 1,416 662 32 4.8
Communications 1,266 413 13 3.1
Insurance 1,138 142 -- --
Agriculture/forestry/fishing 1,052 680 18 2.6
Transportation 852 432 11 2.5
Public administration 702 246 -- --
Mining 410 163 -- --
Individuals 163 113 1 .9
Other 2,290 2,062 21 1.0
- ------------------------------------------------------------------------------------------
Total $43,260 $17,118 $345 2.0%
======= ======= ====
- ------------------------------------------------------------------------------------------
FIGURE 23. SUMMARY OF CHANGES IN NONPERFORMING LOANS
2003 2002
------------------------------------- ---------------------
in millions THIRD SECOND FIRST FOURTH THIRD
- -----------------------------------------------------------------------------------------------------------------------
Balance at beginning of period $ 837 $ 904 $ 943 $ 987 $ 957
Loans placed on nonaccrual status 240 168 237 339 281
Charge-offs (123) (141) (161) (186) (185)
Loans sold (73) (42) (23) (36) (25)
Payments (73) (26) (58) (149) (41)
Transfers to OREO (6) (1) (19) -- --
Loans returned to accrual status (7) (25) (15) (13) --
Acquisition of Union Bankshares, Ltd. -- -- -- 1 --
- -----------------------------------------------------------------------------------------------------------------------
Balance at end of period $ 795 $ 837 $ 904 $ 943 $ 987
===== ===== ===== ===== =====
- -----------------------------------------------------------------------------------------------------------------------
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 third quarter
of 2003, core deposits averaged $42.2 billion, and represented 57% of the funds
Key used to support earning assets, compared with $37.2 billion and 52%,
respectively, during the same quarter in 2002. The composition of Key's deposits
is shown in Figure 6, 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, the
introduction of new products, including free checking, and an increase in escrow
deposits associated with the servicing of commercial real estate loans. 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 $14.2 billion during the
third quarter of 2003, compared with $15.5 billion during the year-ago quarter.
Although large certificates of deposit have remained relatively unchanged from a
year ago, deposits in the foreign branch and short-term borrowings both 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. During the first nine months of 2003, Key
securitized and sold $835 million of education loans, all of which occurred in
the third quarter.
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.
61
- - We try to structure the maturities of our loans so we receive a
relatively consistent stream of payments from borrowers.
- - We have the ability to access the securitization markets for a variety
of loan types.
- - Our 900 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 September 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 nine-month periods ended September 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.
During the first nine months of 2003, affiliate banks paid KeyCorp a total of
$70 million in dividends. As of September 30, 2003, the affiliate banks had an
additional $260 million available to pay dividends to KeyCorp without prior
regulatory approval. KeyCorp generally maintains excess funds in short-term
investments.
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 nine months of 2003, Key's affiliate banks
raised $1.5 billion under Key's bank note program. Of the notes issued during
the year, $1.1 billion 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
September 30, 2003, $16.6 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 million
of borrowings issued under this program during the first nine months of 2003. At
September 30, 2003, $4.0 billion was available for future issuance.
62
KEYCORP MEDIUM-TERM NOTE PROGRAM AND OTHER SECURITIES. In November 2001, KeyCorp
registered, under a registration statement filed with the Securities and
Exchange Commission, $2.2 billion of securities. At September 30, 2003, of the
amount registered, $1.0 billion had been allocated for the issuance of
medium-term notes. On October 7, 2003, KeyCorp allocated the remaining amount,
$1.2 billion, for the issuance of medium-term notes. At September 30, 2003,
unused capacity under KeyCorp's universal shelf registration statement totaled
$1.5 billion.
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 September 30, 2003, there were no borrowings outstanding
under either the commercial paper program or the revolving credit agreement. The
revolving credit agreement expired on October 2, 2003, and was not renewed.
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 September 30, 2003,
borrowings outstanding under this commercial paper program totaled $795 million
in Canadian currency and $27 million in U.S. currency (equivalent to $36 million
in Canadian currency).
Key's debt ratings are shown in Figure 24 below. Management believes that these
debt ratings, under normal conditions in the capital markets, allow for future
offerings of securities by KeyCorp or its affiliate banks that would be
marketable to investors at a competitive cost.
FIGURE 24. DEBT RATINGS
SENIOR SUBORDINATED
SHORT-TERM LONG-TERM LONG-TERM CAPITAL
SEPTEMBER 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 September 30, 2003, was $7.0
billion, up $142 million from the balance at December 31, 2002. Growth in
retained earnings 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 were the largest contributors to the
increase. Other factors, including share repurchases discussed below, that
contributed to the change in shareholders' equity during the first nine months
of 2003 are shown in the Consolidated Statements of Changes in Shareholders'
Equity presented on page 5.
SHARE REPURCHASES. In September 2003, the Board of Directors authorized the
repurchase of up to 25,000,000 common shares, including 6,264,400 shares
remaining at the time from an earlier repurchase program. These shares may be
repurchased in the open market or through negotiated transactions. During the
first nine months of 2003, Key repurchased a total of 7,500,000 of its common
shares under the
63
previous program at an average price per share of $25.43. At September 30, 2003,
a remaining balance of 25,000,000 shares may be repurchased under the September
2003 authorization.
At September 30, 2003, Key had 72,622,333 treasury shares. Management may
reissue those shares from time-to-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 nine months of 2003, Key reissued
2,822,802 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 8.26% at September 30,
2003, and 7.97% at September 30, 2002. Key's ratio of tangible equity to
tangible assets was 6.94% at September 30, 2003, and exceeded management's
targeted range of 6.25% to 6.75%. Management believes that Key's strong capital
position provides the flexibility to take advantage of future investment
opportunities and to repurchase shares when appropriate. The tangible equity to
tangible assets ratio is expected to be managed downward over time to be within
management's targeted range.
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 September 30, 2003,
Key's Tier 1 capital ratio was 8.21%, and its total capital ratio was 12.46%.
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 September 30, 2003, Key
had a leverage ratio of 8.36%.
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 September 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 September 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 September
30, 2003, December 31, 2002 and September 30, 2002.
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FIGURE 25. CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30,
dollars in millions 2003 2002 2002
- ---------------------------------------------------------------------------------------------------
TIER 1 CAPITAL
Common shareholders' equity(a) $ 6,937 $ 6,738 $ 6,597
Qualifying capital securities 1,247 1,096 1,121
Less: Goodwill 1,154 1,142 1,105
Other assets(b) 76 60 46
- ---------------------------------------------------------------------------------------------------
Total Tier 1 capital 6,954 6,632 6,567
- ---------------------------------------------------------------------------------------------------
TIER 2 CAPITAL
Allowable portion of allowance for loan losses 1,083 986 977
Qualifying long-term debt 2,513 2,639 2,441
- ---------------------------------------------------------------------------------------------------
Total Tier 2 capital 3,596 3,625 3,418
- ---------------------------------------------------------------------------------------------------
Total risk-based capital $ 10,550 $ 10,257 $ 9,985
============ ============ ==============
RISK-WEIGHTED ASSETS
Risk-weighted assets on balance sheet $ 67,878 $ 67,051 $ 67,734
Risk-weighted off-balance sheet exposure 18,451 16,595 12,595
Less: Goodwill 1,154 1,142 1,105
Other assets(b) 379 251 218
Plus: Market risk-equivalent assets 213 192 214
- ---------------------------------------------------------------------------------------------------
Gross risk-weighted assets 85,009 82,445 79,220
Less: Excess allowance for loan losses 322 466 512
- ---------------------------------------------------------------------------------------------------
Net risk-weighted assets $ 84,687 $ 81,979 $ 78,708
============ ============ ==============
AVERAGE QUARTERLY TOTAL ASSETS $ 84,722 $ 82,735 $ 81,935
============ ============ ==============
CAPITAL RATIOS
Tier 1 risk-based capital ratio 8.21% 8.09% 8.34%
Total risk-based capital ratio 12.46 12.51 12.69
Leverage ratio(c) 8.36 8.15 8.15
- ---------------------------------------------------------------------------------------------------
(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, which begins on
page 46 in the Management's Discussion and Analysis of Financial Condition and
Results of Operations, 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.
66
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
10.1 Trust Agreement for certain amounts that may become payable to
certain executives and directors of KeyCorp, dated April 1,
1997, and amended as of August 25, 2003.
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
July 18, 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 July 18, 2003, the Registrant issued a press release
announcing its earnings results for the three- and six-month periods
ended June 30, 2003, and providing a slide presentation reviewed in the
related conference call/webcast.
September 11, 2003 - Item 9. Regulation FD Disclosure. Reporting that
on September 10, 2003, the Registrant provided updated earnings
guidance at the Lehman Brothers Financial Services Conference and
providing a slide presentation reviewed at the conference.
No other reports on Form 8-K were filed during the three-month period
ended September 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 Securities and
Exchange Commission.
67
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: November 12, 2003 /s/ Lee Irving
------------------------------------
By: Lee Irving
Executive Vice President
and Chief Accounting Officer
68