10-Q 1 l84501ae10-q.txt KEYCORP FORM 10-Q 1 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, 2000 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] ------------------------------------------------------ (Exact name of registrant as specified in its charter) Ohio 34-6542451 -------------------------------- ----------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 127 Public Square, Cleveland, Ohio 44114-1306 ---------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (216) 689-6300 ------------------------------------------------------ (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate 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 425,826,510 Shares ---------------------------------------- --------------------------------- (Title of class) (Outstanding at October 31, 2000) 2 KEYCORP TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS PAGE NUMBER Consolidated Balance Sheets -- September 30, 2000, December 31, 1999 and September 30, 1999 3 Consolidated Statements of Income -- Three months and nine months ended September 30, 2000 and 1999 4 Consolidated Statements of Changes in Shareholders' Equity -- Nine months ended September 30, 2000 and 1999 5 Consolidated Statements of Cash Flow -- Nine months ended September 30, 2000 and 1999 6 Notes to Consolidated Financial Statements 7 Independent Accountants' Review Report 26 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 27 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK 59 PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS 60 Item 5. OTHER INFORMATION 61 Item 6. EXHIBITS AND REPORTS ON FORM 8-K 62 Signature 62
2 3 PART I. FINANCIAL INFORMATION Item 1. Financial Statements
Consolidated Balance Sheets September 30, December 31, September 30, dollars in millions 2000 1999 1999 ------------------------------------------------------------------------------------------------------- (Unaudited) (Unaudited) ASSETS Cash and due from banks $ 2,691 $ 2,816 $ 3,018 Short-term investments 1,570 1,860 2,094 Securities available for sale 6,664 6,665 6,567 Investment securities (fair value: $1,262, $998 and $1,005) 1,253 986 989 Loans, net of unearned income of $1,756, $1,621 and $1,566 66,299 64,222 63,181 Less: Allowance for loan losses 1,001 930 930 ------------------------------------------------------------------------------------------------------- Net loans 65,298 63,292 62,251 Premises and equipment 711 797 818 Goodwill 1,339 1,389 1,422 Other intangible assets 48 60 64 Corporate owned life insurance 2,185 2,110 2,080 Other assets 3,741 3,420 3,274 ------------------------------------------------------------------------------------------------------- Total assets $85,500 $83,395 $82,577 ======= ======= ======= LIABILITIES Deposits in domestic offices: Noninterest-bearing $ 8,386 $8,607 $9,050 Interest-bearing 35,016 33,390 34,029 Deposits in foreign office -- interest-bearing 4,407 1,236 387 ------------------------------------------------------------------------------------------------------- Total deposits 47,809 43,233 43,466 Federal funds purchased and securities sold under repurchase agreements 5,324 4,177 3,510 Bank notes and other short-term borrowings 6,407 8,439 8,551 Other liabilities 4,397 4,033 3,595 Long-term debt 13,800 15,881 15,815 Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely subordinated debentures of the Corporation (See Note 9) 1,243 1,243 1,243 ------------------------------------------------------------------------------------------------------- Total liabilities 78,980 77,006 76,180 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 1,402 1,412 1,412 Retained earnings 6,205 5,833 5,686 Loans to ESOP trustee (13) (24) (24) Treasury stock, at cost (64,628,931, 48,462,243 and 43,064,912 shares) (1,502) (1,197) (1,058) Accumulated other comprehensive loss (64) (127) (111) ------------------------------------------------------------------------------------------------------- Total shareholders' equity 6,520 6,389 6,397 ------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $85,500 $83,395 $82,577 ======= ======= ======= ------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements (Unaudited).
3 4
Consolidated Statements of Income (Unaudited) Three months ended September 30, Nine months ended September 30, -------------------------------- ------------------------------- dollars in millions, except per share amounts 2000 1999 2000 1999 --------------------------------------------------------------------------------------------------------------------------------- INTEREST INCOME Loans $1,460 $1,299 $4,204 $3,800 Taxable investment securities 8 4 18 11 Tax-exempt investment securities 5 7 18 24 Securities available for sale 106 106 325 310 Short-term investments 17 17 60 61 --------------------------------------------------------------------------------------------------------------------------------- Total interest income 1,596 1,433 4,625 4,206 INTEREST EXPENSE Deposits 462 331 1,275 955 Federal funds purchased and securities sold under repurchase agreements 88 51 194 168 Bank notes and other short-term borrowings 99 103 328 310 Long-term debt, including capital securities 263 248 800 691 --------------------------------------------------------------------------------------------------------------------------------- Total interest expense 912 733 2,597 2,124 --------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME 684 700 2,028 2,082 Provision for loan losses 131 78 382 265 --------------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 553 622 1,646 1,817 NONINTEREST INCOME Trust and investment services income 148 145 458 445 Investment banking and capital markets income 91 77 278 243 Service charges on deposit accounts 85 83 256 246 Corporate owned life insurance income 28 25 78 76 Credit card fees 1 16 9 47 Net loan securitization gains (losses) (2) 32 7 82 Net securities gains (losses) (50) 2 (47) 26 Gains from divestitures -- 13 332 161 Other income 104 103 315 317 --------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 405 496 1,686 1,643 NONINTEREST EXPENSE Personnel 342 349 1,085 1,104 Net occupancy 55 58 168 175 Computer processing 59 60 178 173 Equipment 41 48 131 153 Marketing 29 35 82 84 Amortization of intangibles 26 25 76 79 Professional fees 30 18 70 50 Restructuring charges 102 7 109 7 Other expense 103 108 313 360 --------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 787 708 2,212 2,185 INCOME BEFORE INCOME TAXES 171 410 1,120 1,275 Income taxes 50 140 384 432 --------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 121 $ 270 $ 736 $ 843 ====== ====== ====== ===== Per common share: Net income $.28 $.60 $1.69 $1.88 Net Income - assuming dilution .28 .60 1.68 1.86 Weighted average common shares outstanding (000) 429,584 448,742 435,156 448,764 Weighted average common shares and potential common shares outstanding (000) 431,972 452,886 437,231 453,267 ---------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 4 5
Consolidated Statements of Changes in Shareholders' Equity (Unaudited) Accumulated Loans to Treasury Other Common Capital Retained ESOP Stock, Comprehensive Comprehensive dollars in millions, except per share amounts Shares Surplus Earnings Trustee at Cost (Loss) Income Income (b) ----------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1998 $492 $1,412 $5,192 $(34) $ (923) $ 28 Net income 843 $843 Other comprehensive losses: Net unrealized losses on securities available for sale, net of income taxes of $(85)(a) (136) (136) Foreign currency translation adjustments (3) (3) ----- Total comprehensive income $704 ===== Cash dividends on common shares ($.78 per share) (350) Issuance of common shares: Acquisition - 632,183 shares 6 15 Employee benefit and dividend reinvestment plans - 2,146,512 net shares (6) 52 Repurchase of common shares - 6,406,424 shares (202) ESOP transactions 1 10 ----------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 1999 $492 $1,412 $5,686 $(24) $(1,058) $(111) ==== ====== ====== ==== ======= ===== ----------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1999 $492 $1,412 $5,833 $(24) $(1,197) $(127) Net income 736 $736 Other comprehensive losses: Net unrealized gains on securities available for sale, net of income taxes of $41 (a) 73 73 Foreign currency translation adjustments (10) (10) ----- Total comprehensive income $799 ===== Cash dividends on common shares ($.84 per share) (364) Issuance of common shares: Employee benefit and dividend reinvestment plans -1,486,112 net shares (10) 35 Repurchase of common shares-17,652,800 shares (340) ESOP transactions 11 ----------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2000 $492 $1,402 $6,205 $(13) $(1,502) $ (64) ==== ====== ====== ==== ======= ===== -----------------------------------------------------------------------------------------------------------------
(a) Net of reclassification adjustments. (b) For the three months ended September 30, 2000 and 1999, comprehensive income was $205 million and $266 million, respectively. See Notes to Consolidated Financial Statements (Unaudited). 5 6
Consolidated Statements of Cash Flow (Unaudited) Nine months ended September 30, ------------------------------- in millions 2000 1999 ------------------------------------------------------------------------------------------------------------------------------ OPERATING ACTIVITIES Net income $ 736 $ 843 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 382 265 Depreciation expense and software amortization 211 219 Amortization of intangibles 76 79 Net gains from divestitures (332) (161) Net securities (gains) losses 47 (26) Net gains from venture capital investments (55) (26) Net gains from loan securitizations and sales (26) (107) Deferred income taxes 203 304 Net increase in mortgage loans held for sale (448) (13) Net (increase) decrease in trading account assets 39 (326) Net increase (decrease) in accrued restructuring charges 48 (2) Other operating activities, net (456) (298) ------------------------------------------------------------------------------------------------------------------------------ NET CASH PROVIDED BY OPERATING ACTIVITIES 425 751 INVESTING ACTIVITIES Net increase in loans, excluding acquisitions, sales and divestitures (5,615) (6,019) Purchases of loans -- (7) Proceeds from loan securitizations and sales 4,377 4,374 Purchases of investment securities (276) (169) Proceeds from sales of investment securities 32 9 Proceeds from prepayments and maturities of investment securities 127 192 Purchases of securities available for sale (4,908) (4,241) Proceeds from sales of securities available for sale 4,162 382 Proceeds from prepayments and maturities of securities available for sale 723 2,961 Net decrease in other short-term investments 251 206 Purchases of premises and equipment (60) (61) Proceeds from sales of premises and equipment 19 23 Proceeds from sales of other real estate owned 19 10 Cash used in acquisitions, net of cash acquired (375) -- ------------------------------------------------------------------------------------------------------------------------------ NET CASH USED IN INVESTING ACTIVITIES (1,524) (2,340) FINANCING ACTIVITIES Net increase in deposits 4,576 883 Net decrease in short-term borrowings (885) (2,115) Net proceeds from issuance of long-term debt, including capital securities 3,153 5,147 Payments on long-term debt, including capital securities (5,217) (2,094) Loan payment received from ESOP trustee 11 10 Purchases of treasury shares (317) (202) Net proceeds from issuance of common stock 17 32 Cash dividends (364) (350) ------------------------------------------------------------------------------------------------------------------------------ NET CASH PROVIDED BY FINANCING ACTIVITIES 974 1,311 ------------------------------------------------------------------------------------------------------------------------------ NET DECREASE IN CASH AND DUE FROM BANKS (125) (278) CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 2,816 3,296 ------------------------------------------------------------------------------------------------------------------------------ CASH AND DUE FROM BANKS AT END OF PERIOD $ 2,691 $ 3,018 ======= ======= ------------------------------------------------------------------------------------------------------------------------------ Additional disclosures relative to cash flow: Interest paid $ 2,560 $ 2,013 Income taxes paid 83 170 Net amount received on portfolio swaps 21 8 Noncash items: Transfer of credit card receivables to loans held for sale -- $ 1,299 Reclassification of financial instruments from loans to securities available for sale -- 374 Fair value of Concord EFS, Inc. shares received -- 170 Carrying amount of Electronic Payment Services, Inc. shares divested -- 36 Net transfer of premises and equipment to other assets $ 17 -- Net transfer of loans to other real estate owned 26 -- ------------------------------------------------------------------------------------------------------------------------------
6 7 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. Management believes that the unaudited condensed consolidated interim financial statements reflect all adjustments of a normal recurring nature and disclosures which 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 1999 Annual Report to Shareholders. 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. ACCOUNTING PRONOUNCEMENTS PENDING ADOPTION TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES. In September 2000, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (SFAS 140), which replaces SFAS 125. SFAS 140 retains most of the SFAS 125 control provisions, but includes new rules: - for determining whether a special purpose entity ("SPE") is a qualifying SPE, and that limit the amount and type of derivative instruments that a qualifying SPE can hold and the activities that it may engage in; - that provide more restrictive guidance with respect to the circumstances under which a transfer of assets to a qualifying SPE relinquishes control of such assets and may be accounted for as a sale; and - that require extensive disclosures about collateral, assets securitized and accounted for as a sale, and retained interests in securitized assets. SFAS 140 is effective for transactions entered into after March 31, 2001. However, the statement is effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Management is currently reviewing SFAS 140 and has not yet determined the extent to which it will impact Key's financial condition and results of operations. DERIVATIVES AND HEDGING ACTIVITIES. In June 2000, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS 133." This new statement addresses a limited number of issues causing implementation difficulties for entities that apply SFAS 133. In July 1999, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 137, "Deferral of the Effective Date of SFAS 133." This new statement delays the effective date of SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," until fiscal years beginning after June 15, 2000. SFAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively called "derivatives") and for hedging activities. SFAS 133 requires that all derivatives be recognized on the balance sheet at fair value. 7 8 Depending on the nature of the hedge, and the extent to which it is effective, the changes in fair value of the derivative will either be offset against the change in fair value of the hedged item (which also is recognized in earnings) or recorded in comprehensive income and subsequently recognized in earnings in the period the hedged item affects earnings. The portion of a hedge that is deemed ineffective and all changes in the fair value of derivatives not designated as hedges will be recognized immediately in earnings. Key will adopt the provisions of SFAS 133 as of January 1, 2001. Management is in the final stages of testing the systems that will be relied upon to comply with SFAS 133 and to determine the related impact on Key's financial condition and results of operations. The financial impact of the transition to the provisions of SFAS 133 can not be precisely measured prior to the effective date because of several fluid factors, primary among which are the level of interest rates and the shape of the yield curve. However, if we were to have adopted the statement at September 30, 2000, the financial impact on Key would not have been material at that time. 2. Earnings per Common Share The computation of Key's basic and diluted earnings per common share is as follows:
Three months ended September 30, Nine months ended September 30, -------------------------------- ------------------------------- dollars in millions, except per share amounts 2000 1999 2000 1999 ---------------------------------------------------------------------------------------------------------------------------------- NET INCOME $121 $270 $736 $843 ==== ==== ==== ==== ---------------------------------------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE COMMON SHARES Weighted average common shares outstanding (000) 429,584 448,742 435,156 448,764 Effect of dilutive common stock options (000) 2,388 4,144 2,075 4,503 ---------------------------------------------------------------------------------------------------------------------------------- Weighted average common shares and potential 431,972 452,886 437,231 453,267 common shares outstanding (000) ======= ======= ======= ======= ---------------------------------------------------------------------------------------------------------------------------------- EARNINGS PER COMMON SHARE Net income per common share $.28 $.60 $1.69 $1.88 Net income per common share - assuming dilution .28 .60 1.68 1.86 ----------------------------------------------------------------------------------------------------------------------------------
3. Acquisitions and Divestitures Business acquisitions and divestitures that Key completed during 1999 and the first nine months of 2000 are summarized below. ACQUISITIONS ------------ NEWPORT MORTGAGE COMPANY L.P. On September 30, 2000, Key purchased certain net assets of Newport Mortgage Company, L.P., a commercial mortgage company headquartered in Dallas, Texas, for $22 million in cash. Goodwill of approximately $4 million was recorded and is being amortized using the straight-line method over a period of 10 years. NATIONAL REALTY FUNDING L.C. On January 31, 2000, Key purchased certain net assets of National Realty Funding L.C., a commercial finance company headquartered in Kansas City, Missouri, for $359 million in cash. Goodwill of approximately $10 million was recorded and is being amortized using the straight-line method over a period of 15 years. DIVESTITURES ------------ CREDIT CARD PORTFOLIO On January 31, 2000, Key sold its credit card portfolio of $1.3 billion in receivables and nearly 600,000 active VISA and MasterCard accounts to Associates National Bank (Delaware). Key recognized a gain of 8 9 $332 million ($207 million after tax), which is included in "gains from divestitures" on the income statement. BRANCH DIVESTITURES On October 18, 1999, Key sold its Long Island franchise, which included 28 KeyCenters with $1.3 billion in deposits and $505 million in loans. This transaction resulted in a gain of $194 million ($122 million after tax). COMPAQ CAPITAL EUROPE LLC AND COMPAQ CAPITAL ASIA PACIFIC LLC On July 28, 1999, Key sold its 50% interests in Compaq Capital Europe LLC and Compaq Capital Asia Pacific LLC to Compaq Capital Corporation. Key and Compaq formed these limited liability companies in 1998 to provide customized equipment leasing and financing programs to Compaq's clients in the United Kingdom, Europe and Asia. Key recognized a gain of $13 million ($8 million after tax). ELECTRONIC PAYMENT SERVICES, INC. On February 28, 1999, Electronic Payment Services, Inc., an electronic funds transfer processor in which Key held a 20% interest, merged with a wholly owned subsidiary of Concord EFS, Inc. Key received 5,931,825 shares of Concord EFS in exchange for its Electronic Payment Services stock, and recognized a gain of $134 million ($85 million after tax), which is included in "gains from divestitures" on the income statement. On June 17, 1999, Key sold its Concord EFS shares and recognized a gain of $15 million ($9 million after tax). KEY MERCHANT SERVICES, LLC On January 21, 1998, Key sold a 51% interest in Key Merchant Services, LLC, a wholly owned subsidiary formed to provide merchant credit card processing services, to NOVA Information Systems, Inc. Key recognized a $23 million gain ($14 million after tax) at the time of closing. Under the terms of the agreement with NOVA, Key was entitled to receive additional payments if Key Merchant Services achieved certain revenue-related performance targets. These additional payments created a gain of $27 million ($17 million after tax) in the fourth quarter of 1998 and a final gain of $14 million ($9 million after tax) during the first quarter of 1999. These gains are included in "gains from divestitures" on the income statement. Due to a confidentiality clause in the agreement, the terms, which are not material, have not been disclosed. 9 10 4. Line of Business Results Key's four major lines of business are Key Retail Banking, Key Specialty Finance, Key Corporate Capital and Key Capital Partners. KEY RETAIL BANKING Key Retail Banking delivers a complete line of branch-based financial products and services to small businesses and consumers. These products and services are delivered through 932 KeyCenters, a 24-hour telephone banking call center services group, 2,490 ATMs that access 13 different networks (resulting in one of the largest ATM networks in the United States) and a core team of relationship management professionals. KEY SPECIALTY FINANCE Key Specialty Finance provides indirect, non-branch-based consumer loan products, including automobile loans and leases, home equity loans, education loans, and marine and recreational vehicle loans. As of December 31, 1999, based on the volume of loans generated, Key Specialty Finance was one of the nation's leading providers of financing for education loans, automobile loans and leases, and purchases of marine and recreational vehicles. KEY CORPORATE CAPITAL Key Corporate Capital offers a complete range of financing, transaction processing, corporate electronic commerce ("e-commerce") and financial advisory services to corporations nationwide, and operates one of the largest bank-affiliated equipment leasing companies in the world, with operations in the United States, Europe and Asia. Based on total transaction volume, Key Corporate Capital is also one of the leading cash management providers in the United States. Key Corporate Capital's business units are organized around six specialized industry client segments: commercial banking, commercial real estate, lease financing, structured finance, healthcare and media/telecommunications. These targeted client segments can receive a number of specialized services, including international banking, cash management and corporate finance advisory services. Key Corporate Capital also offers investment banking, capital markets, 401(k) and trust custody products in cooperation with Key Capital Partners. KEY CAPITAL PARTNERS Key Capital Partners provides asset management, brokerage, investment banking, capital markets and insurance expertise. It also offers specialized services to high-net-worth clients through the wealth management and private banking businesses. This line of business generates a substantial amount of Key's fee income. The table that spans pages 12 and 13 shows selected financial data for each major line of business for the three- and nine-month periods ended September 30, 2000 and 1999. The financial information was derived from the internal profitability reporting system that management uses to monitor and manage Key's financial performance. The selected financial data are based on internal accounting policies designed to ensure that results are compiled on a consistent basis and reflect the underlying economics of Key's four major businesses. In accordance with these policies: - Funds transfer pricing was used in the determination of net interest income by assigning a standard cost for funds used (or a standard credit for funds provided) to assets and liabilities based on their 10 11 maturity, prepayment and/or repricing characteristics. The net effect of funds transfer pricing is included in the "Treasury and Other" columns of the table. - Indirect expenses, such as computer servicing costs and corporate overhead, were allocated based on the extent to which each line of business actually used the service. - The provision for loan losses was allocated among the lines of business based primarily upon their actual net charge-offs, adjusted for loan growth and changes in risk profile. The level of the consolidated provision is based upon the methodology that Key uses to estimate its 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 1999 Annual Report to Shareholders. - Income taxes were allocated based on the statutory Federal income tax rate of 35% (adjusted for tax-exempt income from corporate owned life insurance, nondeductible goodwill amortization 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% for the periods presented. - Capital was assigned to each line of business based on management's assessment of economic risk factors (primarily credit, operating and market risk). Developing and applying the methodologies that management follows 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 segment of Key's business or changes in Key's structure. Starting in the first quarter of 2000 the financial data for both 2000 and 1999 presented in the table reflects a change in the manner of reporting the results of divested businesses. The impact of these businesses is now being included under the "Reconciling Items" columns, as opposed to being allocated to the major business lines. In addition, the financial data presented for both years reflects the second quarter 2000 reclassification of the Deposit Marketing unit from Treasury and Other to Key Retail Banking. There is no authoritative guidance for "management accounting"--the way that management uses its judgment and experience to guide line of business reporting decisions--similar to generally accepted accounting principles for financial accounting. Consequently, the line of business results that Key reports are not necessarily comparable with those presented by other companies. 11 12
Three months ended September 30, Key Retail Banking Key Specialty Finance Key Corporate Capital ------------------ --------------------- --------------------- dollars in millions 2000 1999 2000 1999 2000 1999 ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $ 313 $ 292 $ 131 $ 128 $ 268 $ 248 Noninterest income 91 81 5 45 54 69 Revenue sharing (a) 19 16 -- -- 33 26 ----------------------------------------------------------------------------------------------------------------------------------- Total revenue (b) 423 389 136 173 355 343 Provision for loan losses 28 15 32 25 53 29 Depreciation and amortization expense 35 38 13 15 16 16 Other noninterest expense 179 186 64 69 128 119 Expense sharing (a) 13 14 -- -- 21 17 ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) 168 136 27 64 137 162 Allocated income taxes and taxable equivalent adjustments 65 53 12 26 52 61 ----------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 103 $ 83 $ 15 $ 38 $ 85 $ 101 ======= ======= ======= ======= ======= ======= Percent of consolidated net income 85% 31% 12% 14% 70% 37% Percent of total segments' net income 49 34 7 16 40 42 ----------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $11,026 $10,026 $15,081 $14,352 $31,648 $29,293 Total assets (b) 12,531 11,557 16,222 15,476 33,103 30,758 Deposits 35,528 33,096 164 145 3,071 2,853 ----------------------------------------------------------------------------------------------------------------------------------- OTHER FINANCIAL DATA Efficiency ratio (g) 53.92% 61.17% 56.48% 48.44% 46.23% 45.89% -----------------------------------------------------------------------------------------------------------------------------------
Nine months ended September 30, Key Retail Banking Key Specialty Finance Key Corporate Capital ------------------ --------------------- --------------------- dollars in millions 2000 1999 2000 1999 2000 1999 ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $ 910 $ 885 $ 384 $ 396 $ 787 $ 731 Noninterest income 262 240 40 127 174 193 Revenue sharing (a) 55 52 1 1 97 83 ----------------------------------------------------------------------------------------------------------------------------------- Total revenue (b) 1,227 1,177 425 524 1,058 1,007 Provision for loan losses 62 46 80 79 117 80 Depreciation and amortization expense 107 114 39 45 48 45 Other noninterest expense 536 569 199 202 380 366 Expense sharing (a) 42 44 -- -- 61 53 ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) 480 404 107 198 452 463 Allocated income taxes and taxable equivalent adjustments 186 156 46 79 174 175 ----------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 294 $ 248 $ 61 $ 119 $ 278 $ 288 ======= ====== ======= ======= ======= ======= Percent of consolidated net income 40% 29% 8% 14% 38% 34% Percent of total segments' net income 42 34 9 17 40 40 ----------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $10,771 $ 9,747 $14,884 $14,436 $31,281 $28,581 Total assets (b) 12,286 11,287 16,073 15,547 32,857 29,965 Deposits 34,671 33,050 139 126 2,965 2,780 ----------------------------------------------------------------------------------------------------------------------------------- OTHER FINANCIAL DATA Efficiency ratio (g) 55.87% 61.87% 56.28% 47.20% 46.14% 46.65% -----------------------------------------------------------------------------------------------------------------------------------
(a) Represents the assignment of Key Capital Partners' revenue and expense to the lines of business principally responsible for maintaining the relationships with the clients that used Key Capital Partners' products and services. (b) Substantially all revenue generated by Key's major lines of business 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 lines of business are located in the United States. (c) "Reconciling items" reflect certain nonrecurring items, the results of divested businesses and charges related to unallocated nonearning assets of corporate support functions, which are included in net interest income and allocated to the business segments through noninterest expense. During the third quarter of 1999, divested businesses added $20 million ($12 million after tax) to noninterest income and $50 million ($31 million after tax) to net interest income. For the first nine months of 2000, noninterest income includes a $332 million ($207 million after tax) gain from the January sale of Key's credit card business and $6 million ($3 million after tax) earned by divested businesses. For the first nine months of 1999, noninterest income includes gains totaling $163 million ($103 million after tax) from certain divestitures and $57 million ($36 million after tax) earned by divested businesses. These businesses also added $13 million ($8 million after tax) to net interest income in the first nine months of 2000 and $138 million ($87 million after tax) to net interest income in the same period last year. (d) The provision for loan losses includes additional provisions of $27 million ($17 million after tax) and $121 million ($76 million after tax) recorded in the third and first quarters of 2000, respectively. The latter provision resulted from the implementation of an enhanced methodology for assessing credit risk, particularly in the commercial loan portfolio. In the first quarter of 1999, 12 13
Key Capital Partners Treasury and Other Total Segments Reconciling Items KeyCorp Consolidated ---------------------- --------------------- ---------------------- ------------------- -------------------- 2000 1999 2000 1999 2000 1999 2000 1999 2000 1999 -------------------------------------------------------------------------------------------------------------------------- $ 55 $ 47 $ (34) $ (25) $ 733 $ 690 $ (42) $ 19 $ 691 $ 709 259 234 (1) 44 408 473 (3) 23 405 496 (52) (42) -- -- -- -- -- -- -- -- -------------------------------------------------------------------------------------------------------------------------- 262 239 (35) 19 1,141 1,163 (45)(c) 42(c) 1,096 1,205 3 1 1 1 117 71 14 7 131 78 23 24 7 7 94 100 2 -- 96 100 201 207 26 31 598 612 93(e) (4)(e) 691 608 (34) (31) -- -- -- -- -- -- -- -- -------------------------------------------------------------------------------------------------------------------------- 69 38 (69) (20) 332 380 (154) 39 178 419 28 15 (37) (17) 120 138 (63) 11 57 149 -------------------------------------------------------------------------------------------------------------------------- $ 41 $ 23 $ (32) $ (3) $ 212 $ 242 $ (91) $ 28 $ 121 $ 270 ====== ====== ======= ======= ======= ======= ======= ====== ======= ======= 34% 9% (26)% (1)% 175% 90% (75)% 10% 100% 100% 19 9 (15) (1) 100 100 N/A N/A N/A N/A -------------------------------------------------------------------------------------------------------------------------- $5,563 $4,429 $ 2,232 $ 2,710 $65,550 $60,810 $ 227 $1,989 $65,777 $62,799 9,574 8,282 10,889 11,475 82,319 77,548 1,786(f) 3,747(f) 84,105 81,295 3,380 3,175 3,680 1,911 45,823 41,180 16 1,283 45,839 42,463 -------------------------------------------------------------------------------------------------------------------------- 72.79% 84.46% N/M N/M 60.65% 61.22% N/M N/M 58.38% 58.91% --------------------------------------------------------------------------------------------------------------------------
Key Capital Partners Treasury and Other Total Segments Reconciling Items KeyCorp Consolidated ---------------------- --------------------- ---------------------- ------------------- ---------------------- 2000 1999 2000 1999 2000 1999 2000 1999 2000 1999 ---------------------------------------------------------------------------------------------------------------------------- $ 155 $ 146 $ (85) $ (66) $ 2,151 $ 2,092 $ (102) $ 14 $ 2,049 $ 2,106 782 717 86 121 1,344 1,398 342 245 1,686 1,643 (153) (136) -- -- -- -- -- -- -- -- ---------------------------------------------------------------------------------------------------------------------------- 784 727 1 55 3,495 3,490 240(c) 259(c) 3,735 3,749 4 3 2 3 265 211 117(d) 54(d) 382 265 70 71 21 19 285 294 2 4 287 298 642 628 76 88 1,833 1,853 92(e) 34(e) 1,925 1,887 (103) (97) -- -- -- -- -- -- -- -- ---------------------------------------------------------------------------------------------------------------------------- 171 122 (98) (55) 1,112 1,132 29 167 1,141 1,299 70 51 (67) (49) 409 412 (4) 44 405 456 ---------------------------------------------------------------------------------------------------------------------------- $ 101 $ 71 $ (31) $ (6) $ 703 $ 720 $ 33 $ 123 $ 736 $ 843 ====== ====== ======= ======== ======= ======= ======== ======= ======= ======= 14% 9% (4)% (1)% 96% 85% 4% 15% 100% 100% 14 10 (5) (1) 100 100 N/A N/A N/A N/A ---------------------------------------------------------------------------------------------------------------------------- $5,266 $4,352 $ 2,339 $ 2,933 $64,541 $60,049 $ 335 $ 1,987 $64,876 $62,036 9,543 8,111 11,022 11,665 81,781 76,575 1,787(f) 3,823(f) 83,568 80,398 3,383 3,140 3,751 1,420 44,909 40,516 11 1,274 44,920 41,790 ---------------------------------------------------------------------------------------------------------------------------- 77.59% 83.07% N/M N/M 60.60% 61.52% N/M N/M 60.31% 59.74% ----------------------------------------------------------------------------------------------------------------------------
the provision includes an additional provision of $30 million ($19 million after tax) related to an enhancement of the allowance methodology pertaining to the credit card portfolio. (e) Noninterest expense in the third quarter of 2000 includes $114 million ($72 million after tax) of nonrecurring charges recorded in connection with strategic actions being taken to improve Key's operating efficiency and profitability. Noninterest expense for the third quarter of 1999 includes $7 million ($4 million after tax) of restructuring charges and $19 million ($12 million after tax) incurred by divested businesses. For the first nine months of 2000, noninterest expense includes $130 million ($82 million after tax) of nonrecurring charges recorded in connection with strategic actions being taken to improve Key's operating efficiency and profitability and $7 million ($5 million after tax) incurred by divested businesses. For the first nine months of 1999, noninterest expense includes special contributions of $23 million ($15 million after tax) made to the charitable foundation that Key sponsors, $7 million ($4 million after tax) of restructuring charges, $27 million ($17 million after tax) of other nonrecurring charges and $57 million ($36 million after tax) incurred by divested businesses. (f) Total assets represent primarily the unallocated portion of nonearning assets of corporate support functions. (g) This ratio, which measures the extent to which recurring revenues are absorbed by operating expenses, is calculated as follows: noninterest expense (excluding significant nonrecurring items) divided by the sum of taxable-equivalent net interest income and noninterest income (excluding significant nonrecurring items). N/M = Not Meaningful N/A = Not Applicable 13 14 5. Securities Key classifies its securities into three categories: trading, investment and available for sale. 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. These securities are reported at fair value ($729 million, $768 million and $1.1 billion at September 30, 2000, December 31, 1999 and September 30, 1999, respectively) and included in "short-term investments" on the balance sheet. Realized and unrealized gains and losses on trading account securities are reported in "other income" on the income statement. INVESTMENT SECURITIES. These include securities held to maturity and equity securities that do not have readily determinable fair values. Securities held to maturity are debt securities that Key has the intent and ability to hold until maturity. These securities are carried at cost, adjusted for amortization of premiums and accretion of discounts using the level-yield method. SECURITIES AVAILABLE FOR SALE. These are debt and equity securities that Key has not classified as trading account securities or investment securities. Securities available for sale are reported at fair value with unrealized gains and losses (net of income taxes) recorded in shareholders' equity as a component of "accumulated other comprehensive income." Actual gains and losses on the sales of these securities are computed using the specific identification method and included in "net securities gains (losses)" on the income statement. When Key retains an interest in securitized loans, Key bears the risk that the loans will be prepaid (which results in less interest income) or not paid at all. Key's retained interests (which include both certificated and uncertificated interests) are accounted for like debt securities that are classified as available for sale or as trading account securities. The amortized cost, unrealized gains, losses and approximate fair value of Key's investment securities and securities available for sale were as follows:
SEPTEMBER 30, 2000 ----------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE ------------------------------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 364 $ 9 -- $ 373 Other securities 889 -- -- 889 ------------------------------------------------------------------------------------------------------------------- Total investment securities $1,253 $ 9 -- $1,262 ====== === ====== SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $2,105 -- -- $2,105 States and political subdivisions 48 -- -- 48 Collateralized mortgage obligations 2,561 $12 $ 99 2,474 Other mortgage-backed securities 1,425 6 23 1,408 Retained interests in securitizations 341 -- 15 326 Other securities 278 28 3 303 ------------------------------------------------------------------------------------------------------------------- Total securities available for sale $6,758 $46 $140 $6,664 ====== === ==== ====== -------------------------------------------------------------------------------------------------------------------
14 15
DECEMBER 31, 1999 -------------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE ------------------------------------------------------------------------------------------------------------------------ INVESTMENT SECURITIES States and political subdivisions $ 447 $12 -- $ 459 Other securities 539 -- -- 539 ------------------------------------------------------------------------------------------------------------------------ Total investment securities $ 986 $12 -- $ 998 ====== === ====== SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $128 -- $ 1 $ 127 States and political subdivisions 53 -- -- 53 Collateralized mortgage obligations 4,426 -- 189 4,237 Other mortgage-backed securities 1,705 $ 6 33 1,678 Retained interests in securitizations 340 3 -- 343 Other securities 223 4 -- 227 ------------------------------------------------------------------------------------------------------------------------ Total securities available for sale $6,875 $13 $223 $6,665 ====== === ==== ====== ------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 1999 -------------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE ------------------------------------------------------------------------------------------------------------------------ INVESTMENT SECURITIES States and political subdivisions $ 490 $16 -- $ 506 Other securities 499 -- -- 499 ------------------------------------------------------------------------------------------------------------------------ Total investment securities $ 989 $16 -- $1,005 ====== === ====== SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 128 $ 1 $ 1 $ 128 States and political subdivisions 61 1 1 61 Collateralized mortgage obligations 4,240 1 157 4,084 Other mortgage-backed securities 1,772 9 29 1,752 Retained interests in securitizations 365 -- 14 351 Other securities 184 8 1 191 ------------------------------------------------------------------------------------------------------------------------ Total securities available for sale $6,750 $20 $203 $6,567 ====== === ==== ====== ------------------------------------------------------------------------------------------------------------------------
15 16 6. Loans Key's loans by category are summarized as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2000 1999 1999 ------------------------------------------------------------------------------------------------------------------------- Commercial, financial and agricultural $19,884 $18,497 $18,275 Real estate -- commercial mortgage 6,900 6,836 6,831 Real estate -- construction 5,019 4,528 4,298 Commercial lease financing 7,011 6,665 6,399 ------------------------------------------------------------------------------------------------------------------------- Total commercial loans 38,814 36,526 35,803 Real estate -- residential mortgage 4,264 4,333 4,331 Home equity 9,344 7,602 7,502 Consumer -- direct 2,633 2,565 2,566 Consumer -- indirect lease financing 3,035 3,195 3,107 Consumer -- indirect other 5,891 6,398 6,488 ------------------------------------------------------------------------------------------------------------------------- Total consumer loans 25,167 24,093 23,994 Real estate -- commercial mortgage 588 146 152 Real estate -- residential mortgage 54 48 58 Home equity -- 371 153 Credit card -- 1,362 1,299 Education 1,676 1,676 1,722 ------------------------------------------------------------------------------------------------------------------------- Total loans held for sale 2,318 3,603 3,384 ------------------------------------------------------------------------------------------------------------------------- Total loans $66,299 $64,222 $63,181 ======= ======= ======= -------------------------------------------------------------------------------------------------------------------------
Key uses portfolio interest rate swaps to manage interest rate risk; these swaps modify the repricing and maturity characteristics of certain loans. For more information about the notional amount, fair value, and weighted average rate of such swaps at September 30, 2000, see Note 11 ("Financial Instruments with Off-Balance Sheet Risk"), which begins on page 21. Changes in the allowance for loan losses are summarized as follows:
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------- -------------------------------- in millions 2000 1999 2000 1999 ------------------------------------------------------------------------------------------------------------------ Balance at beginning of period $ 979 $ 930 $ 930 $ 900 Charge-offs (129) (102) (387) (314) Recoveries 25 24 81 79 ------------------------------------------------------------------------------------------------------------------ Net charge-offs (104) (78) (306) (235) Allowance related to loans sold (5) -- (5) -- Provision for loan losses 131 78 382 265 ------------------------------------------------------------------------------------------------------------------ Balance at end of period $1,001 $ 930 $1,001 $930 ====== ===== ====== ==== ------------------------------------------------------------------------------------------------------------------
16 17 7. Impaired Loans and Other Nonperforming Assets At September 30, 2000, impaired loans totaled $305 million. This amount includes $206 million of impaired loans with a specifically allocated allowance for loan losses of $83 million and $99 million of impaired loans that are carried at their estimated fair value without a specifically allocated allowance. At the end of 1999, impaired loans totaled $246 million; $153 million of those loans had a specifically allocated allowance of $63 million and $93 million were carried at their estimated fair value. The average investment in impaired loans for the third quarter of 2000 and 1999 was $291 million and $204 million, respectively. Nonperforming assets were as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2000 1999 1999 ------------------------------------------------------------------------------------------------------------- Impaired loans $305 $246 $219 Other nonaccrual loans 287 201 193 ------------------------------------------------------------------------------------------------------------- Total nonperforming loans 592 447 412 OREO 26 27 32 Allowance for OREO losses (1) (3) (8) ------------------------------------------------------------------------------------------------------------- OREO, net of allowance 25 24 24 Other nonperforming assets -- 2 4 ------------------------------------------------------------------------------------------------------------- Total nonperforming assets $617 $473 $440 ==== ==== ==== -------------------------------------------------------------------------------------------------------------
When appropriate, an impaired loan is assigned a specific allowance. Management calculates the extent of the impairment, which is the carrying amount of the loan less the fair value of any existing collateral (for a secured loan) or the estimated present value of future cash flows (for an unsecured loan). When collateral value or expected cash flow does not justify the carrying amount of a loan, the amount that management deems uncollectible (the impaired amount) is charged against the allowance for loan losses. When collateral value or other sources of repayment appear sufficient, but management remains uncertain about whether the loan will be repaid in full, an amount is specifically allocated in the allowance for loan losses. Key does not perform a specific impairment valuation for smaller-balance, homogeneous, nonaccrual loans (shown in the preceding table as "Other nonaccrual loans"). Generally, this portfolio includes loans to finance residential mortgages, automobiles, recreational vehicles, boats and mobile homes. Management applies historical loss experience rates to these loans, adjusted based on assessments of emerging credit trends and other factors, and then allocates a portion of the allowance for loan losses to each loan type. The amounts presented in the above table at September 30, 1999, have been restated from those previously reported. This restatement reflects a reclassification of certain loans from those reported as 90 days past due and still accruing to those reported as nonaccrual. The reclassified loans are predominantly home equity loans held by Key Home Equity Services, a division of Key Bank USA, National Association that acts as a third-party purchaser of home equity loans. Although these loans had not been properly categorized as nonaccrual in Key's internal reporting system, the accrual of interest on the balances had, in fact, ceased. Therefore, the restatement had no impact on Key's earnings. 17 18 8. LONG-TERM DEBT The components of Key's long-term debt, presented net of unamortized discount where applicable, were as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2000 1999 1999 --------------------------------------------------------------------------------------------------------------- Senior medium-term notes due through 2005 (a) $ 303 $ 396 $ 401 Subordinated medium-term notes due through 2005 (a) 103 133 133 7.50% Subordinated notes due 2006 (b) 250 250 250 6.75% Subordinated notes due 2006 (b) 200 200 200 8.125% Subordinated notes due 2002 (b) 199 199 199 8.00% Subordinated notes due 2004 (b) 125 125 125 8.404% Notes due through 2001 13 24 24 All other long-term debt (h) 1 4 4 --------------------------------------------------------------------------------------------------------------- Total parent company (i) 1,194 1,331 1,336 Senior medium-term bank notes due through 2039 (c) 6,389 9,396 9,394 Senior euro medium-term bank notes due through 2007 (d) 3,466 2,413 2,383 6.50% Subordinated remarketable securities due 2027 (e) 312 312 313 6.95% Subordinated notes due 2028 (e) 300 300 300 7.125% Subordinated notes due 2006 (e) 250 250 250 7.25% Subordinated notes due 2005 (e) 200 200 200 6.75% Subordinated notes due 2003 (e) 200 200 200 7.50% Subordinated notes due 2008 (e) 165 165 165 7.30% Subordinated notes due 2011 (e) 107 107 107 7.85% Subordinated notes due 2002 (e) 93 93 93 7.55% Subordinated notes due 2006 (e) 75 75 75 7.375% Subordinated notes due 2008 (e) 70 70 70 Lease financing debt due through 2006 (f) 588 613 580 Federal Home Loan Bank advances due through 2030 (g) 249 242 241 All other long-term debt (h) 142 114 108 --------------------------------------------------------------------------------------------------------------- Total subsidiaries 12,606 14,550 14,479 --------------------------------------------------------------------------------------------------------------- Total long-term debt $13,800 $15,881 $15,815 ======= ======= ======= ---------------------------------------------------------------------------------------------------------------
Key uses portfolio interest rate swaps and caps to manage interest rate risk; these instruments modify the repricing and maturity characteristics of certain long-term debt. For more information about the notional amount, fair value and weighted average rate of such financial instruments at September 30, 2000, see Note 11 ("Financial Instruments with Off-Balance Sheet Risk"), which begins on page 21. (a) At September 30, 2000, December 31, 1999 and September 30,1999, the senior medium-term notes had weighted average interest rates of 6.77%, 6.83% and 6.54%, respectively, and the subordinated medium-term notes had a weighted average interest rate of 7.32%, 7.09% and 7.09% at each respective date. These notes had a combination of fixed and floating interest rates. (b) The 7.50%, 6.75%, 8.125%, and 8.00% subordinated notes may not be redeemed or prepaid prior to maturity. (c) At September 30, 2000, December 31,1999 and September 30, 1999, senior medium-term bank notes of subsidiaries had weighted average interest rates of 6.68%, 5.98% and 5.48%, respectively. These notes had a combination of fixed and floating interest rates. (d) At September 30, 2000, December 31, 1999 and September 30, 1999, senior euro medium-term notes had weighted average interest rates of 6.88%, 6.26%, and 5.56%, respectively. These notes, which are obligations of KeyBank National Association, had fixed and floating interest rates based on the three-month London Interbank Offered Rate (known as "LIBOR"). 18 19 (e) The subordinated notes and securities are all obligations of KeyBank National Association, with the exception of the 7.55% notes, which are obligations of Key Bank USA, National Association. These notes may not be redeemed prior to their maturity dates. (f) At September 30, 2000, December 31, 1999 and September 30, 1999, lease financing debt had weighted average interest rates of 7.78%, 7.64% and 6.70%, respectively. This category of debt primarily comprises nonrecourse debt collateralized by leased equipment under operating, direct financing and sales type leases. (g) At September 30, 2000, December 31, 1999 and September 30, 1999, long-term advances from the Federal Home Loan Bank had weighted average interest rates of 6.56%, 6.27% and 5.43% respectively. These advances, which had a combination of fixed and floating interest rates, were secured by $374 million, $363 million, and $361 million of real estate loans and securities at September 30, 2000, December 31, 1999 and September 30, 1999, respectively. (h) Other long-term debt, comprising industrial revenue bonds, capital lease obligations, and various secured and unsecured obligations of corporate subsidiaries, had weighted average interest rates of 7.84%, 6.76%, and 7.01% at September 30, 2000, December 31, 1999 and September 30, 1999, respectively. (i) At September 30, 2000, unused capacity under KeyCorp's shelf registration totaled $412 million, all of which is reserved for future issuance of medium-term notes. 9. Capital Securities KeyCorp guarantees the corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely subordinated debentures of the Corporation ("capital securities"). These securities were issued by five business trusts: KeyCorp Institutional Capital A, KeyCorp Institutional Capital B, KeyCorp Capital I, KeyCorp Capital II and KeyCorp Capital III. As guarantor, KeyCorp unconditionally guarantees payment of: - accrued and unpaid distributions required to be paid on the capital securities; - the redemption price when a capital security is called for redemption; and - amounts due if a trust is liquidated or terminated. KeyCorp owns all of the outstanding common stock of each of the five trusts. The trusts used the proceeds from the issuance of their capital securities and common stock to buy debentures issued by KeyCorp. These debentures are the trusts' only assets and the interest payments from the debentures finance the distributions paid on the capital securities. Key's financial statements do not reflect the debentures or the related income statement effects because they are eliminated in consolidation. The capital securities, common securities and related debentures are summarized as follows:
PRINCIPAL INTEREST RATE MATURITY CAPITAL AMOUNT OF OF CAPITAL OF CAPITAL SECURITIES, COMMON DEBENTURES, SECURITIES AND SECURITIES AND dollars in millions NET OF DISCOUNT(a) SECURITIES NET OF DISCOUNT(b) DEBENTURES(c) DEBENTURES ------------------------------------------------------------------------------------------------------------------------------- September 30, 2000 KeyCorp Institutional Capital A $ 350 $11 $ 361 7.826% 2026 KeyCorp Institutional Capital B 150 4 154 8.250 2026 KeyCorp Capital I 247 8 255 7.519 2028 KeyCorp Capital II 247 8 255 6.875 2029 KeyCorp Capital III 249 8 257 7.750 2029 ------------------------------------------------------------------------------------------------------------------------------- Total $1,243 $39 $1,282 7.612% -- ====== === ====== ------------------------------------------------------------------------------------------------------------------------------- December 31, 1999 $1,243 $39 $1,282 7.473% -- ====== === ====== ------------------------------------------------------------------------------------------------------------------------------- September 30, 1999 $1,243 $39 $1,282 7.328% -- ====== === ====== -------------------------------------------------------------------------------------------------------------------------------
(a) The capital securities are mandatorily redeemable when the related debentures mature, or earlier if provided in the governing indenture. Each issue of capital securities carries an interest rate identical to that of the related debenture. The capital securities constitute minority interests in the equity accounts of KeyCorp's consolidated subsidiaries and, therefore, qualify as Tier 1 capital under Federal Reserve Board guidelines. 19 20 (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), and July 16, 1999 (for debentures owned by Capital III); 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 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 the greater of: (i) the principal amount, plus any accrued but unpaid interest or (ii) 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 is generally slightly more favorable to Key. (c) The interest rates for Capital A, Capital B, Capital II, and Capital III are fixed. Capital I has a floating interest rate (which reprices quarterly) equal to three-month LIBOR plus 74 basis points. The rates shown as the total at September 30, 2000, December 31, 1999, and September 30, 1999, are weighted average rates. 10. Restructuring Charges During 1999 and the first nine months of 2000, KeyCorp recorded net restructuring charges of $98 million ($62 million after tax) and $111 million ($70 million after tax), respectively, in connection with a three-year "competitiveness initiative" undertaken last November to improve Key's operating efficiency and profitability. In the first phase of the initiative, the primary strategic actions taken include the outsourcing of certain technology and other corporate support functions, the consolidation of sites in a number of Key's businesses and a reduction in the number of management layers. During the third quarter of 2000, KeyCorp recorded restructuring charges of $102 million ($64 million after tax) in connection with the second and final phase of this initiative. The final phase will focus on: - simplifying Key's business structure by consolidating 22 business lines into 12; - streamlining and automating business operations and processes; - standardizing product offerings and internal processes; - consolidating operating facilities and service centers; and - outsourcing certain noncore activities. As a result of the competitiveness initiative, we expect to significantly reduce Key's workforce with reductions occurring at all levels throughout the organization. At September 30, 2000, over 2,100 positions had been eliminated. In the second phase of the initiative, we expect to reduce our workforce by approximately 2,300 additional positions over the next 15 months. Changes in the restructuring charge liability associated with the above actions are as follows:
DECEMBER 31, RESTRUCTURING CASH SEPTEMBER 30, in millions 1999 CHARGES PAYMENTS 2000 ------------------------------------------------------------------------------------ Severance $60 $ 56 $37 $ 79 Site consolidations 24 51 14 61 Equipment and other 7 4 6 5 ------------------------------------------------------------------------------------ Total $91 $111 $57 $145 === ==== === ==== ------------------------------------------------------------------------------------
During the first quarter of 2000, KeyCorp also recorded a $2 million ($1 million after tax) credit to restructuring charges in connection with separate actions initiated during the fourth quarter of 1996 to complete Key's transformation to a nationwide bank-based financial services company. The credit was taken to reduce the remaining liability associated with branch consolidations, since favorable market 20 21 conditions resulted in lower costs to consolidate these branches than originally expected. At September 30, 2000, the remaining liability associated with this initiative was approximately $1 million. 11. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Key, mainly through its lead bank (KeyBank National Association), is party to various financial instruments with off-balance sheet risk. These financial instruments may be used for lending-related purposes, asset and liability management or trading purposes. Generally, these instruments help Key meet clients' financing needs and manage its exposure to "market risk"--the possibility that net interest income will be adversely affected due to changes in interest rates or other economic factors. However, like other financial instruments, these 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 financial instruments that Key uses are commitments to extend credit; standby and commercial letters of credit; interest rate swaps, caps and futures; and foreign exchange forward contracts. All of the foreign exchange forward contracts and interest rate swaps and caps held are over-the-counter instruments. FINANCIAL INSTRUMENTS HELD OR ISSUED FOR LENDING-RELATED PURPOSES These instruments--primarily loan commitments and standby letters of credit--involve credit risk not reflected on Key's balance sheet. Key mitigates its exposure to credit risk with internal controls that guide the way staff reviews and approves applications for credit, establishes credit limits and, when necessary, demands collateral. In particular, Key evaluates the credit-worthiness of each prospective borrower on a case-by-case basis. Key does not have any significant concentrations of credit risk. COMMITMENTS TO EXTEND CREDIT are agreements to provide financing at predetermined terms, as long as the client continues to meet specified criteria. Loan commitments generally carry variable rates of interest and have fixed expiration dates or other termination clauses. In many cases, a client must pay a fee to induce Key to issue a loan commitment. Since a commitment may expire without resulting in a loan, the total amount of outstanding commitments does not necessarily represent the future cash outlay that Key will make. STANDBY LETTERS OF CREDIT enhance the credit-worthiness of Key's clients by assuring their financial performance to third parties in connection with particular transactions. Amounts drawn under standby letters of credit are essentially loans: they bear interest (generally at variable rates) and pose the same credit risk to Key as a loan would. The following table shows the contractual amount of each class of lending-related, off-balance sheet financial instrument outstanding. The table discloses Key's maximum possible accounting loss, which is equal to the contractual amount of the various instruments. The estimated fair values of these commitments and standby letters of credit are not material. 21 22
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2000 1999 1999 ------------------------------------------------------------------------------------------------------------------------- Loan commitments: Credit card lines - $7,108 $6,776 Home equity $4,616 4,560 4,630 Commercial real estate and construction 2,019 1,842 1,778 Commercial and other 24,835 22,023 21,979 ------------------------------------------------------------------------------------------------------------------------- Total loan commitments 31,470 35,533 35,163 Other commitments: Standby letters of credit 1,932 1,987 1,870 Commercial letters of credit 128 120 155 Loans sold with recourse - 16 17 ------------------------------------------------------------------------------------------------------------------------- Total loan and other commitments $33,530 $37,656 $37,205 ======= ======= ======= -------------------------------------------------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS HELD OR ISSUED FOR ASSET AND LIABILITY MANAGEMENT PURPOSES Key manages exposure to interest rate risk, in part, by using off-balance sheet financial instruments, commonly referred to as derivatives. Instruments used for this purpose modify the repricing or maturity characteristics of specified on-balance sheet assets and liabilities. The principal financial instruments that Key uses to manage exposure to interest rate risk are interest rate swaps and caps, also referred to as "portfolio" swaps and caps. In addition, Key uses treasury-based interest rate locks to manage the risk associated with anticipated loan securitizations. To qualify for hedge accounting treatment, a derivative must be effective at reducing the risk associated with the exposure being managed and must be designated as a risk management transaction at the inception of the derivative contract. To be considered effective, there must be a high degree of interest rate correlation between the derivative and the asset or liability being managed, both at inception and over the life of the derivative contract. The following table summarizes the features of the various types of portfolio swaps and caps that Key held at September 30, 2000.
SEPTEMBER 30, 2000 DECEMBER 31, 1999 ----------------------------------------------------------- ----------------- WEIGHTED AVERAGE RATE NOTIONAL FAIR MATURITY -------------------------------- NOTIONAL FAIR dollars in millions AMOUNT VALUE (YEARS) RECEIVE PAY STRIKE AMOUNT VALUE ------------------------------------------------------------------------------------------------------------------------------------ Interest rate swaps: Received fixed/pay variable-indexed amortizing(a) $ 48 - 1.1 7.98 % 6.74 % N/A $ 104 $ 1 Receive fixed/pay variable-conventional 4,413 $ (67) 6.7 6.64 6.77 N/A 5,962 (135) Pay fixed/receive variable-conventional 6,155 34 3.8 6.71 6.40 N/A 5,545 105 Pay fixed/receive variable-forward starting 13 - 10.0 6.62 6.85 N/A 278 - Basis swaps 5,571 (126) 1.9 6.60 6.73 N/A 6,783 (20) ------------------------------------------------------------------------------------------------------------------------------------ Total 16,200 (159) - 6.64 % 6.60 % - 18,672 (49) Interest rate caps and collars: Caps purchased - one- to three-month LIBOR-based 350 3 .9 N/A N/A 5.67% 2,000 7 Collar - one- to three-month LIBOR-based 250 - .3 N/A N/A 4.75 and 6.50 250 - ------------------------------------------------------------------------------------------------------------------------------------ Total 600 3 - - - - 2,250 7 ------------------------------------------------------------------------------------------------------------------------------------ Total $16,800 $(156) - - - - $20,922 $(42) ======= ====== ======= ===== ------------------------------------------------------------------------------------------------------------------------------------
(a) Maturity is based upon expected average lives rather than contractual terms. N/A = Not Applicable INTEREST RATE SWAP CONTRACTS involve the exchange of interest payments calculated on an agreed-upon amount (known as the "notional amount"). Swaps are generally used to mitigate Key's exposure to interest rate risk on certain loans, securities, deposits, short-term borrowings and long-term debt. Key generally uses three types of interest rate swap contracts. - CONVENTIONAL INTEREST RATE SWAP CONTRACTS involve the receipt of interest payments based on a fixed or variable rate in exchange for payments based on variable or fixed rates, without an exchange of the underlying notional amount. 22 23 - INDEXED AMORTIZING SWAP CONTRACTS differ from conventional swaps because the notional amount of an indexed amortizing swap contract remains constant for a specified period of time. Then, based upon the level of an index at agreed-upon dates, one of three events will occur: the swap contract will mature, the notional amount will begin to amortize or the swap will continue in effect until it matures. At September 30, 2000, Key was party to $48 million of indexed amortizing swaps that used a LIBOR index. - BASIS SWAP CONTRACTS involve the exchange of interest payments based on different floating indices. INTEREST RATE CAPS require the buyer to pay a premium to the seller for the right to receive an amount equal to the difference between the current interest rate and an agreed-upon interest rate (known as the "strike rate") applied to a notional amount. Key generally purchases caps, enters into collars (which involves simultaneously purchasing a cap and selling a floor) and enters into corridors (which involves simultaneously purchasing a cap at a specified strike rate and selling a cap at a higher strike rate) to manage the risk of adverse movements in interest rates on specified long-term debt and short-term borrowings. The notional amount of swaps and caps is significantly greater than the amount at risk. CREDIT RISK. Swaps and caps present credit risk because the counterparty may not meet the terms of the contract. This risk is measured as the cost of replacing contracts - at current market rates - that have generated unrealized gains. To mitigate credit risk, Key deals exclusively with counterparties that have high credit ratings. Key uses two additional precautions to manage exposure to credit risk on swap contracts. First, Key generally enters into bilateral collateral and master netting arrangements. These agreements include legal rights of setoff that provide for the net settlement of the subject contracts with the same counterparty in the event of default. Second, a credit committee monitors credit risk exposure to the counterparty on each interest rate swap to determine appropriate limits on Key's total credit exposure and the amount of collateral required, if any. At September 30, 2000, Key had 35 different counterparties to portfolio swaps and swaps entered into to offset the risk of client swaps. Key had aggregate credit exposure of $160 million to 19 of these counterparties, with the largest credit exposure to an individual counterparty amounting to $28 million. As of the same date, Key's aggregate credit exposure on its interest rate caps totaled $65 million. Based on management's assessment as of September 30, 2000, all counterparties were expected to meet their obligations. ACCOUNTING TREATMENT AND VALUATION. Management estimated the aggregate fair value of interest rate swaps at a negative $159 million at September 30, 2000. Fair value in this case represents an estimate of the unrealized loss that would be recognized if the swap portfolio, but not the assets or liabilities being managed, were to be liquidated at that date. However, because these swaps qualify for hedge accounting treatment, their estimated negative fair values should be substantially offset by the unrecognized positive fair values of the assets and liabilities whose risk characteristics they are being used to modify. Management arrived at this estimate by using discounted cash flow models, which predict interest rates using the applicable forward yield curve. Interest from a portfolio swap is recognized on an accrual basis over the life of the contract as an adjustment of the interest income or expense of the asset or liability whose risk is being managed. Gains and losses realized upon the termination of interest rate swaps prior to maturity are deferred as an adjustment to the carrying amount of the related asset or liability. The deferred gain or loss is amortized using the straight-line method over the projected remaining life of the swap at its termination or the projected remaining life of the underlying asset or liability, whichever is shorter. During the first nine months of 2000, swaps with a notional amount of $2.8 billion were terminated, resulting in a net deferred loss of $3 million. During the same period last year, swaps with a notional amount of $3.2 billion were terminated, resulting in a net deferred gain of $12 million. At September 30, 23 24 2000, Key had a cumulative net deferred swap gain of $14 million with a weighted average life of 4.1 years related to the management of debt, and a cumulative net deferred gain of $3 million with a weighted average life of 7.5 years related to the management of loans. FINANCIAL INSTRUMENTS HELD OR ISSUED FOR TRADING PURPOSES FUTURES CONTRACTS AND INTEREST RATE SWAPS, CAPS AND FLOORS. Key uses these instruments for dealer activities (which are generally limited to the banks' commercial loan clients), and enters into other positions with third parties to mitigate the interest rate risk of the client positions. The swaps entered into with clients are generally limited to conventional swaps. All of the above instruments are recorded at their estimated fair values. Adjustments to fair value are included in "investment banking and capital markets income" on the income statement. FOREIGN EXCHANGE FORWARD CONTRACTS. Key uses these instruments to accommodate the business needs of clients and for proprietary trading purposes. Foreign exchange forward contracts provide for the delayed delivery or purchase of foreign currency. Key mitigates the associated foreign exchange risk by entering into other foreign exchange contracts with third parties. Adjustments to the fair value of all foreign exchange forward contracts are included in "investment banking and capital markets income" on the income statement. OPTIONS AND FUTURES. Key uses these instruments for proprietary trading purposes. Adjustments to the fair value of all such options are included in "investment banking and capital markets income" on the income statement. CREDIT RISK. At September 30, 2000, credit exposure from financial instruments held or issued for trading purposes was limited to the aggregate fair value of each contract with a positive fair value, or $518 million. Key manages credit risk by contracting only with counterparties with high credit ratings, continuously monitoring counterparties' performance, and entering into master netting agreements when possible. The following table shows trading income recognized on interest rate, foreign exchange forward, and option and futures contracts. NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- in millions 2000 1999 ----------------------------------------------------------------------------- Interest rate contracts $21 $28 Foreign exchange forward contracts 27 21 Option and futures contracts 2 5 ----------------------------------------------------------------------------- The table on page 25 summarizes the notional amount and fair value of derivative financial instruments held or issued for trading purposes at September 30, 2000, and on average for the nine-month period then ended. The interest rate swaps and caps related to securitization positions were executed in connection with the residual interests retained when Key securitized certain home equity and education loans. The positive fair values represent assets and the negative fair values represent liabilities. The $27.5 billion notional amount of client interest rate swaps presented in the table includes $12.6 billion of client swaps that receive a fixed rate and pay a variable rate, $10 billion of client swaps that pay a fixed rate and receive a variable rate, and $4.9 billion of basis swaps. As of September 30, 2000, the client swaps had an average expected life of 5.3 years, carried a weighted average rate received of 6.62%, and had a weighted average rate paid of 6.65%. 24 25
SEPTEMBER 30, 2000 NINE MONTHS ENDED SEPTEMBER 30, 2000 --------------------------------- --------------------------------------- NOTIONAL FAIR AVERAGE AVERAGE in millions AMOUNT VALUE NOTIONAL AMOUNT FAIR VALUE --------------------------------------------------------------------------------------------------------------------------------- Interest rate contracts - client positions: Swap assets $14,193 $339 $12,543 $401 Swap liabilities 13,323 (169) 12,981 (271) Caps and floors purchased 773 5 701 5 Caps and floors sold 813 (5) 784 (6) Futures purchased 754 - 465 - Futures sold 11,145 (8) 9,218 6 Interest rate contracts - securitization positions: Swap assets $1,130 $29 $1,083 $27 Caps purchased 1,079 57 1,068 57 Caps sold 2,574 (57) 2,163 (57) Foreign exchange forward contracts: Assets $1,383 $70 $1,695 $66 Liabilities 1,464 (64) 1,624 (58) Option contracts: Options purchased $2,758 $18 $1,678 $16 Options sold 3,092 (14) 2,455 (13) -----------------------------------------------------------------------------------------------------------------------------------
25 26 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, 2000 and 1999, 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, 2000 and 1999. 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, 1999, 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 14, 2000, 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, 1999, 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 12, 2000 26 27 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION This Management's Discussion and Analysis reviews the financial condition and results of operations of KeyCorp and its subsidiaries for the quarterly and year-to-date periods ended September 30, 2000 and 1999. Some tables may cover more than these periods to comply with Securities and Exchange Commission disclosure requirements or to illustrate trends over a period of time. When you read this discussion, you should also look at the consolidated financial statements and related notes that appear on pages 3 through 25. TERMINOLOGY This report contains some shortened names and industry-specific terms. We want to explain some of these terms at the outset so you can better understand the discussion that follows. - KEYCORP refers solely to the parent company. - 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, primarily through the Key Capital Partners line of business. These activities encompass a variety of 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), invest in new or growing ventures and conduct transactions in foreign currencies (both to accommodate clients' needs and to benefit from fluctuations in exchange rates). - CORE FINANCIAL RESULTS exclude the effects of significant nonrecurring items such as gains from divestitures and restructuring charges. - 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. - All earnings per share data included in this discussion are presented on a DILUTED basis, which takes into account all common shares outstanding and 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 several classes. Federal regulations prescribe that at least half of a bank or bank holding company's TOTAL RISK-ADJUSTED 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 and dividends" which begins on page 57. OUR PROJECTIONS ARE NOT FOOLPROOF This report contains "forward-looking statements" about issues like anticipated improvement in earnings, expected expense reductions and revenue growth, and related objectives (such as the anticipated reduction in Key's employment base). 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. 27 28 - If the economy or segments of the economy slow, the demand for new loans and the ability of borrowers to repay outstanding loans may decline. - The stock and bond markets could suffer a disruption, which may have a negative effect 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, or we may be unable to implement those initiatives at all. - Acquisitions and dispositions of assets, business units or affiliates could affect us in ways that management has not anticipated. - We may become subject to new legal obligations or the resolution of existing litigation may have a negative effect on our financial condition. - We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements. HIGHLIGHTS OF KEY'S PERFORMANCE ------------------------------- FINANCIAL PERFORMANCE Some of the highlights of Key's core financial performance for the third quarter and first nine months of 2000 are discussed below. - Core income was $245 million, or $.57 per common share, compared with $266 million, or $.59 per common share, for the third quarter of 1999. For the first nine months of the year, Key's core net income was $737 million, or $1.69 per common share, compared with $787 million, or $1.74 reported for the same period last year. - Key's core return on average equity was 14.97% and 16.81% for the third quarter of 2000 and 1999, respectively. For the first nine months of the year, Key's core return on average equity was 15.15%, down from 17.00% for the first nine months of 1999. - Key's third quarter core return on average total assets was 1.16% compared with 1.30% for the third quarter of 1999. For the first nine months of the year, Key's core return on average total assets was 1.18%, down from 1.31% for the comparable period in 1999. In both the current and prior year, Key's financial results have been affected by various nonrecurring items. The most significant of these items and their impact on both earnings and primary financial ratios are summarized in Figure 1. Each of these items is discussed in greater detail elsewhere in this report. 28 29 FIGURE 1. SIGNIFICANT NONRECURRING ITEMS
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------- ------------------------------- dollars in millions, except per share amounts 2000 1999 2000 1999 -------------------------------------------------------------------------------------------------------------------------------- Net income as reported $121 $270 $ 736 $843 Nonrecurring items (net of tax): Gain from sale of credit card portfolio - - (207) - Additional provisions for loan losses 17 - 93 19 Restructuring and other special charges 71 4 80 4 Net losses from investment portfolio reconfiguration 32 - 32 - Gain from sale of Electronic Payment Services, Inc. - - - (85) Gain from sale of Compaq Capital Europe LLC and Compaq Capital Asia Pacific LLC - (8) - (8) Gains from sale of Key Merchant Services, LLC - - - (9) Gain from sale of Concord EFS, Inc. common stock - - - (9) Other nonrecurring items 4 - 3 32 -------------------------------------------------------------------------------------------------------------------------------- Net income - core $245 $266 $ 737 $787 ==== ==== ===== ==== Net income per diluted common share $.28 $.60 $1.68 $1.86 Net income per diluted common share - core .57 .59 1.69 1.74 Return on average total assets .57 % 1.32 % 1.18 % 1.40 % Return on average total assets - core 1.16 1.30 1.18 1.31 Return on average equity 7.39 17.06 15.12 18.21 Return on average equity - core 14.97 16.81 15.15 17.00 --------------------------------------------------------------------------------------------------------------------------------
The decline in Key's core net income from the respective 1999 periods is due in part to the short-term effects of actions that have been taken over the past year to support the generation of consistent longer-term growth. These actions include the October 1999 sale of Key's Long Island district branches and the January 2000 sale of Key's credit card business. The decline in core earnings also reflects the impact of our decision to de-emphasize the securitization and sale of home equity loans originated by our home equity finance affiliate. By retaining these loans on the balance sheet, we intend to replace over time the earnings capacity lost with the divestiture of the credit card business. Management estimates that after excluding earnings from the divested businesses and net gains from the securitization and sale of home equity loans, Key's third quarter core net income of $245 million, or $.57 per common share, was up 10% on a per share basis from adjusted core earnings of $234 million, or $.52, in the third quarter of 1999. Adjusting for the same items, earnings for the first nine months of 2000 were $728 million, or $1.67 per common share, compared with $696 million, or $1.54, for the comparable period last year. The primary factors contributing to the change in Key's revenue and expense components relative to the third quarter and first nine months of 1999 are reviewed in detail in the remainder of this discussion. Figure 2 summarizes Key's financial performance on a reported basis for each of the past five quarters and the first nine months of 2000 and 1999. 29 30 FIGURE 2. SELECTED FINANCIAL DATA
2000 1999 NINE MONTHS ENDED SEPTEMBER 30, --------------------------- --------------------- ------------------------------- dollars in millions, except per share amounts THIRD SECOND FIRST FOURTH THIRD 2000 1999 ----------------------------------------------------------------------------------------------------------------------------------- FOR THE PERIOD Interest income $1,596 $1,540 $1,489 $1,489 $1,433 $4,625 $4,206 Interest expense 912 867 818 784 733 2,597 2,124 Net interest income 684 673 671 705 700 2,028 2,082 Provision for loan losses 131 68 183 83 78 382 265 Noninterest income 405 475 806 672 496 1,686 1,643 Noninterest expense 787 698 727 885 708 2,212 2,185 Income before income taxes 171 382 567 409 410 1,120 1,275 Net income 121 248 367 264 270 736 843 ----------------------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE Net income $ .28 $ .57 $ .83 $ .59 $ .60 $ 1.69 $ 1.88 Net income-assuming dilution .28 .57 .83 .59 .60 1.68 1.86 Cash dividends .28 .28 .28 .26 .26 .84 .78 Book value at period end 15.26 15.09 14.84 14.41 14.25 15.26 14.25 Market price: High 27.06 23.00 22.25 29.75 33.50 27.06 38.13 Low 17.50 17.00 15.56 21.00 25.19 15.56 25.19 Close 25.31 17.63 19.00 22.13 25.81 25.31 25.81 Weighted average common shares (000) 429,584 434,112 441,834 446,402 448,742 435,156 448,764 Weighted average common shares and potential common shares (000) 431,972 436,022 443,757 449,678 452,886 437,231 453,267 ----------------------------------------------------------------------------------------------------------------------------------- AT PERIOD END Loans $66,299 $65,612 $64,064 $64,222 $63,181 66,299 $63,181 Earning assets 75,786 74,748 73,953 73,733 72,831 75,786 72,831 Total assets 85,500 84,719 83,504 83,395 82,577 85,500 82,577 Deposits 47,809 49,076 46,036 43,233 43,466 47,809 43,466 Long-term debt 13,800 14,097 14,784 15,881 15,815 13,800 15,815 Shareholders' equity 6,520 6,507 6,493 6,389 6,397 6,520 6,397 Full-time equivalent employees 22,457 23,005 23,474 24,568 25,523 22,457 25,523 Branches 932 938 937 936 963 932 963 ----------------------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets .57% 1.20% 1.77% 1.27% 1.32% 1.18% 1.40% Return on average equity 7.39 15.40 22.68 16.18 17.06 15.12 18.21 Efficiency(a) 58.38 60.26 62.27 59.23 58.91 60.31 59.74 Overhead(b) 30.68 32.50 35.75 30.39 31.03 32.96 31.91 Net interest margin (taxable equivalent) 3.68 3.68 3.68 3.88 3.92 3.68 3.95 ----------------------------------------------------------------------------------------------------------------------------------- CAPITAL RATIOS AT PERIOD END Equity to assets 7.63% 7.68% 7.78% 7.66% 7.75% 7.63% 7.75% Tangible equity to tangible assets 6.10 6.12 6.16 6.03 6.06 6.10 6.06 Tier 1 risk-adjusted capital 7.59 7.88 7.98 7.68 7.84 7.59 7.84 Total risk-adjusted capital 11.34 11.74 12.04 11.66 11.94 11.34 11.94 Leverage 7.76 7.90 7.89 7.77 7.85 7.76 7.85 -----------------------------------------------------------------------------------------------------------------------------------
Key has completed several acquisitions and divestitures during the periods shown in this table. One or more of these transactions may have had a significant effect on Key's results, making it difficult to compare results from one period to the next. Note 3 ("Acquisitions and Divestitures") beginning on page 8 has specific information about the acquisitions and divestitures that Key completed in the periods presented above to help you understand how those transactions impacted Key's financial condition and results of operations. (a) This ratio measures the extent to which recurring revenues are absorbed by operating expenses and is calculated as follows: noninterest expense (excluding significant nonrecurring items) DIVIDED BY the sum of taxable-equivalent net interest income and noninterest income (excluding significant nonrecurring items). (b) This ratio is the difference between noninterest expense (excluding significant nonrecurring items) and noninterest income (excluding significant nonrecurring items) DIVIDED BY taxable-equivalent net interest income. 30 31 CORPORATE STRATEGY Key's corporate strategy encompasses an ongoing review of business lines to identify opportunities to generate higher earnings growth by deploying capital from low-growth to high-growth businesses. We continue to focus on acquiring or growing businesses that we believe are capable of achieving double-digit earnings growth rates and selling portfolios and business units that have low anticipated growth rates or do not have a competitive advantage or significant market share. This long-standing strategy was supplemented in the fourth quarter of 1999 by a new three-year competitiveness initiative to improve profitability by reducing the costs of doing business, sharpening the focus on the most profitable growth businesses and enhancing revenues. Key's corporate strategy also reflects the growing importance of the Internet and related information technologies to the daily activities of people, companies, and other institutions. As such, the strategy calls for the continual and thoughtful application of such technologies to enhance Key's product and service offerings and to streamline its internal business practices. PRINCIPAL STRATEGIC ACTIONS DURING THE FIRST NINE MONTHS OF 2000 On January 31, Key sold its $1.3 billion credit card portfolio as part of an overall effort to direct financial resources and free up capital to support faster growing businesses, such as the home equity business. The small size of the credit card portfolio in relation to those of competitors did not provide the scale necessary to allow Key to compete effectively in credit card lending. The sale of the credit card portfolio is described in Note 3 (Acquisitions and Divestitures) which begins on page 8. In addition, throughout the year Key has continued to take actions, including investing in high growth businesses, to increase the potential for additional growth in fee income: - during the first quarter, we launched a retirement services campaign and introduced an e-commerce program for our middle market corporate clients. We also announced the acquisition of certain net assets of National Realty Funding L.C., a commercial finance company headquartered in Kansas City, Missouri. Through this acquisition we expect to expand our capabilities in originating and servicing loans in the commercial real estate market. In the second quarter this was demonstrated by Key's participation in the securitization and non-recourse sale of $816 million of commercial mortgage loans, including Key loans totaling $483 million. Key remains the primary servicer for all of its loans sold in the transaction; - during the second quarter we announced our intent to form a strategic alliance that will enhance and expand the trade products and services that Key offers to its international clients. Under this alliance, ABN AMRO, the world's sixth-largest bank, will process international trade transactions for Key's clients through a variety of channels, including the Internet. The completion of the alliance is expected to occur by the end of the first quarter of 2001; - during the third quarter, we acquired certain net assets of Newport Mortgage Company, L.P., a commercial mortgage company headquartered in Dallas, Texas. Through this acquisition we expect to expand the breadth of our lending capabilities. We also reached an agreement with InsLogic, a leader in online insurance services, which will allow us to offer various insurance products and services on the Key web site sometime during the fourth quarter. Finally, we entered into an agreement with MasterCard International to provide MasterCard-branded debit card processing services to other financial institutions that have limited or no access to an ATM network; and - early in the fourth quarter, we announced that our corporate e-commerce program, which allows our middle market clients to buy and sell products online, has moved from its pilot phase to a fully-functioning operation. 31 32 During the third quarter, we entered the second and final phase of our three-year competitiveness initiative. Key now expects that annual savings of approximately $360 million will be achieved from the overall initiative when actions are fully implemented by the end of 2002. In the initial phase, which began last November, Key reduced its operating expenses by approximately $100 million as a result of efforts to outsource certain nonstrategic support functions, consolidate sites in a number of our businesses and reduce management layers. The final phase will focus on: - simplifying Key's business structure by consolidating 22 business lines into 12; - streamlining and automating business operations and processes; - standardizing product offerings and internal processes; - consolidating operating facilities and service centers; and - outsourcing certain noncore activities. In the final phase, we expect to reduce Key's workforce by approximately 2,300 positions over the next 15 months. This will bring workforce reductions to well above 4,000 positions for both phases of the initiative. In connection with the competitiveness initiative we recorded an additional net $130 million of restructuring and other special charges during the first nine months of 2000 ($114 million during the third quarter), bringing the cumulative charges recorded for this initiative to a net $282 million. The section entitled "Noninterest expense," which begins on page 47, and Note 10 ("Restructuring Charges"), which begins on page 20, provide more information about Key's restructuring charges. 32 33 CASH BASIS FINANCIAL DATA ------------------------- The selected financial data presented in Figure 3 highlight Key's performance on a cash basis for each of the past five quarters and the first nine months of 2000 and 1999. We provide cash basis financial data because we believe it offers a useful tool for measuring Key's ability to support future growth, evaluating liquidity and determining Key's ability to pay dividends and repurchase shares. "Cash basis" accounting can mean different things. When we apply "cash basis" accounting, the only adjustments that we make to get from the information in Figure 2 (which is presented on an accrual basis) to the comparable line items in Figure 3 are to exclude goodwill and other intangibles that do not qualify as Tier 1 capital, and to exclude the amortization of those assets. Figure 3 does not exclude the impact of other noncash items (such as depreciation and deferred taxes) and significant nonrecurring items. Goodwill and other intangibles that do not qualify as Tier 1 capital are the result of business combinations that Key recorded using the "purchase" method of accounting. Under the purchase method, assets and liabilities of acquired companies are recorded at their fair values and any amount paid in excess of the fair value of the net assets acquired is recorded as goodwill. If the same transactions had qualified for accounting using the "pooling of interests" method, the acquired company's financial statements would simply have been combined with Key's. After a combination using purchase accounting, Key must amortize goodwill and other intangibles by taking periodic charges against income, but those charges are only accounting entries, not actual cash expenses. Thus, from an investor's perspective, the economic effect of a transaction is the same whether we account for it as a purchase or a pooling. For the same reason, the amortization of intangibles does not impact Key's liquidity and funds management activities. This is the only section of this Financial Review that discusses Key's financial results on a cash basis. FIGURE 3. CASH BASIS SELECTED FINANCIAL DATA
NINE MONTHS ENDED 2000 1999 SEPTEMBER 30, ------------------------------ ------------------- -------------------- dollars in millions, except per share amounts THIRD SECOND FIRST FOURTH THIRD 2000 1999 ------------------------------------------------------------------------------------------------------------------------------------ FOR THE PERIOD Noninterest expense $763 $672 $702 $860 $684 $2,137 $2,108 Income before income taxes 195 408 592 434 434 1,195 1,352 Net income 143 271 390 287 291 804 912 ------------------------------------------------------------------------------------------------------------------------------------ PER COMMON SHARE Net income $.33 $.62 $.88 $.64 $.65 $1.85 $2.03 Net income - assuming dilution .33 .62 .88 .64 .64 1.84 2.01 Weighted average common shares (000) 429,584 434,112 441,834 446,402 448,742 435,156 448,764 Weighted average common shares and potential common shares (000) 431,972 436,022 443,757 449,678 452,886 437,231 453,267 ------------------------------------------------------------------------------------------------------------------------------------ PERFORMANCE RATIOS Return on average total assets .69 % 1.33 % 1.92 % 1.40 % 1.45 % 1.31 % 1.55 % Return on average equity 11.12 21.56 30.97 22.64 24.13 21.15 26.01 Efficiency(a) 56.30 58.01 60.10 57.18 56.89 58.14 57.58 ------------------------------------------------------------------------------------------------------------------------------------ GOODWILL AND NON-QUALIFYING INTANGIBLES Goodwill average balance $1,346 $1,370 $1,386 $1,402 $1,429 $1,367 $1,431 Non-qualifying intangibles average balance 50 54 58 62 66 54 70 Goodwill amortization (after tax) 20 21 20 20 20 61 61 Non-qualifying intangibles amortization (after tax) 2 2 3 3 1 7 8 ------------------------------------------------------------------------------------------------------------------------------------
Key has completed several acquisitions and divestitures during the periods presented in this table. One or more of these transactions may have had a significant effect on Key's results, making it difficult to compare results from one period to the next. Note 3 ("Acquisitions and Divestitures") beginning on page 8 has specific information about the acquisitions and divestitures that Key completed in the periods presented above to help you understand how those transactions impacted Key's financial condition and results of operations. (a) This ratio measures the extent to which recurring revenues are absorbed by operating expenses and is calculated as follows: noninterest expense (excluding significant nonrecurring items and the amortization of goodwill and non-qualifying intangibles) DIVIDED BY the sum of taxable-equivalent net interest income and noninterest income (excluding significant nonrecurring items). 33 34 LINE OF BUSINESS RESULTS ------------------------ Key has four primary lines of business: KEY RETAIL BANKING offers branch-based financial products and services to small businesses and consumers. KEY SPECIALTY FINANCE offers non-branch-based consumer loan products, such as education loans, home equity loans, automobile loans and leases, and marine and recreational vehicle loans. KEY CORPORATE CAPITAL offers financing, transaction processing, e-commerce, financial advisory, equipment leasing and a number of other specialized services. KEY CAPITAL PARTNERS offers asset management, brokerage, investment banking, capital markets, and insurance products and services. It also provides specialized services to high-net-worth clients through the wealth management and private banking businesses. This section summarizes the financial performance of each line of business and its most recent strategic developments. To better understand the discussion below concerning each line of business, see Note 4 ("Line of Business Results"), which begins on page 10 and describes the activities and financial results of each line of business in greater detail. Figure 4 shows Key's net income (loss) by line of business for the three- and nine-month periods ended September 30, 2000 and 1999. FIGURE 4. NET INCOME (LOSS) BY LINE OF BUSINESS
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------------ ------------------------ ------------------------- -------------------- dollars in millions 2000 1999 AMOUNT PERCENT 2000 1999 AMOUNT PERCENT ---------------------------------------------------------------------------------------------------------------------------------- Key Retail Banking $103 $83 $ 20 24.1 % $294 $248 $ 46 18.5 % Key Specialty Finance 15 38 (23) (60.5) 61 119 (58) (48.7) Key Corporate Capital 85 101 (16) (15.8) 278 288 (10) (3.5) Key Capital Partners(a) 41 23 18 78.3 101 71 30 42.3 Treasury and Other (32) (3) (29) (966.7) (31) (6) (25) (416.7) ---------------------------------------------------------------------------------------------------------------------------------- Total segments 212 242 (30) (12.4) 703 720 (17) (2.4) Reconciling items (91) 28 (119) N/M 33 123 (90) (73.2) ---------------------------------------------------------------------------------------------------------------------------------- Total net income $121 $270 $(149) (55.2)% $736 $843 $(107) (12.7)% ==== ==== ====== ==== ==== ====== ----------------------------------------------------------------------------------------------------------------------------------
(a) Noninterest income and expense attributable to Key Capital Partners is assigned to either Key Corporate Capital or Key Retail Banking if one of those lines is principally responsible for maintaining the relationship with the client that used Key Capital Partners' products and services. Key Capital Partners had net income of $52 million and $32 million in the third quarter of 2000 and 1999, respectively, and $131 million and $96 million in the first nine months of 2000 and 1999, respectively, before the assignment of income and expense. N/M=Not Meaningful KEY RETAIL BANKING Net income for Key Retail Banking was $294 million for the first nine months of 2000, or approximately 40% of Key's consolidated earnings. In comparison, net income was $248 million for the first nine months of 1999, or approximately 29% of consolidated earnings. The increase in net income is primarily attributable to a $50 million increase in total revenue, reflecting equal contributions from net interest income and noninterest income, and a $42 million decline in noninterest expense. These positive factors were partially offset by a $16 million increase in the provision for loan losses that reflected a higher level of net charge-offs. Revenue growth from the first nine months of 1999 includes a $25 million improvement in net interest income, primarily due to continued loan growth. Average loans outstanding rose by 11%, reflecting 34 35 growth in the commercial and consumer portfolios. Also contributing to the rise in net interest income was a 5% increase in average deposit balances. Noninterest income was up $25 million from the first nine months of last year. Increases in both service charges on deposit accounts and electronic banking fees are the primary factors driving the improvement. The increase in service charges reflects the repricing of services, while the growth in electronic banking fees resulted from a higher volume of activity. The noninterest expense decrease of $42 million from the same period last year is principally the result of lower costs associated with personnel, depreciation and amortization expense, and various indirect charges. The decline in personnel expense reflects a decrease in the number of employees. KEY SPECIALTY FINANCE Net income for Key Specialty Finance was $61 million in the first nine months of 2000, or approximately 8% of Key's consolidated earnings. In comparison, net income was $119 million for the first nine months of 1999, or approximately 14% of consolidated earnings. The decline in net income had been anticipated by management as a consequence of strategic changes (discussed in the following two paragraphs) which led to decreases in both net interest income and noninterest income. The decline in these revenue components was partially offset by a reduction in noninterest expense. Net interest income decreased by $12 million from the first nine months of 1999. A 3% increase in average loans outstanding was more than offset by the higher cost of funds used to support the home equity loans originated by Champion Mortgage Co., Inc., our home equity finance affiliate. Starting in 2000, we have de-emphasized our practice of securitizing and selling home equity loans originated by Champion, although we may continue to securitize these loans without then selling them. By retaining these assets on the balance sheet, we intend to replace over time the earnings capacity previously provided by the credit card business, which was sold in January 2000. The higher cost of funds included in net interest income resulted from the fact that since these loans are no longer classified as "held for sale" and are expected to be retained on the balance sheet until maturity, the costs to fund them is based on the higher rates associated with longer holding periods. Virtually all of the $87 million decrease in noninterest income from a year ago is attributable to the absence of home equity securitization gains in the current year, due in part to the change in practice discussed above. We estimate that the change in our home equity loan securitization practice will reduce Key's 2000 diluted earnings per common share by approximately $.08 from what it would have been had we continued to securitize and sell home equity loans. For more information about Key's loan securitization activities, see the section entitled "Loans" which begins on page 50. The provision for loan losses was essentially unchanged, while the level of noninterest expense was down 4% from the prior year as a result of actions taken to control expenses under Key's competitiveness initiative. KEY CORPORATE CAPITAL Net income for Key Corporate Capital was $278 million for the first nine months of 2000, or approximately 38% of Key's consolidated earnings. In comparison, net income was $288 million for the same period last year, or approximately 34% of consolidated earnings. The decrease in net income resulted from a $37 million increase in the provision for loan losses and a $25 million increase in noninterest expense. The increase in noninterest expense included higher personnel expense, depreciation and amortization expense and costs associated with investment banking and capital markets activities. These latter costs are primarily the result of the income and expense sharing relationship described in the Key Capital Partners section on page 36. The higher costs discussed above were substantially offset by a $51 million increase in total revenue. Total average loans grew by 9%, generating a $56 million increase in net interest income. This reflects strong increases in essentially all major business units, including structured finance, lease financing, real estate construction, healthcare, and the middle market portfolios. In 1999, noninterest income included a $13 35 36 million gain from the third quarter sale of Key's interest in a joint venture with Compaq Capital Corporation. Excluding this nonrecurring item, noninterest income grew by $8 million, primarily due to higher income from service charges on deposit accounts, loan fees and various investment banking and capital markets activities. During the first and third quarters of 2000, Key announced the acquisitions of certain net assets of National Realty Funding L.C. and Newport Mortgage Company, L.P., respectively. You can find more discussion of these acquisitions and related activities in the section entitled "Principal strategic actions during the first nine months of 2000," beginning on page 31. KEY CAPITAL PARTNERS Net income for Key Capital Partners was $101 million for the first nine months of 2000, or approximately 14% of Key's consolidated earnings. In comparison, net income was $71 million for the first nine months of 1999, or approximately 9% of consolidated earnings. If personnel in another line of business are responsible for maintaining a relationship with a client that uses the products and services offered by Key Capital Partners, that other line of business is assigned the income and expense arising from our work for the client. As a result, a significant amount of Key Capital Partners' noninterest income and expense is reported under either Key Corporate Capital or Key Retail Banking. If Key Capital Partners had not assigned income and expense to other lines of business, net income for this line would have been $131 million in the first nine months of 2000 (representing approximately 18% of Key's consolidated earnings) and $96 million in the same period last year (representing approximately 11% of Key's consolidated earnings). Total revenue for Key Capital Partners rose by $57 million from the first nine months of 1999. Primary factors contributing to this improvement were higher net gains from equity capital investments, an increase in dealer trading and derivatives income, and growth in trust and investment advisory fees, which reflected an expanded base of clients and the repricing of certain services. The growth of these revenue components was moderated by a decline in investment banking fees due to lower levels of activity and the timing of certain transactions. Noninterest expense was up $7 million from the first nine months of last year, due primarily to higher personnel related costs. TREASURY AND OTHER Treasury and Other includes the Treasury and Electronic Services business units, as well as the net effect of funds transfer pricing. In the first nine months of 2000, this segment generated a net loss of $31 million, compared with a net loss of $6 million for the first nine months of 1999. The higher net loss in the current year is primarily due to $50 million ($32 million after tax) of net losses resulting from the third quarter 2000 reconfiguration of Key's investment portfolio. These losses were partially offset by an increase in the level of net income generated by the Electronic Commerce unit. RECONCILING ITEMS The "reconciling items" shown in Figure 4 reflect certain nonrecurring items and charges related to unallocated nonearning assets of corporate support functions. Also included in both the current and prior year are the results of divested businesses. Prior to restatement in 2000, these results had been included in the individual lines of business to which they pertained. For more specific information regarding the above items, see notes c, d and e to the table included in Note 4 ("Line of Business Results") which begins on page 10. 36 37 RESULTS OF OPERATIONS --------------------- NET INTEREST INCOME Key's principal source of earnings is net interest income, which comprises interest and loan-related fee income less interest expense. 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 off-balance sheet instruments to manage interest rate risk; - interest rate fluctuations; and - asset quality. To make it easier to compare results from one period to the next, as well as the yields on various types of earning assets, we present all net interest income 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 amount to $100. Figure 5 shows various components of the balance sheet that affect interest income and expense, and their respective yields or rates over the past five quarters. Net interest income for the third quarter of 2000 was $691 million, representing an $18 million, or 3%, decrease from the same period last year. The decline reflects a 24 basis point reduction in the net interest margin to 3.68%, which more than offset the impact of a 4% increase in average earning assets (primarily commercial and home equity loans) to $74.7 billion. Both earning assets and the net interest margin were reduced by the sales of Key's Long Island branches and credit card business. These operations contributed approximately $50 million to net interest income in the third quarter of 1999. Although the third quarter margin declined from the year-ago quarter, it was unchanged from the first two quarters of this year despite a challenging interest rate environment and the January sale of the low-growth, but higher-yielding credit card business. The constant margin was largely due to the growth of Key' s retail deposits which allowed us to stabilize our dependence on higher-cost funds. For the first nine months of 2000, net interest income totaled $2.0 billion, down $57 million, or 3%, from the same period last year. The year-to-date reduction also reflected a lower net interest margin which decreased 27 basis points to 3.68%, while the growth of commercial and home equity loans was the primary contributor to a 4% increase in average earning assets to $74.1 billion. The divestitures discussed above added only $13 million to net interest income in the current year, but added $138 million to Key's net interest income in the first nine months of 1999. NET INTEREST MARGIN. There are several reasons that the net interest margin declined over the past year: - the October 1999 divestiture of Key's Long Island branches with approximately $1.3 billion in deposits and the January 2000 sale of the $1.3 billion credit card portfolio resulted in an estimated decrease of 18 basis points in Key's third quarter 2000 net interest margin from that of the 1999 third quarter; - increased competition has impacted the rates that we can charge for loans and the rates that we must pay for deposits; - core deposit growth has not kept pace with loan growth due in part to branch divestitures and client preferences for other investment alternatives; and - we have intensified our efforts to grow deposits such as money market deposit accounts and time deposits. These deposits are among the more costly of our core deposit products, but they provide more stable funding than wholesale sources. 37 38 FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
THIRD QUARTER 2000 SECOND QUARTER 2000 ------------------------------------------ ------------------------------------ AVERAGE YIELD/ AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE ----------------------------------------------------------------------------------------------------------------------------------- ASSETS Loans(a,b) Commercial, financial and agricultural $19,647 $ 434 8.87 % $19,046 $ 405 8.56 % Real estate - commercial mortgage 6,932 160 9.29 6,967 156 9.03 Real estate - construction 4,866 121 9.98 4,625 110 9.51 Commercial lease financing 6,861 122 7.14 6,773 124 7.30 ----------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 38,306 837 8.78 37,411 795 8.53 Real estate - residential 4,273 80 7.51 4,276 83 7.80 Home equity 9,095 219 9.68 8,600 196 9.16 Credit card - - - - - - Consumer - direct 2,595 68 10.50 2,620 66 10.09 Consumer - indirect lease financing 3,052 62 8.08 3,107 62 7.97 Consumer - indirect other 5,952 142 9.55 6,078 142 9.33 ----------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 24,967 571 9.17 24,681 549 8.92 Loans held for sale 2,504 56 8.96 2,725 58 8.52 ----------------------------------------------------------------------------------------------------------------------------------- Total loans 65,777 1,464 8.93 64,817 1,402 8.68 Taxable investment securities 787 8 3.63 671 6 3.63 Tax-exempt investment securities(a) 369 7 8.12 415 9 8.77 ----------------------------------------------------------------------------------------------------------------------------------- Total investment securities 1,156 15 5.06 1,086 15 5.60 Securities available for sale(a,c) 6,275 107 6.67 6,198 107 6.73 Short-term investments 1,501 17 4.76 1,757 23 5.29 ----------------------------------------------------------------------------------------------------------------------------------- Total earning assets 74,709 1,603 8.61 73,858 1,547 8.40 Allowance for loan losses (969) (976) Other assets 10,365 10,523 ----------------------------------------------------------------------------------------------------------------------------------- $84,105 $83,405 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $11,956 102 3.43 $12,403 105 3.41 Savings deposits 2,151 8 1.49 2,275 8 1.44 NOW accounts 592 2 1.59 628 3 1.61 Certificates of deposit ($100,000 or more) 5,269 84 6.40 5,430 82 6.06 Other time deposits 14,634 218 6.01 13,656 190 5.61 Deposits in foreign office 2,860 48 6.70 3,029 48 6.39 ----------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 37,462 462 4.96 37,421 436 4.69 Federal funds purchased and securities sold under repurchase agreements 5,746 88 6.17 4,096 58 5.64 Bank notes and other short-term borrowings 6,403 99 6.19 6,972 103 5.96 Long-term debt, including capital securities(d) 15,356 263 6.91 15,668 270 6.92 ----------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 64,967 912 5.65 64,157 867 5.43 Noninterest-bearing deposits 8,377 8,412 Other liabilities 4,248 4,357 Common shareholders' equity 6,513 6,479 ----------------------------------------------------------------------------------------------------------------------------------- $84,105 $83,405 ======= ======= Interest rate spread (TE) 2.96 2.97 ----------------------------------------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $691 3.68 % $680 3.68 % ==== ====== ==== ======= Capital securities $1,243 $24 $1,243 $24 Taxable-equivalent adjustment(a) 7 7 -----------------------------------------------------------------------------------------------------------------------------------
(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 ESOP debt. TE=Taxable Equivalent 38 39 FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES (CONTINUED)
FIRST QUARTER 2000 FOURTH QUARTER 1999 ------------------------------------- ---------------------------------- AVERAGE YIELD/ AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE ----------------------------------------------------------------------------------------------------------------------------------- ASSETS Loans(a,b) Commercial, financial and agricultural $18,677 $ 379 8.17 % $18,311 $ 364 7.90 % Real estate - commercial mortgage 6,891 150 8.74 6,824 147 8.52 Real estate - construction 4,601 104 9.12 4,438 100 8.88 Commercial lease financing 6,684 122 7.28 6,484 120 7.43 ----------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 36,853 755 8.23 36,057 731 8.05 Real estate - residential 4,318 81 7.48 4,338 80 7.56 Home equity 8,129 179 8.85 7,497 168 8.71 Credit card - - - - - - Consumer - direct 2,572 62 9.72 2,560 63 9.85 Consumer - indirect lease financing 3,174 63 7.93 3,159 62 8.01 Consumer - indirect other 6,286 145 9.22 6,452 151 9.34 ----------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 24,479 530 8.67 24,006 524 8.70 Loans held for sale 2,692 65 9.80 3,423 95 11.09 ----------------------------------------------------------------------------------------------------------------------------------- Total loans 64,024 1,350 8.47 63,486 1,350 8.46 Taxable investment securities 580 4 2.94 506 4 3.26 Tax-exempt investment securities(a) 436 10 8.74 468 11 8.69 ----------------------------------------------------------------------------------------------------------------------------------- Total investment securities 1,016 14 5.43 974 15 5.87 Securities available for sale(a,c) 6,475 112 6.81 6,667 114 6.77 Short-term investments 2,164 20 3.66 1,954 18 3.48 ----------------------------------------------------------------------------------------------------------------------------------- Total earning assets 73,679 1,496 8.15 73,081 1,497 8.15 Allowance for loan losses (899) (916) Other assets 10,407 10,409 ----------------------------------------------------------------------------------------------------------------------------------- $83,187 $82,574 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $12,617 104 3.32 $12,836 100 3.09 Savings deposits 2,357 9 1.61 2,458 9 1.62 NOW accounts 627 3 1.62 610 4 1.76 Certificates of deposit ($100,000 or more) 5,555 80 5.78 5,151 71 5.48 Other time deposits 12,552 164 5.25 12,150 154 5.04 Deposits in foreign office 1,206 17 5.76 906 12 5.45 ----------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 34,914 377 4.34 34,111 350 4.08 Federal funds purchased and securities sold under repurchase agreements 4,003 48 4.85 4,384 52 4.71 Bank notes and other short-term borrowings 8,680 126 5.83 8,243 116 5.57 Long-term debt, including capital securities(d) 16,577 267 6.49 17,095 266 6.17 ----------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 64,174 818 5.13 63,833 784 4.87 Noninterest-bearing deposits 8,160 8,430 Other liabilities 4,344 3,836 Common shareholders' equity 6,509 6,475 ----------------------------------------------------------------------------------------------------------------------------------- $83,187 $82,574 ======= ======= Interest rate spread (TE) 3.02 3.28 ----------------------------------------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $678 3.68 % $713 3.88 % ==== ====== ==== ====== Capital securities $1,243 $23 $1,243 $23 Taxable-equivalent adjustment(a) 7 8 -----------------------------------------------------------------------------------------------------------------------------------
THIRD QUARTER 1999 ---------------------------------- AVERAGE YIELD/ DOLLARS IN MILLIONS BALANCE INTEREST RATE --------------------------------------------------------------------------------------------- ASSETS Loans(a,b) Commercial, financial and agricultural $17,978 $ 348 7.66 % Real estate - commercial mortgage 6,784 141 8.25 Real estate - construction 4,190 89 8.46 Commercial lease financing 6,261 113 7.16 ----------------------------------------------------------------------------------------- Total commercial loans 35,213 691 7.78 Real estate - residential 4,175 80 7.64 Home equity 7,739 161 8.32 Credit card 1,302 54 16.45 Consumer - direct 2,467 60 9.65 Consumer - indirect lease financing 2,993 61 8.15 Consumer - indirect other 6,457 148 9.17 ----------------------------------------------------------------------------------------- Total consumer loans 25,133 564 8.92 Loans held for sale 2,453 50 8.00 ----------------------------------------------------------------------------------------- Total loans 62,799 1,305 8.24 Taxable investment securities 471 4 3.47 Tax-exempt investment securities(a) 499 10 8.55 ----------------------------------------------------------------------------------------- Total investment securities 970 14 6.09 Securities available for sale(a,c) 6,359 106 6.54 Short-term investments 1,836 17 3.74 ----------------------------------------------------------------------------------------- Total earning assets 71,964 1,442 7.96 Allowance for loan losses (920) Other assets 10,251 ----------------------------------------------------------------------------------------- $81,295 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $13,274 100 2.97 Savings deposits 2,699 11 1.63 NOW accounts 610 1 1.37 Certificates of deposit ($100,000 or more) 4,475 59 5.22 Other time deposits 12,095 150 4.91 Deposits in foreign office 776 10 4.99 ----------------------------------------------------------------------------------------- Total interest-bearing deposits 33,929 331 3.87 Federal funds purchased and securities sold under repurchase agreements 4,495 51 4.49 Bank notes and other short-term borrowings 7,428 103 5.50 Long-term debt, including capital securities(d) 17,069 248 5.79 ----------------------------------------------------------------------------------------- Total interest-bearing liabilities 62,921 733 4.62 Noninterest-bearing deposits 8,534 Other liabilities 3,561 Common shareholders' equity 6,279 ----------------------------------------------------------------------------------------- $81,295 Interest rate spread (TE) 3.34 ----------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $709 3.92 % ==== ========= Capital securities $1,205 $22 Taxable-equivalent adjustment(a) 9 -----------------------------------------------------------------------------------------
39 40 INTEREST EARNING ASSETS. Average earning assets for the third quarter totaled $74.7 billion, which was $2.7 billion, or 4%, higher than the third quarter 1999 level. For the first nine months of the year, average earning assets rose 4% to $74.1 billion from the first nine months of 1999. Both the quarterly and year-to-date increases came principally from the loan portfolio, despite the sale of Key's credit card business last January. The largest growth occurred in the commercial loan portfolio, but the growth of the home equity portfolio was also strong. Key's loan growth has been affected by several strategic developments. Late in the first quarter of 2000 we created a commercial loan conduit through which $805 million of lower-spread loans have been sold through September 30. This arrangement allows us to continue to meet our customers' funding needs and to generate servicing revenue without having to retain these lower-spread assets on the balance sheet. In addition, during the second quarter of 2000, Key sold without recourse $483 million of its commercial mortgage loans in its initial participation in the securitization and sale of such assets. Our business of originating and servicing these loans is expected to grow as a result of Key's recent acquisitions of Newport Mortgage Company L.P. and National Realty Funding L.C. Finally, during 1999, we securitized and sold loans aggregating $3.4 billion as part of our strategy to diversify Key's funding sources, but that strategy moderated the growth of the consumer loan portfolio. Earlier this year, we announced our intention to de-emphasize the securitization and sale of home equity loans generated by our home equity finance affiliate. No such transactions occurred during the first nine months of 2000. By retaining the assets generated by this growing business on Key's balance sheet, we intend to replace over time the earnings capacity lost with the divestiture of our credit card business. We will continue, however, to consider securitizations of other portfolios as a source of alternative funding when conditions in the capital markets are favorable. During the first nine months of 2000, Key securitized and sold approximately $1.0 billion of education loans. INTEREST RATE SWAPS AND CAPS. As discussed in the following section entitled "Market risk management," Key uses portfolio interest rate swaps and caps to help manage its interest rate sensitivity position. Interest rate swaps and caps are complicated instruments, but briefly: - INTEREST RATE SWAPS are contracts under which two parties agree to exchange interest payment streams that are calculated on agreed-upon amounts (known as "notional amounts"). For example, party A will pay interest at a fixed rate to, and receive interest at a variable rate from, party B. Key generally uses interest rate swaps to mitigate its exposure to interest rate risk on certain loans, securities, deposits, short-term borrowings and long-term debt. - INTEREST RATE CAPS are contracts that provide for the holder to be compensated based on an agreed-upon notional amount when a benchmark interest rate exceeds a specified level (known as the "strike rate"). Key uses interest rate caps to manage the risk of adverse movements in interest rates on certain of our long-term debt and short-term borrowings. A cap limits Key's exposure to interest rate increases; caps do not have any impact if interest rates decline. For more information about how Key uses interest rate swaps and caps to manage its balance sheet, please see the next section, entitled "Market risk management." Figure 6 shows how changes in yields or rates and average balances from the prior year affected net interest income. You can find more discussion of the changes in earning assets and funding sources in the section entitled "Financial Condition," which begins on page 50. 40 41 FIGURE 6. COMPONENTS OF NET INTEREST INCOME CHANGES
FROM THREE MONTHS ENDED SEPTEMBER 30, 1999, FROM NINE MONTHS ENDED SEPTEMBER 30, 1999, TO THREE MONTHS ENDED SEPTEMBER 30, 2000 TO NINE MONTHS ENDED SEPTEMBER 30, 2000 ------------------------------------------- ----------------------------------------- AVERAGE YIELD/ NET AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE VOLUME RATE CHANGE --------------------------------------------------------------------------------------------------------------------------------- INTEREST INCOME Loans $64 $ 95 $159 $179 $224 $ 403 Taxable investment securities 3 1 4 7 - 7 Tax-exempt investment securities (2) (1) (3) (10) 1 (9) Securities available for sale (1) 2 1 - 16 16 Short-term investments (3) 3 - (1) - (1) --------------------------------------------------------------------------------------------------------------------------------- Total interest income (taxable equivalent) 61 100 161 175 241 416 INTEREST EXPENSE Money market deposit accounts (10) 12 2 (15) 36 21 Savings deposits (2) (1) (3) (6) (4) (10) NOW accounts - 1 1 (3) 3 - Certificates of deposit ($100,000 or more) 11 14 25 63 31 94 Other time deposits 35 33 68 68 63 131 Deposits in foreign office 34 4 38 73 11 84 --------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 68 63 131 180 140 320 Federal funds purchased and securities sold under repurchase agreements 16 21 37 (14) 40 26 Bank notes and other short-term borrowings (15) 11 (4) (19) 37 18 Long-term debt, including capital securities (26) 41 15 (17) 126 109 --------------------------------------------------------------------------------------------------------------------------------- Total interest expense 43 136 179 130 343 473 --------------------------------------------------------------------------------------------------------------------------------- Net interest income (taxable equivalent) $18 $(36) $ (18) $45 $(102) $ (57) === ===== ====== === ====== ====== ---------------------------------------------------------------------------------------------------------------------------------
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 "Market risk" is the exposure to economic loss that arises when the value of a financial instrument adversely changes due to variations in interest rates, foreign exchange rates, equity prices (the value of equity securities held as assets), or other market-driven rates or prices. For example, the value of a fixed-rate bond will decline if market interest rates increase because the bond will become a less attractive investment. Similarly, the value of the U.S. dollar regularly fluctuates in relation to other currencies. Key is not affected in any material way by changes in foreign exchange rates. ASSET AND LIABILITY MANAGEMENT Key's Asset/Liability Management Policy Committee has established guidelines for 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 position. MEASUREMENT OF SHORT-TERM INTEREST RATE EXPOSURE. The primary tool that management uses to measure and manage interest rate risk is a net interest income simulation model. 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. 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 we make are reasonable. Nevertheless, the simulation modeling process only produces a sophisticated estimate, not a precise calculation of exposure. 41 42 Key's guidelines for risk management require management to take preventive measures if a gradual 200 basis point increase or decrease in short-term rates over the next twelve months would affect net interest income over the same period by more than 2%. Key has been operating well within these guidelines. As of September 30, 2000, based on the results of our simulation model, Key would expect net interest income to increase by approximately 1.34% if short-term interest rates gradually decrease. Conversely, if short-term interest rates gradually increase, net interest income would be expected to decrease by approximately .86%. 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 that are 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 off-balance sheet positions based on the current yield curve. Economic value analysis has several limitations. For example, the economic values of asset, liability, and off-balance sheet positions do not represent the true fair values of the positions, since economic values do not consider factors such as credit risk and liquidity. In addition, we must estimate cash flow for assets and liabilities with indeterminate maturities. Moreover, the future structure of the balance sheet derived from ongoing loan and deposit activity by Key's core businesses is not factored into present value calculations. Finally, the analysis requires assumptions about events that span several years. Despite its limitations, the economic value of equity model does provide management with a relatively sophisticated tool for evaluating the longer-term effect of possible interest rate movements. Key's guidelines for risk management require management to take preventive measures if an immediate 200 basis point increase or decrease in interest rates would decrease the economic value of equity by more than 15%. Key has been operating well within these guidelines. OTHER SOURCES 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 also periodically measure the risk to earnings and economic value arising from various other pro forma changes in the overall level of interest rates. The variety of interest rate scenarios modeled, and their potential impact on earnings and economic value, quantify the level of interest rate exposure arising from option risk, basis risk and gap risk. - A financial instrument presents "OPTION RISK" when one party can take advantage of changes in interest rates without penalty. For example, when interest rates decline, borrowers may choose to prepay fixed rate loans by refinancing at a lower rate. Such a prepayment gives Key a return on its investment (the principal plus some interest), but unless there is a prepayment penalty, that return will not be as much as the loan would have generated had payments been received as originally scheduled. Floating rate loans that are capped against potential interest rate increases and deposits that can be withdrawn on demand also present option risk. - One approach that Key uses to manage interest rate risk is to offset floating rate liabilities (such as deposits) with floating rate assets (such as loans). That way, as our interest expense increases, so will our interest income. We face "BASIS RISK" when our floating-rate assets and floating-rate liabilities reprice in response to different market factors or indices. Under those circumstances, even if equal amounts of assets and liabilities are repricing at the same time, interest expense and interest income may not change by the same amount. - We often use an interest-bearing liability to provide funding for an interest-earning asset. For example, Key may sell certificates of deposit and use the proceeds to make loans. That strategy presents "GAP RISK" if the related liabilities and assets do not mature or reprice at the same time. 42 43 MANAGEMENT OF INTEREST RATE EXPOSURE. Key manages 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. In addition, management considers interest rate implications when adding to Key's securities portfolio, issuing new debt and packaging loans for securitization. PORTFOLIO SWAPS AND CAPS. The estimated fair value of Key's portfolio swaps and caps decreased to a negative fair value of $156 million during the first nine months of 2000 from a negative fair value of $42 million at December 31, 1999. Fair value decreased because of the combined impact of a number of factors: interest rates increased, the implied forward yield curve steepened, the value of the euro declined and Key's "receive" fixed interest rate swap portfolio has a slightly longer average remaining maturity than the "pay" fixed portfolio. Because these instruments qualify for hedge accounting treatment, their estimated net negative fair value should be substantially offset by the unrecognized positive fair values of the assets and liabilities whose risk characteristics they are being used to modify. Key terminated swaps with a notional amount of $2.8 billion during the first nine months of 2000, resulting in a net deferred loss of $3 million. Each swap termination was made in response to a unique set of circumstances. Generally, the decision to terminate any swap contract is integrated strategically with asset and liability management and takes many factors into account. During 1999 and the first nine months of 2000, management also used portfolio rate locks and futures from time to time since Key relied more heavily on variable rate funding to support earning asset growth. Figure 7 shows the notional amount and fair values of portfolio swaps and caps by interest rate management strategy. The fair value of an instrument at any given date represents the estimated income (if positive) or cost (if negative) that would be recognized if the instrument was sold at that date. However, because these instruments are used to alter the repricing or maturity characteristics of assets and liabilities, the net unrealized gains and losses are not recognized separately in earnings. Rather, interest from swaps and caps is recognized on an accrual basis as an adjustment of the interest income or expense from the asset or liability being managed. FIGURE 7. PORTFOLIO SWAPS AND CAPS BY INTEREST RATE MANAGEMENT STRATEGY
SEPTEMBER 30, 2000 DECEMBER 31, 1999 SEPTEMBER 30, 1999 -------------------- ----------------- ---------------------- NOTIONAL FAIR NOTIONAL FAIR NOTIONAL FAIR in millions AMOUNT VALUE AMOUNT VALUE AMOUNT VALUE ------------------------------------------------------------------------------------------------------------------------------------ Convert variable rate loans to fixed $ 1,208 $ (11) $ 1,254 $ (24) $ 1,282 $ (6) Convert fixed rate loans to variable 1,065 (4) 587 14 642 9 Convert fixed rate securities to variable 357 10 316 18 322 11 Convert variable rate deposits and short-term borrowings to fixed 900 8 1,100 14 1,150 5 Convert fixed rate deposits and short-term borrowings to variable 471 -- 226 (6) 226 (3) Convert variable rate long-term debt to fixed 3,846 20 3,820 59 1,880 29 Convert fixed rate long-term debt to variable 2,782 (56) 4,586 (104) 4,586 (48) Basis swaps - foreign currency denominated debt 1,089 (124) 321 (23) 321 (9) Basis swaps - interest rate indices 4,482 (2) 6,462 3 8,087 6 ------------------------------------------------------------------------------------------------------------------------------------ Total portfolio swaps 16,200 (159) 18,672 (49) 18,496 (6) Modify characteristics of variable rate short-term borrowings 500 2 2,050 6 2,050 4 Modify characteristics of variable rate long-term debt 100 1 200 1 515 1 ------------------------------------------------------------------------------------------------------------------------------------ Total portfolio caps and collars 600 3 2,250 7 2,565 5 ------------------------------------------------------------------------------------------------------------------------------------ Total portfolio swaps, caps and collars $16,800 $ (156) $ 20,922 $ (42) $ 21,061 $ (1) ======= ======= ======== ====== ========= ====== ------------------------------------------------------------------------------------------------------------------------------------
43 44 Figure 8 summarizes the expected average maturities of Key's portfolio swaps and caps at September 30, 2000. FIGURE 8. EXPECTED AVERAGE MATURITIES OF PORTFOLIO SWAPS AND CAPS
SEPTEMBER 30, 2000 RECEIVE FIXED PAY FIXED --------------------------- ------------------------ TOTAL INDEXED FORWARD- PORTFOLIO in millions AMORTIZING CONVENTIONAL CONVENTIONAL STARTING BASIS SWAPS SWAPS ----------------------------------------------------------------------------------------------------------------------------------- Mature in one year or less -- $ 290 $ 1,478 -- $ 2,015 $ 3,783 Mature after one through five years $ 48 2,556 3,509 -- 3,556 9,669 Mature after five through ten years -- 947 805 -- -- 1,752 Mature after ten years -- 620 363 $ 13 -- 996 ----------------------------------------------------------------------------------------------------------------------------------- Total portfolio swaps, caps and collars $ 48 $ 4,413 $ 6,155 $ 13 $ 5,571 $ 16,200 === ======= ======= ==== ======= ======== ----------------------------------------------------------------------------------------------------------------------------------- in millions CAPS TOTAL -------------------------------------------------------------------------- Mature in one year or less $ 600 $ 4,383 Mature after one through five years -- 9,669 Mature after five through ten years -- 1,752 Mature after ten years -- 996 -------------------------------------------------------------------------- Total portfolio swaps, caps and collars $ 600 $ 16,800 ===== ======== --------------------------------------------------------------------------
Trading Portfolio Risk Management --------------------------------- Key's trading portfolio includes interest rate swap contracts entered into to accommodate the needs of clients, other positions with third parties that are intended to mitigate the interest rate risk of client positions, foreign exchange contracts entered into to accommodate the needs of clients and financial assets and liabilities (trading positions) included in "other assets" and "other liabilities," respectively, on the balance sheet. For more information about off-balance sheet contracts, see Note 11 ("Financial Instruments with Off-Balance Sheet Risk"), which begins on page 21. Management uses a value at risk ("VAR") model to estimate the potential adverse effect of changes in interest and foreign exchange rates on the fair value of Key's trading portfolio. Using statistical methods, this model estimates the maximum potential one-day loss with 95% certainty. At September 30, 2000, Key's aggregate daily VAR was $1.1 million compared with $1 million at September 30, 1999. Aggregate daily VAR averaged less than $1 million for the first nine months of 2000, compared with an average of $1.6 million during 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. NONINTEREST INCOME Noninterest income for the third quarter of 2000 totaled $405 million, down $91 million, or 18%, from the same period last year. For the first nine months of the year, noninterest income was $1.7 billion, representing an increase of $43 million, or 3%, from the first nine months of 1999. In both the current and prior year, noninterest income has been affected by various nonrecurring items. The most significant of these items are shown in Figure 9 and include gains from divestitures, net losses resulting from the reconfiguration of Key's investment portfolio and various other nonrecurring net charges. For more information on the divestitures, see Note 3 ("Acquisitions and Divestitures"), which begins on page 8. Excluding nonrecurring items, core noninterest income was $460 million for the third quarter of 2000 and currently represents 40% of Key's total core revenue. One of management's long-term objectives is to increase core noninterest income as a percentage of total core revenue to 50%. Core noninterest income in the year-ago quarter was $481 million and included $20 million from the divested Long Island branches and credit card business, as well as $17 million of gains resulting from the securitization and sale of home equity loans. No home equity loan securitizations have been recorded in 2000 as a result of our revised strategy discussed on page 45. Excluding earnings from divested businesses and gains from home equity loan securitizations, core noninterest income in the current year was up $16 million, or 4%, from comparable third quarter 1999 results. The largest contribution to this growth came from a $14 million increase in income from investment banking and capital markets activities. 44 45 For the first nine months of 2000, core noninterest income was $1.4 billion compared with $1.5 billion for the comparable period in 1999. The sales of the Long Island branches and credit card business accounted for $51 million of the decrease in core earnings, while the absence of gains from the securitization and sale of home equity loans in the current year accounted for a decrease of $64 million. Adjusting for these items, core noninterest income was up $71 million, or 5%, from the first nine months of 1999. The strongest contributions to this growth came from investment banking and capital markets activities (up $35 million), service charges on deposit accounts (up $16 million) and trust and investment services (up $13 million). The growth of these revenue components reflects the overall strength of the securities markets, new business and the repricing of certain services. Also contributing to the improvement in noninterest income was an $8 million increase in electronic banking fees. The growth in Key's core noninterest income was moderated by an $11 million reduction in net gains from the securitization of loans, other than those of the home equity portfolio. Figure 9 shows the major components of Key's noninterest income. For some of these components, the discussion that follows provides additional information, such as the composition of the component and the primary factors that caused it to change from the prior year. For detailed information about investment banking and capital markets income, and trust and investment services, see Figures 10 and 11, respectively. TRUST AND INVESTMENT SERVICES. Trust and investment services provide Key's largest source of noninterest income. At September 30, 2000, Key's bank, trust, and registered investment advisory subsidiaries had assets under discretionary management (excluding corporate trust assets) of $68 billion, compared with $67 billion at September 30, 1999. This component of noninterest income was renamed in the third quarter and now includes brokerage commission income, which was previously presented as a separate component. CREDIT CARD FEES. Credit card fees for the third quarter and first nine months of 2000 declined by $15 million and $38 million from the respective periods in 1999 due to the sale of Key's credit card business in January 2000. For more information about this transaction, see the section entitled "Highlights of Key's Performance," which begins on page 28, and Note 3 ("Acquisitions and Divestitures") which begins on page 8. LOAN SECURITIZATIONS. Key periodically securitizes and sells loans to generate funds. The extent to which we use securitizations is dependent upon whether conditions in the capital markets make them more attractive than other funding alternatives. We decide which loans to securitize based upon a number of specific factors as discussed in the section entitled "Loans," which begins on page 50. During the third quarter of 2000, we securitized and sold $502 million of education loans at a gain of $6 million, and recorded impairment write-downs relating to prior period securitizations. These transactions resulted in an aggregate net loss of $2 million. For the first nine months of this year, we have securitized and sold loans totaling $1.0 billion, all of which were in the education portfolio. In the current year, we have not securitized any of our home equity loans due in part to our plans announced earlier this year to de-emphasize the securitization and sale of home equity loans originated by our home equity finance affiliate. By retaining these assets on the balance sheet, we intend to replace over time the earnings capacity lost with the divestiture of the credit card portfolio. During the first nine months of last year, we securitized and sold $3.2 billion of consumer loans (including $1.1 billion of home equity loans), resulting in net gains of $82 million. The level of securitizations was particularly high during the first quarter ($1.8 billion) because a securitization originally planned for the fourth quarter of 1998 was postponed due to instability in the capital markets and was added to the expected volume of securitizations for the first quarter of 1999. For information about the type and volume of securitized loans that are either administered or serviced by Key and not recorded on the balance sheet, see the section entitled "Loans," which begins on page 50. 45 46 SIGNIFICANT NONRECURRING ITEMS. Noninterest income for the first nine months of 2000 includes a $332 million first quarter gain from the sale of Key's credit card business and $50 million of net losses that resulted from the reconfiguration of Key's investment portfolio in the third quarter. Results for the first nine months of 1999 include first quarter gains of $134 million from the sale of Key's interest in Electronic Payment Services, Inc. and $14 million, representing the final gain recorded in connection with the 1998 sale of a 51% interest in Key Merchant Services, LLC. Key also recorded a second quarter 1999 gain of $15 million from the sale of common shares obtained in the first quarter sale of Electronic Payment Services, Inc. and a third quarter 1999 gain of $13 million from the sale of its interest in a joint venture with Compaq Capital Corporation. FIGURE 9. NONINTEREST INCOME
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ----------------- ------------------- ------------------- --------------- dollars in millions 2000 1999 AMOUNT PERCENT 2000 1999 Amount Percent ------------------------------------------------------------------------------------------------------------------------------------ Trust and investment services income $ 148 $ 145 $ 3 2.1% $ 458 $ 445 $ 13 2.9% Investment banking and capital markets income 91 77 14 18.2 278 243 35 14.4 Service charges on deposit accounts 85 83 2 2.4 256 246 10 4.1 Corporate owned life insurance income 28 25 3 12.0 78 76 2 2.6 Credit card fees 1 16 (15) (93.8) 9 47 (38) (80.9) Net loan securitization gains (losses) (2) 32 (34) N/M 9 82 (73) (89.0) Net securities gains -- -- -- -- 3 -- 3 N/M Other income: Letter of credit and loan fees 26 25 1 4.0 73 69 4 5.8 Electronic banking fees 18 16 2 12.5 50 42 8 19.0 Insurance income 16 13 3 23.1 47 45 2 4.4 Loan securitization servicing fees 6 6 -- -- 19 21 (2) (9.5) Gains from sales of loans 12 3 9 300.0 24 25 (1) (4.0) Miscellaneous income 31 40 (9) (22.5) 107 115 (8) (7.0) ------------------------------------------------------------------------------------------------------------------------------------ Total other income 109 103 6 5.8 320 317 3 .9 ------------------------------------------------------------------------------------------------------------------------------------ Total core noninterest income 460 481 (21) (4.4) 1,411 1,456 (45) (3.1) Gain from sale of credit card portfolio -- -- -- -- 332 -- 332 N/M Net losses from investment portfolio reconfiguration (50) -- (50) N/M (50) -- (50) N/M Gain from sale of Electronic Payment Services, Inc. -- -- -- -- -- 134 (134) (100.0) Gain from sale of Compaq Capital Europe LLC and Compaq Capital Asia Pacific LLC -- 13 (13) (100.0) -- 13 (13) (100.0) Gain from sale of Key Merchant Services, LLC -- -- -- -- -- 14 (14) (100.0) Gain from sale of Concord EFS, Inc. common shares -- -- -- -- -- 15 (15) (100.0) Net securities gains -- 2 (2) (100.0) -- 11 (11) (100.0) Other nonrecurring items (5) -- (5) N/M (7) -- (7) N/M ------------------------------------------------------------------------------------------------------------------------------------ Total significant nonrecurring items (55) 15 (70) N/M 275 187 88 47.1 ------------------------------------------------------------------------------------------------------------------------------------ Total noninterest income $405 $ 496 $(91) (18.3)% $ 1,686 $ 1,643 $ 43 2.6% ==== ===== ===== ======= ======= ==== ------------------------------------------------------------------------------------------------------------------------------------
N/M=Not Meaningful FIGURE 10. INVESTMENT BANKING AND CAPITAL MARKETS INCOME
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ --------------- ------------- ----------------- dollars in millions 2000 1999 AMOUNT PERCENT 2000 1999 AMOUNT PERCENT ------------------------------------------------------------------------------------------------------------------------------------ Dealer trading and derivatives income $ 34 $ 28 $ 6 21.4% $ 118 $ 99 $ 19 19.2% Investment banking income 25 28 (3) (10.7) 78 92 (14) (15.2) Equity capital income 22 13 9 69.2 55 31 24 77.4 Foreign exchange income 10 8 2 25.0 27 21 6 28.6 ------------------------------------------------------------------------------------------------------------------------------------ Total investment banking and capital markets income $ 91 $ 77 $ 14 18.2% $278 $ 243 $ 35 14.4% ==== ==== ==== ==== ===== ==== ------------------------------------------------------------------------------------------------------------------------------------
FIGURE 11. TRUST AND INVESTMENT SERVICES
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ --------------- --------------- ---------------- dollars in millions 2000 1999 AMOUNT PERCENT 2000 1999 AMOUNT PERCENT --------------------------------------------------------------------------------------------------------------------------------- Personal asset management and custody fees $ 50 $ 48 $ 2 4.2% $ 143 $ 141 $ 2 1.4% Institutional asset management and custody fees 22 22 -- -- 70 70 -- -- Bond services 7 7 -- -- 31 19 12 63.2 Brokerage commission income 34 33 1 3.0 113 117 (4) (3.4) All other fees 35 35 -- -- 101 98 3 3.1 --------------------------------------------------------------------------------------------------------------------------------- Total trust and investment services income $ 148 $ 145 $ 3 2.1% $ 458 $ 445 $ 13 2.9% ===== ===== === ===== ===== ==== --------------------------------------------------------------------------------------------------------------------------------- dollars in billions ------------------------------------------------------------------------------------- SEPTEMBER 30, Discretionary assets $ 68 $ 67 $ 1 1.5% Non-discretionary assets 55 48 7 14.6 ------------------------------------------------------------------------------------- Total trust assets $ 123 $ 115 $ 8 7.0% ---------------------------------------------------------------------------------------------------------------------------------
46 47 NONINTEREST EXPENSE Noninterest expense for the third quarter of 2000 totaled $787 million, up $79 million, or 11%, from the third quarter of 1999. For the first nine months of the year, noninterest expense was $2.2 billion, representing a modest increase of $27 million from the same period last year. Significant nonrecurring items that affect the comparability of results for 2000 and 1999 are shown in Figure 12. In the current year, these items primarily comprise restructuring and other special charges which are discussed in greater detail under the heading "Restructuring and other special charges" on page 48. Primary among the significant nonrecurring items recorded during the first nine months of 1999 are $23 million of charitable contributions made in light of the gain realized from the sale of Key's interest in Electronic Payment Services, Inc. These contributions were recorded prior to the third quarter. Excluding nonrecurring charges, core noninterest expense was $672 million for the third quarter of 2000, down $29 million, or 4%, from the year-ago quarter. This represents Key's lowest quarterly level of core expense since the fourth quarter of 1998 and the third consecutive quarter in which such expense has declined. The improvement came largely from lower costs related to personnel and equipment (each down $7 million) and marketing (down $6 million), and reflects the actions taken by Key since last November to improve its competitiveness, as well as the strategic divestitures discussed earlier. For the first nine months of 2000, core noninterest expense was $2.1 billion, down $42 million from that reported for the same period last year. The largest decreases in expense came from equipment (down $17 million), personnel (down $15 million) and net occupancy (down $7 million). These improvements were partially offset, however, by higher costs associated with professional fees (up $8 million) and computer processing (up $5 million). In addition, miscellaneous expense included a first quarter 2000 charge of $7 million to reduce the carrying amount of residual values related to leased vehicles. Figure 12 shows the components of Key's noninterest expense. The discussion that follows explains the composition of some of these components and the factors that caused some components to change from the prior year. PERSONNEL. Personnel expense, the largest category of Key's noninterest expense, posted decreases from the prior year for both the quarterly and year-to-date periods. These improvements are attributable to the heightened attention to cost management brought about by our competitiveness initiative, as well as the effects of the strategic divestitures. At September 30, 2000, the number of full-time equivalent employees was 22,457, compared with 24,568 at the end of 1999 and 25,523 a year ago. COMPUTER PROCESSING. The increase in computer processing expense for the year-to-date period is due primarily to higher levels of computer software amortization, as well as increases related to software rental and maintenance. EQUIPMENT. Decreases in equipment expense for both the quarterly and year-to- date periods were driven by reductions in both depreciation and rental expense. PROFESSIONAL FEES. Professional fees comprise expenses incurred for legal, audit, consulting and certain other business services. Each of these categories contributed to the increase for the year-to-date period, while all but legal expense contributed to the quarterly increase. 47 48 \ FIGURE 12. NONINTEREST EXPENSE
THREE MONTHS ENDED Nine months ended SEPTEMBER 30, CHANGE September 30, Change ------------------ ----------------- ------------------ ---------------- dollars in millions 2000 1999 AMOUNT PERCENT 2000 1999 Amount Percent ----------------------------------------------------------------------------------------------------------------------------------- Personnel $ 342 $ 349 $ (7) (2.0)% $ 1,085 $ 1,100 $ (15) (1.4)% Net occupancy 55 58 (3) (5.2) 168 175 (7) (4.0) Computer processing 59 60 (1) (1.7) 178 173 5 2.9 Equipment 41 48 (7) (14.6) 131 148 (17) (11.5) Marketing 29 35 (6) (17.1) 82 84 (2) (2.4) Amortization of intangibles 26 25 1 4.0 76 79 (3) (3.8) Professional fees 18 18 -- -- 58 50 8 16.0 Other expense: Postage and delivery 15 17 (2) (11.8) 49 54 (5) (9.3) Telecommunications 12 14 (2) (14.3) 39 42 (3) (7.1) Equity- and gross receipts- based taxes 8 9 (1) (11.1) 24 26 (2) (7.7) OREO expense, net 2 3 (1) (33.3) 5 11 (6) (54.5) Miscellaneous expense 65 65 -- -- 191 186 5 2.7 ----------------------------------------------------------------------------------------------------------------------------------- Total other expense 102 108 (6) (5.6) 308 319 (11) (3.4) ----------------------------------------------------------------------------------------------------------------------------------- Total core noninterest expense 672 701 (29) (4.1) 2,086 2,128 (42) (2.0) Restructuring and other special charges 114 7 107 1,528.6 128 7 121 1,728.6 Other nonrecurring items 1 -- 1 N/M (2) 50 (52) N/M ----------------------------------------------------------------------------------------------------------------------------------- Total significant nonrecurring items 115 7 108 1,542.9 126 57 69 121.1 ----------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense $ 787 $ 708 $ 79 11.2% $ 2,212 $ 2,185 $ 27 1.2% ======= ======= ===== ======= ======== ==== Full-time equivalent employees at period end 22,457 25,523 22,457 25,523 Efficiency ratio(a) 58.38% 58.91% 60.31% 59.74% Overhead ratio(b) 30.68 31.03 32.96 31.91 -----------------------------------------------------------------------------------------------------------------------------------
(a) This ratio measures the extent to which recurring revenues are absorbed by operating expenses and is calculated as follows: noninterest expense (excluding significant nonrecurring items) DIVIDED BY the sum of taxable-equivalent net interest income and noninterest income (excluding significant nonrecurring items). (b) This ratio is the difference between noninterest expense (excluding significant nonrecurring items) and noninterest income (excluding significant nonrecurring items) DIVIDED BY taxable-equivalent net interest income. N/M=Not Meaningful RESTRUCTURING AND OTHER SPECIAL CHARGES. During the first nine months of 2000, we recorded net nonrecurring charges of $130 million (including net restructuring charges of $111 million) in connection with strategic actions related to Key's competitiveness initiative. Of these charges, $114 million were recorded during the third quarter as Key entered the second and final phase of this initiative which began last November. For more information related to the actions taken or to be taken in each phase, anticipated cost savings and expected reductions to Key's workforce, see the section entitled "Principal strategic actions during the first nine months of 2000," which begins on page 31. Additional information related to the restructuring charges can be found in Note 10 ("Restructuring Charges") which begins on page 20. Cash generated by Key's operations will fund the restructuring charge liability and none of the charges will have a material impact on Key's liquidity. During the first quarter of 2000, Key also recorded a $2 million credit to restructuring charges in connection with separate actions initiated during the fourth quarter of 1996 to complete Key's transformation to a nationwide bank-based financial services company. The credit was taken to reduce the remaining liability associated with branch consolidations, since favorable market conditions resulted in lower costs to consolidate these branches than originally expected. 48 49 EFFICIENCY RATIO. The efficiency ratio, which provides a measure of the extent to which recurring revenues are used to pay operating expenses, improved to 58.38% for the third quarter of 2000, from 60.26% for the second quarter of 2000 and 58.91% for the same period last year. "Other expense" includes equity- and gross receipts-based taxes that are assessed in lieu of an income tax in certain states in which Key operates. These taxes represented 70, 69 and 75 basis points of Key's efficiency ratio for the third quarter of 2000, the second quarter of 2000 and the third quarter of 1999, respectively. The extent to which such taxes impact noninterest expense will vary among companies, including Key's financial services peer group, based on the geographic locations in which they conduct their business. INCOME TAXES The provision for income taxes was $50 million for the three-month period ended September 30, 2000, down from $140 million for the comparable period in 1999. The effective tax rate (which is the provision for income taxes as a percentage of income before income taxes) for the third quarter of 2000 was 29.2%, compared with 34.1% for the third quarter of 1999. The effective tax rate for the third quarter of 2000 was distorted by the large dollar amount of significant nonrecurring charges recorded during the quarter. These charges are summarized in Figure 1 on page 29. Excluding these charges and the related tax benefits, the effective tax rate for the third quarter of 2000 was 33.4%. The decline in the adjusted tax rate from that reported for the year-ago quarter is attributable primarily to higher tax-exempt income from corporate owned life insurance and a favorable adjustment to the level of tax credits recorded in the third quarter of 2000. For the first nine months of 2000, the provision for income taxes was $384 million compared with $432 million for the first nine months of last year. The effective tax rates for these periods were 34.3% and 33.9%, respectively. Primary factors contributing to the slight increase in the effective year-to-date tax rate were higher state income taxes and higher levels of amortization related to non-deductible intangible assets. Also contributing to the increase in the effective tax rate was a 1999 tax benefit associated with a charitable contribution of appreciated stock. The effective income tax rate remains below Key's combined statutory Federal and state rate of 37%, primarily because we continue to invest in tax-advantaged assets (such as tax-exempt securities and corporate owned life insurance) and to recognize credits associated with investments in low-income housing projects. 49 50 FINANCIAL CONDITION ------------------- LOANS At September 30, 2000, total loans outstanding were $66.3 billion, compared with $64.2 billion at the end of 1999 and $63.2 billion a year ago. A summary of the composition of the loan portfolio at each of these respective dates is presented in Note 6 ("Loans") on page 16. Key achieved a 5% increase in loans during the past twelve months, primarily as a result of our targeted efforts to increase the commercial and home equity portfolios. These efforts were supported by the overall strength of the economy. Key's success in generating new loan volume has resulted in loan growth that has outpaced the growth of Key's deposits. As a result, we have used alternative funding sources such as securitizations to continue to capitalize on our lending opportunities. Our recent acquisitions of Newport Mortgage Company, L.P. and National Realty Funding L.C. are expected to facilitate these efforts, especially with regard to commercial real estate lending. In addition, during the first quarter, we created a commercial loan conduit. The conduit allows us to continue to meet our customers' funding needs and to generate servicing revenue without having to retain these lower-spread assets on the balance sheet. Loans outstanding (excluding loans held for sale) would have grown by $6.3 billion, or 10%, over the past twelve months, if we had not securitized and/or sold $4.9 billion of loans during that time period. This includes the fourth quarter 1999 divestiture of branches with loan portfolios aggregating $505 million and the first quarter 2000 sale of our $1.3 billion credit card portfolio. Excluding the impact of loan sales, commercial loans rose by $4.8 billion, or 13%, since September 30, 1999, due primarily to strong growth in the structured finance, healthcare and middle market portfolios, an $836 million increase in commercial real-estate mortgage loans, a $612 million increase in the lease financing portfolio and a $726 million increase in real estate-construction loans. Consumer loans (excluding loan sales) rose by $1.5 billion, or 6%, reflecting a $2.1 billion increase in the home equity portfolio. This growth was partially offset by a $506 million decline in Key's installment loans. On the same basis, commercial loans grew by $3.6 billion, or an annualized 13%, from the 1999 year end, reflecting growth in all major sectors of the portfolio. At the same time, home equity loans were up $1.5 billion, or an annualized 26%. SALES, SECURITIZATIONS, AND DIVESTITURES. Among the factors that Key considers in determining which loans to securitize are: - the extent to which 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. During the past twelve months, in addition to selling loans in connection with branch divestitures and the sale of the credit card portfolio, Key sold $1.5 billion of education loans ($1.2 billion through securitizations), $832 million of commercial loans, $667 million of commercial real estate loans and $151 million of home equity loans ($11 million through securitizations). Management will continue to explore opportunities to sell certain loan portfolios, consistent with prudent asset/liability management practices. However, we intend to securitize and sell fewer of the home equity loans originated by our home equity finance affiliate. By retaining these assets, we intend to replace over time the revenue generated by our former credit card business. This is one of the factors that led to the strong growth of the home equity portfolio discussed above. 50 51 Figure 13 summarizes Key's loan sales (including securitizations) and branch divestitures for the first nine months of 2000 and all of 1999. FIGURE 13. LOANS SOLD AND DIVESTED
COMMERCIAL RESIDENTIAL HOME CREDIT CARD in millions COMMERCIAL REAL ESTATE REAL ESTATE EQUITY RECEIVABLES ------------------------------------------------------------------------------------------------------------------------------ 2000 -------------- Third quarter $ 27 $ 70 -- $ 72 -- Second quarter 451 499 -- 23 -- First quarter 354 6 -- 24 $ 1,339 ------------------------------------------------------------------------------------------------------------------------------ Total $ 832 $ 575 -- $ 119 $ 1,339 ====== ===== ===== ======== BRANCH in millions AUTOMOBILE EDUCATION DIVESTITURES TOTAL ------------------------------------------------------------------------------------------------------------ 2000 -------------- Third quarter -- $ 618 -- $ 787 Second quarter -- 518 -- 1,491 First quarter -- 29 -- 1,752 -------------------------------------------------------------------------------------------------------------- Total -- $ 1,165 -- $ 4,030 ======== ======= COMMERCIAL RESIDENTIAL HOME CREDIT CARD in millions COMMERCIAL REAL ESTATE REAL ESTATE EQUITY RECEIVABLES ------------------------------------------------------------------------------------------------------------------------------ 1999 -------------- Fourth quarter -- $ 92 -- $ 32 -- Third quarter -- 100 -- 359 -- Second quarter -- 63 $ 292 442 -- First quarter -- 84 208 428 -- --------------------------------------------------------------------------------------------------------------------------- Total -- $ 339 $ 500 $ 1,261 -- ===== ===== ======= ============================================================================================================================ BRANCH in millions AUTOMOBILE EDUCATION DIVESTITURES TOTAL ------------------------------------------------------------------------------------------------------------ 1999 -------------- Fourth quarter -- $ 299 $ 505 $ 928 Third quarter -- 786 -- 1,245 Second quarter -- 132 -- 929 First quarter $ 555 818 -- 2,093 ------------------------------------------------------------------------------------------------------------- Total $ 555 $ 2,035 $ 505 $ 5,195 ======= ======== ===== ======= =============================================================================================================
Figure 14 shows loans that are either administered or serviced by Key, but are not recorded on the balance sheet. This includes loans that have been both securitized and sold, or simply sold outright. The increase in commercial real estate loans serviced resulted from the first quarter acquisition of National Realty Funding L.C., while the increase in commercial loans reflects sales that occurred through Key's new commercial loan conduit. FIGURE 14. LOANS ADMINISTERED OR SERVICED
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2000 1999 1999 ------------------------------------------------------------------------------------------------ Education loans $ 3,946 $ 3,475 $ 3,377 Automobile loans 505 855 994 Home equity loans 1,266 1,542 1,627 Commercial real estate loans 4,071 -- -- Commercial loans 916 -- -- ------------------------------------------------------------------------------------------------ Total $ 10,704 $ 5,872 $ 5,998 ======== ======= ======= ------------------------------------------------------------------------------------------------
Key derives income from two sources as a result of such arrangements. We earn noninterest income (recorded as "other income") from servicing or administering the loans, and we earn interest income from assets retained in connection with securitizations and accounted for like debt securities that are classified as available for sale or trading account assets. SECURITIES At September 30, 2000, the securities portfolio totaled $7.9 billion and comprised $6.7 billion of securities available for sale and $1.2 billion of investment securities. In comparison, the total portfolio at December 31, 1999, was $7.7 billion, including $6.7 billion of securities available for sale and $986 million of investment securities. 51 52 Figure 15 shows the composition, yields and remaining maturities of Key's securities available for sale. Figure 16 provides the same information about Key's investment securities. For more information about retained interests in securitizations and gross unrealized gains and losses by type of security, please see Note 5 ("Securities"), which begins on page 14. FIGURE 15. 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, 2000 Remaining maturity: One year or less $ 2,081 $ 2 $ 105 $ 2 After one through five years 6 18 1,861 657 After five through ten years 5 28 331 716 After ten years 13 -- 177 33 ----------------------------------------------------------------------------------------------------------------------------------- Fair value $ 2,105 $ 48 $ 2,474 $ 1,408 Amortized cost 2,105 48 2,561 1,425 Weighted average yield(b) 6.52% 4.70% 7.71% 7.15% Weighted average maturity 0.2 YEARS 5.5 YEARS 7.3 YEARS 5.4 YEARS ----------------------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1999 Fair value $ 127 $ 53 $ 4,237 $ 1,678 Amortized cost 128 53 4,426 1,705 ----------------------------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 1999 Fair value $ 128 $ 61 $ 4,084 $ 1,752 Amortized cost 128 61 4,240 1,772 ----------------------------------------------------------------------------------------------------------------------------------- RETAINED WEIGHTED INTERESTS IN OTHER AVERAGE dollars in millions SECURITIZATIONS(a) SECURITIES TOTAL YIELD(b) ------------------------------------------------------------------------------------------------------------------------ September 30, 2000 Remaining maturity: One year or less $ 56 $ 10 $ 2,256 6.60% After one through five years 93 19 2,654 7.02 After five through ten years 177 6 1,263 7.46 After ten years -- 268(c) 491 8.72 ------------------------------------------------------------------------------------------------------------------------ Fair value $ 326 $ 303 $ 6,664 -- Amortized cost 341 278 6,758 7.25% Weighted average yield(b) 9.19% 6.31% 7.25% -- Weighted average maturity 4.0 YEARS 10.5 YEARS 4.6 YEARS -- ------------------------------------------------------------------------------------------------------------------------ DECEMBER 31, 1999 Fair value $ 343 $ 227 $ 6,665 -- Amortized cost 340 223 6,875 6.77% ------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 1999 Fair value $ 351 $ 191 $ 6,567 -- Amortized cost 365 184 6,750 6.78% ------------------------------------------------------------------------------------------------------------------------
(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 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 equity securities with no stated maturity. FIGURE 16. INVESTMENT SECURITIES
STATES AND WEIGHTED POLITICAL OTHER AVERAGE dollars in millions SUBDIVISIONS SECURITIES TOTAL YIELD(a) --------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 2000 Remaining maturity: One year or less $ 123 $ 1 $ 124 8.49% After one through five years 150 -- 150 9.67 After five through ten years 79 24 103 8.86 After ten years 12 864(b) 876 6.23 --------------------------------------------------------------------------------------------------------------- Amortized cost $ 364 $ 889 $ 1,253 8.22% Fair value 373 889 1,262 -- Weighted average yield(a) 9.20% 6.13% 8.22% -- Weighted average maturity 3.1 YEARS 10.0 YEARS 8.1 YEARS -- --------------------------------------------------------------------------------------------------------------- DECEMBER 31, 1999 Amortized cost $ 447 $ 539 $ 986 6.15% Fair value 459 539 998 -- --------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 1999 Amortized cost $ 490 $ 499 $ 989 6.32% Fair value 506 499 1,005 -- ---------------------------------------------------------------------------------------------------------------
(a) Weighted average yields are calculated based on amortized cost and exclude equity securities that have no stated yield. Such yields have been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%. (b) Includes equity securities with no stated maturity. 52 53 ASSET QUALITY Key manages asset quality by following procedures that address the issue from many perspectives. Specifically, Key has groups of professionals that: -- evaluate and monitor the level of risk in credit-related assets; -- formulate underwriting standards and guidelines for line management; -- develop commercial and consumer credit policies and systems; -- establish credit-related concentration limits; -- review loans, leases, and other corporate assets to evaluate credit quality; and -- review the adequacy of the allowance for loan losses. ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses at September 30, 2000, was $1.0 billion, or 1.51% of loans. This compares with $930 million, or 1.47% of loans, at September 30, 1999. The allowance includes $83 million (for 2000) and $47 million (for 1999) that is specifically allocated for impaired loans. For more information about impaired loans, see Note 7 ("Impaired Loans and Other Nonperforming Assets") on page 17. At September 30, 2000, the allowance for loan losses was 169.09% of nonperforming loans, compared with 225.73% at September 30, 1999. Management relies on an iterative methodology to estimate the appropriate level of the allowance for loan losses on a quarterly (and at times more frequent) basis. 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 1999 Annual Report to Shareholders. With the advent of enhanced credit scoring capabilities, management continues to review and refine Key's methodology for estimating the appropriate level of the allowance for loan losses. During the first quarter of 2000, Key enhanced its methodology for assessing credit risk, particularly within the commercial loan portfolio. As a result, we recorded an additional provision for loan losses of $121 million in March. This was followed by an additional $27 million provision in September that was driven principally by the impact of changing conditions within the economy and recorded in accordance with Key's risk management practices. In the prior year, first quarter results included an additional provision of $30 million related to an enhancement in the allowance methodology pertaining to the credit card portfolio. NET LOAN CHARGE-OFFS. As shown in Figure 17, net loan charge-offs for the third quarter of 2000 were $104 million, or .63% of average loans, compared with $78 million, or .49%, for the same period last year. For the first nine months of 2000, net loan charge-offs totaled $306 million, or .63% of average loans, compared with $235 million, or .50%, for the first nine months of 1999. Included in net charge-offs in the current year are $15 million of credit card net charge-offs, including holdbacks and putbacks related to the January 2000 sale of the credit card portfolio. Excluding these net charge-offs and the $57 million of one-time charge-offs discussed below, Key's core net charge-offs for the first nine months of 2000 totaled $234 million, or .48% of average loans. In February 1999, the Federal banking agencies published revised guidelines which, among other things, require that consumer loans be charged off when payments are past due by a prescribed number of days. One of the factors that drove this change is concern that existing guidance is being interpreted differently within the banking industry, resulting in disparity in how financial institutions carry out their charge-off practices. Key elected to implement these new guidelines during the first quarter of 2000, although compliance is not required until the end of this year. This resulted in the acceleration of $57 million of consumer loan charge-offs that might otherwise have occurred at later dates. Key's allowance at December 31, 1999, had already included an allocation for these potential losses. For more information on the revised guidelines, see Item 5 ("Other Information") on page 61. 53 54 In comparison with the third quarter of 1999, net charge-offs in the commercial loan portfolio rose by $34 million. This increase reflected a number of factors including the growth experienced in the overall portfolio, an increase in losses attributable to fraud and $21 million of charge-offs on shared national credits recorded in the third quarter of 2000. The increase in commercial loan net charge-offs was partially offset by an $8 million decline in the level of net charge-offs in the consumer loan portfolio. Net charge-offs of credit card receivables decreased by $19 million due to the sale of the portfolio. At the same time, net charge-offs in the remainder of the consumer portfolio increased by a modest $11 million. FIGURE 17. SUMMARY OF LOAN LOSS EXPERIENCE
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ---------------------------- ---------------------------- dollars in millions 2000 1999 2000 1999 ------------------------------------------------------------------------------------------------------------------------------- Average loans outstanding during the period $ 65,777 $ 62,799 $ 64,876 $ 62,036 ------------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at beginning of period $ 979 $ 930 $ 930 $ 900 Loans charged off: Commercial, financial and agricultural 60 28 131 79 Real estate-commercial mortgage 2 2 6 2 Commercial lease financing 2 4 9 13 ------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 64 34 146 94 Real estate-residential mortgage 1 2 5 7 Home equity 3 2 14 7 Credit card -- 21 16 69 Consumer-direct 14 12 43 34 Consumer-indirect lease financing 2 -- 13 -- Consumer-indirect other 45 31 150 103 ------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 65 68 241 220 ------------------------------------------------------------------------------------------------------------------------------- 129 102 387 314 Recoveries: Commercial, financial and agricultural 4 6 18 21 Real estate-commercial mortgage -- 2 3 4 Commercial lease financing -- -- 2 1 ------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 4 8 23 26 Real estate-residential mortgage 1 1 3 4 Home equity -- -- 1 -- Credit card 1 3 4 11 Consumer-direct 2 2 5 6 Consumer-indirect lease financing -- -- 2 -- Consumer-indirect other 17 10 43 32 ------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 21 16 58 53 ------------------------------------------------------------------------------------------------------------------------------- 25 24 81 79 ------------------------------------------------------------------------------------------------------------------------------- Net loans charged off (104) (78) (306) (235) Allowance related to loans sold (5) -- (5) -- Provision for loan losses 131 78 382 265 ------------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of period $ 1,001 $ 930 $ 1,001 $ 930 ========= ========= ========= ======== ------------------------------------------------------------------------------------------------------------------------------- Net loan charge-offs to average loans .63% .49% .63% .50% Allowance for loan losses to period-end loans 1.51 1.47 1.51 1.47 Allowance for loan losses to nonperforming loans 169.09 225.73 169.09 225.73 -------------------------------------------------------------------------------------------------------------------------------
NONPERFORMING ASSETS. Figure 18 shows the composition of Key's nonperforming assets. These assets totaled $617 million at September 30, 2000, and represented .93% of loans, other real estate owned (known as "OREO") and other nonperforming assets, compared with $440 million, or .70%, at September 30, 1999. The $177 million increase in the level of nonperforming assets over the past twelve months resulted from a $180 million increase in nonperforming loans, offset in part by a $3 million net decrease in OREO and other nonperforming assets. The increase in nonperforming loans reflects, in part, significant loan growth, the maturation of certain segments of the portfolio and the effect of changes in the Government's reimbursement policies for the health care industry. 54 55 The amounts presented in Figure 18 at September 30, 2000, have been restated from those previously reported. This restatement reflects a reclassification of certain loans from those reported as 90 days past due and still accruing to those reported as nonaccrual. The reclassified loans are predominantly home equity loans held by Key Home Equity Services, a division of Key Bank USA, National Association that acts as a third-party purchaser of home equity loans. Although these loans had not been properly categorized as nonaccrual in Key's internal reporting system, the accrual of interest on the balances had, in fact, ceased. Therefore, the restatement had no impact on Key's earnings. FIGURE 18. SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2000 1999 1999 ---------------------------------------------------------------------------------------------------------------------------------- Commercial, financial and agricultural $ 251 $ 175 $ 146 Real estate-- commercial mortgage 92 102 102 Real estate-- construction 28 7 6 Commercial lease financing 45 28 31 ---------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 416 312 285 Real estate-- residential mortgage 50 44 50 Home equity 71 50 42 Consumer-- direct 8 6 5 Consumer-- indirect lease financing 6 3 3 Consumer-- indirect other 41 32 27 ---------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 176 135 127 ---------------------------------------------------------------------------------------------------------------------------------- Total nonperforming loans 592 447 412 OREO 26 27 32 Allowance for OREO losses (1) (3) (8) ---------------------------------------------------------------------------------------------------------------------------------- OREO, net of allowance 25 24 24 Other nonperforming assets -- 2 4 ---------------------------------------------------------------------------------------------------------------------------------- Total nonperforming assets $ 617 $ 473 $ 440 ===== ===== ===== ---------------------------------------------------------------------------------------------------------------------------------- Accruing loans past due 90 days or more $ 252 $ 219 $ 235 ---------------------------------------------------------------------------------------------------------------------------------- Nonperforming loans to period-end loans .89% .70% .65% Nonperforming assets to period-end loans plus OREO and other nonperforming assets .93 .74 .70 ----------------------------------------------------------------------------------------------------------------------------------
DEPOSITS AND OTHER SOURCES OF FUNDS "Core deposits" are Key's primary source of funding. These deposits consist of domestic deposits other than certificates of deposit of $100,000 or more. During the third quarter of 2000, core deposits averaged $37.7 billion, and represented 50% of the funds Key used to support earning assets, compared with $37.2 billion and 52%, respectively, during the same period last year. As shown in Figure 5 (which spans pages 38 and 39), Key has experienced a change in the mix of core deposits over the past twelve months. The levels of money market deposits, savings deposits and NOW accounts declined, primarily because we sold 28 branches with deposits of $1.3 billion as part of the October 1999 divestiture of our Long Island franchise. In addition, client preferences for higher returns and the strength of the securities markets during 1999 have also caused a shift from traditional bank products to nonbank financial investments, such as equity securities. At the same time, Key's time deposits have grown steadily as a result of client preferences for investments that offer higher returns, as well as our heightened focus on building Key's deposit base. During the third quarter, the deposits in Key's Retail Banking line of business grew by an annualized 8% from the prior quarter. 55 56 Purchased funds, comprising large certificates of deposit, deposits in the foreign office, and short-term borrowings, averaged $20.3 billion during the third quarter of 2000, compared with $17.2 billion a year ago. As shown in Figure 5, Key has relied more on purchased deposits and borrowings to fund earning assets in the current year. In addition, Key continues to consider loan securitizations as a funding alternative when market conditions are favorable. During the first nine months of 2000, Key securitized and sold $1.0 billion of education loans, $502 million 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 the needs of 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. LIQUIDITY FOR KEY. Management actively analyzes and manages Key's liquidity. In particular, Key's Funding and Investment Management Group monitors the overall mix of funding sources with the objective of maintaining an appropriate mix in light of the structure of the asset portfolios. We use several tools to maintain sufficient liquidity. - We maintain portfolios of short-term money market investments and securities available for sale, substantially all of which could be converted to cash quickly at a small expense. - Key's portfolio of investment securities generates prepayments (often at a premium) and payments at maturity. - We try to structure the maturities of our loans so we receive a relatively consistent stream of payments from borrowers. We also selectively securitize and package loans for sale. - Our 932 full-service KeyCenters in 13 states generate a sizable volume of core deposits. Key's Funding and Investment Management Group monitors deposit flows and considers alternate 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 outstanding as of September 30, 2000. LIQUIDITY FOR THE PARENT COMPANY. KeyCorp meets its liquidity requirements principally through regular dividends from affiliate banks. During the first nine months of 2000, affiliates paid KeyCorp a total of $506 million in dividends. As of September 30, 2000, the affiliate banks had an additional $703 million available to pay dividends without prior regulatory approval. These excess funds are generally maintained 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. BANK NOTE PROGRAM. During the first nine months of 2000, Key's affiliate banks raised $5.6 billion under Key's bank note program. Of the notes issued during this period of time, $1.8 billion have original maturities in excess of one year and are included in long-term debt; the remaining $3.8 billion have original maturities of one year or less and are included in short-term borrowings. On January 21, 2000, Key commenced a new bank note program which provides for the aggregate issuance of both long- and short-term debt up to $20.0 billion ($19.0 billion by KeyBank National Association and $1.0 billion by Key Bank USA, National Association). 56 57 EURO NOTE PROGRAM. Under Key's euro note program, KeyCorp, KeyBank National Association and Key Bank USA, National Association may issue both long- and short-term debt of up to $7.0 billion in the aggregate. The notes are offered exclusively to non-U.S. investors and can be denominated in U.S. dollars and many other foreign currencies. There were $3.5 billion of borrowings outstanding under this facility as of September 30, 2000, $1.1 billion of which were issued during the current year. COMMERCIAL PAPER AND REVOLVING CREDIT. KeyCorp has a commercial paper program and a two-year revolving credit agreement that provide funding availability of up to $500 million and $400 million, respectively. As of September 30, 2000, $372 million of borrowings were outstanding under the commercial paper program; no amount was outstanding under the revolving credit agreement. OTHER PUBLICLY ISSUED SECURITIES. KeyCorp has a universal shelf registration statement on file with the Securities and Exchange Commission that provides for the possible issuance of up to $1.3 billion of debt and equity securities. At September 30, 2000, unused capacity under the shelf registration totaled $412 million, all of which is reserved for future issuance as medium-term notes. If KeyCorp maintains its favorable debt ratings, shown below as of September 30, 2000, management believes that, under normal conditions in the capital markets, any eventual offering of securities should be well-received by investors. SENIOR SUBORDINATED COMMERCIAL LONG-TERM LONG-TERM PAPER DEBT DEBT -------------------- ------------------- ------------------- Standard & Poor's A-2 A- BBB+ Moody's P-1 A1 A2 For more information about Key's sources and uses of cash for the nine-month periods ended September 30, 2000 and 1999, see the Consolidated Statements of Cash Flow on page 6. CAPITAL AND DIVIDENDS SHAREHOLDERS' EQUITY. Total shareholders' equity at September 30, 2000, was $6.5 billion, up $131 million from the balance at December 31, 1999. Retained earnings grew by $372 million, while net unrealized losses on securities available for sale decreased by $73 million during the first nine months of 2000. The increase resulting from these items was substantially offset by a $305 million net increase in treasury stock stemming from share repurchases. SHARE REPURCHASES. In light of Key's earnings outlook and strong capital position, in September 2000 the Board of Directors authorized the repurchase of 25,000,000 common shares, including the 3,647,200 shares remaining from the prior authority. These shares may be repurchased in the open market or through negotiated transactions. During the first nine months of 2000, Key repurchased a total of 17,652,800 of its common shares (including 1,200,000 shares under the September authorization) at an average price per share of $19.28. At September 30, 2000, Key had 64,628,931 treasury shares. Management expects to reissue those shares over time to support the employee stock purchase, 401(k), stock option, and dividend reinvestment plans, and for other corporate purposes. During the first nine months of 2000, Key reissued 1,486,112 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 7.63% at September 30, 2000, compared with 7.66% at December 31, 1999, and 7.75% at September 30, 1999. 57 58 Banking industry regulators prescribe minimum capital ratios for bank holding companies and their banking subsidiaries. Risk-based capital guidelines require a minimum level of capital as a percent of "risk-adjusted assets," which is total assets plus certain off-balance sheet items that are 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-adjusted assets of 4.0%, and total capital as a percent of risk-adjusted assets of 8.0%. As of September 30, 2000, Key's Tier 1 capital ratio was 7.59%, and its total capital ratio was 11.34%. The leverage ratio is Tier 1 capital as a percentage of 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 3.0%. All other bank holding companies must maintain a minimum ratio of 4.0%. As of September 30, 2000, KeyCorp had a leverage ratio of 7.76%, which is substantially higher than the minimum requirement. Federal bank regulators group FDIC-insured depository institutions into the following five categories based on certain capital ratios: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Both of Key's affiliate banks qualified as "well capitalized" at September 30, 2000, since each exceeded the prescribed thresholds of 10% for total capital, 6% for Tier 1 capital, and 5% for the leverage ratio. If these provisions applied to bank holding companies, KeyCorp would also qualify as "well capitalized" at September 30, 2000. The FDIC-defined capital categories serve a limited regulatory function. Investors should not treat them as a representation of the overall financial condition or prospects of Key or its affiliates. Figure 19 presents the details of Key's regulatory capital position at September 30, 2000, December 31, 1999, and September 30, 1999. 58 59 Figure 19. Capital Components and Risk-Adjusted Assets
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2000 1999 1999 ----------------------------------------------------------------------------------------------------------------------------------- Tier 1 capital Common shareholders' equity(a) $6,565 $6,508 $6,503 Qualifying capital securities 1,243 1,243 1,243 Less: Goodwill (1,339) (1,389) (1,422) Other intangible assets(b) (48) (56) (60) ----------------------------------------------------------------------------------------------------------------------------------- Total Tier 1 capital 6,421 6,306 6,264 ----------------------------------------------------------------------------------------------------------------------------------- Tier 2 capital Allowance for loan losses(c) 1,001 930 930 Net unrealized holding gains(d) 13 3 2 Qualifying long-term debt 2,158 2,330 2,350 ----------------------------------------------------------------------------------------------------------------------------------- Total Tier 2 capital 3,172 3,263 3,282 ----------------------------------------------------------------------------------------------------------------------------------- Total capital $9,593 $9,569 $9,546 ====== ====== ====== Risk-adjusted assets Risk-adjusted assets on balance sheet $71,152 $68,619 $67,342 Risk-adjusted off-balance sheet exposure 14,636 14,513 13,713 Less: Goodwill (1,339) (1,389) (1,422) Other intangible assets(b) (48) (56) (60) Plus: Market risk-equivalent assets 174 391 370 Net unrealized holding gains(d) 13 3 2 ----------------------------------------------------------------------------------------------------------------------------------- Gross risk-adjusted assets 84,588 82,081 79,945 Less: Excess allowance for loan losses(c) - - - ----------------------------------------------------------------------------------------------------------------------------------- Net risk-adjusted assets $84,588 $82,081 $79,945 ====== ====== ====== Average quarterly total assets $84,105 $82,574 $81,295 ====== ====== ====== Capital ratios Tier 1 risk-adjusted capital ratio 7.59 % 7.68 % 7.84 % Total risk-adjusted capital ratio 11.34 11.66 11.94 Leverage ratio(e) 7.76 7.77 7.85 -----------------------------------------------------------------------------------------------------------------------------------
(a) Common shareholders' equity excludes the impact of net unrealized gains or losses on securities, except for net unrealized losses on marketable equity securities. (b) Intangible assets (excluding goodwill) recorded after February 19, 1992, and deductible portions of purchased mortgage servicing rights. (c) The allowance for loan losses included in Tier 2 capital is limited to 1.25% of gross risk-adjusted assets. (d) Net unrealized holding gains included in Tier 2 capital are limited to 45% of net unrealized holding gains on available for sale equity securities with readily determinable fair values. (e) Tier 1 capital as a percentage of average quarterly total assets, less goodwill and other non-qualifying intangible assets as defined in note (b). Item 3. Quantitative and Qualitative Disclosure of Market Risk The information included in the Market Risk Management section beginning on page 41 of the Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. 59 60 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In the ordinary course of business, Key is subject to legal actions which involve claims for substantial monetary relief. Based on information presently known to management and Key's counsel, management does not believe that there exists any legal action to which KeyCorp or any of its subsidiaries is a party, or of which their properties are the subject, that, individually or in the aggregate, will have a material adverse effect on the financial condition of Key. In March 1998, McDonald Investments Inc. ("McDonald"), now a subsidiary of KeyCorp, participated as an initial purchaser in an offering to institutional investors of certain securities of Nakornthai Strip Mill Public Company Ltd. ("NSM"), a Thailand public company, and certain NSM affiliates, including approximately $452 million in debt securities and related warrants (the "Securities"). The offering was part of the financing of an NSM steel mini-mill located in Chonburi, Thailand. McDonald served as a financial advisor to NSM and was an initial purchaser of approximately $44 million of the Securities. On December 24, 1998, holders of Securities gave a Notice of Default alleging a number of defaults under the terms of the Securities. NSM is currently working toward a restructuring of its obligations, including obligations to holders of the Securities and other creditors. Certain purchasers of Securities have commenced litigation against McDonald and other parties in California, Connecticut, Illinois, Minnesota, New Jersey and New York, claiming that McDonald, the other initial purchasers and certain other third party service providers to NSM have violated certain state and federal securities and other laws. The lawsuits are based on alleged misstatements and omissions in the Offering Memorandum for the Securities, and on certain other information and oral statements allegedly provided to potential investors. In each lawsuit the plaintiffs allege misrepresentations relating to (among other things) the physical facilities at the mill, the management of the mill, the supply of inputs to the mill and the use of the proceeds of the offering. There are currently pending eight separate lawsuits brought by purchasers of the Securities against McDonald, as well as other defendants (one suit in Federal District Court in Minnesota; two suits in Federal District Court in New York; two suits in California; and one suit in each of Connecticut, Illinois and New Jersey). The aggregate amount of Securities alleged to have been purchased by the plaintiffs in these eight lawsuits is at least $257 million. While the relief claimed in the lawsuits varies, generally, the plaintiffs seek rescission of the sale of the Securities, compensatory damages, punitive damages, pre- and post judgment interest, legal fees and expenses, and in the case of the New Jersey action (in which plaintiffs allege damages of approximately $54 million), treble damages consistent with applicable law. McDonald is vigorously defending these actions and has filed, or will file, responses to each complaint denying liability. 60 61 ITEM 5. OTHER INFORMATION REGULATORY CAPITAL. In March 2000, the Federal Reserve Board published for public comment a proposal to amend its regulatory capital guidelines to increase the amount of consolidated regulatory capital required to be held by bank holding companies with respect to certain equity and debt investments made by bank holding companies, or their subsidiaries, in nonfinancial companies. The financial impact of the proposal upon Key cannot be determined until a final rule is published. However, based upon its estimate of the impact of applying the proposed rule to Key's current investments covered by the proposed rule, management anticipates that Key's regulatory capital ratios will remain in excess of the ratios required to be maintained by FDIC-insured depository institutions, in order to be considered "well-capitalized" under the prompt corrective action provisions of the FDIA. UNIFORM RETAIL CREDIT POLICY. In February 1999, the Federal banking agencies published their final Uniform Retail Credit Classification and Account Management Policy (the "Retail Credit Policy"), which revises their 1980 Uniform Policy for Classification of Consumer Installment Credit Based on Delinquency Status. The Retail Credit Policy applies to all financial institutions which file call reports or thrift financial reports with a Federal banking agency. In general, the Retail Credit Policy: - establishes uniform delinquency charge-off policies for closed-end and open-end credit; - provides uniform guidance for loans affected by bankruptcy, fraud, and death; - establishes guidelines for re-aging, extending, deferring, or rewriting past due accounts; - classifies certain delinquent residential mortgage and home equity loans; and - broadens recognition of partial payments that qualify as full payments. Key elected to implement these new guidelines during the first quarter of 2000, although compliance is not required until December 31, 2000. This resulted in the acceleration of $57 million of consumer loan charge-offs that might otherwise have occurred at later dates. Key's allowance at December 31, 1999, had already included an allocation for these potential losses. In June, the Federal banking agencies further revised the Retail Credit Policy to clarify certain provisions. The impact of these revisions, however, is not anticipated by management to have any material adverse effect on Key's financial condition and results of operations. 61 62 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (15) Acknowledgment Letter of Independent Auditors (27) Financial Data Schedule (filed electronically only) (b) Reports on Form 8-K July 19, 2000 - Item 5. Other Events and Item 7. Financial Statements and Exhibits. Reporting that on July 18, 2000, the Registrant issued a press release announcing its earnings results for the three- and six-month periods ended June 30, 2000. No other reports on Form 8-K were filed during the three-month period ended September 30, 2000. 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 10, 2000 /s/ Lee Irving ------------------------------------ By: Lee Irving Executive Vice President and Chief Accounting Officer 62