-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, PnqfQKwqBLMNJxKOQexAPcdchedbbZlZAljHa9s6eWx3xIkfjQfCOpec0tV3fz3/ 6ClWsINs/AqbK4xUPP0QrA== 0000950152-03-007570.txt : 20030812 0000950152-03-007570.hdr.sgml : 20030812 20030812151353 ACCESSION NUMBER: 0000950152-03-007570 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20030630 FILED AS OF DATE: 20030812 FILER: COMPANY DATA: COMPANY CONFORMED NAME: KEYCORP /NEW/ CENTRAL INDEX KEY: 0000091576 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 346542451 STATE OF INCORPORATION: OH FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-11302 FILM NUMBER: 03837403 BUSINESS ADDRESS: STREET 1: 127 PUBLIC SQ CITY: CLEVELAND STATE: OH ZIP: 44114-1306 BUSINESS PHONE: 2166896300 MAIL ADDRESS: STREET 1: 127 PUBLIC SQ CITY: CLEVELAND STATE: OH ZIP: 44114-1306 FORMER COMPANY: FORMER CONFORMED NAME: SOCIETY CORP DATE OF NAME CHANGE: 19920703 10-Q 1 l02001ae10vq.txt KEYCORP | FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2003 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From ______ To ______ Commission File Number 0-850 [KEYCORP LOGO] KEYCORP - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) OHIO 34-6542451 - ---------------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 127 PUBLIC SQUARE, CLEVELAND, OHIO 44114-1306 - ---------------------------------------- ------------------- (Address of principal executive offices) (Zip Code) (216) 689-6300 ---------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Shares with a par value of $1 each 420,834,010 Shares - ----------------------------------------- ------------------------------ (Title of class) (Outstanding at July 31, 2003) KEYCORP TABLE OF CONTENTS PART I. FINANCIAL INFORMATION
Page Number ----------- Item 1. Financial Statements Consolidated Balance Sheets -- June 30, 2003, December 31, 2002 and June 30, 2002 3 Consolidated Statements of Income -- Three and six months ended June 30, 2003 and 2002 4 Consolidated Statements of Changes in Shareholders' Equity -- Six months ended June 30, 2003 and 2002 5 Consolidated Statements of Cash Flow -- Six months ended June 30, 2003 and 2002 6 Notes to Consolidated Financial Statements 7 Independent Accountants' Review Report 31 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 32 Item 3. Quantitative and Qualitative Disclosure of Market Risk 66 Item 4. Controls and Procedures 66 PART II. OTHER INFORMATION Item 1. Legal Proceedings 66 Item 4. Submission of Matters to a Vote of Security Holders 66 Item 6. Exhibits and Reports on Form 8-K 67 Signature 69 Exhibits 70
2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31, JUNE 30, dollars in millions 2003 2002 2002 - -------------------------------------------------------------------------------------------------------------------------------- (UNAUDITED) (UNAUDITED) ASSETS Cash and due from banks $ 3,249 $ 3,364 $ 2,929 Short-term investments 1,867 1,632 1,471 Securities available for sale 7,533 8,507 6,410 Investment securities (fair value: $107, $129 and $196) 99 120 186 Other investments 1,003 919 871 Loans, net of unearned income of $1,788, $1,776 and $1,746 63,214 62,457 63,881 Less: Allowance for loan losses 1,405 1,452 1,539 - ------------------------------------------------------------------------------------------------------------------------------ Net loans 61,809 61,005 62,342 Premises and equipment 606 644 659 Goodwill 1,142 1,142 1,105 Other intangible assets 31 35 26 Corporate-owned life insurance 2,470 2,414 2,359 Accrued income and other assets 5,670 5,420 4,419 - ------------------------------------------------------------------------------------------------------------------------------ Total assets $ 85,479 $85,202 $ 82,777 ======== ======= ======== LIABILITIES Deposits in domestic offices: NOW and money market deposit accounts $ 17,900 $16,249 $ 13,184 Savings deposits 2,094 2,029 2,025 Certificates of deposit ($100,000 or more) 4,949 4,749 4,928 Other time deposits 11,231 11,946 12,995 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing 36,174 34,973 33,132 Noninterest-bearing 11,375 10,630 9,095 Deposits in foreign office -- interest-bearing 2,320 3,743 2,578 - ------------------------------------------------------------------------------------------------------------------------------ Total deposits 49,869 49,346 44,805 Federal funds purchased and securities sold under repurchase agreements 3,766 3,862 5,110 Bank notes and other short-term borrowings 3,403 2,823 3,390 Accrued expense and other liabilities 5,760 5,471 4,742 Long-term debt 14,434 15,605 16,895 Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely subordinated debentures of KeyCorp (See Note 9) 1,258 1,260 1,244 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities 78,490 78,367 76,186 SHAREHOLDERS' EQUITY Preferred stock, $1 par value; authorized 25,000,000 shares, none issued -- -- -- Common shares, $1 par value; authorized 1,400,000,000 shares; issued 491,888,780 shares 492 492 492 Capital surplus 1,452 1,449 1,383 Retained earnings 6,633 6,448 6,214 Treasury stock, at cost (70,815,244, 67,945,135 and 65,537,753 shares) (1,667) (1,593) (1,530) Accumulated other comprehensive income 79 39 32 - ------------------------------------------------------------------------------------------------------------------------------ Total shareholders' equity 6,989 6,835 6,591 - ------------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $ 85,479 $85,202 $ 82,777 ======== ======= ======== - ------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 3 CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- -------------------------- dollars in millions, except per share amounts 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------------------------------- INTEREST INCOME Loans $ 910 $ 989 $ 1,814 $ 1,974 Tax-exempt investment securities 1 3 3 6 Securities available for sale 96 96 197 185 Short-term investments 8 7 16 16 Other investments 7 7 13 13 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest income 1,022 1,102 2,043 2,194 INTEREST EXPENSE Deposits 183 231 371 481 Federal funds purchased and securities sold under repurchase agreements 15 24 29 47 Bank notes and other short-term borrowings 15 20 33 47 Long-term debt, including capital securities 113 144 233 282 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest expense 326 419 666 857 - ---------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME 696 683 1,377 1,337 Provision for loan losses 125 135 255 271 - ---------------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 571 548 1,122 1,066 NONINTEREST INCOME Trust and investment services income 131 158 263 316 Service charges on deposit accounts 91 104 183 204 Investment banking and capital markets income 53 47 87 96 Letter of credit and loan fees 40 29 71 57 Corporate-owned life insurance income 27 26 54 52 Electronic banking fees 22 20 41 38 Net securities gains 3 1 7 1 Other income 67 63 125 127 - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 434 448 831 891 NONINTEREST EXPENSE Personnel 371 361 734 724 Net occupancy 56 56 115 113 Computer processing 44 48 88 102 Equipment 34 36 66 70 Marketing 33 30 58 56 Professional fees 32 21 57 42 Other expense 118 113 227 219 - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 688 665 1,345 1,326 INCOME BEFORE INCOME TAXES 317 331 608 631 Income taxes 92 85 166 145 - ---------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 225 $ 246 $ 442 $ 486 ======== ======== ======== ======== Per common share: Net income $ .53 $ .58 $ 1.04 $ 1.14 Net income-- assuming dilution .53 .57 1.03 1.13 Weighted average common shares outstanding (000) 423,882 426,092 424,575 425,477 Weighted average common shares and potential common shares outstanding (000) 427,170 431,935 427,628 430,983 - ----------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 4 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
ACCUMULATED TREASURY OTHER COMMON CAPITAL RETAINED STOCK, COMPREHENSIVE COMPREHENSIVE dollars in millions, except per share amounts SHARES SURPLUS EARNINGS AT COST INCOME (LOSS) INCOME(b) - ----------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2001 $ 492 $ 1,390 $ 5,856 $ (1,585) $ 2 Net income 486 $ 486 Other comprehensive income: Net unrealized gains on securities available for sale, net of income taxes of $9(a) 15 15 Net unrealized gains on derivative financial instruments, net of income taxes of $5 9 9 Foreign currency translation adjustments 6 6 ---- Total comprehensive income $516 ==== Cash dividends declared on common shares ($.30 per share) (128) Issuance of common shares: Employee benefit and dividend reinvestment plans--2,345,971 net shares (7) 55 - --------------------------------------------------------------------------------------------------------------------- BALANCE AT JUNE 30, 2002 $ 492 $ 1,383 $ 6,214 $ (1,530) $ 32 ====== ======= ======== ========= ==== - --------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2002 $ 492 $ 1,449 $ 6,448 $ (1,593) $ 39 Net income 442 $442 Other comprehensive income (losses): Net unrealized losses on securities available for sale, net of income taxes of ($10)(a) (14) (14) Net unrealized gains on derivative financial instruments, net of income taxes of $22 37 37 Foreign currency translation adjustments 17 17 ---- Total comprehensive income $482 ==== Deferred compensation obligation 8 Cash dividends declared on common shares ($.61 per share) (257) Issuance of common shares: Employee benefit and dividend reinvestment plans--2,150,646 net shares (5) 50 Repurchase of common shares - 5,000,000 shares (124) - --------------------------------------------------------------------------------------------------------------------- BALANCE AT JUNE 30, 2003 $ 492 $ 1,452 $ 6,633 $ (1,667) $ 79 ====== ======= ======== ========= ==== - ---------------------------------------------------------------------------------------------------------------------
(a) Net of reclassification adjustments. (b) For the three months ended June 30, 2003 and 2002, comprehensive income was $262 million and $298 million, respectively. See Notes to Consolidated Financial Statements (Unaudited). 5 CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)
SIX MONTHS ENDED JUNE 30, -------------------------- in millions 2003 2002 - ------------------------------------------------------------------------------------------------------------------- OPERATING ACTIVITIES Net income $ 442 $ 486 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 255 271 Depreciation expense and software amortization 99 116 Amortization of intangibles 6 5 Net securities gains (7) (1) Net (gains) losses from principal investments (17) 1 Net gains from loan securitizations and sales (29) (9) Deferred income taxes 22 63 Net (increase) decrease in mortgage loans held for sale (26) 68 Net increase in trading account assets (87) (155) Net decrease in accrued restructuring charges (4) (19) Other operating activities, net 372 (310) - ------------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 1,026 516 INVESTING ACTIVITIES Cash used in acquisitions, net of cash acquired -- (15) Net (increase) decrease in other short-term investments (148) 582 Purchases of securities available for sale (3,579) (2,803) Proceeds from sales of securities available for sale 2,678 292 Proceeds from prepayments and maturities of securities available for sale 1,605 1,514 Purchases of investment securities (19) (14) Proceeds from prepayments and maturities of investment securities 40 53 Purchases of other investments (195) (60) Proceeds from sales of other investments 69 18 Proceeds from prepayments and maturities of other investments 70 22 Net increase in loans, excluding acquisitions, sales and divestitures (1,961) (1,849) Purchases of loans (419) -- Proceeds from loan securitizations and sales 1,283 775 Purchases of premises and equipment (26) (44) Proceeds from sales of premises and equipment 4 7 Proceeds from sales of other real esate owned 33 25 - ------------------------------------------------------------------------------------------------------------------- NET CASH USED IN INVESTING ACTIVITIES (565) (1,497) FINANCING ACTIVITIES Net increase in deposits 514 2 Net increase (decrease) in short-term borrowings 484 (784) Net proceeds from issuance of long-term debt, including capital securities 2,324 3,943 Payments on long-term debt, including capital securities (3,543) (1,915) Purchases of treasury shares (124) -- Net proceeds from issuance of common stock 26 28 Cash dividends paid (257) (255) - ------------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES (576) 1,019 - ------------------------------------------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS (115) 38 CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,364 2,891 - ------------------------------------------------------------------------------------------------------------------- CASH AND DUE FROM BANKS AT END OF PERIOD $ 3,249 $ 2,929 ======= ======= - ------------------------------------------------------------------------------------------------------------------- Additional disclosures relative to cash flow: Interest paid $ 694 $ 825 Income taxes paid 108 159 Noncash items: Transfer of investment securities to other investments -- $ 871 Transfer of investment securities to securities available for sale -- 61 - -------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The unaudited condensed consolidated interim financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. As used in these Notes, KeyCorp refers solely to the parent company and Key refers to the consolidated entity consisting of KeyCorp and its subsidiaries. The Financial Accounting Standards Board ("FASB") issued Interpretation No. 46 in January 2003. The "Accounting Pronouncements Pending Adoption" section of this note, on page 10, and Note 7 ("Variable Interest Entities"), which begins on page 20, provide information on Interpretation No. 46. This interpretation changes the method for determining when to consolidate an entity depending on whether the entity is a voting interest entity or a variable interest entity. It was effective immediately for entities created after January 31, 2003, and applies to previously existing entities in quarters beginning after June 15, 2003. Key currently evaluates whether to consolidate entities in which it invested prior to February 1, 2003, based on the nature and amount of equity contributed by third parties, the decision-making power granted to those parties and the extent of their control over the entity's operating and financial policies. Entities that Key controls, generally through majority ownership, are consolidated and are considered subsidiaries. Unconsolidated investments in entities in which Key has significant influence over operating and financing decisions (usually defined as a voting or economic interest of 20 to 50%) are accounted for by the equity method. Unconsolidated investments in entities in which Key has a voting or economic interest of less than 20% are generally carried at cost. Investments held by KeyCorp's broker/dealer and investment company subsidiaries (principal investments) are carried at estimated fair value. Key uses special purpose entities ("SPEs"), including securitization trusts, in the normal course of business for funding purposes. SPEs established by Key as qualifying SPEs under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are not consolidated. Nonqualifying SPEs established before February 1, 2003, are evaluated for consolidation by Key based on the nature and amount of equity contributed by third parties, the risks and rewards the parties assume and the control the respective parties exercise over the SPE's activities. Securitization trusts sponsored by Key are not consolidated since they are qualifying SPEs. Additional information on SFAS No. 140 is summarized in Note 1 ("Summary of Significant Accounting Policies") of Key's 2002 Annual Report to Shareholders under the heading "Loan Securitizations" on page 59. Additionally, Key has determined that it is the primary beneficiary, as defined in Interpretation No. 46, of an asset-backed commercial paper conduit for which it is a referral agent, as currently structured. Therefore, Key plans to consolidate the conduit in the third quarter in accordance with the interpretation. Key and the conduit owner are currently in the process of restructuring the conduit such that a third party unrelated to Key would become the primary beneficiary during the third quarter and be required to consolidate the conduit at that time. Additional information on the conduit is summarized in Note 7 under the heading "Commercial paper conduits" and in Note 10 ("Contingent Liabilities and Guarantees") under the heading "Guarantees" on page 26. Management believes that the unaudited condensed consolidated interim financial statements reflect all adjustments of a normal recurring nature and disclosures that are necessary for a fair presentation of the results for the interim periods presented. Some previously reported results have been reclassified to conform to current reporting practices. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. When you read these financial statements, you should also look at the audited consolidated financial statements and related notes included in Key's 2002 Annual Report to Shareholders. 7 STOCK-BASED COMPENSATION Through December 31, 2002, Key accounted for stock options issued to employees using the intrinsic value method. This method required that compensation expense be recognized to the extent that the fair value of the stock exceeded the exercise price of the option at the grant date. Key's employee stock options generally have fixed terms and exercise prices that are equal to or greater than the fair value of Key's common shares at the grant date, so Key generally had not recognized compensation expense related to stock options. Effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123, "Accounting for Stock-Based Compensation." Additional information pertaining to this accounting change is summarized under the heading "Accounting Pronouncements Adopted in 2003" on page 9. SFAS No. 123 requires companies like Key that have used the intrinsic value method to account for employee stock options to provide pro forma disclosures of the net income and earnings per share effect of accounting for stock options using the fair value method. Management estimates the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not a perfect indicator of the value of an employee stock option, but it is commonly used for this purpose. The Black-Scholes model requires several assumptions, which management developed and updates based on historical trends and current market observations. The level of accuracy achieved in deriving the estimated fair value of options is directly related to the accuracy of the underlying assumptions. The assumptions for the three- and six-month periods ended June 30, 2003 and 2002, are shown in the following table.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- -------------------------- 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------- Average option life 6.0 YEARS 5.0 years 6.0 YEARS 5.0 years Future dividend yield 4.76% 4.36% 5.07% 4.86% Share price volatility .293 .264 .293 .276 Weighted average risk-free interest rate 2.8% 3.5% 3.2% 4.0% - ----------------------------------------------------------------------------------------------------------
The model assumes that the estimated fair value of an option is amortized over the option's vesting period. The pro forma effect of applying the fair value method of accounting to all forms of stock-based compensation (e.g., stock options, stock purchase plans, restricted stock, etc.) for the three- and six-month periods ended June 30, 2003 and 2002, is shown in the following table and would, if recorded, have been included in personnel expense on the income statement. The information presented may not be indicative of the effect in future periods.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- ------------------------- in millions, except per share amounts 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------------------------- Net income, as reported $225 $246 $ 442 $ 486 Add: Stock-based employee compensation expense included reported net income, net of related tax effects 2 1 4 2 Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects 5 7 10 14 - ----------------------------------------------------------------------------------------------------------------------------------- Net income -- pro forma $222 $240 $ 436 $ 474 ==== ==== ===== ====== Per common share: Net income $.53 $.58 $1.04 $ 1.14 Net income -- pro forma .52 .57 1.03 1.11 Net income assuming dilution .53 .57 1.03 1.13 Net income assuming dilution -- pro forma .52 .56 1.02 1.10 - -----------------------------------------------------------------------------------------------------------------------------------
8 ACCOUNTING PRONOUNCEMENTS ADOPTED IN 2003 ACCOUNTING FOR AND DISCLOSURE OF GUARANTEES. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This interpretation requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of obligations undertaken. The liability that must be recognized is specifically related to the obligation to stand ready to perform over the term of the guarantee. The initial recognition and measurement provisions of this guidance became effective on a prospective basis for guarantees issued or modified on or after January 1, 2003. For guarantees subject to the liability recognition provisions of this interpretation for which Key receives a fee, the initial fair value stand ready obligation is recognized at an amount equal to the fee. For guarantees for which no fee is received, the fair value of the stand ready obligations is determined using expected present value measurement techniques, unless observable transactions for identical or similar guarantees are available. The subsequent accounting for these stand ready obligations depends on the nature of the underlying guarantees. Key accounts for its release from risk for a particular guarantee either upon expiration or settlement, or by a systematic and rational amortization method depending on the risk profile of the particular guarantee. This new accounting guidance also expands the disclosures that a guarantor must make about its obligations under certain guarantees. These disclosure requirements took effect for financial statements of interim or annual periods ending after October 15, 2002. The required disclosures for Key are provided in Note 10 under the heading "Guarantees." The adoption of Interpretation No. 45 did not have any material effect on Key's financial condition or results of operations. COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES. In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This new standard took effect for exit or disposal activities (e.g., activities related to ceasing a line of business, relocating operations, etc.) initiated after December 31, 2002. SFAS No. 146 substantially changes the rules for recognizing costs, such as lease or other contract termination costs and one-time employee termination benefits associated with exit or disposal activities arising from corporate restructurings. Generally, these costs must be recognized when incurred. Previously, those costs could be recognized earlier, for example, when a company committed to an exit or disposal plan. Key adopted SFAS No. 146 for restructuring activities initiated on or after January 1, 2003. The adoption of SFAS No. 146 did not have any material effect on Key's financial condition or results of operations. ASSET RETIREMENT OBLIGATIONS. In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." The new standard was effective for fiscal years beginning after June 15, 2002. SFAS No. 143 addresses the accounting for legal obligations associated with the retirement of tangible long-lived assets and requires a liability to be recognized for the fair value of these obligations in the period they are incurred. Related costs are capitalized as part of the carrying amounts of the assets to be retired and are amortized over the assets' useful lives. Key adopted SFAS No. 143 as of January 1, 2003. The adoption of this accounting guidance did not have any material effect on Key's financial condition or results of operations. ACCOUNTING FOR STOCK-BASED COMPENSATION. As discussed under the heading "Stock-Based Compensation" on page 8, effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123. Management is applying the change in accounting prospectively (prospective method) to all awards as permitted under the transition provisions in SFAS No. 148, "Accounting for Stock-Based Compensation Transition and Disclosure," which was issued in December 2002. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition for an entity that voluntarily changes to the fair value method of accounting for stock compensation. These alternative methods include: (i) the prospective method; (ii) the modified prospective method; and, (iii) the retroactive restatement method. This accounting guidance also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock compensation and the effect of the method used on reported financial results. The required interim disclosures for Key are provided under the aforementioned "Stock-Based Compensation" heading. 9 Based on the valuation and mid-year timing of option grants in 2003, management estimates that the accounting change will reduce Key's diluted earnings per common share by less than $.02 in 2003. The effect on Key's earnings per common share in subsequent years will depend on the number and timing of options granted and the assumptions used to estimate their fair value. ACCOUNTING PRONOUNCEMENTS PENDING ADOPTION ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," which establishes standards for how an issuer is to classify and measure certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify certain financial instruments that would previously have been classified as equity as liabilities (or as assets in some circumstances). Specifically, SFAS No. 150 requires that financial instruments issued in the form of shares that are mandatorily redeemable; financial instruments that embody an obligation to repurchase the issuer's equity shares or are indexed to such an obligation; or financial instruments that embody an unconditional obligation or a conditional obligation that can be settled in certain ways be classified as liabilities. This accounting guidance is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 is not expected to have any material effect on Key's financial condition or results of operations. AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities addressed under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This accounting guidance amends SFAS No. 133 for decisions made by the FASB as part of the Derivatives Implementation Group process and also amends SFAS No. 133 to clarify the definition of a derivative. SFAS No. 149 is effective generally for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 is not expected to have any material effect on Key's financial condition or results of operations. CONSOLIDATION OF VARIABLE INTEREST ENTITIES. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," which significantly changes how Key and other companies determine when to consolidate other entities. Under this guidance, entities are classified as either voting interest entities or variable interest entities ("VIEs"). A voting interest entity is evaluated for consolidation under existing accounting standards, which focus on the equity owner with voting control, while a VIE is consolidated by its primary beneficiary. The primary beneficiary is the party that holds variable interests that expose it to a majority of the entity's expected losses and/or residual returns. Variable interests include equity interests, subordinated debt, derivative contracts, leases, service agreements, guarantees, standby letters of credit, loan commitments and other instruments. Interpretation No. 46 was effective immediately for entities created after January 31, 2003, and applies to previously existing entities in quarters beginning after June 15, 2003. It requires additional disclosures by primary beneficiaries and other significant variable interest holders. See Note 7 for a discussion of the actions that Key expects to take with respect to the adoption of Interpretation No. 46. The most significant impact of this new guidance will be on Key's balance sheet since consolidating or de-consolidating certain entities will either increase, or change the classification of, assets and liabilities and change leverage and capital ratios, as well as reported asset concentrations. While the consolidation of previously unconsolidated entities or the de-consolidation of previously consolidated entities under Interpretation No. 46 will represent an accounting change, it will not affect Key's legal rights or obligations to these entities. Additional information pertaining to VIEs is summarized in Notes 7 and 10. 10 2. EARNINGS PER COMMON SHARE Key calculates its basic and diluted earnings per common share as follows:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- ------------------------- dollars in millions, except per share amounts 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 225 $ 246 $ 442 $ 486 ======== ======== ======== ======== - ----------------------------------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE COMMON SHARES Weighted average common shares outstanding (000) 423,882 426,092 424,575 425,477 Effect of dilutive common stock options (000) 3,288 5,843 3,053 5,506 - ----------------------------------------------------------------------------------------------------------------------------- Weighted average common shares and potential common shares outstanding (000) 427,170 431,935 427,628 430,983 ======== ======== ======== ======== - ----------------------------------------------------------------------------------------------------------------------------- EARNINGS PER COMMON SHARE Net income per common share $ .53 $ .58 $ 1.04 $ 1.14 Net income per common share--assuming dilution .53 .57 1.03 1.13 - -----------------------------------------------------------------------------------------------------------------------------
3. ACQUISITIONS AND DIVESTITURE Business acquisitions and divestitures either completed by Key during 2002 or pending completion at June 30, 2003, are summarized below. There were no such transactions completed during the first six months of 2003. ACQUISITIONS UNION BANKSHARES, LTD. On December 12, 2002, Key purchased Union Bankshares, Ltd., the holding company for Union Bank & Trust, a seven-branch bank headquartered in Denver, Colorado. Key paid $22.63 per Union Bankshares common share for a total cash consideration of $66 million. Goodwill of approximately $34 million and core deposit intangibles of $13 million were recorded. Union Bankshares, Ltd. had assets of $475 million at the date of acquisition. On January 17, 2003, Union Bank & Trust was merged into Key Bank National Association ("KBNA"). CONNING ASSET MANAGEMENT On June 28, 2002, Key purchased substantially all of the mortgage loan and real estate business of Conning Asset Management, headquartered in Hartford, Connecticut. Conning's mortgage loan and real estate business originates, securitizes and services multi-family, retail, industrial and office property mortgage loans on behalf of pension fund and life insurance company investors. At the date of acquisition, the business had net assets of $17 million and serviced approximately $4 billion in commercial mortgage loans through its St. Louis office. In accordance with a confidentiality clause in the purchase agreement, the terms, which are not material, have not been disclosed. DIVESTITURE 401(k) RECORDKEEPING BUSINESS On June 12, 2002, Key sold its 401(k) plan recordkeeping business. Key recognized a gain of $3 million ($2 million after tax) on the transaction. ACQUISITION PENDING AT JUNE 30, 2003 NEWBRIDGE PARTNERS LLC On July 1, 2003, Key acquired NewBridge Partners LLC, a growth equity investment management firm headquartered in New York City with managed assets of approximately $2 billion. The terms of the transaction are not material and have not been disclosed. 11 4. LINE OF BUSINESS RESULTS CONSUMER BANKING RETAIL BANKING provides individuals with branch-based deposit and investment products, personal finance services and loans, including residential mortgages, home equity and various types of installment loans. SMALL BUSINESS provides businesses that have annual sales revenues of $10 million or less with deposit, investment and credit products, and business advisory services. CONSUMER FINANCE consists of two primary business units: Indirect Lending and National Home Equity. Indirect Lending offers automobile and marine loans to consumers through dealers and finances inventory for automobile and marine dealers. This business unit also provides education loans, insurance and interest-free payment plans for students and their parents. National Home Equity provides both prime and nonprime mortgage and home equity loan products to individuals. These products originate outside of Key's retail branch system. This business unit also works with mortgage brokers and home improvement contractors to provide home equity and home improvement solutions. CORPORATE AND INVESTMENT BANKING CORPORATE BANKING provides a full array of products and services to large corporations, middle-market companies, financial institutions and government organizations. These products and services include: financing, treasury management, investment banking, derivatives and foreign exchange, equity and debt trading, and syndicated finance. KEYBANK REAL ESTATE CAPITAL provides construction and interim lending, permanent debt placements and servicing, and equity and investment banking services to developers, brokers and owner-investors. This line of business deals exclusively with nonowner-occupied properties (i.e., generally properties for which the owner occupies less than 60% of the premises). KEY EQUIPMENT FINANCE meets the equipment leasing needs of companies worldwide and provides equipment manufacturers, distributors and resellers with financing options for their clients. Lease financing receivables and related revenues are assigned to other lines of business (primarily Corporate Banking) if those businesses are principally responsible for maintaining the relationship with the client. INVESTMENT MANAGEMENT SERVICES INVESTMENT MANAGEMENT SERVICES consists of two primary business units: Victory Capital Management and McDonald Financial Group. Victory Capital Management manages or gives advice regarding investment portfolios for a national client base, including corporations, labor unions, not-for-profit organizations, governments and individuals. These portfolios may be managed in separate accounts, common funds or the Victory family of mutual funds. McDonald Financial Group offers financial, estate and retirement planning and asset management services to assist high-net-worth clients with their banking, brokerage, trust, portfolio management, insurance, charitable giving and related needs. This unit also provides banking services to public sector institutions. OTHER SEGMENTS Other segments consists primarily of Treasury, Principal Investing and the net effect of funds transfer pricing. RECONCILING ITEMS Total assets included under "Reconciling Items" represent primarily the unallocated portion of nonearning assets of corporate support functions. Charges related to the funding of these assets are part of net interest income and are allocated to the business segments through noninterest expense. Reconciling Items also 12 include certain items that are not allocated to the business segments because they are not reflective of their normal operations. The table that spans pages 14 and 15 shows selected financial data for each major business group for the three- and six-month periods ended June 30, 2003 and 2002. This table is accompanied by additional supplementary information for each of the lines of business that comprise these groups. The information was derived from the internal financial reporting system that management uses to monitor and manage Key's financial performance. Accounting principles generally accepted in the United States guide financial accounting, but there is no authoritative guidance for "management accounting"--the way management uses its judgment and experience to make reporting decisions. Consequently, the line of business results Key reports may not be comparable with line of business results presented by other companies. The selected financial data are based on internal accounting policies designed to compile results on a consistent basis and in a manner that reflects the underlying economics of the businesses. As such: - - Net interest income is determined by assigning a standard cost for funds used to assets or a standard credit for funds provided to liabilities based on their maturity, prepayment and/or repricing characteristics. The net effect of this funds transfer pricing is included in the "Other Segments" columns. - - Indirect expenses, such as computer servicing costs and corporate overhead, are allocated based on assumptions of the extent to which each line actually uses the services. - - Key's consolidated provision for loan losses is allocated among the lines of business based primarily on their actual net charge-offs, adjusted periodically for loan growth and changes in risk profile. The level of the consolidated provision is based on the methodology that management uses to estimate Key's consolidated allowance for loan losses. This methodology is described in Note 1 ("Summary of Significant Accounting Policies") under the heading "Allowance for Loan Losses" on page 58 of Key's 2002 Annual Report to Shareholders. - - Income taxes are allocated based on the statutory federal income tax rate of 35% (adjusted for tax-exempt interest income, income from corporate-owned life insurance and tax credits associated with investments in low-income housing projects) and a blended state income tax rate (net of the federal income tax benefit) of 2.5%. - - Capital is assigned based on management's assessment of economic risk factors (primarily credit, operating and market risk). Developing and applying the methodologies that management uses to allocate items among Key's lines of business is a dynamic process. Accordingly, financial results may be revised periodically to reflect accounting enhancements, changes in the risk profile of a particular business or changes in Key's organization structure. The financial data reported for all periods presented in the tables reflect a number of changes, which occurred during the first half of 2003: - - Key reorganized and renamed some of its business groups and lines of business. Key's Capital Markets line of business moved from the Investment Management Services group (formerly Key Capital Partners) to the Corporate Banking line within the Corporate and Investment Banking group (formerly Key Corporate Finance). Also within Corporate and Investment Banking, Key changed the name of its National Commercial Real Estate line of business to KeyBank Real Estate Capital, and changed the name of its National Equipment Finance line of business to Key Equipment Finance. In addition, Key consolidated the reporting of its National Home Equity and Indirect Lending lines of business into one line of business named Consumer Finance. - - Methodologies used to allocate certain overhead and funding costs were refined. 13
CORPORATE AND INVESTMENT THREE MONTHS ENDED JUNE 30, CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES -------------------- -------------------- -------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 459 $ 448 $ 261 $ 269 $ 61 $ 57 Noninterest income 122 125 124 112 126 164 - -------------------------------------------------------------------------------------------------------------------------- Total revenue (TE)(a) 581 573 385 381 187 221 Provision for loan losses 65 70 56 59 4 6 Depreciation and amortization expense 34 36 9 10 9 12 Other noninterest expense 322 295 173 159 150 154 - -------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (TE) 160 172 147 153 24 49 Allocated income taxes and TE adjustments 60 64 55 58 9 18 - -------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 100 $ 108 $ 92 $ 95 $ 15 $ 31 ======= ======= ======= ======= ======= ======= Percent of consolidated net income 44% 44% 41% 39% 7% 13% Percent of total segments net income 44 45 41 40 7 13 - -------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $28,827 $27,926 $28,172 $29,668 $ 5,031 $ 4,892 Total assets(a) 31,251 30,268 32,566 32,966 6,022 5,874 Deposits 34,781 33,976 4,147 3,104 5,939 3,583 - -------------------------------------------------------------------------------------------------------------------------- OTHER FINANCIAL DATA Net loan charge-offs $ 65 $ 70 $ 73 $ 127 $ 3 $ 6 Return on average allocated equity 18.21% 21.18% 11.05% 11.57% 9.94% 20.15% Average full-time equivalent employees 8,447 8,488 2,269 2,247 2,842 3,182 - --------------------------------------------------------------------------------------------------------------------------
CORPORATE AND INVESTMENT SIX MONTHS ENDED JUNE 30, CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES -------------------- -------------------- -------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 904 $ 884 $ 520 $ 542 $ 120 $ 110 Noninterest income 235 242 234 233 259 324 - -------------------------------------------------------------------------------------------------------------------------- Total revenue (TE)(a) 1,139 1,126 754 775 379 434 Provision for loan losses 143 152 107 110 5 9 Depreciation and amortization expense 68 75 18 21 19 25 Other noninterest expense 619 592 332 317 298 311 - -------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (TE) 309 307 297 327 57 89 Allocated income taxes and TE adjustments 116 115 112 123 21 33 - -------------------------------------------------------------------------------------------------------------------------- Net income $ 193 $ 192 $ 185 $ 204 $ 36 $ 56 ======= ======= ======= ======= ======= ======= Percent of consolidated net income 44% 39% 42% 42% 8% 12% Percent of total segments net income 44 42 42 44 8 12 - -------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $28,628 $27,624 $28,281 $29,754 $ 4,994 $ 4,796 Total assets(a) 31,054 29,973 32,698 33,014 5,973 5,818 Deposits 34,572 34,142 4,093 3,120 5,579 3,627 - -------------------------------------------------------------------------------------------------------------------------- OTHER FINANCIAL DATA Net loan charge-offs $ 143 $ 152 $ 152 $ 248 $ 7 $ 9 Return on average allocated equity 17.99% 19.00% 11.21% 12.57% 11.82% 18.36% Average full-time equivalent employees 8,483 8,501 2,282 2,263 2,893 3,194 - --------------------------------------------------------------------------------------------------------------------------
(a) Substantially all revenue generated by Key's major business groups is derived from clients resident in the United States. Substantially all long-lived assets, including premises and equipment, capitalized software and goodwill, held by Key's major business groups are located in the United States. TE = Taxable Equivalent, N/A = Not Applicable, N/M = Not Meaningful 14
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY - ----------------------- ---------------------- ---------------------- ---------------------- 2003 2002 2003 2002 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------- $ (39) $ (27) $ 742 $ 747 $ (32) $ (26) $ 710 $ 721 62 27 434 428 -- 20 434 448 - ------------------------------------------------------------------------------------------------------------- 23 -- 1,176 1,175 (32) (6) 1,144 1,169 -- -- 125 135 -- -- 125 135 -- -- 52 58 -- -- 52 58 9 8 654 616 (18) (9) 636 607 - ------------------------------------------------------------------------------------------------------------- 14 (8) 345 366 (14) 3 331 369 (5) (13) 119 127 (13) (4) 106 123 - ------------------------------------------------------------------------------------------------------------- $ 19 $ 5 $ 226 $ 239 $ (1) $ 7 $ 225 $ 246 ======== ======== ======== ======== ======== ======== ======== ======== 8% 2% 100% 98% --% 2% 100% 100% 8 2 100 100 N/A N/A N/A N/A - ------------------------------------------------------------------------------------------------------------- $ 851 $ 1,312 $ 62,881 $ 63,798 $ 148 $ 130 $ 63,029 $ 63,928 13,293 10,657 83,132 79,765 1,580 1,795 84,712 81,560 3,699 3,918 48,566 44,581 (67) (77) 48,499 44,504 - ------------------------------------------------------------------------------------------------------------- -- -- $ 141 $ 203 -- -- $ 141 $ 203 20.32% 4.96% 13.90% 15.08% N/M N/M 12.98% 15.16% 34 31 13,592 13,948 6,407 6,955 19,999 20,903 - -------------------------------------------------------------------------------------------------------------
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY - ----------------------- ---------------------- ----------------------- ---------------------- 2003 2002 2003 2002 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------- $ (74) $ (61) $ 1,470 $ 1,475 $ (57) $ (52) $ 1,413 $ 1,423 96 60 824 859 7 32 831 891 - -------------------------------------------------------------------------------------------------------------- 22 (1) 2,294 2,334 (50) (20) 2,244 2,314 -- -- 255 271 -- -- 255 271 -- -- 105 121 -- -- 105 121 16 14 1,265 1,234 (25) (29) 1,240 1,205 - -------------------------------------------------------------------------------------------------------------- 6 (15) 669 708 (25) 9 644 717 (19) (26) 230 245 (28) (14) 202 231 - -------------------------------------------------------------------------------------------------------------- $ 25 $ 11 $ 439 $ 463 $ 3 $ 23 $ 442 $ 486 ======== ======== ======== ======== ======== ======== ======== ======== 5% 2% 99% 95% 1% 5% 100% 100% 6 2 100 100 N/A N/A N/A N/A - -------------------------------------------------------------------------------------------------------------- $ 906 $ 1,378 $ 62,809 $ 63,552 $ 128 $ 157 $ 62,937 $ 63,709 13,046 10,626 82,771 79,431 1,544 1,786 84,315 81,217 3,454 3,432 47,698 44,321 (69) (83) 47,629 44,238 - -------------------------------------------------------------------------------------------------------------- -- -- $ 302 $ 409 -- -- $ 302 $ 409 13.55% 5.45% 13.67% 14.74% N/M N/M 12.94% 15.34% 35 31 13,693 13,989 6,529 7,002 20,222 20,991 - --------------------------------------------------------------------------------------------------------------
15 Supplementary information (Consumer Banking lines of business)
THREE MONTHS ENDED JUNE 30, RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE -------------------- -------------------- -------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 334 $ 331 $ 97 $ 94 $ 150 $ 148 Provision for loan losses 15 14 17 15 33 41 Noninterest expense 216 205 47 43 93 83 Net income 64 70 21 23 15 15 Average loans 9,839 8,760 4,391 4,283 14,597 14,883 Average deposits 30,182 30,076 4,264 3,588 335 312 Net loan charge-offs 15 14 17 15 33 41 Return on average allocated equity 40.75% 49.69% 21.16% 28.04% 5.12% 5.23% Average full-time equivalent employees 6,134 6,149 401 323 1,912 2,016 - -------------------------------------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE -------------------- -------------------- -------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 655 $ 646 $ 191 $ 185 $ 293 $ 295 Provision for loan losses 31 32 35 29 77 91 Noninterest expense 419 409 89 86 179 172 Net income 128 128 42 44 23 20 Average loans 9,706 8,310 4,382 4,293 14,540 15,021 Average deposits 30,057 30,284 4,171 3,543 344 315 Net loan charge-offs 32 32 34 29 77 91 Return on average allocated equity 41.23% 46.76% 22.35% 27.39% 4.00% 3.47% Average full-time equivalent employees 6,163 6,161 390 321 1,930 2,019 - --------------------------------------------------------------------------------------------------------------------------
Supplementary information (Corporate and Investment Banking lines of business)
THREE MONTHS ENDED JUNE 30, CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE -------------------- --------------------------- --------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 221 $ 238 $ 93 $ 83 $ 71 $ 60 Provision for loan losses 48 52 (1) -- 9 7 Noninterest expense 119 114 36 30 27 25 Net income 34 44 36 33 22 18 Average loans 14,002 16,273 7,406 7,711 6,764 5,684 Average deposits 3,421 2,556 712 538 14 10 Net loan charge-offs 65 120 (1) -- 9 7 Return on average allocated equity 6.86% 8.30% 16.97% 17.77% 17.68% 17.15% Average full-time equivalent employees 1,001 1,105 655 522 613 620 - ---------------------------------------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE -------------------- --------------------------- --------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 442 $ 480 $ 173 $ 171 $ 139 $ 124 Provision for loan losses 89 86 3 3 15 21 Noninterest expense 230 232 68 59 52 47 Net income 76 101 64 68 45 35 Average loans 14,167 16,362 7,451 7,772 6,663 5,620 Average deposits 3,391 2,563 689 548 13 9 Net loan charge-offs 134 224 3 3 15 21 Return on average allocated equity 7.63% 9.71% 15.53% 18.09% 18.60% 16.84% Average full-time equivalent employees 1,027 1,120 646 516 609 627 - --------------------------------------------------------------------------------------------------------------------------
16 5. SECURITIES Key classifies its securities into four categories: trading, available for sale, investment and other investments. TRADING ACCOUNT SECURITIES. These are debt and equity securities that are purchased and held by Key with the intent of selling them in the near term, and certain interests retained in loan securitizations. All of these assets are reported at fair value ($888 million at June 30, 2003, $801 million at December 31, 2002, and $752 million at June 30, 2002) and are included in "short-term investments" on the balance sheet. Realized and unrealized gains and losses on trading account securities are reported in "investment banking and capital markets income" on the income statement. SECURITIES AVAILABLE FOR SALE. These include securities that Key intends to hold for an indefinite period of time and that may be sold in response to changes in interest rates, prepayment risk, liquidity needs or other factors. Securities available for sale are reported at fair value and include debt and marketable equity securities with readily determinable fair values. Unrealized gains and losses (net of income taxes) deemed temporary are recorded in shareholders' equity as a component of "accumulated other comprehensive income (loss)." Unrealized gains and losses on specific securities deemed to be "other than temporary" are included in "net securities gains (losses)" on the income statement. Also included in "net securities gains (losses)" are actual gains and losses resulting from sales of specific securities. When Key retains an interest in loans it securitizes, it bears risk that the loans will be prepaid (which would reduce expected interest income) or not paid at all. Key accounts for these retained interests (which include both certificated and uncertificated interests) as debt securities, classifying them as available for sale or as trading account assets. "Other securities" held in the available for sale portfolio primarily are marketable equity securities. INVESTMENT SECURITIES. These are debt securities that Key has the intent and ability to hold until maturity. Debt securities are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method. This method produces a constant rate of return on the basis of the adjusted carrying amount. OTHER INVESTMENTS. Principal investments - investments in equity and mezzanine instruments made by Key's Principal Investing unit - represent the majority of other investments and are carried at fair value. They include direct and indirect investments predominately in privately-held companies. Direct investments are those made in a particular company, while indirect investments are made through funds that include other investors. Changes in estimated fair values and actual gains and losses on sales of principal investments are included in "investment banking and capital markets income" on the income statement. In addition to principal investments, other investments include equity securities that do not have readily determinable fair values. These securities include certain real estate-related investments that are carried at estimated fair value, as well as other types of securities that are generally carried at cost. The carrying amount of the securities carried at cost is adjusted for declines in value that are considered to be "other than temporary." These adjustments are included in "net securities gains" on the income statement. The amortized cost, unrealized gains and losses, and approximate fair value of Key's investment securities and securities available for sale are presented in the following tables. Gross "unrealized" gains and losses are represented by the difference between the amortized cost and the fair values of securities on the balance sheet as of the dates indicated. Accordingly, the amount of these gains and losses may change in the future as market conditions improve or worsen. 17
JUNE 30, 2003 ------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - --------------------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 95 $ 8 -- $ 103 Other securities 4 -- -- 4 - --------------------------------------------------------------------------------------------------------- Total investment securities $ 99 $ 8 -- $ 107 ========== ========== ========== ========== - --------------------------------------------------------------------------------------------------------- SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 34 $ 1 -- $ 35 States and political subdivisions 25 1 -- 26 Collateralized mortgage obligations 6,552 61 $ 51 6,562 Other mortgage-backed securities 567 24 -- 591 Retained interests in securitizations 123 57 -- 180 Other securities 140 -- 1 139 - --------------------------------------------------------------------------------------------------------- Total securities available for sale $ 7,441 $ 144 $ 52 $ 7,533 ========== ========== ========== ========== - ---------------------------------------------------------------------------------------------------------
DECEMBER 31, 2002 ------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - --------------------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 120 $ 9 -- $ 129 - --------------------------------------------------------------------------------------------------------- SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 22 $ 1 -- $ 23 States and political subdivisions 35 -- -- 35 Collateralized mortgage obligations 7,143 129 $ 65 7,207 Other mortgage-backed securities 815 37 -- 852 Retained interests in securitizations 166 43 -- 209 Other securities 208 -- 27 181 - --------------------------------------------------------------------------------------------------------- Total securities available for sale $ 8,389 $ 210 $ 92 $ 8,507 ========== ========== ========== ========== - ---------------------------------------------------------------------------------------------------------
JUNE 30, 2002 ------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - --------------------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 186 $ 10 -- $ 196 - --------------------------------------------------------------------------------------------------------- SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 22 -- -- $ 22 States and political subdivisions 18 $ 1 -- 19 Collateralized mortgage obligations 5,092 99 $ 79 5,112 Other mortgage-backed securities 823 34 -- 857 Retained interests in securitizations 172 35 -- 207 Other securities 216 1 24 193 - --------------------------------------------------------------------------------------------------------- Total securities available for sale $ 6,343 $ 170 $ 103 $ 6,410 ========== ========== ========== ========== - ---------------------------------------------------------------------------------------------------------
18 6. LOANS Key's loans by category are summarized as follows:
JUNE 30, DECEMBER 31, JUNE 30, in millions 2003 2002 2002 - ----------------------------------------------------------------------------------------------- Commercial, financial and agricultural $ 17,381 $ 17,425 $ 18,071 Commercial real estate: Commercial mortgage 5,886 6,015 6,266 Construction 5,192 5,659 5,860 - ----------------------------------------------------------------------------------------------- Total commercial real estate loans 11,078 11,674 12,126 Commercial lease financing 8,009 7,513 7,216 - ----------------------------------------------------------------------------------------------- Total commercial loans 36,468 36,612 37,413 Real estate -- residential mortgage 1,754 1,968 2,117 Home equity 14,688 13,804 13,379 Consumer -- direct 2,170 2,161 2,185 Consumer -- indirect: Automobile lease financing 528 873 1,386 Automobile loans 2,107 2,181 2,297 Marine 2,379 2,088 1,917 Other 595 667 912 - ----------------------------------------------------------------------------------------------- Total consumer -- indirect loans 5,609 5,809 6,512 - ----------------------------------------------------------------------------------------------- Total consumer loans 24,221 23,742 24,193 Loans held for sale: Commercial, financial and agricultural -- 41 -- Real estate -- commercial mortgage 231 193 281 Real estate -- residential mortgage 45 57 19 Education 2,249 1,812 1,975 - ----------------------------------------------------------------------------------------------- Total loans held for sale 2,525 2,103 2,275 - ----------------------------------------------------------------------------------------------- Total loans $ 63,214 $ 62,457 $ 63,881 ========== ========== ========== - -----------------------------------------------------------------------------------------------
Key uses interest rate swaps to manage interest rate risk; these swaps modify the repricing and maturity characteristics of certain loans. For more information about such swaps at June 30, 2003, see Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders. Changes in the allowance for loan losses are summarized as follows:
Three months ended June 30, Six months ended June 30, --------------------------- ------------------------- in millions 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------- Balance at beginning of period $ 1,421 $ 1,607 $ 1,452 $ 1,677 Charge-offs (179) (236) (369) (469) Recoveries 38 33 67 60 - ---------------------------------------------------------------------------------------------------- Net charge-offs (141) (203) (302) (409) Provision for loan losses 125 135 255 271 - ---------------------------------------------------------------------------------------------------- Balance at end of period $ 1,405 $ 1,539 $ 1,405 $ 1,539 ========== ========== ========== ======= - ----------------------------------------------------------------------------------------------------
19 7. VARIABLE INTEREST ENTITIES A variable interest entity ("VIE") is a partnership, limited liability company, trust or other legal entity that does not have sufficient equity to permit it to finance its activities without additional subordinated financial support from other parties, or whose investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include: (i) the direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights; (ii) the obligation to absorb the expected losses of an entity if they occur; and, (iii) the right to receive the expected residual returns of the entity, if they occur. Interpretation No. 46, "Consolidation of Variable Interest Entities," addresses the consolidation of VIEs. This interpretation is summarized in Note 1 ("Basis of Presentation"), under the heading "Accounting Pronouncements Pending Adoption" on page 10. Under Interpretation No. 46, VIEs are consolidated by the party who is exposed to a majority of the VIE's expected losses and/or residual returns (i.e., the primary beneficiary). Transferors of assets to qualifying special purpose entities meeting the requirements of SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are exempt from the scope of Interpretation No. 46. As a result, Key's securitization trusts are exempt from consolidation under this interpretation. Key has determined that it is the primary beneficiary of the following VIEs and will, therefore, consolidate them when Interpretation No. 46 is adopted in the third quarter of 2003. COMMERCIAL PAPER CONDUITS. Key, among others, refers third party assets and borrowers and provides liquidity and credit enhancement to an unconsolidated asset-backed commercial paper conduit. The conduit had assets of $291 million at June 30, 2003. Key has determined that it is the primary beneficiary of the conduit, as currently structured. Therefore, Key plans to consolidate the conduit in July 2003. At June 30, 2003, Key's maximum exposure to loss from its interests in the conduit totaled $60 million, which represents the committed credit enhancement facility. Key and the conduit owner are currently working on restructuring the conduit. Under this restructuring plan, capital notes will be issued to an unrelated third party investor who will absorb the majority of the expected losses of the conduit, if they occur. The issuance of capital notes by the conduit constitutes a material change in the contractual arrangements among parties involved and is a trigger event under Interpretation No. 46, which requires a reassessment of this entity. The capital note investor is expected to be considered the primary beneficiary of the conduit following the restructuring and, therefore, is expected to consolidate it. Key and the conduit owner are currently discussing and reviewing the restructuring plans with their respective independent accountants and attorneys, and restructuring documents are being drafted. Key anticipates that the restructuring will be completed during August 2003, at which time the conduit will be de-consolidated by Key. Additionally, Key holds a subordinated note in and provides referral services and liquidity support to one program within another asset-backed commercial paper conduit. Key has determined that this program does not qualify for evaluation for consolidation separately from the entire conduit. Accordingly, and because the assets in the program are being liquidated rapidly, Key no longer believes that it has a significant interest in this conduit. Additional information pertaining to Key's involvement with conduits is summarized in Note 10 ("Contingent Liabilities and Guarantees") under the heading "Guarantees" on page 26 and under the heading "Other Off-Balance Sheet Risk" on page 28. LOW-INCOME HOUSING TAX CREDIT ("LIHTC") GUARANTEED FUNDS. Key Affordable Housing Corporation ("KAHC") forms limited partnerships (funds) that invest in LIHTC projects. Interests in these funds are offered to qualified investors, who pay a fee to KAHC for a guaranteed return. Key also earns syndication and asset management fees from these funds. At June 30, 2003, the guaranteed funds had unamortized 20 equity of $651 million. Guaranteed funds formed during the quarter ended June 30, 2003, did not have any material effect on Key's financial condition or results of operations. Additional information on return guaranty agreements with LIHTC investors is summarized in Note 10 under the heading "Guarantees." Key's maximum exposure to loss from its relationships with guaranteed LIHTC funds was $815 million at June 30, 2003, which represents undiscounted future payments due to investors for the return on and of their investments. KAHC has established a reserve in the amount of $34 million at June 30, 2003, which management believes will be sufficient to absorb future estimated losses under the guarantees. As required by Interpretation No. 46, assets, liabilities and noncontrolling interests of newly consolidated entities will initially be recorded at their carrying amounts. If determining the carrying amounts is impractical, fair values at the date Interpretation No. 46 first applies may be used. Any difference between the net assets added to Key's balance sheet and the amount of any previously recognized interest in the newly consolidated entities will be recognized as a cumulative effect of an accounting change. The consolidation of the commercial paper conduit and guaranteed LIHTC funds is not expected to have any material effect on Key's financial condition or results of operations. Key has also determined that it is not the primary beneficiary of the following group of currently consolidated VIEs and, accordingly, will de-consolidate them upon adoption of Interpretation No. 46 in the third quarter of 2003. BUSINESS TRUSTS ISSUING MANDATORILY REDEEMABLE PREFERRED CAPITAL SECURITIES. Key owns the common stock of six fully-consolidated subsidiary business trusts, which have issued corporation-obligated mandatorily redeemable preferred capital securities to third party investors. The trusts' only assets, which totaled $1.1 billion at June 30, 2003, are debentures issued by Key, which were acquired by the trusts using proceeds from the issuance of the preferred securities and common stock. Upon de-consolidation, Key will include the debentures in "long-term debt" and Key's equity interest in the business trusts will be included in "accrued income and other assets" on the balance sheet. For regulatory reporting purposes, the Federal Reserve Board has advised that such preferred securities will continue to constitute Tier 1 capital until further notice. Additional information on the trusts is summarized in Note 9 ("Capital Securities") starting on page 23. In addition, Key has significant interests in the following VIE groups. "Significant interests" has been defined by Key as subordinated interests in VIEs that expose Key to a portion of the VIEs' expected losses or residual returns, if they occur. LIHTC NONGUARANTEED FUNDS. KAHC sells investments in certain unconsolidated LIHTC funds without guaranteeing a return to the investors and earns syndication and asset management fees for services provided to these nonguaranteed funds. Key has determined these funds to be VIEs in which Key has significant interests, but for which it is not the primary beneficiary. At June 30, 2003, assets of nonguaranteed LIHTC funds were estimated to be $366 million. Key's maximum exposure to loss from its involvement with these funds is minimal. Nonguaranteed funds formed during the quarter ended June 30, 2003, did not have any material effect on Key's financial condition or results of operations. LIHTC INVESTMENTS. Key makes investments directly in LIHTC projects through the Retail Banking line of business. As a limited partner in these unconsolidated projects, Key is allocated tax credits and deductions associated with the underlying properties. Key is evaluating the impact of applying Interpretation No. 46 to these projects and has not yet completed its analysis. At June 30, 2003, estimated assets of the LIHTC projects totaled $863 million. Key's maximum exposure to loss from its involvement with these LIHTC projects is the unamortized investment balance of $296 million at June 30, 2003, plus $39 million of tax credits claimed, but subject to recapture. During the quarter ended June 30, 2003, Key did not obtain any significant interests in LIHTC projects created after January 31, 2003. COMMERCIAL AND RESIDENTIAL REAL ESTATE INVESTMENTS. Through the KeyBank Real Estate Capital line of business, Key makes mezzanine investments in construction, acquisition and rehabilitation projects that have been determined to be VIEs. Key receives underwriting, asset management and other fees from these VIEs and for certain projects, may also provide the senior financing. It is reasonably possible that, as primary beneficiary, Key will consolidate such VIEs that have estimated assets of $78 million at June 30, 2003. 21 Key's investments in VIEs for which it is not reasonably possible that Key will be determined to be the primary beneficiary totaled $41 million at June 30, 2003. Key's maximum exposure to loss from its involvement with these real estate projects was $245 million at June 30, 2003, which represents the carrying amount of its investments in and loans to the projects. During the quarter ended June 30, 2003, Key made mezzanine investments of $21 million in VIEs created after January 31, 2003, and was determined to be the primary beneficiary for a limited number of these VIEs, which did not have any material effect on Key's financial condition or results of operations. Key's maximum exposure to loss from its involvement with these VIEs is equal to $55 million at June 30, 2003, representing the amount invested in and lent to these projects. PRINCIPAL INVESTMENTS. Key's Principal Investing unit makes direct investments in equity and mezzanine instruments offered by individual companies, some of which have been determined to be VIEs. It is reasonably possible that, as primary beneficiary, Key will consolidate VIEs that have estimated assets of $154 million at June 30, 2003. Key's investments in VIEs for which it is not reasonably possible that Key will be determined to be the primary beneficiary totaled $45 million at June 30, 2003. Key's maximum exposure to loss from its involvement with these VIEs was $84 million at June 30, 2003, which represents the carrying amount of these investments. During the quarter ended June 30, 2003, Key did not obtain any significant interests in VIEs created after January 31, 2003, nor were any principal investments made in VIEs created after January 31, 2003, for which Key was determined to be the primary beneficiary. LEVERAGED LEASES. The Key Equipment Finance line of business uses VIEs, typically grantor and business trusts, in conducting leveraged lease financing transactions. The VIEs facilitate the transfer of ownership of assets, reduce financing costs, and reduce the level of risk for lenders and investors. VIEs used to conduct these financings are consolidated by Key. As of June 30, 2003, Key's investment in leveraged leases totaled $2.6 billion. Interpretation No. 46 will not change Key's accounting for these transactions. During the quarter ended June 30, 2003, Key created one new leveraged lease VIE, which involves $175 million in equipment. Key's maximum exposure to loss from its involvement with this VIE is limited to its equity investment of $45 million. 22 8. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS Impaired loans, which account for the largest portion of Key's nonperforming assets, totaled $498 million at June 30, 2003, compared with $610 million at December 31, 2002, and $671 million at June 30, 2002. Impaired loans averaged $526 million for the second quarter of 2003 and $678 million for the second quarter of 2002. Key's nonperforming assets were as follows:
JUNE 30, DECEMBER 31, JUNE 30, in millions 2003 2002 2002 - -------------------------------------------------------------------------------------------------------------------- Impaired loans $ 498 $ 610 $ 671 Other nonaccrual loans 339 333 286 - -------------------------------------------------------------------------------------------------------------------- Total nonperforming loans 837 943 957 Other real estate owned ("OREO") 60 48 40 Allowance for OREO losses (3) (3) (2) - -------------------------------------------------------------------------------------------------------------------- OREO, net of allowance 57 45 38 Other nonperforming assets 3 5 -- - -------------------------------------------------------------------------------------------------------------------- Total nonperforming assets $ 897 $ 993 $ 995 ====== ====== ====== - --------------------------------------------------------------------------------------------------------------------
At June 30, 2003, Key did not have any significant commitments to lend additional funds to borrowers with loans on nonperforming status. When expected cash flows or collateral values do not justify the carrying amount of an impaired loan, the loan is assigned a specific allowance. Management calculates the extent of the impairment, which is the carrying amount of the loan less the estimated present value of future cash flows and the fair value of any existing collateral. The amount that management deems uncollectible (the impaired amount) is charged against the allowance for loan losses. Even when collateral value or other sources of repayment appear sufficient, if management remains uncertain about whether the loan will be repaid in full, an appropriate amount is specifically allocated in the allowance for loan losses. At June 30, 2003, Key had $302 million of impaired loans with a specifically allocated allowance for loan losses of $109 million, and $196 million of impaired loans that were carried at their estimated fair value without a specifically allocated allowance. At December 31, 2002, impaired loans included $377 million of loans with a specifically allocated allowance of $179 million, and $233 million that were carried at their estimated fair value without a specifically allocated allowance. Key does not perform a loan-specific impairment valuation for smaller-balance, homogeneous, nonaccrual loans (shown in the preceding table as "Other nonaccrual loans"). These typically are consumer loans, including residential mortgages, home equity loans and various types of installment loans. Management applies historical loss experience rates to these loan portfolios, adjusted to reflect emerging credit trends and other factors, and then allocates a portion of the allowance for loan losses to each loan type. 9. CAPITAL SECURITIES KeyCorp has six fully-consolidated subsidiary business trusts that have issued corporation-obligated mandatorily redeemable preferred capital securities ("capital securities"). These securities are carried as liabilities on Key's balance sheet. The securities provide an attractive source of funds since they constitute Tier I capital for regulatory reporting purposes, but have the same tax advantages as debt for federal income tax purposes. To the extent the trusts have funds available to make payments, as guarantor, KeyCorp unconditionally guarantees payment of: - - required distributions on the capital securities; - - the redemption price when a capital security is redeemed; and - - amounts due if a trust is liquidated or terminated. 23 KeyCorp owns the outstanding common stock of each of the trusts. The trusts used the proceeds from the issuance of their capital securities and common stock to buy debentures issued by KeyCorp. These debentures are the trusts' only assets; the interest payments from the debentures finance the distributions paid on the capital securities. Key's financial statements do not reflect the debentures or the related effects on the income statement because they are eliminated in consolidation. Under Interpretation No. 46, Key has determined that these business trusts are VIEs for which it is not the primary beneficiary. Therefore, effective July 1, 2003, these trusts will be de-consolidated. Additional information regarding Interpretation No. 46 and these business trusts is summarized in Note 1 ("Basis of Presentation"), which begins on page 7, and in Note 7 ("Variable Interest Entities") under the heading "Business trusts issuing mandatorily redeemable preferred capital securities" on page 21. The capital securities, common stock and related debentures are summarized as follows:
PRINCIPAL INTEREST RATE MATURITY CAPITAL AMOUNT OF OF CAPITAL OF CAPITAL SECURITIES, COMMON DEBENTURES, SECURITIES AND SECURITIES AND dollars in millions NET OF DISCOUNT(a) SECURITIES NET OF DISCOUNT(b) DEBENTURES(c) DEBENTURES - ---------------------------------------------------------------------------------------------------------------------------------- June 30, 2003 KeyCorp Institutional Capital A $ 415 $ 11 $ 361 7.826% 2026 KeyCorp Institutional Capital B 178 4 154 8.250 2026 KeyCorp Capital I 230 8 238 2.030 2028 KeyCorp Capital II 190 8 165 6.875 2029 KeyCorp Capital III 235 8 187 7.750 2029 Union Bankshares Capital Trust I 10 1 11 9.000 2028 - ---------------------------------------------------------------------------------------------------------------------------------- Total $1,258 $ 40 $1,116 6.678% -- ====== ==== ====== - ---------------------------------------------------------------------------------------------------------------------------------- December 31, 2002 $1,260 $ 40 $1,136 6.779% -- ====== ==== ====== - ---------------------------------------------------------------------------------------------------------------------------------- June 30, 2002 $1,244 $ 39 $1,195 6.749% -- ====== ==== ====== - ----------------------------------------------------------------------------------------------------------------------------------
(a) The capital securities must be redeemed when the related debentures mature, or earlier if provided in the governing indenture. Each issue of capital securities carries an interest rate identical to that of the related debenture. The capital securities constitute minority interests in the equity accounts of KeyCorp's consolidated subsidiaries and, therefore, qualify as Tier 1 capital under Federal Reserve Board guidelines. Included in certain capital securities at June 30, 2003, December 31, 2002 and June 30, 2002, are basis adjustments of $182 million, $164 million and $88 million, respectively, related to fair value hedges. See Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders, for an explanation of fair value hedges. (b) KeyCorp has the right to redeem its debentures: (i) in whole or in part, on or after December 1, 2006 (for debentures owned by Capital A), December 15, 2006 (for debentures owned by Capital B), July 1, 2008 (for debentures owned by Capital I), March 18, 1999 (for debentures owned by Capital II), July 16, 1999 (for debentures owned by Capital III), and December 17, 2003 (for debentures owned by Union Bankshares Capital Trust I); and, (ii) in whole at any time within 90 days after and during the continuation of a "tax event" or a "capital treatment event" (as defined in the applicable offering circular). If the debentures purchased by Capital A or Capital B are redeemed before they mature, the redemption price will be the principal amount, plus a premium, plus any accrued but unpaid interest. If the debentures purchased by Capital I or Union Bankshares Capital Trust I are redeemed before they mature, the redemption price will be the principal amount, plus any accrued but unpaid interest. If the debentures purchased by Capital II or Capital III are redeemed before they mature, the redemption price will be the greater of: (a) the principal amount, plus any accrued but unpaid interest or (b) the sum of the present values of principal and interest payments discounted at the Treasury Rate (as defined in the applicable offering circular), plus 20 basis points (25 basis points for Capital III), plus any accrued but unpaid interest. When debentures are redeemed in response to tax or capital treatment events, the redemption price generally is slightly more favorable to Key. (c) The interest rates for Capital A, Capital B, Capital II, Capital III and Union Bankshares Capital Trust I are fixed. Capital I has a floating interest rate equal to three-month LIBOR plus 74 basis points; it reprices quarterly. The rates shown as the total at June 30, 2003, December 31, 2002 and June 30, 2002, are weighted average rates. During the first half of 2003, the subsidiary business trusts repurchased $20 million of their outstanding capital securities and KeyCorp repurchased a like amount of the related debentures. Management intends to replace certain repurchased capital securities with capital securities that yield a lower cost. Accordingly, $175 million of new capital securities were issued on July 21, 2003. 24 10. CONTINGENT LIABILITIES AND GUARANTEES LEGAL PROCEEDINGS RESIDUAL VALUE INSURANCE LITIGATION. Key Bank USA, National Association ("Key Bank USA") obtained two insurance policies from Reliance Insurance Company ("Reliance") insuring the residual value of certain automobiles leased through Key Bank USA. The two policies ("the Policies"), the "4011 Policy" and the "4019 Policy," together covered leases entered into during the period from January 1, 1997 to January 1, 2001. The 4019 Policy contains an endorsement stating that Swiss Reinsurance America Corporation ("Swiss Re") will assume and reinsure 100% of Reliance's obligations under the 4019 Policy in the event Reliance Group Holdings' ("Reliance's parent") so-called "claims-paying ability" were to fall below investment grade. Key Bank USA also entered into an agreement with Swiss Re and Reliance whereby Swiss Re agreed to issue to Key Bank USA an insurance policy on the same terms and conditions as the 4011 Policy in the event the financial condition of Reliance Group Holdings fell below a certain level. Around May 2000, the conditions under both the 4019 Policy and the Swiss Re agreement were triggered. The 4011 Policy was canceled and replaced as of May 1, 2000, by a policy issued by North American Specialty Insurance Company (a subsidiary or affiliate of Swiss Re) ("the NAS Policy"). Tri-Arc Financial Services, Inc. ("Tri-Arc") acted as agent for Reliance, Swiss Re and NAS. Since February 2000, Key Bank USA has been filing claims under the Policies, but none of these claims has been paid. In July 2000, Key Bank USA filed a claim for arbitration against Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, a declaration of the scope of coverage under the Policies and for damages. On January 8, 2001, Reliance filed an action (litigation) against Key Bank USA in Federal District Court in Ohio seeking rescission or reformation of the Policies because they allegedly do not reflect the intent of the parties with respect to the scope of coverage and how and when claims were to be paid. Key filed an answer and counterclaim against Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, declaratory relief as to the scope of coverage under the Policies, damages for breach of contract and failure to act in good faith, and punitive damages. The parties agreed to proceed with this court action and to dismiss the arbitration without prejudice. On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order placing Reliance in a court supervised "rehabilitation" and purporting to stay all litigation against Reliance. On July 23, 2001, the Federal District Court in Ohio stayed the litigation to allow the rehabilitator to complete her task. On October 3, 2001, the Court in Pennsylvania entered an order placing Reliance into liquidation and canceling all Reliance insurance policies as of November 2, 2001. On November 20, 2001, the Federal District Court in Ohio entered an order that, among other things, required Reliance to report to the Court on the progress of the liquidation. On January 15, 2002, Reliance filed a status report requesting the continuance of the stay for an indefinite period. On February 20, 2002, Key Bank USA filed a Motion for Partial Lifting of the July 23, 2001, Stay in which it asked the Court to allow the case to proceed against the parties other than Reliance. The Court granted Key Bank USA's motion on May 17, 2002. As of February 19, 2003, all claims against Tri-Arc were dismissed through a combination of court action and voluntary dismissal by Key Bank USA. Management believes that Key Bank USA has valid insurance coverage or claims for damages relating to the residual value of automobiles leased through Key Bank USA during the four-year period ending January 1, 2001. With respect to each individual lease, however, it is not until the lease expires and the vehicle is sold that Key Bank USA can determine the existence and amount of any actual loss (i.e., the difference between the residual value provided for in the lease agreement and the vehicle's actual market value at lease expiration). Key Bank USA's actual total losses for which it will file claims will depend to a large measure upon the viability of, and pricing within, the market for used cars throughout the lease run-off period, which extends through 2006. The market for used cars varies. 25 Accordingly, the total expected loss on the portfolio for which Key Bank USA will file claims cannot be determined with certainty at this time. Claims filed by Key Bank USA through June 30, 2003, total approximately $315 million, and management currently estimates that approximately $53 million of additional claims may be filed through year-end 2006 bringing the total aggregate amount of actual and potential claims to $368 million. As discussed previously, a number of factors could affect Key Bank USA's actual loss experience, which may be higher or lower than management's current estimates. Key is filing insurance claims for the entire amount of its losses and is recording as a receivable on its balance sheet a portion of the amount of the insurance claims as and when they are filed. Management believes the amount being recorded as a receivable due from the insurance carriers is appropriate to reflect the collectibility risk associated with the insurance litigation; however, litigation is inherently not without risk, and any actual recovery from the litigation may be more or less than the receivable. While management does not expect an adverse decision, if a court were to make an adverse final determination, such result would cause Key to record a material one-time expense during the period when such determination is made. An adverse determination would not have a material effect on Key's financial condition, but could have a material adverse effect on Key's results of operations in the quarter it occurs. OTHER LITIGATION. In the ordinary course of business, Key is subject to legal actions that involve claims for substantial monetary relief. Based on information presently known to management, management does not believe there is any legal action to which KeyCorp or any of its subsidiaries is a party, or involving any of their properties, that, individually or in the aggregate, could reasonably be expected to have a material adverse effect on Key's financial condition or annual results of operations. GUARANTEES Key is a guarantor in various agreements with third parties. In accordance with Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," certain guarantees issued or modified on or after January 1, 2003, require the recognition of a liability on Key's balance sheet for the "stand ready" obligation associated with such guarantees. The accounting for guarantees existing at December 31, 2002, was not revised. Additional information pertaining to Interpretation No. 45 is summarized in Note 1 ("Basis of Presentation") under the heading "Accounting Pronouncements Adopted in 2003" on page 9. The following table shows the types of guarantees (as defined by Interpretation No. 45) that Key had outstanding at June 30, 2003.
MAXIMUM POTENTIAL UNDISCOUNTED LIABILITY in millions FUTURE PAYMENTS RECORDED - ----------------------------------------------------------------------------------------------------------------- Financial Guarantees: Standby letters of credit $5,418 $ 9 Credit enhancement for asset-backed commercial paper conduit 60 -- Recourse agreement with FNMA 296 4 Return guaranty agreement with LIHTC investors 815 34 Default guarantees 11 -- Written interest rate caps(a) 42 16 - ----------------------------------------------------------------------------------------------------------------- Total $6,642 $ 63 ====== ===== - -----------------------------------------------------------------------------------------------------------------
(a) As of June 30, 2003, the weighted average interest rate of written interest rate caps was 1.3%. Maximum potential undiscounted future payments were calculated assuming a 10% interest rate. STANDBY LETTERS OF CREDIT. These instruments obligate Key to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument, or fails to perform some contractual nonfinancial obligation. Standby letters of credit are issued by many of Key's lines of business to address clients' financing needs. If amounts are drawn under standby letters of credit, such amounts are treated as loans; they bear interest (generally at variable rates) and pose the same credit risk to Key as a loan. At June 30, 2003, Key's standby letters of credit had a remaining weighted average life of approximately 2 years, with remaining actual lives ranging from less than 1 year to as many as 17 years. 26 CREDIT ENHANCEMENT FOR ASSET-BACKED COMMERCIAL PAPER CONDUIT. Key provides credit enhancement in the form of a committed facility to ensure the continuing operations of an asset-backed commercial paper conduit, which is owned by a third party and administered by an unaffiliated financial institution. The commitment to provide credit enhancement extends until September 26, 2003, and specifies that in the event of default by certain borrowers whose loans are held by the conduit, Key will provide financial relief to the conduit in an amount that is based on defined criteria that consider the level of credit risk involved and other factors. At June 30, 2003, Key's funding requirement under the credit enhancement facility totaled $60 million. However, there were no drawdowns under the facility during the six-month period ended June 30, 2003. Key has no recourse or other collateral available to offset any amounts that may be funded under this credit enhancement facility. Key's commitments to provide credit enhancement to the conduit are periodically evaluated by management. No changes to Key's funding requirement under the credit enhancement facility are expected to occur as a result of the restructuring of the conduit discussed in Note 7 ("Variable Interest Entities") under the heading "Commercial paper conduits" on page 20. RECOURSE AGREEMENT WITH FEDERAL NATIONAL MORTGAGE ASSOCIATION. KBNA participates as a lender in the Federal National Mortgage Association ("FNMA") Delegated Underwriting and Servicing ("DUS") program. As a condition to FNMA's delegation of responsibility for originating, underwriting and servicing mortgages, KBNA has agreed to assume a limited portion of the risk of loss during the remaining term on each commercial mortgage loan sold to FNMA. Accordingly, a reserve for such potential losses has been established and is maintained in an amount estimated by management to approximate the fair value of the liability undertaken by KBNA. At June 30, 2003, the outstanding commercial mortgage loans in this program had a weighted average remaining term of 10 years and the unpaid principal balance outstanding of loans sold by KBNA as a participant in this program was approximately $1.5 billion. The maximum potential amount of undiscounted future payments that may be required under this program is equal to 20% of the principal balance of loans outstanding at June 30, 2003. If payment is required under this program, Key would have an interest in the collateral underlying the commercial mortgage loan on which the loss occurred. RETURN GUARANTEE AGREEMENT WITH LOW-INCOME HOUSING TAX CREDIT ("LIHTC") INVESTORS. Key Affordable Housing Corporation ("KAHC"), a subsidiary of KBNA, offers limited partnership interests to qualified investors. Unconsolidated partnerships formed by KAHC invest in low-income residential rental properties that qualify for federal LIHTCs under Section 42 of the Internal Revenue Code. In certain partnerships, investors pay a fee to KAHC for a guaranteed return that is dependent on the financial performance of the property and the property's ability to maintain its LIHTC status throughout the fifteen-year compliance period. If these two conditions are not achieved, Key is obligated to make any necessary payments to investors to provide the guaranteed return. KAHC has the ability to affect changes in the management of the properties to improve performance. However, other than the underlying income stream from the properties, no recourse or collateral would be available to offset the guarantee obligation. These guarantees have expiration dates that extend through 2018. Key meets its obligations pertaining to the guaranteed returns generally through the distribution of tax credits and deductions associated with the specific properties. As shown in the preceding table, KAHC had established a reserve in the amount of $34 million at June 30, 2003, which management believes will be sufficient to cover estimated future obligations under the guarantees. In accordance with Interpretation No. 45, for any return guarantee agreements entered into or modified with LIHTC investors on or after January 1, 2003, the amount of all fees received in consideration for the guarantee has been recognized as the fair value stand ready obligation. VARIOUS TYPES OF DEFAULT GUARANTEES. Some lines of business provide or participate in guarantees that obligate Key to perform if the debtor fails to pay all or a portion of the subject indebtedness and/or related interest. These guarantees are generally undertaken when Key is supporting or protecting its underlying investment or where the risk profile of the debtor should provide an investment return. The terms of these default guarantees range from less than 1 year to as many as 19 years. Although no collateral is held, Key would have recourse against the debtors for any payments made under these default guarantees. 27 WRITTEN INTEREST RATE CAPS. In the ordinary course of business, Key writes interest rate caps for commercial loan clients that have variable rate loans with Key. These caps are purchased by clients to limit their exposure to interest rate increases and at June 30, 2003, had a weighted average life of approximately 7.6 years. Key is obligated to pay the interest rate counterparty if the applicable benchmark interest rate exceeds a specified level (known as the "strike rate"). These instruments are accounted for as derivatives with the fair value liability recorded in "other liabilities" on the balance sheet. Key's potential amount of future payments under these obligations is mitigated by the fact that the company enters into offsetting positions with third parties. OTHER OFF-BALANCE SHEET RISK Other off-balance sheet risk stems from financial instruments that do not meet the definition of a guarantee as specified in Interpretation No. 45 and from other relationships. LIQUIDITY FACILITIES THAT SUPPORT ASSET-BACKED COMMERCIAL PAPER CONDUITS. Key provides liquidity to all or a portion of two separate asset-backed commercial paper conduits that are owned by third parties and administered by unaffiliated financial institutions. These liquidity facilities obligate Key through February 15, 2005, to provide funding if such is required as a result of a disruption in credit markets or other factors. Key provides liquidity to the conduits in the form of committed facilities of $1.2 billion. The amount available to be drawn on these facilities was $547 million at June 30, 2003. However, there were no drawdowns under either of the committed facilities at that time. Of the $1.2 billion of liquidity facility commitments, $92 million is associated with a conduit program that is in the process of being liquidated. Therefore, Key's commitment will decrease as the assets in this conduit program decrease. The remainder of the liquidity facility commitments relate to the asset-backed commercial paper conduit discussed in Note 1 on page 7. Key's commitments to provide liquidity are periodically evaluated by management. No changes to the committed liquidity facilities are expected to occur as a result of the restructuring of the conduit, discussed in Note 7. INDEMNIFICATIONS PROVIDED IN THE ORDINARY COURSE OF BUSINESS. Key provides certain indemnifications primarily through representations and warranties in contracts that are entered into in the ordinary course of business in connection with purchases and sales of businesses, loan sales and other ongoing activities. Management's past experience with these indemnifications has been that the amounts paid, if any, have not had a significant effect on Key's financial condition or results of operations. INTERCOMPANY GUARANTEES. KeyCorp and primarily KBNA are parties to various guarantees that are undertaken to facilitate the ongoing business activities of other Key affiliates. These business activities encompass debt issuance, certain lease and insurance obligations, investments and securities, and certain leasing transactions involving clients. RELATIONSHIP WITH MASTERCARD INTERNATIONAL INC. AND VISA U.S.A. INC. KBNA and Key Bank USA are members of MasterCard International Inc. ("MasterCard") and Visa U.S.A. Inc. ("Visa"). MasterCard's charter documents and bylaws state that MasterCard may assess its members for certain liabilities that it incurs, including litigation liabilities. Visa's charter documents state that Visa may fix fees payable by members in connection with Visa's operations. We understand that descriptions of significant pending lawsuits and MasterCard's and Visa's positions regarding the potential impact of those lawsuits on members are set forth on MasterCard's and Visa's respective websites, as well as in MasterCard's public filings with the Securities and Exchange Commission. Key is not a party to any significant litigation by third parties against MasterCard or Visa. In June 2003, MasterCard and Visa agreed, independently, to settle a class-action lawsuit that was brought against them by Wal-Mart Stores Inc. and many other retailers. The lawsuit alleged that MasterCard and Visa violated federal antitrust laws by conspiring to monopolize the debit card services market and by requiring merchants that accept certain of their debit and credit card services to also accept their higher 28 priced "off-line," signature-verified debit card services. According to published reports, under the terms of the settlements, which are subject to court approval, beginning August 1, 2003, MasterCard and Visa have agreed to pay a total of approximately $3 billion, over a 10-year period, to merchants who claim to have been harmed by their actions and to lower the fees they charge merchants for their "off-line" signature-verified debit card services. Also, as of January 1, 2004, such merchants will no longer be required to accept MasterCard or Visa debit card services when they accept MasterCard or Visa credit card services. Accordingly, management believes that the settlements will result in the reduction of fees earned by KBNA and Key Bank USA from off-line debit card transactions. Management estimates that the impact of the settlement on Key will be a reduction to pre-tax net income of less than $10 million for the balance of 2003 and less than $25 million in 2004. This estimate is subject to change once management completes its evaluation of alternative actions that may be available to it in response to the settlements, and has had an opportunity to observe any changes in the marketplace for card services that occur in response to the settlements. It is management's understanding that certain retailers have opted-out of the class-action settlement and that additional suits have been filed against MasterCard and Visa seeking additional damage recovery. Management is unable at this time to estimate the possible impact of any such actions. 11. DERIVATIVES AND HEDGING ACTIVITIES Key, mainly through its lead bank, KBNA, is party to various derivative instruments. These instruments are used for asset and liability management and trading purposes. Generally, these instruments help Key meet clients' financing needs and manage exposure to "market risk"--the possibility that economic value or net interest income will be adversely affected by changes in interest rates or other economic factors. However, like other financial instruments, these derivatives contain an element of "credit risk"--the possibility that Key will incur a loss because a counterparty fails to meet its contractual obligations. The primary derivatives that Key uses are interest rate swaps, caps and futures, and foreign exchange forward contracts. All foreign exchange forward contracts and interest rate swaps and caps held are over-the-counter instruments. At June 30, 2003, Key had $954 million of derivative assets and $146 million of derivative liabilities on its balance sheet that arose from derivatives that were being used for hedging purposes. As of the same date, derivative assets and liabilities classified as trading derivatives totaled $1.7 billion and $1.6 billion, respectively. Derivative assets and liabilities are recorded at fair value in "accrued income and other assets" and "accrued expense and other liabilities," respectively, on the balance sheet. Key uses a fair value hedging strategy to modify its exposure to interest rate risk and a cash flow hedging strategy to reduce the potential adverse impact of interest rate increases on future interest expense. For more information about these asset and liability management strategies used to modify Key's exposure to interest rate risk, see Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders. The change in "accumulated other comprehensive income (loss)" resulting from cash flow hedges is as follows:
RECLASSIFICATION DECEMBER 31, 2003 OF GAINS TO JUNE 30, in millions 2002 HEDGING ACTIVITY NET INCOME 2003 - -------------------------------------------------------------------------------------------------------------------------- Accumulated other comprehensive income (loss) resulting from cash flow hedges $ 6 $ 39 $ (2) $ 43 - ------------------------------------------------------------------------------------------------------------------------
Key expects to reclassify an estimated $52 million of net gains on derivative instruments from "accumulated other comprehensive income (loss)" to earnings during the next twelve months. Reclassifications will coincide with the income statement impact of the hedged item through the payment of variable-rate interest on debt, the receipt of variable-rate interest on commercial loans and the sale or securitization of commercial real estate loans. 29 TRADING PORTFOLIO Key's trading portfolio includes: - - interest rate swap contracts entered into to accommodate the needs of clients; - - positions with third parties that are intended to offset or mitigate the interest rate risk of client positions; - - foreign exchange forward contracts entered into to accommodate the needs of clients; and - - proprietary trading positions in financial assets and liabilities. The fair values of these trading portfolio items are included in "accrued income and other assets" or "accrued expense and other liabilities" on the balance sheet. Adjustments to the fair values are included in "investment banking and capital markets income" on the income statement. Additional information pertaining to Key's trading portfolio is summarized in Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders. The following table shows trading income recognized on interest rate swaps and foreign exchange forward contracts.
SIX MONTHS ENDED JUNE 30, ------------------------- in millions 2003 2002 - -------------------------------------------------------------------- Interest rate swap contracts $ 4 $ 5 Foreign exchange forward contracts 15 18 - -------------------------------------------------------------------
COUNTERPARTY CREDIT RISK Swaps and caps present credit risk because the counterparty may not meet the terms of the contract. This risk is measured as the expected positive replacement value of contracts. To mitigate credit risk, Key deals exclusively with counterparties that have high credit ratings. Key uses two additional precautions to manage exposure to credit risk on swap contracts. First, Key generally enters into bilateral collateral and master netting arrangements. These agreements include legal rights of setoff that provide for the net settlement of the related contracts with the same counterparty in the event of default. Second, Credit Administration monitors credit risk exposure to the counterparty on each interest rate swap to determine appropriate limits on Key's total credit exposure and whether it is advisable to demand collateral. At June 30, 2003, Key was party to interest rate swaps and caps with 55 different counterparties. Among these were swaps and caps entered into to offset the risk of client exposure. Key had aggregate credit exposure of $147 million (net of collateral of $574 million) on these instruments to 32 of the counterparties. The largest credit exposure to an individual counterparty amounted to approximately $27 million. 30 INDEPENDENT ACCOUNTANTS' REVIEW REPORT SHAREHOLDERS AND BOARD OF DIRECTORS KEYCORP We have reviewed the unaudited condensed consolidated balance sheets of KeyCorp and subsidiaries ("Key") as of June 30, 2003 and 2002, and the related condensed consolidated statements of income for the three- and six-month periods then ended, and the condensed consolidated statements of changes in shareholders' equity and cash flow for the six-month periods ended June 30, 2003 and 2002. These financial statements are the responsibility of Key's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States. We have previously audited, in accordance with auditing standards generally accepted in the United States, the consolidated balance sheet of Key as of December 31, 2002, and the related consolidated statements of income, changes in shareholders' equity, and cash flow for the year then ended (not presented herein) and in our report dated January 13, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2002, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ Ernst & Young LLP Cleveland, Ohio July 18, 2003 31 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION This section generally reviews the financial condition and results of operations of KeyCorp and its subsidiaries for the quarterly and year-to-date periods ended June 30, 2003 and 2002. Some tables may cover more periods to comply with disclosure requirements or to illustrate trends in greater depth. When you read this discussion, you should also refer to the consolidated financial statements and related notes that appear on pages 3 through 30. SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES Key's business is dynamic and complex. Consequently, management must exercise judgment in choosing and applying accounting policies and methodologies in many areas. These choices are important; not only are they necessary to comply with accounting principles generally accepted in the United States, they also reflect management's view of the most appropriate manner in which to record and report Key's overall financial performance. All accounting policies are important, and all policies described in Note 1 ("Summary of Significant Accounting Policies"), which begins on page 57 of Key's 2002 Annual Report to Shareholders, should be reviewed for a greater understanding of how Key's financial performance is recorded and reported. In management's opinion, some accounting policies are more likely than others to have a significant effect on Key's financial results and to expose those results to potentially greater volatility. These policies apply to areas of relatively greater business importance or require management to make assumptions and estimates that affect amounts reported in the financial statements. Because these assumptions and estimates are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. For Key, areas that rely heavily on the use of assumptions and estimates include accounting for the allowance for loan losses, loan securitizations, contingent liabilities and guarantees, principal investments, goodwill, and pension and other postretirement obligations. A brief discussion of each of these areas appears below. ALLOWANCE FOR LOAN LOSSES. Management determines probable losses inherent in Key's loan portfolio (which represents by far the largest category of assets on Key's balance sheet) and establishes an allowance that is sufficient to absorb those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. Nonetheless, if management's underlying assumptions prove to be inaccurate, the allowance for loan losses would have to be adjusted. Our accounting policy related to the allowance is disclosed in Note 1 under the heading "Allowance for Loan Losses" on page 58 of the Annual Report. LOAN SECURITIZATIONS. Key securitizes certain types of loans and accounts for such transactions as sales when the criteria set forth in SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," are met. If future events were to preclude accounting for such transactions as sales, the loans would have to be placed back on Key's balance sheet. This could have a potentially adverse effect on Key's capital ratios and other unfavorable financial implications. In addition, determining the gain or loss resulting from securitization transactions and the subsequent carrying amount of retained interests is dependent on underlying assumptions made by management, the most significant of which are described in Note 8 ("Loan Securitizations and Variable Interest Entities"), which begins on page 70 of the Annual Report. The use of alternative ranges of possible outcomes for these assumptions would change the amount of the initial gain or loss recognized. It could also result in changes in the carrying amount of retained interests, with related effects on results of operations. Our accounting policy related to loan securitizations is disclosed in Note 1 under the heading "Loan Securitizations" on page 59 of the Annual Report. 32 CONTINGENT LIABILITIES AND GUARANTEES. Contingent liabilities arising from litigation, guarantees in various agreements with third parties in which Key is a guarantor and the potential effects of these items on Key's results of operations, are summarized in Note 10 ("Contingent Liabilities and Guarantees"), which begins on page 25. Since Key records a liability for only the fair value of the obligation to stand ready to perform over the term of a guarantee, the risk exists that potential future payments that would be made by Key in the event of a default by a third party could exceed the liability recorded on Key's balance sheet. See Note 10 for a comparison of the liability recorded and the maximum potential undiscounted future payments for the various types of guarantees that Key had outstanding at June 30, 2003. In the normal course of business, Key is routinely subject to examinations and challenges from tax authorities regarding the amount of taxes due in connection with investments and business activities. Currently, the Internal Revenue Service is challenging Key's tax treatment of certain leveraged lease investments. This and other challenges by tax authorities may result in adjustments to the timing or amount of Key's taxable income or deductions or the allocation of income among tax jurisdictions. Management believes these challenges will be resolved without having any material effect on Key's financial condition or results of operations. VALUATION METHODOLOGIES. Valuation methodologies employed by management often involve a significant degree of judgment, particularly when there are no observable liquid markets for the items being valued. The outcome of valuations performed by management have a direct bearing on the carrying amounts of certain assets and liabilities, such as principal investments, goodwill, and pension and other postretirement benefit obligations. To determine the values of these assets and liabilities, as well as the extent to which related assets may be impaired, management makes assumptions and estimates related to discount rates, asset returns, repayment rates and other factors. The use of different discount rates or other valuation assumptions could produce significantly different results, which could have material positive or negative effects on Key's results of operations. The valuation methodology management uses for principal investments is summarized in Note 21 ("Fair Value Disclosures of Financial Instruments") on page 86 of the Annual Report and the methodology used in the testing for goodwill impairment is summarized in Note 1 under the heading "Goodwill and Other Intangible Assets" on page 59 of the Annual Report. The primary assumptions used in determining Key's pension and other postretirement benefit obligations and related expenses are presented in Note 16 ("Employee Benefits"), which begins on page 78 of the Annual Report. When a potential asset impairment is identified through testing, observable changes in liquid markets or other means, management must also exercise judgment in determining the nature of the potential impairment (i.e., whether the impairment is temporary or other than temporary) in order to apply the appropriate accounting treatment. For example, unrealized losses on securities available for sale that are deemed temporary are recorded in shareholders' equity, whereas those deemed "other than temporary" are recorded in earnings. REVENUE RECOGNITION Corporate improprieties related to revenue recognition have received a great deal of attention by regulatory authorities and the news media. Although all companies face the risk of intentional or unintentional misstatements, such misstatements are less likely in the financial services industry because most of the revenue (i.e., interest accruals) recorded is driven by nondiscretionary formulas based on written contracts, such as loan agreements. TERMINOLOGY This report contains some shortened names and industry-specific terms. We want to explain some of these terms at the outset so you can better understand the discussion that follows. - - KEYCORP refers solely to the parent holding company. 33 - - KBNA refers to Key's lead bank, KeyBank National Association. - - KEY refers to the consolidated entity consisting of KeyCorp and its subsidiaries. - - A KEYCENTER is one of Key's full-service retail banking facilities or branches. - - Key engages in CAPITAL MARKETS ACTIVITIES. These activities encompass a variety of products and services. Among other things, we trade securities as a dealer, enter into derivative contracts (both to accommodate clients' financing needs and for proprietary trading purposes), and conduct transactions in foreign currencies (both to accommodate clients' needs and to benefit from fluctuations in exchange rates). - - All earnings per share data included in this discussion are presented on a DILUTED basis, which takes into account all common shares outstanding as well as potential common shares that could result from the exercise of outstanding stock options. Some of the financial information tables also include BASIC earnings per share, which takes into account only common shares outstanding. - - For regulatory purposes, capital is divided into two classes. Federal regulations prescribe that at least one-half of a bank or bank holding company's TOTAL RISK-BASED CAPITAL must qualify as TIER 1. Both total and Tier 1 capital serve as bases for several measures of capital adequacy, which is an important indicator of financial stability and condition. You will find a more detailed explanation of total and Tier 1 capital and how they are calculated in the section entitled "Capital," which begins on page 63. - - When we want to draw your attention to a particular item in Key's Notes to Consolidated Financial Statements, we refer to NOTE ___, giving the particular number, name and starting page number. FORWARD-LOOKING STATEMENTS This report may contain "forward-looking statements" about issues like anticipated earnings, anticipated levels of net loan charge-offs and nonperforming assets, anticipated improvement in profitability and competitiveness and long-term goals. These statements usually can be identified by the use of forward-looking language such as "our goal," "our objective," "our plan," "will likely result," "will be," "are expected to," "as planned," "is anticipated," "intends to," "is projected," or similar words. Forward-looking statements by their nature are subject to assumptions, risks and uncertainties. For a variety of reasons, including the following, actual results could differ materially from those contained in or implied by the forward-looking statements. - - Interest rates could change more quickly or more significantly than we expect, which may have an adverse effect on our financial results. - - If the economy or segments of the economy fail to recover, or decline further, the demand for new loans and the ability of borrowers to repay outstanding loans may decline. - - The stock and bond markets could suffer additional declines or disruptions, which may have adverse effects on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities. - - It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses; we may be unable to implement certain initiatives; or the initiatives may be unsuccessful. - - Acquisitions and dispositions of assets, business units or affiliates could adversely affect us in ways that management has not anticipated. - - We may become subject to new legal obligations, or the resolution of pending litigation may have an adverse effect on our financial results. 34 - - Terrorist activities or military actions could further disrupt the economy and the general business climate, which may have an adverse effect on our financial results or condition and that of our borrowers. - - We may become subject to new accounting, tax, or regulatory practices or requirements. HIGHLIGHTS OF KEY'S PERFORMANCE FINANCIAL PERFORMANCE The primary measures of Key's financial performance for the second quarter and first six months of 2003 and 2002 are summarized below. - - Net income for the second quarter of 2003 was $225 million, or $.53 per common share, compared with net income of $217 million, or $.51 per share, for the previous quarter and net income of $246 million, or $.57 per share, for the second quarter of 2002. For the first six months of 2003, Key's net income was $442 million, or $1.03 per common share, compared with net income of $486 million, or $1.13 per share for the comparable period last year. - - Key's return on average equity was 12.98% for the second quarter of 2003. This result compares with a return of 12.91% for the prior quarter and a return of 15.16% for the year-ago quarter. For the first six months of 2003, Key's return on average equity was 12.94%, compared with a return of 15.34% for the first six months of 2002. - - Key's second quarter 2003 return on average total assets was 1.07%. This result compares with a return of 1.05% for the previous quarter and a return of 1.21% for the second quarter of 2002. For the first six months of 2003, Key's return on average total assets was 1.06%, compared with a return of 1.21% for the comparable period in 2002. Key's improved performance relative to the first quarter of 2003 reflected several positive trends: - - Revenue grew by $52 million, driven by increases in both net interest income and noninterest income. - - Average core deposits grew by an annualized 9% and were up 12% from the same period last year. - - Asset quality continued to improve as the level of Key's nonperforming loans declined for the third consecutive quarter and net loan charge-offs fell to their lowest level since the first quarter of 2001. During the same period, the soft economy continued to adversely affect our earnings, especially in our commercial and market-sensitive businesses. The weak demand for commercial loans has placed pressure on the net interest margin and this pressure is expected to continue as a result of the Federal Reserve Board's June 2003 reduction in interest rates. Although Key's second quarter results benefited from higher principal investing gains, the level of income generated by most of our other market-sensitive businesses was essentially unchanged from the first quarter of 2003 and down from the second quarter of last year. Over the remainder of the year, we expect improvement in our business fundamentals and modest earnings growth. We will continue to focus on expense management and to take advantage of opportunities, such as our recent acquisition of Newbridge Partners, a growth equity investment management firm based in New York City, to ensure that we are well positioned for the anticipated economic rebound. Newbridge will add almost $2 billion to our managed assets, expand our product base and allow us to further leverage our distribution capabilities. For the full year, we are comfortable with the analysts' consensus estimate for earnings per share of $2.13. The primary reasons that Key's revenue and expense components changed from those of the three-and six-month periods ended June 30, 2002, are reviewed in greater detail throughout the remainder of this discussion. 35 Figure 1 on page 37 summarizes Key's financial performance for each of the past five quarters and the first six months of 2003 and 2002. LONG-TERM GOALS Our long-term goals are to achieve an annual return on average equity in the range of 16% to 18% and to grow earnings per common share at an annual rate of 7% to 8%. CORPORATE STRATEGY Our strategy for achieving our long-term goals comprises the following five primary elements: - - FOCUS ON OUR CORE BUSINESSES. We intend to focus on businesses that enable us to build relationships with our clients. We will focus on our "footprint" businesses (i.e., those businesses conducted primarily within the twelve states in which we have retail bank branches) that serve individuals, small businesses and middle market companies. In addition, we intend to focus nationwide on our commercial real estate lending, asset management, home equity lending and equipment leasing businesses. These are businesses in which we believe we possess resources of the scale necessary to compete nationally. - - PUT OUR CLIENTS FIRST. We will work to deepen our relationships with our existing clients, and to build relationships with new clients, including those who have the potential to purchase multiple products and services or to generate repeat business. One way in which we are pursuing this goal is by emphasizing deposit growth across all of our lines of business. We also want to ensure that our clients are receiving a distinctive level of service, so we are putting considerable effort into enhancing our service quality. - - ENHANCE OUR BUSINESS. We will strive for continuous improvement. We will continue to focus on increasing revenues, controlling expenses and better serving our clients. In addition, we will continue to leverage technology to reduce costs and to enhance service quality. Over time, we also intend to diversify our revenue mix by emphasizing the growth of fee income while investing in higher-growth and higher-return businesses. - - CULTIVATE A WORKFORCE THAT DEMONSTRATES KEY'S VALUES AND WORKS TOGETHER FOR A COMMON PURPOSE. Key intends to achieve this by: --paying for performance, but only if achieved in ways that are consistent with Key's values; --attracting, developing and retaining a quality, high-performing and inclusive workforce; --developing leadership at all levels in the company; and --creating a positive, stimulating and entrepreneurial work environment. - - ENHANCE PERFORMANCE MEASUREMENT. We will continue to refine and to rely upon performance measurement mechanisms that help us ensure that we are maximizing returns for our shareholders, that those returns are appropriate considering the inherent levels of risk involved and that our incentive compensation plans are commensurate with the contributions made to our profitability. 36 FIGURE 1. SELECTED FINANCIAL DATA
2003 2002 SIX MONTHS ENDED JUNE 30, ------------------- ------------------------------ ------------------------- dollars in millions, except per share amounts SECOND FIRST FOURTH THIRD SECOND 2003 2002 - -------------------------------------------------------------------------------------------------------------------------------- FOR THE PERIOD Interest income $ 1,022 $ 1,021 $ 1,077 $ 1,095 $ 1,102 $ 2,043 $ 2,194 Interest expense 326 340 365 395 419 666 857 Net interest income 696 681 712 700 683 1,377 1,337 Provision for loan losses 125 130 147 135 135 255 271 Noninterest income 434 397 446 432 448 831 891 Noninterest expense 688 657 668 659 665 1,345 1,326 Income before income taxes 317 291 343 338 331 608 631 Net income 225 217 245 245 246 442 486 - -------------------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE Net income $ .53 $ .51 $ .58 $ .57 $ .58 $ 1.04 $ 1.14 Net income - assuming dilution .53 .51 .57 .57 .57 1.03 1.13 Cash dividends paid .305 .305 .30 .30 .30 .61 .60 Book value at period end 16.60 16.32 16.12 15.66 15.46 12.94 15.46 Market price: High 27.42 27.11 26.75 27.35 29.40 27.42 29.40 Low 22.56 22.31 21.25 20.96 25.95 22.31 22.92 Close 25.27 22.56 25.14 24.97 27.30 25.27 27.30 Weighted average common shares (000) 423,882 425,275 424,578 426,274 426,092 424,575 425,477 Weighted average common shares and potential common shares (000) 427,170 428,090 429,531 431,326 431,935 427,628 430,983 - -------------------------------------------------------------------------------------------------------------------------------- AT PERIOD END Loans $ 63,214 $ 62,719 $ 62,457 $ 62,951 $ 63,881 $ 63,214 $ 63,881 Earning assets 73,716 75,113 73,635 72,548 72,820 73,716 72,820 Total assets 85,479 86,490 85,202 83,518 82,778 85,479 82,778 Deposits 49,869 50,455 49,346 44,610 44,805 49,869 44,805 Long-term debt 14,434 16,269 15,605 16,276 16,895 14,434 16,895 Shareholders' equity 6,989 6,898 6,835 6,654 6,592 6,989 6,592 - -------------------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets 1.07% 1.05% 1.17% 1.19% 1.21% 1.06% 1.21% Return on average equity 12.98 12.91 14.46 14.74 15.16 12.94 15.34 Net interest margin (taxable equivalent) 3.85 3.86 3.98 3.99 3.98 3.86 3.96 - -------------------------------------------------------------------------------------------------------------------------------- CAPITAL RATIOS AT PERIOD END Equity to assets 8.18% 7.98% 8.02% 7.97% 7.96% 8.18% 7.96% Tangible equity to tangible assets 6.90 6.71 6.73 6.71 6.69 6.90 6.69 Tier 1 risk-based capital 8.02 8.22 8.09 8.34 8.23 8.02 8.23 Total risk-based capital 12.26 12.62 12.51 12.69 12.29 12.26 12.29 Leverage 8.12 8.12 8.15 8.15 8.14 8.12 8.14 - -------------------------------------------------------------------------------------------------------------------------------- OTHER DATA Average full-time equivalent employees 19,999 20,447 20,485 20,802 20,903 20,222 20,991 KeyCenters 903 911 910 903 905 903 905 - --------------------------------------------------------------------------------------------------------------------------------
37 LINE OF BUSINESS RESULTS This section summarizes the financial performance and related strategic developments of each of Key's three major business groups: Consumer Banking, Corporate and Investment Banking and Investment Management Services. To better understand this discussion, see Note 4 ("Line of Business Results"), which begins on page 12. Note 4 includes a brief description of the products and services offered by each of the three major business groups, more detailed financial information pertaining to the groups and their respective lines of business and brief descriptions of "Other Segments" and "Reconciling Items" presented in Figure 2. Figure 2 summarizes the contribution made by each major business group to Key's taxable-equivalent revenue and net income for the three- and six-month periods ended June 30, 2003 and 2002. FIGURE 2. MAJOR BUSINESS GROUPS - TAXABLE-EQUIVALENT REVENUE AND NET INCOME
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE --------------------------- ------------------ ------------------------- ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- REVENUE (TAXABLE EQUIVALENT) Consumer Banking $ 581 $ 573 $ 8 1.4 % $ 1,139 $ 1,126 $ 13 1.2% Corporate and Investment Banking 385 381 4 1.0 754 775 (21) (2.7) Investment Management Services 187 221 (34) (15.4) 379 434 (55) (12.7) Other Segments 23 -- 23 N/M 22 (1) 23 N/M - ---------------------------------------------------------------------------------------------------------------------------------- Total segments 1,176 1,175 1 .1 2,294 2,334 (40) (1.7) Reconciling items (32) (6) (26) (433.3) (50) (20) (30) (150.0) - ---------------------------------------------------------------------------------------------------------------------------------- Total $ 1,144 $ 1,169 $ (25) (2.1)% $ 2,244 $ 2,314 $ (70) (3.0)% ======= ======= ======= ======= ======= ====== NET INCOME (LOSS) Consumer Banking $ 100 $ 108 $ (8) (7.4)% $ 193 $ 192 $ 1 .5% Corporate and Investment Banking 92 95 (3) (3.2) 185 204 (19) (9.3) Investment Management Services 15 31 (16) (51.6) 36 56 (20) (35.7) Other Segments 19 5 14 280.0 25 11 14 127.3 - ---------------------------------------------------------------------------------------------------------------------------------- Total segments 226 239 (13) (5.4) 439 463 (24) (5.2) Reconciling items (1) 7 (8) N/M 3 23 (20) (87.0) - ---------------------------------------------------------------------------------------------------------------------------------- Total $ 225 $ 246 $ (21) (8.5)% $ 442 $ 486 $ (44) (9.1)% ======= ======= ======= ======= ======= ====== - ----------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful CONSUMER BANKING As shown in Figure 3, net income for Consumer Banking was $100 million for the second quarter of 2003, representing an $8 million decrease from the year-ago quarter. The decline was attributable to a reduction in noninterest income and a higher level of noninterest expense. These negative changes were partially offset by an increase in taxable-equivalent net interest income and a lower provision for loan losses. Taxable-equivalent net interest income grew by $11 million, or 2%, from the second quarter of 2002, due largely to an improved interest rate spread on earning assets, a 3% increase in average loans outstanding, primarily in the home equity and commercial portfolios, and a higher level of core deposits. These positive results were offset in part by a decline in yield-related loan fees, reflecting our efforts to exit the automobile leasing business. Noninterest income decreased by $3 million, or 2%, due primarily to a $10 million reduction in service charges on deposit accounts generated by the Retail Banking line of business. The decrease in deposit service charges reflects lower overdraft fees, as well as the introduction of free checking products during the second half of 2002. The overall reduction in noninterest income was moderated, however, by increases in mortgage loan processing fees and net gains from loan sales, both in the National Home Equity unit. 38 Noninterest expense rose by $25 million, or 8%, from the second quarter of 2002. Increases in personnel expense, professional fees and various indirect charges accounted for the increase. The provision for loan losses decreased by $5 million, or 7%, reflecting a lower level of net charge-offs in the Indirect Lending unit. This improvement was largely the result of Key's decision in 2001 to exit the automobile leasing business and to scale back indirect prime automobile lending to footprint markets. FIGURE 3. CONSUMER BANKING
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE --------------------------- ------------------ ------------------------- ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 459 $ 448 $ 11 2.5% $ 904 $ 884 $ 20 2.3% Noninterest income 122 125 (3) (2.4) 235 242 (7) (2.9) - ----------------------------------------------------------------------------------------------------------------------------------- Total revenue (TE) 581 573 8 1.4 1,139 1,126 13 1.2 Provision for loan losses 65 70 (5) (7.1) 143 152 (9) (5.9) Noninterest expense 356 331 25 7.6 687 667 20 3.0 - ----------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 160 172 (12) (7.0) 309 307 2 .7 Allocated income taxes and TE adjustments 60 64 (4) (6.3) 116 115 1 .9 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 100 $ 108 $ (8) (7.4)% $ 193 $ 192 $ 1 .5% ======= ======= ======= ======= ======= ======= Percent of consolidated net income 44% 44% N/A N/A 44% 39% N/A N/A AVERAGE BALANCES Loans $28,827 $27,926 $ 901 3.2% $28,628 $27,624 $ 1,004 3.6% Total assets 31,251 30,268 983 3.2 31,054 29,973 1,081 3.6 Deposits 34,781 33,976 805 2.4 34,572 34,142 430 1.3 - -----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE ADDITIONAL CONSUMER BANKING DATA --------------------------- ------------------ ------------------------- ----------------- dollars in billions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- AVERAGE DEPOSITS OUTSTANDING Noninterest-bearing $ 5,421 $ 5,057 $ 364 7.2% $ 5,360 $ 5,005 $ 355 7.1% Money market deposit accounts and other savings 15,178 12,869 2,309 17.9 14,863 12,889 1,974 15.3 Time 14,182 16,050 (1,868) (11.6) 14,349 16,248 (1,899) (11.7) - ----------------------------------------------------------------------------------------------------------------------------------- Total deposits $34,781 $33,976 $ 805 2.4% $34,572 $34,142 $ 430 1.3% ======= ======= ======= ======= ======= ======= - -----------------------------------------------------------------------------------------------------------------------------------
HOME EQUITY LOANS RETAIL BANKING AND SMALL BUSINESS Average balance $ 8.0 $ 6.9 Average loan-to-value ratio 72% 73% Percent first lien positions 56 47 NATIONAL HOME EQUITY Average balance $ 5.1 $ 4.9 Average loan-to-value ratio 75% 76% Percent first lien positions 81 83 - ---------------------------------------------------------------- OTHER DATA On-line clients / percent penetration 665,781 / 35% 489,632 / 28% KeyCenters 903 905 Automated teller machines 2,159 2,284 - ----------------------------------------------------------------
CORPORATE AND INVESTMENT BANKING As shown in Figure 4, net income for Corporate and Investment Banking was $92 million for the second quarter of 2003, down from $95 million for the same period last year. A reduction in taxable-equivalent net interest income and higher noninterest expense accounted for the decrease. These negative changes were offset by an increase in noninterest income and a lower provision for loan losses. Taxable-equivalent net interest income decreased by $8 million, or 3%, from the second quarter of 2002 due primarily to a less favorable interest rate spread on deposits and other funding sources, as well as a decline in average loans outstanding. The adverse effect of these factors was partially offset by the positive effect of deposit growth. 39 Noninterest income increased by $12 million, or 11%, due primarily to increases in non-yield-related loan fees and net gains from loan sales in the KeyBank Real Estate Capital line of business. In addition, results benefited from higher net gains from the residual values of leased equipment in Key Equipment Finance. These positive changes were partially offset by lower income from investment banking and capital markets activities, mainly in the Corporate Banking line. Noninterest expense increased by $13 million, or 8%, due primarily to increases in the cost of employee benefits, business and franchise taxes, and various indirect charges. FIGURE 4. CORPORATE AND INVESTMENT BANKING
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE --------------------------- ------------------ ------------------------- ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 261 $ 269 $ (8) (3.0)% $ 520 $ 542 $ (22) (4.1)% Noninterest income 124 112 12 10.7 234 233 1 .4 - ----------------------------------------------------------------------------------------------------------------------------------- Total revenue (TE) 385 381 4 1.0 754 775 (21) (2.7) Provision for loan losses 56 59 (3) (5.1) 107 110 (3) (2.7) Noninterest expense 182 169 13 7.7 350 338 12 3.6 - ----------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 147 153 (6) (3.9) 297 327 (30) (9.2) Allocated income taxes and TE adjustments 55 58 (3) (5.2) 112 123 (11) (8.9) - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 92 $ 95 $ (3) (3.2)% $ 185 $ 204 $ (19) (9.3)% ======= ======= ======= ======= ======= ======= Percent of consolidated net income 41% 39% N/A N/A 42% 42% N/A N/A AVERAGE BALANCES Loans $28,172 $29,668 $(1,496) (5.0)% $28,281 $29,754 $(1,473) (5.0)% Total assets 32,566 32,966 (400) (1.2) 32,698 33,014 (316) (1.0) Deposits 4,147 3,104 1,043 33.6 4,093 3,120 973 31.2 - -----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable INVESTMENT MANAGEMENT SERVICES As shown in Figure 5, net income for Investment Management Services was $15 million for the second quarter of 2003, down from $31 million in the second quarter of last year. The decrease was attributable to a significant reduction in noninterest income. This reduction was partially offset by an increase in taxable-equivalent net interest income and decreases in both noninterest expense and the provision for loan losses. Taxable-equivalent net interest income increased by $4 million, or 7%, from the second quarter of 2002. The growth was due primarily to an improved interest rate spread on earning assets, combined with strong growth in average deposits. Noninterest income decreased by $38 million, or 23%, as market-sensitive businesses continue to be adversely affected by the weak economy. The reduction was due primarily to an aggregate decline of $29 million in trust and investment services income in the McDonald Financial Group and in Victory Capital Management. This decline was largely attributable to a decrease over the past year in the market value of assets under management, as well as reduced revenue resulting from the June 2002 sale of Key's 401(k) plan recordkeeping business. Funds that clients elected to move from money market funds under management to FDIC insured deposit accounts with Key also contributed to the decline. Noninterest expense decreased by $7 million, or 4%, due primarily to lower variable compensation expense associated with revenue generation. 40 FIGURE 5. INVESTMENT MANAGEMENT SERVICES
THREE MONTHS ENDED JUNE 30, CHANGE SIX MONTHS ENDED JUNE 30, CHANGE --------------------------- ------------------ ------------------------- ---------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 61 $ 57 $ 4 7.0% $ 120 $ 110 $ 10 9.1% Noninterest income 126 164 (38) (23.2) 259 324 (65) (20.1) - ---------------------------------------------------------------------------------------------------------------------------------- Total revenue (TE) 187 221 (34) (15.4) 379 434 (55) (12.7) Provision for loan losses 4 6 (2) (33.3) 5 9 (4) (44.4) Noninterest expense 159 166 (7) (4.2) 317 336 (19) (5.7) - ---------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 24 49 (25) (51.0) 57 89 (32) (36.0) Allocated income taxes and TE adjustments 9 18 (9) (50.0) 21 33 (12) (36.4) - ---------------------------------------------------------------------------------------------------------------------------------- Net income $ 15 $ 31 $ (16) (51.6)% $ 36 $ 56 $ (20) (35.7)% ======= ======= ======= ======= ======= ======= Percent of consolidated net income 7% 13% N/A N/A 8% 12% N/A N/A AVERAGE BALANCES Loans $ 5,031 $ 4,892 $ 139 2.8 % $ 4,994 $ 4,796 $ 198 4.1% Total assets 6,022 5,874 148 2.5 5,973 5,818 155 2.7 Deposits 5,939 3,583 2,356 65.8 5,579 3,627 1,952 53.8 - ----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable ADDITIONAL INVESTMENT MANAGEMENT SERVICES DATA
JUNE 30, DECEMBER 31, JUNE 30, dollars in billions 2003 2002 2002 - ------------------------------------------------------------------------------------------------------- Assets under management $ 63.3 $ 61.7 $ 70.7 Nonmanaged and brokerage assets 61.5 65.0 72.0 - -------------------------------------------------------------------------------------------------------
OTHER SEGMENTS Other segments consist primarily of Treasury, Principal Investing and the net effect of funds transfer pricing. These segments generated net income of $19 million for the second quarter of 2003, compared with net income of $5 million for the same period last year. The improvement reflects net gains of $20 million ($12 million after tax) from principal investing in the second quarter of 2003, compared with net losses of less than $2 million for the year-ago quarter. 41 RESULTS OF OPERATIONS NET INTEREST INCOME Key's principal source of earnings is net interest income, which includes interest paid to Key on earning assets such as loans and securities, as well as loan-related fee income; less interest expense paid on deposits and borrowings. There are several factors that affect net interest income, including: - - the volume, pricing, mix and maturity of earning assets and interest-bearing liabilities; - - the use of derivative instruments to manage interest rate risk; - - market interest rate fluctuations; and - - asset quality. To make it easier to compare results among several periods and the yields on various types of earning assets, we present net interest income in this discussion on a "taxable-equivalent basis." In other words, if we earn $100 of tax-exempt income, we present those earnings at a higher amount (specifically, $154) that--if taxed at the statutory federal income tax rate of 35%--would yield $100. Figure 7, which spans pages 44 and 45, shows the various components of Key's balance sheet that affect interest income and expense, and their respective yields or rates over the past five quarters. This figure also reconciles taxable-equivalent net interest income for each of those quarters to net interest income reported under generally accepted accounting principles ("GAAP"). Taxable-equivalent net interest income for the second quarter of 2003 was $710 million, compared with $721 million a year ago. This decrease reflects the negative effect of a lower net interest margin, which decreased 13 basis points to 3.85%. The net interest margin is an indicator of the profitability of the earning asset portfolio and is calculated by dividing net interest income by average earning assets. During the same period, average earning assets grew by 2% to $73.9 billion. The combination of a soft economy and significant growth in core deposits affected the net interest margin, as well as the size and composition of Key's earning assets portfolio. Over the past twelve months, core deposit growth has exceeded net loan growth. The excess funds have been either invested in securities or used to reduce wholesale funding. Although these actions improved Key's liquidity, the weak demand for commercial loans has placed pressure on the net interest margin. This pressure is expected to continue as a result of the Federal Reserve Board's most recent cut in interest rates in June 2003. NET INTEREST MARGIN. Key's net interest margin decreased over the past twelve months, primarily because: - - competitive market conditions precluded us from passing on the full amount of the Federal Reserve Board's reductions in interest rates to clients' deposit accounts; - - we have experienced a higher level of loan refinancings and prepayments as a result of the low interest rate environment; and - - we invested more heavily in securities available for sale since opportunities to originate loans, which typically have higher interest rate spreads, have been adversely affected by the weak economy. INTEREST EARNING ASSETS. Average earning assets for the second quarter of 2003 totaled $73.9 billion, which was $1.4 billion, or 2%, higher than the second quarter 2002 level. This growth came principally from home equity lending and the securities available-for-sale portfolio. During the same period, soft loan demand resulting from the general economic slowdown contributed to a decline in average commercial loans outstanding. 42 Over the past twelve months, the growth and composition of Key's loan portfolio has been affected by the following actions: - - During the first quarter of 2003, we acquired a $311 million commercial lease financing portfolio and a $71 million commercial loan portfolio from a Canadian financial institution. The acquisition of these portfolios further diversifies our asset base and is expected to result in additional equipment financing opportunities. - - During the second quarter of 2001, management announced that Key would exit the automobile leasing business, de-emphasize indirect prime automobile lending and discontinue certain credit-only commercial relationships. As of June 30, 2003, these portfolios, in the aggregate, have declined by approximately $4.0 billion since the date of the announcement and by approximately $1.6 billion since June 30, 2002. - - We sold commercial mortgage loans of $661 million during the first six months of 2003 and $1.4 billion during 2002. Since some of these loans have been sold with limited recourse, Key established a loss reserve of an amount estimated by management to be appropriate to reflect the recourse risk. More information about the related recourse agreement is provided in Note 10 ("Contingent Liabilities and Guarantees") under the section entitled "Recourse agreement with Federal National Mortgage Association" on page 27. Our business of originating and servicing commercial mortgage loans has grown in part as a result of acquiring Conning Asset Management in the second quarter of 2002 and both Newport Mortgage Company, L.P. and National Realty Funding L.C. in 2000. - - We sold other loans totaling $619 million during the first half of 2003 and $1.9 billion during 2002. These sales included education loans of $156 million during the first six months of 2003 and $1.1 billion ($750 million through securitizations) during 2002. Figure 6 shows how the changes in yields or rates and average balances from the prior year affected net interest income. The section entitled "Financial Condition," which begins on page 52, contains more discussion about changes in earning assets and funding sources. FIGURE 6. COMPONENTS OF NET INTEREST INCOME CHANGES
FROM THREE MONTHS ENDED JUNE 30, 2002 FROM SIX MONTHS ENDED JUNE 30, 2002 TO THREE MONTHS ENDED JUNE 30, 2003 TO SIX MONTHS ENDED JUNE 30, 2003 ------------------------------------- ------------------------------------ AVERAGE YIELD/ NET AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE VOLUME RATE CHANGE - ------------------------------------------------------------------------------------------------------------------------------ INTEREST INCOME Loans $ (14) $ (90) $ (104) $ (25) $ (184) $ (209) Tax-exempt investment securities (2) 1 (1) (4) - (4) Securities available for sale 31 (30) 1 65 (53) 12 Short-term investments - - - (2) 2 - Other investments 1 (1) - 2 (2) - - ------------------------------------------------------------------------------------------------------------------------------ Total interest income (taxable equivalent) 16 (120) (104) 36 (237) (201) INTEREST EXPENSE NOW and money market deposit accounts 10 2 12 19 4 23 Certificates of deposit ($100,000 or more) (1) (8) (9) 1 (20) (19) Other time deposits (15) (32) (47) (32) (75) (107) Deposits in foreign office (1) (3) (4) (2) (5) (7) - ------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing deposits (7) (41) (48) (14) (96) (110) Federal funds purchased and securities sold under repurchase agreements (2) (7) (9) (5) (13) (18) Bank notes and other short-term borrowings (4) (1) (5) (12) (2) (14) Long-term debt, including capital securities (7) (24) (31) 2 (51) (49) - ------------------------------------------------------------------------------------------------------------------------------ Total interest expense (20) (73) (93) (29) (162) (191) - ------------------------------------------------------------------------------------------------------------------------------ Net interest income (taxable equivalent) $ 36 $ (47) $ (11) $ 65 $ (75) $ (10) ======= ====== ====== ======= ====== ====== - ------------------------------------------------------------------------------------------------------------------------------
The change in interest not due solely to volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each. 43 FIGURE 7. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
SECOND QUARTER 2003 FIRST QUARTER 2003 ---------------------------- ----------------------------- AVERAGE YIELD/ AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE - ------------------------------------------------------------------------------------------------------------------- ASSETS Loans(a,b) Commercial, financial and agricultural $17,391 $ 218 5.01% $17,221 $ 206 4.86% Real estate -- commercial mortgage 5,932 80 5.38 6,034 82 5.49 Real estate -- construction 5,331 68 5.14 5,683 72 5.16 Commercial lease financing 7,883 119 6.05 7,790 123 6.30 - ------------------------------------------------------------------------------------------------------------------ Total commercial loans 36,537 485 5.32 36,728 483 5.31 Real estate -- residential 1,803 30 6.54 1,904 32 6.66 Home equity 14,433 219 6.09 14,005 217 6.29 Consumer - direct 2,135 40 7.44 2,129 40 7.68 Consumer - indirect lease financing 601 14 9.40 772 18 9.40 Consumer - indirect other 5,002 105 8.43 4,917 107 8.74 - ------------------------------------------------------------------------------------------------------------------ Total consumer loans 23,974 408 6.82 23,727 414 7.05 Loans held for sale 2,518 29 4.70 2,390 28 4.70 - ------------------------------------------------------------------------------------------------------------------ Total loans 63,029 922 5.86 62,845 925 5.95 Taxable investment securities 5 -- 5.44 2 -- 8.43 Tax-exempt investment securities(a) 110 3 9.46 125 3 8.89 - ------------------------------------------------------------------------------------------------------------------ Total investment securities 115 3 9.27 127 3 8.88 Securities available for sale(a,c) 8,321 97 4.68 7,790 101 5.21 Short-term investments 1,484 8 2.12 1,706 8 1.87 Other investments(c) 985 6 2.47 956 6 2.46 - ------------------------------------------------------------------------------------------------------------------ Total earning assets 73,934 1,036 5.61 73,424 1,043 5.73 Allowance for loan losses (1,409) (1,438) Accrued income and other assets 12,187 11,928 - ------------------------------------------------------------------------------------------------------------------ $84,712 $83,914 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY NOW and money market deposit accounts $17,740 41 .93 $16,747 42 1.03 Savings deposits 2,084 3 .54 2,043 3 .60 Certificates of deposit ($100,000 or more)(d) 4,743 47 3.98 4,654 48 4.20 Other time deposits 11,434 84 2.96 11,799 90 3.09 Deposits in foreign office 2,445 8 1.25 1,719 5 1.24 - ------------------------------------------------------------------------------------------------------------------ Total interest-bearing deposits 38,446 183 1.91 36,962 188 2.07 Federal funds purchased and securities sold under repurchase agreements 5,075 15 1.19 4,800 14 1.19 Bank notes and other short-term borrowings(d) 2,351 15 2.58 2,801 18 2.65 Long-term debt, including capital securities(d) 16,309 113 2.90 17,279 120 2.90 - ------------------------------------------------------------------------------------------------------------------ Total interest-bearing liabilities 62,181 326 2.13 61,842 340 2.25 Noninterest-bearing deposits 10,053 9,788 Accrued expense and other liabilities 5,526 5,465 Common shareholders' equity 6,952 6,819 - ------------------------------------------------------------------------------------------------------------------ $84,712 $83,914 ======= ======= Interest rate spread (TE) 3.48% 3.48% - ------------------------------------------------------------------------------------------------------------------ Net interest income (TE) and net interest margin (TE) 710 3.85% 703 3.86% ==== ==== TE adjustment(a) 14 22 - ------------------------------------------------------------------------------------------------------------------ Net interest income, GAAP basis $ 696 $ 681 ====== ====== Capital securities $ 1,266 $ 18 $ 1,254 $ 18 - ------------------------------------------------------------------------------------------------------------------
(a) Interest income on tax-exempt securities and loans has been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%. (b) For purposes of these computations, nonaccrual loans are included in average loan balances. (c) Yield is calculated on the basis of amortized cost. (d) Rate calculation excludes basis adjustments related to fair value hedges. See Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's Annual Report to Shareholders, for an explanation of fair value hedges. TE = Taxable Equivalent GAAP = Generally Accepted Accounting Principles 44 FIGURE 7. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES (CONTINUED)
FOURTH QUARTER 2002 THIRD QUARTER 2002 SECOND QUARTER 2002 - ---------------------------- ----------------------------- ----------------------------- AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/ BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE - ---------------------------------------------------------------------------------------------------- $17,362 $ 220 5.01% $17,485 $ 225 5.11% $18,213 $ 232 5.11% 6,168 88 5.66 6,207 93 5.92 6,414 95 5.94 5,856 78 5.27 5,822 79 5.37 5,870 79 5.40 7,356 112 6.13 7,215 121 6.72 7,206 126 6.96 - --------------------------------------------------------------------------------------------------- 36,742 498 5.39 36,729 518 5.60 37,703 532 5.65 2,029 33 6.72 2,089 37 7.00 2,148 38 7.04 13,649 226 6.55 13,505 222 6.52 13,072 229 7.03 2,153 44 8.17 2,172 46 8.32 2,210 46 8.37 1,001 24 9.42 1,264 28 8.98 1,514 33 8.84 5,117 116 9.05 5,143 117 9.13 5,131 118 9.19 - --------------------------------------------------------------------------------------------------- 23,949 443 7.36 24,173 450 7.41 24,075 464 7.73 1,986 26 5.28 2,584 35 5.48 2,150 30 5.58 - --------------------------------------------------------------------------------------------------- 62,677 967 6.14 63,486 1,003 6.29 63,928 1,026 6.43 1 -- 8.85 1 -- 8.45 1 -- 8.17 132 3 9.32 166 4 8.76 205 4 8.31 - --------------------------------------------------------------------------------------------------- 133 3 9.31 167 4 8.75 206 4 8.31 7,598 106 5.60 6,424 98 6.11 6,014 96 6.40 1,240 7 2.12 1,151 6 2.28 1,561 8 1.97 906 6 2.39 855 6 2.46 870 6 3.14 - --------------------------------------------------------------------------------------------------- 72,554 1,089 5.97 72,083 1,117 6.17 72,579 1,140 6.30 (1,471) (1,509) (1,579) 11,652 11,361 10,560 - --------------------------------------------------------------------------------------------------- $82,735 $81,935 $81,560 ======= ======= ======= $15,131 40 1.03 $13,293 30 .91 $13,232 29 .88 1,981 4 .63 2,002 3 .67 2,014 3 .67 4,741 51 4.29 4,886 54 4.45 4,816 56 4.69 12,213 101 3.29 12,713 115 3.57 13,085 131 4.02 1,974 6 1.43 2,593 12 1.76 2,638 12 1.76 - --------------------------------------------------------------------------------------------------- 36,040 202 2.22 35,487 214 2.40 35,785 231 2.59 5,502 20 1.44 5,483 23 1.69 5,541 24 1.71 2,192 14 2.53 2,581 18 2.73 2,995 20 2.73 17,040 129 3.09 17,455 140 3.25 17,230 144 3.37 - --------------------------------------------------------------------------------------------------- 60,774 365 2.40 61,006 395 2.59 61,551 419 2.73 9,926 9,177 8,719 5,314 5,159 4,783 6,721 6,593 6,507 - --------------------------------------------------------------------------------------------------- $82,735 $81,935 $81,560 ======= ======= ======= 3.57% 3.58% 3.57% - --------------------------------------------------------------------------------------------------- 724 3.98% 722 3.99% 721 3.98% ==== ==== ===== 12 22 38 - --------------------------------------------------------------------------------------------------- $ 712 $ 700 $ 683 ====== ===== ===== $ 1,233 $ 18 $ 1,249 $ 19 $ 1,236 $ 20 - ---------------------------------------------------------------------------------------------------
45 MARKET RISK MANAGEMENT The values of some financial instruments vary not only with changes in market interest rates, but also with changes in foreign exchange rates, factors influencing valuations in the equity securities markets, and other market-driven rates or prices. For example, the value of a fixed-rate bond will decline if market interest rates increase. As a result, the bond will become a less attractive investment to the holder. Similarly, the value of the U.S. dollar regularly fluctuates in relation to other currencies. The exposure that instruments tied to such external factors present is called "market risk." Most of Key's market risk is derived from interest rate fluctuations. INTEREST RATE RISK MANAGEMENT Key's Asset/Liability Management Policy Committee has developed a program to measure and manage interest rate risk. This committee is also responsible for approving Key's asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing Key's interest rate sensitivity exposure. FACTORS CONTRIBUTING TO INTEREST RATE EXPOSURE. Key uses interest rate exposure models to quantify the potential impact on earnings and economic value of equity arising from a variety of possible future interest rate scenarios. The many interest rate scenarios modeled estimate the level of Key's interest rate exposure arising from option risk, basis risk and gap risk. Each of these types of risk is defined in the discussion of market risk management, which begins on page 30 of Key's 2002 Annual Report to Shareholders. MEASUREMENT OF SHORT-TERM INTEREST RATE EXPOSURE. Key uses a net interest income simulation model to measure interest rate risk over a short time frame. These simulations estimate the impact that various changes in the overall level of interest rates over one- and two-year time horizons would have on net interest income. The results help Key develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions and judgments. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates, and on- and off-balance sheet management strategies. Management believes that, both individually and in the aggregate, the assumptions Key makes are reasonable. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure. Key's guidelines for risk management call for preventive measures to be taken if the simulation modeling demonstrates that a gradual 200 basis point increase or decrease in short-term rates over the next twelve months would adversely affect net interest income over the same period by more than 2%. Key is operating within these guidelines. Since short-term interest rates were relatively low at June 30, 2003, management modified Key's standard rate scenario of a gradual decrease of 200 basis points over twelve months to a gradual decrease of 25 basis points over the next two months and no change over the following ten months. As of June 30, 2003, based on the results of our simulation model, and assuming that management does not take action to alter the outcome, Key would expect net interest income to decrease by approximately 1.13% over the next twelve months if short-term interest rates gradually increase by 200 basis points. Conversely, if short-term interest rates gradually decrease by 25 basis points, net interest income would be expected to increase by approximately .11% over the next twelve months. MEASUREMENT OF LONG-TERM INTEREST RATE EXPOSURE. Key uses an economic value of equity model to complement short-term interest rate risk analysis. The benefit of this model is that it measures exposure to interest rate changes over time frames longer than two years. The economic value of Key's equity is determined by aggregating the present value of projected future cash flows for asset, liability and derivative positions based on the current yield curve. However, economic value does not represent the fair values of asset, liability and derivative positions since it does not consider factors like credit risk and liquidity. Key's guidelines for risk management call for preventive measures to be taken if an immediate 200 basis point increase or decrease in interest rates is estimated to reduce the economic value of equity by more than 15%. Key is operating within these guidelines. Certain short-term interest rates were limited to reductions of less than 200 basis points since interest rates cannot decrease below zero in Key's economic value of equity model. 46 MANAGEMENT OF INTEREST RATE EXPOSURE. Management uses the results of short-term and long-term interest rate exposure models to formulate strategies to improve balance sheet positioning, earnings, or both, within the bounds of Key's interest rate risk, liquidity and capital guidelines. We manage interest rate risk by using portfolio swaps and caps, which modify the repricing or maturity characteristics of some of our assets and liabilities. The decision to use these instruments rather than securities, debt or other on-balance sheet alternatives depends on many factors, including the mix and cost of funding sources, liquidity and capital requirements, and interest rate implications. A brief description of interest rate swaps and caps is included in the discussion of market risk management, which begins on page 30 of Key's 2002 Annual Report to Shareholders. For more information about how Key uses interest rate swaps and caps to manage its balance sheet, see Note 11 ("Derivatives and Hedging Activities"), which begins on page 29. Over the past year, we have invested more heavily in collateralized mortgage obligations as opportunities to originate loans have been adversely affected by the weak economy, while our core deposits have grown significantly. These securities, the majority of which have relatively short average lives, have been used in conjunction with swaps and caps to manage our interest rate risk position. TRADING PORTFOLIO RISK MANAGEMENT Key's trading portfolio is described in Note 11. Management uses a value at risk ("VAR") model to estimate the potential adverse effect of changes in interest and foreign exchange rates, and equity prices on the fair value of Key's trading portfolio. Using statistical methods, this model estimates the maximum potential one-day loss with 95% probability. At June 30, 2003, Key's aggregate daily VAR was $1.4 million, compared with $1.8 million at June 30, 2002. Aggregate daily VAR averaged $1.2 million for the first six months of 2003, compared with an average of $1.6 million for the same period last year. VAR modeling augments other controls that Key uses to mitigate the market risk exposure of the trading portfolio. These controls include loss and portfolio size limits that are based on market liquidity and the level of activity and volatility of trading products. 47 NONINTEREST INCOME Noninterest income for the second quarter of 2003 was $434 million, down $14 million, or 3%, from the same period last year. For the first six months of the year, noninterest income was $831 million, representing a decrease of $60 million, or 7%, from the first six months of 2002. As shown in Figure 8, the reduction in noninterest income for both the quarterly and year-to-date periods was due primarily to lower income from trust and investment services, and service charges on deposit accounts. These negative changes were offset in part by increases in non-yield-related loan fees and net gains from loan sales. FIGURE 8. NONINTEREST INCOME
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, CHANGE JUNE 30, CHANGE ------------------ -------------------- ------------------ ------------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- Trust and investment services income $131 $158 $ (27) (17.1)% $263 $316 $ (53) (16.8)% Service charges on deposit accounts 91 104 (13) (12.5) 183 204 (21) (10.3) Investment banking and capital markets income 53 47 6 12.8 87 96 (9) (9.4) Letter of credit and loan fees 40 29 11 37.9 71 57 14 24.6 Corporate-owned life insurance income 27 26 1 3.8 54 52 2 3.8 Electronic banking fees 22 20 2 10.0 41 38 3 7.9 Net securities gains 3 1 2 200.0 7 1 6 600.0 Other income: Insurance income 13 15 (2) (13.3) 26 28 (2) (7.1) Net gains from loan securitizations and sales 14 3 11 366.7 29 9 20 222.2 Loan securitization servicing fees 2 2 -- -- 4 5 (1) (20.0) Credit card fees 3 2 1 50.0 6 4 2 50.0 Miscellaneous income 35 41 (6) (14.6) 60 81 (21) (25.9) - -------------------------------------------------------------------------------------------------------------------------------- Total other income 67 63 4 6.3 125 127 (2) (1.6) - -------------------------------------------------------------------------------------------------------------------------------- Total noninterest income $434 $448 $ (14) (3.1)% $831 $891 $ (60) (6.7)% ==== ==== ====== ==== ==== ====== - --------------------------------------------------------------------------------------------------------------------------------
The discussion that follows provides additional information, such as the composition of certain components of Key's noninterest income and the factors that caused them to change from the prior year. TRUST AND INVESTMENT SERVICES INCOME. Trust and investment services provide Key's largest source of noninterest income. Its primary components are shown in Figure 9. A significant portion of this income is based on the value of assets under management. Thus, over the past twelve months, the level of revenue derived from these services has been adversely affected by declines in the equity markets. FIGURE 9. TRUST AND INVESTMENT SERVICES INCOME
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, CHANGE JUNE 30, CHANGE ------------------ -------------------- ------------------ ------------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- Personal asset management and custody fees $ 36 $ 41 $ (5) (12.2)% $ 71 $ 81 $ (10) (12.3)% Institutional asset management and custody fees 9 20 (11) (55.0) 20 40 (20) (50.0) Bond services 9 10 (1) (10.0) 19 20 (1) (5.0) Brokerage commission income 48 50 (2) (4.0) 95 101 (6) (5.9) All other fees 29 37 (8) (21.6) 58 74 (16) (21.6) - -------------------------------------------------------------------------------------------------------------------------------- Total trust and investment services income $131 $158 $ (27) (17.1)% $263 $316 $ (53) (16.8)% ==== ==== ===== ==== ==== ===== - --------------------------------------------------------------------------------------------------------------------------------
At June 30, 2003, Key's bank, trust and registered investment advisory subsidiaries had assets under management of $63.3 billion, compared with $70.7 billion at June 30, 2002. These assets are managed on behalf of both institutions and individuals through a variety of equity, fixed income and money market accounts. The composition of Key's assets under management is shown in Figure 10. The 10% decrease in the value of assets under management over the past twelve months reflects a decline in the market value of those assets as well as net asset outflows of approximately $4 billion. The June 2002 sale of Key's 401(k) plan recordkeeping business, which accounted for most of the net asset outflows, accounted for $14 million of the decrease in income from trust and investment services from the second quarter of 2002 and $22 million of the decrease from the first six months of 2002. 48 FIGURE 10. ASSETS UNDER MANAGEMENT
2003 2002 ------------------ ----------------------------- in millions SECOND FIRST FOURTH THIRD SECOND - --------------------------------------------------------------------------------------------------------- Assets under management by investment type: Equity $26,931 $25,415 $27,224 $25,422 $31,064 Fixed income 17,121 16,310 16,133 17,588 18,905 Money market 19,250 19,073 18,337 19,364 20,756 - --------------------------------------------------------------------------------------------------------- Total $63,302 $60,798 $61,694 $62,374 $70,725 ======= ======= ======= ======= ======= Proprietary mutual funds included in assets under management: Equity $ 2,604 $ 2,236 $ 2,878 $ 2,965 $ 3,709 Fixed income 1,144 1,125 1,215 1,377 1,262 Money market 10,362 10,762 11,457 12,129 12,568 - --------------------------------------------------------------------------------------------------------- Total $14,110 $14,123 $15,550 $16,471 $17,539 ======= ======= ======= ======= ======= - ---------------------------------------------------------------------------------------------------------
SERVICE CHARGES ON DEPOSIT ACCOUNTS. Service charges on deposit accounts have declined in each of the past five quarters due primarily to lower overdraft and maintenance fees. The decrease in maintenance fees is attributable to free checking products, which were introduced in the third quarter of 2002 and rolled out to all of Key's markets by the end of the year. INVESTMENT BANKING AND CAPITAL MARKETS INCOME. As shown in Figure 11, the year-to-date decrease in investment banking and capital markets income resulted from declines in three of its four major revenue sources, reflecting the adverse effects of a soft economy. Key's principal investing income is susceptible to volatility since it is derived from investments in small to medium-sized businesses, many of which are in relatively early stages of economic development and strategy implementation. Principal investments consist of direct and indirect investments in predominantly privately-held companies and are carried on the balance sheet at fair value ($717 million at June 30, 2003, and $652 million at June 30, 2002). Thus, the net gains and losses presented in Figure 11 stem from changes in estimated fair values, as well as actual gains and losses on sales of principal investments. FIGURE 11. INVESTMENT BANKING AND CAPITAL MARKETS INCOME
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, CHANGE JUNE 30, CHANGE ------------------ ---------------- ---------------- ---------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- Dealer trading and derivatives income $ 3 $ 7 $ (4) (57.1)% $ 11 $ 24 $ (13) (54.2)% Investment banking income 22 34 (12) (35.3) 44 55 (11) (20.0) Net gains (losses) from principal investing 20 (2) 22 N/M 17 (1) 18 N/M Foreign exchange income 8 8 -- -- 15 18 (3) (16.7) - --------------------------------------------------------------------------------------------------------------------------------- Total investment banking and capital markets income $ 53 $ 47 $ 6 12.8 % $ 87 $ 96 $ (9) (9.4)% ==== ==== ===== ==== ==== ===== - ---------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful LETTER OF CREDIT AND LOAN FEES. As shown in Figure 8, letter of credit and loan fees were up from the prior year on both a quarterly and year-to-date basis due primarily to higher syndication fees and agency origination fees generated during the second quarter of 2003 by the KeyBank Real Estate Capital line of business. OTHER INCOME. Compared with the prior year, other income was affected by offsetting items as shown in Figure 8. Increases in net gains from loan securitizations and sales were offset in part by higher net losses from the sales of residual values of leased equipment included in miscellaneous income. These losses were up $4 million from the second quarter of 2002 and $15 million from the first half of last year. 49 NONINTEREST EXPENSE Noninterest expense for the second quarter of 2003 was $688 million, up $23 million, or 4%, from the same period last year. For the first six months of the year, noninterest expense was $1.3 billion, representing an increase of only $19 million, or 1%, from the first six months of 2002. As shown in Figure 12, increases in professional fees and personnel expense drove the increase in noninterest expense for both the quarterly and year-to-date periods. The aggregate increase in these expense components for the year-to-date period was substantially offset, however, by a reduction in computer processing expense. FIGURE 12. NONINTEREST EXPENSE
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, CHANGE JUNE 30, CHANGE ------------------ ---------------- ----------------- ---------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - --------------------------------------------------------------------------------------------------------------------------- Personnel $ 371 $ 361 $ 10 2.8 % $ 734 $ 724 $ 10 1.4 % Net occupancy 56 56 -- -- 115 113 2 1.8 Computer processing 44 48 (4) (8.3) 88 102 (14) (13.7) Equipment 34 36 (2) (5.6) 66 70 (4) (5.7) Marketing 33 30 3 10.0 58 56 2 3.6 Professional fees 32 21 11 52.4 57 42 15 35.7 Other expense: Postage and delivery 13 14 (1) (7.1) 28 29 (1) (3.4) Telecommunications 8 9 (1) (11.1) 16 17 (1) (5.9) Equity- and gross receipts-based taxes 5 7 (2) (28.6) 10 13 (3) (23.1) OREO expense, net 4 2 2 100.0 5 3 2 66.7 Miscellaneous expense 88 81 7 8.6 168 157 11 7.0 - ------------------------------------------------------------------------------------------------------------------------- Total other expense 118 113 5 4.4 227 219 8 3.7 - ------------------------------------------------------------------------------------------------------------------------- Total noninterest expense $ 688 $ 665 $ 23 3.5 % $ 1,345 $ 1,326 $ 19 1.4% ======= ======== ===== ======= ======= ===== Average full-time equivalent employees 19,999 20,903 (904) (4.3)% 20,222 20,991 (769) (3.7)% - -------------------------------------------------------------------------------------------------------------------------
The discussion that follows explains the composition of certain components of Key's noninterest expense and the factors that caused them to change from the prior year. PERSONNEL. Personnel expense, the largest category of Key's noninterest expense, rose by a modest $10 million, or 1%, from the first six months of 2002. This result reflected a rise in employee benefit costs (primarily pension costs), offset in part by lower incentive compensation accruals. The level of Key's personnel expense continues to reflect the benefits derived from a competitiveness initiative completed last year, as well as the continuous improvement efforts that have evolved from it. We will continue to evaluate staffing levels and to make appropriate changes when they can be accomplished without negatively affecting either customer service or our ability to grow higher return businesses. For the second quarter of 2003, the number of average full-time equivalent employees was 19,999, compared with 20,447 for the first quarter of 2003 and 20,903 for the year-ago quarter. Figure 13 shows the major components of Key's personnel expense. Effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123, "Accounting for Stock-Based Compensation." Compensation expense related to stock option grants totaled less than $1 million in the first half of 2003 and is included in incentive compensation in Figure 13. Additional information pertaining to this accounting change is included in Note 1 ("Basis of Presentation") under the headings "Stock-Based Compensation" on page 8 and "Accounting Pronouncements Adopted in 2003" on page 9. FIGURE 13. PERSONNEL EXPENSE
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, CHANGE JUNE 30, CHANGE ------------------ ---------------- ---------------- ---------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------- Salaries $ 220 $ 215 $ 5 2.3 % $ 445 $ 431 $ 14 3.2% Employee benefits 64 55 9 16.4 136 118 18 15.3 Incentive compensation 87 91 (4) (4.4) 153 175 (22) (12.6) - -------------------------------------------------------------------------------------------------------------- Total personnel expense $ 371 $ 361 $ 10 2.8 % $ 734 $ 724 $ 10 1.4% ===== ===== ===== ===== ===== ==== - --------------------------------------------------------------------------------------------------------------
50 COMPUTER PROCESSING. The decrease in computer processing expense for both the quarterly and year-to-date periods was due primarily to a lower level of computer software amortization. This reduction is attributable to a decline in the number of capitalized software projects. PROFESSIONAL FEES. The increase in professional fees for both the quarterly and year-to-date periods reflects additional costs incurred to enhance Key's sales management systems. INCOME TAXES The provision for income taxes was $92 million for the second quarter of 2003, compared with $85 million for the comparable period in 2002. The effective tax rate, which is the provision for income taxes as a percentage of income before income taxes, was 29.0% for the second quarter of 2003, compared with 25.7% for the second quarter of 2002. For the first six months of 2003, the provision for income taxes was $166 million, compared with $145 million for the first half of 2002. The effective tax rates for these periods were 27.3% and 23.0%, respectively. As discussed below, the management of residual values of certain leases has been transferred to a foreign subsidiary in a lower tax jurisdiction. The increase in the effective tax rate for both the quarterly and year-to-date periods was due primarily to the fact that a smaller number of such leases were transferred in the current year, compared with the first six months of 2002. These rate increases were moderated in the current year, however, by tax-exempt income from corporate-owned life insurance and credits associated with investments in low-income housing projects, both of which represented a higher percentage of income before income taxes compared with the three- and six-month periods ended June 30, 2002. The effective tax rates for both the current and prior year are substantially below Key's combined statutory federal and state rate of 37.5% (37% in 2002) primarily because portions of our equipment leasing portfolio became subject to a lower income tax rate in the latter half of 2001. Responsibility for the management of portions of Key's leasing portfolio was transferred to a foreign subsidiary in a lower tax jurisdiction. Since Key intends to permanently reinvest the earnings of this subsidiary, no deferred income taxes have been recorded on those earnings in accordance with SFAS No. 109, "Accounting for Income Taxes." Other factors that account for the difference between the effective and statutory tax rates in the current and prior year include tax deductions associated with dividends paid to Key's 401(k) savings plan, income from investments in tax-advantaged assets (such as tax-exempt securities and corporate-owned life insurance) and credits associated with investments in low-income housing projects. 51 FINANCIAL CONDITION LOANS At June 30, 2003, total loans outstanding were $63.2 billion, compared with $62.5 billion at the end of 2002 and $63.9 billion a year ago. Among the factors that contributed to the decrease in our loans from one year ago are: - - Loan sales completed to improve the profitability of the overall portfolio or to accommodate our funding needs; - - Weak loan demand due to the sluggish economy; and - - Our decision to exit the automobile leasing business, de-emphasize indirect prime automobile lending and discontinue certain credit-only commercial relationships. Over the past several years, we have used alternative funding sources like loan sales and securitizations to allow us to continue to capitalize on our loan origination capabilities. In addition, Key has completed acquisitions that have improved our ability to generate and securitize new loans, especially in the area of commercial real estate. These acquisitions include the purchase of Conning Asset Management in June 2002, and both Newport Mortgage Company, L.P. and National Realty Funding L.C. in 2000. COMMERCIAL LOAN PORTFOLIO. Commercial loans outstanding decreased by $945 million, or 3%, from one year ago. Over the past year, growth in equipment lease financing receivables was more than offset by a net decline in all other commercial portfolios, reflecting continued weakness in the economy and our decision to discontinue many credit-only relationships in the leveraged financing and nationally syndicated lending businesses. One of the largest segments of Key's commercial loan portfolio is commercial real estate loans. At June 30, 2003, Key's commercial real estate portfolio included mortgage loans of $5.9 billion and construction loans of $5.2 billion. The average size of a mortgage loan was $.5 million and the largest mortgage loan had a balance of $51 million. The average size of a construction loan was $3 million. The largest construction loan commitment was $47 million, of which $32 million was outstanding. Key conducts its commercial real estate lending business through two primary sources: a 12-state banking franchise and KeyBank Real Estate Capital, a national line of business that cultivates relationships both within and beyond the branch system. This line of business deals exclusively with nonowner-occupied properties (i.e., generally properties in which the owner occupies less than 60% of the premises) and accounted for approximately 53% of Key's total average commercial real estate loans during the second quarter of 2003. At June 30, 2003, less than 2% of Key's nonowner-occupied portfolio was either nonperforming or delinquent in payments. Our commercial real estate business as a whole focuses on larger real estate developers and, as shown in Figure 14, is diversified by both industry type and geography. 52 FIGURE 14. COMMERCIAL REAL ESTATE LOANS
GEOGRAPHIC REGION JUNE 30, 2003 ------------------------------------- TOTAL PERCENT OF dollars in millions EAST MIDWEST CENTRAL WEST AMOUNT TOTAL - ---------------------------------------------------------------------------------------------------------------------- Nonowner-occupied: Multi-family properties $ 595 $ 523 $ 642 $ 703 $ 2,463 22.2% Retail properties 273 434 110 224 1,041 9.4 Office buildings 159 109 157 235 660 6.0 Residential properties 97 56 140 484 777 7.0 Warehouses 49 129 99 148 425 3.8 Manufacturing facilities 15 32 7 11 65 .6 Hotels/Motels 6 3 1 9 19 .2 Other 107 275 50 126 558 5.0 - -------------------------------------------------------------------------------------------------------------------- 1,301 1,561 1,206 1,940 6,008 54.2 Owner-occupied 634 2,355 602 1,479 5,070 45.8 - -------------------------------------------------------------------------------------------------------------------- Total $ 1,935 $ 3,916 $ 1,808 $3,419 $11,078 100.0% ======= ======= ======= ====== ======= ====== - -------------------------------------------------------------------------------------------------------------------- Nonowner-occupied: Nonperforming loans $ 4 $ 4 $ 1 $ 8 $ 17 N/M Accruing loans past due 90 days or more 2 6 -- -- 8 N/M Accruing loans past due 30 through 89 days 24 13 -- 29 66 N/M - --------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful CONSUMER LOAN PORTFOLIO. The level of consumer loans outstanding at June 30, 2003, was essentially unchanged from that reported a year ago. Our home equity portfolio increased by $1.3 billion, largely as a result of our focused efforts to grow this business, facilitated by a period of lower interest rates. The growth of the home equity portfolio was substantially offset by declines of $858 million in automobile lease financing receivables and $363 million in residential real estate mortgage loans. The decline in automobile lease financing receivables reflects our decision to exit the automobile leasing business. Excluding loan sales and acquisitions, consumer loans would have increased by $676 million, or 3%, during the past twelve months. The home equity portfolio is by far the largest segment of Key's consumer loan portfolio. Key's home equity portfolio is derived primarily from our Retail Banking line of business (53% of the home equity portfolio at June 30, 2003) and the National Home Equity unit within our Consumer Finance line of business. The National Home Equity unit has two components: Champion Mortgage Company, a home equity finance company, and Key Home Equity Services, which purchases individual loans from an extensive network of correspondents and agents. Prior to the third quarter of 2002, Key Home Equity Services also purchased loans through bulk portfolio acquisitions from home equity loan companies. The average loan-to-value ratio at origination for a loan generated by the National Home Equity unit is 75%. First lien positions comprised 81% of the portfolio for this unit at June 30, 2003. Figure 15 summarizes Key's home equity loan portfolio at the end of each of the last five quarters, as well as certain asset quality statistics and the yields achieved on the portfolio as a whole. 53 FIGURE 15. HOME EQUITY LOANS
2003 2002 ----------------------- ------------------------------------- dollars in millions SECOND FIRST FOURTH THIRD SECOND - -------------------------------------------------------------------------------------------------------------------------- SOURCES OF LOANS OUTSTANDING AT PERIOD END Retail Banking (KeyCenters) $ 7,795 $ 7,445 $ 7,212 $ 7,068 $ 6,833 McDonald Financial Group & other sources 1,775 1,700 1,655 1,612 1,548 Champion Mortgage Company 2,461 2,332 2,210 2,109 2,153 Key Home Equity Services division 2,657 2,667 2,727 2,727 2,845 - -------------------------------------------------------------------------------------------------------------------------- National Home Equity unit 5,118 4,999 4,937 4,836 4,998 - -------------------------------------------------------------------------------------------------------------------------- Total $14,688 $14,144 $13,804 $13,516 $13,379 ======= ======= ======= ======= ======= - -------------------------------------------------------------------------------------------------------------------------- Nonperforming loans at period end $ 152 $ 154 $ 146 $ 124 $ 107 Net charge-offs for the period 13 13 13 12 13 Yield for the period 6.09% 6.29% 6.55% 6.52% 7.03% - --------------------------------------------------------------------------------------------------------------------------
SALES, SECURITIZATIONS AND DIVESTITURES. During the past twelve months, Key sold $1.6 billion of commercial real estate loans, $1.0 billion of education loans ($750 million through a securitization), $508 million of home equity loans and $688 million of other types of loans. Since 1999, Key has securitized only education loans. Among the factors that Key considers in determining which loans to securitize are: - - whether the characteristics of a specific loan portfolio make it conducive to securitization; - - the relative cost of funds; - - the level of credit risk; and - - capital requirements. Figure 16 summarizes Key's loan sales (including securitizations) for the first six months of 2003 and all of 2002. FIGURE 16. LOANS SOLD AND DIVESTED
COMMERCIAL COMMERCIAL RESIDENTIAL HOME CONSUMER in millions COMMERCIAL REAL ESTATE LEASE FINANCING REAL ESTATE EQUITY --INDIRECT EDUCATION TOTAL - ------------------------------------------------------------------------------------------------------------------------- 2003 Second quarter $ 67 $ 408 -- $184 $ 83 -- $ 60 $ 802 First quarter 52 253 -- 4 73 -- 96 478 - -------------------------------------------------------------------------------------------------------------------------- Total $119 $ 661 -- $188 $156 -- $ 156 $1,280 ==== ====== === ==== ==== ==== ====== ====== 2002 Fourth quarter $ 93 $ 603 -- $ 65 $110 $177 $ 100 $1,148 Third quarter 18 352 -- 25 242 3 784 1,424 Second quarter 31 159 $18 20 24 -- 70 322 First quarter -- 319 -- -- 9 -- 116 444 - -------------------------------------------------------------------------------------------------------------------------- Total $142 $1,433 $18 $110 $385 $180 $1,070 $3,338 ==== ====== === ==== ==== ==== ====== ====== - --------------------------------------------------------------------------------------------------------------------------
Figure 17 shows loans that are either administered or serviced by Key, but not recorded on the balance sheet. Included are loans that have been both securitized and sold, or simply sold outright. In the event of default, Key is subject to recourse with respect to approximately $296 million of the $27.1 billion of loans administered or serviced at June 30, 2003. 54 Key derives income from two sources when we sell or securitize loans but retain the right to administer or service them. We earn noninterest income (recorded as "other income") from servicing or administering the loans, and we earn interest income from any securitized assets retained. Conning Asset Management and National Realty Funding L.C. service the commercial real estate loans shown in Figure 17; however, other financial institutions originated most of these loans. FIGURE 17. LOANS ADMINISTERED OR SERVICED
JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, JUNE 30, in millions 2003 2003 2002 2002 2002 - ---------------------------------------------------------------------------------------------------------- Education loans $ 4,161 $ 4,381 $ 4,605 $ 4,756 $ 4,095 Automobile loans 29 40 54 69 87 Home equity loans 334 389 456 519 596 Commercial real estate loans 22,428 20,508 19,508 17,002 16,483 Commercial loans 142 130 123 110 103 - --------------------------------------------------------------------------------------------------------- Total $27,094 $25,448 $24,746 $22,456 $21,364 ======= ======= ======= ======= ======= - ---------------------------------------------------------------------------------------------------------
SECURITIES At June 30, 2003, the securities portfolio totaled $8.6 billion and included $7.5 billion of securities available for sale, $99 million of investment securities and $1.0 billion of other investments (primarily principal investments). In comparison, the total portfolio at December 31, 2002, was $9.5 billion, including $8.5 billion of securities available for sale, $120 million of investment securities and $919 million of other investments. The weighted average maturity of the total portfolio was 2.3 years at June 30, 2003, compared with 3.0 years at December 31, 2002. The size and composition of Key's securities portfolio are dependent largely on our needs for liquidity and the extent to which we are required or elect to hold these assets as collateral to secure public and trust deposits. Although debt securities are generally used for this purpose, other assets, such as securities purchased under resale agreements, may be used temporarily when they provide more favorable yields. SECURITIES AVAILABLE FOR SALE. The majority of Key's securities available for sale portfolio consists of collateralized mortgage obligations that provide a source of interest income and serve as collateral in connection with pledging requirements. A collateralized mortgage obligation (sometimes called a "CMO") is a debt security that is secured by a pool of mortgages, mortgage-backed securities, U.S. government securities, corporate debt obligations or other bonds. At June 30, 2003, Key had $7.2 billion invested in collateralized mortgage obligations and other mortgage-backed securities in the available-for-sale portfolio, compared with $8.1 billion at December 31, 2002, and $6.0 billion at June 30, 2002. Over the past twelve months, Key has invested more heavily in these securities as opportunities to originate loans (Key's preferred earning asset) have been adversely affected by the weak economy. Substantially all of these securities were issued or backed by federal agencies. The CMO securities held by Key are shorter-maturity class bonds that were structured to have more predictable cash flows than other longer-term class bonds during periods of changing interest rates. During the second quarter of 2003, Key reduced the level of its CMOs by approximately $750 million, primarily through sales undertaken to manage prepayment risk. The securities sold were backed by higher coupon mortgages and had very short expected average lives. Figure 18 shows the composition, yields and remaining maturities of Key's securities available for sale. For more information about retained interests in securitizations and gross unrealized gains and losses by type of security, see Note 5 ("Securities"), which begins on page 17. 55 FIGURE 18. SECURITIES AVAILABLE FOR SALE
OTHER U.S. TREASURY, STATES AND COLLATERALIZED MORTGAGE- AGENCIES AND POLITICAL MORTGAGE BACKED dollars in millions CORPORATIONS SUBDIVISIONS OBLIGATIONS(a) SECURITIES(a) - ---------------------------------------------------------------------------------------------- JUNE 30, 2003 Remaining maturity: One year or less $ 1 $ 1 $ 1,174 $ 45 After one through five years 28 5 5,063 535 After five through ten years 2 8 227 3 After ten years 4 12 98 8 - --------------------------------------------------------------------------------------------- Fair value $ 35 $ 26 $ 6,562 $ 591 Amortized cost 34 25 6,552 567 Weighted average yield 2.60% 6.91% 4.51% 5.98% Weighted average maturity 4.1 YEARS 10.5 YEARS 2.1 YEARS 1.7 YEARS - --------------------------------------------------------------------------------------------- DECEMBER 31, 2002 Fair value $ 23 $ 35 $ 7,207 $ 852 Amortized cost 22 35 7,143 815 - --------------------------------------------------------------------------------------------- JUNE 30, 2002 Fair value $ 22 $ 19 $ 5,112 $ 857 Amortized cost 22 18 5,092 823 - ---------------------------------------------------------------------------------------------
RETAINED WEIGHTED INTERESTS IN OTHER AVERAGE dollars in millions SECURITIZATIONS(a) SECURITIES TOTAL YIELD(b) - -------------------------------------------------------------------------------------------------- JUNE 30, 2003 Remaining maturity: One year or less $ 24 -- $ 1,245 4.60% After one through five years 156 $ 3 5,790 4.83 After five through ten years -- 4 244 8.78 After ten years -- 132(c) 254 8.94 - ----------------------------------------------------------------------------------------------- Fair value $ 180 $ 139 $ 7,533 -- Amortized cost 123 140 7,441 5.01% Weighted average yield 27.55% 3.29%(b) 5.01% -- Weighted average maturity 2.6 YEARS 10.0 YEARS 2.3 YEARS -- - ----------------------------------------------------------------------------------------------- DECEMBER 31, 2002 Fair value $ 209 $ 181 $ 8,507 -- Amortized cost 166 208 8,389 5.76% - ----------------------------------------------------------------------------------------------- JUNE 30, 2002 Fair value $ 207 $ 193 $ 6,410 -- Amortized cost 172 216 6,343 6.57% - -----------------------------------------------------------------------------------------------
(a) Maturity is based upon expected average lives rather than contractual terms. (b) Weighted average yields are calculated based on amortized cost and exclude equity securities of $131 million that have no stated yield. Such yields have been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%. (c) Includes primarily marketable equity securities with no stated maturity. INVESTMENT SECURITIES. Securities issued by states and political subdivisions account for the majority of Key's investment securities. Figure 19 shows the composition, yields and remaining maturities of these securities. FIGURE 19. INVESTMENT SECURITIES
STATES AND WEIGHTED POLITICAL OTHER AVERAGE dollars in millions SUBDIVISIONS SECURITIES TOTAL YIELD(a) - ------------------------------------------------------------------------------------------------------ JUNE 30, 2003 Remaining maturity: One year or less $ 25 -- $ 25 9.98% After one through five years 54 $ 4 58 9.02 After five through ten years 15 -- 15 8.17 After ten years 1 -- 1 11.22 - --------------------------------------------------------------------------------------------------- Amortized cost $ 95 $ 4 $ 99 9.14% Fair value 103 4 107 -- Weighted average maturity 2.8 YEARS 4.5 YEARS 2.9 YEARS -- - --------------------------------------------------------------------------------------------------- DECEMBER 31, 2002 Amortized cost $ 120 -- $ 120 9.43% Fair value 129 -- 129 -- - --------------------------------------------------------------------------------------------------- JUNE 30, 2002 Amortized cost $ 186 -- $ 186 8.59% Fair value 196 -- 196 -- - ---------------------------------------------------------------------------------------------------
(a) Weighted average yields are calculated based on amortized cost. Such yields have been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%. 56 OTHER INVESTMENTS. Principal investments - investments in equity and mezzanine instruments made by Key's Principal Investing unit -- are carried at fair value, which aggregated $717 million at June 30, 2003. Of this amount, $2 million represents net unrealized gains. Principal investments represent approximately 71% of other investments and include direct and indirect investments predominately in privately-held companies. Direct investments are those made in a particular company, while indirect investments are made through funds that include other investors. In addition to principal investments, other investments include securities that do not have readily determinable fair values. These securities include certain real estate-related investments. Neither these securities nor principal investments have stated maturities. ASSET QUALITY Key has a multi-faceted program to manage asset quality. Our professionals: - - evaluate and monitor credit quality and risk in credit-related assets; - - develop commercial and consumer credit policies and systems; - - monitor compliance with internal underwriting standards; - - establish credit-related concentration limits; and - - review the adequacy of the allowance for loan losses. ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses at June 30, 2003, was $1.4 billion, or 2.22% of loans. This compares with $1.5 billion, or 2.41% of loans, at June 30, 2002. The allowance includes $109 million that was specifically allocated for impaired loans of $302 million at June 30, 2003, compared with $144 million that was allocated for impaired loans of $312 million a year ago. For more information about impaired loans, see Note 8 ("Impaired Loans and Other Nonperforming Assets") on page 23. At June 30, 2003, the allowance for loan losses was 167.86% of nonperforming loans, representing the highest level of nonperforming loan coverage by the allowance since the 2001 year end. This compares with a ratio of 160.82% at June 30, 2002. Management estimates the appropriate level of the allowance for loan losses on a quarterly (and at times more frequent) basis. The methodology used is described in Note 1 ("Summary of Significant Accounting Policies") under the heading "Allowance for Loan Losses" on page 58 of Key's 2002 Annual Report to Shareholders. Briefly, management assigns a specific allowance to an impaired loan when the carrying amount of the loan exceeds the estimated present value of related future cash flows and the fair value of any existing collateral. The allowance for loan losses arising from nonimpaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics and by exercising judgment to assess the impact of factors such as changes in economic conditions, credit policies or underwriting standards, and the level of credit risk associated with specific industries and markets. The aggregate balance of the allowance for loan losses at June 30, 2003, represents management's best estimate of the losses inherent in the loan portfolio at that date. The allowance specifically allocated for Key's impaired loans decreased by $35 million, or 24%, over the past twelve months, reflecting Key's continued efforts to resolve problem credits, combined with stabilizing credit quality trends in certain portfolios. During the same period, the allowance allocated for nonimpaired loans decreased by $99 million, or 7%, due largely to stabilizing credit quality trends in certain portfolios. The level of watch credits in most commercial portfolios decreased from year-ago levels. Watch credits are loans with the potential for further deterioration in quality due to the debtor's current financial condition and related ability to perform in accordance with the terms of the loan. The commercial loan portfolios with the most significant decreases in watch credits were large corporate and media. Other portfolios, including middle market, showed more modest improvement. These changes reflect the fluctuations that occur in loan portfolios from time to time, underscoring the benefits of Key's strategy to limit the concentration of credit risk in any single portfolio. 57 NET LOAN CHARGE-OFFS. Net loan charge-offs for the second quarter of 2003 totaled $141 million, or .90% of average loans, representing the lowest level of net charge-offs since the first quarter of 2001. These results compare with net charge-offs of $203 million, or 1.27% of average loans, for the same period last year. The composition of Key's loan charge-offs and recoveries by type of loan is shown in Figure 20. The decrease in net charge-offs from the year-ago quarter occurred primarily in the middle market and healthcare segments of the commercial loan portfolio. Included in second quarter 2003 net charge-offs are $17 million of losses charged to the now depleted portion of Key's allowance for loan losses that had been segregated in connection with management's decision to discontinue many credit-only relationships in the leveraged financing and nationally syndicated lending businesses and to facilitate sales of distressed loans in other portfolios. Considering the progress that has been made in exiting the commitments related to these two portfolios, management believes that it is no longer necessary to segregate the run-off portfolio for reporting purposes. FIGURE 20. SUMMARY OF LOAN LOSS EXPERIENCE
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, ----------------------------- --------------------------- dollars in millions 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------- Average loans outstanding during the period $ 63,029 $ 63,928 $ 62,937 $ 63,709 - --------------------------------------------------------------------------------------------------------------- Allowance for loan losses at beginning of period $ 1,421 $ 1,607 $ 1,452 $ 1,677 Loans charged off: Commercial, financial and agricultural 77 114 164 211 Real estate--commercial mortgage 14 13 25 48 Real estate--construction -- 12 4 12 - --------------------------------------------------------------------------------------------------------------- Total commercial real estate loans(a) 14 25 29 60 Commercial lease financing 19 18 31 38 - --------------------------------------------------------------------------------------------------------------- Total commercial loans 110 157 224 309 Real estate--residential mortgage 1 2 3 3 Home equity 15 15 29 29 Consumer--direct 13 13 25 27 Consumer--indirect lease financing 4 6 9 13 Consumer--indirect other 36 43 79 88 - --------------------------------------------------------------------------------------------------------------- Total consumer loans 69 79 145 160 - --------------------------------------------------------------------------------------------------------------- 179 236 369 469 Recoveries: Commercial, financial and agricultural 10 9 16 19 Real estate -- commercial mortgage 3 2 8 3 Real estate -- construction -- -- 3 -- - --------------------------------------------------------------------------------------------------------------- Total commercial real estate loans(a) 3 2 11 3 Commercial lease financing 4 3 5 4 - --------------------------------------------------------------------------------------------------------------- Total commercial loans 17 14 32 26 Real estate--residential mortgage 1 -- 1 1 Home equity 2 2 3 2 Consumer--direct 2 2 4 4 Consumer--indirect lease financing 2 2 3 4 Consumer--indirect other 14 13 24 23 - --------------------------------------------------------------------------------------------------------------- Total consumer loans 21 19 35 34 - --------------------------------------------------------------------------------------------------------------- 38 33 67 60 - --------------------------------------------------------------------------------------------------------------- Net loans charged off (141) (203) (302) (409) Provision for loan losses 125 135 255 271 - --------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of period $ 1,405 $ 1,539 $ 1,405 $ 1,539 ======== ======== ======== ======== - --------------------------------------------------------------------------------------------------------------- Net loan charge-offs to average loans .90% 1.27% .97% 1.29% Allowance for loan losses to period-end loans 2.22 2.41 2.22 2.41 Allowance for loan losses to nonperforming loans 167.86 160.82 167.86 160.82 - ---------------------------------------------------------------------------------------------------------------
(a) See Figure 14 on page 53 and the accompanying discussion on page 52 for more information related to Key's commercial real estate portfolio. NONPERFORMING ASSETS. Figure 21 shows the composition of Key's nonperforming assets, which have declined in each of the past three quarters. These assets totaled $897 million at June 30, 2003, and represented 1.42% of loans, other real estate owned (known as "OREO") and other nonperforming assets, compared with $993 million, or 1.59%, at December 31, 2002, and $995 million, or 1.56%, at June 30, 2002. 58 FIGURE 21. SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS
JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, JUNE 30, dollars in millions 2003 2003 2002 2002 2002 - ----------------------------------------------------------------------------------------------------------------------- Commercial, financial and agricultural $ 361 $ 381 $ 448 $ 484 $ 471 Real estate -- commercial mortgage 143 165 157 149 179 Real estate -- construction 22 37 50 79 61 - ----------------------------------------------------------------------------------------------------------------------- Total commercial real estate loans(a) 165 202 207 228 240 Commercial lease financing 92 91 69 88 76 - ----------------------------------------------------------------------------------------------------------------------- Total commercial loans 618 674 724 800 787 Real estate -- residential mortgage 38 39 36 34 34 Home equity 152 154 146 124 107 Consumer--direct 13 13 13 6 6 Consumer--indirect lease financing 4 5 5 6 7 Consumer--indirect other 12 19 19 17 16 - ----------------------------------------------------------------------------------------------------------------------- Total consumer loans 219 230 219 187 170 - ----------------------------------------------------------------------------------------------------------------------- Total nonperforming loans 837 904 943 987 957 OREO 60 62 48 30 40 Allowance for OREO losses (3) (3) (3) (2) (2) - ----------------------------------------------------------------------------------------------------------------------- OREO, net of allowance 57 59 45 28 38 Other nonperforming assets 3 5 5 2 -- - ----------------------------------------------------------------------------------------------------------------------- Total nonperforming assets $ 897 $ 968 $ 993 $ 1,017 $ 995 ======= ======= ======= ======= ======= - ----------------------------------------------------------------------------------------------------------------------- Accruing loans past due 90 days or more $ 172 $ 207 $ 198 $ 208 $ 186 Accruing loans past due 30 through 89 days 731 721 790 787 780 - ----------------------------------------------------------------------------------------------------------------------- Nonperforming loans to period-end loans 1.32% 1.44% 1.51% 1.57% 1.50% Nonperforming assets to period-end loans plus OREO and other nonperforming assets 1.42 1.54 1.59 1.61 1.56 - -----------------------------------------------------------------------------------------------------------------------
(a) See Figure 14 on page 53 and the accompanying discussion on page 52 for more information related to Key's commercial real estate portfolio. The reduction in nonperforming loans during the second quarter was attributable largely to decreases in the structured finance and healthcare portfolios. Structured finance refers to a type of lending characterized by a high degree of leverage in the borrower's financial condition and a relatively low level of tangible loan collateral. The economic slowdown can be expected to continue to impact Key's loan portfolio in general. At June 30, 2003, two segments of the commercial, financial and agricultural portfolio (loans to middle market clients and loans underwritten as structured finance credits) accounted for $255 million and $72 million, respectively, of Key's nonperforming loans. Although these two segments comprised only 14% of Key's total loans, they accounted for 39% of total nonperforming loans. At June 30, 2003, our 20 largest nonperforming loans totaled $248 million, representing 30% of total loans on nonperforming status. Information pertaining to the credit exposure by industry classification inherent in the largest sector of Key's loan portfolio, commercial, financial and agricultural loans, is presented in Figure 22. Within the transportation category, Key had approximately $255 million of exposure to the commercial passenger airline industry at June 30, 2003. The types of activity that caused the change in Key's nonperforming loans during the last five quarters are represented in Figure 23. 59 FIGURE 22. COMMERCIAL, FINANCIAL AND AGRICULTURAL LOANS
NONPERFORMING LOANS ------------------------- JUNE 30, 2003 TOTAL LOANS % OF LOANS dollars in millions COMMITMENTS OUTSTANDING AMOUNT OUTSTANDING - ------------------------------------------------------------------------------------------------- Industry classification: Manufacturing $ 9,082 $ 3,683 $ 130 3.5% Services 6,287 2,529 65 2.6 Financial services 5,806 959 2 .2 Retail trade 4,309 808 19 2.4 Property management 3,053 2,875 5 .2 Wholesale trade 2,686 1,248 25 2.0 Public utilities 1,792 499 -- -- Building contractors 1,385 692 39 5.6 Communications 1,340 451 12 2.7 Agriculture/forestry/fishing 1,051 677 23 3.4 Transportation 804 452 19 4.2 Public administration 748 244 -- -- Insurance 886 130 -- -- Mining 407 166 -- -- Individuals 179 121 1 .8 Other 2,025 1,847 21 1.1 - ---------------------------------------------------------------------------------------------- Total $41,840 $17,381 $ 361 2.1% ======= ======= ======= - ----------------------------------------------------------------------------------------------
FIGURE 23. SUMMARY OF CHANGES IN NONPERFORMING LOANS
2003 2002 ----------------------- ---------------------------- in millions SECOND FIRST FOURTH THIRD SECOND - ------------------------------------------------------------------------------------------------------ Balance at beginning of period $ 904 $ 943 $ 987 $ 957 $ 973 Loans placed on nonaccrual status 168 237 339 281 254 Charge-offs (141) (161) (186) (185) (203) Loans sold (42) (23) (36) (25) (18) Payments (26) (58) (149) (41) (49) Transfers to OREO (1) (19) -- -- -- Loans returned to accrual status (25) (15) (13) -- -- Acquisition -- -- 1 -- -- - ----------------------------------------------------------------------------------------------------- Balance at end of period $ 837 $ 904 $ 943 $ 987 $ 957 ===== ===== ===== ===== ===== - -----------------------------------------------------------------------------------------------------
60 DEPOSITS AND OTHER SOURCES OF FUNDS "Core deposits" -- domestic deposits other than certificates of deposit of $100,000 or more -- are Key's primary source of funding. During the second quarter of 2003, core deposits averaged $41.3 billion, and represented 56% of the funds Key used to support earning assets, compared with $37.1 billion and 51% during the same quarter in 2002. The composition of Key's deposits is shown in Figure 7, which spans pages 44 and 45. The increase in the level of Key's core deposits over the past twelve months was due primarily to higher levels of NOW and money market deposit accounts as well as noninterest-bearing deposits. The growth of these deposits reflected client preferences for investments that provide high levels of liquidity in a low interest rate environment. Also contributing to the significant growth in noninterest-bearing deposits were our intensified cross-selling efforts and the introduction of new products, including free checking. A more aggressive pricing structure implemented in mid 2002 supported the growth in savings deposits. During the same period, time deposits decreased by 13% in part because, like our competitors, Key reduced the rates paid for them, as the Federal Reserve Board reduced interest rates in general. Purchased funds, comprising large certificates of deposit, deposits in the foreign branch and short-term borrowings, averaged $14.6 billion during the second quarter of 2003, compared with $16.0 billion during the year-ago quarter. Each of these funding sources has declined over the past twelve months. This is attributable in part to reduced funding needs resulting from core deposit growth, loan sales, slow demand for loans and our decision to scale back or discontinue certain types of lending. Key continues to consider loan sales and securitizations as funding alternatives when market conditions are favorable. LIQUIDITY "Liquidity" measures whether an entity has sufficient cash flow to meet its financial obligations when due. Key has sufficient liquidity when it can meet its obligations to depositors, borrowers and creditors at a reasonable cost, on a timely basis, and without adverse consequences. KeyCorp has sufficient liquidity when it can pay dividends to shareholders, service its debt, and support customary corporate operations and activities, including acquisitions, at a reasonable cost, in a timely manner and without adverse consequences. LIQUIDITY RISK. There are both direct and indirect circumstances that could adversely affect Key's liquidity or materially affect the cost of funds. For example, events unrelated to Key, such as terrorism or war, natural disasters, political events, or the default or bankruptcy of a major corporation, mutual fund or hedge fund can have market-wide consequences. An example of a direct (but hypothetical) event would be a significant downgrade in Key's public credit rating by a rating agency due to a deterioration in asset quality, a large charge to earnings, a significant merger or acquisition or other events. Similarly, market speculation or rumors about Key or the banking industry in general may cause normal funding sources to withdraw credit until further information becomes available. LIQUIDITY FOR KEY. Key's Funding and Investment Management Group monitors the overall mix of funding sources with the objective of maintaining an appropriate mix in light of the structure of the asset portfolios. We use several tools to maintain sufficient liquidity. - - We maintain portfolios of short-term money market investments and securities available for sale, substantially all of which could be converted to cash quickly at a small expense. - - Key's portfolio of investment securities generates prepayments (often at a premium) and payments at maturity. - - We try to structure the maturities of our loans so we receive a relatively consistent stream of payments from borrowers. 61 - - We have the ability to access the securitization markets for a variety of loan types. - - Our 903 full-service KeyCenters in 12 states generate a sizable volume of core deposits. We monitor deposit flows and use alternative pricing structures to attract deposits when necessary. For more information about core deposits, see the previous section entitled "Deposits and other sources of funds." - - Key has access to various sources of money market funding (such as federal funds purchased, securities sold under repurchase agreements, and bank notes) and also can borrow from the Federal Reserve Bank to meet short-term liquidity requirements. Key did not have any borrowings from the Federal Reserve Bank outstanding at June 30, 2003. The Consolidated Statements of Cash Flow on page 6 summarize Key's sources and uses of cash by type of activity for the six-month periods ended June 30, 2003 and 2002. As shown in these statements, Key's largest cash flows relate to both investing and financing activities. Over the past two years, the primary sources of cash from investing activities have been loan securitizations and sales and the sales, prepayments and maturities of securities available for sale. Investing activities that have required the greatest use of cash include lending and the purchases of new securities. Over the past two years, the primary source of cash from financing activities has been the issuance of long-term debt. However, in 2002, deposits were also a significant source of cash. In each of the past two years, major outlays of cash have been made to repay debt issued in prior periods. During 2002, cash was also used to reduce the level of short-term borrowings. LIQUIDITY FOR KEYCORP. KeyCorp meets its liquidity requirements principally through regular dividends from affiliate banks. Federal banking law limits the amount of capital distributions that banks can make to their holding companies without obtaining prior regulatory approval. A national bank's dividend paying capacity is affected by several factors, including the amount of its net profits (as defined by statute) for the two previous calendar years, and net profits for the current year up to the date of dividend declaration. Due to this constraint, and the restructuring charges taken by KBNA and Key Bank USA in 2001, as of January 1, 2003, neither bank could pay dividends or make other capital distributions to KeyCorp without prior regulatory approval. In February 2003, KBNA obtained regulatory approval to make capital distributions to KeyCorp of up to $365 million in the aggregate in the first and second quarters. As of June 30, 2003, the entire amount had been distributed. Key Bank USA restored its dividend paying capacity during the first quarter and KBNA restored its dividend paying capacity during the second quarter. As of June 30, 2003, the affiliate banks had an additional $86 million available to pay dividends to KeyCorp without prior regulatory approval. At June 30, 2003, KeyCorp had approximately $914 million of cash or short-term investments available to pay dividends on its common shares, to service its debt and to finance its corporate operations. ADDITIONAL SOURCES OF LIQUIDITY. Management has implemented several programs that enable Key and KeyCorp to raise money in the public and private markets when necessary. The proceeds from all of these programs can be used for general corporate purposes, including acquisitions. Each of the programs is replaced or extended from time to time as needed. BANK NOTE PROGRAM. During the first half of 2003, Key's affiliate banks raised $1.4 billion under Key's bank note program. Of the notes issued during the year, $975 million have original maturities in excess of one year and are included in long-term debt. The remaining notes have original maturities of one year or less and are included in short-term borrowings. Key's current bank note program provides for the issuance of both long- and short-term debt of up to $20.0 billion ($19.0 billion by KBNA and $1.0 billion by Key Bank USA). At June 30, 2003, $16.8 billion was available for future issuance under this program. EURO NOTE PROGRAM. Under Key's euro note program, KeyCorp, KBNA and Key Bank USA may issue both long- and short-term debt of up to $10.0 billion in the aggregate. The notes are offered exclusively to non-U.S. investors and can be denominated in U.S. dollars and many foreign currencies. There were $197 62 million of borrowings issued under this program during the first half of 2003. At June 30, 2003, $4.0 billion was available for future issuance. KEYCORP MEDIUM-TERM NOTE PROGRAM AND OTHER SECURITIES. KeyCorp may issue, under a registration statement filed with the Securities and Exchange Commission, up to $2.2 billion of securities, which could include long- or short-term debt, or equity securities. Of the amount registered, $1.0 billion has been allocated for the issuance of medium-term notes. At June 30, 2003, unused capacity under KeyCorp's universal shelf registration statement totaled $1.5 billion, including $275 million allocated for the issuance of medium-term notes. COMMERCIAL PAPER AND REVOLVING CREDIT. KeyCorp has a commercial paper program and a revolving credit agreement with an unaffiliated financial institution that provide funding availability of up to $500 million and $400 million, respectively. As of June 30, 2003, there were no borrowings outstanding under either the commercial paper program or the revolving credit agreement. Key also has a commercial paper program with unaffiliated Canadian financial institutions that provides funding availability of up to $1.0 billion in Canadian currency or the equivalent in U.S. currency. As of June 30, 2003, borrowings outstanding under this commercial paper program totaled $789 million in Canadian currency and $26 million in U.S. currency (equivalent to $35 million in Canadian currency). Key has favorable debt ratings as shown in Figure 24 below. As long as those debt ratings are maintained, management believes that, under normal conditions in the capital markets, future offerings of securities by KeyCorp or its affiliate banks would be marketable to investors at a competitive cost. FIGURE 24. DEBT RATINGS
SENIOR SUBORDINATED SHORT-TERM LONG-TERM LONG-TERM CAPITAL JUNE 30, 2003 BORROWINGS DEBT DEBT SECURITIES - ------------------------------------------------------------------------------------------------------------------------------ KEYCORP Standard & Poor's A-2 A- BBB+ BBB Moody's P-1 A2 A3 Baa1 Fitch F1 A A- A KBNA Standard & Poor's A-1 A A- N/A Moody's P-1 A1 A2 N/A Fitch F1 A A- N/A KEY NOVA SCOTIA FUNDING COMPANY ("KNSF") Dominion Bond Rating Service(a) R-1 (middle) N/A N/A N/A - ------------------------------------------------------------------------------------------------------------------------------
(a) Reflects the guarantee by KBNA of KNSF's issuance of Canadian commercial paper. N/A = Not Applicable CAPITAL SHAREHOLDERS' EQUITY. Total shareholders' equity at June 30, 2003, was $7.0 billion, up $154 million from the balance at December 31, 2002. Growth in retained earnings, net unrealized gains on derivative financial instruments and the issuance of common shares out of the treasury stock account in connection with employee stock purchase, 401(k), dividend reinvestment and stock option programs contributed to the increase. Other factors contributing to the change in shareholders' equity during the first half of 2003 are shown in the Consolidated Statements of Changes in Shareholders' Equity presented on page 5. SHARE REPURCHASES. In September 2000, the Board of Directors authorized the repurchase of up to 25,000,000 common shares, including 3,647,200 shares remaining at the time from an earlier repurchase program. These shares may be repurchased in the open market or through negotiated transactions. During 63 the first half of 2003, Key repurchased a total of 5,000,000 of its common shares at an average price per share of $24.70. At June 30, 2003, a remaining balance of 8,764,670 shares may be repurchased under the September 2000 authorization. At June 30, 2003, Key had 70,815,244 treasury shares. Management may reissue those shares over time to support the employee stock purchase, 401(k), stock option, deferred compensation and dividend reinvestment plans, and for other corporate purposes. During the first half of 2003, Key reissued 2,150,646 treasury shares for employee benefit and dividend reinvestment plans. CAPITAL ADEQUACY. Capital adequacy is an important indicator of financial stability and performance. Overall, Key's capital position remains strong: the ratio of total shareholders' equity to total assets was 8.18% at June 30, 2003, and 7.96% at June 30, 2002. Banking industry regulators prescribe minimum capital ratios for bank holding companies and their banking subsidiaries. Note 14 ("Shareholders' Equity"), which begins on page 76 of Key's 2002 Annual Report to Shareholders, explains the implications of failing to meet specific capital requirements imposed by the banking regulators. Risk-based capital guidelines require a minimum level of capital as a percent of "risk-weighted assets," which is total assets plus certain off-balance sheet items, both adjusted for predefined credit risk factors. Currently, banks and bank holding companies must maintain, at a minimum, Tier 1 capital as a percent of risk-weighted assets of 4.00%, and total capital as a percent of risk-weighted assets of 8.00%. As of June 30, 2003, Key's Tier 1 capital ratio was 8.02%, and its total capital ratio was 12.26%. Another indicator of capital adequacy, the leverage ratio, is defined as Tier 1 capital as a percentage of average quarterly tangible assets. Leverage ratio requirements vary with the condition of the financial institution. Bank holding companies that either have the highest supervisory rating or have implemented the Federal Reserve's risk-adjusted measure for market risk--as KeyCorp has--must maintain a minimum leverage ratio of 3.00%. All other bank holding companies must maintain a minimum ratio of 4.00%. As of June 30, 2003, Key had a leverage ratio of 8.12%. Federal bank regulators group FDIC-insured depository institutions into five categories, ranging from "critically undercapitalized" to "well capitalized." Both of Key's affiliate banks qualified as "well capitalized" at June 30, 2003, since each exceeded the prescribed thresholds of 10.00% for total capital, 6.00% for Tier 1 capital and 5.00% for the leverage ratio. If these provisions applied to bank holding companies, Key would also qualify as "well capitalized" at June 30, 2003. The FDIC-defined capital categories serve a limited supervisory function. Investors should not treat them as a representation of the overall financial condition or prospects of Key or its affiliate banks. Figure 25 presents the details of Key's regulatory capital position at June 30, 2003, December 31, 2002 and June 30, 2002. 64 FIGURE 25. CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS
JUNE 30, DECEMBER 31, JUNE 30, dollars in millions 2003 2002 2002 - ---------------------------------------------------------------------------------------- TIER 1 CAPITAL Common shareholders' equity(a) $ 6,885 $ 6,738 $ 6,527 Qualifying capital securities 1,076 1,096 1,156 Less: Goodwill 1,142 1,142 1,105 Other assets(b) 62 60 49 - ---------------------------------------------------------------------------------------- Total Tier 1 capital 6,757 6,632 6,529 - ---------------------------------------------------------------------------------------- TIER 2 CAPITAL Allowable portion of allowance for loan losses 1,077 986 987 Qualifying long-term debt 2,491 2,639 2,233 - ---------------------------------------------------------------------------------------- Total Tier 2 capital 3,568 3,625 3,220 - ---------------------------------------------------------------------------------------- Total risk-based capital $ 10,325 $ 10,257 $ 9,749 ========= ========= ========= RISK-WEIGHTED ASSETS Risk-weighted assets on balance sheet $ 67,752 $ 67,051 $ 68,273 Risk-weighted off-balance sheet exposure 18,031 16,595 12,611 Less: Goodwill 1,142 1,142 1,105 Other assets(b) 327 251 248 Plus: Market risk-equivalent assets 223 192 312 - ---------------------------------------------------------------------------------------- Gross risk-weighted assets 84,537 82,445 79,843 Less: Excess allowance for loan losses 328 466 552 - ---------------------------------------------------------------------------------------- Net risk-weighted assets $ 84,209 $ 81,979 $ 79,291 ========= ========= ========= AVERAGE QUARTERLY TOTAL ASSETS $ 84,712 $ 82,735 $ 81,560 ========= ========= ========= CAPITAL RATIOS Tier 1 risk-based capital ratio 8.02% 8.09% 8.23% Total risk-based capital ratio 12.26 12.51 12.29 Leverage ratio(c) 8.12 8.15 8.14 - ----------------------------------------------------------------------------------------
(a) Common shareholders' equity does not include net unrealized gains or losses on securities (except for net unrealized losses on marketable equity securities) nor net gains or losses on cash flow hedges. (b) "Other assets" deducted from Tier 1 capital consists of intangible assets (excluding goodwill) recorded after February 19, 1992, deductible portions of purchased mortgage servicing rights and deductible portions of nonfinancial equity investments. "Other assets" deducted from risk-weighted assets consists of intangible assets (excluding goodwill) recorded after February 19, 1992, deductible portions of purchased mortgage servicing rights and nonfinancial equity investments. (c) This ratio is Tier 1 capital divided by average quarterly total assets less goodwill and the nonqualifying intangible assets described in footnote (b). 65 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK The information presented in the Market Risk Management section of the Management's Discussion and Analysis of Financial Condition and Results of Operations, which begins on page 32, is incorporated herein by reference. ITEM 4. CONTROLS AND PROCEDURES As a bank holding company, KeyCorp is subject to the internal control reporting requirements of the Federal Deposit Insurance Corporation Improvement Act, which became effective in 1993 ("FDICIA"). FDICIA requirements include an annual assessment by our Chief Executive Officer and Chief Financial Officer of the effectiveness of our internal controls over financial reporting, which generally includes those controls relating to the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. In addition, under FDICIA, our independent auditors have annually examined and attested to, without qualification, management's assertions regarding the effectiveness of our internal controls. Accordingly, we have had an established process of maintaining and evaluating our internal controls over financial reporting. In connection with recent legislation and regulations, our management has also focused its attention on our "disclosure controls and procedures," which, as defined by the SEC, are generally those controls and procedures designed to ensure that financial and nonfinancial information required to be disclosed in KeyCorp's reports filed with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to KeyCorp's management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In light of the requirements imposed by the recently adopted SEC regulations, we engaged in a process of reviewing our disclosure controls and procedures. As a result of our review, and although we believe that our pre-existing disclosure controls and procedures were effective in enabling us to comply with our disclosure obligations, we implemented enhancements, which included establishing a disclosure committee and generally formalizing and documenting disclosure controls and procedures that we already had in place. During the quarterly period covered by this report, KeyCorp carried out an evaluation, under the supervision and with the participation of KeyCorp's management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of KeyCorp's disclosure controls and procedures. Based upon that evaluation, KeyCorp's Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective, in all material respects, as of the end of the period covered by this report. In conjunction with its normal on-going risk management and risk review process, and consistent with the requirements of recently adopted SEC regulations, management has undertaken a further comprehensive evaluation of its internal control over financial reporting that may result in additional future refinements to our existing internal control over financial reporting framework. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The information presented in Note 10 ("Contingent Liabilities and Guarantees"), which begins on page 25 of the Notes to Consolidated Financial Statements, is incorporated herein by reference. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the 2003 Annual Meeting of Shareholders of KeyCorp held on May 22, 2003, five directors were elected for three-year terms expiring in 2006, and shareholders adopted resolutions to approve the KeyCorp Amended and Restated Discounted Stock Purchase Plan, to approve the KeyCorp Deferred Equity Allocation Plan, and to approve the KeyCorp Directors' Deferred Share Plan, and to ratify the appointment 66 by the Audit Committee of the Board of Directors of Ernst & Young LLP as independent auditors for KeyCorp for the fiscal year ending December 31, 2003. Director nominees for terms expiring in 2006 were: William G. Bares, Dr. Carol A. Cartwright, Henry S. Hemingway, Steven A. Minter, and Thomas C. Stevens. Directors whose term in office as a director continued after the Annual Meeting of Shareholders were: Cecil D. Andrus, Edward P. Campbell, Alexander M. Cutler, Charles R. Hogan, Dr. Shirley A. Jackson, Douglas J. McGregor, Eduardo R. Menasce, Henry L. Meyer III, Bill R. Sanford, Dennis W. Sullivan, and Peter G. Ten Eyck, II. The vote on each issue was as follows:
For Against Abstain --------------------------------------- Election of Directors William G. Bares 356,995,210 * 11,868,726 Dr. Carol A. Cartwright 356,562,057 * 12,301,878 Henry S. Hemingway 356,572,407 * 12,291,527 Steven A. Minter 356,352,942 * 12,510,993 Thomas C. Stevens 357,134,371 * 11,729,564 Approval of the KeyCorp Amended 344,259,226 19,921,227 4,683,481 and Restated Discounted Stock Purchase Plan Approval of the KeyCorp Deferred 320,216,837 43,114,699 5,532,398 Equity Allocation Plan Approval of the KeyCorp Directors' 314,910,264 47,891,386 6,062,283 Deferred Share Plan Ratification of Ernst & Young 274,019,655 91,398,687 3,445,593 as independent auditors of KeyCorp
* Proxies provide that shareholders may either cast a vote for, or abstain from voting for, directors. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS 15 Acknowledgment Letter of Independent Auditors. 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) REPORTS ON FORM 8-K April 17, 2003 - Item 7. Financial Statements and Exhibits and Item 9. Regulation FD Disclosure and Information Furnished under Item 12 (Disclosure of Results of Operations and Financial Condition). Reporting that on April 17, 2003, the Registrant issued a press release announcing its 67 earnings results for the three-month period ended March 31, 2003, and providing a slide presentation reviewed in the related conference call/webcast. No other reports on Form 8-K were filed during the three-month period ended June 30, 2003. INFORMATION AVAILABLE ON WEBSITE KeyCorp makes available free of charge on its website, WWW.KEY.COM, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after KeyCorp electronically files such material with, or furnishes it to, the SEC. 68 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KEYCORP -------------------------------- (Registrant) Date: August 11, 2003 /s/ Lee Irving -------------------------------- By: Lee Irving Executive Vice President and Chief Accounting Officer 69 EX-15 3 l02001aexv15.txt EX-15 ACKNOWLEDGEMENT LETTER-INDEPENDENT AUDITORS Exhibit 15 ACKNOWLEDGMENT LETTER OF INDEPENDENT AUDITORS Shareholders and Board of Directors KeyCorp We are aware of the incorporation by reference in the following KeyCorp ("Key") Registration Statements of our review report, dated July 18, 2003, relating to the unaudited condensed consolidated interim financial statements of Key, included in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2003. Form S-3 No. 33-58405 Form S-3 No. 333-10577 (Post-Effective Amendment No. 1) Form S-3 No. 333-55959 Form S-3 No. 333-64601 Form S-3 No. 333-59175 Form S-3 No. 333-76619 (Post-Effective Amendment No. 1) Form S-3 No. 333-88063 Form S-3 No. 333-50802 Form S-3 No. 333-56258 Form S-3 No. 333-63104 Form S-3 No. 333-73380 (Amendment No. 1) Form S-3 No. 333-88934 (Amendment No. 1) Form S-4 No. 33-31569 Form S-4 No. 33-44657 Form S-4 No. 33-51717 Form S-4 No. 33-55573 Form S-4 No. 33-57329 Form S-4 No. 33-61539 Form S-4 No. 333-19151 Form S-4 No. 333-61025 Form S-8 No. 2-97452 Form S-8 No. 33-21643 Form S-8 No. 333-49609 Form S-8 No. 333-49633 Form S-8 No. 333-65391 Form S-8 No. 333-70669 Form S-8 No. 333-70703 Form S-8 No. 333-70775 Form S-8 No. 333-72189 Form S-8 No. 333-92881 Form S-8 No. 333-45320 Form S-8 No. 333-45322 Form S-8 No. 333-99493 Form S-8 No. 333-99495 Form S-8 No. 33-31569 (Post-Effective Amendment No. 1 to Form S-4) Form S-8 No. 33-51717 (Post-Effective Amendment No. 1 to Form S-4) Form S-8 No. 33-44657 (Post-Effective Amendment No. 1 to Form S-4) Form S-8 No. 333-61025 (Post-Effective Amendment No. 1 to Form S-4) /s/ Ernst & Young LLP Cleveland, Ohio August 7, 2003 EX-31.1 4 l02001aexv31w1.txt EX-31.2 302 CERTIFICATION OF CEO Exhibit 31.1 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Henry L. Meyer III, certify that: 1. I have reviewed this quarterly report on Form 10-Q of KeyCorp; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) [Reserved] c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 11, 2003 /s/ Henry L. Meyer III ---------------------------------- Henry L. Meyer III Chairman, President and Chief Executive Officer A signed original of this written statement required by Section 302 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. EX-31.2 5 l02001aexv31w2.txt EX-31.2 302 CERTIFICATION OF CFOO Exhibit 31.2 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Jeffrey B. Weeden, certify that: 1. I have reviewed this quarterly report on Form 10-Q of KeyCorp; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) [Reserved] c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 11, 2003 /s/ Jeffrey B. Weeden ---------------------------------- Jeffrey B. Weeden Chief Financial Officer A signed original of this written statement required by Section 302 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.1 6 l02001aexv32w1.txt EX-32.1 906 CERTIFICATION OF CEO Exhibit 32.1 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Pursuant to 18 U.S.C. 1350, the undersigned officer of KeyCorp (the "COMPANY"), hereby certifies that the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 (the "REPORT") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. August 11, 2003 /s/ Henry L. Meyer III ---------------------------------- Henry L. Meyer III Chairman, President and Chief Executive Officer A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. EX-32.2 7 l02001aexv32w2.txt EX-32.2 906 CERTIFICATION OF CFO Exhibit 32.2 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 Pursuant to 18 U.S.C. 1350, the undersigned officer of KeyCorp (the "COMPANY"), hereby certifies that the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 (the "REPORT") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. August 11, 2003 /s/ Jeffrey B. Weeden ---------------------------------- Jeffrey B. Weeden Chief Financial Officer A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----