-----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, BInDyf1jJPP4nfeD3gGMdTYRCuRXbbaQCFcUL1TL76nexWGXr4GKcCjCfFFsM878 v8Y4Xkq5PI5xvZd1+gK8LA== 0000950152-03-009682.txt : 20031113 0000950152-03-009682.hdr.sgml : 20031113 20031113151812 ACCESSION NUMBER: 0000950152-03-009682 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20030930 FILED AS OF DATE: 20031113 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: 03997773 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 l03467ae10vq.txt KEYCORP 10-Q/QUARTER END 9-30-2003 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2003 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From ______ To ______ Commission File Number 0-850 [KEYCORP LOGO] ------------------------------------------------------ (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 419,143,413 Shares - ----------------------------------------- --------------------------------- (Title of class) (Outstanding at October 31, 2003) KEYCORP TABLE OF CONTENTS Page Number ----------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets -- September 30, 2003, December 31, 2002 and September 30, 2002 3 Consolidated Statements of Income -- Three and nine months ended September 30, 2003 and 2002 4 Consolidated Statements of Changes in Shareholders' Equity -- Nine months ended September 30, 2003 and 2002 5 Consolidated Statements of Cash Flow -- Nine months ended September 30, 2003 and 2002 6 Notes to Consolidated Financial Statements 7 Independent Accountants' Review Report 31 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 32 Item 3. Quantitative and Qualitative Disclosure of Market Risk 66 Item 4. Controls and Procedures 66 PART II. OTHER INFORMATION Item 1. Legal Proceedings 66 Item 6. Exhibits and Reports on Form 8-K 67 Signature 68 Exhibits 69
2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2003 2002 2002 - ---------------------------------------------------------------------------------------------------------------------------------- (UNAUDITED) (UNAUDITED) ASSETS Cash and due from banks $ 2,398 $ 3,364 $ 3,039 Short-term investments 1,776 1,632 1,190 Securities available for sale 7,550 8,507 7,409 Investment securities (fair value: $113, $129 and $158) 106 120 148 Other investments 1,103 919 848 Loans, net of unearned income of $1,928, $1,776 and $1,808 62,723 62,457 62,951 Less: Allowance for loan losses 1,405 1,452 1,489 - --------------------------------------------------------------------------------------------------------------------------------- Net loans 61,318 61,005 61,462 Premises and equipment 614 644 651 Goodwill 1,154 1,142 1,105 Other intangible assets 41 35 23 Corporate-owned life insurance 2,483 2,414 2,384 Accrued income and other assets 5,917 5,420 5,257 - --------------------------------------------------------------------------------------------------------------------------------- Total assets $ 84,460 $ 85,202 $ 83,516 ======== ======== ======== LIABILITIES Deposits in domestic offices: NOW and money market deposit accounts $ 18,389 $ 16,249 $ 14,094 Savings deposits 2,079 2,029 1,987 Certificates of deposit ($100,000 or more) 4,887 4,749 4,807 Other time deposits 11,034 11,946 12,413 - --------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing 36,389 34,973 33,301 Noninterest-bearing 10,947 10,630 10,063 Deposits in foreign office-- interest-bearing 1,403 3,743 1,246 - --------------------------------------------------------------------------------------------------------------------------------- Total deposits 48,739 49,346 44,610 Federal funds purchased and securities sold under repurchase agreements 4,804 3,862 6,350 Bank notes and other short-term borrowings 2,707 2,823 2,908 Accrued expense and other liabilities 5,891 5,471 5,438 Long-term debt 15,342 15,605 16,276 Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely subordinated debentures of KeyCorp (See Note 9) -- 1,260 1,282 - --------------------------------------------------------------------------------------------------------------------------------- Total liabilities 77,483 78,367 76,864 SHAREHOLDERS' EQUITY Preferred stock, $1 par value; authorized 25,000,000 shares, none issued -- -- -- Common shares, $1 par value; authorized 1,400,000,000 shares; issued 491,888,780 shares 492 492 492 Capital surplus 1,454 1,449 1,382 Retained earnings 6,732 6,448 6,330 Treasury stock, at cost (72,622,333, 67,945,135 and 67,024,459 shares) (1,718) (1,593) (1,569) Accumulated other comprehensive income 17 39 17 - --------------------------------------------------------------------------------------------------------------------------------- Total shareholders' equity 6,977 6,835 6,652 - --------------------------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 84,460 $ 85,202 $ 83,516 ======== ======== ======== - ----------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 3 CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, --------------------- -------------------- dollars in millions, except per share amounts 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------------------------- INTEREST INCOME Loans $ 880 $ 983 $ 2,694 $ 2,957 Tax-exempt investment securities 2 2 5 8 Securities available for sale 77 97 274 282 Short-term investments 6 7 22 23 Other investments 6 6 19 19 - ------------------------------------------------------------------------------------------------------------------------------- Total interest income 971 1,095 3,014 3,289 INTEREST EXPENSE Deposits 168 214 539 695 Federal funds purchased and securities sold under repurchase agreements 12 23 41 70 Bank notes and other short-term borrowings 13 18 46 65 Long-term debt, including capital securities 101 140 334 422 - ------------------------------------------------------------------------------------------------------------------------------- Total interest expense 294 395 960 1,252 - ------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME 677 700 2,054 2,037 Provision for loan losses 123 135 378 406 - ------------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 554 565 1,676 1,631 NONINTEREST INCOME Trust and investment services income 139 151 402 467 Service charges on deposit accounts 93 102 276 306 Investment banking and capital markets income 52 34 139 130 Letter of credit and loan fees 42 36 113 93 Corporate-owned life insurance income 27 25 81 77 Electronic banking fees 20 21 61 59 Net securities gains 2 -- 9 1 Other income 88 63 213 190 - ------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 463 432 1,294 1,323 NONINTEREST EXPENSE Personnel 380 358 1,114 1,082 Net occupancy 56 57 171 170 Computer processing 43 45 131 147 Equipment 35 33 101 103 Marketing 30 33 88 89 Professional fees 30 21 87 63 Other expense 125 112 352 331 - ------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 699 659 2,044 1,985 INCOME BEFORE INCOME TAXES 318 338 926 969 Income taxes 91 93 257 238 - ------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 227 $ 245 $ 669 $ 731 ======== ======== ======== ======== Per common share: Net income $ .54 $ .57 $ 1.58 $ 1.72 Net income -- assuming dilution .53 .57 1.57 1.69 Weighted average common shares outstanding (000) 421,971 426,274 423,697 425,746 Weighted average common shares and potential common shares outstanding (000) 425,669 431,326 426,968 431,098 - -------------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 4 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
COMMON SHARES COMMON CAPITAL RETAINED dollars in millions, except per share amounts OUTSTANDING (000) SHARES SURPLUS EARNINGS - ------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2001 424,005 $ 492 $ 1,390 $ 5,856 Net income 731 Other comprehensive income (losses): Net unrealized gains on securities available for sale, net of income taxes of $10(a) Net unrealized losses on derivative financial instruments, net of income taxes of ($7) Foreign currency translation adjustments Total comprehensive income Cash dividends declared on common shares ($.60 per share) (257) Issuance of common shares under employee benefit and dividend reinvestment plans 2,639 (8) Repurchase of common shares (1,780) - ------------------------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2002 424,864 $ 492 $ 1,382 $ 6,330 ======= ====== ======= ======== - ------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2002 423,944 $ 492 $ 1,449 $ 6,448 Net income 669 Other comprehensive income (losses): Net unrealized losses on securities available for sale, net of income taxes of ($35)(a) Net unrealized gains on derivative financial instruments, net of income taxes of $10 Foreign currency translation adjustments Total comprehensive income Deferred compensation obligation 8 Cash dividends declared on common shares ($.915 per share) (385) Issuance of common shares under employee benefit and dividend reinvestment plans 2,822 (3) Repurchase of common shares (7,500) - ------------------------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2003 419,266 $ 492 $ 1,454 $ 6,732 ======= ====== ======= ======== - ------------------------------------------------------------------------------------------------------------------------------- ACCUMULATED TREASURY OTHER STOCK, COMPREHENSIVE COMPREHENSIVE dollars in millions, except per share amounts AT COST INCOME (LOSS) INCOME(b) - --------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2001 $ (1,585) $ 2 Net income $ 731 Other comprehensive income (losses): Net unrealized gains on securities available for sale, net of income taxes of $10(a) 15 15 Net unrealized losses on derivative financial instruments, net of income taxes of ($7) (10) (10) Foreign currency translation adjustments 10 10 ----- Total comprehensive income $ 746 ===== Cash dividends declared on common shares ($.60 per share) Issuance of common shares under employee benefit and dividend reinvestment plans 62 Repurchase of common shares (46) - ----------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2002 $ (1,569) $ 17 ======== ========= - ----------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2002 $ (1,593) $ 39 Net income $ 669 Other comprehensive income (losses): Net unrealized losses on securities available for sale, net of income taxes of ($35)(a) (56) (56) Net unrealized gains on derivative financial instruments, net of income taxes of $10 15 15 Foreign currency translation adjustments 19 19 ----- Total comprehensive income $ 647 ===== Deferred compensation obligation Cash dividends declared on common shares ($.915 per share) Issuance of common shares under employee benefit and dividend reinvestment plans 66 Repurchase of common shares (191) - ----------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2003 $ (1,718) $ 17 ======== ========= - -----------------------------------------------------------------------------------------------------
(a) Net of reclassification adjustments. (b) For the three months ended September 30, 2003 and 2002, comprehensive income was $165 million and $230 million, respectively. See Notes to Consolidated Financial Statements (Unaudited). 5 CONSOLIDATED STATEMENTS OF CASH FLOW(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, ----------------------- in millions 2003 2002 - ------------------------------------------------------------------------------------------------------------------- OPERATING ACTIVITIES Net income $ 669 $ 731 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 378 406 Depreciation expense and software amortization 148 169 Amortization of intangibles 10 8 Net securities gains (9) (1) Net (gains) losses from principal investing (32) 1 Net gains from loan securitizations and sales (68) (34) Deferred income taxes 13 64 Net (increase) decrease in mortgage loans held for sale (19) 10 Net increase in trading account assets (241) (153) Net decrease in accrued restructuring charges (8) (27) Other operating activities, net (95) (214) - ------------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 746 960 INVESTING ACTIVITIES Cash used in acquisitions, net of cash acquired (17) (15) Net decrease in other short-term investments 97 861 Purchases of securities available for sale (5,547) (4,965) Proceeds from sales of securities available for sale 3,271 1,004 Proceeds from prepayments and maturities of securities available for sale 2,962 1,928 Purchases of investment securities (19) (18) Proceeds from prepayments and maturities of investment securities 45 72 Purchases of other investments (254) (67) Proceeds from sales of other investments 64 37 Proceeds from prepayments and maturities of other investments 122 29 Net increase in loans, excluding acquisitions, sales and divestitures (3,859) (2,448) Purchases of loans (453) -- Proceeds from loan securitizations and sales 3,716 2,224 Purchases of premises and equipment (73) (68) Proceeds from sales of premises and equipment 11 8 Proceeds from sales of other real estate owned 47 32 - ------------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 113 (1,386) FINANCING ACTIVITIES Net decrease in deposits (599) (229) Net increase (decrease) in short-term borrowings 826 (26) Net proceeds from issuance of long-term debt, including capital securities 2,723 4,467 Payments on long-term debt, including capital securities (4,236) (3,241) Purchases of treasury shares (191) (46) Net proceeds from issuance of common stock 37 32 Cash dividends paid (385) (383) - ------------------------------------------------------------------------------------------------------------------- NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES (1,825) 574 - ------------------------------------------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS (966) 148 CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,364 2,891 - ------------------------------------------------------------------------------------------------------------------- CASH AND DUE FROM BANKS AT END OF PERIOD $ 2,398 $ 3,039 ========= ======== - ------------------------------------------------------------------------------------------------------------------- Additional disclosures relative to cash flow: Interest paid $ 989 $ 1,199 Income taxes paid 186 131 Noncash items: Transfer of investment securities to other investments -- $ 848 Transfer of investment securities to securities available for sale -- 60 Net transfer of loans to other real estate owned $ 75 27 - -------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited). 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The unaudited condensed consolidated interim financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. As used in these Notes, KeyCorp refers solely to the parent company and Key refers to the consolidated entity consisting of KeyCorp and its subsidiaries. The Financial Accounting Standards Board ("FASB") issued Interpretation No. 46, "Consolidation of Variable Interest Entities," in January 2003. This accounting guidance significantly changes how companies determine whether they must consolidate an entity depending on whether the entity is a voting rights entity or a variable interest entity ("VIE"). Interpretation No. 46 was effective immediately for entities created after January 31, 2003, and was effective originally for previously existing entities in the first interim or annual period beginning after June 15, 2003. In October 2003, the FASB issued final guidance that deferred the effective date of Interpretation No. 46 for entities created before February 1, 2003, to no later than the first interim or annual period ending after December 15, 2003. As permitted, Key elected to early-adopt Interpretation No. 46 for such entities effective July 1, 2003. The "Accounting Pronouncements Adopted in 2003" section of this note, which begins on page 9, and Note 7 ("Variable Interest Entities"), which begins on page 20, provide further information on Interpretation No. 46. In accordance with the new guidance, Key considers a voting rights entity to be a subsidiary and consolidates it if Key has a controlling financial interest in the entity. VIEs are consolidated by Key if it is exposed to the majority of the VIE's expected losses and/or residual returns (i.e., Key is considered to be the primary beneficiary). Variable interests include equity interests, subordinated debt, derivative contracts, leases, service agreements, guarantees, standby letters of credit, loan commitments and other instruments. Unconsolidated investments in voting rights entities or VIEs in which Key has significant influence over operating and financing decisions (usually defined as a voting or economic interest of 20 to 50%) are accounted for using the equity method. Unconsolidated investments in voting rights entities or VIEs in which Key has a voting or economic interest of less than 20% are generally carried at cost. Investments held by KeyCorp's broker/dealer and investment company subsidiaries (primarily principal investments) are carried at estimated fair value. Prior to the adoption of Interpretation No. 46, KeyCorp generally determined whether consolidation of an entity was appropriate based on the nature and amount of equity contributed by third parties, the decision-making power granted to those parties and the extent of their control over the entity's operating and financial policies. Entities controlled, generally through majority ownership, were consolidated and were considered subsidiaries. Qualifying special purpose entities, including securitization trusts, established by Key under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are not consolidated. Additional information on SFAS No. 140 is summarized in Note 1 ("Summary of Significant Accounting Policies") of Key's 2002 Annual Report to Shareholders under the heading "Loan Securitizations" on page 59. Management believes that the unaudited condensed consolidated interim financial statements reflect all adjustments of a normal recurring nature and disclosures that are necessary for a fair presentation of the results for the interim periods presented. Some previously reported results have been reclassified to conform to current reporting practices. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. When you read these financial statements, you should also look at the audited consolidated financial statements and related notes included in Key's 2002 Annual Report to Shareholders. 7 STOCK-BASED COMPENSATION Through December 31, 2002, Key accounted for stock options issued to employees using the intrinsic value method outlined in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." This method requires that compensation expense be recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the grant date. Key's employee stock options generally have fixed terms and exercise prices that are equal to or greater than the fair value of Key's common shares at the grant date, so Key generally had not recognized compensation expense related to stock options. Effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123, "Accounting for Stock-Based Compensation." Additional information pertaining to this accounting change is summarized under the heading "Accounting Pronouncements Adopted in 2003" on page 9. SFAS No. 123 requires companies like Key that have used the intrinsic value method to account for employee stock options to provide pro forma disclosures of the net income and earnings per share effect of accounting for stock options using the fair value method. Management estimates the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. As a result, the Black-Scholes model is not a perfect indicator of the value of an employee stock option, but it is commonly used for this purpose. The Black-Scholes model requires several assumptions, which management developed and updates based on historical trends and current market observations. The level of accuracy achieved in deriving the estimated fair value of options is directly related to the accuracy of the underlying assumptions. The assumptions pertaining to options issued during the three- and nine-month periods ended September 30, 2003 and 2002, are shown in the following table.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------------ ------------------------ 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------- Average option life 5.0 YEARS 5.0 years 5.0 YEARS 5.0 years Future dividend yield 4.76 % 4.87 % 4.76 % 4.86 % Share price volatility .280 .276 .280 .276 Weighted average risk-free interest rate 2.9 % 2.5 % 2.9 % 4.0 % - -----------------------------------------------------------------------------------------------------------
The model assumes that the estimated fair value of an option is amortized over the option's vesting period. The pro forma effect of applying the fair value method of accounting to all forms of stock-based compensation (e.g., stock options, stock purchase plans, restricted stock, etc.) for the three- and nine-month periods ended September 30, 2003 and 2002, is shown in the following table and would, if recorded, have been included in personnel expense on the income statement. The information presented may not be indicative of the effect in future periods.
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- ------------------- in millions, except per share amounts 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------------------------------- Net income, as reported $ 227 $ 245 $ 669 $ 731 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 5 1 9 3 Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects 8 7 18 20 - ---------------------------------------------------------------------------------------------------------------------------------- Net income - pro forma $ 224 $ 239 $ 660 $ 714 ======= ======= ======= ====== Per common share: Net income $ .54 $ .57 $ 1.58 $ 1.72 Net income - pro forma .53 .56 1.56 1.68 Net income assuming dilution .53 .57 1.57 1.69 Net income assuming dilution - pro forma .53 .55 1.55 1.66 - ----------------------------------------------------------------------------------------------------------------------------------
8 ACCOUNTING PRONOUNCEMENTS ADOPTED IN 2003 ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify certain financial instruments that would previously have been classified as equity as liabilities (or as assets in some circumstances). Specifically, SFAS No. 150 requires that financial instruments issued in the form of shares that are mandatorily redeemable; financial instruments that embody an obligation to repurchase the issuer's equity shares or are indexed to such an obligation; or financial instruments that embody an unconditional obligation or a conditional obligation that can be settled in certain ways be classified as liabilities. This accounting guidance was effective for financial instruments entered into or modified after May 31, 2003, and otherwise became effective for Key on July 1, 2003. In November 2003, the FASB indefinitely deferred the effective date of the measurement and recognition provisions of SFAS No. 150 for mandatorily redeemable noncontrolling interests associated with finite-lived subsidiaries. Additional information on this deferral is summarized in Note 7 under the heading "Low-Income Housing Tax Credit ("LIHTC") guaranteed funds." The application of SFAS No. 150 to all other financial instruments did not have any material effect on Key's financial condition or results of operations. AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities addressed under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This accounting guidance amends SFAS No. 133 for decisions made by the FASB as part of the Derivatives Implementation Group process and also amends SFAS No. 133 to clarify the definition of a derivative. SFAS No. 149 generally became effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of this accounting guidance did not have any material effect on Key's financial condition or results of operations. CONSOLIDATION OF VARIABLE INTEREST ENTITIES. As disclosed previously on page 7 of this note, in January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," which significantly changes how Key and other companies determine whether they must consolidate an entity. Key's July 1, 2003, adoption of the new guidance primarily affected Key's balance sheet; consolidating previously unconsolidated VIEs increased, and in some cases changed the classification of, assets and liabilities. As of September 30, 2003, the adoption of Interpretation No. 46 resulted in an $847 million increase to Key's assets, with no material effect on Key's results of operations. While the consolidation of previously unconsolidated entities or the de-consolidation of previously consolidated entities under Interpretation No. 46 represents an accounting change, it does not affect Key's legal rights or obligations to these entities. Interpretation No. 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. See Note 7 for more detailed information pertaining to Key's adoption of Interpretation No. 46 and its involvement with VIEs. Additional information pertaining to VIEs is summarized in Note 10 ("Contingent Liabilities and Guarantees"), which begins on page 25. ACCOUNTING FOR AND DISCLOSURE OF GUARANTEES. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This interpretation requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of obligations undertaken. The liability that must be recognized is specifically related to the obligation to stand ready to perform over the term of the guarantee. The initial recognition and measurement provisions of this guidance became effective on a prospective basis for guarantees issued or modified on or after January 1, 2003. For guarantees subject to the liability recognition provisions of this interpretation for which Key receives a fee, the initial fair value stand ready obligation is recognized at an amount equal to the fee. For guarantees for which no fee is received, the fair value of the stand ready obligations is determined using expected present value measurement techniques, unless observable transactions for identical or similar guarantees are available. The subsequent accounting for these stand ready obligations depends on the nature of the underlying guarantees. Key accounts for its release from risk for a particular guarantee either upon 9 expiration or settlement, or by a systematic and rational amortization method depending on the risk profile of the particular guarantee. This new accounting guidance also expands the disclosures that a guarantor must make about its obligations under certain guarantees. These disclosure requirements took effect for financial statements of interim or annual periods ending after October 15, 2002. The required disclosures for Key are provided in Note 10 under the heading "Guarantees" on page 26. The adoption of Interpretation No. 45 did not have any material effect on Key's financial condition or results of operations. ACCOUNTING FOR STOCK-BASED COMPENSATION. As discussed under the heading "Stock-Based Compensation" on page 8, effective January 1, 2003, Key adopted the fair value method of accounting as outlined in SFAS No. 123. Management is applying the change in accounting prospectively (prospective method) to all awards as permitted under the transition provisions in SFAS No. 148, "Accounting for Stock-Based Compensation Transition and Disclosure," which was issued in December 2002. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition for an entity that voluntarily changes to the fair value method of accounting for stock compensation. These alternative methods include: (i) the prospective method; (ii) the modified prospective method; and, (iii) the retroactive restatement method. This accounting guidance also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock compensation and the effect of the method used on reported financial results. The required interim disclosures for Key are provided under the aforementioned "Stock-Based Compensation" heading. Based on the valuation and mid-year timing of option grants in 2003, management estimates that the accounting change will reduce Key's diluted earnings per common share by less than $.02 in 2003. The effect on Key's earnings per common share in subsequent years will depend on the number and timing of options granted and the assumptions used to estimate their fair value. COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES. In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This new standard took effect for exit or disposal activities (e.g., activities related to ceasing a line of business, relocating operations, etc.) initiated after December 31, 2002. SFAS No. 146 substantially changes the rules for recognizing costs, such as lease or other contract termination costs and one-time employee termination benefits, associated with exit or disposal activities arising from corporate restructurings. Generally, these costs must be recognized when incurred. Previously, those costs could be recognized earlier; for example, when a company committed to an exit or disposal plan. Key adopted SFAS No. 146 for restructuring activities initiated on or after January 1, 2003. The adoption of SFAS No. 146 did not have any material effect on Key's financial condition or results of operations. ASSET RETIREMENT OBLIGATIONS. In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." The new standard was effective for fiscal years beginning after June 15, 2002. SFAS No. 143 addresses the accounting for legal obligations associated with the retirement of tangible long-lived assets and requires a liability to be recognized for the fair value of these obligations in the period they are incurred. Related costs are capitalized as part of the carrying amounts of the assets to be retired and are amortized over the assets' useful lives. Key adopted SFAS No. 143 as of January 1, 2003. The adoption of this accounting guidance did not have any material effect on Key's financial condition or results of operations. 10 2. EARNINGS PER COMMON SHARE Key calculates its basic and diluted earnings per common share as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------------------------- dollars in millions, except per share amounts 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------- NET INCOME $ 227 $ 245 $ 669 $ 731 ======== ======== ======== ======== - -------------------------------------------------------------------------------------------- WEIGHTED AVERAGE COMMON SHARES Weighted average common shares outstanding (000) 421,971 426,274 423,697 425,746 Effect of dilutive common stock options (000) 3,698 5,052 3,271 5,352 - -------------------------------------------------------------------------------------------- Weighted average common shares and potential common shares outstanding (000) 425,669 431,326 426,968 431,098 ======== ======== ======== ======== - -------------------------------------------------------------------------------------------- EARNINGS PER COMMON SHARE Net income per common share $ .54 $ .57 $ 1.58 $ 1.72 Net income per common share -- assuming dilution .53 .57 1.57 1.69 - --------------------------------------------------------------------------------------------
3. ACQUISITIONS AND DIVESTITURE Business acquisitions and divestitures that Key completed during 2002 and the first nine months of 2003 are summarized below. ACQUISITIONS NEWBRIDGE PARTNERS LLC On July 1, 2003, Key acquired NewBridge Partners LLC, a growth equity investment management firm headquartered in New York City with managed assets of $1.8 billion at the date of acquisition. The terms of the transaction are not material and have not been disclosed. UNION BANKSHARES, LTD. On December 12, 2002, Key purchased Union Bankshares, Ltd., the holding company for Union Bank & Trust, a seven-branch bank headquartered in Denver, Colorado. Key paid $22.63 per Union Bankshares common share for a total cash consideration of $66 million. Goodwill of approximately $34 million and core deposit intangibles of $13 million were recorded. Union Bankshares, Ltd. had assets of $475 million at the date of acquisition. On January 17, 2003, Union Bank & Trust was merged into Key Bank National Association ("KBNA"). CONNING ASSET MANAGEMENT On June 28, 2002, Key purchased substantially all of the mortgage loan and real estate business of Conning Asset Management, headquartered in Hartford, Connecticut. Conning's mortgage loan and real estate business originates, securitizes and services multi-family, retail, industrial and office property mortgage loans on behalf of pension fund and life insurance company investors. At the date of acquisition, the business had net assets of $17 million and serviced approximately $4 billion in commercial mortgage loans through its St. Louis office. In accordance with a confidentiality clause in the purchase agreement, the terms, which are not material, have not been disclosed. DIVESTITURE 401(k) PLAN RECORDKEEPING BUSINESS On June 12, 2002, Key sold its 401(k) plan recordkeeping business. Key recognized a gain of $3 million ($2 million after tax) on the transaction. 11 4. LINE OF BUSINESS RESULTS CONSUMER BANKING RETAIL BANKING provides individuals with branch-based deposit and investment products, personal finance services and loans, including residential mortgages, home equity and various types of installment loans. SMALL BUSINESS provides businesses that have annual sales revenues of $10 million or less with deposit, investment and credit products, and business advisory services. CONSUMER FINANCE consists of two primary business units: Indirect Lending and National Home Equity. Indirect Lending offers automobile and marine loans to consumers through dealers and finances inventory for automobile and marine dealers. This business unit also provides education loans, insurance and interest-free payment plans for students and their parents. National Home Equity provides both prime and nonprime mortgage and home equity loan products to individuals. These products originate outside of Key's retail branch system. This business unit also works with mortgage brokers and home improvement contractors to provide home equity and home improvement solutions. CORPORATE AND INVESTMENT BANKING CORPORATE BANKING provides a full array of products and services to large corporations, middle-market companies, financial institutions and government organizations. These products and services include: financing, treasury management, investment banking, derivatives and foreign exchange, equity and debt trading, and syndicated finance. KEYBANK REAL ESTATE CAPITAL provides construction and interim lending, permanent debt placements and servicing, and equity and investment banking services to developers, brokers and owner-investors. This line of business deals exclusively with nonowner-occupied properties (i.e., generally properties for which the owner occupies less than 60% of the premises). KEY EQUIPMENT FINANCE meets the equipment leasing needs of companies worldwide and provides equipment manufacturers, distributors and resellers with financing options for their clients. Lease financing receivables and related revenues are assigned to other lines of business (primarily Corporate Banking) if those businesses are principally responsible for maintaining the relationship with the client. INVESTMENT MANAGEMENT SERVICES INVESTMENT MANAGEMENT SERVICES consists of two primary business units: Victory Capital Management and McDonald Financial Group. Victory Capital Management manages or gives advice regarding investment portfolios for a national client base, including corporations, labor unions, not-for-profit organizations, governments and individuals. These portfolios may be managed in separate accounts, common funds or the Victory family of mutual funds. McDonald Financial Group offers financial, estate and retirement planning and asset management services to assist high-net-worth clients with their banking, brokerage, trust, portfolio management, insurance, charitable giving and related needs. This unit also provides banking services to public sector institutions. OTHER SEGMENTS Other segments consists primarily of Treasury, Principal Investing and the net effect of funds transfer pricing. RECONCILING ITEMS Total assets included under "Reconciling Items" represent primarily the unallocated portion of nonearning assets of corporate support functions. Charges related to the funding of these assets are part of net interest income and are allocated to the business segments through noninterest expense. Reconciling Items also 12 include certain items that are not allocated to the business segments because they are not reflective of their normal operations. The table that spans pages 14 and 15 shows selected financial data for each major business group for the three- and nine-month periods ended September 30, 2003 and 2002. This table is accompanied by additional supplementary information for each of the lines of business that comprise these groups. The information was derived from the internal financial reporting system that management uses to monitor and manage Key's financial performance. Accounting principles generally accepted in the United States guide financial accounting, but there is no authoritative guidance for "management accounting"--the way management uses its judgment and experience to make reporting decisions. Consequently, the line of business results Key reports may not be comparable with line of business results presented by other companies. The selected financial data are based on internal accounting policies designed to compile results on a consistent basis and in a manner that reflects the underlying economics of the businesses. As such: - - Net interest income is determined by assigning a standard cost for funds used to assets or a standard credit for funds provided to liabilities based on their maturity, prepayment and/or repricing characteristics. The net effect of this funds transfer pricing is included in the "Other Segments" columns. - - Indirect expenses, such as computer servicing costs and corporate overhead, are allocated based on assumptions of the extent to which each line actually uses the services. - - Key's consolidated provision for loan losses is allocated among the lines of business based primarily on their actual net charge-offs, adjusted periodically for loan growth and changes in risk profile. The level of the consolidated provision is based on the methodology that management uses to estimate Key's consolidated allowance for loan losses. This methodology is described in Note 1 ("Summary of Significant Accounting Policies") under the heading "Allowance for Loan Losses" on page 58 of Key's 2002 Annual Report to Shareholders. - - Income taxes are allocated based on the statutory federal income tax rate of 35% (adjusted for tax-exempt interest income, income from corporate-owned life insurance and tax credits associated with investments in low-income housing projects) and a blended state income tax rate (net of the federal income tax benefit) of 2.5%. - - Capital is assigned based on management's assessment of economic risk factors (primarily credit, operating and market risk). Developing and applying the methodologies that management uses to allocate items among Key's lines of business is a dynamic process. Accordingly, financial results may be revised periodically to reflect accounting enhancements, changes in the risk profile of a particular business or changes in Key's organization structure. The financial data reported for all periods presented in the tables reflect a number of changes that occurred during the first nine months of 2003: - - Key reorganized and renamed some of its business groups and lines of business. Key's Capital Markets line of business moved from the Investment Management Services group (formerly Key Capital Partners) to the Corporate Banking line within the Corporate and Investment Banking group (formerly Key Corporate Finance). Also within Corporate and Investment Banking, Key changed the name of its National Commercial Real Estate line of business to KeyBank Real Estate Capital, and changed the name of its National Equipment Finance line of business to Key Equipment Finance. In addition, Key consolidated the reporting of its National Home Equity and Indirect Lending lines of business into one line of business named Consumer Finance. - - Methodologies used to allocate certain overhead and funding costs were refined. 13
CORPORATE AND INVESTMENT CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES THREE MONTHS ENDED SEPTEMBER 30, --------------------- ----------------------- ----------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 475 $ 441 $ 258 $ 268 $ 65 $ 56 Noninterest income 141 136 125 111 143 150 - ----------------------------------------------------------------------------------------------------------------------- Total revenue (TE)(a) 616 577 383 379 208 206 Provision for loan losses 70 69 48 64 5 2 Depreciation and amortization expense 32 34 10 11 11 11 Other noninterest expense 323 303 171 158 150 151 - ----------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (TE) 191 171 154 146 42 42 Allocated income taxes and TE adjustments 71 64 58 55 16 16 - ----------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 120 $ 107 $ 96 $ 91 $ 26 $ 26 ======== ======== ======== ======== ======== ======== Percent of consolidated net income 53 % 44 % 42 % 37 % 11 % 11 % Percent of total segments net income 52 45 41 38 11 11 - ----------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $ 29,100 $ 28,243 $ 27,784 $ 29,123 $ 5,100 $ 4,826 Total assets(a) 31,516 30,593 32,469 32,749 6,311 5,782 Deposits 34,999 33,580 4,621 3,384 6,382 3,695 - ----------------------------------------------------------------------------------------------------------------------- OTHER FINANCIAL DATA Net loan charge-offs $ 70 $ 70 $ 48 $ 113 $ 5 $ 2 Return on average allocated equity 21.08 % 20.22 % 11.36 % 11.08 % 16.72 % 16.77 % Average full-time equivalent employees 8,508 8,439 2,475 2,461 2,791 3,119 - -----------------------------------------------------------------------------------------------------------------------
CORPORATE AND INVESTMENT CONSUMER BANKING INVESTMENT BANKING MANAGEMENT SERVICES NINE MONTHS ENDED SEPTEMBER 30, ----------------------- ----------------------- ----------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 1,379 $ 1,327 $ 778 $ 808 $ 184 $ 166 Noninterest income 377 378 359 344 402 474 - ----------------------------------------------------------------------------------------------------------------------- Total revenue (TE)(a) 1,756 1,705 1,137 1,152 586 640 Provision for loan losses 213 222 155 173 10 11 Depreciation and amortization expense 96 105 30 34 32 38 Other noninterest expense 942 901 500 473 443 461 - ----------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (TE) 505 477 452 472 101 130 Allocated income taxes and TE adjustments 189 179 169 176 38 48 - ----------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 316 $ 298 $ 283 $ 296 $ 63 $ 82 ======== ======== ======== ======== ======== ======== Percent of consolidated net income 47 % 41 % 42 % 41 % 10 % 11 % Percent of total segments net income 47 43 42 42 9 12 - ----------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $ 28,819 $ 27,889 $ 28,082 $ 29,486 $ 5,030 $ 4,806 Total assets(a) 31,228 30,223 32,605 32,882 6,088 5,807 Deposits 34,714 33,950 4,272 3,216 5,850 3,649 - ----------------------------------------------------------------------------------------------------------------------- OTHER FINANCIAL DATA Net loan charge-offs $ 213 $ 223 $ 200 $ 360 $ 12 $ 11 Return on average allocated equity 18.97 % 19.17 % 11.28 % 12.14 % 13.67 % 17.97 % Average full-time equivalent employees 8,494 8,482 2,456 2,436 2,872 3,185 - -----------------------------------------------------------------------------------------------------------------------
(a) Substantially all revenue generated by Key's major business groups is derived from clients resident in the United States. Substantially all long-lived assets, including premises and equipment, capitalized software and goodwill, held by Key's major business groups are located in the United States. TE = Taxable Equivalent, N/A = Not Applicable, N/M = Not Meaningful 14
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY - ------------------------ ----------------------- ------------------------ ----------------------- 2003 2002 2003 2002 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------- $ (76) $ (20) $ 722 $ 745 $ (32) $ (23) $ 690 $ 722 51 32 460 429 3 3 463 432 - --------------------------------------------------------------------------------------------------------- (25) 12 1,182 1,174 (29) (20) 1,153 1,154 -- -- 123 135 -- -- 123 135 -- -- 53 56 -- -- 53 56 9 6 653 618 (7) (15) 646 603 - --------------------------------------------------------------------------------------------------------- (34) 6 353 365 (22) (5) 331 360 (24) (8) 121 127 (17) (12) 104 115 - --------------------------------------------------------------------------------------------------------- $ (10) $ 14 $ 232 $ 238 $ (5) $ 7 $ 227 $ 245 ======== ======== ======== ======== ======== ======== ======== ======== (4) % 5 % 102 % 97 % (2) % 3 % 100 % 100 % (4) 6 100 100 N/A N/A N/A N/A - --------------------------------------------------------------------------------------------------------- $ 947 $ 1,209 $ 62,931 $ 63,401 $ 147 $ 85 $ 63,078 $ 63,486 12,707 11,195 83,003 80,319 1,719 1,616 84,722 81,935 2,834 4,076 48,836 44,735 (137) (71) 48,699 44,664 - --------------------------------------------------------------------------------------------------------- -- -- $ 123 $ 185 -- -- $ 123 $ 185 (10.17) % 13.45 % 13.90 % 14.79 % N/M N/M 13.06 % 14.74 % 35 34 13,809 14,053 6,250 6,749 20,059 20,802 - ---------------------------------------------------------------------------------------------------------
OTHER SEGMENTS TOTAL SEGMENTS RECONCILING ITEMS KEY - ------------------------ ----------------------- ------------------------ ----------------------- 2003 2002 2003 2002 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------- $ (149) $ (80) $ 2,192 $ 2,221 $ (89) $ (76) $ 2,103 $ 2,145 147 92 1,285 1,288 9 35 1,294 1,323 - --------------------------------------------------------------------------------------------------------- (2) 12 3,477 3,509 (80) (41) 3,397 3,468 -- -- 378 406 -- -- 378 406 -- -- 158 177 -- -- 158 177 25 19 1,910 1,854 (24) (46) 1,886 1,808 - --------------------------------------------------------------------------------------------------------- (27) (7) 1,031 1,072 (56) 5 975 1,077 (42) (32) 354 371 (48) (25) 306 346 - --------------------------------------------------------------------------------------------------------- $ 15 $ 25 $ 677 $ 701 $ (8) $ 30 $ 669 $ 731 ======== ======== ======== ======== ======== ======== ======== ======== 2 % 3 % 101 % 96 % (1) % 4 % 100 % 100 % 2 3 100 100 N/A N/A N/A N/A - --------------------------------------------------------------------------------------------------------- $ 920 $ 1,321 $ 62,851 $ 63,502 $ 134 $ 132 $ 62,985 $ 63,634 12,951 10,818 82,872 79,730 1,593 1,729 84,465 81,459 3,245 3,649 48,081 44,464 (92) (82) 47,989 44,382 - --------------------------------------------------------------------------------------------------------- -- -- $ 425 $ 594 -- -- $ 425 $ 594 5.25 % 8.21 % 13.76 % 14.75 % N/M N/M 12.98 % 15.13 % 35 32 13,857 14,135 6,317 6,792 20,174 20,927 - ---------------------------------------------------------------------------------------------------------
15 Supplementary information (Consumer Banking lines of business)
RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE THREE MONTHS ENDED SEPTEMBER 30, --------------------- --------------------- --------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - -------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 342 $ 337 $ 102 $ 98 $ 172 $ 142 Provision for loan losses 14 16 17 16 39 37 Noninterest expense 212 207 49 46 94 84 Net income 73 71 23 23 24 13 Average loans 10,194 9,122 4,406 4,343 14,500 14,778 Average deposits 30,051 29,448 4,564 3,799 384 333 Net loan charge-offs 14 17 17 16 39 37 Return on average allocated equity 45.25 % 48.48 % 21.94 % 24.08 % 7.91 % 4.53 % Average full-time equivalent employees 6,203 6,154 404 327 1,901 1,958 - --------------------------------------------------------------------------------------------------------------
RETAIL BANKING SMALL BUSINESS CONSUMER FINANCE NINE MONTHS ENDED SEPTEMBER 30, -------------------- -------------------- -------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 997 $ 983 $ 295 $ 286 $ 464 $ 436 Provision for loan losses 46 49 51 44 116 129 Noninterest expense 625 613 141 136 272 257 Net income 204 201 64 66 48 31 Average loans 9,870 8,584 4,421 4,366 14,528 14,939 Average deposits 30,054 30,001 4,303 3,628 357 321 Net loan charge-offs 46 50 51 44 116 129 Return on average allocated equity 42.88 % 47.99 % 21.02 % 23.91 % 5.42 % 3.61 % Average full-time equivalent employees 6,175 6,157 397 325 1,922 2,000 - ---------------------------------------------------------------------------------------------------------
Supplementary information (Corporate and Investment Banking lines of business)
CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE THREE MONTHS ENDED SEPTEMBER 30, -------------------- --------------------------- --------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 224 $ 230 $ 93 $ 93 $ 66 $ 56 Provision for loan losses 42 50 1 2 5 12 Noninterest expense 119 114 37 33 25 22 Net income 40 42 34 36 22 13 Average loans 13,653 15,355 7,303 7,832 6,828 5,936 Average deposits 3,777 2,785 830 590 14 9 Net loan charge-offs 42 99 1 2 5 12 Return on average allocated equity 8.11 % 8.12 % 15.21 % 18.74 % 17.08 % 11.67 % Average full-time equivalent employees 1,184 1,263 671 592 620 606 - ---------------------------------------------------------------------------------------------------------------------
CORPORATE BANKING KEYBANK REAL ESTATE CAPITAL KEY EQUIPMENT FINANCE NINE MONTHS ENDED SEPTEMBER 30, ----------------- --------------------------- --------------------- dollars in millions 2003 2002 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------------------- Total revenue (taxable equivalent) $ 664 $ 708 $ 267 $ 264 $ 206 $ 180 Provision for loan losses 129 134 4 5 22 34 Noninterest expense 349 345 105 93 76 69 Net income 117 143 99 104 67 49 Average loans 13,941 15,914 7,401 7,782 6,740 5,790 Average deposits 3,522 2,644 737 562 13 10 Net loan charge-offs 174 321 4 5 22 34 Return on average allocated equity 7.84 % 9.21 % 15.41 % 18.42 % 17.84 % 15.27 % Average full-time equivalent employees 1,189 1,274 654 541 613 621 - ----------------------------------------------------------------------------------------------------------------------
16 5. SECURITIES Key classifies its securities into four categories: trading, available for sale, investment and other investments. TRADING ACCOUNT SECURITIES. These are debt and equity securities that are purchased and held by Key with the intent of selling them in the near term, and certain interests retained in loan securitizations. All of these assets are reported at fair value ($1.0 billion at September 30, 2003, $801 million at December 31, 2002, and $750 million at September 30, 2002) and are included in "short-term investments" on the balance sheet. Realized and unrealized gains and losses on trading account securities are reported in "investment banking and capital markets income" on the income statement. SECURITIES AVAILABLE FOR SALE. These include securities that Key intends to hold for an indefinite period of time and that may be sold in response to changes in interest rates, prepayment risk, liquidity needs or other factors. Securities available for sale are reported at fair value and include debt and marketable equity securities with readily determinable fair values. Unrealized gains and losses (net of income taxes) deemed temporary are recorded in shareholders' equity as a component of "accumulated other comprehensive income (loss)." Unrealized gains and losses on specific securities deemed to be other than temporary are included in "net securities gains (losses)" on the income statement. Also included in "net securities gains (losses)" are actual gains and losses resulting from sales of specific securities. When Key retains an interest in loans it securitizes, it bears risk that the loans will be prepaid (which would reduce expected interest income) or not paid at all. Key accounts for these retained interests (which include both certificated and uncertificated interests) as debt securities, classifying them as available for sale or as trading account assets. "Other securities" held in the available for sale portfolio primarily are marketable equity securities. INVESTMENT SECURITIES. These are debt securities that Key has the intent and ability to hold until maturity. Debt securities are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method. This method produces a constant rate of return on the basis of the adjusted carrying amount. OTHER INVESTMENTS. Principal investments - investments in equity and mezzanine instruments made by Key's Principal Investing unit - represent the majority of other investments and are carried at fair value ($729 million at September 30, 2003, $677 million at December 31, 2002, and $631 million at September 30, 2002). They include direct and indirect investments predominately in privately-held companies. Direct investments are those made in a particular company, while indirect investments are made through funds that include other investors. Changes in estimated fair values and actual gains and losses on sales of principal investments are included in "investment banking and capital markets income" on the income statement. In addition to principal investments, other investments include equity securities that do not have readily determinable fair values. These securities include certain real estate-related investments that are carried at estimated fair value, as well as other types of securities that are generally carried at cost. The carrying amount of the securities carried at cost is adjusted for declines in value that are considered to be other than temporary. These adjustments are included in "net securities gains" on the income statement. The amortized cost, unrealized gains and losses, and approximate fair value of Key's investment securities and securities available for sale are presented in the following tables. Gross unrealized gains and losses are represented by the difference between the amortized cost and the fair values of securities on the balance sheet as of the dates indicated. Accordingly, the amount of these gains and losses may change in the future as market conditions improve or worsen. 17
SEPTEMBER 30, 2003 --------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - --------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 91 $ 7 -- $ 98 Other securities 15 -- -- 15 - ---------------------------------------------------------------------------------------------- Total investment securities $ 106 $ 7 -- $ 113 ========= ====== ======= ======= - --------------------------------------------------------------------------------------------- SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 59 -- -- $ 59 States and political subdivisions 24 $ 1 -- 25 Collateralized mortgage obligations 6,545 52 $ 115 6,482 Other mortgage-backed securities 575 22 1 596 Retained interests in securitizations 120 64 -- 184 Other securities 200 4 -- 204 - --------------------------------------------------------------------------------------------- Total securities available for sale $ 7,523 $ 143 $ 116 $ 7,550 ========= ====== ======= ======= - ---------------------------------------------------------------------------------------------
DECEMBER 31, 2002 --------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - --------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 120 $ 9 -- $ 129 - --------------------------------------------------------------------------------------------- SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 22 $ 1 -- $ 23 States and political subdivisions 35 -- -- 35 Collateralized mortgage obligations 7,143 129 $ 65 7,207 Other mortgage-backed securities 815 37 -- 852 Retained interests in securitizations 166 43 -- 209 Other securities 208 -- 27 181 - --------------------------------------------------------------------------------------------- Total securities available for sale $ 8,389 $ 210 $ 92 $ 8,507 ========= ====== ======= ======= - ---------------------------------------------------------------------------------------------
SEPTEMBER 30, 2002 --------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - --------------------------------------------------------------------------------------------- INVESTMENT SECURITIES States and political subdivisions $ 148 $ 10 -- $ 158 - --------------------------------------------------------------------------------------------- SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 20 $ 1 -- $ 21 States and political subdivisions 17 1 -- 18 Collateralized mortgage obligations 6,156 98 $ 60 6,194 Other mortgage-backed securities 748 35 -- 783 Retained interests in securitizations 182 35 -- 217 Other securities 216 -- 40 176 - --------------------------------------------------------------------------------------------- Total securities available for sale $ 7,339 $ 170 $ 100 $ 7,409 ========= ====== ======= ======= - ---------------------------------------------------------------------------------------------
18 6. LOANS Key's loans by category are summarized as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2003 2002 2002 - --------------------------------------------------------------------------------------------- Commercial, financial and agricultural $ 17,118 $ 17,425 $ 17,419 Commercial real estate: Commercial mortgage 5,822 6,015 6,237 Construction 5,236 5,659 5,845 - ------------------------------------------------------------------------------------------- Total commercial real estate loans 11,058 11,674 12,082 Commercial lease financing 8,123 7,513 7,369 - ------------------------------------------------------------------------------------------- Total commercial loans 36,299 36,612 36,870 Real estate--residential mortgage 1,665 1,968 2,098 Home equity 14,879 13,804 13,516 Consumer--direct 2,154 2,161 2,167 Consumer--indirect: Automobile lease financing 400 873 1,137 Automobile loans 2,093 2,181 2,256 Marine 2,489 2,088 2,047 Other 561 667 870 - ------------------------------------------------------------------------------------------- Total consumer--indirect loans 5,543 5,809 6,310 - ------------------------------------------------------------------------------------------- Total consumer loans 24,241 23,742 24,091 Loans held for sale: Commercial, financial and agricultural -- 41 -- Real estate--commercial mortgage 210 193 309 Real estate--residential mortgage 59 57 49 Education 1,914 1,812 1,632 - ------------------------------------------------------------------------------------------- Total loans held for sale 2,183 2,103 1,990 - ------------------------------------------------------------------------------------------- Total loans $ 62,723 $ 62,457 $ 62,951 =========== ========== ========== - -------------------------------------------------------------------------------------------
Key uses interest rate swaps to manage interest rate risk; these swaps modify the repricing and maturity characteristics of certain loans. For more information about such swaps, see Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders. Changes in the allowance for loan losses are summarized as follows:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ -------------------- in millions 2003 2002 2003 2002 - ---------------------------------------------------------------------------- Balance at beginning of period $ 1,405 $ 1,539 $ 1,452 $ 1,677 Charge-offs (159) (211) (528) (680) Recoveries 36 26 103 86 - --------------------------------------------------------------------------- Net charge-offs (123) (185) (425) (594) Provision for loan losses 123 135 378 406 - --------------------------------------------------------------------------- Balance at end of period $ 1,405 $ 1,489 $ 1,405 $ 1,489 ======= ======= ======= ======= - ---------------------------------------------------------------------------
19 7. VARIABLE INTEREST ENTITIES A VIE is a partnership, limited liability company, trust or other legal entity that does not have sufficient equity to permit it to finance its activities without additional subordinated financial support from other parties, or whose investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics are: (i) the direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights; (ii) the obligation to absorb the expected losses of an entity if they occur; and (iii) the right to receive the expected residual returns of the entity, if they occur. Interpretation No. 46, "Consolidation of Variable Interest Entities," addresses the consolidation of VIEs. This interpretation is summarized in Note 1 ("Basis of Presentation"), under the heading "Accounting Pronouncements Adopted in 2003" on page 9. Under Interpretation No. 46, VIEs are consolidated by the party who is exposed to a majority of the VIE's expected losses and/or residual returns (i.e., the primary beneficiary). Transferors of assets to qualifying special purpose entities meeting the requirements of SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," are exempt from the scope of Interpretation No. 46. As a result, Key's securitization trusts are exempt from consolidation under this interpretation. Effective July 1, 2003, Key adopted Interpretation No. 46. As of September 30, 2003, the consolidation or de-consolidation of VIEs in accordance with the implementation of Interpretation No. 46 increased Key's assets by $847 million and had no material effect on Key's results of operations for the third quarter of 2003. As required, assets, liabilities and noncontrolling interests of newly consolidated entities were initially recorded at their carrying amounts. Key's involvement with VIEs, including those consolidated and de-consolidated and those in which Key holds a significant interest, are described below. "Significant interests" has been defined by Key as subordinated interests in VIEs that expose Key to a portion of the VIEs' expected losses or residual returns, if they occur. COMMERCIAL PAPER CONDUIT. Key, among others, refers third party assets and borrowers and provides liquidity and credit enhancement to an asset-backed commercial paper conduit. Key determined that it is the primary beneficiary of this conduit and consolidated it effective July 1, 2003. At September 30, 2003, the conduit had assets of $276 million, of which $200 million are recorded in "loans" and $72 million are recorded in "securities available for sale" on the balance sheet. These assets serve as collateral for the conduit's obligations to commercial paper holders. The commercial paper holders have no recourse to Key's general credit other than through Key's committed credit enhancement facility of $60 million. Additional information pertaining to Key's involvement with the conduit is summarized in Note 10 ("Contingent Liabilities and Guarantees") under the heading "Guarantees" on page 26 and under the heading "Other Off-Balance Sheet Risk" on page 28. LOW-INCOME HOUSING TAX CREDIT ("LIHTC") GUARANTEED FUNDS. Key Affordable Housing Corporation ("KAHC") forms limited partnerships (funds) that invest in LIHTC operating partnerships. Interests in these funds are offered to qualified investors who pay a fee to KAHC for a guaranteed return. Key also earns syndication and asset management fees from these funds. Key determined that it is the primary beneficiary of these funds and consolidated them effective July 1, 2003. The funds' assets are primarily investments in LIHTC operating partnerships, which totaled $470 million at September 30, 2003. These investments are recorded in "accrued income and other assets" on the balance sheet and serve as collateral for the funds' limited obligations. No new guaranteed funds were formed during the quarter ended September 30, 2003, and in October management elected to discontinue new projects under this program. Additional information on return guaranty agreements with LIHTC investors is summarized in Note 10 under the heading "Guarantees." Under the terms of its partnership agreement, each guaranteed fund is required to be dissolved by a certain date. Therefore, in accordance with SFAS No. 150, the noncontrolling interests associated with these funds are mandatorily redeemable instruments and are recorded in "accrued expense and other liabilities" on the balance sheet. In November 2003, the FASB indefinitely deferred the measurement and recognition provisions of SFAS No. 150 for mandatorily redeemable noncontrolling interests associated with finite-lived subsidiaries. Key currently accounts for these noncontrolling interests as minority interests, and adjusts the financial statements each period for the investors' share of fund profits and losses. At September 30, 2003, the settlement value of these noncontrolling interests was estimated to be between $631 million and $785 million, while the recorded value, including reserves, totaled $455 million. Additional information on SFAS No. 150 is summarized in Note 1 under the heading "Accounting Pronouncements Adopted in 2003." 20 LIHTC NONGUARANTEED FUNDS. KAHC sells investments in certain LIHTC funds without guaranteeing a return to the investors and earns syndication and asset management fees for services provided to these nonguaranteed funds. Key determined that it is the primary beneficiary of those nonguaranteed funds that do not have a majority investor and consolidated them effective July 1, 2003. The funds' assets are primarily investments in LIHTC operating partnerships, which totaled $78 million at September 30, 2003. These investments are recorded in "accrued income and other assets" on the balance sheet and serve as collateral for the funds' limited obligations. The investors have no recourse to Key's general credit. Key has determined that all other nonguaranteed funds in which it has invested are VIEs in which Key has significant interests, but for which it is not the primary beneficiary. Therefore, these funds remain unconsolidated. At September 30, 2003, assets of these unconsolidated nonguaranteed funds were estimated to be $255 million. Key's maximum exposure to loss from its involvement with these funds is minimal. Nonguaranteed funds formed in the third quarter of 2003 did not have any material effect on Key's financial condition or results of operations. In October 2003, management elected to discontinue new projects under this program. BUSINESS TRUSTS ISSUING MANDATORILY REDEEMABLE PREFERRED CAPITAL SECURITIES. Key owns the common stock of seven business trusts that have issued corporation-obligated mandatorily redeemable preferred capital securities to third party investors. The trusts' only assets, which totaled $1.3 billion at September 30, 2003, are debentures issued by Key that were acquired by the trusts using proceeds from the issuance of preferred securities and common stock. Prior to July 1, 2003, Key consolidated these trusts. Upon adoption of Interpretation No. 46, Key determined that it is not the primary beneficiary of these trusts and de-consolidated them effective July 1, 2003. Key recorded the debentures in "long-term debt" and its equity interest in the business trusts in "accrued income and other assets" on the balance sheet. For regulatory reporting purposes, the Federal Reserve Board has advised that such preferred securities will continue to constitute Tier 1 capital until further notice. Additional information on the trusts is summarized in Note 9 ("Capital Securities Issued by Unconsolidated Subsidiaries"), which begins on page 23. LIHTC INVESTMENTS. For more than ten years, Key has made investments directly in LIHTC operating partnerships through the Retail Banking line of business. As a limited partner in these operating partnerships, Key is allocated tax credits and deductions associated with the underlying properties. Key has determined that the operating partnerships are VIEs in which Key has significant interests, but for which it is not the primary beneficiary. Therefore, these operating partnerships remain unconsolidated. At September 30, 2003, assets of these unconsolidated LIHTC operating partnerships totaled approximately $900 million. Key's maximum exposure to loss from its involvement with these partnerships is the unamortized investment balance of $290 million at September 30, 2003, plus $47 million of tax credits claimed, but subject to recapture. During the third quarter of 2003, Key obtained no significant interests in LIHTC operating partnerships. COMMERCIAL AND RESIDENTIAL REAL ESTATE INVESTMENTS AND PRINCIPAL INVESTMENTS. Through the KeyBank Real Estate Capital line of business, Key makes mezzanine investments in construction, acquisition and rehabilitation projects that Key has determined to be VIEs. Key receives underwriting and other fees from these VIEs and, for certain projects, may also provide the senior financing. Key's Principal Investing unit makes direct investments in equity and mezzanine instruments offered by individual companies, some of which Key has determined to be VIEs. These investments are held by nonregistered investment companies subject to the provisions of the AICPA Audit and Accounting Guide, "Audits of Investment Companies" ("Audit Guide"). In October 2003, the FASB issued final guidance that defers the effective date of Interpretation No. 46 for such nonregistered investment companies until the AICPA finalizes its Statement of Position on the clarification of the scope of the Audit Guide. As a result, Key is not currently applying the accounting or disclosure provisions of Interpretation No. 46 to its real estate mezzanine and principal investments, which remain unconsolidated. 21 8. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS Impaired loans, which account for the largest portion of Key's nonperforming assets, totaled $459 million at September 30, 2003, compared with $610 million at December 31, 2002, and $645 million at September 30, 2002. Impaired loans averaged $479 million for the third quarter of 2003 and $658 million for the third quarter of 2002. Key's nonperforming assets were as follows:
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2003 2002 2002 - ----------------------------------------------------------------------------------- Impaired loans $ 459 $ 610 $ 645 Other nonaccrual loans 336 333 342 - ----------------------------------------------------------------------------------- Total nonperforming loans 795 943 987 Other real estate owned ("OREO") 69 48 30 Allowance for OREO losses (4) (3) (2) - ----------------------------------------------------------------------------------- OREO, net of allowance 65 45 28 Other nonperforming assets 2 5 2 - ----------------------------------------------------------------------------------- Total nonperforming assets $ 862 $ 993 $ 1,017 ====== ======= ======== - -----------------------------------------------------------------------------------
At September 30, 2003, Key did not have any significant commitments to lend additional funds to borrowers with loans on nonperforming status. When expected cash flows or collateral values do not justify the carrying amount of an impaired loan, the loan is assigned a specific allowance. Management calculates the extent of the impairment, which is the carrying amount of the loan less the estimated present value of future cash flows and the fair value of any existing collateral. The amount that management deems uncollectible (the impaired amount) is charged against the allowance for loan losses. Even when collateral value or other sources of repayment appear sufficient, if management remains uncertain about whether the loan will be repaid in full, an appropriate amount is specifically allocated in the allowance for loan losses. At September 30, 2003, Key had $286 million of impaired loans with a specifically allocated allowance for loan losses of $93 million, and $173 million of impaired loans that were carried at their estimated fair value without a specifically allocated allowance. At December 31, 2002, impaired loans included $377 million of loans with a specifically allocated allowance of $179 million, and $233 million that were carried at their estimated fair value without a specifically allocated allowance. Key does not perform a loan-specific impairment valuation for smaller-balance, homogeneous, nonaccrual loans (shown in the preceding table as "Other nonaccrual loans"). These typically are consumer loans, including residential mortgages, home equity loans and various types of installment loans. Management applies historical loss experience rates to these loan portfolios, adjusted to reflect emerging credit trends and other factors, and then allocates a portion of the allowance for loan losses to each loan type. 22 9. CAPITAL SECURITIES ISSUED BY UNCONSOLIDATED SUBSIDIARIES Prior to July 1, 2003, KeyCorp fully consolidated six subsidiary business trusts that issued corporation-obligated mandatorily redeemable preferred capital securities ("capital securities"). These securities were carried as liabilities on Key's balance sheet prior to July 1, 2003. In July 2003, KeyCorp Capital V, KeyCorp's seventh business trust, issued its preferred capital securities. KeyCorp owns the outstanding common stock of each of these trusts, which used the proceeds from the issuance of their capital securities and common stock to buy debentures issued by KeyCorp. These debentures are the trusts' only assets; the interest payments from the debentures finance the distributions paid on the capital securities. Prior to July 1, 2003, Key's financial statements did not reflect the debentures or the related effects on the income statement because they were eliminated in consolidation. Under Interpretation No. 46, Key determined that these business trusts are VIEs for which it is not the primary beneficiary. Therefore, effective July 1, 2003, the trusts were de-consolidated and are accounted for using the equity method. Additional information regarding Interpretation No. 46 and these business trusts is summarized in Note 1 ("Basis of Presentation"), which begins on page 7, and in Note 7 ("Variable Interest Entities") under the heading "Business trusts issuing mandatorily redeemable preferred capital securities" on page 21. The characteristics of the business trusts and capital securities have not changed with the de-consolidation of the trusts. The capital securities provide an attractive source of funds since they constitute Tier 1 capital for regulatory reporting purposes, but have the same tax advantages as debt for federal income tax purposes. Although the Federal Reserve Board has indicated that it will continue to treat capital securities as Tier 1 capital until further notice, management believes that the change in accounting treatment for capital securities (i.e., de-consolidation) could possibly move the Federal Reserve Board to propose changes in the capital treatment of such securities in the future. Because no specific proposal to this effect has been published, however, management is unable to determine how such change could affect Key. To the extent the trusts have funds available to make payments, as guarantor, KeyCorp continues to unconditionally guarantee payment of: - - required distributions on the capital securities; - - the redemption price when a capital security is redeemed; and - - amounts due if a trust is liquidated or terminated. During the first nine months of 2003, the business trusts repurchased $30 million of their outstanding capital securities and KeyCorp repurchased a like amount of the related debentures. On July 21, 2003, $175 million of lower cost securities were issued by the Capital V trust. 23 The capital securities, common stock and related debentures are summarized as follows:
PRINCIPAL INTEREST RATE MATURITY CAPITAL AMOUNT OF OF CAPITAL OF CAPITAL SECURITIES, COMMON DEBENTURES, SECURITIES AND SECURITIES AND dollars in millions NET OF DISCOUNT(a) STOCK NET OF DISCOUNT(b) DEBENTURES(c) DEBENTURES - ---------------------------------------------------------------------------------------------------------------------- September 30, 2003 KeyCorp Institutional Capital A $ 402 $ 11 $ 361 7.826 % 2026 KeyCorp Institutional Capital B 173 4 154 8.250 2026 KeyCorp Capital I 210 8 218 1.854 2028 KeyCorp Capital II 177 8 165 6.875 2029 KeyCorp Capital III 232 8 197 7.750 2029 KeyCorp Capital V 175 5 180 5.875 2033 Union Bankshares Capital Trust I 10 1 11 9.000 2028 - ---------------------------------------------------------------------------------------------------------------------- Total $ 1,379 $ 45 $ 1,286 6.596 % -- ========== ====== ========= - ---------------------------------------------------------------------------------------------------------------------- December 31, 2002 $ 1,260 $ 40 $ 1,136 6.779 % -- ========== ====== ========= - ---------------------------------------------------------------------------------------------------------------------- September 30, 2002 $ 1,282 $ 39 $ 1,159 6.784 % -- ========== ====== ========= - ----------------------------------------------------------------------------------------------------------------------
(a) The capital securities must be redeemed when the related debentures mature, or earlier if provided in the governing indenture. Each issue of capital securities carries an interest rate identical to that of the related debenture. Prior to July 1, 2003, the capital securities constituted minority interests in the equity accounts of KeyCorp's consolidated subsidiaries. Effective July 1, 2003, the business trusts that issued the capital securities were de-consolidated. However, until further notice from the Federal Reserve Board, the capital securities continue to qualify as Tier 1 capital under Federal Reserve Board guidelines. Included in certain capital securities at September 30, 2003, December 31, 2002 and September 30, 2002, are basis adjustments of $138 million, $164 million and $162 million, respectively, related to fair value hedges. See Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders, for an explanation of fair value hedges. (b) KeyCorp has the right to redeem its debentures: (i) in whole or in part, on or after December 1, 2006 (for debentures owned by Capital A), December 15, 2006 (for debentures owned by Capital B), July 1, 2008 (for debentures owned by Capital I), March 18, 1999 (for debentures owned by Capital II), July 16, 1999 (for debentures owned by Capital III), July 21, 2008 (for debentures owned by Capital V), and December 17, 2003 (for debentures owned by Union Bankshares Capital Trust I); and, (ii) in whole at any time within 90 days after and during the continuation of a "tax event" or a "capital treatment event" (as defined in the applicable offering circular). If the debentures purchased by Capital A or Capital B are redeemed before they mature, the redemption price will be the principal amount, plus a premium, plus any accrued but unpaid interest. If the debentures purchased by Capital I, Capital V, or Union Bankshares Capital Trust I are redeemed before they mature, the redemption price will be the principal amount, plus any accrued but unpaid interest. If the debentures purchased by Capital II or Capital III are redeemed before they mature, the redemption price will be the greater of: (a) the principal amount, plus any accrued but unpaid interest or (b) the sum of the present values of principal and interest payments discounted at the Treasury Rate (as defined in the applicable offering circular), plus 20 basis points (25 basis points for Capital III), plus any accrued but unpaid interest. When debentures are redeemed in response to tax or capital treatment events, the redemption price generally is slightly more favorable to Key. (c) The interest rates for Capital A, Capital B, Capital II, Capital III, Capital V, and Union Bankshares Capital Trust I are fixed. Capital I has a floating interest rate equal to three-month LIBOR plus 74 basis points; it reprices quarterly. The rates shown as the total at September 30, 2003, December 31, 2002 and September 30, 2002, are weighted average rates. 24 10. CONTINGENT LIABILITIES AND GUARANTEES LEGAL PROCEEDINGS RESIDUAL VALUE INSURANCE LITIGATION. Key Bank USA, National Association ("Key Bank USA") obtained two insurance policies from Reliance Insurance Company ("Reliance") insuring the residual value of certain automobiles leased through Key Bank USA. The two policies ("the Policies"), the "4011 Policy" and the "4019 Policy," together covered leases entered into during the period from January 1, 1997 to January 1, 2001. The 4019 Policy contains an endorsement stating that Swiss Reinsurance America Corporation ("Swiss Re") will assume and reinsure 100% of Reliance's obligations under the 4019 Policy in the event Reliance Group Holdings' ("Reliance's parent") so-called "claims-paying ability" were to fall below investment grade. Key Bank USA also entered into an agreement with Swiss Re and Reliance whereby Swiss Re agreed to issue to Key Bank USA an insurance policy on the same terms and conditions as the 4011 Policy in the event the financial condition of Reliance Group Holdings fell below a certain level. Around May 2000, the conditions under both the 4019 Policy and the Swiss Re agreement were triggered. The 4011 Policy was canceled and replaced as of May 1, 2000, by a policy issued by North American Specialty Insurance Company (a subsidiary or affiliate of Swiss Re) ("the NAS Policy"). Tri-Arc Financial Services, Inc. ("Tri-Arc") acted as agent for Reliance, Swiss Re and NAS. Since February 2000, Key Bank USA has been filing claims under the Policies, but none of these claims has been paid. In July 2000, Key Bank USA filed a claim for arbitration against Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, a declaration of the scope of coverage under the Policies and for damages. On January 8, 2001, Reliance filed an action (litigation) against Key Bank USA in Federal District Court in Ohio seeking rescission or reformation of the Policies because they allegedly do not reflect the intent of the parties with respect to the scope of coverage and how and when claims were to be paid. Key filed an answer and counterclaim against Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, declaratory relief as to the scope of coverage under the Policies, damages for breach of contract and failure to act in good faith, and punitive damages. The parties agreed to proceed with this court action and to dismiss the arbitration without prejudice. On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order placing Reliance in a court supervised "rehabilitation" and purporting to stay all litigation against Reliance. On July 23, 2001, the Federal District Court in Ohio stayed the litigation to allow the rehabilitator to complete her task. On October 3, 2001, the Court in Pennsylvania entered an order placing Reliance into liquidation and canceling all Reliance insurance policies as of November 2, 2001. On November 20, 2001, the Federal District Court in Ohio entered an order that, among other things, required Reliance to report to the Court on the progress of the liquidation. On January 15, 2002, Reliance filed a status report requesting the continuance of the stay for an indefinite period. On February 20, 2002, Key Bank USA filed a Motion for Partial Lifting of the July 23, 2001, Stay in which it asked the Court to allow the case to proceed against the parties other than Reliance. The Court granted Key Bank USA's motion on May 17, 2002. As of February 19, 2003, all claims against Tri-Arc were dismissed through a combination of court action and voluntary dismissal by Key Bank USA. Management believes that Key Bank USA has valid insurance coverage or claims for damages relating to the residual value of automobiles leased through Key Bank USA during the four-year period ending January 1, 2001. With respect to each individual lease, however, it is not until the lease expires and the vehicle is sold that Key Bank USA can determine the existence and amount of any actual loss (i.e., the difference between the residual value provided for in the lease agreement and the vehicle's actual market value at lease expiration). Key Bank USA's actual total losses for which it will file claims will depend to a large measure upon the viability of, and pricing within, the market for used cars throughout the lease run-off period, which extends through 2006. The market for used cars varies. 25 Accordingly, the total expected loss on the portfolio for which Key Bank USA will file claims cannot be determined with certainty at this time. Claims filed by Key Bank USA through September 30, 2003, total approximately $330 million, and management currently estimates that approximately $57 million of additional claims may be filed through year-end 2006 bringing the total aggregate amount of actual and potential claims to $387 million. As discussed previously, a number of factors could affect Key Bank USA's actual loss experience, which may be higher or lower than management's current estimates. Key is filing insurance claims for its losses and is recording as a receivable on its balance sheet a portion of the amount of the insurance claims as and when they are filed. Management believes the amount being recorded as a receivable due from the insurance carriers is appropriate to reflect the collectibility risk associated with the insurance litigation; however, litigation is inherently not without risk, and any actual recovery from the litigation may be more or less than the receivable. While management does not expect an adverse decision, if a court were to make an adverse final determination, such result would cause Key to record a material one-time expense during the period when such determination is made. An adverse determination would not have a material effect on Key's financial condition, but could have a material adverse effect on Key's results of operations in the quarter it occurs. OTHER LITIGATION. In the ordinary course of business, Key is subject to legal actions that involve claims for substantial monetary relief. Based on information presently known to management, management does not believe there is any legal action to which KeyCorp or any of its subsidiaries is a party, or involving any of their properties, that, individually or in the aggregate, could reasonably be expected to have a material adverse effect on Key's financial condition or annual results of operations. GUARANTEES Key is a guarantor in various agreements with third parties. In accordance with Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," certain guarantees issued or modified on or after January 1, 2003, require the recognition of a liability on Key's balance sheet for the "stand ready" obligation associated with such guarantees. The accounting for guarantees existing at December 31, 2002, was not revised. Additional information pertaining to Interpretation No. 45 is summarized in Note 1 ("Basis of Presentation") under the heading "Accounting Pronouncements Adopted in 2003" on page 9. The following table shows the types of guarantees (as defined by Interpretation No. 45) that Key had outstanding at September 30, 2003.
MAXIMUM POTENTIAL UNDISCOUNTED LIABILITY in millions FUTURE PAYMENTS RECORDED - ----------------------------------------------------------------------------------------------- Financial Guarantees: Standby letters of credit $ 5,915 $ 24 Credit enhancement for asset-backed commercial paper conduit 60 -- Recourse agreement with FNMA 524 4 Return guaranty agreement with LIHTC investors 785 34 Default guarantees 9 -- Written interest rate caps(a) 72 18 - ---------------------------------------------------------------------------------------------- Total $ 7,365 $ 80 ========== ======= - ----------------------------------------------------------------------------------------------
(a) As of September 30, 2003, the weighted average interest rate of written interest rate caps was 1.3%. Maximum potential undiscounted future payments were calculated assuming a 10% interest rate. STANDBY LETTERS OF CREDIT. These instruments obligate Key to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument, or fails to perform some contractual nonfinancial obligation. Standby letters of credit are issued by many of Key's lines of business to address clients' financing needs. If amounts are drawn under standby letters of credit, such amounts are treated as loans; they bear interest (generally at variable rates) and pose the same credit risk to Key as a loan. At September 30, 2003, Key's standby letters of credit had a remaining weighted average life of approximately 2 years, with remaining actual lives ranging from less than 1 year to as many as 16 years. 26 CREDIT ENHANCEMENT FOR ASSET-BACKED COMMERCIAL PAPER CONDUIT. Key provides credit enhancement in the form of a committed facility to ensure the continuing operations of an asset-backed commercial paper conduit, which is owned by a third party and administered by an unaffiliated financial institution. The commitment to provide credit enhancement extends until September 25, 2004, and specifies that in the event of default by certain borrowers whose loans are held by the conduit, Key will provide financial relief to the conduit in an amount that is based on defined criteria that consider the level of credit risk involved and other factors. Key consolidated the conduit upon adoption of Interpretation No. 46 on July 1, 2003. At September 30, 2003, Key's funding requirement under the credit enhancement facility totaled $60 million. However, there were no drawdowns under the facility during the nine-month period ended September 30, 2003. Key has no recourse or other collateral available to offset any amounts that may be funded under this credit enhancement facility. Key's commitments to provide credit enhancement to the conduit are periodically evaluated by management. RECOURSE AGREEMENT WITH FEDERAL NATIONAL MORTGAGE ASSOCIATION. KBNA participates as a lender in the Federal National Mortgage Association ("FNMA") Delegated Underwriting and Servicing ("DUS") program. As a condition to FNMA's delegation of responsibility for originating, underwriting and servicing mortgages, KBNA has agreed to assume a limited portion of the risk of loss during the remaining term on each commercial mortgage loan sold to FNMA. Accordingly, a reserve for such potential losses has been established and is maintained in an amount estimated by management to approximate the fair value of the liability undertaken by KBNA. At September 30, 2003, the outstanding commercial mortgage loans in this program had a weighted average remaining term of 10 years and the unpaid principal balance outstanding of loans sold by KBNA as a participant in this program was approximately $1.6 billion. The maximum potential amount of undiscounted future payments that may be required under this program is equal to one-third of the principal balance of loans outstanding at September 30, 2003. If payment is required under this program, Key would have an interest in the collateral underlying the commercial mortgage loan on which the loss occurred. RETURN GUARANTEE AGREEMENT WITH LOW-INCOME HOUSING TAX CREDIT ("LIHTC") INVESTORS. Key Affordable Housing Corporation ("KAHC"), a subsidiary of KBNA, offers limited partnership interests to qualified investors. Partnerships formed by KAHC invest in low-income residential rental properties that qualify for federal LIHTCs under Section 42 of the Internal Revenue Code. In certain partnerships, investors pay a fee to KAHC for a guaranteed return that is dependent on the financial performance of the property and the property's ability to maintain its LIHTC status throughout the fifteen-year compliance period. If these two conditions are not achieved, Key is obligated to make any necessary payments to investors to provide the guaranteed return. Key consolidated these partnerships upon adoption of Interpretation No. 46 on July 1, 2003. Additional information regarding Interpretation No. 46 and these partnerships is summarized in Note 1 and Note 7 ("Variable Interest Entities"), which begins on page 20. KAHC has the ability to affect changes in the management of the properties to improve performance. However, other than the underlying income stream from the properties, no recourse or collateral would be available to offset the guarantee obligation. These guarantees have expiration dates that extend through 2018. Key meets its obligations pertaining to the guaranteed returns generally through the distribution of tax credits and deductions associated with the specific properties. As shown in the preceding table, KAHC established a reserve in the amount of $34 million at September 30, 2003, which management believes will be sufficient to cover estimated future obligations under the guarantees. The maximum exposure to loss reflected in the preceding table represents undiscounted future payments due to investors for the return on and of their investments. In accordance with Interpretation No. 45, for any return guarantee agreements entered into or modified with LIHTC investors on or after January 1, 2003, the amount of all fees received in consideration for the guarantee has been recognized in the stand ready obligation. VARIOUS TYPES OF DEFAULT GUARANTEES. Some lines of business provide or participate in guarantees that obligate Key to perform if the debtor fails to pay all or a portion of the subject indebtedness and/or related interest. These guarantees are generally undertaken when Key is supporting or protecting its underlying investment or where the risk profile of the debtor should provide an investment return. The terms of these default guarantees range from less than 1 year to as many as 18 years. Although no collateral is held, Key would have recourse against the debtors for any payments made under these default guarantees. 27 WRITTEN INTEREST RATE CAPS. In the ordinary course of business, Key writes interest rate caps for commercial loan clients that have variable rate loans with Key. These caps are purchased by clients to limit their exposure to interest rate increases and at September 30, 2003, had a weighted average life of approximately 5 years. Key is obligated to pay the interest rate counterparty if the applicable benchmark interest rate exceeds a specified level (known as the "strike rate"). These instruments are accounted for as derivatives with the fair value liability recorded in "accrued expense and other liabilities" on the balance sheet. Key's potential amount of future payments under these obligations is mitigated by the fact that the company enters into offsetting positions with third parties. OTHER OFF-BALANCE SHEET RISK Other off-balance sheet risk stems from financial instruments that do not meet the definition of a guarantee as specified in Interpretation No. 45 and from other relationships. LIQUIDITY FACILITY THAT SUPPORTS ASSET-BACKED COMMERCIAL PAPER CONDUIT. Key provides liquidity to an asset-backed commercial paper conduit that is owned by a third party and administered by an unaffiliated financial institution. See further discussion of the conduit in Note 7. This liquidity facility obligates Key, through February 15, 2005, to provide funding if such is required as a result of a disruption in credit markets or other factors. Key provides liquidity to this conduit in the form of a committed facility of $1.1 billion. The amount available to be drawn was $435 million at September 30, 2003. However, there were no drawdowns under this committed facility at that time. Key's commitment to provide liquidity is periodically evaluated by management. INDEMNIFICATIONS PROVIDED IN THE ORDINARY COURSE OF BUSINESS. Key provides certain indemnifications primarily through representations and warranties in contracts that are entered into in the ordinary course of business in connection with loan sales and other ongoing activities, as well as in connection with purchases and sales of businesses. Management's past experience with these indemnifications has been that the amounts paid, if any, have not had a significant effect on Key's financial condition or results of operations. INTERCOMPANY GUARANTEES. KeyCorp and primarily KBNA are parties to various guarantees that are undertaken to facilitate the ongoing business activities of other Key affiliates. These business activities encompass debt issuance, certain lease and insurance obligations, investments and securities, and certain leasing transactions involving clients. RELATIONSHIP WITH MASTERCARD INTERNATIONAL INC. AND VISA U.S.A. INC. KBNA and Key Bank USA are members of MasterCard International Incorporated ("MasterCard") and Visa U.S.A. Inc. ("Visa"). MasterCard's charter documents and bylaws state that MasterCard may assess its members for certain liabilities that it incurs, including litigation liabilities. Visa's charter documents state that Visa may fix fees payable by members in connection with Visa's operations. We understand that descriptions of significant pending lawsuits and MasterCard's and Visa's positions regarding the potential impact of those lawsuits on members are set forth on MasterCard's and Visa's respective websites, as well as in MasterCard's public filings with the Securities and Exchange Commission. Key is not a party to any significant litigation by third parties against MasterCard or Visa. In June 2003, MasterCard and Visa agreed, independently, to settle a class-action lawsuit that was brought against them by Wal-Mart Stores Inc. and many other retailers. The lawsuit alleged that MasterCard and Visa violated federal antitrust laws by conspiring to monopolize the debit card services market and by requiring merchants that accept certain of their debit and credit card services to also accept their higher priced "off-line," signature-verified debit card services. Under the terms of the proposed settlements, which remain subject to court approval, beginning August 1, 2003, MasterCard and Visa have agreed to pay a total of approximately $3 billion, over a 10-year period, to merchants who claim to have been harmed by their actions and to lower the fees they charge merchants for their "off-line" signature-verified debit card services. Also, as of January 1, 2004, such merchants will no longer be required to accept MasterCard or Visa debit card services when they accept MasterCard or Visa credit card services. Accordingly, management believes that the settlements will result in the reduction of fees earned by KBNA and Key Bank USA from off-line debit card transactions. Management estimates that the impact of the settlement on 28 Key will be a reduction to pre-tax net income of less than $5 million for the balance of 2003 and less than $25 million in 2004. This estimate is subject to change once management completes its evaluation of alternative actions that may be available to it in response to the settlements, and has had an opportunity to observe any changes in the marketplace for card services that occur in response to the settlements. It is management's understanding that certain retailers have opted-out of the class-action settlement and that additional suits have been filed against MasterCard and Visa seeking additional damage recovery. Management is unable at this time to estimate the possible impact of any such actions. 11. DERIVATIVES AND HEDGING ACTIVITIES Key, mainly through its lead bank, KBNA, is party to various derivative instruments. These instruments are used for asset and liability management and trading purposes. Generally, these instruments help Key meet clients' financing needs and manage exposure to "market risk"--the possibility that economic value or net interest income will be adversely affected by changes in interest rates or other economic factors. However, like other financial instruments, these derivatives contain an element of "credit risk"--the possibility that Key will incur a loss because a counterparty fails to meet its contractual obligations. The primary derivatives that Key uses are interest rate swaps, caps and futures, and foreign exchange forward contracts. All foreign exchange forward contracts and interest rate swaps and caps held are over-the-counter instruments. At September 30, 2003, Key had $788 million of derivative assets and $146 million of derivative liabilities on its balance sheet that arose from derivatives that were being used for hedging purposes. As of the same date, derivative assets and liabilities classified as trading derivatives totaled $1.4 billion and $1.3 billion, respectively. Derivative assets and liabilities are recorded at fair value in "accrued income and other assets" and "accrued expense and other liabilities," respectively, on the balance sheet. Key uses a fair value hedging strategy to modify its exposure to interest rate risk and a cash flow hedging strategy to reduce the potential adverse impact of interest rate increases on future interest expense. For more information about these asset and liability management strategies used to modify Key's exposure to interest rate risk, see Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders. The change in "accumulated other comprehensive income (loss)" resulting from cash flow hedges is as follows:
RECLASSIFICATION DECEMBER 31, 2003 OF GAINS TO SEPTEMBER 30, in millions 2002 HEDGING ACTIVITY NET INCOME 2003 - -------------------------------------------------------------------------------------------------------------------- Accumulated other comprehensive income (loss) resulting from cash flow hedges $ 6 $ 34 $ (19) $ 21 - --------------------------------------------------------------------------------------------------------------------
Key expects to reclassify an estimated $26 million of net gains on derivative instruments from "accumulated other comprehensive income (loss)" to earnings during the next twelve months. Reclassifications will coincide with the income statement impact of the hedged item through the payment of variable-rate interest on debt, the receipt of variable-rate interest on commercial loans and the sale or securitization of commercial real estate loans. TRADING PORTFOLIO Key's trading portfolio includes: - - interest rate swap contracts entered into to accommodate the needs of clients; - - positions with third parties that are intended to offset or mitigate the interest rate risk of client positions; - - foreign exchange forward contracts entered into to accommodate the needs of clients; and - - proprietary trading positions in financial assets and liabilities. 29 The fair values of these trading portfolio items are included in "accrued income and other assets" or "accrued expense and other liabilities" on the balance sheet. Adjustments to the fair values are included in "investment banking and capital markets income" on the income statement. Additional information pertaining to Key's trading portfolio is summarized in Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's 2002 Annual Report to Shareholders. The following table shows trading income recognized on interest rate swaps and foreign exchange forward contracts.
NINE MONTHS ENDED SEPTEMBER 30, ----------------- in millions 2003 2002 - ------------------------------------------------------- Interest rate swap contracts $ 6 $ 8 Foreign exchange forward contracts 25 26 - -------------------------------------------------------
COUNTERPARTY CREDIT RISK Swaps and caps present credit risk because the counterparty, which may be a bank or a broker/dealer, may not meet the terms of the contract. This risk is measured as the expected positive replacement value of contracts. To mitigate credit risk, Key deals exclusively with counterparties that have high credit ratings. Key uses two additional means to manage exposure to credit risk on swap contracts. First, Key generally enters into bilateral collateral and master netting arrangements. These agreements include legal rights of setoff that provide for the net settlement of the related contracts with the same counterparty in the event of default. Second, Credit Administration monitors credit risk exposure to the counterparty on each interest rate swap to determine appropriate limits on Key's total credit exposure and whether it is advisable to demand collateral. At September 30, 2003, Key was party to interest rate swaps and caps with 59 different counterparties. Among these were swaps and caps entered into to offset the risk of client exposure. Key had aggregate exposure of $200 million (net of collateral of $472 million) on these instruments to 34 of the counterparties. The largest exposure to an individual counterparty amounted to approximately $62 million. Key has established a reserve in the amount of $12 million at September 30, 2003, which management believes will be sufficient to cover estimated future losses on the trading portfolio in the event of default. 30 INDEPENDENT ACCOUNTANTS' REVIEW REPORT SHAREHOLDERS AND BOARD OF DIRECTORS KEYCORP We have reviewed the unaudited condensed consolidated balance sheets of KeyCorp and subsidiaries ("Key") as of September 30, 2003 and 2002, and the related condensed consolidated statements of income for the three- and nine-month periods then ended, and the condensed consolidated statements of changes in shareholders' equity and cash flow for the nine-month periods ended September 30, 2003 and 2002. These financial statements are the responsibility of Key's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States. We have previously audited, in accordance with auditing standards generally accepted in the United States, the consolidated balance sheet of Key as of December 31, 2002, and the related consolidated statements of income, changes in shareholders' equity, and cash flow for the year then ended (not presented herein) and in our report dated January 13, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2002, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ Ernst & Young LLP Cleveland, Ohio October 14, 2003 31 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION This section generally reviews the financial condition and results of operations of KeyCorp and its subsidiaries for the quarterly and year-to-date periods ended September 30, 2003 and 2002. Some tables may cover more periods to comply with disclosure requirements or to illustrate trends in greater depth. When you read this discussion, you should also refer to the consolidated financial statements and related notes that appear on pages 3 through 30. SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES Key's business is dynamic and complex. Consequently, management must exercise judgment in choosing and applying accounting policies and methodologies in many areas. These choices are important; not only are they necessary to comply with accounting principles generally accepted in the United States, they also reflect management's view of the most appropriate manner in which to record and report Key's overall financial performance. All accounting policies are important, and all policies described in Note 1 ("Summary of Significant Accounting Policies"), which begins on page 57 of Key's 2002 Annual Report to Shareholders, should be reviewed for a greater understanding of how Key's financial performance is recorded and reported. In management's opinion, some accounting policies are more likely than others to have a significant effect on Key's financial results and to expose those results to potentially greater volatility. These policies apply to areas of relatively greater business importance or require management to make assumptions and estimates that affect amounts reported in the financial statements. Because these assumptions and estimates are based on current circumstances, they may change over time or prove to be inaccurate based on actual experience. For Key, areas that rely heavily on the use of assumptions and estimates include accounting for the allowance for loan losses, loan securitizations, contingent liabilities and guarantees, principal investments, goodwill, and pension and other postretirement obligations. A brief discussion of each of these areas appears below. ALLOWANCE FOR LOAN LOSSES. Management determines probable losses inherent in Key's loan portfolio (which represents by far the largest category of assets on Key's balance sheet) and establishes an allowance that is sufficient to absorb those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. Nonetheless, if management's underlying assumptions prove to be inaccurate, the allowance for loan losses would have to be adjusted. Our accounting policy related to the allowance is disclosed in Note 1 under the heading "Allowance for Loan Losses" on page 58 of the Annual Report. LOAN SECURITIZATIONS. Key securitizes certain types of loans and accounts for such transactions as sales when the criteria set forth in SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," are met. If future events were to preclude accounting for such transactions as sales, the loans would have to be placed back on Key's balance sheet. This could have a potentially adverse effect on Key's capital ratios and other unfavorable financial implications. In addition, determining the gain or loss resulting from securitization transactions and the subsequent carrying amount of retained interests is dependent on underlying assumptions made by management, the most significant of which are described in Note 8 ("Loan Securitizations and Variable Interest Entities"), which begins on page 70 of the Annual Report. The use of alternative ranges of possible outcomes for these assumptions would change the amount of the initial gain or loss recognized. It could also result in changes in the carrying amount of retained interests, with related effects on results of operations. Our accounting policy related to loan securitizations is disclosed in Note 1 under the heading "Loan Securitizations" on page 59 of the Annual Report. 32 CONTINGENT LIABILITIES AND GUARANTEES. Contingent liabilities arising from litigation, guarantees in various agreements with third parties in which Key is a guarantor and the potential effects of these items on Key's results of operations, are summarized in Note 10 ("Contingent Liabilities and Guarantees"), which begins on page 25. Since Key records a liability for only the fair value of the obligation to stand ready to perform over the term of a guarantee, the risk exists that potential future payments that would be made by Key in the event of a default by a third party could exceed the liability recorded on Key's balance sheet. See Note 10 for a comparison of the liability recorded and the maximum potential undiscounted future payments for the various types of guarantees that Key had outstanding at September 30, 2003. In the normal course of business, Key is routinely subject to examinations and challenges from tax authorities regarding the amount of taxes due in connection with investments and business activities. Currently, the Internal Revenue Service is challenging Key's tax treatment of certain leveraged lease investments. This and other challenges by tax authorities may result in adjustments to the timing or amount of Key's taxable income or deductions or the allocation of income among tax jurisdictions. Management believes these challenges will be resolved without having any material effect on Key's financial condition or results of operations. VALUATION METHODOLOGIES. Valuation methodologies employed by management often involve a significant degree of judgment, particularly when there are no observable liquid markets for the items being valued. The outcome of valuations performed by management have a direct bearing on the carrying amounts of certain assets and liabilities, such as principal investments, goodwill, and pension and other postretirement benefit obligations. To determine the values of these assets and liabilities, as well as the extent to which related assets may be impaired, management makes assumptions and estimates related to discount rates, asset returns, repayment rates and other factors. The use of different discount rates or other valuation assumptions could produce significantly different results, which could have material positive or negative effects on Key's results of operations. The valuation methodology management uses for principal investments is summarized in Note 21 ("Fair Value Disclosures of Financial Instruments") on page 86 of the Annual Report and the methodology used in the testing for goodwill impairment is summarized in Note 1 under the heading "Goodwill and Other Intangible Assets" on page 59 of the Annual Report. The primary assumptions used in determining Key's pension and other postretirement benefit obligations and related expenses are presented in Note 16 ("Employee Benefits"), which begins on page 78 of the Annual Report. When a potential asset impairment is identified through testing, observable changes in liquid markets or other means, management must also exercise judgment in determining the nature of the potential impairment (i.e., whether the impairment is temporary or other than temporary) in order to apply the appropriate accounting treatment. For example, unrealized losses on securities available for sale that are deemed temporary are recorded in shareholders' equity, whereas those deemed "other than temporary" are recorded in earnings. REVENUE RECOGNITION Corporate improprieties related to revenue recognition have received a great deal of attention by regulatory authorities and the news media. Although all companies face the risk of intentional or unintentional misstatements, Key's management believes that such misstatements are less likely in the financial services industry because most of the revenue (i.e., interest accruals) recorded is driven by nondiscretionary formulas based on written contracts, such as loan agreements. TERMINOLOGY This report contains some shortened names and industry-specific terms. We want to explain some of these terms at the outset so you can better understand the discussion that follows. 33 - - KEYCORP refers solely to the parent holding company. - - KBNA refers to Key's lead bank, KeyBank National Association. - - KEY refers to the consolidated entity consisting of KeyCorp and its subsidiaries. - - A KEYCENTER is one of Key's full-service retail banking facilities or branches. - - Key engages in CAPITAL MARKETS ACTIVITIES. These activities encompass a variety of products and services. Among other things, we trade securities as a dealer, enter into derivative contracts (both to accommodate clients' financing needs and for proprietary trading purposes), and conduct transactions in foreign currencies (both to accommodate clients' needs and to benefit from fluctuations in exchange rates). - - All earnings per share data included in this discussion are presented on a DILUTED basis, which takes into account all common shares outstanding as well as potential common shares that could result from the exercise of outstanding stock options. Some of the financial information tables also include BASIC earnings per share, which takes into account only common shares outstanding. - - For regulatory purposes, capital is divided into two classes. Federal regulations prescribe that at least one-half of a bank or bank holding company's TOTAL RISK-BASED CAPITAL must qualify as TIER 1. Both total and Tier 1 capital serve as bases for several measures of capital adequacy, which is an important indicator of financial stability and condition. You will find a more detailed explanation of total and Tier 1 capital and how they are calculated in the section entitled "Capital," which begins on page 63. - - When we want to draw your attention to a particular item in Key's Notes to Consolidated Financial Statements, we refer to NOTE ___, giving the particular number, name and starting page number. FORWARD-LOOKING STATEMENTS This report may contain "forward-looking statements" about issues like anticipated earnings, anticipated levels of net loan charge-offs and nonperforming assets, anticipated improvement in profitability and competitiveness and long-term goals. These statements usually can be identified by the use of forward-looking language such as "our goal," "our objective," "our plan," "will likely result," "will be," "are expected to," "as planned," "is anticipated," "intends to," "is projected," or similar words. Forward-looking statements by their nature are subject to assumptions, risks and uncertainties. For a variety of reasons, including the following, actual results could differ materially from those contained in or implied by the forward-looking statements. - - Interest rates could change more quickly or more significantly than we expect, which may have an adverse effect on our financial results. - - If the economy or segments of the economy fail to recover, or decline further, the demand for new loans and the ability of borrowers to repay outstanding loans may decline. - - The stock and bond markets could suffer additional declines or disruptions, which may have adverse effects on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities. - - It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses; we may be unable to implement certain initiatives; or the initiatives may be unsuccessful. - - Acquisitions and dispositions of assets, business units or affiliates could adversely affect us in ways that management has not anticipated. - - We may become subject to new legal obligations, or the resolution of pending litigation may have an adverse effect on our financial results. 34 - - Terrorist activities or military actions could further disrupt the economy and the general business climate, which may have an adverse effect on our financial results or condition and that of our borrowers. - - We may become subject to new accounting, tax, or regulatory practices or requirements. HIGHLIGHTS OF KEY'S PERFORMANCE FINANCIAL PERFORMANCE The primary measures of Key's financial performance for the third quarter and first nine months of 2003 and 2002 are summarized below. - - Net income for the third quarter of 2003 was $227 million, or $.53 per common share, compared with net income of $225 million, or $.53 per share, for the previous quarter and net income of $245 million, or $.57 per share, for the third quarter of 2002. For the first nine months of 2003, Key's net income was $669 million, or $1.57 per common share, compared with net income of $731 million, or $1.69 per share for the comparable period last year. - - Key's return on average equity was 13.06% for the third quarter of 2003. This result compares with a return of 12.98% for the prior quarter and a return of 14.74% for the year-ago quarter. For the first nine months of 2003, Key's return on average equity was 12.98%, compared with a return of 15.13% for the first nine months of 2002. - - Key's third quarter 2003 return on average total assets was 1.06%. This result compares with a return of 1.07% for the previous quarter and a return of 1.19% for the third quarter of 2002. For the first nine months of 2003, Key's return on average total assets was 1.06%, compared with a return of 1.20% for the comparable period in 2002. Key's third quarter results reflected several improved performance trends relative to the second quarter: - - Noninterest income grew by $29 million, driven by higher net gains from loan securitizations and sales and an increase in income from trust and investment services. - - Average core deposits grew by an annualized 8% and were up 13% from the same period last year. - - Asset quality continued to improve as the level of Key's nonperforming loans declined for the fourth consecutive quarter. Both nonperforming loans and net loan charge-offs reached their lowest levels since the first quarter of 2001. However, the third quarter also presented a difficult environment for net interest income, which declined by $19 million. A 12 basis point reduction in the net interest margin drove the decrease and was attributable to a number of factors, including the effects of a soft economy, significant prepayments of higher rate consumer loans and mortgage backed securities which began to slow late in the third quarter, and narrower deposit spreads resulting from declining interest rates. During the same period, the level of Key's average earning assets was essentially unchanged as continued growth in home equity loans was offset by declines in the levels of both commercial loans and securities. During the third quarter, earnings were also moderated by an $11 million increase in noninterest expense, due primarily to higher incentive compensation accruals and the expensing of stock options granted in July 2003. In future periods, we will continue to evaluate staffing levels and to make appropriate expense-reducing changes when they can be accomplished without negatively affecting either customer service or our ability to grow higher return businesses. We believe Key is well positioned to reap benefits as economic activity begins to improve. We expect that smaller and medium-size businesses, in which Key holds a position of strength in the marketplace, will be among the first to seek additional funding as the economy continues to improve. Considering recent trends, we expect Key's earnings for the fourth quarter to be in the range of $.52 to $.55 per share. 35 The primary reasons that Key's revenue and expense components changed from those of the three-and nine-month periods ended September 30, 2002, are reviewed in greater detail throughout the remainder of the Management's Discussion and Analysis section. Figure 1 on page 37 summarizes Key's financial performance for each of the past five quarters and the first nine months of 2003 and 2002. LONG-TERM GOALS Our long-term goals are to achieve an annual return on average equity in the range of 16% to 18% and to grow earnings per common share at an annual rate of 7% to 8%. CORPORATE STRATEGY Our strategy for achieving our long-term goals comprises the following five primary elements: - - FOCUS ON OUR CORE BUSINESSES. We intend to focus on businesses that enable us to build relationships with our clients. We will focus on our "footprint" businesses (i.e., those businesses conducted primarily within the twelve states in which we have retail bank branches) that serve individuals, small businesses and middle market companies. In addition, we intend to focus nationwide on our commercial real estate lending, asset management, home equity lending and equipment leasing businesses. These are businesses in which we believe we possess resources of the scale necessary to compete nationally. - - PUT OUR CLIENTS FIRST. We will work to deepen our relationships with our existing clients, and to build relationships with new clients, including those who have the potential to purchase multiple products and services or to generate repeat business. One way in which we are pursuing this goal is by emphasizing deposit growth across all of our lines of business. We also want to ensure that our clients are receiving a distinctive level of service, so we are putting considerable effort into enhancing our service quality. - - ENHANCE OUR BUSINESS. We will strive for continuous improvement. We will continue to focus on increasing revenues, controlling expenses and better serving our clients. In addition, we will continue to leverage technology to reduce costs and to enhance service quality. Over time, we also intend to diversify our revenue mix by emphasizing the growth of fee income while investing in higher-growth and higher-return businesses. - - CULTIVATE A WORKFORCE THAT DEMONSTRATES KEY'S VALUES AND WORKS TOGETHER FOR A COMMON PURPOSE. Key intends to achieve this by: --paying for performance if achieved in ways that are consistent with Key's values; --attracting, developing and retaining a quality, high-performing and inclusive workforce; --developing leadership at all levels in the company; and --creating a positive, stimulating and entrepreneurial work environment. - - ENHANCE PERFORMANCE MEASUREMENT. We will continue to refine and to rely upon performance measurement mechanisms that help us ensure that we are maximizing returns for our shareholders, that those returns are appropriate considering the inherent levels of risk involved and that our incentive compensation plans are commensurate with the contributions made to our profitability. 36 FIGURE 1. SELECTED FINANCIAL DATA
NINE MONTHS ENDED 2003 2002 SEPTEMBER 30, -------------------------------- -------------------- -------------------- dollars in millions, except per share amounts THIRD SECOND FIRST FOURTH THIRD 2003 2002 - -------------------------------------------------------------------------------------------------------------------------------- FOR THE PERIOD Interest income $ 971 $ 1,022 $ 1,021 $ 1,077 $ 1,095 $ 3,014 $ 3,289 Interest expense 294 326 340 365 395 960 1,252 Net interest income 677 696 681 712 700 2,054 2,037 Provision for loan losses 123 125 130 147 135 378 406 Noninterest income 463 434 397 446 432 1,294 1,323 Noninterest expense 699 688 657 668 659 2,044 1,985 Income before income taxes 318 317 291 343 338 926 969 Net income 227 225 217 245 245 669 731 - -------------------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE Net income $ .54 $ .53 $ .51 $ .58 $ .57 $ 1.58 $ 1.72 Net income -- assuming dilution .53 .53 .51 .57 .57 1.57 1.69 Cash dividends paid .305 .305 .305 .30 .30 .915 .90 Book value at period end 16.64 16.60 16.32 16.12 15.66 16.64 15.66 Market price: High 27.88 27.42 27.11 26.75 27.35 27.88 29.40 Low 24.86 22.56 22.31 21.25 20.96 22.31 20.96 Close 25.57 25.27 22.56 25.14 24.97 25.57 24.97 Weighted average common shares (000) 421,971 423,882 425,275 424,578 426,274 423,697 425,746 Weighted average common shares and potential common shares (000) 425,669 427,170 428,090 429,531 431,326 426,968 431,098 - -------------------------------------------------------------------------------------------------------------------------------- AT PERIOD END Loans $ 62,723 $ 63,214 $ 62,719 $ 62,457 $ 62,951 $ 62,723 $ 62,951 Earning assets 73,258 73,716 75,113 73,635 72,546 73,258 72,546 Total assets 84,460 85,479 86,490 85,202 83,516 84,460 83,516 Deposits 48,739 49,869 50,455 49,346 44,610 48,739 44,610 Long-term debt 15,342 14,434 16,269 15,605 16,276 15,342 16,276 Shareholders' equity 6,977 6,989 6,898 6,835 6,652 6,977 6,652 - -------------------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets 1.06% 1.07% 1.05% 1.17% 1.19% 1.06% 1.20% Return on average equity 13.06 12.98 12.91 14.46 14.74 12.98 15.13 Net interest margin (taxable equivalent) 3.73 3.85 3.86 3.98 3.99 3.81 3.97 - -------------------------------------------------------------------------------------------------------------------------------- CAPITAL RATIOS AT PERIOD END Equity to assets 8.26% 8.18% 7.98% 8.02% 7.97% 8.26% 7.97% Tangible equity to tangible assets 6.94 6.90 6.71 6.73 6.71 6.94 6.71 Tier 1 risk-based capital 8.21 8.02 8.22 8.09 8.34 8.21 8.34 Total risk-based capital 12.46 12.26 12.62 12.51 12.69 12.46 12.69 Leverage 8.36 8.12 8.12 8.15 8.15 8.36 8.15 - -------------------------------------------------------------------------------------------------------------------------------- OTHER DATA Average full-time equivalent employees 20,059 19,999 20,447 20,485 20,802 20,174 20,927 KeyCenters 900 903 911 910 903 900 903 - --------------------------------------------------------------------------------------------------------------------------------
37 LINE OF BUSINESS RESULTS This section summarizes the financial performance and related strategic developments of each of Key's three major business groups: Consumer Banking, Corporate and Investment Banking and Investment Management Services. To better understand this discussion, see Note 4 ("Line of Business Results"), which begins on page 12. Note 4 includes a brief description of the products and services offered by each of the three major business groups, more detailed financial information pertaining to the groups and their respective lines of business and brief descriptions of "Other Segments" and "Reconciling Items" presented in Figure 2. Figure 2 summarizes the contribution made by each major business group to Key's taxable-equivalent revenue and net income for the three- and nine-month periods ended September 30, 2003 and 2002. FIGURE 2. MAJOR BUSINESS GROUPS - TAXABLE-EQUIVALENT REVENUE AND NET INCOME
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ------------------ ----------------- ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------- Revenue (taxable equivalent) Consumer Banking $ 616 $ 577 $ 39 6.8% $1,756 $ 1,705 $ 51 3.0% Corporate and Investment Banking 383 379 4 1.1 1,137 1,152 (15) (1.3) Investment Management Services 208 206 2 1.0 586 640 (54) (8.4) Other Segments (25) 12 (37) N/M (2) 12 (14) N/M - ---------------------------------------------------------------------------------------------------------------------- Total segments 1,182 1,174 8 .7 3,477 3,509 (32) (.9) Reconciling items (29) (20) (9) (45.0) (80) (41) (39) (95.1) - ---------------------------------------------------------------------------------------------------------------------- Total $ 1,153 $ 1,154 $ (1) (.1)% $3,397 $ 3,468 $ (71) (2.0)% ======= ======= ======= ====== ======= ======= Net income (loss) Consumer Banking $ 120 $ 107 $ 13 12.1% $ 316 $ 298 $ 18 6.0% Corporate and Investment Banking 96 91 5 5.5 283 296 (13) (4.4) Investment Management Services 26 26 -- -- 63 82 (19) (23.2) Other Segments (10) 14 (24) N/M 15 25 (10) (40.0) - ---------------------------------------------------------------------------------------------------------------------- Total segments 232 238 (6) (2.5) 677 701 (24) (3.4) Reconciling items (5) 7 (12) N/M (8) 30 (38) N/M - ---------------------------------------------------------------------------------------------------------------------- Total $ 227 $ 245 $ (18) (7.3)% $ 669 $ 731 $ (62) (8.5)% ======= ======= ======= ====== ======= ======= - ----------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful 38 CONSUMER BANKING As shown in Figure 3, net income for Consumer Banking was $120 million for the third quarter of 2003, representing a $13 million increase from the year-ago quarter. The increase was due primarily to growth in both taxable-equivalent net interest income and noninterest income, offset in part by a higher level of noninterest expense. Taxable-equivalent net interest income grew by $34 million, or 8%, from the third quarter of 2002, due largely to an improved interest rate spread on earning assets, a 3% increase in average loans outstanding, primarily in the home equity and commercial portfolios, and a higher level of average core deposits. The positive effect of these factors was offset in part by the adverse effect of a less favorable interest rate spread on deposits. Noninterest income increased by $5 million, or 4%, due to a reduction in losses incurred on the residual values of leased vehicles and an increase in net gains from the annual securitization and sale of education loans, both in the Indirect Lending unit. These improvements were substantially offset by a reduction in service charges on deposit accounts generated by the Retail Banking line of business. The decrease in deposit service charges reflects lower overdraft fees, as well as the introduction of free checking products during the second half of 2002. Noninterest expense rose by $18 million, or 5%, from the third quarter of 2002. Most of the increase was attributable to personnel expense, costs associated with other real estate owned and various indirect charges. FIGURE 3. CONSUMER BANKING
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ----------------- ------------------ ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 475 $ 441 $ 34 7.7% $ 1,379 $ 1,327 $ 52 3.9% Noninterest income 141 136 5 3.7 377 378 (1) (.3) - ---------------------------------------------------------------------------------------------------------------------------------- Total revenue (TE) 616 577 39 6.8 1,756 1,705 51 3.0 Provision for loan losses 70 69 1 1.4 213 222 (9) (4.1) Noninterest expense 355 337 18 5.3 1,038 1,006 32 3.2 - ---------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 191 171 20 11.7 505 477 28 5.9 Allocated income taxes and TE adjustments 71 64 7 10.9 189 179 10 5.6 - ---------------------------------------------------------------------------------------------------------------------------------- Net income $ 120 $ 107 $ 13 12.1% $ 316 $ 298 $ 18 6.0% ======= ======= ======= ======= ======= ======= Percent of consolidated net income 53% 44% N/A N/A 47% 41% N/A N/A AVERAGE BALANCES Loans $29,100 $28,243 $ 857 3.0% $28,819 $27,889 $ 930 3.3% Total assets 31,516 30,593 923 3.0 31,228 30,223 1,005 3.3 Deposits 34,999 33,580 1,419 4.2 34,714 33,950 764 2.3 - ----------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
ADDITIONAL CONSUMER BANKING DATA THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ----------------------- ---------------- ----------------- ----------------- dollars in billions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- AVERAGE DEPOSITS OUTSTANDING Noninterest-bearing $ 5,704 $ 5,184 $ 520 10.0% $ 5,477 $ 5,065 $ 412 8.1% Money market deposit accounts and other savings 15,576 12,819 2,757 21.5 15,100 12,863 2,237 17.4 Time 13,719 15,577 (1,858) (11.9) 14,137 16,022 (1,885) (11.8) - --------------------------------------------------------------------------------------------------------------------------------- Total deposits $34,999 $33,580 $ 1,419 4.2% $34,714 $33,950 $ 764 2.3% =========== ======= ======= ======= ======= ======= - ---------------------------------------------------------------------------------------------------------------------------------- HOME EQUITY LOANS Retail Banking and Small Business Average balance $ 8.3 $ 7.3 Average loan-to-value ratio 72% 72% Percent first lien positions 58 49 National Home Equity Average balance $ 5.2 $ 5.0 Average loan-to-value ratio 74% 77% Percent first lien positions 82 77 - ------------------------------------------------------------------- OTHER DATA On-line clients / household penetration 722,172/37% 534,385/30% KeyCenters 900 903 Automated teller machines 2,158 2,249 - -------------------------------------------------------------------
39 CORPORATE AND INVESTMENT BANKING As shown in Figure 4, net income for Corporate and Investment Banking was $96 million for the third quarter of 2003, up from $91 million for the same period last year. Significantly higher noninterest income and a substantial reduction in the provision for loan losses were partially offset by a decrease in taxable-equivalent net interest income and higher noninterest expense. Taxable-equivalent net interest income decreased by $10 million, or 4%, from the third quarter of 2002 due primarily to less favorable interest rate spreads on deposits and other funding sources. Declines in average loans outstanding and yield-related loan fees also contributed to the decrease. The adverse effect of these factors was partially offset by the positive effects of core deposit growth and a more favorable interest rate spread on earning assets. Noninterest income increased by $14 million, or 13%, due largely to an increase in non-yield-related loan fees and higher net gains from loan sales in the KeyBank Real Estate Capital line of business. Noninterest expense rose by $12 million, or 7%, reflecting increases in personnel expense, professional fees and various indirect charges. The provision for loan losses decreased by $16 million, or 25%, as a result of improved asset quality in both the Corporate Banking and Key Equipment Finance lines. FIGURE 4. CORPORATE AND INVESTMENT BANKING
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ------------------ ------------------ ------------------ dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 258 $ 268 $ (10) (3.7)% $ 778 $ 808 $ (30) (3.7)% Noninterest income 125 111 14 12.6 359 344 15 4.4 - -------------------------------------------------------------------------------------------------------------------------------- Total revenue (TE) 383 379 4 1.1 1,137 1,152 (15) (1.3) Provision for loan losses 48 64 (16) (25.0) 155 173 (18) (10.4) Noninterest expense 181 169 12 7.1 530 507 23 4.5 - -------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 154 146 8 5.5 452 472 (20) (4.2) Allocated income taxes and TE adjustments 58 55 3 5.5 169 176 (7) (4.0) - -------------------------------------------------------------------------------------------------------------------------------- Net income $ 96 $ 91 $ 5 5.5% $ 283 $ 296 $ (13) (4.4)% ======= ======= ======= ======= ======= ======= Percent of consolidated net income 42% 37% N/A N/A 42% 41% N/A N/A AVERAGE BALANCES Loans $27,784 $29,123 $(1,339) (4.6% $28,082 $29,486 $(1,404) (4.8)% Total assets 32,469 32,749 (280) (.9) 32,605 32,882 (277) (.8) Deposits 4,621 3,384 1,237 36.6 4,272 3,216 1,056 32.8 - --------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable 40 INVESTMENT MANAGEMENT SERVICES As shown in Figure 5, net income for Investment Management Services was $26 million for the third quarter of 2003, unchanged from the third quarter of last year. Growth in taxable-equivalent net interest income was offset by a decrease in noninterest income and a higher provision for loan losses. Noninterest expense was essentially unchanged. Taxable-equivalent net interest income increased by $9 million, or 16%, from the third quarter of 2002. The increase was due primarily to strong growth in both average loans and core deposits. The positive effect of this growth was offset in part by the adverse effect of a less favorable interest rate spread on deposits. Noninterest income decreased by $7 million, or 5%, due to a $9 million decrease in trust and investment services income. The decline was due largely to the June 2002 sale of Key's 401(k) plan recordkeeping business. The provision for loan losses rose by $3 million, reflecting a higher level of net charge-offs in the McDonald Financial Group. On July 1, 2003, Key acquired NewBridge Partners LLC. This company was merged into Key's Investment Management Services Group and accounted for $1.4 billion of Key's $65.0 billion of assets under management at September 30, 2003. The acquisition did not have any material effect on Investment Management Services' results of operations for the third quarter of 2003. FIGURE 5. INVESTMENT MANAGEMENT SERVICES
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ------------------ ------------------ ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 65 $ 56 $ 9 16.1% $ 184 $ 166 $ 18 10.8% Noninterest income 143 150 (7) (4.7) 402 474 (72) (15.2) - --------------------------------------------------------------------------------------------------------------------------------- Total revenue (TE) 208 206 2 1.0 586 640 (54) (8.4) Provision for loan losses 5 2 3 150.0 10 11 (1) (9.1) Noninterest expense 161 162 (1) (.6) 475 499 (24) (4.8) - --------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 42 42 -- -- 101 130 (29) (22.3) Allocated income taxes and TE adjustments 16 16 -- -- 38 48 (10) (20.8) - --------------------------------------------------------------------------------------------------------------------------------- Net income $ 26 $ 26 -- --% $ 63 $ 82 $ (19) (23.2)% ======= ======= ======= ======= ======= ======= Percent of consolidated net income 11% 11% N/A N/A 10% 11% N/A N/A AVERAGE BALANCES Loans $ 5,100 $ 4,826 $ 274 5.7% $ 5,030 $ 4,806 $ 224 4.7% Total assets 6,311 5,782 529 9.1 6,088 5,807 281 4.8 Deposits 6,382 3,695 2,687 72.7 5,850 3,649 2,201 60.3 - ---------------------------------------------------------------------------------------------------------------------------------
TE = Taxable Equivalent, N/A = Not Applicable
ADDITIONAL INVESTMENT MANAGEMENT SERVICES DATA SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in billions 2003 2002 2002 - ------------------------------------------------------------------------------------------------------- Assets under management $65.0 $61.7 $62.4 Nonmanaged and brokerage assets 63.4 65.0 67.2 - -------------------------------------------------------------------------------------------------------
OTHER SEGMENTS Other segments consist primarily of Treasury, Principal Investing and the net effect of funds transfer pricing. These segments generated a net loss of $10 million for the third quarter of 2003, compared with net income of $14 million for the same period last year. The change in results from the third quarter of 2002 was due primarily to the net effect of funds transfer pricing and includes the effect of loan and security sales and prepayments. 41 RESULTS OF OPERATIONS NET INTEREST INCOME Key's principal source of earnings is net interest income, which includes interest paid to Key on earning assets such as loans and securities, as well as loan-related fee income; less interest expense paid on deposits and borrowings. There are several factors that affect net interest income, including: - - the volume, pricing, mix and maturity of earning assets and interest-bearing liabilities; - - the use of derivative instruments to manage interest rate risk; - - market interest rate fluctuations; and - - asset quality. To make it easier to compare results among several periods and the yields on various types of earning assets, we present net interest income in this discussion on a "taxable-equivalent basis." In other words, if we earn $100 of tax-exempt income, we present those earnings at a higher amount (specifically, $154) that--if taxed at the statutory federal income tax rate of 35%--would yield $100. Figure 6, which spans pages 44 and 45, shows the various components of Key's balance sheet that affect interest income and expense, and their respective yields or rates over the past five quarters. This figure also reconciles taxable-equivalent net interest income for each of those quarters to net interest income reported under accounting principles generally accepted in the United States ("GAAP"). Taxable-equivalent net interest income for the third quarter of 2003 was $690 million, compared with $722 million a year ago. This decrease reflects the negative effect of a lower net interest margin, which decreased 26 basis points to 3.73%. The net interest margin is an indicator of the profitability of the earning asset portfolio and is calculated by dividing net interest income by average earning assets. During the same period, average earning assets grew by 2% to $73.6 billion. The combination of a soft economy and significant growth in core deposits have affected the net interest margin, as well as the size and composition of Key's earning assets portfolio. Over the past twelve months, core deposit growth has exceeded net loan growth. The excess funds have been either invested in securities or used to reduce wholesale funding. Although these actions improved Key's liquidity, the weak demand for commercial loans and the Federal Reserve Board's reduction in interest rates in June 2003 placed downward pressure on third quarter net interest income. Management anticipates that Key's margin will remain near the current level over the remainder of the year. NET INTEREST MARGIN. Key's net interest margin decreased over the past twelve months, primarily because: - - competitive market conditions precluded us from passing on the full amount of the Federal Reserve Board's reductions in interest rates to clients' deposit accounts; - - we have experienced exceptionally high levels of prepayments on both investment and consumer loan portfolios as a result of the low interest rate environment; and - - we invested more heavily in securities available for sale since opportunities to originate loans, which typically have higher interest rate spreads, have been adversely affected by the weak economy. INTEREST EARNING ASSETS. Average earning assets for the third quarter of 2003 totaled $73.6 billion, which was $1.5 billion, or 2%, higher than the third quarter 2002 level. This growth came principally from home equity lending and the securities available-for-sale portfolio. During the same period, soft loan demand resulting from the general economic slowdown contributed to a decline in average commercial loans outstanding. Average consumer loans, other than home equity loans, also declined during this period, primarily as a result of management's efforts to scale back or exit certain types of indirect lending. 42 Over the past twelve months, the growth and composition of Key's loan portfolio has been affected by the following actions: - - During the third quarter of 2003, Key consolidated an asset-backed commercial paper conduit as a result of adopting Interpretation No. 46. This consolidation added approximately $200 million to Key's commercial loan portfolio. More information about Interpretation No. 46 is provided in Note 7 ("Variable Interest Entities"), which begins on page 20. - - During the first quarter of 2003, we acquired a $311 million commercial lease financing portfolio and a $71 million commercial loan portfolio from a Canadian financial institution. The acquisition of these portfolios further diversified our asset base and is expected to result in additional equipment financing opportunities. - - During the second quarter of 2001, management announced that Key would exit the automobile leasing business, de-emphasize indirect prime automobile lending and discontinue certain credit-only commercial relationships. As of September 30, 2003, these portfolios, in the aggregate, have declined by approximately $4.3 billion since the date of the announcement and by approximately $1.4 billion since September 30, 2002. - - We sold commercial mortgage loans of $1.1 billion during the first nine months of 2003 and $1.4 billion during all of 2002. Since some of these loans have been sold with limited recourse, Key established a loss reserve of an amount estimated by management to be appropriate to reflect the recourse risk. More information about the related recourse agreement is provided in Note 10 ("Contingent Liabilities and Guarantees") under the section entitled "Recourse agreement with Federal National Mortgage Association" on page 27. Our business of originating and servicing commercial mortgage loans has grown in part as a result of acquiring Conning Asset Management in the second quarter of 2002 and both Newport Mortgage Company, L.P. and National Realty Funding L.C. in 2000. - - We sold education loans of $1.1 billion ($835 million through securitizations) during the first nine months of 2003 and $1.1 billion ($750 million through securitizations) during all of 2002. Key has used the securitization market for education loans as a cost effective means of diversifying its funding sources. - - We sold other loans (primarily home equity and residential mortgage loans) totaling $1.5 billion during the first nine months of 2003 and $835 million during all of 2002. Figure 7 shows how the changes in yields or rates and average balances from the prior year affected net interest income. The section entitled "Financial Condition," which begins on page 52, contains more discussion about changes in earning assets and funding sources. 43 FIGURE 6. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
THIRD QUARTER 2003 SECOND QUARTER 2003 --------------------------- -------------------------- AVERAGE YIELD/ AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE - ----------------------------------------------------------------------------------------------------------- ASSETS Loans(a,b) Commercial, financial and agricultural $ 17,188 $ 202 4.65 % $ 17,391 $ 218 5.01 % Real estate - commercial mortgage 5,859 77 5.21 5,932 80 5.38 Real estate construction 5,196 66 5.05 5,331 68 5.14 Commercial lease financing 7,995 118 5.91 7,883 119 6.05 - --------------------------------------------------------------------------------------------------------- Total commercial loans 36,238 463 5.07 36,537 485 5.32 Real estate - residential 1,707 28 6.43 1,803 30 6.54 Home equity 14,862 218 5.80 14,433 219 6.09 Consumer - direct 2,162 39 7.19 2,135 40 7.44 Consumer - indirect lease financing 460 11 9.60 601 14 9.40 Consumer - indirect other 5,123 105 8.23 5,002 105 8.43 - --------------------------------------------------------------------------------------------------------- Total consumer loans 24,314 401 6.55 23,974 408 6.82 Loans held for sale 2,526 29 4.53 2,518 29 4.70 - --------------------------------------------------------------------------------------------------------- Total loans 63,078 893 5.62 63,029 922 5.86 Taxable investment securities 14 -- 4.46 5 -- 5.44 Tax-exempt investment securities(a) 91 2 9.76 110 3 9.46 - --------------------------------------------------------------------------------------------------------- Total investment securities 105 2 9.07 115 3 9.27 Securities available for sale(a,c) 7,877 77 3.91 8,321 97 4.68 Short-term investments 1,531 6 1.70 1,484 8 2.12 Other investments(c) 1,032 6 2.68 985 6 2.47 - --------------------------------------------------------------------------------------------------------- Total earning assets 73,623 984 5.32 73,934 1,036 5.61 Allowance for loan losses (1,396) (1,409) Accrued income and other assets 12,495 12,187 - --------------------------------------------------------------------------------------------------------- $ 84,722 $ 84,712 ======== ========= LIABILITIES AND SHAREHOLDERS' EQUITY NOW and money market deposit accounts $ 18,381 35 .75 $ 17,740 41 .93 Savings deposits 2,092 2 .48 2,084 3 .54 Certificates of deposit ($100,000 or more)(d) 4,898 46 3.78 4,743 47 3.98 Other time deposits 11,073 81 2.89 11,434 84 2.96 Deposits in foreign office 1,627 4 1.04 2,445 8 1.25 - --------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 38,071 168 1.76 38,446 183 1.91 Federal funds purchased and securities sold under repurchase agreements 5,133 12 .93 5,075 15 1.19 Bank notes and other short-term borrowings(d) 2,559 13 2.05 2,351 15 2.58 Long-term debt, including capital securities(d) 15,421 101 2.68 16,309 113 2.90 - --------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 61,184 294 1.93 62,181 326 2.13 Noninterest-bearing deposits 10,628 10,053 Accrued expense and other liabilities 6,016 5,526 Common shareholders' equity 6,894 6,952 - --------------------------------------------------------------------------------------------------------- $ 84,722 $ 84,712 ======== ========= Interest rate spread (TE) 3.39 % 3.48 % - --------------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) 690 3.73 % 710 3.85 % ==== ==== TE adjustment(a) 13 14 - --------------------------------------------------------------------------------------------------------- Net interest income, GAAP basis $ 677 $ 696 ======= ====== Capital securities -- -- $ 1,266 $ 18 - ---------------------------------------------------------------------------------------------------------
(a) Interest income on tax-exempt securities and loans has been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%. (b) For purposes of these computations, nonaccrual loans are included in average loan balances. (c) Yield is calculated on the basis of amortized cost. (d) Rate calculation excludes basis adjustments related to fair value hedges. See Note 20 ("Derivatives and Hedging Activities"), which begins on page 84 of Key's Annual Report to Shareholders, for an explanation of fair value hedges. TE = Taxable Equivalent GAAP = Accounting Principles Generally Accepted in the United States 44 FIGURE 6. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES (CONTINUED)
FIRST QUARTER 2003 FOURTH QUARTER 2002 THIRD QUARTER 2002 - -------------------------- ------------------------- ------------------------ AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/ BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE - ---------------------------------------------------------------------------------------- $17,221 $ 206 4.86 % $17,362 $ 220 5.01 % $17,485 $ 225 5.11 % 6,034 82 5.49 6,168 88 5.66 6,207 93 5.92 5,683 72 5.16 5,856 78 5.27 5,822 79 5.37 7,790 123 6.30 7,356 112 6.13 7,215 121 6.72 - --------------------------------------------------------------------------------------- 36,728 483 5.31 36,742 498 5.39 36,729 518 5.60 1,904 32 6.66 2,029 33 6.72 2,089 37 7.00 14,005 217 6.29 13,649 226 6.55 13,505 222 6.52 2,129 40 7.68 2,153 44 8.17 2,172 46 8.32 772 18 9.40 1,001 24 9.42 1,264 28 8.98 4,917 107 8.74 5,117 116 9.05 5,143 117 9.13 - --------------------------------------------------------------------------------------- 23,727 414 7.05 23,949 443 7.36 24,173 450 7.41 2,390 28 4.70 1,986 26 5.28 2,584 35 5.48 - --------------------------------------------------------------------------------------- 62,845 925 5.95 62,677 967 6.14 63,486 1,003 6.29 2 -- 8.43 1 -- 8.85 1 -- 8.45 125 3 8.89 132 3 9.32 166 4 8.76 - --------------------------------------------------------------------------------------- 127 3 8.88 133 3 9.31 167 4 8.75 7,790 101 5.21 7,598 106 5.60 6,424 97 6.11 1,706 8 1.87 1,240 7 2.12 1,151 7 2.28 956 6 2.46 906 6 2.39 855 6 2.46 - --------------------------------------------------------------------------------------- 73,424 1,043 5.73 72,554 1,089 5.97 72,083 1,117 6.17 (1,438) (1,471) (1,509) 11,928 11,652 11,361 - --------------------------------------------------------------------------------------- $83,914 $82,735 $81,935 ======= ======= ======= $16,747 42 1.03 $15,131 40 1.03 $13,293 30 .91 2,043 3 .60 1,981 4 .63 2,002 3 .67 4,654 48 4.20 4,741 51 4.29 4,886 54 4.45 11,799 90 3.09 12,213 101 3.29 12,713 115 3.57 1,719 5 1.24 1,974 6 1.43 2,593 12 1.76 - --------------------------------------------------------------------------------------- 36,962 188 2.07 36,040 202 2.22 35,487 214 2.40 4,800 14 1.19 5,502 20 1.44 5,483 23 1.69 2,801 18 2.65 2,192 14 2.53 2,581 18 2.73 17,279 120 2.90 17,040 129 3.09 17,455 140 3.25 - --------------------------------------------------------------------------------------- 61,842 340 2.25 60,774 365 2.40 61,006 395 2.59 9,788 9,926 9,177 5,465 5,314 5,159 6,819 6,721 6,593 - --------------------------------------------------------------------------------------- $83,914 $82,735 $81,935 ======= ======= ======= 3.48 % 3.57 % 3.58 % - ---------------------------------------------------------------------------------------- 703 3.86 % 724 3.98 % 722 3.99 % ==== ==== ==== 22 12 22 - ---------------------------------------------------------------------------------------- $ 681 $ 712 $ 700 ====== ======== ======== $ 1,254 $ 18 $ 1,233 $ 18 $1,249 $ 19 - ----------------------------------------------------------------------------------------
45 FIGURE 7. COMPONENTS OF NET INTEREST INCOME CHANGES
FROM THREE MONTHS ENDED SEPTEMBER 30, 2002 TO THREE MONTHS ENDED SEPTEMBER 30, 2003 ------------------------------------------ AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE - -------------------------------------------------------------------------------------------- INTEREST INCOME Loans $ (6) $(104) $ (110) Tax-exempt investment securities (2) -- (2) Securities available for sale 19 (40) (21) Short-term investments 2 (2) -- Other investments 1 (1) -- - ---------------------------------------------------------------------------------------- Total interest income (taxable equivalent) 14 (147) (133) INTEREST EXPENSE NOW and money market deposit accounts 10 (5) 5 Savings deposits -- (1) (1) Certificates of deposit ($100,000 or more) -- (8) (8) Other time deposits (14) (20) (34) Deposits in foreign office (4) (4) (8) - ---------------------------------------------------------------------------------------- Total interest-bearing deposits (8) (38) (46) Federal funds purchased and securities sold under repurchase agreements (1) (10) (11) Bank notes and other short-term borrowings -- (5) (5) Long-term debt, including capital securities (15) (24) (39) - ---------------------------------------------------------------------------------------- Total interest expense (24) (77) (101) - ---------------------------------------------------------------------------------------- Net interest income (taxable equivalent) $ 38 $ (70) $(32) ===== ===== ==== - ---------------------------------------------------------------------------------------- FROM NINE MONTHS ENDED SEPTEMBER 30, 2002 TO NINE MONTHS ENDED SEPTEMBER 30, 2003 ----------------------------------------- AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE - -------------------------------------------------------------------------------------------- INTEREST INCOME Loans $ (31) $ (290) $ (321) Tax-exempt investment securities (6) 2 (4) Securities available for sale 82 (90) (8) Short-term investments -- (1) (1) Other investments 3 (3) -- - -------------------------------------------------------------------------------------------- Total interest income (taxable equivalent) 48 (382) (334) INTEREST EXPENSE NOW and money market deposit accounts 29 (2) 27 Savings deposits -- (2) (2) Certificates of deposit ($100,000 or more) 1 (27) (26) Other time deposits (45) (95) (140) Deposits in foreign office (6) (9) (15) - -------------------------------------------------------------------------------------------- Total interest-bearing deposits (21) (135) (156) Federal funds purchased and securities sold under repurchase agreements (6) (23) (29) Bank notes and other short-term borrowings (12) (7) (19) Long-term debt, including capital securities (15) (73) (88) - -------------------------------------------------------------------------------------------- Total interest expense (54) (238) (292) - -------------------------------------------------------------------------------------------- Net interest income (taxable equivalent) $ 102 $(144) $ (42) ====== ===== ======= - --------------------------------------------------------------------------------------------
The change in interest not due solely to volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each. MARKET RISK MANAGEMENT The values of some financial instruments vary not only with changes in market interest rates, but also with changes in foreign exchange rates, factors influencing valuations in the equity securities markets, and other market-driven rates or prices. For example, the value of a fixed-rate bond will decline if market interest rates increase. As a result, the bond will become a less attractive investment to the holder. Similarly, the value of the U.S. dollar regularly fluctuates in relation to other currencies. The exposure that instruments tied to such external factors present is called "market risk." Most of Key's market risk is derived from interest rate fluctuations. Interest rate risk management Key's Asset/Liability Management Policy Committee has developed a program to measure and manage interest rate risk. This committee is also responsible for approving Key's asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing Key's interest rate sensitivity exposure. FACTORS CONTRIBUTING TO INTEREST RATE EXPOSURE. Key uses interest rate exposure models to quantify the potential impact on earnings and economic value of equity arising from a variety of possible future interest rate scenarios. The many interest rate scenarios modeled estimate the level of Key's interest rate exposure arising from option risk, basis risk and gap risk. Each of these types of risk is defined in the discussion of market risk management, which begins on page 30 of Key's 2002 Annual Report to Shareholders. MEASUREMENT OF SHORT-TERM INTEREST RATE EXPOSURE. Key uses a net interest income simulation model to measure interest rate risk over a short time frame. These simulations estimate the impact that various changes in the overall level of interest rates over one- and two-year time horizons would have on net interest income. The results help Key develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions and judgments. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates, and on- and off-balance sheet management strategies. Management believes that, both individually and in the aggregate, the assumptions Key makes are reasonable. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure. Key's guidelines for risk management call for preventive measures to be taken if the simulation modeling demonstrates that a gradual 200 basis point increase or decrease in short-term rates over the next twelve months would adversely affect net interest income over the same period by more than 2%. Key is operating within these guidelines. Since short-term interest rates were relatively low at September 30, 2003, 46 management modified Key's standard rate scenario of a gradual decrease of 200 basis points over twelve months to a gradual decrease of 25 basis points over the next two months and no change over the following ten months. As of September 30, 2003, based on the results of our simulation model, and assuming that management does not take action to alter the outcome, Key would expect net interest income to decrease by approximately 1.22% over the next twelve months if short-term interest rates gradually increase by 200 basis points. Conversely, if short-term interest rates gradually decrease by 25 basis points, net interest income would be expected to increase by approximately .20% over the next twelve months. MEASUREMENT OF LONG-TERM INTEREST RATE EXPOSURE. Key uses an economic value of equity model to complement short-term interest rate risk analysis. The benefit of this model is that it measures exposure to interest rate changes over time frames longer than two years. The economic value of Key's equity is determined by aggregating the present value of projected future cash flows for asset, liability and derivative positions based on the current yield curve. However, economic value does not represent the fair values of asset, liability and derivative positions since it does not consider factors like credit risk and liquidity. Key's guidelines for risk management call for preventive measures to be taken if an immediate 200 basis point increase or decrease in interest rates is estimated to reduce the economic value of equity by more than 15%. Key is operating within these guidelines. Certain short-term interest rates were limited to reductions of less than 200 basis points since interest rates cannot decrease below zero in Key's economic value of equity model. MANAGEMENT OF INTEREST RATE EXPOSURE. Management uses the results of short-term and long-term interest rate exposure models to formulate strategies to improve balance sheet positioning, earnings, or both, within the bounds of Key's interest rate risk, liquidity and capital guidelines. We manage interest rate risk by using portfolio swaps and caps, which modify the repricing or maturity characteristics of some of our assets and liabilities. The decision to use these instruments rather than securities, debt or other on-balance sheet alternatives depends on many factors, including the mix and cost of funding sources, liquidity and capital requirements, and interest rate implications. A brief description of interest rate swaps and caps is included in the discussion of market risk management, which begins on page 30 of Key's 2002 Annual Report to Shareholders. For more information about how Key uses interest rate swaps and caps to manage its balance sheet, see Note 11 ("Derivatives and Hedging Activities"), which begins on page 29. Over the past year, we have invested more heavily in collateralized mortgage obligations as opportunities to originate loans have been adversely affected by the weak economy, while our core deposits have grown significantly. These securities, the majority of which have relatively short average lives, have been used in conjunction with swaps to manage our interest rate risk position. Trading portfolio risk management Key's trading portfolio is described in Note 11. Management uses a value at risk ("VAR") model to estimate the potential adverse effect of changes in interest and foreign exchange rates, and equity prices on the fair value of Key's trading portfolio. Using statistical methods, this model estimates the maximum potential one-day loss with 95% probability. At September 30, 2003, Key's aggregate daily VAR was $1.3 million, compared with $1.1 million at September 30, 2002. Aggregate daily VAR averaged $1.2 million for the first nine months of 2003, compared with an average of $1.4 million for the same period last year. VAR modeling augments other controls that Key uses to mitigate the market risk exposure of the trading portfolio. These controls include loss and portfolio size limits that are based on market liquidity and the level of activity and volatility of trading products. 47 NONINTEREST INCOME Noninterest income for the third quarter of 2003 was $463 million, up $31 million, or 7%, from the same period last year. For the first nine months of the year, noninterest income was $1.3 billion, representing a decrease of $29 million, or 2%, from the first nine months of 2002. As shown in Figure 8, the growth in noninterest income from the year-ago quarter was due primarily to a $16 million increase in net gains from principal investing included in "investment banking and capital markets income," higher net gains from loan securitizations and sales and an $11 million decrease in net losses incurred on the residual values of leased vehicles included in "miscellaneous income." These positive changes were offset in part by lower income from trust and investment services and from service charges on deposit accounts. For the year-to-date period, decreases in income from trust and investment services and from service charges on deposit accounts more than offset an increase in net gains from loan sales and securitizations and the growth in non-yield-related loan fees. FIGURE 8. NONINTEREST INCOME
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ---------------- ----------------- ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ------------------------------------------------------------------------------------------------------------------------------- Trust and investment services income $139 $151 $(12) (7.9)% $ 402 $ 467 $(65) (13.9)% Service charges on deposit accounts 93 102 (9) (8.8) 276 306 (30) (9.8) Investment banking and capital markets income 52 34 18 52.9 139 130 9 6.9 Letter of credit and loan fees 42 36 6 16.7 113 93 20 21.5 Corporate-owned life insurance income 27 25 2 8.0 81 77 4 5.2 Electronic banking fees 20 21 (1) (4.8) 61 59 2 3.4 Net securities gains 2 -- 2 N/M 9 1 8 800.0 Other income: Insurance income 12 14 (2) (14.3) 38 42 (4) (9.5) Net gains from loan securitizations and sales 39 25 14 56.0 68 34 34 100.0 Loan securitization servicing fees 2 2 -- -- 6 7 (1) (14.3) Credit card fees 2 2 -- -- 8 6 2 33.3 Miscellaneous income 33 20 13 65.0 93 101 (8) (7.9) - ------------------------------------------------------------------------------------------------------------------------------ Total other income 88 63 25 39.7 213 190 23 12.1 - ------------------------------------------------------------------------------------------------------------------------------ Total noninterest income $463 $432 $31 7.2 % $1,294 $1,323 $(29) (2.2)% ==== ==== ====== ====== ====== ====== - -------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful The discussion that follows explains the composition of certain components of Key's noninterest income and the factors that caused them to change from the prior year. TRUST AND INVESTMENT SERVICES INCOME. Trust and investment services provide Key's largest source of noninterest income. Its primary components are shown in Figure 9. The decrease in trust and investment services income relative to the prior year is attributable largely to the June 2002 sale of Key's 401(k) plan recordkeeping business. The divestiture of this business accounted for $10 million of the decrease in income from the third quarter of 2002 and $29 million of the decrease from the first nine months of last year. FIGURE 9. TRUST AND INVESTMENT SERVICES INCOME
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ---------------- ----------------- ---------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - --------------------------------------------------------------------------------------------------------------------------- Personal asset management and custody fees $ 39 $ 38 $1 2.6 % $111 $120 $(9) (7.5)% Institutional asset management and custody fees 10 20 (10) (50.0) 29 60 (31) (51.7) Bond services 10 9 1 11.1 29 29 -- -- Brokerage commission income 47 48 (1) (2.1) 141 149 (8) (5.4) All other fees 33 36 (3) (8.3) 92 109 (17) (15.6) - ------------------------------------------------------------------------------------------------------------------------- Total trust and investment services income $139 $151 $(12) (7.9)% $402 $467 $(65) (13.9)% ==== ==== ====== ==== ==== ====== - -------------------------------------------------------------------------------------------------------------------------
A significant portion of Key's trust and investment services income is based on the value of assets under management. Thus, declines in the equity and fixed income markets that occurred during 2002 and the first half of 2003 also contributed to the year-to-date decrease in revenue compared with that reported for the first nine months of 2002. Income from trust and investment services for the third quarter of 2003 rose by 48 $8 million from the prior quarter due largely to the recent improvement in the financial markets and a modest boost from the acquisition of NewBridge Partners. At September 30, 2003, Key's bank, trust and registered investment advisory subsidiaries had assets under management of $65.0 billion, compared with $62.4 billion at September 30, 2002. These assets are managed on behalf of both institutions and individuals through a variety of equity, fixed income and money market accounts. The composition of Key's assets under management is shown in Figure 10. The 4% increase in the value of assets under management over the past twelve months was due primarily to an increase in the market value of those assets. During the same period, net asset inflows accounted for a small amount of the increase in assets under management, due largely to the July 2003 acquisition of NewBridge Partners. FIGURE 10. ASSETS UNDER MANAGEMENT
2003 2002 ------------------------------ -------------------- in millions THIRD SECOND FIRST FOURTH THIRD - ---------------------------------------------------------------------------------------------------------------------------- Assets under management by investment type: Equity $28,839 $26,931 $25,415 $27,224 $25,422 Fixed income 17,300 17,121 16,310 16,133 17,588 Money market 18,901 19,250 19,073 18,337 19,364 - ---------------------------------------------------------------------------------------------------------------------------- Total $65,040 $63,302 $60,798 $61,694 $62,374 ------- ------- ------- ------- ------- Proprietary mutual funds included in assets under management: Equity $2,777 $2,604 $2,236 $2,878 $2,965 Fixed income 1,087 1,144 1,125 1,215 1,377 Money market 10,205 10,362 10,762 11,457 12,129 - ---------------------------------------------------------------------------------------------------------------------------- Total $14,069 $14,110 $14,123 $15,550 $16,471 ======= ======= ======= ======= ======= - ----------------------------------------------------------------------------------------------------------------------------
SERVICE CHARGES ON DEPOSIT ACCOUNTS. The reduction in service charges for both the quarterly and year-to-date periods was due primarily to lower overdraft and maintenance fees. The decrease in maintenance fees is attributable to free checking products, which were introduced in the third quarter of 2002 and rolled out to all of Key's markets by the end of the year. INVESTMENT BANKING AND CAPITAL MARKETS INCOME. As shown in Figure 11, improved results from principal investing activities drove the increase from the prior year in investment banking and capital markets income for both the quarterly and year-to-date periods. Key's principal investing income is susceptible to volatility since it is derived from investments in small to medium-sized businesses, some of which are in relatively early stages of economic development and strategy implementation. Principal investments consist of direct and indirect investments in predominantly privately-held companies and are carried on the balance sheet at fair value ($729 million at September 30, 2003, and $631 million at September 30, 2002). Thus, the net gains and losses presented in Figure 11 stem from changes in estimated fair values, as well as actual gains and losses on sales of principal investments. FIGURE 11. INVESTMENT BANKING AND CAPITAL MARKETS INCOME
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ----------------- ----------------- ------------------ dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- Dealer trading and derivatives income $ 3 $ 3 -- -- $ 15 $ 27 $ (12) (44.4)% Investment banking income 23 23 -- -- 67 78 (11) (14.1) Net gains (losses) from principal investing 16 -- $ 16 N/M 32 (1) 33 N/M Foreign exchange income 10 8 2 25.0% 25 26 (1) (3.8) - --------------------------------------------------------------------------------------------------------------------------------- Total investment banking and capital markets income $ 52 $ 34 $ 18 52.9% $ 139 $130 $ 9 6.9 % ==== ==== ====== ===== ==== ====== - ----------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful LETTER OF CREDIT AND LOAN FEES. As shown in Figure 8, letter of credit and loan fees were up from the prior year on both a quarterly and year-to-date basis due primarily to higher agency origination, servicing and syndication fees generated by the KeyBank Real Estate Capital line of business. These improved results 49 were due in part to the acquisition of Conning Asset Management in June 2002. Higher fees from letter of credit activities also contributed to the increases. OTHER INCOME. The increase in other income for both the quarterly and year-to-date periods was due largely to higher net gains from loan securitizations and sales as shown in Figure 8. In addition, the increase in other income for the third quarter compared with the same period last year reflects an $11 million decrease in net losses incurred on the residual values of leased vehicles included in "miscellaneous income." NONINTEREST EXPENSE Noninterest expense for the third quarter of 2003 was $699 million, up $40 million, or 6%, from the same period last year. For the first nine months of the year, noninterest expense was $2.0 billion, representing an increase of $59 million, or 3%, from the first nine months of 2002. As shown in Figure 12, increases in personnel expense and professional fees drove the increase in noninterest expense for both the quarterly and year-to-date periods. The aggregate increase in these expense components for the year-to-date period was substantially offset, however, by a reduction in computer processing expense. FIGURE 12. NONINTEREST EXPENSE
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------- ----------------- ----------------- ----------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- Personnel $ 380 $ 358 $ 22 6.1 % $ 1,114 $ 1,082 $ 32 3.0% Net occupancy 56 57 (1) (1.8) 171 170 1 .6 Computer processing 43 45 (2) (4.4) 131 147 (16) (10.9) Equipment 35 33 2 6.1 101 103 (2) (1.9) Marketing 30 33 (3) (9.1) 88 89 (1) (1.1) Professional fees 30 21 9 42.9 87 63 24 38.1 Other expense: Postage and delivery 15 15 -- -- 43 44 (1) (2.3) Telecommunications 8 9 (1) (11.1) 24 26 (2) (7.7) Equity- and gross receipts-based taxes 5 7 (2) (28.6) 15 20 (5) (25.0) OREO expense, net 5 1 4 400.0 10 4 6 150.0 Miscellaneous expense 92 80 12 15.0 260 237 23 9.7 - --------------------------------------------------------------------------------------------------------------------------------- Total other expense 125 112 13 11.6 352 331 21 6.3 - --------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense $ 699 $ 659 $ 40 6.1 % $ 2,044 $ 1,985 $ 59 3.0% ====== ====== ====== ======= ======= ====== Average full-time equivalent employees 20,059 20,802 (743) (3.6)% 20,174 20,927 (753) (3.6)% - ---------------------------------------------------------------------------------------------------------------------------------
The discussion that follows explains the composition of certain components of Key's noninterest expense and the factors that caused them to change from the prior year. PERSONNEL. As shown in Figure 13, personnel expense, the largest category of Key's noninterest expense, rose by $32 million, or 3%, from the first nine months of 2002. This increase resulted from higher salaries expense, a rise in employee benefit costs (primarily pension costs), and an increase in stock options expense, offset in part by lower incentive compensation accruals. Effective January 1, 2003, Key adopted the fair value method of accounting for stock option expense as outlined in SFAS No. 123, "Accounting for Stock-Based Compensation." Additional information pertaining to this accounting change is included in Note 1 ("Basis of Presentation") under the headings "Stock-Based Compensation" on page 8 and "Accounting Pronouncements Adopted in 2003" on page 9. The level of Key's personnel expense continues to reflect the benefits derived from a competitiveness initiative completed last year, as well as the continuous improvement efforts that have evolved from it. We will continue to evaluate staffing levels and to make appropriate changes when they can be accomplished without negatively affecting either customer service or our ability to grow higher return businesses. For the third quarter of 2003, the number of average full-time equivalent employees was 20,059, compared with 19,999 for the second quarter of 2003 and 20,802 for the year-ago quarter. 50 FIGURE 13. PERSONNEL EXPENSE
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE ------------------ ----------------- ------------------ ---------------- dollars in millions 2003 2002 AMOUNT PERCENT 2003 2002 AMOUNT PERCENT - --------------------------------------------------------------------------------------------------------------------- Salaries $215 $218 $ (3) (1.4)% $ 656 $ 647 $ 9 1.4% Employee benefits 63 53 10 18.9 198 171 27 15.8 Incentive compensation 94 85 9 10.6 245 259 (14) (5.4) Stock-based compensation 8 2 6 300.0 15 5 10 200.0 - -------------------------------------------------------------------------------------------------------------------- Total personnel expense $380 $358 $ 22 6.1% $1,114 $1,082 $ 32 3.0% ==== ==== ==== ====== ====== ==== - --------------------------------------------------------------------------------------------------------------------
COMPUTER PROCESSING. The decrease in computer processing expense for both the quarterly and year-to-date periods was due primarily to a lower level of computer software amortization. This reduction is attributable to a decline in the number of capitalized software projects. PROFESSIONAL FEES. The increase in professional fees for both the quarterly and year-to-date periods reflects additional costs incurred to enhance Key's sales management systems and for outside legal services. INCOME TAXES The provision for income taxes was $91 million for the third quarter of 2003, compared with $93 million for the comparable period in 2002. The effective tax rate, which is the provision for income taxes as a percentage of income before income taxes, was 28.6% for the third quarter of 2003, compared with 27.5% for the third quarter of 2002. For the first nine months of 2003, the provision for income taxes was $257 million, compared with $238 million for the first nine months of 2002. The effective tax rates for these periods were 27.8% and 24.6%, respectively. As discussed below, the management of residual values of certain leases has been transferred to a foreign subsidiary in a lower tax jurisdiction. The increase in the effective tax rate for both the quarterly and year-to-date periods was due primarily to the fact that a smaller number of such leases were transferred in the current year, compared with the first nine months of 2002. These rate increases were moderated in the current year, however, by tax-exempt income from corporate-owned life insurance and credits associated with investments in low-income housing projects, both of which represented a higher percentage of income before income taxes compared with the three- and nine-month periods ended September 30, 2002. The effective tax rates for both the current and prior year are substantially below Key's combined statutory federal and state rate of 37.5% (37% in 2002) primarily because portions of our equipment leasing portfolio became subject to a lower income tax rate in the latter half of 2001. Responsibility for the management of portions of Key's leasing portfolio was transferred to a foreign subsidiary in a lower tax jurisdiction. Since Key intends to permanently reinvest the earnings of this subsidiary, no deferred income taxes have been recorded on those earnings in accordance with SFAS No. 109, "Accounting for Income Taxes." Other factors that account for the difference between the effective and statutory tax rates in the current and prior year include tax deductions associated with dividends paid to Key's 401(k) savings plan, income from investments in tax-advantaged assets (such as tax-exempt securities and corporate-owned life insurance) and credits associated with investments in low-income housing projects. 51 FINANCIAL CONDITION LOANS At September 30, 2003, total loans outstanding were $62.7 billion, compared with $62.5 billion at the end of 2002 and $63.0 billion a year ago. The composition of Key's loan portfolio at each of these dates is presented in Note 6 ("Loans") on page 19. Among the factors that contributed to the decrease in our loans from one year ago are: - - Loan sales completed to improve the profitability of the overall portfolio or to accommodate our funding needs; - - Weak loan demand due to the sluggish economy; and - - Our decision to exit the automobile leasing business, de-emphasize indirect prime automobile lending and discontinue certain credit-only commercial relationships. Over the past several years, we have used alternative funding sources like loan sales and securitizations to allow us to continue to capitalize on our loan origination capabilities. In addition, Key has completed acquisitions that have improved our ability to generate and securitize new loans, especially in the area of commercial real estate. These acquisitions include the purchase of Conning Asset Management in June 2002, and both Newport Mortgage Company, L.P. and National Realty Funding L.C. in 2000. COMMERCIAL LOAN PORTFOLIO. Commercial loans outstanding decreased by $571 million, or 2%, from one year ago. Over the past year, growth in equipment lease financing receivables was more than offset by a net decline in all other commercial portfolios, reflecting continued weakness in the economy and our decision to discontinue many credit-only relationships in the leveraged financing and nationally syndicated lending businesses. Commercial real estate loans comprise one of the largest segments of Key's commercial loan portfolio. At September 30, 2003, Key's commercial real estate portfolio included mortgage loans of $5.8 billion and construction loans of $5.2 billion. The average size of a mortgage loan was $.5 million and the largest mortgage loan had a balance of $45 million. The average size of a construction loan was $7 million. The largest construction loan commitment was $49 million, of which $38 million was outstanding. Key conducts its commercial real estate lending business through two primary sources: a 12-state banking franchise and KeyBank Real Estate Capital, a national line of business that cultivates relationships both within and beyond the branch system. This line of business deals exclusively with nonowner-occupied properties (i.e., generally properties in which the owner occupies less than 60% of the premises) and accounted for approximately 52% of Key's total average commercial real estate loans during the third quarter of 2003. Our commercial real estate business as a whole focuses on larger real estate developers and, as shown in Figure 14, is diversified by both industry type and geography. 52 FIGURE 14. COMMERCIAL REAL ESTATE LOANS
GEOGRAPHIC REGION SEPTEMBER 30, 2003 --------------------------------------------- TOTAL PERCENT OF dollars in millions EAST MIDWEST CENTRAL WEST AMOUNT TOTAL - ----------------------------------------------------------------------------------------------------------------------------------- Nonowner-occupied: Multi-family properties $ 619 $ 550 $ 676 $ 683 $ 2,528 23.0% Retail properties 225 469 106 233 1,033 9.3 Office buildings 135 91 174 223 623 5.6 Residential properties 116 59 140 505 820 7.4 Warehouses 39 126 104 136 405 3.7 Manufacturing facilities 15 14 7 13 49 .4 Hotels/Motels 6 9 1 8 24 .2 Other 112 299 58 162 631 5.7 - ----------------------------------------------------------------------------------------------------------------------------------- 1,267 1,617 1,266 1,963 6,113 55.3 Owner-occupied 667 2,190 608 1,480 4,945 44.7 - ----------------------------------------------------------------------------------------------------------------------------------- Total $1,934 $3,807 $1,874 $3,443 $11,058 100.0% ====== ====== ====== ====== ======= ===== - ----------------------------------------------------------------------------------------------------------------------------------- Nonowner-occupied: Nonperforming loans -- $ 18 $ 3 $ 15 $ 36 N/M Accruing loans past due 90 days or more $ 2 16 -- 3 21 N/M Accruing loans past due 30 through 89 days 21 8 -- 8 37 N/M - -----------------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful CONSUMER LOAN PORTFOLIO. Consumer loans outstanding increased by $150 million, or 1%, from one year ago. Our home equity portfolio increased by $1.4 billion, largely as a result of our focused efforts to grow this business, facilitated by a period of lower interest rates. The growth of the home equity portfolio was substantially offset by declines of $737 million in automobile lease financing receivables and $433 million in residential real estate mortgage loans. The decline in automobile lease financing receivables reflects our decision to exit the automobile leasing business. Residential real estate loans declined since most of the new loans originated by Key over the past twelve months were originated for sale, and low interest rates led to significant mortgage prepayment activity. Excluding loan sales and acquisitions, consumer loans would have increased by $1.1 billion, or 5%, during the past twelve months. The home equity portfolio is by far the largest segment of Key's consumer loan portfolio. Key's home equity portfolio is derived primarily from our Retail Banking line of business (54% of the home equity portfolio at September 30, 2003) and the National Home Equity unit within our Consumer Finance line of business. The National Home Equity unit has two components: Champion Mortgage Company, a home equity finance company, and Key Home Equity Services, which purchases individual loans from an extensive network of correspondents and agents. Prior to the third quarter of 2002, Key Home Equity Services also purchased loans through bulk portfolio acquisitions from home equity loan companies. Figure 15 summarizes Key's home equity loan portfolio at the end of each of the last five quarters, as well as certain asset quality statistics and yields on the portfolio as a whole. 53 FIGURE 15. HOME EQUITY LOANS
2003 2002 ------------------------------------- ---------------------- dollars in millions THIRD SECOND FIRST FOURTH THIRD - ------------------------------------------------------------------------------------------------------------------------ SOURCES OF LOANS OUTSTANDING AT PERIOD END Retail Banking (KeyCenters) and Small Business $ 8,324 $ 8,152 $ 7,788 $ 7,549 $ 7,395 McDonald Financial Group and other sources 1,455 1,418 1,357 1,318 1,285 Champion Mortgage Company 2,747 2,461 2,332 2,210 2,109 Key Home Equity Services division 2,353 2,657 2,667 2,727 2,727 - ------------------------------------------------------------------------------------------------------------------------ National Home Equity unit 5,100 5,118 4,999 4,937 4,836 - ------------------------------------------------------------------------------------------------------------------------ Total $14,879 $14,688 $14,144 $13,804 $13,516 ======= ======= ======= ======= ======= - ------------------------------------------------------------------------------------------------------------------------ Nonperforming loans at period end $ 151 $ 152 $ 154 $ 146 $ 124 Net charge-offs for the period 14 13 13 13 12 Yield for the period 5.80% 6.09% 6.29% 6.55% 6.52% - ------------------------------------------------------------------------------------------------------------------------
SALES, SECURITIZATIONS AND DIVESTITURES. During the past twelve months, Key sold $1.7 billion of commercial real estate loans, $1.2 billion of education loans ($835 million through a securitization), $829 million of home equity loans, $607 million of residential real estate loans, and $509 million of other types of loans. Since 1999, Key has securitized only education loans. Among the factors that Key considers in determining which loans to securitize are: - - whether the characteristics of a specific loan portfolio make it conducive to securitization; - - the relative cost of funds; - - the level of credit risk; and - - capital requirements. Figure 16 summarizes Key's loan sales (including securitizations) for the first nine months of 2003 and all of 2002. FIGURE 16. LOANS SOLD AND DIVESTED
COMMERCIAL COMMERCIAL RESIDENTIAL HOME CONSUMER in millions COMMERCIAL REAL ESTATE LEASE FINANCING REAL ESTATE EQUITY -INDIRECT EDUCATION TOTAL - -------------------------------------------------------------------------------------------------------------------------- 2003 - -------------- Third quarter $120 $ 423 -- $211 $473 -- $ 895 $2,122 Second quarter 67 408 -- 184 134 -- 85 878 First quarter 52 253 -- 147 112 -- 109 673 - ------------------------------------------------------------------------------------------------------------------------- Total $239 $1,084 -- $542 $719 -- $1,089 $3,673 ==== ====== === ==== ==== ==== ====== ====== 2002 - -------------- Fourth quarter $ 93 $ 603 -- $ 65 $110 $177 $ 100 $1,148 Third quarter 18 352 -- 25 242 3 784 1,424 Second quarter 31 159 $18 20 24 -- 70 322 First quarter -- 319 -- -- 9 -- 116 444 - ------------------------------------------------------------------------------------------------------------------------- Total $142 $1,433 $18 $110 $385 $180 $1,070 $3,338 ==== ====== === ==== ==== ==== ====== ====== - -------------------------------------------------------------------------------------------------------------------------
Figure 17 shows loans that are either administered or serviced by Key, but not recorded on the balance sheet. Included are loans that have been both securitized and sold, or simply sold outright. In the event of default, Key is subject to recourse with respect to approximately $524 million of the $29.6 billion of loans administered or serviced at September 30, 2003. 54 Key derives income from two sources when we sell or securitize loans but retain the right to administer or service them. We earn noninterest income (recorded as "other income") from servicing or administering the loans, and we earn interest income from any securitized assets retained and from the investment of funds generated by escrow deposits. Conning Asset Management and National Realty Funding L.C. service the commercial real estate loans shown in Figure 17; however, other financial institutions originated most of these loans. FIGURE 17. LOANS ADMINISTERED OR SERVICED
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, in millions 2003 2003 2003 2002 2002 - -------------------------------------------------------------------------------------------------------------------------- Education loans $ 4,750 $ 4,161 $ 4,381 $ 4,605 $ 4,756 Automobile loans -- 29 40 54 69 Home equity loans 283 334 389 456 519 Commercial real estate loans 24,379 22,428 20,508 19,508 17,002 Commercial loans 153 142 130 123 110 - -------------------------------------------------------------------------------------------------------------------------- Total $29,565 $27,094 $25,448 $24,746 $22,456 ======= ======= ======= ======= ======= - --------------------------------------------------------------------------------------------------------------------------
SECURITIES At September 30, 2003, the securities portfolio totaled $8.8 billion and included $7.6 billion of securities available for sale, $106 million of investment securities and $1.1 billion of other investments (primarily principal investments). In comparison, the total portfolio at December 31, 2002, was $9.5 billion, including $8.5 billion of securities available for sale, $120 million of investment securities and $919 million of other investments. The weighted average maturity of the total portfolio was 3.4 years at September 30, 2003, compared with 3.0 years at December 31, 2002. The size and composition of Key's securities portfolio are dependent largely on our needs for liquidity and the extent to which we are required or elect to hold these assets as collateral to secure public and trust deposits. Although debt securities are generally used for this purpose, other assets, such as securities purchased under resale agreements, may be used temporarily when they provide more favorable yields. SECURITIES AVAILABLE FOR SALE. The majority of Key's securities available for sale portfolio consists of collateralized mortgage obligations that provide a source of interest income and serve as collateral in connection with pledging requirements. A collateralized mortgage obligation (sometimes called a "CMO") is a debt security that is secured by a pool of mortgages, mortgage-backed securities, U.S. government securities, corporate debt obligations or other bonds. At September 30, 2003, Key had $7.1 billion invested in collateralized mortgage obligations and other mortgage-backed securities in the available-for-sale portfolio, compared with $8.1 billion at December 31, 2002, and $7.0 billion at September 30, 2002. Key has invested more heavily in these securities as opportunities to originate loans (Key's preferred earning asset) have been adversely affected by the weak economy. However, during the second quarter of 2003, Key reduced the level of its CMOs by approximately $750 million, primarily through sales undertaken to manage prepayment risk. The securities sold were backed by higher coupon mortgages and had very short expected average lives. Substantially all of Key's mortgage-backed securities are issued or backed by federal agencies. The CMO securities held by Key are shorter-maturity class bonds that are structured to have more predictable cash flows than other longer-term class bonds during periods of rising interest rates. Figure 18 shows the composition, yields and remaining maturities of Key's securities available for sale. For more information about retained interests in securitizations and gross unrealized gains and losses by type of security, see Note 5 ("Securities"), which begins on page 17. 55 FIGURE 18. SECURITIES AVAILABLE FOR SALE
OTHER U.S.TREASURY, STATES AND COLLATERALIZED MORTGAGE- AGENCIES AND POLITICAL MORTGAGE BACKED dollars in millions CORPORATIONS SUBDIVISIONS OBLIGATIONS(a) SECURITIES(a) - -------------------------------------------------------------------------------------------- SEPTEMBER 30, 2003 Remaining maturity: One year or less $ 26 $ 1 $ 36 $ 112 After one through five years 28 5 6,136 358 After five through ten years 2 7 224 115 After ten years 3 12 86 11 - -------------------------------------------------------------------------------------------- Fair value $ 59 $ 25 $6,482 $ 596 Amortized cost 59 24 6,545 575 Weighted average yield 2.10% 6.98% 4.25% 5.46% Weighted average maturity 2.1 YEARS 10.6 YEARS 3.4 YEARS 2.7 YEARS - -------------------------------------------------------------------------------------------- DECEMBER 31, 2002 Fair value $ 23 $ 35 $7,207 $ 852 Amortized cost 22 35 7,143 815 - -------------------------------------------------------------------------------------------- SEPTEMBER 30, 2002 Fair value $ 21 $ 18 $6,194 $ 783 Amortized cost 20 17 6,156 748 - -------------------------------------------------------------------------------------------- RETAINED WEIGHTED INTERESTS IN OTHER AVERAGE dollars in millions SECURITIZATIONS(a) SECURITIES TOTAL YIELD(b) - -------------------------------------------------------------------------------------------- SEPTEMBER 30, 2003 Remaining maturity: One year or less -- $ 13 $ 188 4.04% After one through five years $ 167 185(c) 6,879 4.58 After five through ten years -- -- 348 7.57 After ten years 17 6 135 9.32 - --------------------------------------------------------------------------------------- Fair value $ 184 $204 $ 7,550 -- Amortized cost 120 200 7,523 4.77% Weighted average yield 35.67% 1.47(b)% 4.77% -- Weighted average maturity 4.3 YEARS 3.7 YEARS 3.4 YEARS -- - --------------------------------------------------------------------------------------- DECEMBER 31, 2002 Fair value $ 209 $ 181 $ 8,507 -- Amortized cost 166 208 8,389 5.76% - --------------------------------------------------------------------------------------- SEPTEMBER 30, 2002 Fair value $ 217 $ 176 $ 7,409 -- Amortized cost 182 216 7,339 5.95% - ---------------------------------------------------------------------------------------
(a) Maturity is based upon expected average lives rather than contractual terms. (b) Weighted average yields are calculated based on amortized cost and exclude equity securities of $114 million that have no stated yield. Such yields have been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%. (c) Includes primarily marketable equity securities with no stated maturity. INVESTMENT SECURITIES. Securities issued by states and political subdivisions account for the majority of Key's investment securities. Figure 19 shows the composition, yields and remaining maturities of these securities. FIGURE 19. INVESTMENT SECURITIES
STATES AND WEIGHTED POLITICAL OTHER AVERAGE dollars in millions SUBDIVISIONS SECURITIES TOTAL YIELD(a) - ------------------------------------------------------------------------------------------ SEPTEMBER 30, 2003 Remaining maturity: One year or less $ 24 $ 2 $ 26 9.65% After one through five years 56 8 64 8.61 After five through ten years 10 5 15 6.73 After ten years 1 -- 1 11.30 - ------------------------------------------------------------------------------------------ Amortized cost $ 91 $15 $106 8.57% Fair value 98 15 113 -- Weighted average maturity 2.5 YEARS 3.9 YEARS 2.7 YEARS -- - ------------------------------------------------------------------------------------------ DECEMBER 31, 2002 Amortized cost $120 -- $120 9.43% Fair value 129 -- 129 -- - ------------------------------------------------------------------------------------------ SEPTEMBER 30, 2002 Amortized cost $148 -- $148 9.33% Fair value 158 -- 158 -- - ------------------------------------------------------------------------------------------
(a) Weighted average yields are calculated based on amortized cost. Such yields have been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%. 56 OTHER INVESTMENTS. Principal investments - investments in equity and mezzanine instruments made by Key's Principal Investing unit - are carried at fair value, which aggregated $729 million at September 30, 2003. Of this amount, $16 million represents net unrealized gains. Principal investments represent approximately 66% of other investments and include direct and indirect investments predominately in privately-held companies. Direct investments are those made in a particular company, while indirect investments are made through funds that include other investors. In addition to principal investments, other investments include securities that do not have readily determinable fair values. These securities include certain real estate-related investments. Neither these securities nor principal investments have stated maturities. ASSET QUALITY Key has a multi-faceted program to manage asset quality. Our professionals: - - evaluate and monitor credit quality and risk in credit-related assets; - - develop commercial and consumer credit policies and systems; - - monitor compliance with internal underwriting standards; - - establish credit-related concentration limits; and - - review the adequacy of the allowance for loan losses. ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses at September 30, 2003, was $1.4 billion, or 2.24% of loans. This compares with $1.5 billion, or 2.37% of loans, at September 30, 2002. The allowance includes $93 million that was specifically allocated for impaired loans of $286 million at September 30, 2003, compared with $200 million that was allocated for impaired loans of $414 million a year ago. For more information about impaired loans, see Note 8 ("Impaired Loans and Other Nonperforming Assets") on page 22. At September 30, 2003, the allowance for loan losses was 176.73% of nonperforming loans, representing the highest level of nonperforming loan coverage by the allowance since December 31, 2001. This compares with a ratio of 150.86% at September 30, 2002. Management estimates the appropriate level of the allowance for loan losses on a quarterly (and at times more frequent) basis. The methodology used is described in Note 1 ("Summary of Significant Accounting Policies") under the heading "Allowance for Loan Losses" on page 58 of Key's 2002 Annual Report to Shareholders. Briefly, management assigns a specific allowance to an impaired loan when the carrying amount of the loan exceeds the estimated present value of related future cash flows and the fair value of any existing collateral. The allowance for loan losses arising from nonimpaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics and by exercising judgment to assess the impact of factors such as changes in economic conditions, credit policies or underwriting standards, and the level of credit risk associated with specific industries and markets. The aggregate balance of the allowance for loan losses at September 30, 2003, represents management's best estimate of the losses inherent in the loan portfolio at that date. The allowance specifically allocated for Key's impaired loans decreased by $107 million, or 54%, over the past twelve months, reflecting Key's continued efforts to resolve problem credits, combined with stabilizing credit quality trends in certain portfolios. The level of watch credits in the commercial portfolio has decreased in each of the last three quarters. Watch credits are loans with the potential for further deterioration in quality due to the debtor's current financial condition and related inability to perform in accordance with the terms of the loan. The commercial loan portfolios with the most significant decreases in watch credits were commercial real estate, structured finance and media. Structured finance refers to a type of lending characterized by a high degree of leverage in the borrower's financial condition and a relatively low level of tangible loan collateral. These changes reflect the fluctuations that occur in loan portfolios from time to time, underscoring the benefits of Key's strategy to limit the concentration of credit risk in any single portfolio. 57 NET LOAN CHARGE-OFFS. Net loan charge-offs for the third quarter of 2003 totaled $123 million, or .77% of average loans, representing the lowest level of net charge-offs since the first quarter of 2001. These results compare with net charge-offs of $185 million, or 1.16% of average loans, for the same period last year. The composition of Key's loan charge-offs and recoveries by type of loan is shown in Figure 20. The decrease in net charge-offs from the year-ago quarter occurred primarily in the structured finance and media segments of the commercial loan portfolio. FIGURE 20. SUMMARY OF LOAN LOSS EXPERIENCE
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- ------------------ dollars in millions 2003 2002 2003 2002 - ------------------------------------------------------------------------------------------------------------------------ Average loans outstanding during the period $63,078 $63,486 $62,985 $63,634 - ------------------------------------------------------------------------------------------------------------------------ Allowance for loan losses at beginning of period $ 1,405 $ 1,539 $ 1,452 $ 1,677 Loans charged off: Commercial, financial and agricultural 61 110 225 321 Real estate -- commercial mortgage 11 11 36 59 Real estate -- construction 1 5 5 17 - ------------------------------------------------------------------------------------------------------------------------ Total commercial real estate loans(a) 12 16 41 76 Commercial lease financing 14 18 45 56 - ------------------------------------------------------------------------------------------------------------------------ Total commercial loans 87 144 311 453 Real estate -- residential mortgage 2 1 5 4 Home equity 15 13 44 42 Consumer -- direct 12 11 37 38 Consumer -- indirect lease financing 3 6 12 19 Consumer -- indirect other 40 36 119 124 - ------------------------------------------------------------------------------------------------------------------------ Total consumer loans 72 67 217 227 - ------------------------------------------------------------------------------------------------------------------------ 159 211 528 680 Recoveries: Commercial, financial and agricultural 11 6 27 25 Real estate -- commercial mortgage 2 -- 10 3 Real estate -- construction -- 2 3 2 - ------------------------------------------------------------------------------------------------------------------------ Total commercial real estate loans(a) 2 2 13 5 Commercial lease financing 6 2 11 6 - ------------------------------------------------------------------------------------------------------------------------ Total commercial loans 19 10 51 36 Real estate -- residential mortgage -- -- 1 1 Home equity 1 1 4 3 Consumer -- direct 3 2 7 6 Consumer -- indirect lease financing 2 2 5 6 Consumer -- indirect other 11 11 35 34 - ------------------------------------------------------------------------------------------------------------------------ Total consumer loans 17 16 52 50 - ------------------------------------------------------------------------------------------------------------------------ 36 26 103 86 - ------------------------------------------------------------------------------------------------------------------------ Net loans charged off (123) (185) (425) (594) Provision for loan losses 123 135 378 406 - ------------------------------------------------------------------------------------------------------------------------ Allowance for loan losses at end of period $ 1,405 $ 1,489 $ 1,405 $ 1,489 ======= ======= ======= ======= - ------------------------------------------------------------------------------------------------------------------------ Net loan charge-offs to average loans .77% 1.16% .90% 1.25% Allowance for loan losses to period-end loans 2.24 2.37 2.24 2.37 Allowance for loan losses to nonperforming loans 176.73 150.86 176.73 150.86 - ------------------------------------------------------------------------------------------------------------------------
(a) See Figure 14 on page 53 and the accompanying discussion on page 52 for more information related to Key's commercial real estate portfolio. 58 NONPERFORMING ASSETS. Figure 21 shows the composition of Key's nonperforming assets, which have declined for four consecutive quarters. These assets totaled $862 million at September 30, 2003, and represented 1.37% of loans, other real estate owned (known as "OREO") and other nonperforming assets, compared with $993 million, or 1.59%, at December 31, 2002, and $1.0 billion, or 1.61%, at September 30, 2002. FIGURE 21. SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, dollars in millions 2003 2003 2003 2002 2002 - ------------------------------------------------------------------------------------------------------------------------------- Commercial, financial and agricultural $ 345 $ 361 $ 381 $ 448 $ 484 Real estate--commercial mortgage 89 143 165 157 149 Real estate--construction 38 22 37 50 79 - ------------------------------------------------------------------------------------------------------------------------------- Total commercial real estate loans(a) 127 165 202 207 228 Commercial lease financing 108 92 91 69 88 - ------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 580 618 674 724 800 Real estate--residential mortgage 36 38 39 36 34 Home equity 151 152 154 146 124 Consumer--direct 12 13 13 13 6 Consumer--indirect lease financing 3 4 5 5 6 Consumer--indirect other 13 12 19 19 17 - ------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 215 219 230 219 187 - ------------------------------------------------------------------------------------------------------------------------------- Total nonperforming loans 795 837 904 943 987 OREO 69 60 62 48 30 Allowance for OREO losses (4) (3) (3) (3) (2) - ------------------------------------------------------------------------------------------------------------------------------- OREO, net of allowance 65 57 59 45 28 Other nonperforming assets 2 3 5 5 2 - ------------------------------------------------------------------------------------------------------------------------------- Total nonperforming assets $ 862 $ 897 $ 968 $ 993 $ 1,017 ===== ===== ===== ===== ======= - ------------------------------------------------------------------------------------------------------------------------------- Accruing loans past due 90 days or more $ 165 $ 172 $ 207 $ 198 $ 208 Accruing loans past due 30 through 89 days 710 731 721 790 787 - ------------------------------------------------------------------------------------------------------------------------------- Nonperforming loans to period-end loans 1.27% 1.32% 1.44% 1.51% 1.57% Nonperforming assets to period-end loans plus OREO and other nonperforming assets 1.37 1.42 1.54 1.59 1.61 - -------------------------------------------------------------------------------------------------------------------------------
(a) See Figure 14 on page 53 and the accompanying discussion on page 52 for more information related to Key's commercial real estate portfolio. The reduction in nonperforming loans during the third quarter was attributable largely to decreases in the healthcare, middle market and structured finance portfolios. At September 30, 2003, our 20 largest nonperforming loans totaled $267 million, representing 34% of total loans on nonperforming status. Information pertaining to the credit exposure by industry classification inherent in the largest sector of Key's loan portfolio, commercial, financial and agricultural loans, is presented in Figure 22. The types of activity that caused the change in Key's nonperforming loans during the last five quarters are represented in Figure 23. 59 FIGURE 22. COMMERCIAL, FINANCIAL AND AGRICULTURAL LOANS
NONPERFORMING LOANS ---------------------- SEPTEMBER 30, 2003 TOTAL LOANS % OF LOANS dollars in millions COMMITMENTS OUTSTANDING AMOUNT OUTSTANDING - ------------------------------------------------------------------------------------------ Industry classification: Manufacturing $ 9,450 $ 3,381 $140 4.1% Services 6,525 2,503 69 2.8 Financial services 5,606 977 1 .1 Retail trade 4,550 2,539 16 .6 Property management 3,099 1,162 4 .3 Wholesale trade 2,717 1,268 17 1.3 Public utilities 2,024 375 2 .5 Building contractors 1,416 662 32 4.8 Communications 1,266 413 13 3.1 Insurance 1,138 142 -- -- Agriculture/forestry/fishing 1,052 680 18 2.6 Transportation 852 432 11 2.5 Public administration 702 246 -- -- Mining 410 163 -- -- Individuals 163 113 1 .9 Other 2,290 2,062 21 1.0 - ------------------------------------------------------------------------------------------ Total $43,260 $17,118 $345 2.0% ======= ======= ==== - ------------------------------------------------------------------------------------------
FIGURE 23. SUMMARY OF CHANGES IN NONPERFORMING LOANS
2003 2002 ------------------------------------- --------------------- in millions THIRD SECOND FIRST FOURTH THIRD - ----------------------------------------------------------------------------------------------------------------------- Balance at beginning of period $ 837 $ 904 $ 943 $ 987 $ 957 Loans placed on nonaccrual status 240 168 237 339 281 Charge-offs (123) (141) (161) (186) (185) Loans sold (73) (42) (23) (36) (25) Payments (73) (26) (58) (149) (41) Transfers to OREO (6) (1) (19) -- -- Loans returned to accrual status (7) (25) (15) (13) -- Acquisition of Union Bankshares, Ltd. -- -- -- 1 -- - ----------------------------------------------------------------------------------------------------------------------- Balance at end of period $ 795 $ 837 $ 904 $ 943 $ 987 ===== ===== ===== ===== ===== - -----------------------------------------------------------------------------------------------------------------------
60 DEPOSITS AND OTHER SOURCES OF FUNDS "Core deposits" - domestic deposits other than certificates of deposit of $100,000 or more - are Key's primary source of funding. During the third quarter of 2003, core deposits averaged $42.2 billion, and represented 57% of the funds Key used to support earning assets, compared with $37.2 billion and 52%, respectively, during the same quarter in 2002. The composition of Key's deposits is shown in Figure 6, which spans pages 44 and 45. The increase in the level of Key's core deposits over the past twelve months was due primarily to higher levels of NOW and money market deposit accounts as well as noninterest-bearing deposits. The growth of these deposits reflected client preferences for investments that provide high levels of liquidity in a low interest rate environment. Also contributing to the significant growth in noninterest-bearing deposits were our intensified cross-selling efforts, the introduction of new products, including free checking, and an increase in escrow deposits associated with the servicing of commercial real estate loans. A more aggressive pricing structure implemented in mid-2002 supported the growth in savings deposits. During the same period, time deposits decreased by 13% in part because, like our competitors, Key reduced the rates paid for them, as the Federal Reserve Board reduced interest rates in general. Purchased funds, comprising large certificates of deposit, deposits in the foreign branch and short-term borrowings, averaged $14.2 billion during the third quarter of 2003, compared with $15.5 billion during the year-ago quarter. Although large certificates of deposit have remained relatively unchanged from a year ago, deposits in the foreign branch and short-term borrowings both declined over the past twelve months. This is attributable in part to reduced funding needs resulting from core deposit growth, loan sales, slow demand for loans and our decision to scale back or discontinue certain types of lending. Key continues to consider loan sales and securitizations as funding alternatives when market conditions are favorable. During the first nine months of 2003, Key securitized and sold $835 million of education loans, all of which occurred in the third quarter. LIQUIDITY "Liquidity" measures whether an entity has sufficient cash flow to meet its financial obligations when due. Key has sufficient liquidity when it can meet its obligations to depositors, borrowers and creditors at a reasonable cost, on a timely basis, and without adverse consequences. KeyCorp has sufficient liquidity when it can pay dividends to shareholders, service its debt, and support customary corporate operations and activities, including acquisitions, at a reasonable cost, in a timely manner and without adverse consequences. LIQUIDITY RISK. There are both direct and indirect circumstances that could adversely affect Key's liquidity or materially affect the cost of funds. For example, events unrelated to Key, such as terrorism or war, natural disasters, political events, or the default or bankruptcy of a major corporation, mutual fund or hedge fund can have market-wide consequences. An example of a direct (but hypothetical) event would be a significant downgrade in Key's public credit rating by a rating agency due to a deterioration in asset quality, a large charge to earnings, a significant merger or acquisition or other events. Similarly, market speculation or rumors about Key or the banking industry in general may cause normal funding sources to withdraw credit until further information becomes available. LIQUIDITY FOR KEY. Key's Funding and Investment Management Group monitors the overall mix of funding sources with the objective of maintaining an appropriate mix in light of the structure of the asset portfolios. We use several tools to maintain sufficient liquidity. - - We maintain portfolios of short-term money market investments and securities available for sale, substantially all of which could be converted to cash quickly at a small expense. - - Key's portfolio of investment securities generates prepayments (often at a premium) and payments at maturity. 61 - - We try to structure the maturities of our loans so we receive a relatively consistent stream of payments from borrowers. - - We have the ability to access the securitization markets for a variety of loan types. - - Our 900 full-service KeyCenters in 12 states generate a sizable volume of core deposits. We monitor deposit flows and use alternative pricing structures to attract deposits when necessary. For more information about core deposits, see the previous section entitled "Deposits and other sources of funds." - - Key has access to various sources of money market funding (such as federal funds purchased, securities sold under repurchase agreements, and bank notes) and also can borrow from the Federal Reserve Bank to meet short-term liquidity requirements. Key did not have any borrowings from the Federal Reserve Bank outstanding at September 30, 2003. The Consolidated Statements of Cash Flow on page 6 summarize Key's sources and uses of cash by type of activity for the nine-month periods ended September 30, 2003 and 2002. As shown in these statements, Key's largest cash flows relate to both investing and financing activities. Over the past two years, the primary sources of cash from investing activities have been loan securitizations and sales and the sales, prepayments and maturities of securities available for sale. Investing activities that have required the greatest use of cash include lending and the purchases of new securities. Over the past two years, the primary source of cash from financing activities has been the issuance of long-term debt. However, in 2002, deposits were also a significant source of cash. In each of the past two years, major outlays of cash have been made to repay debt issued in prior periods. During 2002, cash was also used to reduce the level of short-term borrowings. LIQUIDITY FOR KEYCORP. KeyCorp meets its liquidity requirements principally through regular dividends from affiliate banks. Federal banking law limits the amount of capital distributions that banks can make to their holding companies without obtaining prior regulatory approval. A national bank's dividend paying capacity is affected by several factors, including the amount of its net profits (as defined by statute) for the two previous calendar years, and net profits for the current year up to the date of dividend declaration. During the first nine months of 2003, affiliate banks paid KeyCorp a total of $70 million in dividends. As of September 30, 2003, the affiliate banks had an additional $260 million available to pay dividends to KeyCorp without prior regulatory approval. KeyCorp generally maintains excess funds in short-term investments. ADDITIONAL SOURCES OF LIQUIDITY. Management has implemented several programs that enable Key and KeyCorp to raise money in the public and private markets when necessary. The proceeds from all of these programs can be used for general corporate purposes, including acquisitions. Each of the programs is replaced or extended from time to time as needed. BANK NOTE PROGRAM. During the first nine months of 2003, Key's affiliate banks raised $1.5 billion under Key's bank note program. Of the notes issued during the year, $1.1 billion have original maturities in excess of one year and are included in long-term debt. The remaining notes have original maturities of one year or less and are included in short-term borrowings. Key's current bank note program provides for the issuance of both long- and short-term debt of up to $20.0 billion ($19.0 billion by KBNA and $1.0 billion by Key Bank USA). At September 30, 2003, $16.6 billion was available for future issuance under this program. EURO NOTE PROGRAM. Under Key's euro note program, KeyCorp, KBNA and Key Bank USA may issue both long- and short-term debt of up to $10.0 billion in the aggregate. The notes are offered exclusively to non-U.S. investors and can be denominated in U.S. dollars and many foreign currencies. There were $197 million of borrowings issued under this program during the first nine months of 2003. At September 30, 2003, $4.0 billion was available for future issuance. 62 KEYCORP MEDIUM-TERM NOTE PROGRAM AND OTHER SECURITIES. In November 2001, KeyCorp registered, under a registration statement filed with the Securities and Exchange Commission, $2.2 billion of securities. At September 30, 2003, of the amount registered, $1.0 billion had been allocated for the issuance of medium-term notes. On October 7, 2003, KeyCorp allocated the remaining amount, $1.2 billion, for the issuance of medium-term notes. At September 30, 2003, unused capacity under KeyCorp's universal shelf registration statement totaled $1.5 billion. COMMERCIAL PAPER AND REVOLVING CREDIT. KeyCorp has a commercial paper program and a revolving credit agreement with an unaffiliated financial institution that provide funding availability of up to $500 million and $400 million, respectively. As of September 30, 2003, there were no borrowings outstanding under either the commercial paper program or the revolving credit agreement. The revolving credit agreement expired on October 2, 2003, and was not renewed. Key also has a commercial paper program with unaffiliated Canadian financial institutions that provides funding availability of up to $1.0 billion in Canadian currency or the equivalent in U.S. currency. As of September 30, 2003, borrowings outstanding under this commercial paper program totaled $795 million in Canadian currency and $27 million in U.S. currency (equivalent to $36 million in Canadian currency). Key's debt ratings are shown in Figure 24 below. Management believes that these debt ratings, under normal conditions in the capital markets, allow for future offerings of securities by KeyCorp or its affiliate banks that would be marketable to investors at a competitive cost. FIGURE 24. DEBT RATINGS
SENIOR SUBORDINATED SHORT-TERM LONG-TERM LONG-TERM CAPITAL SEPTEMBER 30, 2003 BORROWINGS DEBT DEBT SECURITIES - ----------------------------------------------------------------------------------------------------- KEYCORP Standard & Poor's A-2 A- BBB+ BBB Moody's P-1 A2 A3 Baa1 Fitch F1 A A- A KBNA Standard & Poor's A-1 A A- N/A Moody's P-1 A1 A2 N/A Fitch F1 A A- N/A KEY NOVA SCOTIA FUNDING COMPANY ("KNSF") Dominion Bond Rating Service(a) R-1 (middle) N/A N/A N/A - -----------------------------------------------------------------------------------------------------
(a) Reflects the guarantee by KBNA of KNSF's issuance of Canadian commercial paper. N/A = Not Applicable CAPITAL SHAREHOLDERS' EQUITY. Total shareholders' equity at September 30, 2003, was $7.0 billion, up $142 million from the balance at December 31, 2002. Growth in retained earnings and the issuance of common shares out of the treasury stock account in connection with employee stock purchase, 401(k), dividend reinvestment and stock option programs were the largest contributors to the increase. Other factors, including share repurchases discussed below, that contributed to the change in shareholders' equity during the first nine months of 2003 are shown in the Consolidated Statements of Changes in Shareholders' Equity presented on page 5. SHARE REPURCHASES. In September 2003, the Board of Directors authorized the repurchase of up to 25,000,000 common shares, including 6,264,400 shares remaining at the time from an earlier repurchase program. These shares may be repurchased in the open market or through negotiated transactions. During the first nine months of 2003, Key repurchased a total of 7,500,000 of its common shares under the 63 previous program at an average price per share of $25.43. At September 30, 2003, a remaining balance of 25,000,000 shares may be repurchased under the September 2003 authorization. At September 30, 2003, Key had 72,622,333 treasury shares. Management may reissue those shares from time-to-time to support the employee stock purchase, 401(k), stock option, deferred compensation and dividend reinvestment plans, and for other corporate purposes. During the first nine months of 2003, Key reissued 2,822,802 treasury shares for employee benefit and dividend reinvestment plans. CAPITAL ADEQUACY. Capital adequacy is an important indicator of financial stability and performance. Overall, Key's capital position remains strong: the ratio of total shareholders' equity to total assets was 8.26% at September 30, 2003, and 7.97% at September 30, 2002. Key's ratio of tangible equity to tangible assets was 6.94% at September 30, 2003, and exceeded management's targeted range of 6.25% to 6.75%. Management believes that Key's strong capital position provides the flexibility to take advantage of future investment opportunities and to repurchase shares when appropriate. The tangible equity to tangible assets ratio is expected to be managed downward over time to be within management's targeted range. Banking industry regulators prescribe minimum capital ratios for bank holding companies and their banking subsidiaries. Note 14 ("Shareholders' Equity"), which begins on page 76 of Key's 2002 Annual Report to Shareholders, explains the implications of failing to meet specific capital requirements imposed by the banking regulators. Risk-based capital guidelines require a minimum level of capital as a percent of "risk-weighted assets," which is total assets plus certain off-balance sheet items, both adjusted for predefined credit risk factors. Currently, banks and bank holding companies must maintain, at a minimum, Tier 1 capital as a percent of risk-weighted assets of 4.00%, and total capital as a percent of risk-weighted assets of 8.00%. As of September 30, 2003, Key's Tier 1 capital ratio was 8.21%, and its total capital ratio was 12.46%. Another indicator of capital adequacy, the leverage ratio, is defined as Tier 1 capital as a percentage of average quarterly tangible assets. Leverage ratio requirements vary with the condition of the financial institution. Bank holding companies that either have the highest supervisory rating or have implemented the Federal Reserve's risk-adjusted measure for market risk--as KeyCorp has--must maintain a minimum leverage ratio of 3.00%. All other bank holding companies must maintain a minimum ratio of 4.00%. As of September 30, 2003, Key had a leverage ratio of 8.36%. Federal bank regulators group FDIC-insured depository institutions into five categories, ranging from "critically undercapitalized" to "well capitalized." Both of Key's affiliate banks qualified as "well capitalized" at September 30, 2003, since each exceeded the prescribed thresholds of 10.00% for total capital, 6.00% for Tier 1 capital and 5.00% for the leverage ratio. If these provisions applied to bank holding companies, Key would also qualify as "well capitalized" at September 30, 2003. The FDIC-defined capital categories serve a limited supervisory function. Investors should not treat them as a representation of the overall financial condition or prospects of Key or its affiliate banks. Figure 25 presents the details of Key's regulatory capital position at September 30, 2003, December 31, 2002 and September 30, 2002. 64 FIGURE 25. CAPITAL COMPONENTS AND RISK-WEIGHTED ASSETS
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2003 2002 2002 - --------------------------------------------------------------------------------------------------- TIER 1 CAPITAL Common shareholders' equity(a) $ 6,937 $ 6,738 $ 6,597 Qualifying capital securities 1,247 1,096 1,121 Less: Goodwill 1,154 1,142 1,105 Other assets(b) 76 60 46 - --------------------------------------------------------------------------------------------------- Total Tier 1 capital 6,954 6,632 6,567 - --------------------------------------------------------------------------------------------------- TIER 2 CAPITAL Allowable portion of allowance for loan losses 1,083 986 977 Qualifying long-term debt 2,513 2,639 2,441 - --------------------------------------------------------------------------------------------------- Total Tier 2 capital 3,596 3,625 3,418 - --------------------------------------------------------------------------------------------------- Total risk-based capital $ 10,550 $ 10,257 $ 9,985 ============ ============ ============== RISK-WEIGHTED ASSETS Risk-weighted assets on balance sheet $ 67,878 $ 67,051 $ 67,734 Risk-weighted off-balance sheet exposure 18,451 16,595 12,595 Less: Goodwill 1,154 1,142 1,105 Other assets(b) 379 251 218 Plus: Market risk-equivalent assets 213 192 214 - --------------------------------------------------------------------------------------------------- Gross risk-weighted assets 85,009 82,445 79,220 Less: Excess allowance for loan losses 322 466 512 - --------------------------------------------------------------------------------------------------- Net risk-weighted assets $ 84,687 $ 81,979 $ 78,708 ============ ============ ============== AVERAGE QUARTERLY TOTAL ASSETS $ 84,722 $ 82,735 $ 81,935 ============ ============ ============== CAPITAL RATIOS Tier 1 risk-based capital ratio 8.21% 8.09% 8.34% Total risk-based capital ratio 12.46 12.51 12.69 Leverage ratio(c) 8.36 8.15 8.15 - ---------------------------------------------------------------------------------------------------
(a) Common shareholders' equity does not include net unrealized gains or losses on securities (except for net unrealized losses on marketable equity securities) nor net gains or losses on cash flow hedges. (b) "Other assets" deducted from Tier 1 capital consists of intangible assets (excluding goodwill) recorded after February 19, 1992, deductible portions of purchased mortgage servicing rights and deductible portions of nonfinancial equity investments. "Other assets" deducted from risk-weighted assets consists of intangible assets (excluding goodwill) recorded after February 19, 1992, deductible portions of purchased mortgage servicing rights and nonfinancial equity investments. (c) This ratio is Tier 1 capital divided by average quarterly total assets less goodwill and the nonqualifying intangible assets described in footnote (b). 65 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK The information presented in the Market Risk Management section, which begins on page 46 in the Management's Discussion and Analysis of Financial Condition and Results of Operations, is incorporated herein by reference. ITEM 4. CONTROLS AND PROCEDURES As a bank holding company, KeyCorp is subject to the internal control reporting requirements of the Federal Deposit Insurance Corporation Improvement Act, which became effective in 1993 ("FDICIA"). FDICIA requirements include an annual assessment by our Chief Executive Officer and Chief Financial Officer of the effectiveness of our internal controls over financial reporting, which generally includes those controls relating to the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. In addition, under FDICIA, our independent auditors have annually examined and attested to, without qualification, management's assertions regarding the effectiveness of our internal controls. Accordingly, we have had an established process of maintaining and evaluating our internal controls over financial reporting. In connection with recent legislation and regulations, our management has also focused its attention on our "disclosure controls and procedures," which, as defined by the SEC, are generally those controls and procedures designed to ensure that financial and nonfinancial information required to be disclosed in KeyCorp's reports filed with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to KeyCorp's management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In light of the requirements imposed by the recently adopted SEC regulations, we engaged in a process of reviewing our disclosure controls and procedures. As a result of our review, and although we believe that our pre-existing disclosure controls and procedures were effective in enabling us to comply with our disclosure obligations, we implemented enhancements, which included establishing a disclosure committee and generally formalizing and documenting disclosure controls and procedures that we already had in place. During the quarterly period covered by this report, KeyCorp carried out an evaluation, under the supervision and with the participation of KeyCorp's management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of KeyCorp's disclosure controls and procedures. Based upon that evaluation, KeyCorp's Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective, in all material respects, as of the end of the period covered by this report. In conjunction with its normal on-going risk management and risk review process, and consistent with the requirements of recently adopted SEC regulations, management has undertaken a further comprehensive evaluation of its internal control over financial reporting that may result in additional future refinements to our existing internal control over financial reporting framework. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The information presented in Note 10 ("Contingent Liabilities and Guarantees"), which begins on page 25 of the Notes to Consolidated Financial Statements, is incorporated herein by reference. 66 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS 10.1 Trust Agreement for certain amounts that may become payable to certain executives and directors of KeyCorp, dated April 1, 1997, and amended as of August 25, 2003. 15 Acknowledgment Letter of Independent Auditors. 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) REPORTS ON FORM 8-K July 18, 2003 - Item 7. Financial Statements and Exhibits and Item 9. Regulation FD Disclosure and Information Furnished under Item 12 (Disclosure of Results of Operations and Financial Condition). Reporting that on July 18, 2003, the Registrant issued a press release announcing its earnings results for the three- and six-month periods ended June 30, 2003, and providing a slide presentation reviewed in the related conference call/webcast. September 11, 2003 - Item 9. Regulation FD Disclosure. Reporting that on September 10, 2003, the Registrant provided updated earnings guidance at the Lehman Brothers Financial Services Conference and providing a slide presentation reviewed at the conference. No other reports on Form 8-K were filed during the three-month period ended September 30, 2003. INFORMATION AVAILABLE ON WEBSITE KeyCorp makes available free of charge on its website, www.Key.com, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after KeyCorp electronically files such material with, or furnishes it to, the Securities and Exchange Commission. 67 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KEYCORP ------------------------------------ (Registrant) Date: November 12, 2003 /s/ Lee Irving ------------------------------------ By: Lee Irving Executive Vice President and Chief Accounting Officer 68 EX-10.1 3 l03467aexv10w1.txt EXHIBIT 10.1 EXHIBIT 10.1 TRUST AGREEMENT FOR CERTAIN AMOUNTS THAT MAY BECOME PAYABLE TO CERTAIN EXECUTIVES AND DIRECTORS OF KEYCORP THIS TRUST AGREEMENT, made as of the 1st day of April, 1997, and amended as of August 25, 2003, is between KeyCorp, an Ohio corporation ("Key"), and Wachovia Bank, National Association, formerly known as Wachovia Bank of North Carolina, N.A. (the "Trustee"). Key has established a number of nonqualified retirement and deferred compensation plans to provide benefits to certain of its executives, Key has entered into a number of agreements with certain of its executives under which those executives may become entitled to payments and benefits after a change of control of Key (as defined in those agreements), and Key has established a plan pursuant to which members of the Board of Directors may defer a portion of the compensation payable to them in consideration of their services as directors and a plan pursuant to which members of the Board of Directors will receive deferred shares as part of the compensation payable to them in consideration for their services as directors. Key has identified and caused to be set forth on Exhibit A to this Trust Agreement a list of all such plans and agreements that Key intends to be subject to the terms of this Trust Agreement. Key desires to establish a trust (the "Trust") and to contribute to the Trust assets that shall be held therein until paid to or on behalf of a Participant, and that shall be subject, while so held, to the claims of the creditors of Key in the event Key becomes Insolvent (as defined in Section 5.1 below). It is the intention of the parties that the Trust shall constitute an unfunded arrangement for purposes of Title I of the Employee Retirement Income Security Act of 1974. (Certain capitalized terms not defined elsewhere in this Trust Agreement are defined in Article 15 below.) In consideration of the premises, Key and the Trustee do hereby establish the Trust and agree that the Trust shall be comprised, held, and disposed of as follows: Article 1. Establishment of Trust 1.1 Key hereby deposits with the Trustee in trust $100, which shall become the principal of the Trust to be held, administered, and disposed of by the Trustee as provided in this Trust Agreement. 1.2 The Trust hereby established may be revoked by Key at any time before the occurrence of the first to occur of (a) a Potential Change of Control (as defined in Section 15.9) and (b) a Change of Control (as defined in Section 15.3). If any Potential Change of Control occurs, the Trust hereby established may not be revoked by Key until both that particular Potential Change of Control and any other Potential Change of Control that may have also occurred have been "terminated" (as defined in Section 15.10) and the Trust then may be 1 revoked by Key if and only if no Change of Control has then occurred. Upon the occurrence of a Change of Control, the Trust hereby established shall become irrevocable. Key's General Counsel shall notify the Trustee promptly upon the occurrence of any Change of Control and of any Potential Change of Control. 1.3 The Trust is intended to be a grantor trust, of which Key is the grantor, within the meaning of subpart F, part 1, subchapter J, chapter 1, subtitle A of the Internal Revenue Code, and shall be construed accordingly. 1.4 The principal of the Trust and any earnings thereon shall be held separate and apart from other funds of Key and shall be used exclusively for the uses and purposes of Participants and general creditors as herein set forth. Participants shall have no preferred claim on, or any beneficial ownership interest in, any assets of the Trust. Any rights created under the Covered Plans (as defined in Section 15.4 below) and this Trust Agreement shall be mere unsecured contractual rights of Participants against Key. Any assets held by the Trust will be subject to the claims of general creditors of Key under federal and state law in the event Key becomes Insolvent. Article 2. Additional Funding 2.1 Key, in its sole discretion, may at any time, or from time to time, make or cause to be made, directly or indirectly, additional deposits of cash or other property in trust with the Trustee to augment the principal to be held, administered, and disposed of by the Trustee as provided in this Trust Agreement. 2.2 If a Potential Change of Control occurs, Key shall, not later than the day before the occurrence of any Change of Control related to that Potential Change of Control, contribute to the Trust an amount equal to the excess, if any, of the Full Funding Amount (as defined in Section 15.5) over the value of the assets in the Trust (the "Current Trust Asset Value") immediately prior to the contribution. At the time any contribution is made pursuant to Section 2.1 or this Section 2.2, Key may specify, in a written notice to the Trustee, that Key retains the right to withdraw the amount so contributed at any time before the earlier of (a) the occurrence of a Change of Control or (b) the delivery by Key to the Trustee of a waiver of the right so retained. Absent such a notice by Key at the time of the contribution, the contribution shall be subject to withdrawal by Key only as provided in Article 3, dealing with discretionary withdrawals generally, or in Article 6, dealing with reversion of excess assets. 2.3 Immediately upon the occurrence of the first Change of Control to occur after the execution of this Trust Agreement and thereafter on each and every anniversary of that Change of Control, Key shall contribute to the Trust an amount equal to the excess, if any, of the Full Funding Amount over the Current Trust Asset Value immediately prior to the contribution. Article 3. Discretionary Withdrawals 3.1 Key, in its sole discretion, at any time before the occurrence of the first to occur of a Potential Change of Control or a Change of Control, may withdraw assets from the Trust 2 provided that no such withdrawal shall reduce the Current Trust Asset Value, immediately after the withdrawal, to an amount below $100. 3.2 Except in the exercise of a right of withdrawal retained as provided in the second sentence of Section 2.2, Key shall not be entitled to make any discretionary withdrawal of assets from the Trust, after any Potential Change of Control has occurred, until both that particular Potential Change of Control and any other Potential Change of Control that may have also occurred have been terminated and Key may then make such a discretionary withdrawal if and only if no Change of Control has then occurred. No discretionary withdrawal under this Section 3.2 shall reduce the Current Trust Asset Value, immediately after the withdrawal, to an amount below $100. 3.3 After a Change of Control has occurred, Key may not make any discretionary withdrawal from the Trust. Nothing in this Article 3 shall restrict the right of Key to receive a reversion of excess assets under Article 6. Article 4. Payments to Participants. 4.1 Not later than 120 days after the occurrence of a Potential Change of Control and again not later than 10 days following the occurrence of a Change of Control, Key shall deliver to the Trustee a schedule (the "Payment Schedule") that lists the names and addresses of all Participants and indicates the amounts payable and to become payable to each Participant and/or provides a formula or other instructions acceptable to the Trustee for determining the amounts so payable and that indicates the form in which such amounts are to be paid, as provided for or available under each Covered Plan, and the time of commencement for payment of such amounts. At the same time as Key delivers the Payment Schedule to the Trustee, Key shall deliver to each Participant that portion of the Payment Schedule that pertains to amounts that may become payable to that particular Participant. After the occurrence of a Change of Control, Key shall update the Payment Schedule, provide revised versions thereof to the Trustee, and provide the relevant portions thereof to each Participant from time to time and at such times so that each termination of the employment of any Participant (or the occurrence of any other fact or circumstance that alters the payments due or to become due to any Participant under any of the Covered Plans) is taken into account in a current revised Payment Schedule that has been appropriately delivered to the Trustee and to each Participant (to the extent relevant to each such Participant) not later than 10 days after its occurrence. Except as otherwise provided herein, the Trustee shall make payments to the Participants in accordance with the Payment Schedule as it may be revised from time to time. The Trustee shall make provision for the reporting and withholding of any federal, state, or local taxes that may be required to be withheld with respect to the payment of benefits pursuant to the terms of each Covered Plan and shall pay amounts withheld to the appropriate taxing authorities or determine that such amounts have been reported, withheld, and paid by Key. 4.2 Except as otherwise specifically provided herein, the entitlement of a Participant to payments from Key under a particular Covered Plan shall be determined under the terms of the particular Covered Plan at issue. It is Key's intention that any and all amounts that may become 3 payable to Participants under the Covered Plans will be paid to the Participants at the times and in the amounts specified in the relevant Covered Plan. 4.3 In order to provide added assurances to the Participants that the amounts to which they may be entitled under the Covered Plans will be calculated in good faith and paid promptly at the times and in the amounts specified in the respective Covered Plans, the following procedure shall be followed: (a) If, concurrently with or after the occurrence of a Change of Control, Key delivers to the Trustee a Payment Schedule indicating that a Participant is entitled to payments under a Covered Plan, the Trustee shall promptly thereafter deliver a copy of the relevant portion of the Payment Schedule to the Participant and shall make the payments so indicated in the Payment Schedule. (b) If, after the occurrence of a Change of Control, a Participant (either because no Payment Schedule has been delivered to the Trustee or because the Participant believes that the amounts specified in the Payment Schedule are incorrect) delivers written notice (a "Participant Payment Notice") to the Trustee that the Participant is entitled to payments under a Covered Plan and requesting that the Trustee make payments to the Participant pursuant to that Covered Plan, the Trustee shall promptly deliver a copy of the Participant Payment Notice to Key and thereafter: (i) if Key has not, within ten business days of the delivery of the Participant Payment Notice to the Trustee, delivered to the Trustee a notice (a "Key Stop Payment Notice") in which Key asserts that the Participant is not entitled to the payments set forth in the Participant Payment Notice, the Trustee shall make the payments set forth in the Participant Payment Notice, or, alternatively, (ii) if Key has, within ten business days of the delivery of the Participant Payment Notice to the Trustee, delivered to the Trustee a Key Stop Payment Notice, the disparity between the Participant Payment Notice and the Key Stop Payment Notice shall be resolved as provided in Section 4.4 below and any payments or portions thereof that are not in dispute shall be paid by the Trustee as and when due to the Participant. 4.4 If the Trustee has received both a Participant Payment Notice and a Key Stop Payment Notice with regard to the same Covered Plan: (a) the Trustee shall engage the Accounting Firm (as defined in Section 15.1), at Key's expense, to determine what payments the Participant is entitled to under the particular Covered Plan, which determination shall be made by the Accounting Firm as promptly as practicable but in all events within 30 days of the engagement of the Accounting Firm by the Trustee, (b) Key shall cooperate with the Accounting Firm and provide to it all information that is available to Key and is required by the Accounting Firm to make the determination referred to in (a) above within the time frame set forth therein, and 4 (c) unless and until ordered to do otherwise by an award of arbitrators following arbitration proceedings instituted pursuant to Section 4.5 below, the Trustee shall make payments to the Participant in the amount or amounts and at the time or times determined by the Accounting Firm. 4.5 In the event of any dispute between a Participant and Key with respect to whether the Participant is entitled to payments (or the amounts thereof) under a Covered Plan and/or to payment thereof from the assets of the Trust, either party (Key or the Participant) may deliver to the other a demand for binding arbitration. If either party delivers any such demand to the other, the dispute shall be determined by binding arbitration conducted in Cleveland, Ohio according to the Commercial Arbitration Rules of the American Arbitration Association. In any such arbitration the arbitrators may consider, with such weight as they may deem appropriate, any determination by the Accounting Firm that may have been made as provided in Section 4.4 above. The award of the arbitrators will be final and binding and judgment on the award may be entered in any court having jurisdiction over the subject matter and the parties. 4.6 In order to discourage Key from disputing, otherwise than in good faith, any amounts properly due to a Participant, the costs and expenses related to any arbitration proceeding referred to in Section 4.5 shall be borne as provided in this Section 4.6. Key shall bear the cost of its own attorneys and other representatives and all of the fees and expenses of the arbitrators and the arbitration proceedings. The reasonable fees and expenses of the Participant's attorneys relating to the subject matter of the arbitration shall be paid by Key unless and to the extent the arbitrators determine (which determination shall be final and binding upon the parties) that the positions advanced by the Participant in any such arbitration have no reasonable basis (which determination need not be made simply because the arbitrators decide against the Participant on any or all substantive points). If Key fails to pay any of the costs and expenses related to any arbitration as specified in this Section 4.6, the Trustee shall pay such amounts from the assets of the Trust. 4.7 Key may make payments under any Covered Plan directly to or on behalf of a Participant as they become due under the terms of the Covered Plan. If Key makes any such payment it shall notify the Trustee of its decision to make such payments directly prior to the time amounts are payable to or on behalf of the Participant. In addition, if the principal of the Trust and any earnings thereon are not sufficient to make any payments that are due and payable under any Covered Plan in accordance with its terms, Key shall make the balance of each such payment as it falls due. The Trustee shall notify Key whenever principal and earnings are not sufficient. 4.8 When making any payment to a Participant under a Covered Plan that is overdue, the Trustee shall increase the amount of the payment to include interest on the overdue payment from the date due to the date of the distribution calculated on a daily basis, compounded as of the end of each calendar month, and using as the interest rate for each calendar month or part thereof during the period with respect to which interest is due the prime lending rate published by KeyBank National Association or its successor and in effect on the first day of that calendar month. 5 4.9 Whenever a payment under a Covered Plan with respect to a Participant is payable to a beneficiary of the Participant rather than to the Participant, the beneficiary shall be entitled to all of the rights of the Participant under all of the provisions of this Trust Agreement with respect to that payment. 4.10 Notwithstanding any other provision of this Trust Agreement, if at any time circumstances are such that Key would be prohibited from making any particular payment under a Covered Plan by the regulations adopted by the Federal Deposit Insurance Corporation limiting payments in the nature of golden parachutes in certain circumstances (12 CFR Parts 303 and 359), the Trustee shall refrain from making those same payments until such time as Key would not be prohibited from making those same payments by those regulations. Unless and until the Trustee is notified in writing by Key or by a federal banking agency that circumstances are such that Key would be prohibited from making any particular payment by reason of the regulations referred to in the immediately preceding sentence, the Trustee may conclusively presume that no such prohibition exists. Article 5. Trustee Responsibility Regarding Payments to Participants when Key Is Insolvent. 5.1 The Trustee shall cease payments to Participants from the Trust if Key is Insolvent. Key shall be considered "Insolvent" for purposes of this Trust Agreement if (a) it is unable to pay its debts as they become due, or (b) it is subject to a pending proceeding as a debtor under the United States Bankruptcy Code. 5.2 At all times during the continuance of the Trust, the principal and income of the Trust shall be subject to claims of general creditors of Key under federal and state law as set forth below. (a) The Board of Directors and the Chief Executive Officer of Key shall have the duty to inform the Trustee in writing of Key's Insolvency. If a person claiming to be a creditor of Key alleges in writing to the Trustee that Key has become Insolvent, the Trustee shall determine whether Key is Insolvent and, pending such determination, the Trustee shall discontinue payments from the Trust to Participants. (b) Unless the Trustee has actual knowledge of Key's Insolvency, or has received notice from Key or a person claiming to be a creditor alleging that Key is Insolvent, the Trustee shall have no duty to inquire whether Key is Insolvent. The Trustee may in all events rely on such evidence concerning Key's solvency as may be furnished to the Trustee and that provides the Trustee with a reasonable basis for making a determination concerning Key's solvency. (c) If at any time the Trustee has determined that Key is Insolvent, the Trustee shall discontinue payments to Participants and shall hold the assets of the Trust for the benefit of the general creditors of Key. Nothing in this Trust Agreement shall in any way diminish any 6 rights of Participants to pursue their rights as general creditors of Key with respect to benefits due under the Covered Plans or otherwise. (d) The Trustee shall resume the making of payments to Participants in accordance with Section 4 of this Trust Agreement only after the Trustee has determined that Key is not Insolvent (or is not any longer Insolvent). 5.3 Provided that there are sufficient assets, if the Trustee discontinues payments under the Covered Plans from the Trust pursuant to Section 5.2 hereof and subsequently resumes such payments, the first payment following such discontinuance shall include the aggregate amount of all payments due to Participants under the terms of the Covered Plans for the period of such discontinuance, less the aggregate amount of any payments made to the Participants by Key in lieu of the payments provided for hereunder during any such period of discontinuance. Article 6. Reversion of Excess Assets. From time to time after the third anniversary of the first Change of Control occurring after the execution of this Trust Agreement, if and when requested by Key to do so, the Trustee shall engage the services of the Accounting Firm, at the expense of Key, to determine the Aggregate Plan Liability (as defined in Section 15.2). If the Current Trust Asset Value at the time of the calculation exceeds 150% of the dollar amount of the Aggregate Plan Liability and the Trustee is requested to do so by Key, the Trustee shall pay the amount of any such excess over 150% to Key. The Trustee shall determine, in its sole discretion, how the funds necessary to make any such payment are to be raised from Trust assets. Article 7. Payments to Key. Except as provided in Article 3 or in Article 6, Key shall not have any right or power to direct the Trustee to return to Key or to divert to others any of the Trust assets before all payments that may become payable to any and all Participants under the Covered Plans have been made to Participants. At such point in time as no further payments are payable or may become payable in the future to or with respect to any Participant under any Covered Plan, the remaining assets of the Trust shall be paid to Key. Article 8. Investment Authority. 8.1 The Trustee shall invest and reinvest the trust property, including any income accumulated and added to principal, only in (a) annuity or life insurance contracts that either have been contributed to the trust property by Key or are issued by one or more insurance companies that are rated at least A++ by Best Life Insurance Reports at the time of issuance; (b) interest-bearing deposit accounts or certificates issued or offered by any one or more Federal Deposit Insurance Corporation insured financial institutions having in each case an investment grade rating from Moody's Investor Services and Standard & Poor's Investment Advisory Service and a capital and surplus of at least $1,000,000,000 in the aggregate (but excluding obligations of Key); (c) direct obligations of the United States of America, or obligations the payment of which is guaranteed, as to both principal and interest, by the government or an 7 agency of the government of the United States of America; (d) readily marketable debt securities listed on a United States national securities exchange (other than securities of Key) that are rated at least "investment grade" by one or more nationally recognized rating agencies; or (e) shares or other units of participation in any mutual fund or investment trust fund maintained by the Trustee, which are invested exclusively or predominantly in assets described in the foregoing clauses (a) through (d) of this Section 8.1. In no event may the Trustee invest in securities (including stock or rights to acquire stock) or obligations issued by Key, other than a de minimis amount held in common investment vehicles in which the Trustee invests. All rights associated with assets of the Trust shall be exercised by the Trustee or the person designated by the Trustee, and shall in no event be exercisable by or rest with Participants. The Trustee shall not be liable to any Participant or beneficiary under any Covered Plan for any insufficiency of the trust property to discharge all benefits due the same under the Covered Plan; rather, the liability for all such benefits shall be and remain the primary and ultimate responsibility of Key and any such benefits not discharged in full by payments made by the Trustee under this Trust Agreement shall be paid by Key. 8.2 The Trustee is empowered to register securities, and to take and hold title to other property, in the name of the Trustee or in the name of a nominee without disclosing the Trust. Securities also may be held in bearer form and may be held in bulk with certificates of the same class and issuer which are assets of other fiduciary accounts. The Trustee shall be responsible for any wrongful acts of any nominee of the Trustee. 8.3 The Trustee is empowered to take all actions necessary or advisable in order to collect any life insurance, annuity, or other benefits or payments of which the Trustee is the designated beneficiary. Key may maintain in force all life insurance policies held in the Trust by paying premiums and other charges due thereon; but if any such premiums or other charges are not paid directly by Key, the Trustee shall pay such premiums and other charges on or before the due date thereof. 8.4 Subject to the Trustee's obligation, as set forth in Section 4, to use Trust assets for payment of benefits to Participants or their beneficiaries: (a) to the extent the Trustee has cash or its equivalent readily available for the payment of premiums due or policy loans and/or dividends are available for such purpose, the Trustee shall pay premiums due with such cash or its equivalent or policy loans and/or dividends, as the Trustee may deem best; but if the Trustee does not have sufficient cash or its equivalent readily available and policy loans and dividends are not available, then the Trustee shall dispose of or otherwise use other assets held by it in the Trust to generate the necessary cash or, if no such other assets are available, the Trustee may surrender one or more of the life insurance policies in order to generate cash with which to pay premiums on one or more of the other life insurance policies. If the Trustee determines to surrender one or more of the life insurance policies as permitted by the immediately preceding sentence, the Trustee may consult with Key, both before and after a Change of Control, as to which life insurance policies should be surrendered to maximize the aggregate economic benefit to the Trust of all of the life insurance policies. The Trustee shall have no liability to Key or any other person if, as a result of an insufficiency of cash or its equivalent, policy loans and dividends, and assets that can be disposed of or otherwise used to generate cash, the Trustee is unable to pay premiums as they become due. 8 8.5 The Trustee shall be named sole owner and beneficiary of each life insurance policy held in the Trust and shall have full authority and power to exercise all rights of ownership relating to the policy, including the right to borrow against the policy, except that the Trustee shall have no power to name a beneficiary of the policy other than the Trust, to assign the policy (as distinct from conversion of the policy to a different form) other than to a successor Trustee, or to loan to any person the proceeds of any borrowing against such policy. 8.6 The Trustee shall have the power to acquire additional life insurance coverage on Participants through application for new life insurance when directed by Key. The Trustee shall acquire any additional life insurance from the agent or agents designated by Key. Article 9. Accounting by Trustee. The Trustee shall keep accurate and detailed records of all investments, receipts, disbursements, and all other transactions required to be made, including such specific records as shall be agreed upon in writing between Key and the Trustee. All such accounts, books, and records shall be open to inspection and audit at all reasonable times by Key. Within 60 days following the close of each calendar year and within 60 days after the removal or resignation of the Trustee, the Trustee shall deliver to Key a written account of its administration of the Trust during such year or during the period from the close of the last preceding year to the date of such removal or resignation, setting forth all investments, receipts, disbursements, and other transactions effected by it, including a description of all securities and investments purchased and sold with the cost or net proceeds of such purchases or sales (accrued interest paid or receivable being shown separately), and showing all cash, securities, and other property held in the Trust at the end of such year or as of the date of such removal or resignation, as the case may be. Article 10. Calculations of Current Trust Asset Value and Aggregate Plan Liability. 10.1 Any determination of the Current Trust Asset Value that is to be made before the occurrence of any Change of Control shall be made by Key. After the occurrence of a Change of Control, all determinations of the Current Trust Asset Value shall be reasonably made by the Trustee and may be based on the determination of one or more qualified independent appraisers, consultants, or other experts retained by the Trustee for that purpose. 10.2 Any determination of the Aggregate Plan Liability that is to be made before the occurrence of any Change of Control shall be made by Key. After the occurrence of a Change of Control, all determinations of the Aggregate Plan Liability shall be reasonably made by the Trustee and may be based on the determination of one or more qualified independent actuaries, consultants, or other experts retained by the Trustee for that purpose. All such determinations shall be based on the terms of the Covered Plans and the actuarial assumptions and methodology set forth in Exhibit B. 10.3 Key shall pay all costs incurred in determining the Current Trust Asset Value and/or the Aggregate Plan Liability from time to time. If not so paid, these costs shall be paid from the 9 Trust. Key shall reimburse the Trust within 30 days after receipt of a bill from the Trustee for any such costs paid out of the Trust. Article 11. Responsibility of Trustee. 11.1 The Trustee shall at all times act in accordance with, and its obligations hereunder shall be at all times subject to, all applicable laws and regulations as from time to time in effect. The Trustee shall act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; provided, however, that the Trustee shall incur no liability to any person for any action taken pursuant to a direction, request, or approval that is contemplated by, and in conformity with, the terms of the Trust and is given in writing by Key prior to the occurrence of any Change of Control. If the Trustee determines that Key is Insolvent, the Trustee shall not be liable to any person on account of the Trustee's discontinuation of payment from the Trust to Participants for so long as the Trustee deems Key to be Insolvent. Except as otherwise provided in Section 4.5 above with respect to binding arbitration of disputes between a Participant and Key, in the event of a dispute between Key and any other party, the Trustee may apply to a court of competent jurisdiction to resolve the dispute. 11.2 If the Trustee undertakes or defends any litigation arising in connection with the Trust, Key agrees to indemnify the Trustee against the Trustee's costs, expenses, and liabilities (including, without limitation, attorneys' fees and expenses) relating thereto and to be primarily liable for such payments. If such costs, expenses, and liabilities are not paid by Key in a reasonably timely manner, the Trustee may obtain payment from the Trust. Key shall reimburse the Trust within 30 days after receipt of a bill from the Trustee for any such costs, expenses, and liabilities paid out of the Trust. 11.3 The Trustee may consult with legal counsel (who may also be counsel for the Trustee generally) with respect to any of its duties or obligations hereunder. 11.4 The Trustee may hire agents, accountants, actuaries, investment advisors, financial consultants, or other professionals and may rely on the advice given by such professionals, to assist it in performing any of its duties or obligations hereunder, including, without limitation, to assist it in enforcing against Key any of the obligations of Key under this Trust Agreement. 11.5 The Trustee shall have, without exclusion, all powers conferred on trustees by applicable law, unless expressly provided otherwise herein. 11.6 Notwithstanding any powers granted to the Trustee pursuant to this Trust Agreement or to applicable law, the Trustee shall not have any power that could give the Trust the objective of carrying on a business and dividing the gains therefrom, within the meaning of section 301.7701-2 of the Procedure and Administrative Regulations promulgated pursuant to the Internal Revenue Code. 10 Article 12. Compensation and Expenses of Trustee. The Trustee shall be entitled to receive reasonable compensation for its services in accordance with its published fee schedule as in effect from time to time. The Trustee shall be entitled to receive its reasonable expenses incurred with respect to the administration of the Trust, including fees incurred by the Trustee pursuant to Sections 11.3 and 11.4 of this Trust Agreement. Such compensation and expenses shall be payable by Key. If not so paid, the fees and expenses shall be paid from the Trust. Key shall reimburse the Trust within 30 days after receipt of a bill from the Trustee for any such fees or expenses paid out of the Trust. Article 13. Tenure and Succession of Trustee. 13.1 Key may remove any trustee from time to time serving under this Trust Agreement at any time upon giving 60 days written notice to such trustee and each trustee from time to time serving under this instrument shall have the right to resign by delivering a written notice of resignation to Key, except that: (a) Key shall not have any power to remove the Trustee at any time after a Change of Control, and (b) no such removal or resignation shall become effective until the acceptance of the trust by a successor trustee designated in accordance with Section 13.2. 13.2 If Wachovia Bank, National Association, or any successor to it designated in accordance with this Section 13.2, for any reason shall decline, cease, or otherwise fail to serve as trustee, the vacancy in the trusteeship shall be filled by such bank or trust company, wherever located, having a capital and surplus of at least $100,000,000 in the aggregate, as shall be designated by Key (if the designation is made prior to the occurrence of any Change of Control) or by the resigning Trustee (if the designation is made after the occurrence of any Change of Control). If neither Key nor the resigning Trustee designates a successor trustee in circumstances where such a designation is contemplated by this Section 13.2, any party in interest, including any Participant or Beneficiary, may apply to any court of competent jurisdiction sitting in Cuyahoga County, Ohio to have a successor trustee designated by the court. 13.3 Upon acceptance of the trust, each successor trustee shall be vested with the title to the trust property possessed by the trustee that it succeeds and shall have all the powers, discretions, and duties of such predecessor trustee. No successor trustee shall be required to furnish bond. 13.4 Each successor trustee may accept as complete and correct and may rely upon any accounting by any predecessor trustee and upon any statement or representation by any predecessor trustee as to the assets comprising or any other matter pertaining to the administration of the Trust. No successor trustee shall be liable for any act or omission of any predecessor trustee or have any duty to enforce or seek to enforce any claim of any kind against any predecessor trustee on account of any such act or omission. 11 Article 14. Amendment or Termination. 14.1 Except as provided in the second sentence of this Section 14.1, at any time before the occurrence of the first Change of Control to occur after the execution of this Agreement, Key, in its sole discretion, may amend this Trust Agreement (including the exhibits hereto) in any manner and may terminate this Trust Agreement. If at any particular point in time (a) one or more Potential Changes of Control have occurred, (b) one or more of those Potential Changes of Control has not yet been terminated, and (c) no Change of Control has occurred, then Key may not, at that particular point in time, terminate this Trust Agreement and Key may only amend this Trust Agreement if and to the extent permitted by Section 14.2 below. 14.2 At any particular point in time when (a) one or more Potential Changes of Control have occurred, (b) one or more of those Potential Changes of Control has not yet been terminated, and (c) no Change of Control has occurred: Key may not terminate this Trust Agreement but Key may add one or more additional plans or agreements to the class of Covered Plans and Key may amend this Trust Agreement (including the exhibits hereto), provided that (x) Key determines, in the exercise of its reasonable discretion, that the amendment is in the best interests of the Participants, taken as a group, and (y) no such amendment shall remove any plan or agreement from the class of Covered Plans unless the plan has been terminated and there are no further obligations due or to become due thereunder to any Participant. 14.3 After a Change of Control has occurred, this Trust Agreement (including the exhibits hereto) may not be amended or terminated except as provided in Section 14.5. 14.4 Unless earlier revoked pursuant to Section 1.2, the Trust shall not terminate until the date on which Participants are no longer entitled to any further payments pursuant to the terms of any of the Covered Plans. Upon termination of the Trust on or after that date, any assets remaining in the Trust shall be returned to Key. 14.5 Upon written approval of all Participants who are or may in the future be entitled to receive any payment pursuant to the terms of any of the Covered Plans, Key may terminate the Trust prior to the time all payments that are or may become due in the future under the Covered Plans have been made. All assets in the Trust at any such termination shall be returned to Key. Article 15. Certain Definitions. 15.1 From and after the occurrence of the first Change of Control to occur after the execution of this Trust Agreement, the term "Accounting Firm" shall mean the independent auditors of Key for the fiscal year preceding the first year in which there occurred either (a) that Change of Control or (b) any Potential Change of Control that had not terminated before the occurrence of that Change of Control and such firm's successor or successors; provided, however, if such firm is unable or unwilling to serve and perform in the capacity contemplated by this Trust Agreement, the Trustee shall select another national accounting firm of recognized standing to serve and perform in that capacity under this Trust Agreement, except that such other accounting firm shall not be the then independent auditors for Key or any of its affiliates (as defined in Rule 12b-2 promulgated under the 1934 Act). 12 15.2 The term "Aggregate Plan Liability" as at any time shall mean the maximum amount of payments that have not yet been paid but could become payable in the future under the Covered Plans, determined as provided in Section 10.2. 15.3 A "Change of Control" shall be deemed to occur if and when there occurs any of the circumstances set forth in any of clauses (a) through (d) of this Section 15.3. For these purposes and for purposes of Section 15.9, Key will be deemed to have become a subsidiary of another corporation if any other corporation (which term shall, for all purposes of this Section 15.3 and of Section 15.9, include, in addition to a corporation, a limited liability company, partnership, trust, or other organization) owns, directly or indirectly, 50 percent or more of the total combined outstanding voting power of all classes of stock of Key or any successor to Key: (a) Key is merged with or into, is consolidated with, or becomes the subsidiary of another corporation and, immediately after giving effect to that transaction, either: (i) less than 45% of the then outstanding voting securities of the surviving or resulting corporation or (if Key becomes a subsidiary in the transaction) of the ultimate parent of Key represent or were issued in exchange for voting securities of Key outstanding immediately prior to the transaction, or (ii) individuals who were directors of Key on the day before the first public announcement of (A) the pendency of the transaction or (B) the intention of any Person to cause the transaction to occur, cease for any reason to constitute at least 50% of the directors of the surviving or resulting corporation or (if Key becomes a subsidiary in the transaction) of the ultimate parent of Key. (b) Any Person becomes the beneficial owner of 35% or more of the outstanding voting stock of Key or files a report on Schedule 13D or Schedule 14D-1, each as adopted under the 1934 Act (or any successor schedule, form, or report), disclosing the acquisition of 35% or more of the outstanding voting stock of Key in a transaction or series of transactions. (c) The shareholders of Key approve a plan providing for the dissolution of Key or for the sale, lease, exchange, or other disposal of (in one transaction or a series of related transactions) all or substantially all of the assets of Key and its subsidiaries, taken as a whole. (d) Without the prior approval, solicitation, invitation, or recommendation of the Board of Directors of Key, any Person makes a public announcement of a bona fide intention (i) to engage in a transaction with Key that, if consummated, would result in a Change of Control under any of subclauses (a) through (c) above, (ii) to "solicit" (as defined in Rule 14a-1 under the 1934 Act) proxies in connection with a proposal that is not approved or recommended by the Board of Directors of Key, or (iii) to engage in an election contest relating to the election of directors of Key (pursuant to Regulation 14A, including Rule 14a-11, under the 1934 Act), and, at any time within the 24 month period immediately following the date of the announcement of that intention, individuals who, on the day before that announcement, constituted the directors of Key (the "Incumbent Directors") cease for any reason to 13 constitute at least 50% thereof unless both (x) the election, or the nomination for election by Key's shareholders, of each new director was approved by a vote of at least two-thirds of the Incumbent Directors in office at the time of the election or nomination for election of such new director, and (y) prior to the time that the Incumbent Directors no longer constitute at least 50% of the Board of Directors, the Incumbent Directors then in office, by a vote of at least 75% of their number, reasonably determine in good faith that the change in Board membership that has occurred before the date of that determination and that is anticipated to thereafter occur within the balance of the 24 month period to cause the Incumbent Directors to no longer be at least 50% of the Board of Directors was not caused by or attributable to, in whole or in any significant part, directly or indirectly, proximately or remotely, any event under items (i), (ii), or (iii) of this subclause (d). 15.4 The term "Covered Plan" means any one of the plans and agreements identified on Exhibit A, as the same may be amended from time to time in accordance with Section 14.2 above. To the extent that certain benefits under any one or more of the plans and agreements listed on Exhibit A are secured by one or more "Prior Rabbi Trusts" (as defined in Section 15.11), those benefits, to the extent they are so secured, shall not be treated as benefits under a Covered Plan for purposes of this Trust Agreement (i.e. there is no intention to provide duplicate coverage for any particular benefits) and no benefits that are secured by one or more Prior Rabbi Trusts shall be paid by the Trustee pursuant to this Trust Agreement or taken into account for any purpose under this Trust Agreement. 15.5 The term "Full Funding Amount" as of any point in time shall mean an amount equal to 125% of the Aggregate Plan Liability as of that point in time. 15.6 The term "Internal Revenue Code" shall mean the Internal Revenue Code of 1986, as amended. 15.7 The term "Person" shall mean a "person" as used in Section 13(d) and Section 14(d)(2) of the 1934 Act. 15.8 The term "Participant" shall mean an executive or director who is a participant in or party to any of the Covered Plans. 15.9 A "Potential Change of Control" shall be deemed to occur if and when there occurs any of the circumstances set forth in any of the following clauses (a) through (d): (a) Key enters into a definitive agreement pursuant to which Key is to be merged with or into, is to be consolidated with, or is to become the subsidiary of another corporation and the definitive agreement contemplates that, immediately after giving effect to that transaction, either: (i) less than 45% of the then outstanding voting securities of the surviving or resulting corporation or (if Key becomes a subsidiary in the transaction) of the ultimate parent of Key will represent or have been issued in exchange for voting securities of Key outstanding immediately prior to the transaction, or 14 (ii) individuals who were directors of Key on the day before the first public announcement of (A) the pendency of the transaction or (B) the intention of any Person to cause the transaction to occur, will cease for any reason to constitute at least 50% of the directors of the surviving or resulting corporation or (if Key becomes a subsidiary in the transaction) of the ultimate parent of Key. (b) A tender offer or exchange offer is commenced providing for the acquisition of 35% or more of the outstanding voting stock of Key or any application, letter, or notice is delivered to or filed with any state or Federal regulatory authority indicating an intention to acquire 35% or more of the outstanding voting stock of Key. (c) Without the prior approval, solicitation, invitation, or recommendation of the Board of Directors of Key, any Person makes a public announcement of a bona fide intention (i) to engage in a transaction that, if consummated, would constitute a Change of Control, (ii) to "solicit" (as defined in Rule 14a-1 under the 1934 Act) proxies in connection with a proposal that is not approved or recommended by the Board of Directors of Key, or (iii) to engage in an election contest relating to the election of directors of Key (pursuant to Regulation 14A, including Rule l4a-11, under the 1934 Act) which, if successful, would result in the election of one or more directors, not nominated by the Board of Directors of Key. (d) There is delivered to the shareholders of Key proxy material soliciting approval a plan providing for the dissolution of Key or for the sale, lease, exchange, or other disposal of (in one transaction or a series of related transactions) all or substantially all of the assets of Key and its subsidiaries, taken as a whole. 15.10 A Potential Change of Control shall be deemed to have "terminated:" (a) In the case of a Potential Change of Control described in Section 15.9(a), upon the termination of the definitive agreement without the occurrence of a Change of Control. (b) In the case of a Potential Change of Control described in Section 15.9(b), upon the termination or consummation of the tender or exchange offer, or the withdrawal, rejection, or denial of the application, letter, or notice, without the acquisition of 35% or more of the outstanding voting stock of Key. (c) In the case of a Potential Change of Control described in Section 15.9(c), the abandonment of the intention to engage in the transaction that, if consummated, would have constituted a Change of Control, the termination of the solicitation without a shareholder vote, or the defeat by the shareholders of the proposal or the termination of the election contest without the election of any director not nominated by the Board of Directors of Key, as the case may be. (d) In the case of a Potential Change of Control described in Section 15.9(d), the abandonment of the plan before a shareholder vote or the vote by the shareholders not to approve the plan. 15 15.11 The term "Prior Rabbi Trust" shall mean any one of the following trust agreements: (a) the Trust Agreement entered into between Ameritrust Corporation and Wachovia Bank and Trust Company, N.A. on November 3, 1988, (b) the KeyCorp Umbrella Trust for Executives entered into between Key and NBD Bank, N.A. as of July 1, 1990, or (c) the KeyCorp Umbrella Trust for Directors entered into between Key and NBD Bank, N.A. as of July 1, 1990. 15.12 The term "SEC" shall mean the Securities and Exchange Commission. 15.13 The term "1934 Act" shall mean the Securities Exchange Act of 1934, as amended. 16. Miscellaneous 16.1 Any provision of this Trust Agreement prohibited by law shall be ineffective to the extent of any such prohibition, without invalidating the remaining provisions hereof. 16.2 This Trust Agreement shall be governed by and construed in accordance with the laws of the State of Ohio. 16.3 Each Participant is an intended beneficiary under the Trust, and as an intended beneficiary shall be entitled to enforce all terms and provisions of this Trust Agreement with the same force and effect as if such person had been a party to this Trust Agreement. IN WITNESS WHEREOF, Key and the Trustee have executed this Amended Trust Agreement as of August 25, 2003. Wachovia Bank, National Association KEYCORP By_______________________________ By__________________________ Beverley H. Wood Thomas E. Helfrich Senior Vice President Executive Vice President 16 EXHIBIT A COVERED PLANS INDIVIDUAL BY INDIVIDUAL LIMITATION ON PLANS SPECIFIED IN CATEGORY 1 OR CATEGORY 2: Plans specified in either of Category 1 or Category 2 below are to be covered by the Trust insofar, but only insofar, as the plans provide benefits to individuals who (a) had terminated their employment with Key or a predecessor on or before January 1, 1997 and are listed on Annex I to this Exhibit A, (b) were in job grade 89 (or equivalent) or above with Key or an affiliate at any time on or after January 1, 1997, or (c) were or are members of the KeyCorp Board of Directors. TIME LIMITATION ON BENEFITS PAYABLE UNDER PLANS SPECIFIED IN CATEGORY 1 OR CATEGORY 2: In general, benefits payable under plans specified in either of Category 1 or Category 2 are to be covered by the Trust insofar, but only insofar, as the benefits arise out of or are related to the performance of services by an individual on or before the second anniversary of the first Change of Control to occur after the date of execution of the Trust Agreement. In addition, benefits payable with respect to any such plan that are provided pursuant to an agreement specified in either of Category 3 or Category 4 of this Exhibit A are to be covered by the Trust. AMENDMENTS, ETC.: If, before the first Change of Control to occur after the date of execution of the Trust Agreement, any of the plans and agreements specified in Categories 1 through 4 below are from time to time amended or modified, or a new plan or agreement is entered into in replacement thereof or substitution therefor, the reference shall be deemed to include the amendment or modification, or the replacement or substitute plan or agreement, as the case may be. CATEGORY 1. RETIREE BENEFIT PLANS - KeyCorp Excess Cash Balance Pension Plan (new plan as of 1/1/95) - KeyCorp Excess 401(k) Savings Plan (old Society Supplemental Stock Purchase and Savings Plan from 4/15/87) - KeyCorp Supplemental Retirement Plan (old Society Supplemental Retirement Plan from 5/14/81) - KeyCorp Supplemental Retirement Benefit Plan (old Key plan from 1/1/81, restated 8/16/90) - KeyCorp Executive Supplemental Pension Plan (new plan as of 1/1/95) - Retirement Benefits to be provided pursuant to employment or other agreements with those particular individuals listed on Annex 1 or Annex 2 to this Exhibit A. CATEGORY 2. DEFERRED COMPENSATION PLAN - KeyCorp Deferred Compensation Plan (new Key plan for 1997, into which the KeyCorp Executive Deferred Compensation Plan was merged) - KeyCorp Director Deferred Compensation Plan - KeyCorp Automatic Deferral Plan - KeyCorp Directors' Deferred Share Plan - KeyCorp Signing Bonus Plan 17 CATEGORY 3. EMPLOYMENT AGREEMENTS (3) - Robert T. Clutterbuck - Henry L. Meyer III - William B. Summers CATEGORY 4. CHANGE OF CONTROL AGREEMENTS (30 AS OF AUGUST 20, 2003) - Patrick V. Auletta - William Barnes - Kevin M. Blakely - Richard J. Buoncore - Thomas W. Bunn - Michael A. Butler - George E. Emmons, Jr. - Michael L. Evans - Barbara Godin - Christopher M. Gorman - Linda A. Grandstaff - Karen R. Haefling - Paul N. Harris - Robert B. Heisler, Jr. - Thomas E. Helfrich - Leroy G. Irving - Robert G. Jones - Jack L. Kopnisky - Paul A. Larkins - Michael J. Monroe - Peter K. Potchen - Robert G. Rickert - Kevin P. Riley - David J. Schutter - Thomas C. Stevens - Patrick J. Swanick - Andrew R. Tyson - Joseph M. Vayda - Jeffrey B. Weeden - Len E. Williams Plus any other Change of Control Agreement that (a) is substantially similar to the Change of Control Agreements listed above and (b) is entered into by Key before the occurrence of the first Change of Control to occur after the execution of this Trust Agreement. 18 ANNEX 1 TO EXHIBIT A Wilson M. Brown, Jr. Donald Cruse Richard Kesslar Bruce C. Murray Robert Patrick Frank Ponchak Perry B. Wydman Gordon E. Heffern 19 ANNEX 2 TO EXHIBIT A Robert W. Gillespie Roger Noall 20 EXHIBIT B Assumptions and Methodology for Determining Aggregate Plan Liability 1. The liability for benefits under each Plan will be calculated using two different assumptions as to when Participants terminate service: (a) As of the date of the first Change of Control occurring after the execution of this Trust Agreement. (b) Twenty four months after the first Change of Control occurring after the execution of this Trust Agreement, assuming future compensation continues at current levels, and future deferrals under deferred compensation plans continue through the end of the twenty four month period at levels that are consistent with the levels of deferrals elected by the participants in those plans under the last elections made before the first to occur of (i) the first Change of Control occurring after execution of this Trust Agreement and (ii) any Potential Change of Control related to that Change of Control. The liability for accrued benefits under each Plan will be the greater of the liabilities calculated in accordance with (a) and (b) above. If the liability for benefits varies depending upon the circumstances under which a Participant terminates service (for example, whether the Participant resigns or is terminated by action of the employer), the liability shall be calculated based on the greatest potential benefit to the Participant. 2. Calculations will be based upon the most valuable optional form of payment available to the Participant. 3. The liability for benefits under deferred compensation or other defined contribution Plans shall be equal to the deferral or other account balances (vested and unvested) of Participants as of the applicable date, plus projected deferrals expected to be made within 24 months after the applicable date pursuant to prior elections. Account balances of Participants under a Plan shall be calculated based on crediting the highest rate of interest that was being credited under that Plan on the date six months before the first to occur of (i) the first Change of Control occurring after execution of this Trust Agreement and (ii) any Potential Change of Control related to that Change of Control. 4. The liability for benefits under other Plans shall be equal to the present value of accrued benefits (vested and unvested) of Participants as of the relevant dates under 1(a) or (b) above. 5. No mortality is assumed prior to the commencement of benefits. Future mortality is assumed to occur in accordance with the 1983 Group Annuity Table Unisex Rates after the commencement of benefits. 21 6. The present value of amounts shall be determined using a discount rate equal to the average of the Pension Benefit Guaranty Corporation immediate annuity rate for a nonmultiemployer plan for the full six months prior to the calculation date. 7. In determining the dollar cost of providing any benefit that is to be provided in stock or the value of which is dependent upon the value of KeyCorp Common Shares, the dollar cost of providing those benefits shall be determined using a value for KeyCorp Common Shares equal to 140% of the highest closing price for KeyCorp Common Shares at any time within the six month period ending on the determination date. 8. Where left undefined above, calculations will be performed in accordance with generally accepted actuarial principles. 22 EX-15 4 l03467aexv15.txt EXHIBIT 15 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 October 14, 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 September 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. 333-44657 (Post-Effective Amendment No. 1 to Form S-4) Form S-8 No. 333-61025 (Post-Effective Amendment No. 1 to Form S-4) Form S-8 No. 333-107074 Form S-8 No. 333-107075 Form S-8 No. 333-107076 Form S-8 No. 333-109273 /s/ Ernst & Young LLP Cleveland, Ohio November 10, 2003 EX-31.1 5 l03467aexv31w1.txt EXHIBIT 31.1 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: November 12, 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 6 l03467aexv31w2.txt EXHIBIT 31.2 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: November 12, 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 7 l03467aexv32w1.txt EXHIBIT 32.1 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 September 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. November 12, 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 8 l03467aexv32w2.txt EXHIBIT 32.2 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 September 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. November 12, 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-----