Acquisition and Discontinued Operations

3 Months Ended

Mar. 31, 2012

Acquisition and Discontinued Operations [Abstract]

Acquisition and Discontinued Operations

11. Acquisition and Discontinued Operations

Acquisition

HSBC Branches.  On January 11, 2012, Key signed a purchase and assumption agreement to acquire 37 retail banking branches in Buffalo and Rochester, New York. The branches are being sold by First Niagara Bank in connection with their recent acquisition of HSBC’s upstate New York banking franchise. Under the terms of the purchase and assumption agreement, Key will assume deposits consisting primarily of transaction and savings accounts and purchase commercial and residential loans. The deposits associated with these branches total approximately $2.4 billion, while loans total approximately $400 million. The transaction is expected to close early in the third quarter of 2012, subject to customary closing conditions. On April 18, 2012 we received regulatory approval from the OCC for the transaction.

Discontinued operations

Education lending.  In September 2009, we decided to exit the government-guaranteed education lending business. As a result, we have accounted for this business as a discontinued operation.

“Income (loss) from discontinued operations, net of taxes” on the income statement includes (i) the changes in fair value of the assets and liabilities of the education loan securitization trusts and the loans at fair value in portfolio (discussed later in this note), and (ii) the interest income and expense from the loans and the securities of the trusts and the loans in portfolio at both amortized cost and fair value. These amounts are shown separately in the following table. Gains and losses attributable to changes in fair value are recorded as a component of noninterest income or expense. Interest income and expense related to the loans and securities are shown as a component of “Net interest income.”

The components of “income (loss) from discontinued operations, net of taxes” for the education lending business are as follows:

	Three months ended March 31,
in millions	2012		2011
Net interest income	$	31	$	36
Provision for loan and lease losses		4		32
Net interest income (expense) after provision for loan and lease losses		27		4
Noninterest income		(18)		(10)
Noninterest expense		9		11
Income (loss) before income taxes		—		(17)
Income taxes		—		(6)
Income (loss) from discontinued operations, net of taxes (a)		—	$	(11)

(a) Includes after-tax charges of $14 million and $13 million for the three-month periods ended March 31, 2012 and 2011, respectively, determined by applying a matched funds transfer pricing methodology to the liabilities assumed necessary to support the discontinued operations.

The discontinued assets and liabilities of our education lending business included on the balance sheet are as follows:

		0000000000		0000000000		0000000000
in millions	March 31, 2012		December 31, 2011		March 31, 2011
Trust loans at fair value	$	2,714	$	2,726	$	3,065
Portfolio loans at fair value		74		76		—
Loans, net of unearned income of ($2), ($2) and $1		2,927		3,010		3,239
Less: Allowance for loan and lease losses		90		104		111
Net loans		5,625		5,708		6,193
Loans held for sale		—		—		14
Trust accrued income and other assets at fair value		112		121		153
Total assets	$	5,737	$	5,829	$	6,360
Trust accrued expense and other liabilities at fair value	$	30	$	28	$	34
Trust securities at fair value		2,512		2,522		2,894
Total liabilities	$	2,542	$	2,550	$	2,928

In the past, as part of our education lending business model, we originated and securitized education loans. The process of securitization involves taking a pool of loans from our balance sheet and selling them to a bankruptcy-remote QSPE, or trust. This trust then issues securities to investors in the capital markets to raise funds to pay for the loans. The interest generated on the loans pays holders of the securities issued. As the transferor, we retain a portion of the risk in the form of a residual interest and also retain the right to service the securitized loans and receive servicing fees.

As of January 1, 2010, we consolidated our ten outstanding securitization trusts since we hold the residual interests and are the master servicer with the power to direct the activities that most significantly influence the economic performance of the trusts.

The trust assets can be used only to settle the obligations or securities the trusts issue; we cannot sell the assets or transfer the liabilities. The loans in the consolidated trusts consist of both private and government-guaranteed loans. The security holders or beneficial interest holders do not have recourse to Key. Our economic interest or risk of loss associated with these education loan securitization trusts is approximately $205 million as of March 31, 2012. We record all income and expense (including fair value adjustments) through the “income (loss) from discontinued operations, net of tax” line item in our income statement.

We elected to consolidate these trusts at fair value. Carrying the assets and liabilities of the trusts at fair value better depicts our economic interest. The fair value of the assets and liabilities of the trusts is determined by calculating the present value of the future expected cash flows. We rely on unobservable inputs (Level 3) when determining the fair value of the assets and liabilities of the trusts because observable market data is not available. See further discussion regarding our valuation process later in this note.

A cumulative effect adjustment of approximately $45 million, which increased our beginning balance of retained earnings at January 1, 2010, was recorded when the trusts were consolidated. The amount of this cumulative effect adjustment was driven primarily by derecognizing the residual interests and servicing assets related to these trusts and consolidating the assets and liabilities at fair value.

During the third quarter of 2011, we corrected an error related to the $45 million cumulative effect adjustment recorded to beginning retained earnings upon consolidation of the education loan securitization trusts on January 1, 2010. Deferred taxes had not been appropriately recognized for the assets and liabilities of the trusts consolidated which were accounted for at fair value for book purposes but not for tax. We assessed the materiality of the error in accordance with the applicable SEC guidance and concluded that the error was not material, individually or in the aggregate, to our financial position for any prior period or the quarter ending September 30, 2011, to trends for those periods affected, or to a fair presentation of our financial statements for those periods. The error had no impact on our results of operations. Accordingly, results for periods prior to the quarter ending September 30, 2011 were not restated. Instead, accrued income and other assets and retained earnings were reduced by $30 million to correct this error in the third quarter of 2011.

On September 27, 2011, we purchased the government-guaranteed loans from one of the education loan securitization trusts pursuant to the legal terms of the particular trust. The trust used the cash proceeds from the sale of these loans to retire the outstanding securities related to these government-guaranteed loans. This particular trust remains in existence and continues to maintain the private education loan portfolio and has securities related to these loans outstanding. The government-guaranteed loans we purchased are held as portfolio loans and continue to be accounted for at fair value. The portfolio loans were valued using an internal discounted cash flow model, which was affected by assumptions for defaults, expected credit losses, discount rates and prepayments. The portfolio loans are considered to be Level 3 assets since we rely on unobservable inputs when determining fair value. See following discussion regarding our valuation process for these loans as well as the trust loans and securities.

Corporate Treasury, within our Finance area, is responsible for the quarterly valuation process that determines the fair value of the loans and securities in our education loan securitization trusts as well as our student loans held in portfolio that are accounted for at fair value. Corporate Treasury provides these fair values to a Working Group Committee (“the Working Group”) that is comprised of representatives from the line of business, Credit and Market Risk Management, Accounting, Business Finance (part of our Finance area), and Corporate Treasury. The Working Group is a subcommittee of the Fair Value Committee that is discussed in more detail in Note 5 (“Fair Value Measurements”). The Working Group reviews all significant inputs and assumptions and approves the resulting fair values.

The Working Group reviews actual performance trends of the loans and securities on a quarterly basis and uses statistical analysis and qualitative measures to determine assumptions for future performance. Predictive models that incorporate delinquency and charge-off trends along with economic outlooks assist the Working Group to forecast future defaults. The Working Group uses this information to formulate the credit outlook for each of the securitization trusts. Higher projected defaults, fewer expected recoveries, elevated prepayment speeds and higher discount rates would be expected to result in a lower fair value of the loans and securities in these securitization trusts as well as the portfolio loans at fair value. Default expectations and discount rate changes have the most significant impact on the fair values of the loans and securities. It is important to note that increased cash flow uncertainty, whether through higher defaults and prepayments or fewer recoveries, can result in higher discount rates for use in the fair value process for these loans and securities.

The valuation process for the education loan securitization trust and portfolio loans that are accounted for at fair value is based on a discounted cash flow analysis using a model purchased from a third party that is maintained by Corporate Treasury. The market for student loans, either whole-loan purchases or securitization, is relatively illiquid and has not recovered from the effects of the financial crisis. The valuation process begins with loan-by-loan-level data that is aggregated into pools, based on underlying loan structural characteristics (i.e., current unpaid principal balance, contractual term, interest rate, etc.). Cash flows for these loan pools are developed using a financial model that reflects certain assumptions for defaults, recoveries, status change and prepayments.

A net earnings stream, taking into account cost of funding, is calculated and discounted back to the measurement date using an appropriate discount rate. This resulting amount is used to determine the present value of the loans which represents their fair value to a market participant.

The unobservable inputs set forth in the following table are reviewed and approved by the Working Group on a quarterly basis. The Working Group determines these assumptions based on available data, discussions with appropriate individuals internal and external to Key, as well as the knowledge and experience of the individuals on the Working Group.

A similar discounted cash flow approach to that described above is used on a quarterly basis by Corporate Treasury to fair value the trust securities. In valuing these securities, the discount rates used are provided by a third-party valuation consultant. These discount rates are based primarily on secondary market spread indices for similar student loans and asset-backed securities and are developed by the consultant using market-based data. On a quarterly basis, the Working Group reviews the discount rate inputs used in the valuation process for reasonableness based on the historical and current market knowledge of the Working Group members.

A quarterly variance analysis reconciles valuation changes in the model used to calculate the fair value of the trust loans and securities and the portfolio loans at fair value. This quarterly analysis considers loan and securities runoff, yields, future default and recovery changes, and the timing of cash releases to us from the trusts. Back testing for expected defaults to actual experience is also performed as the impact of future defaults has a significant impact on the fair value of these loans and securities over time. In addition, our internal model risk review group periodically performs a review to ensure the accuracy and validity of the model for determining the fair value of these loans and securities.

At March 31, 2012, the significant unobservable inputs used to measure the fair value of the education loan securitization trust loans and securities and the portfolio loans accounted for at fair value are shown in the following table:

March 31, 2012 dollars in millions	Fair Value of Level 3 Assets and Liabilities		Valuation Technique	Significant Unobservable Input	Range (Weighted-Average)
Trust loans and	$	2,714	Discounted cash flow	Prepayment speed		4.00 - 26.00% (10.22%)
portfolio loans				Expected credit losses		2.00 - 80.00% (52.34%)
accounted for at fair				Discount rate		2.50 - 8.40% (4.70%)
value				Expected defaults		3.75 - 40.00% (18.58%)
Trust securities		2,512	Discounted cash flow	Discount rate		1.80 - 7.20% (4.10%)

The following table shows the consolidated trusts’ assets and liabilities at fair value and the portfolio loans at fair value and their related contractual values as of March 31, 2012. At March 31, 2012, loans held by the trusts with unpaid principal balances of $41 million ($40 million on a fair value basis) and portfolio loans at fair value with unpaid principal balances of $3 million ($3 million on a fair value basis) were 90 days or more past due. Loans held by the trusts aggregating $16 million ($16 million on a fair value basis) were in nonaccrual status, while portfolio loans at fair value in nonaccrual status aggregated to less than $1 million on both a contractual amount and fair value basis.

		0000000000		0000000000
March 31, 2012 in millions	Contractual Amount		Fair Value
ASSETS
Portfolio loans	$	72	$	74
Trust loans		2,809		2,714
Trust other assets		33		33
LIABILITIES
Trust securities	$	2,878	$	2,512
Trust other liabilities		30		30

The following table presents the assets and liabilities of the trusts that were consolidated and are measured at fair value, as well as the portfolio loans that are measured at fair value on a recurring basis.

		0000000000		0000000000		0000000000		0000000000
March 31, 2012 in millions	Level 1		Level 2		Level 3		Total
ASSETS MEASURED ON A RECURRING BASIS
Portfolio loans		—		—	$	74	$	74
Trust loans		—		—		2,714		2,714
Trust other assets		—		—		33		33
Total assets on a recurring basis at fair value		—		—	$	2,821	$	2,821
LIABILITIES MEASURED ON A RECURRING BASIS
Trust securities		—		—	$	2,512	$	2,512
Trust other liabilities		—		—		30		30
Total liabilities on a recurring basis at fair value		—		—	$	2,542	$	2,542

The following table shows the change in the fair values of the Level 3 consolidated education loan securitization trusts for the three-month period ended March 31, 2012.

		00000000		00000000		00000000		00000000		00000000
in millions	Portfolio Student Loans		Trust Student Loans		Trust Other Assets		Trust Securities		Trust Other Liabilities
Balance at January 1, 2012	$	76	$	2,726	$	34	$	2,522	$	28
Gains (losses) recognized in earnings (a)		(1)		74		—		91		—
Purchases		—		—		—		—		—
Sales		—		—		—		—		—
Issuances		—		—		—		—		—
Settlements		(1)		(86)		(1)		(101)		2
Balance at March 31, 2012	$	74	$	2,714	$	33	$	2,512	$	30

(a) Gains (losses) on the Trust Student Loans and Trust Securities were driven primarily by fair value adjustments.

Austin Capital Management, Ltd.   In April 2009, we decided to wind down the operations of Austin, a subsidiary that specialized in managing hedge fund investments for institutional customers. As a result, we have accounted for this business as a discontinued operation.

The results of this discontinued business are included in “income (loss) from discontinued operations, net of taxes” on the income statement. The components of “income (loss) from discontinued operations, net of taxes” for Austin are as follows:

		00000000		00000000
	Three months ended March 31,
in millions	2012		2011
Noninterest income		—	$	1
Noninterest expense	$	8		1
Income (loss) before income taxes		(8)		—
Income taxes		(3)		—
Income (loss) from discontinued operations, net of taxes	$	(5)		—

The discontinued assets and liabilities of Austin included on the balance sheet are as follows:

		00000000		00000000		00000000
in millions	March 31, 2012		December 31, 2011		March 31, 2011
Cash and due from banks	$	30	$	31	$	33
Accrued income and other assets		1		—		—
Total assets	$	31	$	31	$	33
Accrued expense and other liabilities	$	7		—	$	1
Total liabilities	$	7		—	$	1

Combined discontinued operations. The combined results of the discontinued operations are as follows:

	Three months ended March 31,
in millions	2012		2011
Net interest income	$	31	$	36
Provision for loan and lease losses		4		32
Net interest income (expense) after provision for loan and lease losses		27		4
Noninterest income		(18)		(9)
Noninterest expense		17		12
Income (loss) before income taxes		(8)		(17)
Income taxes		(3)		(6)
Income (loss) from discontinued operations, net of taxes (a)	$	(5)	$	(11)

(a) Includes after-tax charges of $14 million and $13 million for the three-month periods ended March 31, 2012 and 2011, respectively, determined by applying a matched funds transfer pricing methodology to the liabilities assumed necessary to support the discontinued operations.

The combined assets and liabilities of the discontinued operations are as follows:

		0000000000		0000000000		0000000000
in millions	March 31, 2012		December 31, 2011		March 31, 2011
Cash and due from banks	$	30	$	31	$	33
Trust loans at fair value		2,714		2,726		3,065
Portfolio loans at fair value		74		76		—
Loans, net of unearned income of ($2), ($2) and $1		2,927		3,010		3,239
Less: Allowance for loan and lease losses		90		104		111
Net loans		5,625		5,708		6,193
Loans held for sale		—		—		14
Trust accrued income and other assets at fair value		113		121		153
Total assets	$	5,768	$	5,860	$	6,393
Trust accrued expense and other liabilities at fair value	$	30	$	28	$	34
Accrued expense and other liabilities		7		—		1
Trust securities at fair value		2,512		2,522		2,894
Total liabilities	$	2,549	$	2,550	$	2,929