11. Acquisitions and Discontinued Operations

Acquisitions

Mortgage Servicing Rights On June 24, 2013, in the first of multiple closings, we acquired substantially all third party commercial loan servicing rights comprised of CMBS Master, Primary and Special Servicing as well as other servicing from Bank of America’s Global Mortgages & Securitized Products business. Simultaneously, we entered into a subservicing agreement with Berkadia Commercial Mortgage LLC related to all CMBS primary servicing. This acquisition was accounted for as a business combination and fulfilled part of our strategy to drive growth by building scale and becoming one of the top three largest servicers of commercial/multifamily loans in the U.S. and the fifth largest special servicer of CMBS. The acquisition date fair value of the MSRs acquired on June 24, 2013, which were included on our balance sheet at June 30, 2013, was approximately $117 million. Related to this acquisition of MSRs, a second and third closing occurred on July 22, 2013 and August 26, 2013 respectively. The acquisition date fair value of these separately acquired MSRs was $1 million. The total fair value of the MSRs acquired during the second and third quarter of 2013 and included in our September 30, 2013 financial results was $118 million. No goodwill was recognized as a result of this acquisition. A fourth and last closing occurred on October 7, 2013 that resulted in approximately $1 million of additional MSRs. These additional MSRs acquired subsequent to September 30, 2013 will be included in our fourth quarter financial results. Additional information regarding our mortgage servicing assets is provided in Note 8 (“Mortgage Servicing Assets”).

Key-Branded Credit Card Portfolio On August 1, 2012, we acquired Key-branded credit card assets from Elan Financial Services, Inc. This acquisition was accounted for as an asset purchase. The fair value of the credit card assets purchased was approximately $718 million at the acquisition date. We also recorded a purchased credit card relationship intangible asset of approximately $135 million and a rewards liability of approximately $9 million in the Community Bank reporting unit.

Western New York Branches On July 13, 2012, we acquired 37 retail banking branches in Western New York. This acquisition was accounted for as a business combination. The acquisition date fair value of the assets and deposits acquired was approximately $2 billion. We received loans with a fair value of $244 million (including $25 million of PCI loans), $8 million of premises and equipment and assumed $2 billion of deposits. Cash of $1.8 billion was received to assume the net liabilities, and we recorded a core deposit intangible asset of $40 million and a goodwill asset of $62 million in the Key Community Bank reporting unit during the third quarter of 2012. All of the goodwill related to this acquisition is expected to be deductible for tax purposes.

A second closing of this acquisition occurred on September 14, 2012, when we acquired credit card assets with a fair value of approximately $68 million and remitted a cash payment of $68 million to the seller. We also recorded a purchased credit card relationship intangible asset of approximately $1 million and a rewards liability of approximately $1 million in the Key Community Bank reporting unit. No additional goodwill resulted from the acquisition of these credit card assets.

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 September 30,						Nine months ended September 30,
in millions	2013			2012			2013			2012
Net interest income	$	26		$	28		$	80		$	89
Provision (credit) for loan and lease losses		6			(2	)		10			4

Net interest income (expense) after provision for loan and lease losses		20			30			70			85
Noninterest income		(94	)		(21	)		(128	)		(41	)
Noninterest expense		6		$	9			20			27

Income (loss) before income taxes		(80	)		—			(78	)		17
Income taxes		(30	)		—			(29	)		6

Income (loss) from discontinued operations, net of taxes ^(a)	$	(50	)		—		$	(49	)	$	11

(a)

Includes after-tax charges of $9 million and $13 million for the three-month periods ended September 30, 2013 and 2012, and $30 and $39 million for the nine-month periods ended September 30, 2013 and 2012, 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:


	September 30,		December 31,		September 30,
in millions	2013		2012		2012
Trust loans at fair value	$	2,135	$	2,369	$	2,513
Portfolio loans at fair value		148		157		71
Loans, net of unearned income of ($6), ($5) and ($2)		2,455		2,675		2,744
Less: Allowance for loan and lease losses		38		55		65

Net loans		4,700		5,146		5,263
Trust accrued income and other assets at fair value		23		26		29
Accrued income and other assets		64		60		68

Total assets	$	4,787	$	5,232	$	5,360


Trust accrued expense and other liabilities at fair value	$	21	$	22	$	25
Trust securities at fair value		2,016		2,159		2,310

Total liabilities	$	2,037	$	2,181	$	2,335

The discontinued education lending business consists of assets and liabilities in the securitization trusts (recorded at fair value), as well as loans in portfolio (recorded at fair value) and loans in portfolio (recorded at carrying value with appropriate valuation reserves) that are held outside the trusts.

At September 30, 2013, portfolio loans recorded at carrying value include 1,010 TDRs with a recorded investment of approximately $11 million (pre-modification and post-modification). A specifically allocated allowance of $1 million was assigned to these loans as of September 30, 2013. There have been no significant payment defaults. There are no significant commitments outstanding to lend additional funds to these borrowers. Additional information regarding TDR classification and ALLL methodology is provided in Note 4 (“Asset Quality”).

In the past, as part of our education lending business model, we originated and securitized education loans. The process of securitization involved taking a pool of loans from our balance sheet and selling them to a bankruptcy-remote QSPE, or trust. This trust then issued 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 $121 million as of September 30, 2013. During the third quarter of 2013, we recorded an after-tax loss of $48 million related to the fair value of the loans and securities in these securitization trusts. This loss resulted in a reduction in the value of our economic interest in these trusts. 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.

At September 30, 2013 there are $142 million of loans that were purchased from two of the outstanding securitizations trusts pursuant to the legal terms of these particular trusts. These loans are held as portfolio loans and continue to be accounted for at fair value. These portfolio loans were valued using an internal discounted cash flow model, which was affected by assumptions for defaults, loss severity, discount rates and prepayments. These portfolio loans are considered to be Level 3 assets since we rely on unobservable inputs when determining fair value. See the following discussion regarding our valuation process for these loans as well as the trust loans and securities. Portfolio loans accounted for at fair value had a value of $148 million at September 30, 2013, $157 million at December 31, 2012, and $71 million at September 30, 2012.

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”) comprising 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 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). 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, and the knowledge and experience of the Working Group members.

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 validation group periodically performs a review to ensure the accuracy and validity of the model for determining the fair value of these loans and securities.

The following table shows 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 as of September 30, 2013, December 31, 2012, and September 30, 2012:


September 30, 2013	Fair Value of Level 3		Valuation	Significant	Range
dollars in millions	Assets and Liabilities		Technique	Unobservable Input	(Weighted-Average)
Trust loans and portfolio loans accounted for at fair value	$	2,283	Discounted cash flow	Prepayment speed	4.00 - 13.50% (6.04%)
				Loss severity	2.00 - 79.50% (37.67%)
				Discount rate	2.00 - 10.50% (7.09%)
				Default rate	8.02 - 23.78% (15.97%)

Trust securities		2,016	Discounted cash flow	Discount rate	1.10 - 3.80% (2.64%)


December 31, 2012	Fair Value of Level 3		Valuation	Significant	Range
dollars in millions	Assets and Liabilities		Technique	Unobservable Input	(Weighted-Average)
Trust loans and portfolio loans accounted for at fair value	$	2,526	Discounted cash flow	Prepayment speed	4.00 - 26.00% (9.74%)
				Loss severity	2.00 - 80.00% (49.61%)
				Discount rate	2.40 - 10.50% (5.12%)
				Default rate	8.13 - 21.50% (13.44%)

Trust securities		2,159	Discounted cash flow	Discount rate	1.50 - 6.10% (4.14%)


September 30, 2012	Fair Value of Level 3		Valuation	Significant	Range
dollars in millions	Assets and Liabilities		Technique	Unobservable Input	(Weighted-Average)
Trust loans and portfolio loans accounted for at fair value	$	2,584	Discounted cash flow	Prepayment speed	4.00 - 26.00% (10.08%)
				Loss severity	2.00 - 80.00% (51.05%)
				Discount rate	2.60 - 10.50% (5.04%)
				Default rate	8.00 - 21.50% (12.60%)

Trust securities		2,310	Discounted cash flow	Discount rate	1.80 - 6.50% (4.30%)

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 September 30, 2013. At September 30, 2013, loans held by the trusts with unpaid principal balances of $29 million ($28 million on a fair value basis) and portfolio loans at fair value with unpaid principal balances of $5 million ($5 million on a fair value basis) were 90 days or more past due. Loans held by the trusts aggregating $12 million ($12 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. Portfolio loans at carrying value that are 90 days or more past due were $38 million at September 30, 2013 and $47 million at September 30, 2012, respectively. Portfolio loans at carrying value in nonaccrual (and nonperforming) status were $9 million and $5 million at September 30, 2013, and 2012, respectively. Our policies for determining past due loans, placing loans on nonaccrual, applying payments on nonaccrual loans and resuming accrual of interest are disclosed in Note 1 (“Summary of Significant Accounting Policies”) under the heading “Nonperforming Loans” on page 120 of our 2012 Form 10-K.


September 30, 2013	Contractual		Fair
in millions	Amount		Value
ASSETS
Portfolio loans	$	142	$	148
Trust loans		2,190		2,135
Trust other assets		23		23

LIABILITIES
Trust securities	$	2,200	$	2,016
Trust other liabilities		21		21

During the third quarter of 2013, additional market participant information about projected trends for default and recovery rates became available. Based on this information and our related internal analysis, certain assumptions related to valuing the loans and securities in these securitization trusts were adjusted. As a result, a $48 million after-tax loss was recognized during the third quarter of 2013 related to the fair value of the loans and securities in the education loan securitization trusts.

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.


September 30, 2013
in millions	Level 1		Level 2		Level 3		Total
ASSETS MEASURED ON A RECURRING BASIS
Portfolio loans		—		—	$	148	$	148
Trust loans		—		—		2,135		2,135
Trust other assets		—		—		23		23

Total assets on a recurring basis at fair value		—		—	$	2,306	$	2,306

LIABILITIES MEASURED ON A RECURRING BASIS
Trust securities		—		—	$	2,016	$	2,016
Trust other liabilities		—		—		21		21

Total liabilities on a recurring basis at fair value		—		—	$	2,037	$	2,037

The following table shows the change in the fair values of the Level 3 consolidated education loan securitization trusts and portfolio loans for the three and nine-month periods ended September 30, 2013.


	Portfolio			Trust			Trust						Trust
	Student			Student			Other			Trust			Other
in millions	Loans			Loans			Assets			Securities			Liabilities
Balance at December 31, 2012	$	157		$	2,369		$	26		$	2,159		$	22
Gains (losses) recognized in earnings ^(a)		—			6			—			130			—
Purchases		—			—			—			—			—
Sales		—			—			—			—			—
Issuances		—			—			—			—			—
Settlements		(9	)		(240	)		(3	)		(273	)		(1	)

Balance at September 30, 2013	$	148		$	2,135		$	23		$	2,016		$	21


Balance at June 30, 2013	$	151		$	2,317		$	24		$	2,118		$	21
Gains (losses) recognized in earnings ^(a)		—			(105	)		—			(14	)		—
Purchases		—			—			—			—			—
Sales		—			—			—			—			—
Issuances		—			—			—			—			—
Settlements		(3	)		(77	)		(1	)		(88	)		—

Balance at September 30, 2013	$	148		$	2,135		$	23		$	2,016		$	21

(a)	Gains (losses) were driven primarily by fair value adjustments.

Victory Capital Management and Victory Capital Advisors. On July 31, 2013, we completed the sale of our investment management subsidiary Victory Capital Management and its broker-dealer affiliate Victory Capital Advisors (collectively, “Victory”) to a private equity fund. As a result of this sale, we recorded an after-tax gain of $92 million as of September 30, 2013. The cash portion of the gain was $72 million. An additional gain may be recognized based on client consents received through January 31, 2014. Due to the lack of certainty in securing these remaining consents, there was no accrual for these consents included in the gain as of September 30, 2013. Since February 21, 2013 when we agreed to sell Victory, 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 Victory which includes the gain on the sale of this business on July 31, 2013 are as follows:


	Three months ended September 30,				Nine months ended September 30,
in millions	2013		2012		2013		2012
Noninterest income	$	155	$	26	$	212	$	84
Noninterest expense		16		22		59		67

Income (loss) before income taxes		139		4		153		17
Income taxes		52		1		57		6

Income (loss) from discontinued operations, net of taxes	$	87	$	3	$	96	$	11

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


	September 30,		December 31,		September 30,
in millions	2013		2012		2012
Cash and due from banks		—	$	1	$	1
Accrued income and other assets	$	31		27		18

Total assets	$	31	$	28	$	19


Accrued expense and other liabilities		—	$	38	$	33

Total liabilities		—	$	38	$	33

The only remaining asset of Victory is a $31 million Seller note that is accounted for at fair value and is classified as a Level 3 asset. The Seller note will be accounted for at fair value until December 31, 2013 when the contingency involving certain fund outflows will be resolved. Corporate Treasury is responsible for the quarterly valuation process that determines the fair value of this Seller note. Corporate Treasury determined the fair value of this Seller note at closing on July 31, 2013 and again on September 30, 2013 and will also fair value this note at December 31, 2013. This Seller note is valued using a discounted cash flow methodology that incorporates an appropriate discount rate based on the credit, market, and interest risks associated with this note. The discount rate used in valuing this Seller note is determined by using the Capital Asset Pricing Model that is derived using adjusted quarterly changes in the seven-year U.S. Treasury Rate and an average beta of Victory’s peers. The alpha used is equal to the one-year probability of default for similar risk-rated loans per our internal risk rating system and credit policy. The discount rate used for the Seller note at September 30, 2013 was 12.75%. A Mergers & Acquisitions Working Group, which is a subcommittee of the Fair Value Committee that is discussed in more detail in Note 5, reviews the determination of the discount rate and approves the resulting fair value.

The following table presents the Victory Seller note that is measured at fair value on a recurring basis through December 31, 2013.


September 30, 2013
in millions	Level 1		Level 2		Level 3		Total
ASSETS MEASURED ON A RECURRING BASIS
Seller note		—		—	$	31	$	31

Total assets on a recurring basis at fair value		—		—	$	31	$	31

The following table shows the change in the fair value of the Level 3 Victory Seller note for the three-month period ended September 30, 2013.


in millions	Seller note
Balance at June 30, 2013		—
Gains (losses) recognized in earnings ^(a)	$	(1	)
Purchases		—
Sales		—
Issuances		32
Settlements		—

Balance at September 30, 2013	$	31

(a)	Gains (losses) 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.


	Three months ended September 30,					Nine months ended September 30,
in millions	2013			2012		2013			2012
Noninterest expense	$	1			—	$	1		$	9

Income (loss) before income taxes		(1	)		—		(1	)		(9	)
Income taxes	$	(1	)		—		1			(3	)

Income (loss) from discontinued operations, net of taxes		—			—	$	(2	)	$	(6	)

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


	September 30,		December 31,		September 30,
in millions	2013		2012		2012
Cash and due from banks	$	20	$	22	$	21

Total assets	$	20	$	22	$	21


Accrued expense and other liabilities		—	$	1		—

Total liabilities		—	$	1		—

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


	Three months ended September 30,					Nine months ended September 30,
in millions	2013		2012			2013		2012
Net interest income	$	26	$	28		$	80	$	89
Provision (credit) for loan and lease losses		6		(2	)		10		4

Net interest income (expense) after provision for loan and lease losses		20		30			70		85
Noninterest income		61		5			84		43
Noninterest expense		23		31			80		103

Income (loss) before income taxes		58		4			74		25
Income taxes		21		1			29		9

Income (loss) from discontinued operations, net of taxes ^(a)	$	37	$	3		$	45	$	16

(a)

Includes after-tax charges of $9 million and $13 million for the three-month periods ended September 30, 2013 and 2012, respectively, and $30 million and $39 million for the nine-month periods ended September 30, 2013 and 2012, 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:


	September 30,		December 31,		September 30,
in millions	2013		2012		2012
Cash and due from banks	$	20	$	23	$	22
Trust loans at fair value		2,135		2,369		2,513
Portfolio loans at fair value		148		157		71
Loans, net of unearned income of ($6), ($5), and ($2)		2,455		2,675		2,744
Less: Allowance for loan and lease losses		38		55		65

Net loans		4,700		5,146		5,263
Trust accrued income and other assets at fair value		23		26		29
Accrued income and other assets		95		87		86

Total assets	$	4,838	$	5,282	$	5,400


Trust accrued expense and other liabilities at fair value	$	21	$	22	$	25
Accrued expense and other liabilities		—		39		33
Trust securities at fair value		2,016		2,159		2,310

Total liabilities	$	2,037	$	2,220	$	2,368