11. Acquisitions and Discontinued Operations

Acquisitions

Pacific Crest Securities. On September 3, 2014, we acquired Pacific Crest Securities, a leading technology-focused investment bank and capital markets firm based in Portland, Oregon. This acquisition, which was accounted for as a business combination, expanded our corporate and investment banking business unit and added technology to our other industry verticals. During the fourth quarter of 2014, we recorded identifiable intangible assets of $13 million and goodwill of $78 million in Key Corporate Bank for this acquisition. During the third quarter of 2015, goodwill increased $3 million to account for a tax item associated with the business combination. The identifiable intangible assets and the goodwill related to this acquisition are non-deductible for tax purposes. Additional information regarding the identifiable intangible assets and the goodwill related to this acquisition is provided in Note 10 (“Goodwill and Other Intangible Assets”) beginning on page 173 of our 2014 Form 10-K.

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.

As of January 1, 2010, we consolidated our 10 outstanding education lending securitization trusts since we held 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.

On September 30, 2014, we sold the residual interests in all of our outstanding education lending securitization trusts to a third party for $57 million. In selling the residual interests, we no longer have the obligation to absorb losses or the right to receive benefits related to the securitization trusts. Therefore, in accordance with the applicable accounting guidance, we deconsolidated the securitization trusts and removed trust assets of $1.7 billion and trust liabilities of $1.6 billion from our balance sheet at September 30, 2014. As part of the sale and deconsolidation, we recognized an after-tax loss of $25 million, which was recorded in “income (loss) from discontinued operations, net of tax” on our income statement. We continue to service the securitized loans in eight of the securitization trusts and receive servicing fees, whereby we are adequately compensated, as well as remain a counterparty to derivative contracts with three of the securitization trusts. We retained interests in the securitization trusts through our ownership of an insignificant percentage of certificates in two of the securitization trusts and two interest-only strips in one of the securitization trusts. These retained interests were remeasured at fair value on September 30, 2014, and their fair value of $1 million was recorded in “discontinued assets” on our balance sheet. These assets were valued using a similar approach and inputs that have been used to value the education loan securitization trust loans and securities, which are further discussed later in this note.

“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, the loans at fair value in portfolio, and the loans held for sale 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, the loans in portfolio, and the loans held for sale 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 “noninterest expense.” Interest income and interest expense related to the loans and securities are included as components 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	2015			2014			2015		2014
Net interest income	$	9		$	21		$	29	$	67
Provision for credit losses		7			5			9		15

Net interest income after provision for credit losses		2			16			20		52
Noninterest income		(2	)		(41	)		1		(111	)
Noninterest expense		5			7			13		19

Income (loss) before income taxes		(5	)		(32	)		8		(78	)
Income taxes		(2	)		(12	)		3		(29	)

Income (loss) from discontinued operations, net of taxes ^(a)	$	(3	)	$	(20	)	$	5	$	(49	)

(a)

Includes after-tax charges of $7 million and $9 million for the three-month periods ended September 30, 2015, and September 30, 2014, respectively, and $18 million and $26 million for the nine-month periods ended September 30, 2015, and September 30, 2014, respectively, determined by applying a matched funds transfer pricing methodology to the liabilities assumed necessary to support the discontinued operations.

The discontinued assets of our education lending business included on the balance sheet are as follows. There were no discontinued liabilities for the periods presented below.


	September 30,		December 31,		September 30,
in millions	2015		2014		2014
Held-to-maturity securities	$	1	$	1	$	1
Portfolio loans at fair value		—		191		201
Loans, net of unearned income^(a)		1,891		2,104		2,174
Less: Allowance for loan and lease losses		23		29		31

Net loans		1,868		2,266		2,344
Portfolio loans held for sale at fair value		169		—		—
Accrued income and other assets		33		38		40

Total assets	$	2,071	$	2,305	$	2,385

(a)	At September 30, 2015, December 31, 2014, and September 30, 2014, unearned income was less than $1 million.

The discontinued education lending business consisted of loans in portfolio (recorded at fair value) and loans in portfolio (recorded at carrying value with appropriate valuation reserves). As of June 30, 2015, we decided to sell the portfolio loans that are recorded at fair value, and these loans were reclassified to portfolio loans held for sale at fair value within discontinued operations. The assets and liabilities in the securitization trusts (recorded at fair value) were removed with the deconsolidation of the securitization trusts on September 30, 2014.

At September 30, 2015, education loans included 1,845 TDRs with a recorded investment of approximately $20 million (pre-modification and post-modification). A specifically allocated allowance of $2 million was assigned to these loans as of September 30, 2015. 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 qualifying special purpose entity, or trust. This trust then issued securities to investors in the capital markets to raise funds to pay for the loans. The cash flows generated from the loans pays holders of the securities issued. As the transferor, we retained a portion of the risk in the form of a residual interest and also retained the right to service the securitized loans and receive servicing fees.

The trust assets can be used only to settle the obligations or securities the trusts issue; the assets cannot be sold and the liabilities cannot be transferred. The loans in the trusts consist of both private and government-guaranteed loans. The security holders or beneficial interest holders do not have recourse to Key. We no longer had economic interest or risk of loss associated with these education loan securitization trusts as of September 30, 2014, and therefore, the securitization trusts were deconsolidated. During the second quarter of 2014, additional market information became available. Based on this information and our related internal analysis, we adjusted certain assumptions related to valuing the loans in the securitization trusts. As a result, we recognized a net after-tax loss of $22 million during the second quarter of 2014 related to the fair value of the loans and securities in the securitization trusts. These losses 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 “income (loss) from discontinued operations, net of tax” on our income statement.

On June 27, 2014, we purchased the private loans from one of the education loan securitization trusts through the execution of a clean-up call option. The trust used the cash proceeds from the sale of these loans to retire the outstanding securities related to these private loans, and there are no future commitments or obligations to the holders of the securities. The portfolio loans were valued using an internal discounted cash flow method, 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.

At September 30, 2015, there were loans held for sale with a contractual amount of $173 million that were previously purchased from three of the outstanding securitizations trusts pursuant to the legal terms of these particular trusts. These loans were transferred to held for sale in June 2015 and continue to be accounted for at fair value. As of September 30, 2015, the portfolio loans held for sale were valued based on indicative bids to sell the loans. These portfolio loans were previously valued using an internal discounted cash flow model, which was affected by assumptions for defaults, loss severity, discount rates, and prepayments. These loans are considered Level 3 assets since we rely on unobservable inputs when determining fair value. Our valuation process for these loans as well as the trust loans and securities is discussed in more detail below. Portfolio loans held for sale accounted for at fair value had a value of $169 million at September 30, 2015. On October 29, 2015, $117 million of these loans were sold. Portfolio loans accounted for at fair value had a value of $191 million at December 31, 2014, and $201 million at September 30, 2014.

When we first consolidated the education loan securitization trusts, we made an election to record them at fair value. Carrying the assets and liabilities of the trusts at fair value better depicted our economic interest. The fair value of the assets and liabilities of the trusts was determined by calculating the present value of the future expected cash flows. We relied on unobservable inputs (Level 3) when determining the fair value of the assets and liabilities of the trusts because observable market data was not available. Our valuation process is described in more detail below.

Corporate Treasury, within our Finance area, is responsible for the quarterly valuation process that previously determined the fair value of our student loans held in portfolio that were accounted for at fair value and for our loans and securities in our education loan securitization trusts. Corporate Treasury provided 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 reviewed all significant inputs and assumptions and approved the resulting fair values.

The Working Group reviewed actual performance trends of the loans on a quarterly basis and used statistical analysis and qualitative measures to determine assumptions for future performance. Predictive models that incorporate delinquency and charge-off trends along with economic outlooks assisted the Working Group to forecast future defaults. The Working Group used this information to formulate the credit outlook related to the loans. 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 portfolio loans at fair value. Default expectations and discount rate changes had the most significant impact on the fair values of the loans. 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. This process was previously used in the valuation of the education loan securitization trust loans.

The valuation process for the portfolio loans that were accounted for at fair value was based on a discounted cash flow analysis using a model purchased from a third party and maintained by Corporate Treasury. The valuation process began with loan-level data that was 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 were developed using a financial model that reflected certain assumptions for defaults, recoveries, status changes, and prepayments. A net earnings stream, taking into account cost of funding, was calculated and discounted back to the measurement date using an appropriate discount rate. This resulting amount was used to determine the present value of the loans, which represented 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 within and outside of Key, and the knowledge and experience of the Working Group members.

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

A quarterly variance analysis reconciled 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 considered loan and securities run-off, yields, future default and recovery changes, and the timing of cash releases to us from the trusts. We also performed back-testing to compare expected defaults to actual experience; the impact of future defaults could significantly affect the fair value of these loans and securities over time. In addition, our internal model validation group periodically performed 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 portfolio loans held for sale and portfolio loans accounted for at fair value at September 30, 2015, December 31, 2014, and September 30, 2014:

September 30, 2015

dollars in millions

Fair Value of Level 3
Assets and Liabilities

Valuation Technique

Significant
Unobservable Input

Range

Portfolio loans held for sale accounted for at fair value

169

Market approach

Indicative bids

84.50 - 104.00%

December 31, 2014

dollars in millions

Fair Value of Level 3
Assets and Liabilities

Valuation Technique

Significant
Unobservable Input

Range
(Weighted-Average)

Portfolio loans accounted for at fair value

191

Discounted cash flow

Prepayment speed

5.40 - 5.60% (5.50%)

Loss severity

2.00 - 77.00% (25.66%)

Discount rate

3.90 - 4.00% (3.92%)

Default rate

.86 - 1.70% (1.12%)

September 30, 2014

dollars in millions

Fair Value of Level 3
Assets and Liabilities

Valuation Technique

Significant
Unobservable Input

Range
(Weighted-Average)

Portfolio loans accounted for at fair value

201

Discounted cash flow

Prepayment speed

5.00 - 5.80% (5.25%)

Loss severity

2.00 - 77.00% (25.71%)

Discount rate

3.60 - 3.90% (3.69%)

Default rate

.93 - 1.91% (1.24%)

The following table shows the principal and fair value amounts for our portfolio loans held for sale at fair value, portfolio loans at carrying value, and portfolio loans at fair value at September 30, 2015, December 31, 2014, and September 30, 2014. 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” beginning on page 116 of our 2014 Form 10-K.


	September 30, 2015				December 31, 2014				September 30, 2014
in millions	Principal		Fair Value		Principal		Fair Value		Principal		Fair Value
Portfolio loans held for sale at fair value
Accruing loans past due 90 days or more	$	5	$	4		—		—		—		—
Portfolio loans at carrying value
Accruing loans past due 90 days or more	$	26		N/A	$	29		N/A	$	31		N/A
Loans placed on nonaccrual status		8		N/A		11		N/A		9		N/A
Portfolio loans at fair value
Accruing loans past due 90 days or more		—		—	$	5	$	5	$	5	$	5

The following table shows the portfolio loans held for sale at fair value and portfolio loans at fair value and their related contractual amounts at September 30, 2015, December 31, 2014, and September 30, 2014.


	September 30, 2015				December 31, 2014				September 30, 2014
in millions	Contractual Amount		Fair Value		Contractual Amount		Fair Value		Contractual Amount		Fair Value
ASSETS
Portfolio loans held for sale	$	173	$	169		—		—		—		—
Portfolio loans		—		—	$	192	$	191	$	199	$	201

The following tables present the assets of the portfolio loans held for sale and portfolio loans measured at fair value on a recurring basis at September 30, 2015, December 31, 2014, and September 30, 2014.

September 30, 2015

in millions

Level 1

Level 2

Level 3

Total

ASSETS MEASURED ON A RECURRING BASIS

Portfolio loans held for sale

—

169

Total assets on a recurring basis at fair value

—

169


December 31, 2014 in millions	Level 1		Level 2		Level 3		Total
ASSETS MEASURED ON A RECURRING BASIS
Portfolio loans		—		—	$	191	$	191

Total assets on a recurring basis at fair value		—		—	$	191	$	191


September 30, 2014 in millions	Level 1		Level 2		Level 3		Total
ASSETS MEASURED ON A RECURRING BASIS
Portfolio loans		—		—	$	201	$	201

Total assets on a recurring basis at fair value		—		—	$	201	$	201

The following table shows the change in the fair values of the Level 3 portfolio loans held for sale, portfolio loans, and consolidated education loan securitization trusts for the three- and nine-month periods ended September 30, 2015, and September 30, 2014.


	Portfolio
	Student			Portfolio			Trust			Trust						Trust
	Loans Held			Student			Student			Other			Trust			Other
in millions	For Sale			Loans			Loans			Assets			Securities			Liabilities
Balance at December 31, 2014		—		$	191			—			—			—			—
Gains (losses) recognized in earnings^(a)	$	(4	)		1			—			—			—			—
Settlements		(6	)		(13	)		—			—			—			—
Loans transferred to held for sale		179			(179	)		—			—			—			—

Balance at September 30, 2015^(b)	$	169			—			—			—			—			—

Balance at June 30, 2015	$	179			—			—			—			—			—
Gains (losses) recognized in earnings^(a)		(4	)		—			—			—			—			—
Settlements		(6	)		—			—			—			—			—

Balance at September 30, 2015^(b)	$	169			—			—			—			—			—

Balance at December 31, 2013		—		$	147		$	1,960		$	20		$	1,834		$	20
Gains (losses) recognized in earnings^(a)		—			(4	)		(34	)		—			33			—
Purchases		—			74			—			—			—			—
Sales		—			—			(74	)		—			—			—
Settlements		—			(16	)		(202	)		(1	)		(278	)		(3	)
Transfers out due to deconsolidation		—			—			(1,650	)		(19	)		(1,589	)		(17	)

Balance at September 30, 2014^(b)		—		$	201			—			—			—			—

Balance at June 30, 2014		—		$	209		$	1,711		$	19		$	1,660		$	17
Gains (losses) recognized in earnings^(a)		—			—			—			—			—			—
Purchases		—			—			—			—			—			—
Sales		—			—			—			—			—			—
Settlements		—			(8	)		(61	)		—			(71	)		—
Transfers out due to deconsolidation		—			—			(1,650	)		(19	)		(1,589	)		(17	)

Balance at September 30, 2014^(b)		—		$	201			—			—			—			—

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

(b)	There were no issuances, transfers into Level 3, or transfers out of Level 3 for the three- and nine-month periods ended September 30, 2015. There were no issuances or transfers into Level 3 for the three- and nine-month periods ended September 30, 2014.

Victory Capital Management and Victory Capital Advisors. On July 31, 2013, we completed the sale of Victory to a private equity fund. During March 2014, client consents were secured and assets under management were finalized and, as a result, we recorded an additional after-tax cash gain of $6 million as of March 31, 2014. 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 additional gain recorded as of March 31, 2014, on the sale of this business, are as follows:


	Three months ended September 30,				Nine months ended September 30,
in millions	2015		2014		2015		2014
Net interest income		—	$	5		—	$	7
Noninterest income		—		—		—		10
Noninterest expense		—		—		—		—

Income (loss) before income taxes		—		5		—		17
Income taxes		—		2		—		7

Income (loss) from discontinued operations, net of taxes		—	$	3		—	$	10

The discontinued assets of Victory included on the balance sheet are as follows. There were no discontinued liabilities for the periods presented below.


	September 30,		December 31,		September 30,
in millions	2015		2014		2014
Seller note ^(a)		—		—	$	17

Total assets		—		—	$	17

(a)	At September 30, 2014, the only remaining asset of Victory was the Seller note. The Seller note was paid off during the fourth quarter of 2014.

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	2015		2014		2015		2014
Noninterest expense		—		—		—	$	4

Income (loss) before income taxes		—		—		—		(4	)
Income taxes		—		—		—		(2	)

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

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


	September 30,		December 31,		September 30,
in millions	2015		2014		2014
Cash and due from banks	$	15	$	19	$	19

Total assets	$	15	$	19	$	19

Accrued expense and other liabilities		—	$	3	$	3

Total liabilities		—	$	3	$	3

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	2015			2014			2015		2014
Net interest income	$	9		$	26		$	29	$	74
Provision for credit losses		7			5			9		15

Net interest income after provision for credit losses		2			21			20		59
Noninterest income		(2	)		(41	)		1		(101	)
Noninterest expense		5			7			13		23

Income (loss) before income taxes		(5	)		(27	)		8		(65	)
Income taxes		(2	)		(10	)		3		(24	)

Income (loss) from discontinued operations, net of taxes ^(a)	$	(3	)	$	(17	)	$	5	$	(41	)

(a)

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


	September 30,		December 31,		September 30,
in millions	2015		2014		2014
Cash and due from banks	$	15	$	19	$	19
Held-to-maturity securities		1		1		1
Seller note		—		—		17
Portfolio loans at fair value		—		191		201
Loans, net of unearned income^(a)		1,891		2,104		2,174
Less: Allowance for loan and lease losses		23		29		31

Net loans		1,868		2,266		2,344
Portfolio loans held for sale at fair value		169		—		—
Accrued income and other assets		33		38		40

Total assets	$	2,086	$	2,324	$	2,421

Accrued expense and other liabilities		—	$	3	$	3

Total liabilities		—	$	3	$	3

(a)	At September 30, 2015, December 31, 2014, and September 30, 2014, unearned income was less than $1 million.