1
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 1998
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
[LOGO]
KEYCORP
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(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
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(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 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 439,868,135 Shares
- --------------------------------------------- ------------------------------
(Title of class) (Outstanding at July 31, 1998)
The number of pages of this report is 48.
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KEYCORP
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements Page Number
-------------------- -----------
Consolidated Balance Sheets --
June 30, 1998, December 31, 1997 and June 30, 1997 3
Consolidated Statements of Income --
Three months and six months ended June 30, 1998 and 1997 4
Consolidated Statements of Changes in Shareholders' Equity --
Six months ended June 30, 1998 and 1997 5
Consolidated Statements of Cash Flow --
Six months ended June 30, 1998 and 1997 6
Notes to Consolidated Financial Statements 7
Independent Accountants' Review Report 19
Item 2. Management's Discussion and Analysis of Financial Condition
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And Results of Operations 20
-------------------------
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 46
-----------------
Item 4. Submission of Matters to a Vote of Security Holders 46
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Item 6. Exhibits and Reports on Form 8-K 47
--------------------------------
Signature 47
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3
PART I. FINANCIAL INFORMATION
KEYCORP AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30, December 31, June 30,
dollars in millions 1998 1997 1997
- ------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
ASSETS
Cash and due from banks $ 3,050 $ 3,651 $ 2,911
Short-term investments 1,652 1,928 653
Securities available for sale 6,482 7,708 7,727
Investment securities (fair value: $1,066, $1,262 and $1,516) 1,038 1,230 1,484
Loans, net of unearned income of $1,313, $1,197 and $951) 57,769 53,380 51,644
Less: Allowance for loan losses 900 900 880
- ----------------------------------------------------------------------------------------------------------------
Net loans 56,869 52,480 50,764
Premises and equipment 894 985 1,025
Goodwill 1,028 1,071 795
Other intangible assets 88 105 123
Corporate owned life insurance 1,945 1,895 1,562
Other assets 2,732 2,646 2,628
- ----------------------------------------------------------------------------------------------------------------
Total assets $ 75,778 $ 73,699 $ 69,672
======== ======== ========
LIABILITIES
Deposits in domestic offices:
Noninterest-bearing $ 8,967 $ 9,368 $ 9,519
Interest-bearing 31,262 32,005 33,655
Deposits in foreign offices -- interest-bearing 1,565 3,700 1,452
- ----------------------------------------------------------------------------------------------------------------
Total deposits 41,794 45,073 44,626
Federal funds purchased and securities sold under repurchase agreements 6,828 6,979 6,830
Bank notes and other short-term borrowings 7,855 5,967 5,447
Other liabilities 2,583 2,303 2,023
Long-term debt 10,196 7,446 5,182
- ------------------------------------------------------------------------------------------------------------------
Total liabilities 69,256 67,768 64,108
Corporation-obligated mandatorily redeemable preferred capital
securities of subsidiary trusts holding solely debentures of
the Corporation (See Note 8) 997 750 750
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, 491,888,780 and 245,944,390 shares 492 492 246
Capital surplus 1,284 1,283 1,477
Retained earnings 4,889 4,611 4,311
Loans to ESOP trustee (42) (42) (49)
Treasury stock, at cost (51,536,469, 53,824,950 and 27,564,764 shares) (1,126) (1,174) (1,135)
Accumulated other comprehensive income 28 11 (36)
- ----------------------------------------------------------------------------------------------------------------
Total shareholders' equity 5,525 5,181 4,814
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Total liabilities, capital securities and shareholders' equity $ 75,778 $ 73,699 $ 69,672
======== ======== ========
- ----------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
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KEYCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
Three months Six months
ended June 30, ended June 30,
-------------- --------------
dollars in millions, except per share amounts 1998 1997 1998 1997
- ---------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ 1,218 $ 1,131 $ 2,383 $ 2,226
Taxable investment securities 4 3 7 6
Tax-exempt investment securities 12 18 25 36
Securities available for sale 117 136 246 270
Short-term investments 21 7 38 12
- ---------------------------------------------------------------------------------------------------------------------
Total interest income 1,372 1,295 2,699 2,550
INTEREST EXPENSE
Deposits 346 378 693 731
Federal funds purchased and securities sold under repurchase agreements 89 84 182 172
Bank notes and other short-term borrowings 114 64 212 121
Long-term debt 143 73 268 141
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Total interest expense 692 599 1,355 1,165
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NET INTEREST INCOME 680 696 1,344 1,385
Provision for loan losses 72 75 149 142
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Net interest income after provision for loan losses 608 621 1,195 1,243
NONINTEREST INCOME
Service charges on deposit accounts 75 74 153 145
Trust and asset management income 80 64 157 128
Investment banking and capital markets income 50 21 97 39
Credit card fees 17 25 32 48
Insurance and brokerage income 24 21 46 42
Corporate owned life insurance income 24 21 47 40
Loan securitization income 8 3 18 4
Net securities gains 2 -- 4 --
Gains from sales of branches/subsidiaries 33 10 62 10
Other income 67 49 120 91
- ---------------------------------------------------------------------------------------------------------------------
Total noninterest income 380 288 736 547
NONINTEREST EXPENSE
Personnel 302 283 596 573
Net occupancy 56 54 112 110
Equipment 45 44 88 87
Amortization of intangibles 22 21 45 42
Marketing 28 22 56 43
Professional fees 15 13 32 24
Other expense 148 145 287 278
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Total noninterest expense 616 582 1,216 1,157
INCOME BEFORE INCOME TAXES 372 327 715 633
Income taxes 123 104 231 198
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NET INCOME $ 249 $ 223 $ 484 $ 435
======== ======== ======== ========
Per Common Share:
Net income $ .57 $ .51 $ 1.10 $ .99
Net Income - assuming dilution .56 .51 1.09 .98
Weighted average Common Shares outstanding (000) 440,092 437,946 439,345 440,628
Weighted average Common Shares and potential Common
Shares outstanding (000) 446,568 442,480 445,707 445,504
- ---------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
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5
KEYCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
Accumulated
Other
Loans to Treasury Compre-
Common Capital Retained ESOP Stock hensive Comprehensive
dollars in millions, except per share amounts Shares Surplus Earnings Trustee at Cost Income Income (2)
- -----------------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1996 $ 246 $ 1,484 $ 4,060 $ (49) $ (854) $ (6)
Net income 435 $ 435
Other comprehensive income:
Adjustment related to change in
accounting for transfers of financial
assets, net of deferred tax benefit
of $(25) (43) (43)
Net unrealized gains on securities
available for sale, net of income taxes
of $7 (1) 13 13
-------
Total comprehensive income $ 405
=======
Cash dividends on Common Shares ($.42 per share) (184)
Issuance of Common Shares under employee benefit
and dividend reinvestment plans-
1,428,289 net shares (7) 64
Repurchase of Common Shares-6,502,700 shares (345)
===============================================================================================================
BALANCE AT JUNE 30, 1997 $ 246 $ 1,477 $ 4,311 $ (49) $(1,135) $ (36)
======= ======= ======= ======= ======= =======
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BALANCE AT DECEMBER 31, 1997 $ 492 $ 1,283 $ 4,611 $ (42) $(1,174) $ 11
Net income 484 $ 484
Other comprehensive income:
Net unrealized gains on securities
available for sale, net of income
taxes of $9 (1) 17 17
--------
Total comprehensive income $ 501
========
Cash dividends on Common Shares ($.47 per share) (206)
Issuance of Common Shares under employee
benefit and dividend reinvestment plans-
2,388,481 net shares 1 52
Repurchase of Common Shares-100,000 shares (4)
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BALANCE AT JUNE 30, 1998 $ 492 $ 1,284 $ 4,889 $ (42) $(1,126) $ 28
======= ======= ======= ======= ======= =======
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1 Net of reclassification adjustments.
2 For the three months ended June 30, 1998 and 1997, comprehensive income
was $269 million and $304 million, respectively.
See Notes to Consolidated Financial Statements (Unaudited).
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KEYCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)
Six months ended June 30
------------------------
in millions 1998 1997
- ------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net income $ 484 $ 435
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Provision for loan losses 149 142
Depreciation expense 77 78
Amortization of intangibles 45 42
Net gains from sales of branches/subsidiaries (62) (10)
Net securities gains (4) --
Deferred income taxes 154 32
Net increase in mortgage loans held for sale (324) (14)
Net increase in trading account assets (228) (133)
Decrease in accrued restructuring charge (18) (49)
Other operating activities, net (10) (525)
- ------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES 263 (2)
INVESTING ACTIVITIES
Net increase in loans, excluding acquisitions, sales and divestitures (3,861) (3,227)
Purchases of loans (827) --
Loans sold 336 683
Purchases of investment securities (55) (187)
Proceeds from sales of investment securities 43 7
Proceeds from prepayments and maturities of investment securities 232 371
Purchases of securities available for sale (61) (848)
Proceeds from sales of securities available for sale 43 37
Proceeds from prepayments and maturities of securities available for sale 1,281 1,006
Net decrease in other short-term investments 504 176
Purchases of premises and equipment (27) (89)
Proceeds from sales of premises and equipment 23 53
Proceeds from sales of other real estate owned 4 7
Net cash paid for sales of branches/subsidiaries (433) (116)
- ------------------------------------------------------------------------------------------------------------------------
NET CASH USED IN INVESTING ACTIVITIES (2,798) (2,127)
FINANCING ACTIVITIES
Net decrease in deposits (2,621) (540)
Net increase in short-term borrowings 1,739 1,383
Net proceeds from issuance of long-term debt 3,248 1,500
Payments on long-term debt (503) (525)
Proceeds from the issuance of capital securities 247 250
Purchases of treasury shares (4) (345)
Proceeds from issuance of common stock pursuant to employee
benefit and dividend reinvestment plans 34 57
Cash dividends (206) (184)
- ------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY FINANCING ACTIVITIES 1,934 1,596
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NET DECREASE IN CASH AND DUE FROM BANKS (601) (533)
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,651 3,444
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CASH AND DUE FROM BANKS AT END OF PERIOD $3,050 $2,911
====== ======
- ------------------------------------------------------------------------------------------------------------------------
Additional disclosures relative to cash flow:
Interest paid $1,329 $1,150
Income taxes paid 79 135
Net amount received on portfolio swaps 10 41
Noncash items:
Assets sold $165 $ 29
Liabilities sold 660 155
Transfer of other assets to securities available for sale -- 280
- ------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements (Unaudited).
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KEYCORP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
I. BASIS OF PRESENTATION
The unaudited consolidated interim financial statements include the accounts of
KeyCorp and its subsidiaries ("Key"). All significant intercompany accounts and
transactions have been eliminated in consolidation. In the opinion of
management, the unaudited consolidated interim financial statements reflect all
adjustments of a normal recurring nature and disclosures which are necessary for
a fair presentation of the results for the interim periods presented, and should
be read in conjunction with the audited consolidated financial statements and
related notes included in Key's 1997 Annual Report to Shareholders. In addition,
certain reclassifications have been made to prior year amounts to conform with
the current year presentation. The results of operations for the interim periods
are not necessarily indicative of the results of operations to be expected for
the full year.
ACCOUNTING PRONOUNCEMENTS ADOPTED IN 1998
As of January 1, 1998, Key adopted Statement of Financial Accounting Standards
("SFAS") No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes
reporting and display standards for comprehensive income and its components in a
full set of general-purpose financial statements. Comprehensive income is
defined as the change in equity of a business enterprise during a period from
transactions and other events and circumstances arising from nonowner sources.
The new statement requires Key's unrealized gains or losses on securities
available for sale, which prior to adoption were reported as a separate
component of shareholders' equity, to be included in other comprehensive income.
Since SFAS No. 130 requires only the disclosure and presentation in a prescribed
format of information customarily presented elsewhere in the financial
statements, it had no impact on Key's financial condition or results of
operations. Prior year financial statements have been reclassified to conform
with the new requirements. Comprehensive income is presented in the Statement of
Changes in Shareholders' Equity on page 5.
ACCOUNTING PRONOUNCEMENTS PENDING ADOPTION
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities." This
statement establishes accounting and reporting standards for derivative
instruments including certain derivative instruments embedded in other contracts
(collectively "derivatives") and for hedging activities. It requires that all
derivatives be recognized in the balance sheet and measured at fair value. SFAS
No. 133 is effective for all fiscal quarters of all fiscal years beginning after
June 15, 1999. Earlier application of all of the provisions of this statement is
permitted as of the beginning of any fiscal quarter starting after June 30,
1998. Key will adopt the provisions of SFAS No. 133 as of January 1, 2000. Key
is currently reviewing SFAS No. 133 and has not yet determined the extent to
which the statement will alter its use of certain derivatives in the future and
the impact on its financial condition and results of operations.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position ("SOP")
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use." This SOP provides guidance on accounting for such costs,
including the characteristics to be considered in defining internal-use software
and the circumstances under which related costs should be expensed or
capitalized. SOP 98-1 is effective for financial statements for fiscal years
beginning after December 15, 1998, with earlier adoption encouraged on a
prospective basis; restatement of financial statements for earlier periods is
not permitted. Key will adopt the provisions of SOP 98-1 as of January 1, 1999.
The provisions of SOP 98-1 are substantially consistent with Key's current
accounting practices as disclosed in Note 1, Summary of Significant Accounting
Policies, of Key's Annual Report to Shareholders. The effect of prospective
adoption is not expected to have a material impact on Key's financial condition
or results of operations.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about
Pensions and Other Postretirement Benefits." SFAS No. 132 supersedes the
disclosure requirements in SFAS No. 87, "Employers' Accounting for Pensions,"
SFAS No. 88, "Accounting for Settlements and Curtailments of Defined Benefit
Pension Plans and for Termination Benefits," and SFAS No. 106, "Employers'
Accounting for Postretirement Benefits Other than Pensions." The overall
objective of SFAS No. 132 is to improve and standardize disclosures about
pensions and other postretirement benefits and to make the required information
easier to prepare and more understandable. The statement addresses disclosure
issues only and does not change the measurement or recognition provisions
specified in the above statements. SFAS No. 132 is effective for fiscal years
beginning after December 15, 1997. Key will include the disclosures required by
SFAS No. 132 in its December 31, 1998, financial statements.
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In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information." SFAS No. 131 requires that financial and
descriptive information be disclosed for each reportable operating segment based
on the management approach. The management approach focuses on financial
information that an enterprise's decision-makers use to assess performance and
make decisions about resource allocation. Key expects that its reportable
operating segments will be its major lines of business. The statement also
prescribes the enterprise-wide disclosures to be made about products, services,
geographic areas and major customers. SFAS No. 131 is effective for annual
financial statements issued for periods beginning after December 15, 1997, and
for interim financial statements in the second year of application. Comparative
information presented for earlier periods must be restated. Key will include the
disclosures required by SFAS No. 131 in its December 31, 1998, financial
statements.
2. EARNINGS PER COMMON SHARE
The computation of Key's basic and diluted earnings per Common Share is as
follows:
Three months ended June 30, Six months ended June 30,
---------------------------- -------------------------
dollars in millions, except per share amounts 1998 1997 1998 1997
- --------------------------------------------------------------------------------------------------------------
NET INCOME $249 $223 $484 $435
======= ======= ======= =======
- --------------------------------------------------------------------------------------------------------------
WEIGHTED AVERAGE COMMON SHARES
Weighted average Common Shares outstanding (000) 440,092 437,946 439,345 440,628
Potential Common Shares outstanding (000) (1) 6,476 4,534 6,362 4,876
- --------------------------------------------------------------------------------------------------------------
Weighted average Common Shares and potential
Common Shares outstanding (000) 446,568 442,480 445,707 445,504
======= ======= ======= =======
- --------------------------------------------------------------------------------------------------------------
EARNINGS PER COMMON SHARE
Net income per Common Share $ .57 $ .51 $ 1.10 $ .99
Net income per Common Share - assuming dilution .56 .51 1.09 .98
- --------------------------------------------------------------------------------------------------------------
1 Dilutive common stock options.
3. MERGERS, ACQUISITIONS AND DIVESTITURES
COMPLETED MERGERS AND ACQUISITIONS
Business combinations completed by Key during 1997 (both of which were accounted
for as purchases) are summarized below. There were no such transactions during
the six-month period ended June 30, 1998.
Common
dollars in millions Location Date Assets Shares Issued
- ------------------------------------------------------------------------------------------------------------------
Champion Mortgage Co., Inc. New Jersey August 1997 $317 3,336,118 (1)
Leasetec Corporation Colorado July 1997 1,080 See note (2)
- ------------------------------------------------------------------------------------------------------------------
1 Pre-split Common Shares.
2 In accordance with a confidentiality clause in the purchase agreement, the
terms, which are not material, have not been publicly disclosed.
CHAMPION MORTGAGE CO., INC.
On August 29, 1997, Key acquired Champion Mortgage Co., Inc. ("Champion"), a
home equity finance company headquartered in Parsippany, New Jersey. Under the
terms of the agreement, 3,336,118 pre-split Common Shares, with a value of
approximately $200 million, were exchanged for all of the outstanding shares of
Champion common stock in a transaction structured as a tax-free exchange and
accounted for as a purchase. The agreement also provides an opportunity for
Champion's shareholders to receive additional consideration in the form of Key
Common Shares valued at up to $100 million in the event that certain performance
targets related to significant increases in profitability and origination
volumes established at the date of closing are achieved over the three-year
period following the closing. In connection with the transaction, Key recorded
goodwill of approximately $195 million, which is being amortized using the
straight-line method over a period of 25 years. At closing, Champion became a
wholly owned subsidiary of Key Bank USA, National Association ("KeyBank USA"), a
wholly owned subsidiary of the parent company.
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LEASETEC CORPORATION
On July 1, 1997, Key acquired an 80% interest (with an option to purchase the
remaining 20%) in Leasetec Corporation ("Leasetec"), an equipment leasing
company headquartered in Boulder, Colorado, with operations in the United States
and overseas. In connection with the transaction, which was accounted for as a
purchase, Key recorded goodwill of approximately $126 million, which is being
amortized using the straight-line method over a period of 25 years. On June 26,
1998, Key acquired the remaining 20% interest in Leasetec. This resulted in
additional goodwill of approximately $26 million, which will be amortized over
the remainder of the 25-year period which began July 1, 1997.
COMPLETED DIVESTITURES
KEY MERCHANT SERVICES, LLC
On January 21, 1998, Key sold a 51% interest in Key Merchant Services, LLC ("Key
Merchant"), a wholly owned subsidiary formed to provide merchant services to
businesses, to NOVA Information Systems, Inc. ("NOVA"). A $23 million gain ($14
million after tax) was recognized at the time of closing. Under the terms of the
agreement with NOVA, Key can receive additional consideration at the end of each
of the three years through 2000, provided certain revenue-related performance
targets are met. In accordance with a confidentiality clause in the agreement,
the terms, which are not material, have not been disclosed.
KEYBANK NATIONAL ASSOCIATION (WYOMING)
On July 14, 1997, Key sold KeyBank National Association (Wyoming) ("KeyBank
Wyoming"), its 28-branch Wyoming bank subsidiary. KeyBank Wyoming had assets and
deposits of approximately $1.1 billion and $931 million, respectively, at the
time of the transaction. A $53 million ($35 million after tax) gain was realized
on the KeyBank Wyoming sale and included in gains from sales of
branches/subsidiaries on the income statement.
BRANCH DIVESTITURES
On November 26, 1996, Key announced its intention to divest approximately 140
branch offices (including the 28 branches associated with the sale of KeyBank
Wyoming). During the first six months of 1998, 46 such branches with deposits of
approximately $658 million were sold, resulting in aggregate gains of $39
million ($22 million after tax) which were recorded in gains from sales of
branches/subsidiaries on the income statement. During the last three quarters of
1997, excluding the KeyBank Wyoming transaction, 76 such branches with deposits
of approximately $1.3 billion were sold, resulting in aggregate gains of $98
million ($62 million after tax) which were recorded in gains from sales of
branches/subsidiaries on the income statement.
TRANSACTION PENDING AT JUNE 30, 1998
MCDONALD & COMPANY INVESTMENTS, INC.
On June 15, 1998, Key entered into a definitive agreement to acquire McDonald &
Company Investments, Inc. ("McDonald"), a full-service investment banking and
securities brokerage company headquartered in Cleveland, Ohio, in a tax-free
exchange of stock. Under the terms of the agreement, McDonald stockholders will
receive approximately $35 in value of Key Common Shares for each share of
McDonald common stock, subject to adjustment if the average closing price of the
Key Common Shares during a specified period prior to closing is below $33 or
above $44.50 per common share. Based upon the market price of Key Common Shares
on June 12, 1998, (the last trading day preceding the announcement of the
agreement) this would result in the issuance of approximately 17.7 million Key
Common Shares with a value of approximately $653 million. Key plans to
repurchase, prior to the closing of the transaction, up to half of the shares to
be issued. In connection with the transaction, which will be accounted for as a
purchase, Key expects to record approximately $497 million of goodwill, which
will be amortized using the straight line method over a period of 25 years. In
addition, Key established a retention program under which cash and options
valued at approximately $68 million will be paid to certain McDonald employees
over a three-year period. The transaction is expected to close during the fourth
quarter of 1998, pending approval by McDonald's stockholders and certain
regulatory agencies.
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4. SECURITIES
Debt securities that Key has the positive intent and ability to hold to maturity
are classified as securities held to maturity and carried at cost, adjusted for
amortization of premiums and accretion of discounts using the level yield
method. Securities held to maturity and equity securities that do not have
readily determinable fair values are presented as investment securities on the
balance sheet. Debt and equity securities that are bought and held principally
for the purpose of selling them in the near term are classified as trading
account assets, reported at fair value ($763 million, $535 million and $170
million at June 30, 1998, December 31, 1997 and June 30, 1997, respectively) and
included in short-term investments on the balance sheet. Realized and unrealized
gains and losses on such assets are reported in other income on the income
statement. Debt and equity securities that Key has not classified as investment
securities or trading account assets are classified as securities available for
sale and, as such, are reported at fair value, with unrealized gains and losses,
net of income taxes, reported as a component of shareholders' equity. Gains and
losses from sales of securities available for sale are computed using the
specific identification method and included in net securities gains (losses) on
the income statement.
The amortized cost, unrealized gains and losses and approximate fair value of
securities were as follows:
June 30, 1998
-------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
in millions Cost Gains Losses Value
- -----------------------------------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 143 $ 2 -- $ 145
States and political subdivisions 76 1 -- 77
Collateralized mortgage obligations 3,182 20 $ 1 3,201
Other mortgage-backed securities 2,564 43 4 2,603
Retained interests in securitizations 409 -- 27 382
Other securities 61 13 -- 74
- -----------------------------------------------------------------------------------------------------------------------
Total securities available for sale $6,435 $79 $32 $6,482
====== === === ======
INVESTMENT SECURITIES
States and political subdivisions $ 762 $28 -- $ 790
Other securities 276 -- -- 276
- -----------------------------------------------------------------------------------------------------------------------
Total investment securities $1,038 $28 -- $1,066
====== === ======
- -----------------------------------------------------------------------------------------------------------------------
December 31, 1997
-------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
in millions Cost Gains Losses Value
- -----------------------------------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 202 $ 2 -- $ 204
States and political subdivisions 52 -- -- 52
Collateralized mortgage obligations 4,045 9 $ 3 4,051
Other mortgage-backed securities 2,908 53 10 2,951
Retained interests in securitizations 418 -- 44 374
Other securities 75 1 -- 76
- -----------------------------------------------------------------------------------------------------------------------
Total securities available for sale $7,700 $65 $57 $7,708
====== === === ======
INVESTMENT SECURITIES
States and political subdivisions $ 973 $32 -- $1,005
Other securities 257 -- -- 257
- -----------------------------------------------------------------------------------------------------------------------
Total investment securities $1,230 $32 -- $1,262
====== === === ======
- -----------------------------------------------------------------------------------------------------------------------
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June 30, 1997
-------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
in millions Cost Gains Losses Value
- -----------------------------------------------------------------------------------------------------------------------
SECURITIES AVAILABLE FOR SALE
U.S. Treasury, agencies and corporations $ 499 $ 2 $ 3 $ 498
States and political subdivisions 48 1 1 48
Collateralized mortgage obligations 3,559 4 23 3,540
Other mortgage-backed securities 3,336 39 36 3,339
Retained interests in securitizations 289 -- 53 236
Other securities 65 1 -- 66
- -----------------------------------------------------------------------------------------------------------------------
Total securities available for sale $7,796 $47 $116 $7,727
====== === ==== ======
INVESTMENT SECURITIES
States and political subdivisions $1,209 $33 $ 1 $1,241
Other securities 275 -- -- 275
- -----------------------------------------------------------------------------------------------------------------------
Total investment securities $1,484 $33 $ 1 $1,516
====== === ==== ======
- -----------------------------------------------------------------------------------------------------------------------
5. LOANS
Loans, net of unearned income, are summarized as follows:
June 30, December 31, June 30,
in millions 1998 1997 1997
- -----------------------------------------------------------------------------------
Commercial, financial and agricultural $15,595 $14,023 $13,495
Real estate-- commercial mortgage 7,017 6,952 7,185
Real estate-- construction 2,841 2,231 1,935
Commercial lease financing 4,803 4,439 2,714
- ----------------------------------------------------------------------------------
Total commercial loans 30,256 27,645 25,329
Real estate-- residential mortgage 5,508 6,204 6,130
Home equity 6,183 5,421 5,274
Credit card 1,451 1,521 1,785
Consumer--direct 2,084 1,739 2,312
Consumer--indirect 8,813 7,989 8,147
- ----------------------------------------------------------------------------------
Total consumer loans 24,039 22,874 23,648
Loans held for sale 3,474 2,861 2,667
- ----------------------------------------------------------------------------------
Total loans $57,769 $53,380 $51,644
======= ======= =======
- ----------------------------------------------------------------------------------
Portfolio interest rate swaps are used to manage interest rate risk by modifying
the repricing and maturity characteristics of certain loans. Additional
information pertaining to the notional amount, fair value and weighted average
rate of such swaps as of June 30, 1998, is presented in Note 10, Financial
Instruments with Off-Balance Sheet Risk, beginning on page 15.
11
12
Changes in the allowance for loan losses are summarized as follows:
Three months Six months
ended June 30, ended June 30,
-------------- --------------
in millions 1998 1997 1998 1997
- -----------------------------------------------------------------------------------
Balance at beginning of period $ 900 $ 870 $ 900 $ 870
Charge-offs (97) (88) (197) (177)
Recoveries 25 23 48 45
- -----------------------------------------------------------------------------------
Net charge-offs (72) (65) (149) (132)
Provision for loan losses 72 75 149 142
- -----------------------------------------------------------------------------------
Balance at end of period $ 900 $ 880 $ 900 $ 880
===== ===== ===== =====
- -----------------------------------------------------------------------------------
6. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS
At June 30, 1998, impaired loans totaled $200 million. Included in this amount
are $86 million of impaired loans for which the specifically allocated allowance
for loan losses is $23 million, and $114 million of impaired loans which are
carried at their estimated fair value without a specifically allocated allowance
for loan losses. At the end of the prior year, impaired loans totaled $196
million, of which $91 million had a specifically allocated allowance of $26
million and $105 million were carried at their estimated fair value. The average
investment in impaired loans for the second quarter of 1998 and 1997 was $181
million and $191 million, respectively.
Nonperforming assets were as follows:
June 30, December 31, June 30,
in millions 1998 1997 1997
- ---------------------------------------------------------------------------------------------
Impaired loans $200 $196 $188
Other nonaccrual loans 174 185 184
- ---------------------------------------------------------------------------------------------
Total nonperforming loans 374 381 372
Other real estate owned ("OREO") 62 66 68
Allowance for OREO losses (23) (21) (9)
- ---------------------------------------------------------------------------------------------
OREO, net of allowance 39 45 59
Other nonperforming assets 4 5 2
- ---------------------------------------------------------------------------------------------
Total nonperforming assets $417 $431 $433
==== ==== ====
- ---------------------------------------------------------------------------------------------
Impaired loans are evaluated individually. The fair value of collateral, if any,
or estimates of the present value of the estimated future cash flows on the loan
are used to determine the extent of impairment. When such amounts do not support
the carrying amount of the loan, the amount which management deems uncollectible
is charged to the allowance for loan losses. In instances where collateral or
other sources of repayment are sufficient, yet uncertainty exists regarding the
ultimate repayment, an allowance is specifically allocated for in the allowance
for loan losses.
Key excludes smaller-balance, homogeneous nonaccrual loans (shown in the
preceding table as "Other nonaccrual loans") from impairment evaluation.
Generally, this portfolio includes loans to finance residential mortgages,
automobiles, recreational vehicles, boats and mobile homes. Key applies
historical loss experience rates to these loans, adjusted based on management's
assessment of emerging credit trends and other factors. The resulting loss
estimates are specifically allocated for by loan type in the allowance for loan
losses.
12
13
7. LONG-TERM DEBT
The components of long-term debt, presented net of unamortized discount where
applicable, were as follows:
June 30, December 31, June 30,
dollars in millions 1998 1997 1997
- ---------------------------------------------------------------------------------------------------------------------------
Senior medium-term notes due through 2005 (1) $ 419 $ 493 $ 493
Subordinated medium-term notes due through 2005 (1) 133 183 183
7.50% Subordinated notes due 2006(2) 250 250 250
6.75% Subordinated notes due 2006(2) 200 200 200
8.125% Subordinated notes due 2002(2) 199 199 199
8.00% Subordinated notes due 2004 125 125 125
8.40% Subordinated capital notes due 1999 (3) 75 75 75
8.404% Notes due through 2001 42 42 49
All other long-term debt(9) 12 14 15
- ---------------------------------------------------------------------------------------------------------------------------
Total parent company(10) 1,455 1,581 1,589
Senior medium-term bank notes due through 2003(4) 4,794 3,103 2,253
Senior euro medium-term bank notes due through 2007(5) 1,364 840 --
6.50% Subordinated remarketable securities due 2027(6) 313 -- --
6.95% Subordinated notes due 2028(6) 300 -- --
7.25% Subordinated notes due 2005(6) 200 200 200
7.85% Subordinated notes due 2002(6) 200 200 200
6.75% Subordinated notes due 2003(6) 200 200 200
7.50% Subordinated notes due 2008(6) 165 165 165
7.125% Subordinated notes due 2006(6) 250 250 250
7.55% Subordinated notes due 2006(6) 75 75 75
7.375% Subordinated notes due 2008(6) 70 70 70
Lease financing debt due through 2003(7) 508 549 --
Federal Home Loan Bank advances due through 2018(8) 263 163 170
All other long-term debt(9) 39 50 10
- ---------------------------------------------------------------------------------------------------------------------------
Total subsidiaries(11) 8,741 5,865 3,593
- ---------------------------------------------------------------------------------------------------------------------------
Total long-term debt $10,196 $7,446 $5,182
======= ====== ======
- ---------------------------------------------------------------------------------------------------------------------------
Portfolio interest rate swaps, caps and floors are used to manage interest rate
risk by modifying the repricing and maturity characteristics of certain
long-term debt. Additional information pertaining to the notional amount, fair
value and weighted average rate of such financial instruments as of June 30,
1998, is presented in Note 10, Financial Instruments with Off-Balance Sheet
Risk, beginning on page 15.
1 At June 30, 1998, December 31, 1997 and June 30, 1997, the senior
medium-term notes had weighted average interest rates of 6.70%, 6.64%
and 6.63%, respectively, and the subordinated medium-term notes had
weighted average interest rates of 7.09%, 6.90% and 6.87%, respectively.
These notes had a combination of both fixed and floating interest rates.
2 The 7.50%, 6.75% and 8.125% subordinated notes may not be redeemed or
prepaid prior to maturity.
3 The 8.40% subordinated capital notes may, at maturity, be exchanged for
common stock, preferred stock or other eligible securities having a
market value equal to the principal amount of the notes.
4 At June 30, 1998, December 31, 1997 and June 30, 1997, senior
medium-term bank notes of subsidiaries had weighted average interest
rates of 5.74%, 5.51% and 5.82%, respectively. These notes had a
combination of both fixed and floating interest rates.
5 At June 30, 1998 and December 31, 1997, the senior euro medium-term bank
notes had weighted average interest rates of 5.45% and 5.91%,
respectively. These notes are obligations of KeyBank National
Association ("KeyBank N. A.") and had fixed and floating interest rates
based on the three-month London Interbank Offered Rate ("LIBOR"). As of
June 30, 1998, the $5.0 billion Euronote Program had an unused capacity
of $3.6 billion
13
14
6 The subordinated notes and securities are all obligations of KeyBank
N.A., with the exception of the 7.55% note which is an obligation of
KeyBank USA. The notes may not be redeemed prior to their respective
maturity dates. The remarketable securities are mandatorily redeemable
upon the remarketing dates (the first of which is April 15, 2008, with
the others as provided in the offering circular) if they are not
remarketed. If such securities are remarketed, the related interest rate
may be adjusted.
7 At June 30, 1998 and December 31, 1997, lease financing debt had
weighted average interest rates of 7.27% and 7.12%, respectively, and
represented primarily nonrecourse debt collateralized by lease equipment
under operating, direct financing and sales type leases.
8 At June 30, 1998, long-term advances from the Federal Home Loan Bank
("FHLB") had adjustable and fixed interest rates ranging from 5.25% to
12.125%. Real estate loans and securities of $367 million, $218 million
and $228 million at June 30, 1998, December 31, 1997 and June 30, 1997,
respectively, collateralize FHLB advances.
9 Other long-term debt at June 30, 1998, December 31, 1997 and June 30,
1997, consisted of industrial revenue bonds, capital lease obligations
and various secured and unsecured obligations of corporate subsidiaries
and had weighted average interest rates of 8.08%, 8.06% and 10.58%,
respectively.
10 At June 30, 1998, unused capacity under the parent company's shelf
registration totaled $1.3 billion, including $750 million reserved for
future issuance as medium-term notes.
11 As of June 30, 1998, the Bank Note Program had an unused capacity of
$6.1 billion.
8. CAPITAL SECURITIES
The corporation-obligated mandatorily redeemable preferred capital securities of
subsidiary trusts holding solely debentures of the Corporation ("capital
securities") were issued by four business trusts, KeyCorp Institutional Capital
A ("Capital A"), KeyCorp Institutional Capital B ("Capital B"), KeyCorp
Institutional Capital C ("Capital C") and KeyCorp Capital I ("Capital I"), all
of whose common securities are owned by the parent company. Capital A and
Capital B were formed in the fourth quarter of 1996, Capital C was formed in the
second quarter of 1997 and Capital I was formed in the second quarter of 1998.
The proceeds from the issuances of the capital securities and common securities
were used to purchase debentures of the parent company. Capital A, Capital B and
Capital I hold solely junior subordinated deferrable interest debentures of the
parent company. Capital C holds solely coupon adjusted pass-through security
debentures of the parent company. Both the debentures and related income
statement effects are eliminated in Key's financial statements.
The parent company has entered into contractual arrangements which, taken
collectively, fully and unconditionally guarantee payment of: (i) accrued and
unpaid distributions required to be paid on the capital securities; (ii) the
redemption price with respect to any capital securities called for redemption by
the trusts; and (iii) payments due upon a voluntary or involuntary liquidation,
winding-up or termination of the trusts.
The capital securities, common securities and related debentures are summarized
as follows:
Interest Rate Maturity
Principal of Capital of Capital
Capital Common Amount of Securities and Securities and
dollars in millions Securities Securities Debentures Debentures Debentures
(1) (2) (3)
- ---------------------------------------------------------------------------------------------------------------
June 30, 1998
Capital A $350 $11 $361 7.826% 2026
Capital B 150 4 154 8.250 2026
Capital C 250 8 258 6.625 2029
Capital I 247 8 255 6.428 2028
- ----------------------------------------------------------------------------------------------------------
Total $997 $31 $1,028 7.242% --
==== === ======
- ----------------------------------------------------------------------------------------------------------
December 31, 1997 $750 $23 $773 7.510% --
==== === ====
- ----------------------------------------------------------------------------------------------------------
June 30, 1997 $750 $23 $773 7.510% --
==== === ====
- ----------------------------------------------------------------------------------------------------------
1 The capital securities are mandatorily redeemable upon the respective
maturity dates of the debentures or upon earlier redemption as provided
in the indenture. Each issue of capital securities carries an interest
rate identical to that of the respective debenture. The interest rate
related to the capital securities issued by Capital C may be adjusted
upon the remarketing of the capital securities on the coupon adjustment
date (June 1, 1999). The capital securities issued by Capital A, Capital
B and Capital I constitute minority interests in the equity accounts of
consolidated subsidiaries and, therefore, qualify as Tier 1 capital
under Federal Reserve Board Guidelines.
14
15
2 The parent company has the right to redeem the debentures purchased by Capital
A, Capital B, Capital C and Capital I: (i) in whole or in part, on or after
December 1, 2006, December 15, 2006, June 1, 2009 and July 1, 2008,
respectively, (ii) in whole at any time within 90 days following the
occurrence and during the continuation of a tax event or a capital treatment
event (as defined in the applicable offering circular); and (iii) for Capital
C, in whole or in part on the coupon adjustment date. If the debentures
purchased by Capital A, Capital B or Capital C are redeemed prior to maturity,
the redemption price will be expressed as a certain percentage of, or factor
added to, the principal amount, plus any accrued but unpaid interest. If the
debentures purchased by Capital I are redeemed prior to maturity, the
redemption price will be equal to 100% of the principal amount of such
debentures, plus any accrued but unpaid interest.
3 The interest rates for Capital A, Capital B and Capital C are fixed interest
rates. The interest rate for Capital I is a floating interest rate equal to
three-month LIBOR plus 74 basis points and is repriced quarterly. The rates
shown as the total at June 30, 1998, December 31, 1997 and June 30, 1997, are
weighted average rates.
9. SHAREHOLDERS' EQUITY
At the Annual Meeting of Shareholders held May 7, 1998, shareholders increased
the authorized number of Key Common Shares from 900,000,000 to 1,400,000,000
Common Shares. Additionally, on January 15, 1998, the Board voted to cancel and
retire all 1,400,000 authorized shares of Key's 10% Cumulative Preferred Stock,
Class A, none of which were outstanding.
On January 15, 1998, Key announced a two-for-one stock split effected by means
of a 100% stock dividend payable March 6, 1998, to shareholders of record as of
February 18, 1998. Except where express reference is made to Common Shares on a
pre-split basis, all relevant Common Share amounts and per Common Share data in
this report have been adjusted to reflect the split.
10. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
Key, mainly through its lead bank (KeyBank N. A.), is party to various financial
instruments with off-balance sheet risk. It uses these financial instruments in
the normal course of business to meet the financing needs of its customers and
to manage its exposure to market risk. Market risk includes the possibility that
Key's net interest income will be adversely affected as a result of changes in
interest rates or other economic factors. The primary financial instruments used
include commitments to extend credit, standby and commercial letters of credit,
interest rate swaps, caps and floors, futures and foreign exchange forward
contracts. All of the interest rate swaps, caps and floors, and foreign exchange
forward contracts held are over-the-counter instruments. These financial
instruments may be used for lending-related, asset and liability management and
trading purposes, as discussed in the remainder of this note. In addition to the
market risk inherent in the use of these financial instruments, each contains an
element of credit risk. Credit risk is the possibility that Key will incur a
loss due to a counterparty's failure to meet its contractual obligations.
FINANCIAL INSTRUMENTS HELD OR ISSUED FOR LENDING-RELATED PURPOSES
These instruments involve, to varying degrees, credit risk in addition to
amounts recognized in Key's balance sheet. Key mitigates its exposure to credit
risk through internal controls over the extension of credit. These controls
include the process of credit approval and review, the establishment of credit
limits and, when deemed necessary, securing collateral.
Key's commitments to extend credit are agreements with customers to provide
financing at predetermined terms as long as the customer continues to meet
specified criteria. Loan commitments serve to meet the financing needs of
customers and generally carry variable rates of interest, have fixed expiration
dates or other termination clauses, and may require the payment of fees. Since
the commitments may expire without being drawn upon, the total amount of the
commitments does not necessarily represent the future cash outlay to be made by
Key. The credit-worthiness of each customer is evaluated on a case-by-case
basis. The estimated fair values of these commitments and standby letters of
credit discussed below are not material. Key does not have any significant
concentrations of credit risk.
Standby letters of credit enhance the credit-worthiness of Key's customers by
assuring the customers' financial performance to third parties in connection
with specified transactions. Amounts drawn under standby letters of credit
generally carry variable rates of interest, and the credit risk involved is
essentially the same as that involved in the extension of loan facilities.
15
16
The following is a summary of the contractual amount of each class of
lending-related off-balance sheet financial instrument outstanding wherein Key's
maximum possible accounting loss equals the contractual amount of the
instruments.
June 30, December 31, June 30,
in millions 1998 1997 1997
- ----------------------------------------------------------------------------------------------------
Loan commitments:
Credit card lines $ 6,849 $ 8,205 $ 8,259
Home equity 4,528 3,977 3,538
Commercial real estate and construction 1,487 1,073 2,313
Commercial and other 20,751 15,867 11,982
- ----------------------------------------------------------------------------------------------------
Total loan commitments 33,615 29,122 26,092
Other commitments:
Standby letters of credit 1,529 1,431 1,440
Commercial letters of credit 180 109 130
Loans sold with recourse 24 27 202
- ----------------------------------------------------------------------------------------------------
Total loan and other commitments $35,348 $30,689 $27,864
======= ======= =======
- ----------------------------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS HELD OR ISSUED FOR ASSET AND LIABILITY MANAGEMENT
PURPOSES
Key manages its exposure to interest rate risk, in part, by using off-balance
sheet financial instruments, commonly referred to as derivatives. Instruments
used for this purpose modify the repricing or maturity characteristics of
specified on-balance sheet assets and liabilities. The instruments must be both
effective at reducing the risk associated with the exposure being managed, and
designated as a risk management transaction at the inception of the derivative
contract. In addition, to be considered effective, a high degree of interest
rate correlation must exist between the derivative and the specified assets or
liabilities being managed at inception and over the life of the derivative
contract. Primary among the financial instruments used by Key to manage exposure
to interest rate risk are interest rate swaps, caps and floors, otherwise
referred to as portfolio swaps, caps and floors.
The following table summarizes the notional amount, fair value, maturity,
weighted average rate received and paid, and weighted average strike price for
the various types of portfolio swaps, caps and floors used by Key.
June 30, 1998
----------------------------------------------------------------------
Notional Fair Maturity Weighted Average Rate
---------------------------------
dollars in millions Amount Value (Years) Receive Pay
- -----------------------------------------------------------------------------------------------------------------------------------
Interest rate swaps:
Receive fixed/pay variable-indexed amortizing(1) $ 1,654 $ 10 1.0 6.82% 5.69%
Receive fixed/pay variable-conventional 4,197 131 5.5 6.60 5.74
Pay fixed/receive variable-conventional 3,846 (21) 2.9 5.74 6.16
Pay fixed/receive variable-forward starting 577 (2) 4.4 5.83 5.99
Basis swaps 1,804 (3) 2.4 5.39 5.66
- ----------------------------------------------------------------------------------------------------------------------------------
Total 12,078 115 -- 6.14% 5.87%
Interest rate caps, collars and corridors:
Caps purchased - one to three month LIBOR based(2) 3,445 9 1.4 N/A N/A
Collars - one to three month LIBOR based 350 -- 3.9 N/A N/A
Collar - thirty year US Treasury based 250 (17) 0.9 N/A N/A
1% payout corridor (3) 200 -- 1.4 N/A N/A
- ----------------------------------------------------------------------------------------------------------------------------------
Total 4,245 (8) -- -- --
- ----------------------------------------------------------------------------------------------------------------------------------
Total $16,323 $ 107 -- -- --
======= =======
- ----------------------------------------------------------------------------------------------------------------------------------
June 30, 1998 December 31, 1997
--------------------- -------------------------
Weighted Average Rate
--------------------- Notional Fair
dollars in millions Strike Amount Value
- -------------------------------------------------------------------------------------------------------------
Interest rate swaps:
Receive fixed/pay variable-indexed amortizing(1) N/A $ 3,449 $ 12
Receive fixed/pay variable-conventional N/A 3,626 100
Pay fixed/receive variable-conventional N/A 2,990 (7)
Pay fixed/receive variable-forward starting N/A -- --
Basis swaps N/A 1,110 (3)
- -------------------------------------------------------------------------------------------------------------
Total -- 11,175 102
Interest rate caps, collars and corridors:
Caps purchased - one to three month LIBOR based(2) 5.79 % 2,845 11
Collars - one to three month LIBOR based 4.75 and 6.50 100 --
Collar - thirty year US Treasury based 6.02 and 8.21 250 (15)
1% payout corridor (3) 6.00 to 7.00 200 1
- -------------------------------------------------------------------------------------------------------------
Total -- 3,395 (3)
- -------------------------------------------------------------------------------------------------------------
Total -- $14,570 $ 99
======= ======
- -------------------------------------------------------------------------------------------------------------
1 Maturity is based upon expected average lives rather than contractual
terms.
2 Includes $800 million and $1.0 billion of forward starting caps as of
June 30, 1998 and December 31, 1997, respectively.
3 Payout is indexed to three-month LIBOR.
N/A = Not Applicable
Interest rate swap contracts involve the exchange of interest payments
calculated based on an agreed-upon amount (notional amount) and are generally
used to mitigate Key's exposure to interest rate risk on certain loans,
deposits, short-term borrowings and long-term debt. Interest rate caps and
floors involve the payment of a premium by the
16
17
buyer to the seller for the right to receive an interest differential equal to
the difference between the current interest rate and an agreed-upon interest
rate ("strike rate") applied to a notional amount. With respect to interest rate
caps and floors, Key generally purchases caps, enters into collars (a
combination of simultaneously purchasing a cap and selling a floor), and enters
into corridors (a combination of simultaneously purchasing a cap at a specified
strike price and selling a cap at a higher strike price); these instruments are
used to manage the risk of adverse movements in interest rates on specified
long-term debt and short-term borrowings. The notional amount associated with
the execution of swaps, caps and floors is significantly greater than the amount
at risk.
Credit risk on swaps, caps and floors results from the possibility that the
counterparty will not meet the terms of the contract and is measured as the cost
of replacing, at current market rates, contracts in an unrealized gain position.
Key deals exclusively with counterparties with high credit ratings. With regard
to its swap contracts, Key enters into bilateral collateral arrangements and
generally arranges master netting agreements. These agreements include legal
rights of setoff that provide for the net settlement of the subject contracts
with the same counterparty in the event of default. In addition, the credit risk
exposure to the counterparty on each interest rate swap is monitored by a credit
committee. Based upon credit reviews of the counterparties, limits on the total
credit exposure Key may have with each counterparty and the amount of collateral
required, if any, are determined. Although Key is exposed to credit-related
losses in the event of nonperformance by the counterparties, based on
management's assessment as of June 30, 1998, all counterparties were expected to
meet their obligations. At June 30, 1998, Key had 40 different counterparties to
portfolio swaps and swaps entered into to offset the risk of customer swaps. Key
had aggregate credit exposure of $113 million to 18 of these counterparties,
with the largest credit exposure to an individual counterparty amounting to $27
million. As of the same date, Key's aggregate credit exposure on its interest
rate caps and floors totaled $10 million. Portfolio swaps (including the impact
of both the spread on the swap portfolio and the amortization of deferred gains
and losses resulting from terminated swaps) and portfolio caps and floors
increased net interest income by $9 million in the second quarter of 1998 and
$19 million in the second quarter of 1997.
Conventional interest rate swap contracts involve the receipt of amounts based
on a fixed or variable rate in exchange for payments based on variable or fixed
rates, without an exchange of the underlying notional amount. Under an indexed
amortizing swap contract, the notional amount remains constant for a specified
period of time after which, based upon the level of an index at each review
date, the swap contract will mature, the notional amount will begin to amortize,
or the swap will continue in effect until its contractual maturity. Otherwise,
the characteristics of these swaps are similar to those of conventional swap
contracts. At June 30, 1998, Key was party to $525 million and $1.1 billion of
indexed amortizing swaps that used a LIBOR index and a Constant Maturity
Treasuries ("CMT") index, respectively, for the review date measurement. Under
basis swap contracts, interest payments based on different floating indices are
exchanged.
Based on the weighted average rates in effect at June 30, 1998, the spread on
portfolio swaps, excluding the amortization of net deferred gains on terminated
swaps, provided a positive impact on net interest income (since the weighted
average rate received exceeded the weighted average rate paid by 27 basis
points). The aggregate fair value of $115 million at the same date was derived
through the use of discounted cash flow models, which contemplate interest rates
using the applicable forward yield curve, and represents an estimate of the
unrealized gain that would be recognized if the portfolio were to be liquidated
at that date.
Interest from portfolio swaps is recognized on an accrual basis over the lives
of the respective contracts as an adjustment of the interest income or expense
of the asset or liability whose risk is being managed. Gains and losses realized
upon the termination of interest rate swaps prior to maturity are deferred as an
adjustment to the carrying amount of the asset or liability. The deferred gain
or loss is amortized using the straight-line method over the shorter of the
projected remaining life of the related contract at its termination or the
underlying asset or liability. During the first six months of 1998, swaps with a
notional amount of $268 million were terminated, resulting in a net deferred
loss of $1 million. During the same period last year, swaps with a notional
amount of $200 million were terminated, resulting in no deferred gain or loss.
At June 30, 1998, Key had a net deferred swap gain of $13 million with a
weighted average life of 4.9 years related to the management of debt and a net
deferred loss of $1 million with a weighted average life of 3.7 years related to
the management of loans.
In addition to interest rate swaps, caps and floors, Key uses treasury-based
interest rate locks as a component of its interest rate risk management
strategy. These rate locks are being used to reduce the price risk related to
the anticipated securitization of certain indirect consumer loans. At June 30,
1998, the rate locks had a notional amount of $705 million, a weighted average
maturity of less than one month and a negative fair value of ($5) million.
17
18
FINANCIAL INSTRUMENTS HELD OR ISSUED FOR TRADING PURPOSES
Key also uses interest rate swaps, caps and floors, and futures contracts for
dealer activities (which are generally limited to the banks' commercial loan
customers) and enters into other positions with third parties that are intended
to mitigate the interest rate risk of the customer positions. Interest rate swap
contracts entered into with customers are typically limited to conventional
swaps, as previously described. The customer swaps, caps and floors, and
futures, as well as the third-party positions, are recorded at their estimated
fair values, and adjustments to fair value are included in investment banking
and capital markets income on the income statement.
Foreign exchange forward contracts are used by Key to accommodate the business
needs of its customers and for proprietary trading purposes. These contracts
provide for the delayed delivery or purchase of foreign currency. The foreign
exchange risk associated with such contracts is mitigated by entering into other
foreign exchange contracts with third parties. Adjustments to the fair value of
all such foreign exchange forward contracts are included in investment banking
and capital markets income on the income statement.
Key also enters into treasury options and treasury futures options for
proprietary trading purposes. Adjustments to the fair value of all such options
are included in investment banking and capital markets income on the income
statement.
At June 30, 1998, credit exposure from financial instruments held or issued for
trading purposes was limited to the aggregate fair value of each contract with a
positive fair value, or $257 million. The risk of counterparties defaulting on
their obligations is monitored on an ongoing basis. Key contracts with
counterparties with high credit ratings and enters into master netting
agreements when possible in an effort to manage credit risk.
Trading income recognized on interest rate, foreign exchange forward and
treasury-based option contracts totaled $32 million, $10 million and $3 million,
respectively, for the first six months of 1998 and $14 million, $8 million and
zero, respectively, for the first six months of 1997.
A summary of the notional amount and the respective fair value of derivative
financial instruments held or issued for trading purposes at June 30, 1998, and
on average for the six-month period then ended, is presented below. The positive
fair values represent assets to Key and are recorded in other assets, while the
negative fair values represent liabilities and are recorded in other liabilities
on the balance sheet. The $13.5 billion notional amount of customer swaps
presented in the table includes $6.3 billion of interest rate swaps that receive
a fixed rate and pay a variable rate, $4.4 billion of interest rate swaps that
pay a fixed rate and receive a variable rate and $2.8 billion of basis swaps. As
of June 30, 1998, these swaps had an average expected life of 6.5 years, carried
a weighted average rate received of 6.40% and had a weighted average rate paid
of 6.26%.
June 30, 1998 Six months ended June 30, 1998
------------------------- ---------------------------------------------
Notional Fair Average Average
in millions Amount Value Notional Amount Fair Value
- ------------------------------------------------------------------------------------------------------------------------
Interest rate contracts:
Swap assets $ 9,073 $ 183 $8,514 $ 160
Swap liabilities 4,470 (102) 3,995 (89)
Caps and floors purchased 401 1 725 1
Caps and floors sold 564 (1) 896 (1)
Futures purchased 584 3 482 1
Futures sold 10,107 (8) 7,791 (5)
Foreign exchange forward contracts:
Assets 1,091 29 979 25
Liabilities 868 (27) 908 (24)
Treasury-based option contracts:
Options purchased 4,610 41 3,869 31
Options sold 4,805 (40) 3,955 (32)
- --------------------------------------------------------------------------------------------------------------------------
18
19
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
Shareholders and Board of Directors
KeyCorp
We have reviewed the unaudited condensed consolidated balance sheets of KeyCorp
and subsidiaries ("Key") as of June 30, 1998 and 1997, and the related condensed
consolidated statements of income for the three- and six-month periods then
ended, and the condensed consolidated statements of changes in shareholders'
equity and cash flow for the six-month periods ended June 30, 1998 and 1997.
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 generally accepted auditing standards, 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 generally accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of Key as of December 31, 1997, 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, 1998, 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, 1997,
is fairly stated, in all material respects, in relation to the consolidated
balance sheet from which it has been derived.
/s/ Ernst & Young LLP
Cleveland, Ohio
July 14, 1998
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KEYCORP AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
INTRODUCTION
This section of the report, including the highlights summarized below, provides
a discussion and analysis of the financial condition and results of operations
of Key for the periods presented. It should be read in conjunction with the
unaudited consolidated interim financial statements and notes thereto, presented
on pages 3 through 18.
This report contains forward-looking statements which are subject to numerous
assumptions, risks and uncertainties. Statements pertaining to future periods
are subject to uncertainty because of the possibility of changes in underlying
factors and assumptions. Actual results could differ materially from those
contained in or implied by such forward-looking statements for a variety of
factors including: sharp and/or rapid changes in interest rates; significant
changes in the economic scenario from the current anticipated scenario which
could materially change anticipated credit quality trends and the ability to
generate loans; significant delay in or inability to execute strategic
initiatives designed to grow revenues and/or manage expenses; consummation of
significant business combinations or divestitures; unforeseen business risks
related to Year 2000 computer systems issues; and significant changes in
accounting, tax, or regulatory practices or requirements.
Key's earnings results for the second quarter of 1998 reflected strong growth in
noninterest income, continued growth in commercial loans and strong asset
quality. Growth occurred in nearly all major components of core noninterest
income, achieving a 25% improvement over the year-ago quarter. In addition,
noninterest income in the second quarter of 1998 included $33 million of gains
resulting from the sales of 33 KeyCenters. These sales marked the completion of
the planned divestiture of KeyCenters announced in November 1996 in conjunction
with Key's efforts to streamline operations and to manage operating expenses
more effectively. In total, 150 KeyCenters were sold in this divestiture
program. Commercial loans rose by 19% from the 1997 second quarter, and lower
net charge-offs permitted a reduction in the provision for loan losses.
During the first half of 1998, Key continued to evolve as a bank-based financial
services company by broadening the scope of products and services it offers and
by continuing to reallocate its resources (including those made available or
generated by its above-mentioned divestitures of KeyCenters) to businesses with
higher earnings potential. Specifically, during the first quarter, Key entered
into a joint venture with NOVA, an Atlanta-based company which provides
transaction processing and electronic payment services to merchant clients
nationwide. This joint venture, in which Key retained a 49% interest in its
proprietary merchant processing business, enables Key to participate in the same
business, but with enhanced growth prospects due to NOVA's greater presence and
ability to focus on the business as a niche specialty. Key also capitalized on
its 1997 acquisition of Leasetec by entering into an agreement to form a joint
venture with Compaq Capital Corporation to provide customized equipment leasing
and financing programs to Compaq's customers in the United Kingdom, Europe and
Asia.
In the second quarter, Key announced an agreement under which it will acquire
McDonald, a full-service investment banking and securities brokerage company.
Leveraged by Key's capabilities in technology, marketing and sales, the McDonald
transaction is expected to significantly strengthen Key's product lines which
provide capital markets, investment banking and asset management expertise to
business and private clients. This transaction is expected to close during the
fourth quarter of 1998, pending approval by McDonald's stockholders and certain
regulatory agencies. During the second quarter, Key also acquired an $805
million marine/recreational vehicle installment loan portfolio originated
through another bank's dealer distribution network. Key's marine/recreational
vehicle portfolio, which aggregated $3.3 billion at June 30, 1998, is the
largest such portfolio held by any bank holding company in the United States.
The preceding items are described in greater detail in the remainder of this
discussion and in the notes to the consolidated interim financial statements.
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PERFORMANCE OVERVIEW
The selected financial data set forth in Figure 1 presents certain information
highlighting the financial performance of Key for each of the last five quarters
and the year-to-date periods ended June 30, 1998 and 1997. Each of the items
referred to in this performance overview and in Figure 1 is more fully described
in the following discussion or in the notes to the consolidated interim
financial statements presented on pages 7 through 18. Unless otherwise stated,
all earnings per share data included in this section and throughout the
remainder of this discussion are presented on a diluted basis.
Net income for the second quarter of 1998 reached a record high of $249 million,
up 12% from $223 million in the second quarter of 1997. On a diluted per Common
Share basis, Key's second quarter 1998 earnings were $.56, representing a 10%
increase from $.51 recorded in the year-ago quarter. On an annualized basis, the
return on average equity for the second quarter of 1998 was 18.47%, compared
with 18.85% for the same period last year. The annualized returns on average
total assets were 1.35% and 1.32% for the second quarters of 1998 and 1997,
respectively.
The increase in earnings relative to the second quarter of 1997 resulted from a
$92 million improvement in noninterest income (including a $23 million increase
in gains from branch divestitures) and a slight decline in the provision for
loan losses. These positive factors were partially offset by a $34 million
increase in noninterest expense. Included in noninterest expense in the second
quarter of 1998 were $6 million ($3 million in the second quarter of 1997) of
Year 2000 computer information system compliance expenses and distributions on
capital securities (which more closely resemble interest payments than overhead)
of $14 million and $11 million in the second quarters of 1998 and 1997,
respectively. Excluding these charges, noninterest expense increased by less
than 5% from the second quarter of 1997. Also contributing to the offset of the
growth in noninterest income was an $18 million decrease in taxable-equivalent
net interest income, due to a 50 basis point decline in the net interest margin
which more than offset a $5.5 billion, or 9%, increase in average earning
assets.
For the first half of 1998, earnings were $484 million, or $1.09 per diluted
Common Share, both amounts up 11% from $435 million, or $.98, for the same
period last year. On an annualized basis, the return on average equity for the
first six months of 1998 was 18.36%, compared with 18.46% for the comparable
year-ago period. The annualized returns on average total assets were 1.34% and
1.31% for the first half of 1998 and 1997, respectively. Affecting comparative
results was a $189 million increase in noninterest income (including a $29
million increase in gains from branch divestitures). The positive impact of this
growth was moderated by a $59 million increase in noninterest expense, a $45
million decrease in taxable-equivalent net interest income and a $7 million
increase in the provision for loan losses. Excluding year-to date distributions
on capital securities of $28 million in 1998 and $21 million in 1997, as well as
Year 2000 computer information system compliance expenses of $12 million and $5
million in each respective year, noninterest expense was down $45 million, or
4%, from the first six months of last year.
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FIGURE 1. SELECTED QUARTERLY FINANCIAL DATA
1998 1997 Six months ended June 30,
--------------------- --------------------------------- ---------------------------
dollars in millions, except per
share amounts Second First Fourth Third Second 1998 1997
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FOR THE PERIOD
Interest income $ 1,372 $ 1,327 $ 1,365 $ 1,347 $ 1,295 $ 2,699 $ 2,550
Interest expense 692 663 660 643 599 1,355 1,165
Net interest income 680 664 705 704 696 1,344 1,385
Provision for loan losses 72 77 76 102 75 149 142
Noninterest income 380 356 366 393 288 736 547
Noninterest expense 616 600 630 648 582 1,216 1,157
Income before income taxes 372 343 365 347 327 715 633
Net income 249 235 248 236 223 484 435
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PER COMMON SHARE
Net income $ .57 $ .53 $ .56 $ .54 $ .51 $ 1.10 $ .99
Net income-assuming dilution .56 .53 .56 .53 .51 1.09 .98
Cash dividends .235 .235 .21 .21 .21 .47 .42
Book value at period end 12.55 12.15 11.83 11.55 11.02 12.55 11.02
Market price:
High 44.88 39.25 36.59 32.72 29.22 44.88 29.22
Low 34.44 31.56 28.50 27.63 23.94 31.56 23.94
Close 35.63 37.81 35.41 31.82 27.94 35.63 27.94
Weighted average Common Shares (000) 440,092 438,589 438,746 436,214 437,946 439,345 440,628
Weighted average Common Shares and
potential Common Shares (000) 446,568 444,836 445,152 442,050 442,480 445,707 445,504
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AT PERIOD END
Loans $ 57,769 $ 54,900 $ 53,380 $ 53,676 $ 51,644 $ 57,769 $ 51,644
Earning assets 66,941 64,368 64,246 63,800 61,508 66,941 61,508
Total assets 75,778 73,198 73,699 72,077 69,672 75,778 69,672
Deposits 41,794 41,661 45,073 43,870 44,626 41,794 44,626
Long-term debt 10,196 9,041 7,446 7,567 5,182 10,196 5,182
Shareholders' equity 5,525 5,338 5,181 5,076 4,814 5,525 4,814
Full-time equivalent employees 24,711 24,650 24,595 25,622 25,882 24,711 25,882
Full-service banking offices 962 1,006 1,015 1,088 1,130 962 1,130
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PERFORMANCE RATIOS
Return on average total assets 1.35% 1.32% 1.38% 1.34% 1.32% 1.34% 1.31%
Return on average equity 18.47 18.25 19.16 19.41 18.85 18.36 18.46
Efficiency (1) 58.22 57.39 56.81 56.75 57.66 57.81 58.28
Overhead (2) 37.30 35.36 36.17 37.76 41.02 36.34 42.36
Net interest margin (TE) 4.19 4.23 4.50 4.58 4.69 4.21 4.72
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CAPITAL RATIOS AT PERIOD END
Equity to assets (3) 8.28% 7.98% 7.71% 7.74% 7.63% 8.28% 7.63%
Tangible equity to tangible assets (3) 6.91 6.51 6.21 6.16 6.39 6.91 6.39
Tier 1 risk-adjusted capital 7.15 6.81 6.65 6.73 7.14 7.15 7.14
Total risk-adjusted capital 11.86 11.38 10.83 11.10 11.66 11.86 11.66
Leverage 7.04 6.61 6.40 6.33 6.65 7.04 6.65
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The comparability of the information presented above is affected by certain
acquisitions and divestitures completed by KeyCorp in the time periods
presented. For further information concerning these transactions, refer to Note
2, Mergers, Acquisitions and Divestitures, beginning on page 8.
1 Calculated as noninterest expense (excluding certain nonrecurring
charges and distributions on capital securities) divided by
taxable-equivalent net interest income plus noninterest income
(excluding net securities transactions and gains from branch
divestitures).
2 Calculated as noninterest expense (excluding certain nonrecurring
charges and distributions on capital securities) less noninterest income
(excluding net securities transactions and gains from branch
divestitures) divided by taxable-equivalent net interest income.
3 Excluding certain capital securities receiving Tier 1 treatment, these
ratios at June 30, 1998, are 7.29% and 5.91% respectively; at March 31,
1998, are 7.29% and 5.81%, respectively; at December 31, 1997, are 7.03%
and 5.52%, respectively; at September 30, 1997, are 7.04% and 5.46%,
respectively; and at June 30, 1997, are 6.91% and 5.67%, respectively.
TE = Taxable Equivalent
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CASH BASIS FINANCIAL DATA
The selected financial data presented in Figure 2 presents certain information
highlighting the performance of Key for each of the last five quarters, adjusted
to exclude the amortization of goodwill and other intangibles considered
nonqualifying in regulatory capital computations, and related balances resulting
from business combinations recorded by Key under the purchase method of
accounting. Had these business combinations qualified for accounting under the
pooling of interest method, no intangible assets would have been recorded. Since
the amortization of goodwill and other intangibles does not result in a cash
expense, the economic value to shareholders under either accounting method is
essentially the same. Moreover, such amortization does not impact Key's
liquidity and funds management activities. Cash basis financial data provide an
additional basis for measuring a company's ability to support future growth, pay
dividends and repurchase shares. Cash basis financial data, as defined above and
presented in Figure 2, have not been adjusted to exclude the impact of other
noncash items such as depreciation, provision for loan losses, deferred income
taxes, etc. This is the only section of this report in which Key's financial
results are discussed on a cash basis.
FIGURE 2 CASH BASIS SELECTED FINANCIAL DATA
1998 1997
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dollars in millions, except per share amounts Second First Fourth Third Second
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FOR THE PERIOD
Noninterest expense $ 595 $ 578 $ 611 $ 628 $ 563
Income before income taxes 393 365 384 367 346
Net income 267 254 269 253 239
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PER COMMON SHARE
Net income $ .61 $ .58 $ .61 $ .58 $ .55
Net income - assuming dilution .60 .57 .60 .57 .54
Weighted average Common Shares (000) 440,092 438,589 438,746 436,214 437,946
Weighted average Common Shares and potential
Common Shares (000) 446,568 444,836 445,152 442,050 442,480
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PERFORMANCE RATIOS
Return on average total assets 1.47% 1.45 % 1.52% 1.45% 1.43%
Return on average equity 25.08 25.37 27.07 26.82 25.03
Efficiency(1) 56.19 55.24 55.01 54.81 55.74
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GOODWILL AND NONQUALIFYING INTANGIBLES
Goodwill average balance $ 1,042 $ 1,063 $ 1,083 $ 977 $ 803
Nonqualifying intangibles average balance 96 99 108 106 111
Goodwill amortization (after tax) 15 16 18 14 13
Nonqualifying intangibles amortization (after tax) 3 3 3 3 3
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The comparability of the information presented above is affected by certain
acquisitions and divestitures completed by Key in the time periods presented.
For further information concerning these transactions, refer to Note 3, Mergers,
Acquisitions and Divestitures, beginning on page 8.
1 Calculated as noninterest expense (excluding certain nonrecurring charges, the
amortization of goodwill and nonqualifying intangibles, and distributions on
capital securities) divided by taxable-equivalent net interest income plus
noninterest income (excluding net securities transactions and gains from
branch divestitures).
LINE OF BUSINESS RESULTS
Key's four major lines of business are Key Corporate Capital, Key Consumer
Finance, Key Community Bank and Key Capital Partners ("KCP"). A summary of
financial results and significant performance measures for each major line of
business for the six-month periods ended June 30, 1998 and 1997, is presented in
Figure 3.
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FIGURE 3. LINE OF BUSINESS RESULTS
Six months ended June 30, 1998 Key Key Key Key Key
Corporate Consumer Community Capital Support KeyCorp
dollars in millions Capital Finance Bank Partners & Admin. Consolidated
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SUMMARY OF OPERATIONS
Net interest income (TE) $ 223 $ 272 $ 871 $ (3) $ (1) $ 1,362
Provision for loan losses 17 97 51 -- (16) 149
Noninterest income 33 64 295 302 42 736
Revenue sharing--KCP(1) 52 -- 114 (166) -- --
Noninterest expense 66 152 763 201 34 1,216
Expense sharing--KCP(1) 44 -- 58 (102) -- --
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Income before income taxes (TE) 181 87 408 34 23 733
Allocated income taxes and TE adjustment 68 36 132 13 -- 249
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Net income $ 113 $ 51 $ 276 $ 21 $ 23 $ 484
======= ======= ======= ======= ======= =======
Percent of consolidated net income 23 % 11 % 57 % 4 % 5 % 100 %
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AVERAGE BALANCES
Loans $12,027 $13,575 $29,598 -- -- $55,200
Earning assets 12,134 13,966 37,291 $ 1,473 -- 64,864
Deposits 494 1,085 39,910 3 -- 41,492
Allocated equity 878 1,226 3,033 177 $ 1 5,315
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PERFORMANCE RATIOS
Return on average allocated equity 25.95% 8.39% 18.35% 23.93% N/M 18.36%
Efficiency 35.71 45.24 62.15 74.44 N/M 57.81
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Six months ended June 30, 1997 Key Key Key Key Key
Corporate Consumer Community Capital Support KeyCorp
dollars in millions Capital Finance Bank Partners & Admin. Consolidated
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SUMMARY OF OPERATIONS
Net interest income (TE) $ 164 $ 257 $ 985 $ (2) $ 3 $ 1,407
Provision for loan losses 1 100 41 -- -- 142
Noninterest income 26 52 262 197 10 547
Revenue sharing--KCP(1) 45 -- 80 (125) -- --
Noninterest expense 55 126 789 157 30 1,157
Expense sharing--KCP(1) 38 -- 49 (87) -- --
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Income (loss) before income taxes (TE) 141 83 448 -- (17) 655
Allocated income taxes and TE adjustment 51 33 150 1 (15) 220
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Net income (loss) $ 90 $ 50 $ 298 $ (1) $ (2) $ 435
======= ======= ======= ======= ======= =======
Percent of consolidated net income 21% 12% 68% -- (1)% 100%
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AVERAGE BALANCES
Loans $ 9,355 $12,810 $27,632 -- -- $49,797
Earning assets 9,355 13,034 36,692 $ 590 -- 59,671
Deposits 423 938 42,975 1 -- 44,337
Allocated equity 622 962 3,059 107 -- 4,750
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PERFORMANCE RATIOS
Return on average allocated equity 29.18% 10.69% 19.58% (1.88)% N/M 18.46%
Efficiency 38.30 40.78 61.57 100.00 N/M 58.28
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1 Represents the assignment of KCP revenue and expense to the lines of
business principally responsible for maintaining the relevant customer
relationships (See description of KCP on page 27).
TE = Taxable Equivalent
N/M = Not Meaningful
The financial information discussed in the remainder of this section was derived
from the internal profitability reporting system used by management to monitor
and manage the financial performance of Key. The financial results and
performance measures reported are based on internal management accounting
policies which have been developed so as to enable the results to be compiled on
a consistent basis and to reflect the underlying economics of the businesses.
These policies address the methodologies applied in connection with funds
transfer pricing as well as the allocation of certain costs and capital. Funds
transfer pricing was used in the determination of net interest income by
assigning a standard cost for funds used (or a standard credit for funds
provided) to assets and liabilities based on their maturity, prepayment and/or
repricing characteristics. The net effect of transfer pricing is included in the
Key Community Bank line of business where the securities portfolios are also
maintained. Indirect expenses were allocated based on actual volume measurements
and other criteria, as appropriate. The provision for
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loan losses was allocated in an amount based primarily upon the actual net
charge-offs of each respective line of business, adjusted for loan growth and
changes in risk profile. The level of the consolidated provision for loan losses
was based upon the application of methodologies designed by management to assess
the adequacy of the consolidated allowance by focusing on a number of specific
factors. These factors are more fully discussed in the Asset Quality section of
Key's Annual Report to Shareholders.
Income taxes were allocated based on the statutory Federal income tax rate of
35% (adjusted for tax-exempt income from corporate owned life insurance,
nondeductible goodwill amortization, and tax credits associated with investments
in low-income housing projects) and a blended state income tax rate of 1.8% (net
of the Federal income tax benefit) for the periods presented. Capital was
assigned to each line of business based on management's assessment of economic
risk factors (primarily credit, operating and market risk).
The development and application of these methodologies is a dynamic process.
Accordingly, financial results may be revised periodically to reflect management
accounting enhancements, changes in risk profile or changes in the
organization's structure. Further, unlike financial accounting, there is no
authoritative guidance for management accounting similar to generally accepted
accounting principles. Consequently, reported results are not necessarily
comparable with those presented by other companies. During the first quarter of
1998, Key enhanced its capital allocation process, including the adoption of a
refined methodology for estimating credit risk that applies more detailed risk
factors to loans, considering both their grades and terms. This methodology is
also reflected in the results of operations for the first half of 1997 presented
in Figure 3.
A description of each of Key's major lines of business is presented below.
KEY CORPORATE CAPITAL
Key offers a complete range of financing, transaction processing and financial
advisory services to corporations throughout the country through its Key
Corporate Capital unit. It also operates one of the largest bank-affiliated
equipment leasing companies with operations conducted both domestically and
throughout Europe and Asia. Key Corporate Capital's business units are organized
around specialized industry client segments, inclusive of healthcare,
media/telecommunications, structured finance and commercial real estate. In
serving these targeted segments, Key Corporate Capital provides a number of
specialized services including international banking, corporate finance advisory
services, investment banking and capital markets products through Key Capital
Partners, and 401(k) and trust custody products. Key is also one of the leading
cash management providers in the country.
During the first six months of 1998, Key Corporate Capital contributed
approximately 23% of Key's consolidated earnings with net income of $113
million, resulting in a return on average allocated equity of 25.95%. In the
same period last year, net income was $90 million, or approximately 21% of Key's
consolidated earnings, and the return on average allocated equity was 29.18%.
The increase in earnings relative to the prior year reflected higher net
interest income resulting from a 29% increase in total average loans due in
large part to both commercial lending and lease financing originations, as well
as the impact of the July 1997 acquisition of Leasetec. Also contributing to the
improved earnings performance was a $14 million rise in noninterest income, led
by investment banking and capital markets activities, and trust and asset
management income. The $17 million increase in noninterest expense compared with
that of the first half of 1997 was attributable primarily to Leasetec, which
added approximately $18 million to Key Corporate Capital's operating costs,
while also adding $28 million to total revenue. The $16 million increase in the
provision for loan losses from the first six months of 1997 was made in
precautionary response to strong loan growth.
KEY CONSUMER FINANCE
Key Consumer Finance is responsible for Key's indirect, non-branch-based
consumer loan and deposit products. This line of business specializes in credit
cards, automobile loans and leases, marine and recreational vehicle loans,
education loans, home equity loans and branchless deposit-generating activities.
As of December 31, 1997, based on the volume of loans generated, Key Consumer
Finance was the third largest education lender in the nation, ranked in the top
ten in retail automobile financing and was one of the leading providers of
financing for consumer purchases of marine and recreational vehicles.
For the first six months of 1998, Key Consumer Finance generated net income of
$51 million, or approximately 11% of Key's consolidated earnings, and a return
on average allocated equity of 8.39%. In
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the comparable prior year period, net income was $50 million, representing
approximately 12% of Key's consolidated earnings, and the return on average
allocated equity was 10.69%. Primary factors affecting financial performance
relative to the prior year were higher levels of net interest income and
noninterest income and a lower provision for loan losses resulting from improved
credit quality, offset by growth in noninterest expense. Net interest income
rose by $15 million due to the growth in loans which more than offset the impact
of a lower net interest margin. The growth in loans included the April 1998
acquisition of an $805 million marine/recreational vehicle installment loan
portfolio, giving Key one of the largest such portfolios in the United States.
Both loan growth and the net interest margin were adversely affected by the
fourth quarter 1997 securitization of $949 million of prime credit automobile
loans with low returns on equity, and the sale of the credit card receivables
discussed below. The automobile loan securitization is consistent with Key's
goal of divesting assets which do not support its return on equity objective.
The $12 million increase in noninterest income was attributable primarily to
loan securitization servicing fees. This reflected substantial growth in
securitized loans which are serviced by Key to $4.3 billion at June 30, 1998,
from $2.8 billion a year ago. The increase in noninterest income was moderated
by a decline in credit card fees which resulted from the sale of $365 million of
out-of-franchise credit card receivables during the first and third quarters of
1997. The August 1997 acquisition of Champion accounted for $18 million of the
$27 million increase in total revenue, while adding $33 million of noninterest
expense in the first half of 1998. Champion's revenues, unlike its noninterest
expenses, have tended to fluctuate directly with new securitizations. No
securitizations were done in Key Consumer Finance, including Champion, during
the first six months of 1998. Due to their attractive yield and risk
characteristics, management currently intends to retain, for Key's balance
sheet, most of Champion's loan originations. This may be expected, over time, to
lead to less fluctuation in Champion's revenues.
Legislation adopted by Congress in 1993 provided that, effective July 1, 1998,
the interest rates that financial institutions may earn from certain Federal
government-guaranteed education loans would be based on a blended long-term
interest rate plus 1%, rather than the basis in effect prior to the scheduled
change; the 91-day Treasury bill rate plus 2.5% (during in-school periods) and
3.1% (during repayment periods). This would represent a significant reduction in
interest rates based on the current interest rate environment. In May 1998,
Congress approved a temporary measure which provides that the interest rates
that financial institutions may earn from such loans made during the third
quarter of 1998 will be based on the 91-day Treasury bill rate plus 2.2% during
in-school periods and 2.8% during repayment periods. Congress is expected to
enact a long-term resolution to the interest rate structure on Federal
government-guaranteed education loans prior to the end of the year. The outcome
of the final legislation could have a substantial impact on the profitability
and extent of Key's future education lending business. Management is currently
in the process of evaluating the effect of the potential change in legislation
on Key, including alternative lending strategies. Key's Federal
government-guaranteed education loans generated approximately 2% of Key's total
interest on loans recorded during the first six months of 1998.
KEY COMMUNITY BANK
Key Community Bank is responsible for delivering a complete line of branch-based
financial products and services to small businesses, consumers, and commercial
banking and public sector businesses. The delivery of these products and
services is accomplished through 962 KeyCenters, a 24-hour telephone banking
call center services group, nearly 2,600 automated teller machines ("ATMs") that
access 14 different networks and comprise one of the largest ATM networks in the
United States, and a core team of relationship management professionals.
In the first half of 1998, net income for Key Community Bank totaled $276
million, or approximately 57% of Key's consolidated earnings, compared with $298
million, or 68%, respectively, for the first half of 1997. Its return on average
allocated equity was 18.35% in the first six months of 1998 and 19.58% for the
same period last year. The decrease in earnings relative to the prior year
reflected a decline in net interest income and a higher provision for loan
losses, which were substantially offset by growth in noninterest income and a
reduction in noninterest expense. The $114 million decline in net interest
income resulted from a lower net interest margin which more than offset the
benefits derived from a $2.0 billion, or 7%, increase in average loan
outstandings. The lower net interest margin was due to a number of factors,
including greater reliance placed on higher-cost funding to support the
incremental increase in loan portfolios, the reduction in core deposits stemming
from branch divestitures, and changes in the mix and pricing of the remaining
core deposit base in response to customer preferences and competitive pressures.
The $10 million increase in the provision for loan losses reflected both growth
in loans as well as a higher level of net charge-offs. Noninterest income rose
$67 million, or 20%, due in part to the increased focus on and diversification
of fee income sources. The largest contributions to this growth came from trust
and asset management income, investment banking and capital markets income, and
service charges on deposit accounts. Also included in
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first half 1998 noninterest income was a $23 million gain recognized in
connection with the joint venture with NOVA. The $17 million reduction in
noninterest expense was due primarily to lower personnel costs resulting from a
decrease in the employment base as part of Key's consolidation and expense
control initiatives.
During the first half of 1998, strategic developments centered around continued
efforts to reconfigure Key's delivery systems. Specific activities included the
sale of 46 branches in Maine, Idaho, Oregon and Washington, expansion of the ATM
delivery network through the installation of 598 ATMs (representing the progress
made on completing a projected total of 668 installations to occur in ARCO
convenience stores in California, Nevada, Arizona, Washington, and Oregon under
terms of an agreement announced in late 1997), the completion of the merchant
processing joint venture with NOVA and the opening of in-store branches in
Colorado and the New England states.
KEY CAPITAL PARTNERS
Key Capital Partners was formed at the end of 1997 to provide clients with asset
management, investment banking and capital markets, and insurance and brokerage
expertise, and is expected to play a major role in developing fee income through
its broad range of investment choices and customized products. Leveraging Key's
corporate and community banking distribution channels and client relationships
will be an essential factor in ensuring Key Capital Partners' future growth and
success.
As indicated in Figure 3, a significant amount of noninterest income and expense
generated by Key Capital Partners is reported under either Key Corporate Capital
or Key Community Bank. This reflects Key's management accounting practice of
assigning such income and expense to whichever of those two lines of business is
principally responsible for maintaining the relationships with the customers who
also avail themselves of the products and services offered by Key Capital
Partners. On an all-inclusive basis (i.e., prior to the aforementioned
assignments), Key Capital Partners' net income totaled $61 million (representing
13% of Key's consolidated earnings) in the first six months of 1998 and $23
million (representing 5% of Key's consolidated earnings) in the comparable prior
year period. Noninterest income rose $105 million ($64 million after revenue
sharing) from the first six months of last year. The largest contribution to the
improvement came from investment banking and capital markets income which
increased $58 million, or 149%, to $97 million, due to higher revenues from
dealer and trading activities and gains recognized from the sales of equity
capital investments. In addition, revenues related to trust and asset management
activities, which comprise the majority of Key Capital Partners' noninterest
income, rose $29 million, or 23%, to $157 million, reflecting among other
factors the continuing strength of the stock and bond markets. The increase in
noninterest income was partially offset by a $44 million ($29 million after
expense sharing) increase in noninterest expense, primarily personnel expense
which tends to rise with the growth in noninterest income due to incentive
compensation arrangements.
During the second quarter of 1998, Key entered into a definitive agreement to
acquire McDonald, a full-service investment banking and securities brokerage
company based in Cleveland, Ohio. The acquisition is expected to significantly
strengthen all of the individual Key Capital Partners product lines, including
those providing capital markets, investment banking and asset management
expertise to business and private clients on a national basis. With the addition
of McDonald, Key Capital Partners will have a revenue base of nearly $1 billion
along with people, products and resources needed to compete in this growing
segment of the financial services industry. The new Key Capital Partners will
have two major business groups. One group, to be operated under the name
McDonald-Key Investments, will house Key's Section 20 subsidiary and will
include retail and institutional brokerage, equity and fixed income trading and
underwriting, investment banking, capital markets products, loan syndication and
trading, public finance, and clearing operations. The second major business
group will include asset management, mutual funds, institutional asset services,
venture capital, mezzanine finance, alliance funds, wealth management and
insurance. Further information pertaining to the terms of this transaction are
included in Note 3, Mergers, Acquisitions and Divestitures, beginning on page 8.
KEY SUPPORT AND ADMINISTRATION
Key Support and Administration includes activities that are not directly
attributable to one of the four major lines of business. Included in this
category are certain nonbanking affiliates, eliminations of certain intercompany
transactions and certain nonrecurring transactions. Also included are portions
of certain assets, capital and support functions not specifically identifiable
with the four major lines of business. Included in year-to-date results for 1998
and 1997 were gains of $39 million and $10 million, respectively, from the
divestiture of banking offices. These gains are more fully described elsewhere
in this management's discussion.
27
28
RESULTS OF OPERATIONS
NET INTEREST INCOME
Net interest income, which is comprised of interest and loan-related fee income
less interest expense, is the principal source of earnings for Key. Net interest
income is affected by a number of factors including the level, pricing, mix and
maturity of earning assets and interest-bearing liabilities (including
off-balance sheet instruments described in Note 10, Financial Instruments with
Off-Balance Sheet Risk, beginning on page 15), interest rate fluctuations and
asset quality. To facilitate comparisons in the following discussion, net
interest income is presented on a taxable-equivalent basis, which restates
tax-exempt income to an amount that would yield the same after-tax income had
the income been subject to taxation at the statutory Federal income tax rate.
Various components of the balance sheet and their respective yields and rates
which affect interest income and expense are illustrated in Figure 4. The
information presented in Figure 5 provides a summary of the effect on net
interest income of changes in yields/rates and average balances for the
quarterly and year-to-date periods from the same periods in the prior year. A
more in-depth discussion of changes in earning assets and funding sources is
presented in the Financial Condition section beginning on page 37.
For the second quarter of 1998, net interest income was $689 million, down $18
million, or 3%, from the same period last year. This decrease reflected a 50
basis point reduction in the net interest margin to 4.19%, which more than
offset a 9% increase in average earning assets (primarily loans) to $65.8
billion. Compared with the first quarter of 1998, net interest income increased
by $16 million as average earning assets rose by $1.8 billion, while the net
interest margin experienced a decline of only 4 basis points. The 4 basis point
decline was the smallest quarterly change in the net interest margin since the
fourth quarter of 1996. The net interest margin is computed by dividing
annualized taxable-equivalent net interest income by average earning assets.
The decrease in the margin since the year-ago quarter resulted from a number of
factors. Primary among these are the repricing of preexisting loan portfolios in
a period of competitive interest rate spread compression, greater reliance
placed on higher-cost funding to support the incremental increase in loan
portfolios, the reduction in core deposits stemming from branch divestitures,
and changes in the mix and pricing of the remaining core deposit base in
response to customer preferences and competitive pressures. Another factor
contributing to the contraction of the margin was an increase in the cost of
funds associated with the growth in noninterest-earning assets (such as
corporate owned life insurance). The effects of these factors were especially
pronounced during an unusually (by historical standards) prolonged period of
flatness in the yield curve which has prevailed since the third quarter of 1997.
Average earning assets for the second quarter totaled $65.8 billion, which was
$5.5 billion, or 9%, higher than the second quarter 1997 level and $1.8 billion,
or an annualized 11%, above the first quarter of 1998. The growth from the
year-ago quarter reflected a $6.1 billion, or 12%, increase in loans, with
approximately 80% of the increase coming from the commercial portfolio. The
growth in total loans relative to the prior quarter reflected strong commercial
loan growth as well as the acquisition of an $805 million marine/recreational
vehicle installment loan portfolio in April 1998. Key's strategy with respect to
its loan portfolio is discussed in greater detail in the Loan section beginning
on page 37.
Key uses portfolio interest rate swaps, caps and floors (as defined in Note 10)
in the management of its interest rate sensitivity position. The notional amount
of such swaps increased to $12.1 billion at June 30, 1998, from $11.2 billion at
year-end 1997. Over the same period, the notional amount of interest rate caps
and floors rose $850 million to $4.2 billion. For the second quarter of 1998,
interest rate swaps (including the impact of both the spread on the swap
portfolio and the amortization of deferred gains and losses resulting from
terminated swaps) and interest rate caps and floors contributed $9 million and 6
basis points to net interest income and the net interest margin, respectively.
For the same period last year, these instruments increased net interest income
by $19 million and the net interest margin by 13 basis points. The manner in
which interest rate swaps, caps and floors are used in Key's overall program of
asset and liability management is described in the following Asset and Liability
Management section.
28
29
FIGURE 4. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES
Second Quarter 1998 First Quarter 1998
------------------------------------- -----------------------------------
Average Yield/ Average Yield/
dollars in millions Balance Interest Rate Balance Interest Rate
- -----------------------------------------------------------------------------------------------------------------------------
ASSETS
Loans (1,2)
Commercial, financial and agricultural $15,026 $ 309 8.25 $14,066 $ 288 8.30
Real estate -- commercial mortgage 6,944 153 8.84 6,944 156 9.11
Real estate -- construction 2,694 62 9.23 2,347 52 8.99
Commercial lease financing 4,634 86 7.44 4,471 83 7.53
- --------------------------------------------------------------------------------------------------------------------------------
Total commercial loans 29,298 610 8.35 27,828 579 8.44
Real estate -- residential 5,549 121 8.75 5,773 113 7.94
Credit card 1,449 53 14.67 1,482 54 14.78
Other consumer 16,742 367 8.79 15,771 359 9.23
- --------------------------------------------------------------------------------------------------------------------------------
Total consumer loans 23,740 541 9.14 23,026 526 9.26
Loans held for sale 3,403 70 8.25 3,092 63 8.26
- --------------------------------------------------------------------------------------------------------------------------------
Total loans 56,441 1,221 8.68 53,946 1,168 8.78
Taxable investment securities 270 4 5.51 256 3 4.53
Tax-exempt investment securities(1) 871 18 8.29 940 19 8.20
- --------------------------------------------------------------------------------------------------------------------------------
Total investment securities 1,141 22 7.63 1,196 22 7.46
Securities available for sale(1,3) 6,765 117 6.94 7,457 129 7.02
Interest-bearing deposits with banks 22 1 10.33 29 1 12.54
Federal funds sold and securities
purchased under resale agreements 790 10 4.92 912 11 4.89
Trading account assets 610 10 6.42 409 5 4.96
- --------------------------------------------------------------------------------------------------------------------------------
Total short-term investments 1,422 21 5.92 1,350 17 5.11
- --------------------------------------------------------------------------------------------------------------------------------
Total earning assets 65,769 1,381 8.42 63,949 1,336 8.47
Allowance for loan losses (888) (889)
Other assets 9,185 9,062
- --------------------------------------------------------------------------------------------------------------------------------
$74,066 $72,122
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
Money market deposit accounts $11,494 95 3.32 $11,159 90 3.27
Savings deposits 3,307 16 1.94 3,499 18 2.09
NOW accounts 1,250 5 1.60 1,244 5 1.63
Certificates of deposit ($100,000 or more) 3,502 49 5.61 3,362 46 5.55
Other time deposits 12,375 166 5.38 12,716 171 5.45
Deposits in foreign offices 1,095 15 5.49 1,245 17 5.54
- --------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits 33,023 346 4.20 33,225 347 4.24
Federal funds purchased and securities
sold under repurchase agreements 6,773 89 5.27 7,117 93 5.30
Bank notes and other short-term borrowings 7,710 113 5.88 6,683 98 5.95
Long-term debt (4) 9,511 144 6.07 8,326 125 6.09
- --------------------------------------------------------------------------------------------------------------------------------
Total interest-bearing liabilities 57,017 692 4.87 55,351 663 4.86
Noninterest-bearing deposits 8,328 8,409
Other liabilities 2,547 2,390
Capital securities 766 750
Common shareholders' equity 5,408 5,222
- --------------------------------------------------------------------------------------------------------------------------------
$74,066 $72,122
======= =======
Interest rate spread (TE) 3.55 3.61
- --------------------------------------------------------------------------------------------------------------------------------
Net interest income (TE) and net
interest margin (TE) $ 689 4.19% $ 673 4.23%
======= ==== ======= =====
Taxable-equivalent adjustment (1) $9 $9
- -----------------------------------------------------------------------------------------------------------------------------
1 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%.
2 For purposes of these computations, nonaccrual loans are included in the
average loan balances.
3 Yield is calculated on the basis of amortized cost.
4 Rate calculation excludes ESOP debt.
TE = Taxable Equivalent
29
30
Fourth Quarter 1997 Third Quarter 1997 Second Quarter 1997
--------------------------------- --------------------------------- ----------------------------------------
Average Yield/ Average Yield/ Average Yield/
Balance Interest Rate Balance Interest Rate Balance Interest Rate
-----------------------------------------------------------------------------------------------------------------
$13,435 $ 290 8.56% $13,101 $ 286 8.66% $12,844 $ 282 8.81%
7,132 170 9.46 7,088 165 9.24 7,121 165 9.29
2,214 54 9.68 2,015 49 9.65 1,853 45 9.74
4,144 77 7.37 3,820 70 7.27 2,632 42 6.40
-----------------------------------------------------------------------------------------------------------------
26,925 591 8.71 26,024 570 8.69 24,450 534 8.76
6,257 140 8.88 6,161 131 8.44 6,153 127 8.28
1,487 55 14.67 1,788 68 15.09 1,781 66 14.86
15,990 373 9.25 15,926 372 9.27 15,389 356 9.28
-----------------------------------------------------------------------------------------------------------------
23,734 568 9.49 23,875 571 9.49 23,323 549 9.44
2,645 46 6.90 2,809 54 7.63 2,600 50 7.71
-----------------------------------------------------------------------------------------------------------------
53,304 1,205 8.97 52,708 1,195 8.99 50,373 1,133 9.02
243 3 4.90 270 3 5.88 252 3 5.79
1,027 21 8.11 1,143 22 7.64 1,349 27 8.03
-----------------------------------------------------------------------------------------------------------------
1,270 24 7.50 1,413 25 7.02 1,601 30 7.52
7,502 130 6.87 7,399 127 6.86 7,822 136 7.05
34 1 12.31 8 --- 3.94 17 --- 3.66
811 9 4.40 535 6 4.45 337 5 5.95
559 7 4.97 264 5 7.51 143 2 5.61
-----------------------------------------------------------------------------------------------------------------
1,404 17 4.80 807 11 5.41 497 7 5.65
-----------------------------------------------------------------------------------------------------------------
63,480 1,376 8.60 62,327 1,358 8.64 60,293 1,306 8.69
(893) (873) (866)
8,903 8,658 8,351
-----------------------------------------------------------------------------------------------------------------
$ 71,490 $70,112 $67,778
======== ======= =======
$10,883 87 3.17 $10,714 82 3.04 $10,984 83 3.03
3,789 20 2.09 4,161 22 2.10 4,519 25 2.22
1,370 6 1.74 1,547 8 2.05 1,644 9 2.20
3,307 47 5.64 3,166 46 5.76 3,341 47 5.64
13,084 180 5.46 13,389 183 5.42 13,584 181 5.34
1,663 21 5.01 2,065 29 5.57 2,361 33 5.61
-----------------------------------------------------------------------------------------------------------------
34,096 361 4.20 35,042 370 4.19 36,433 378 4.16
7,335 96 5.19 6,939 91 5.20 6,461 84 5.21
5,678 89 6.22 5,001 73 5.79 4,350 64 5.90
7,443 114 6.08 6,879 109 6.33 4,772 73 6.20
-----------------------------------------------------------------------------------------------------------------
54,552 660 4.80 53,861 643 4.74 52,016 599 4.62
8,750 8,551 8,432
2,304 2,125 1,998
750 750 588
5,134 4,825 4,744
-----------------------------------------------------------------------------------------------------------------
$ 71,490 $70,112 $67,778
======== ======= =======
3.80 3.90 4.07
-----------------------------------------------------------------------------------------------------------------
$ 716 4.50% $ 715 4.58% $ 707 4.69%
======= ==== ======= ==== ======== ====
$11 $ 11 $11
------------------------------------------------------------------------------------------------------------------
30
31
FIGURE 5 COMPONENTS OF NET INTEREST INCOME CHANGES
From three months ended June 30, 1997, From six months ended June 30, 1997,
to three months ended June 30, 1998 to six months ended June 30, 1998
--------------------------------- --------------------------------------
Average Yield/ Net Average Yield/ Net
in millions Volume Rate Change Volume Rate Change
- ------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Loans $ 133 $ (45) $ 88 $ 236 $ (77) $ 159
Taxable investment securities -- 1 1 1 -- 1
Tax-exempt investment securities (10) 1 (9) (19) 2 (17)
Securities available for sale (18) (1) (19) (24) -- (24)
Short-term investments 14 -- 14 26 -- 26
- ------------------------------------------------------------------------------------------------------------------
Total interest income (TE) 119 (44) 75 220 (75) 145
INTEREST EXPENSE
Money market deposit accounts 4 8 12 5 16 21
Savings deposits (6) (3) (9) (13) (5) (18)
NOW accounts (2) (2) (4) (4) (4) (8)
Certificates of deposit ($100,000 or more) 2 -- 2 (2) -- (2)
Other time deposits (16) 1 (15) (20) 5 (15)
Deposits in foreign offices (17) (1) (18) (16) -- (16)
- ------------------------------------------------------------------------------------------------------------------
Total interest-bearing deposits (35) 3 (32) (50) 12 (38)
Federal funds purchased and securities sold
under repurchase agreements 4 1 5 5 5 10
Bank notes and other short-term borrowings 49 -- 49 90 -- 90
Long-term debt 72 (1) 71 129 (1) 128
- ------------------------------------------------------------------------------------------------------------------
Total interest expense 90 3 93 174 16 190
- ------------------------------------------------------------------------------------------------------------------
Net interest income (TE) $ 29 $ (47) $ (18) $ 46 $ (91) $ (45)
===== ===== ===== ===== ===== =====
- ------------------------------------------------------------------------------------------------------------------
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.
TE = Taxable Equivalent
ASSET AND LIABILITY MANAGEMENT
Market risk is the exposure to economic loss that arises from changes in the
values of certain market risk sensitive instruments. Types of market risk
include interest rate, foreign exchange and equity price risk; foreign exchange
and equity price risk are not material to Key. Key manages its interest rate
risk through an active program of asset and liability management pursuant to
guidelines established by its Asset/Liability Management Policy Committee
("ALCO"). The ALCO has responsibility for approving the asset/liability
management policies of Key, overseeing the formulation and implementation of
strategies to improve balance sheet positioning and/or earnings, and reviewing
the interest rate sensitivity positions of Key and each of its affiliate banks.
SHORT-TERM INTEREST RATE EXPOSURE
The primary tool utilized by management to measure and manage interest rate risk
is a net interest income simulation model. Use of the model to perform
simulations of changes in interest rates over one- and two-year time horizons
has enabled management to develop strategies for managing exposure to interest
rate risk. In its simulations, management estimates the impact on net interest
income of various pro forma changes in the overall level of interest rates.
These estimates are based on a large number of assumptions related to loan and
deposit growth, asset and liability prepayments, interest rates, on and
off-balance sheet management strategies and other factors. Management believes
that both individually and in the aggregate these assumptions are reasonable,
but the complexity of the simulation modeling process results in a sophisticated
estimate, not a precise calculation of exposure. The ALCO guidelines provide
that a gradual 200 basis point increase or decrease in short-term rates over the
next twelve-month period should not result in more than a 2% impact on net
interest income over the same period from what net interest income would have
been if such interest rates did not change. Based on the results of the
simulation model using the ALCO guidelines, as of June 30, 1998, Key would
expect its net interest income to increase by approximately $19 million if
short-term interest rates gradually decrease. Conversely, if short-term interest
rates gradually increase, net interest income would be expected to decrease by
approximately $20 million. As shown in Figure 6, Key has been operating well
within the above guidelines.
31
32
FIGURE 6 NET INTEREST INCOME AT RISK TO CHANGES IN INTEREST RATES
ESTIMATED CHANGE IN NET INTEREST INCOME
Rise Decline
---- -------
Sep-96 -0.0123 0.0060
Dec-96 -0.0128 0.0071
Mar-97 -0.0128 0.0090
Jun-97 -0.0113 0.0050
Sep-97 -0.0091 0.0024
Dec-97 -0.0107 0.0096
Mar-98 -0.0079 0.0082
Jun-98 -0.0072 0.0067
LONG-TERM INTEREST RATE EXPOSURE
Short-term interest rate risk analysis is complemented by an economic value of
equity model. This model provides the added benefit of measuring exposure to
interest rate changes outside the one- to two-year time frame measured by the
simulation model. The economic value of Key's equity is determined by modeling
the net present value of future cash flows for asset, liability and off-balance
sheet positions based on the implied forward yield curve. Economic value
analysis has several limitations including: the economic values of asset,
liability and off-balance sheet positions do not represent the true fair values
of the positions, since they do not consider factors such as credit risk and
liquidity; estimated cash flows are required for assets and liabilities with
indeterminate maturities; the future structure of the balance sheet derived from
ongoing loan and deposit activity by Key's core businesses is not factored into
present value calculations; and the analysis requires assumptions about events
that span an even longer time frame than that used in the simulation model. The
ALCO guidelines provide that an immediate 200 basis point increase or decrease
in interest rates should not result in more than a 1.75% change in the ratio of
base case economic value of equity to the sum of base case economic value of
assets and net receive fixed interest rate swaps, caps and floors. Key has been
operating well within these guidelines.
MANAGEMENT OF INTEREST RATE EXPOSURE
Key utilizes the results of its short-term and long-term interest rate exposure
models to formulate strategies to improve balance sheet positioning and/or
earnings within interest rate risk, liquidity and capital guidelines established
by the ALCO. In addition to the interest rate exposure measured using ALCO
guidelines, the risk to earnings and economic value arising from various other
pro forma changes in the overall level of interest rates is periodically
measured. The variety of interest rate scenarios modeled, and their impact on
earnings and economic value, quantifies the level of interest rate exposure
arising from several sources, namely option risk, basis risk and gap risk.
Option risk exists in the form of options (including caps and floors) embedded
in certain products. These options permit the customer (either a loan customer
or a depositor) to take advantage of changes in interest rates without penalty.
Examples include floating-rate loans that contain an interest rate cap,
fixed-rate loans that do not contain prepayment penalties and deposits that are
withdrawable on demand. Basis risk refers to floating-rate assets and
floating-rate liabilities that reprice simultaneously, but are tied to different
indices. The risk arises when one index does not move consistently with another.
Gap risk is the risk that assets, liabilities or related interest rate swaps,
caps and floors will mature in different time frames. For example, floating-rate
loans that reprice monthly may be funded with fixed-rate certificates of deposit
that mature in one year.
To manage interest rate risk, management regularly utilizes Key's securities
portfolios, issues debt, and securitizes and sells certain consumer loans. In
addition, management has utilized interest rate swaps, caps and floors to manage
interest rate risk by modifying the repricing or maturity characteristics of
specified on-balance sheet assets and liabilities. Instruments used for this
purpose are designated as portfolio swaps, caps and floors. The decision to use
these instruments versus the on-balance sheet alternatives mentioned above
depends on various factors, including the mix and cost of funding sources,
liquidity and capital requirements. Further details pertaining to portfolio
swaps, caps and floors are included in Note 10, Financial Instruments with
Off-Balance Sheet Risk, beginning on page 15.
In addition to interest rate swaps, caps and floors, Key uses treasury-based
interest rate locks as a component of its interest rate risk management
strategy. These rate locks are being used to reduce the
32
33
price risk related to the anticipated securitization of certain indirect
consumer loans. At June 30, 1998, the rate locks had a notional amount of $705
million, a weighted average maturity of less than one month and a negative fair
value of ($5) million.
PORTFOLIO SWAPS, CAPS AND FLOORS
As shown in Note 10, the estimated fair value of Key's portfolio swaps increased
to $115 million at June 30, 1998, from a fair value of $102 million at December
31, 1997, while the notional amount of such swaps rose $903 million to $12.1
billion. The increase in fair value over the past six months reflected the
combined impact of a number of factors, including the decline in interest rates,
the flattening of the yield curve, and the fact that a greater proportion of
Key's swap portfolio is in a receive fixed interest rate position with a longer
average maturity. Swaps with a notional amount of $268 million were terminated
during the first six months of 1998, resulting in a net deferred loss of $1
million. Further information pertaining to the balance and remaining
amortization period of Key's deferred swap gains and losses at June 30, 1998, is
also presented in Note 10. Each swap termination was made in response to a
unique set of circumstances and for various reasons; however, the decision to
terminate any swap contract is integrated strategically with asset and liability
management and other appropriate processes. During 1997 and continuing through
the first half of 1998, Key increased its use of portfolio caps in response to
its reduced sensitivity to potential declines in interest rates and the heavier
reliance placed on higher cost funding to support earning asset growth. These
instruments are used primarily to protect against the adverse impact that a
future rise in interest rates could have on variable rate short-term borrowings,
while having no impact in the event of a decline in rates. Portfolio swaps, caps
and floors activity for the six-month period ended June 30, 1998, is summarized
in Figure 7.
FIGURE 7 PORTFOLIO SWAPS, CAPS AND FLOORS ACTIVITY
Receive Fixed
---------------------- Pay Fixed- Total Caps
Indexed Pay Fixed- Forward- Basis Portfolio and
in millions Amortizing Conventional Conventional Starting Swaps Swaps Floors Total
- ---------------------------------------------------------------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1997 $ 3,449 $ 3,626 $ 2,990 -- $ 1,110 $11,175 $ 3,395 $14,570
Additions -- 607 1,427 $ 577 894 3,505 950 4,455
Maturities -- 36 571 -- 200 807 100 907
Terminations 268 -- -- -- -- 268 -- 268
Amortization 1,527 -- -- -- -- 1,527 -- 1,527
- ---------------------------------------------------------------------------------------------------------------------------------
BALANCE AT JUNE 30, 1998 $ 1,654 $ 4,197 $ 3,846 $ 577 $ 1,804 $12,078 $ 4,245 $16,323
======= ======= ======= ======= ======= ======= ======= =======
- ---------------------------------------------------------------------------------------------------------------------------------
A summary of the notional amount and fair values of portfolio swaps, caps and
floors by interest rate management strategy is presented in Figure 8. The fair
value at any given date represents the estimated income (if positive) or cost
(if negative) that would be recognized if the portfolios were to be liquidated
at that date. However, because these instruments are used to alter the repricing
or maturity characteristics of specific assets and liabilities, the net
unrealized gains and losses are not recognized in earnings. Rather, interest
from these swaps, caps and floors is recognized on an accrual basis as an
adjustment of the interest income or expense from the asset or liability being
managed.
FIGURE 8 PORTFOLIO SWAPS, CAPS AND FLOORS BY INTEREST RATE MANAGEMENT STRATEGY
June 30, 1998 December 31, 1997 June 30, 1997
-------------------- --------------------- --------------------
Notional Fair Notional Fair Notional Fair
in millions Amount Value Amount Value Amount Value
- -------------------------------------------------------------------------------------------------------------------------------
Convert variable rate loans to fixed $ 3,141 $ 33 $ 4,630 $ 25 $ 5,903 $ (37)
Convert fixed rate loans to variable 592 (16) 160 (1) -- --
Convert variable rate deposits and short-term
borrowings to fixed 2,981 (5) 2,080 (4) 2,582 3
Convert variable rate long-term debt to fixed 850 (2) 750 (2) 500 (1)
Convert fixed rate long-term debt to variable 2,710 108 2,445 87 2,087 12
Basis swaps - foreign currency 304 (3) 280 (3) -- --
Basis swaps - other 1,500 -- 830 -- 600 --
- -------------------------------------------------------------------------------------------------------------------------------
Total portfolio swaps 12,078 115 11,175 102 11,672 (23)
Modify characteristics of variable rate short-term
borrowings 3,430 8 2,580 2 2,424 16
Modify characteristics of variable rate
long-term debt 565 1 565 10 665 7
Modify characteristics of capital securities
remarketing 250 (17) 250 (15) 250 --
- -------------------------------------------------------------------------------------------------------------------------------
Total portfolio caps and floors 4,245 (8) 3,395 (3) 3,339 23
- -------------------------------------------------------------------------------------------------------------------------------
Total portfolio swaps, caps and floors $ 16,323 $ 107 $ 14,570 $ 99 $ 15,011 $ --
======== ======== ======== ======== ======== ========
- -------------------------------------------------------------------------------------------------------------------------------
33
34
The expected average maturities of the portfolio swaps, caps and floors at
June 30, 1998, are summarized in Figure 9.
FIGURE 9 EXPECTED AVERAGE MATURITIES OF PORTFOLIO SWAPS, CAPS AND FLOORS
June 30, 1998 Receive Fixed
------------------------------- Pay Fixed-
Indexed Pay Fixed- Forward- Basis
in millions Amortizing Conventional Conventional Starting Swaps
- ---------------------------------------------------------------------------------------------------------------------
Mature in one year or less -- $ 327 $2,350 -- $ 930
Mature after one through five years $1,654 1,432 1,083 $500 849
Mature after five through ten years -- 2,203 154 18 25
Mature after ten years -- 235 259 59 --
- ---------------------------------------------------------------------------------------------------------------------
Total portfolio swaps, caps and floors $1,654 $4,197 $3,846 $577 $1,804
====== ====== ====== ==== ======
- ---------------------------------------------------------------------------------------------------------------------
June 30, 1998
Total Caps
Portfolio and
in millions Swaps Floors Total
- ------------------------------------------------------------------------------------
Mature in one year or less $ 3,607 $1,120 $ 4,727
Mature after one through five years 5,518 3,125 8,643
Mature after five through ten years 2,400 -- 2,400
Mature after ten years 553 -- 553
- ------------------------------------------------------------------------------------
Total portfolio swaps, caps and floors $12,078 $4,245 $16,323
======= ====== =======
- ------------------------------------------------------------------------------------
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This statement, which will be adopted by
Key as of January 1, 2000, establishes the accounting and reporting standards
for derivatives and requires that all such instruments be recognized in the
balance sheet and measured at fair value. It also disqualifies the use of hedge
accounting for indexed amortizing swaps currently accounted for by Key as
hedging instruments and, therefore, will likely alter Key's use of such
instruments in the future. Key is currently reviewing SFAS No. 133 and has not
yet determined the extent to which the statement will alter its use of certain
derivatives in the future and the impact on its financial condition and results
of operations.
TRADING PORTFOLIO
Key's trading portfolio includes interest rate swap contracts entered into to
accommodate the needs of its customers, and other positions with third parties
that are intended to mitigate the interest rate risk of the customer positions,
foreign exchange contracts entered into to accommodate the needs of its
customers and financial assets and liabilities (trading positions) included in
short-term investments and other liabilities, respectively, on the balance
sheet. Further information pertaining to the off-balance sheet contracts is
included in Note 10, Financial Instruments with Off-Balance Sheet Risk,
beginning on page 15.
During the second half of 1997, Key began using a value at risk ("VAR") model to
estimate the adverse effect of changes in interest and foreign exchange rates on
the fair value of its trading portfolio. VAR uses statistical methods to
estimate the maximum potential one-day loss with a 95% confidence level. At June
30, 1998, Key's aggregate daily VAR was $.9 million and averaged $.7 million for
the first six months of 1998. As of the 1997 year end, Key's aggregate daily VAR
was less than $.8 million and averaged less than $.5 million for the second half
of 1997. VAR augments other controls used by Key to mitigate the market risk
exposure of its trading portfolio. These controls are established by Key's
Financial Markets Committee and include, in addition to VAR, loss and position
equivalent limits which are based on the level of activity and volatility of
trading products and market liquidity.
NONINTEREST INCOME
As shown in Figure 10, noninterest income for the 1998 second quarter totaled
$380 million, up $92 million, or 32%, from the same period last year. Excluding
branch divestiture gains of $33 million and $10 million recorded in the second
quarter of 1998 and 1997, respectively, noninterest income increased by $69
million, or 25%, and comprised 34% of total revenue for the quarter, compared
with 29% in the year-ago quarter. The largest increases came from various
investment banking and capital markets activities (up $29 million) and trust and
asset management income (up $16 million). The increase in investment banking and
capital markets income reflected higher revenues from dealer and trading
activities, as well as increased gains from the sales of equity capital
investments. Growth in trust and asset management income resulted from continued
strong performance of both the stock and bond markets and new business.
Additional detail pertaining to the composition of this noninterest income
component is presented in Figure 11. Key did not execute any loan
securitizations during the 1998 second quarter; the improvement in loan
securitization income came primarily from servicing fees. This reflected growth
in loans securitized and sold, which are either administered or serviced by Key,
to $4.3 billion at June 30, 1998, from $2.8 billion a year ago. Additional
information pertaining to the type and volume of these loans is included in the
Loans section beginning on page 37. The only major category of noninterest
income experiencing a decrease was credit card fees, which declined by $8
million due primarily to the sales of $324 million of Key's credit card
receivables during the third quarter of 1997 and lower merchant services revenue
resulting from the first quarter 1998 joint venture with NOVA, discussed below.
The acquisitions of Leasetec and Champion,
34
35
which were completed during the third quarter of last year, contributed
approximately $6 million to the increase in Key's noninterest income from that
of the second quarter of 1997.
For the first six months of 1998, noninterest income totaled $736 million, up
$189 million, or 35%, from the comparable 1997 period. Excluding gains from
sales of branches/subsidiaries of $62 million and $10 million recorded in the
first half of 1998 and 1997, respectively, noninterest income increased by $137
million, or 26%. The year-to-date increase was also attributable largely to the
growth in investment banking and capital markets income (up $58 million) and
trust and asset management income (up $29 million) as a result of the same
factors described in the preceding paragraph. Leasetec and Champion contributed
approximately $12 million to the increase in Key's noninterest income from that
of the first six months of last year.
Included in 1998 year-to-date gains from the sales of branches/subsidiaries was
$39 million in branch divestiture gains and a $23 million gain recognized in the
first quarter in connection with the joint venture with NOVA. The agreement with
NOVA also specifies that Key can receive additional consideration at the end of
each of the three years through the year 2000, provided that certain
revenue-related performance targets are met. The $23 million gain was
accompanied by related reductions in both merchant services revenue and
noninterest expense (primarily personnel). The NOVA transaction is more fully
disclosed in Note 3, Mergers, Acquisitions and Divestitures, beginning on page
8.
FIGURE 10 NONINTEREST INCOME
Three months ended
June 30, Change
------------------------------- -------------------------------
dollars in millions 1998 1997 Amount Percent
- ------------------------------------------------------------------------------------------------------------------------------
Service charges on deposit accounts $ 75 $ 74 $ 1 1.4%
Trust and asset management income 80 64 16 25.0
Investment banking and capital markets income 50 21 29 138.1
Credit card fees 17 25 (8) (32.0)
Insurance and brokerage income 24 21 3 14.3
Corporate owned life insurance income 24 21 3 14.3
Loan securitization income 8 3 5 166.7
Net securities gains 2 -- 2 N/M
Gains from sales of branches/subsidiaries 33 10 23 230.0
Other income:
Letter of credit and loan fees 14 11 3 27.3
Electronic banking fees 12 10 2 20.0
Mortgage banking income 1 2 (1) (50.0)
Miscellaneous income 40 26 14 53.8
- ------------------------------------------------------------------------------------------------------------------------------
Total other income 67 49 18 36.7
- ------------------------------------------------------------------------------------------------------------------------------
Total noninterest income $380 $288 $92 31.9%
==== ==== ===
- ------------------------------------------------------------------------------------------------------------------------------
Six months ended
June 30, Change
------------------------------- -------------------------------
dollars in millions 1998 1997 Amount Percent
- ----------------------------------------------------------------------------------------------------------------------------
Service charges on deposit accounts $153 $145 $ 8 5.5%
Trust and asset management income 157 128 29 22.7
Investment banking and capital markets income 97 39 58 148.7
Credit card fees 32 48 (16) (33.3)
Insurance and brokerage income 46 42 4 9.5
Corporate owned life insurance income 47 40 7 17.5
Loan securitization income 18 4 14 350.0
Net securities gains 4 -- 4 N/M
Gains from sales of branches/subsidiaries 62 10 52 520.0
Other income:
Letter of credit and loan fees 31 22 9 40.9
Electronic banking fees 21 17 4 23.5
Mortgage banking income 3 4 (1) (25.0)
Miscellaneous income 65 48 17 35.4
- ------------------------------------------------------------------------------------------------------------------------
Total other income 120 91 29 31.9
- ------------------------------------------------------------------------------------------------------------------------
Total noninterest income $736 $547 $189 34.6%
==== ==== ====
- ------------------------------------------------------------------------------------------------------------------------
N/M = Not Meaningful
FIGURE 11 TRUST AND ASSET MANAGEMENT
Three months Six months ended
ended June 30, Change June 30, Change
------------- ------------------ ----------- -------------------
dollars in millions 1998 1997 Amount Percent 1998 1997 Amount Percent
- ---------------------------------------------------------------------------------------------------------------------------------
Personal asset management and custody fees $ 41 $ 35 $ 6 17.1% $ 81 $ 69 $ 12 17.4%
Institutional asset management and custody fees 22 18 4 22.2 43 35 8 22.9
Bond services -- 1 (1) (100.0) -- 4 (4) (100.0)
All other fees 17 10 7 70.0 33 20 13 65.0
- ---------------------------------------------------------------------------------------------------------------------------------
Total trust and asset management income $ 80 $ 64 $ 16 25.0% $157 $128 $ 29 22.7%
==== ==== ==== ==== ==== ====
dollars in billions
- ------------------------------------------------------------------------------------
June 30,
Discretionary assets $ 66 $ 50 $ 16 32.0%
Non-discretionary assets 49 51 (2) (3.9)
- ------------------------------------------------------------------------------------
Total trust assets $115 $101 $ 14 13.9%
==== ==== ====
- ------------------------------------------------------------------------------------
NONINTEREST EXPENSE
As shown in Figure 12, noninterest expense for the second quarter of 1998
totaled $616 million, up $34 million, or 6%, from the second quarter of 1997.
Contributing to the increase in noninterest expense from the year-ago quarter
was $3 million in distributions accrued on capital securities (tax-advantaged
preferred securities) and a $3 million increase in costs incurred in connection
with efforts being undertaken by Key to modify computer information systems to
be Year 2000 compliant. As of June 30, 1998, Key had recognized approximately
$30 million of the estimated $45 to $50 million of expense that it expects to
incur (primarily for internal and external programmers) to substantially
complete this project by the end of
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36
1998. Further information pertaining to the Year 2000 issue is included below.
The capital securities are more fully described in Note 8, Capital Securities,
beginning on page 14. Excluding the above items, noninterest expense was $28
million, or 5%, above the year-ago quarter. The largest increases came from
personnel expense (up $19 million) and marketing expense (up $6 million). The
increase in personnel expense was due largely to the impact of acquisitions
completed in the third quarter of 1997, merit increases which took effect on
April 1, 1998, and higher costs associated with various incentive programs,
including those related to investment banking and capital markets activities.
Marketing expense rose as a result of additional costs incurred by Key to
establish brand identity. The 1997 acquisitions of Leasetec and Champion
accounted for approximately $22 million of the total increase in noninterest
expense from the year-ago quarter.
Noninterest expense totaled $1.2 billion for the first six months of 1998, up
$59 million, or 5%, from the same period last year. Excluding increases of $7
million in both capital securities distributions and Year 2000 expenses,
noninterest expense was up $45 million, or 4%, from the first half of last year.
This reflected higher costs associated with personnel expense (up $23 million),
marketing expense (up $13 million) and professional fees (up $8 million).
Leasetec and Champion contributed approximately $40 million to the increase in
Key's noninterest expense from the first six months of last year.
The efficiency ratio, which provides a measure of the extent to which recurring
revenues are used to pay operating expenses, was 58.22% for the second quarter
compared with 57.66% in the second quarter of 1997 and 57.39% for the prior
quarter. The slight increase from the first quarter of 1998 resulted from the
proportionately greater increase in Key's noninterest expense relative to the
increase in Key's recurring revenues. Included in other expense are equity-and
gross receipts-based taxes which are assessed in lieu of an income tax in
certain states in which Key operates. These taxes, which are shown in Figure 12,
represented 87, 88 and 81 basis points of Key's efficiency ratio for the second
quarter of 1998, the first quarter of 1998 and the second quarter of 1997,
respectively. The extent to which such taxes impact the level of noninterest
expense will vary among companies based on the geographic locations in which
they conduct their business.
YEAR 2000
The Year 2000 issue refers to the fact that many computer systems were
originally programmed using two digits rather than four digits to identify the
applicable year. When the year 2000 occurs, these systems could interpret the
year as 1900 rather than 2000. Unless hardware, system software and applications
are corrected to be Year 2000 compliant, computers and the devices they control
could generate miscalculations and create operational problems. Various systems
could be affected ranging from complex computer systems to telephone systems,
ATMs and elevators.
To address this issue, Key developed an extensive plan, including the formation
of a team consisting of internal resources and third-party experts. The plan,
originally developed in 1995, has been in implementation since that time and has
undergone appropriate modifications as warranted by the related circumstances.
Key prioritized the various operating systems (including those maintained by its
business suppliers) that could be affected by the Year 2000, and efforts to
ensure compliance of core systems deemed critical to Key's operations have been
accelerated. The cost of the project (currently estimated to be $45 to $50
million) and timing of its implementation are based on management's best
estimates, which were derived using numerous assumptions about future events,
including the continued availability of certain resources and other factors.
However, there can be no guarantee that these estimates will be achieved, and
actual results could differ materially from those anticipated. It is currently
expected that approximately $10 million of the estimated $15 to $20 million of
costs yet to be incurred in this project will be recognized during the second
half of 1998 and the remainder in 1999. Key is monitoring the efforts of its
business partners, suppliers and customers involved in addressing the potential
problem on an ongoing basis and expects to complete substantially all of the
necessary work by the end of 1998, allowing 1999 as a year of final testing and
refinement. As of June 30, 1998, compliance efforts had been completed for
approximately 40% of the core systems identified.
In addition, financial institutions may experience increases in problem loans
and credit losses in the event that borrowers fail to properly respond to this
issue, and higher funding costs may come about if consumers react to publicity
about the issue by withdrawing deposits. Key also could be impacted if third
parties it deals with in conducting its business, such as foreign banks,
governmental agencies, clearing houses, telephone companies, and other service
providers, fail to properly address this issue. Accordingly, Key has
36
37
formed a separate internal team charged with the task of identifying critical
business interfaces, assessing potential problems, and where appropriate,
developing contingency plans. Because the Year 2000 issue has never previously
occurred, it is not possible to foresee or quantify the overall financial and
operational impact and/or to determine whether it will be material to the
financial condition or operations of Key.
FIGURE 12 NONINTEREST EXPENSE
Three months ended
June 30, Change
----------------------------------- ------------------------
dollars in millions 1998 1997 Amount Percent
- -------------------------------------------------------------------------------------------------------------------------
Personnel $302 $283 $19 6.7%
Net occupancy 56 54 2 3.7
Equipment 45 44 1 2.3
Amortization of intangibles 22 21 1 4.8
Marketing 28 22 6 27.3
Professional fees 15 13 2 15.4
Other expense:
Distributions on capital securities 14 11 3 27.3
Equity-and gross receipts-based taxes 9 8 1 12.5
OREO expense, net(1) 1 1 -- --
FDIC insurance assessments 1 2 (1) (50.0)
Year 2000 expense 6 3 3 100.0
Miscellaneous 117 120 (3) (2.5)
- -------------------------------------------------------------------------------------------------------------------------
Total other expense 148 145 3 2.1
- -------------------------------------------------------------------------------------------------------------------------
Total noninterest expense $616 $582 $34 5.8%
==== ==== ===
Full-time equivalent employees at period end 24,711 25,882
Efficiency ratio(2) 58.22% 57.66%
Overhead ratio(3) 37.30 41.02
- -------------------------------------------------------------------------------------------------------------------------
Six months ended
June 30, Change
----------------------------------- ------------------------
dollars in millions 1998 1997 Amount Percent
- --------------------------------------------------------------------------------------------------------------------------
Personnel $ 596 $ 573 $23 4.0%
Net occupancy 112 110 2 1.8
Equipment 88 87 1 1.1
Amortization of intangibles 45 42 3 7.1
Marketing 56 43 13 30.2
Professional fees 32 24 8 33.3
Other expense:
Distributions on capital securities 28 21 7 33.3
Equity-and gross receipts-based taxes 18 18 -- --
OREO expense, net(1) 2 2 -- --
FDIC insurance assessments 3 3 -- --
Year 2000 expense 12 5 7 140.0
Miscellaneous 224 229 (5) (2.2)
- ----------------------------------------------------------------------------------------------------------------------------
Total other expense 287 278 9 3.2
- ----------------------------------------------------------------------------------------------------------------------------
Total noninterest expense $1,216 $1,157 $ 59 5.1%
====== ====== ====
Full-time equivalent employees at period end 24,711 25,882
Efficiency ratio(2) 57.81% 58.28%
Overhead ratio(3) 36.34 42.36
- --------------------------------------------------------------------------------------------------------------------------
1 OREO expense is net of income of $1 million for the second quarter of 1998
and 1997.
2 Calculated as noninterest expense (excluding certain nonrecurring charges and
distributions on capital securities) divided by taxable-equivalent net
interest income plus noninterest income (excluding net securities
transactions and gains from branch divestitures).
3 Calculated as noninterest expense (excluding certain nonrecurring charges and
distributions on capital securities) less noninterest income (excluding net
securities transactions and gains from branch divestitures) divided by
taxable-equivalent net interest income.
INCOME TAXES
The provision for income taxes was $123 million for the three-month period ended
June 30, 1998, up from $104 million for the same period in 1997. The effective
tax rate (provision for income taxes as a percentage of income before income
taxes) for the 1998 second quarter was 32.9% compared with 31.8% for the second
quarter of 1997. For the first six months of 1998, the provision for income
taxes was $231 million compared with $198 for the first six months of last year.
The effective tax rate for these periods was 32.3% and 31.3%, respectively.
Primary factors contributing to the increase in the effective tax rate for both
the quarterly and year-to-date periods were a lower proportion of tax-exempt
income to pretax earnings in the current year, and the write-off of
nondeductible goodwill in connection with the 1998 branch divestitures. The
effective income tax rate remains below the statutory Federal rate of 35% due
primarily to continued investment in tax-advantaged assets (such as tax-exempt
securities and corporate owned life insurance) and the recognition of credits
associated with investments in low-income housing projects.
FINANCIAL CONDITION
LOANS
At June 30, 1998, total loans outstanding were $57.8 billion, up from $53.4
billion at December 31, 1997, and $51.6 billion at June 30, 1997. The
composition of the loan portfolio by loan type, as of each of these respective
dates, is presented in Note 5, Loans, beginning on page 11.
The $6.2 billion, or 12%, increase in loans outstanding from the June 30, 1997,
level was due primarily to internal growth, but also included the net impact of
acquisitions, sales and divestitures. During the second quarter of 1998, Key
acquired an $805 million marine/recreational vehicle installment loan portfolio.
This followed the third quarter 1997 acquisitions of Leasetec and Champion,
which added total loans outstanding of approximately $1.0 billion and $225
million, respectively. The sales and divestitures which occurred during 1998 and
1997 are summarized in Figure 13 and included the impact of planned bank and
branch divestitures, as well as the securitization and/or sale of education
loans, automobile loans, certain
37
38
non-prime home equity loans and other loans which do not meet certain return on
equity, credit or other internal standards. Key generally sells or securitizes
education loans when a borrower enters repayment status. In addition, home
equity loans originated by Champion and all non-prime automobile loans were
targeted for securitization in 1997. In addition to bank and branch
divestitures, activity since June 30, 1997, included the sales of $1.1 billion
of education loans (of which $744 million was associated with securitizations),
$1.2 billion of automobile loans, $302 million of home equity loans and $167
million of commercial real estate loans. All of the automobile loan sales and
$205 million of the home equity loan sales were associated with securitizations.
Included in the automobile loan sales was $949 million of prime credit loans
with low returns on equity. This particular portfolio was sold during the fourth
quarter of 1997 in keeping with Key's strategy of divesting assets which do not
support its return on equity objective. Also moderating the increase in total
loans over the past year was the sale of $324 million of out-of-franchise credit
card receivables which had an historically high level of delinquency. Management
will continue to explore opportunities for sales and/or other arrangements with
respect to its credit card and certain other portfolios in efforts to improve
financial returns and manage credit risk over the remainder of 1998.
Excluding the net impact of acquisitions, sales and divestitures, loan
portfolios (other than one-to-four family mortgages and loans held for sale)
increased $6.1 billion, or 14%, since June 30, 1997, and were up $3.8 billion,
or an annualized 17% from the 1997 year end. Key's policy since 1994 regarding
new originations of one-to-four family mortgage loans is to originate such loans
as a customer and community accommodation, but to retain few of such loans on
the balance sheet due to their marginal returns. Over the past year, the largest
increase came from commercial loans which rose by $4.3 billion, due primarily to
higher levels of commercial, financial and agricultural loans (up $2.3 billion),
lease financing receivables (up $1.1 billion) and real estate-construction loans
(up $914 million). Additionally, consumer loans rose by $1.7 billion, and
included increases of $1.0 billion in home equity loans and $735 million in
installment loans.
FIGURE 13 LOANS SOLD AND DIVESTED
Commercial Credit Card
in millions Education Automobile Home Equity Real Estate Receivables All Other Total
- ---------------------------------------------------------------------------------------------------------------------------
1998
- ----------------
Second quarter $ 45 -- $53 $167 -- $124(1) $389
First quarter 71 -- -- -- -- 20(1) 91
- ---------------------------------------------------------------------------------------------------------------------------
$116 -- $53 $167 -- $144 $480
==== === ==== ==== ====
1997
- ----------------
Fourth quarter $ 879 $1,046 $ 44 -- -- $147(1) $2,116
Third quarter 100 112 205 -- $324 491(1) 1,232
Second quarter 52 103 -- -- -- -- 155
First quarter 31 456 -- -- 41 -- 528
- ---------------------------------------------------------------------------------------------------------------------------
Total $1,062 $1,717 $249 -- $365 $638 $4,031
====== ====== ==== ==== ==== ======
- ---------------------------------------------------------------------------------------------------------------------------
1 Part of branch divestures, including the sale of KeyBank Wyoming in the third
quarter of 1997.
The $4.4 billion increase in loans from the December 31, 1997, level also
reflected strong growth in loan portfolios other than one-to-four family
mortgages and loans held for sale. Excluding the second quarter 1998 acquisition
of the marine/recreational installment loan portfolio and the impact of loan
sales and branch divestitures shown in Figure 13, such loans increased $3.8
billion, or an annualized 17%, during the first six months of 1998. Commercial
loans accounted for $2.7 billion of the increase with the largest growth coming
from commercial, financial and agricultural loans (up $1.6 billion) and
construction loans (up $610 million). On the same basis, the aggregate
annualized growth rate of average outstanding balances in the commercial loan
portfolio was 21% for the second quarter of 1998 and exceeded 12% in each of the
prior four quarters. Consumer loans contributed $1.1 billion to the year-to-date
increase in loans, due principally to growth in the home equity portfolio.
Shown in Figure 14 are loans which have been securitized/sold and are either
administered or serviced by Key, but not recorded on its balance sheet. Income
recognized in connection with such transactions is derived from two sources.
Noninterest income earned from servicing or administering the loans is
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recorded as loan securitization income, while income earned on assets retained
in connection with securitizations and accounted for like investments in
interest-only strip securities, is recorded as interest income on securities
available for sale.
FIGURE 14 LOANS SECURITIZED/SOLD AND ADMINISTERED OR SERVICED
June 30, December 31, June 30,
in millions 1998 1997 1997
- -----------------------------------------------------------------------------------------
Education loans $2,438 $2,611 $1,959
Automobile loans 1,299 1,601 846
Home equity loans 567 735 --
- -----------------------------------------------------------------------------------------
Total $4,304 $4,947 $2,805
====== ====== ======
- -----------------------------------------------------------------------------------------
SECURITIES
At June 30, 1998, the securities portfolio totaled $7.5 billion, consisting of
$6.5 billion of securities available for sale and $1.0 billion of investment
securities. This compares with a total portfolio of $8.9 billion, comprised of
$7.7 billion of securities available for sale and $1.2 billion of investment
securities, at December 31, 1997. The composition of the two securities
portfolios by type of security, as of each of these respective dates, is
presented in Note 4, Securities, beginning on page 10. The decrease in
collateralized mortgage obligations and other mortgage backed securities since
the 1997 year end was due primarily to scheduled amortization, as well as
prepayments which occurred in connection with refinancings completed in the
continued low interest rate environment. Certain information pertaining to the
composition, yields, and maturities of the securities available for sale and
investment securities portfolios is presented in Figures 15 and 16,
respectively.
FIGURE 15 SECURITIES AVAILABLE FOR SALE
Other
U.S. Treasury, States and Collateralized Mortgage-
Agencies and Political Mortgage Backed
dollars in millions Corporations Subdivisions Obligations(1) Securities(1)
- --------------------------------------------------------------------------------------------------------------------------
JUNE 30, 1998
Maturity:
One year or less $ 63 $ 1 $ 827 $ 17
After one through five years 41 10 2,291 1,579
After five through ten years 18 58 83 947
After ten years 23 8 -- 60
- --------------------------------------------------------------------------------------------------------------------------
Fair value $145 $77 $3,201 $2,603
Amortized cost 143 76 3,182 2,564
Weighted average yield 7.07% 6.17% 6.76% 7.23%
Weighted average maturity 4.6 years 7.0 years 2.1 years 4.7 years
- --------------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 1997
Fair Value $204 $52 $4,051 $2,951
Amortized cost 202 52 4,045 2,908
- --------------------------------------------------------------------------------------------------------------------------
JUNE 30, 1997
Fair Value $498 $48 $3,540 $3,339
Amortized cost 499 48 3,559 3,336
- --------------------------------------------------------------------------------------------------------------------------
Retained Weighted
Interests in Other Average
dollars in millions Securitizations Securities Total Yield(2)
- ------------------------------------------------------------------------------------------------------------------
JUNE 30, 1998
Maturity:
One year or less -- $16 $ 924 6.62%
After one through five years $136 18 4,075 7.10
After five through ten years 246 6 1,358 7.17
After ten years -- 34(3) 125 7.01
- ------------------------------------------------------------------------------------------------------------------
Fair value $382 $74 $6,482 --
Amortized cost 409 61 6,435 7.05%
Weighted average yield 8.50% 5.92% 7.05% --
Weighted average maturity 6.0 years 7.1 years 3.6 years --
- ------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 1997
Fair Value $374 $76 $7,708 --
Amortized cost 418 75 7,700 7.19%
- ------------------------------------------------------------------------------------------------------------------
JUNE 30, 1997
Fair Value $236 $66 $7,727 --
Amortized cost 289 65 7,796 6.69%
- ------------------------------------------------------------------------------------------------------------------
1 Maturity is based upon expected average lives rather than contractual
terms.
2 Weighted average yields are calculated on the basis of amortized cost.
Such yields have been adjusted to a taxable-equivalent basis using the
statutory Federal income tax rate of 35%.
3 Includes equity securities with no stated maturity.
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40
FIGURE 16 INVESTMENT SECURITIES
States and Weighted
Political Other Average
dollars in millions Subdivisions Securities Total Yield 1
- --------------------------------------------------------------------------------------------------------------
JUNE 30, 1998
Maturity:
One year or less $229 $ 13 $ 242 7.68%
After one through five years 360 93 453 8.30
After five through ten years 139 -- 139 9.87
After ten years 34 170 204 6.32
- --------------------------------------------------------------------------------------------------------------
Amortized cost $762 $276 $1,038 7.98%
Fair value 790 276 1,066 --
Weighted average yield 8.73% 5.90% 7.98% --
Weighted average maturity 3.3 years 6.7 years 4.2 years --
- --------------------------------------------------------------------------------------------------------------
DECEMBER 31, 1997
Amortized cost $ 973 $257 $1,230 7.59%
Fair value 1,005 257 1,262 --
- ---------------------------------------------------------------------------------------------------------------
JUNE 30, 1997
Amortized cost $1,209 $275 $1,484 7.86%
Fair value 1,241 275 1,516 --
- ---------------------------------------------------------------------------------------------------------------
1 Weighted average yields are calculated on the basis of amortized cost.
Such yields have been adjusted to a taxable-equivalent basis using the
statutory Federal income tax rate of 35%.
ASSET QUALITY
Key has established groups dedicated to evaluating and monitoring the level of
risk in its credit-related assets; formulating underwriting standards and
guidelines for line management; developing commercial and consumer credit
policies and systems; establishing credit-related concentration limits;
reviewing loans, leases and other corporate assets to evaluate credit quality;
and reviewing the adequacy of the allowance for loan losses ("Allowance").
Geographic diversity throughout Key is a significant factor in managing credit
risk.
Management has developed methodologies designed to assess the adequacy of the
Allowance. The Allowance allocation methodologies applied at Key focus on
changes in the size and character of the loan portfolio, changes in the levels
of impaired and other nonperforming and past due loans, the risk inherent in
specific loans, concentrations of loans to specific borrowers or industries,
existing and prospective economic conditions and historical losses on a
portfolio basis. In addition, indirect risk in the form of off-balance sheet
exposure for unfunded commitments is taken into consideration. Management
continues to target and maintain an Allowance equal to the allocated requirement
plus an unallocated portion, as appropriate. Management believes this is an
appropriate posture in light of current and expected economic conditions and
trends, the geographic and industry mix of the loan portfolio and similar
risk-related matters.
As shown in Figure 17, net loan charge-offs for the second quarter of 1998 were
$72 million, or .51% of average loans, compared with $65 million, or .52% of
average loans, for the same period last year. The higher level of net
charge-offs was concentrated in the commercial, financial and agricultural
segment of the commercial loan portfolio and reflects the significant growth in
these loans which has occurred over the past twelve months. This was partially
offset by a decline in the level of consumer loan net charge-offs (primarily
credit card receivables). Key's credit card portfolio was significantly reduced
in 1997 as a result of the sale of $365 million of outstandings which had
historically high levels of delinquency. Overall, the level of net loan
charge-offs has been fairly consistent over the past six quarters and is
expected to benefit from the fourth quarter 1997 sale of $949 million of prime
credit automobile loans. At $72 million, the provision for loan losses for the
second quarter of 1998 was at the lowest level since the first quarter of last
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41
year. The provision for loan losses matched the level of net charge-offs in
accordance with management's long-standing policy of maintaining the provision
at a level equal to or above net charge-offs.
FIGURE 17. SUMMARY OF LOAN LOSS EXPERIENCE
Three months ended June 30, Six months ended June 30,
--------------------------- ------------------------
dollars in millions 1998 1997 1998 1997
- ------------------------------------------------------------------------------------------------
Average loans outstanding during the period $56,441 $50,373 $55,200 $49,797
- ------------------------------------------------------------------------------------------------
Allowance for loan losses at beginning of period $ 900 $ 870 $ 900 $ 870
Loans charged off:
Commercial, financial and agricultural 19 10 35 22
Real estate--commercial mortgage 3 2 7 5
Real estate--construction 1 1 1 2
Commercial lease financing 1 -- 2 3
- ------------------------------------------------------------------------------------------------
Total commercial loans 24 13 45 32
Real estate--residential mortgage 1 2 5 5
Home equity 2 -- 4 1
Credit card 26 32 53 61
Consumer--direct 11 10 22 18
Consumer--indirect 31 31 66 60
- ------------------------------------------------------------------------------------------------
Total consumer loans 71 75 150 145
- ------------------------------------------------------------------------------------------------
95 88 195 177
Recoveries:
Commercial, financial and agricultural 8 8 14 16
Real estate--commercial mortgage 1 2 3 5
- ------------------------------------------------------------------------------------------------
Total commercial loans 9 10 17 21
Real estate--residential mortgage 1 1 2 2
Credit card 3 2 5 4
Consumer--direct 2 2 4 4
Consumer--indirect 8 8 18 14
- ------------------------------------------------------------------------------------------------
Total consumer loans 14 13 29 24
- ------------------------------------------------------------------------------------------------
23 23 46 45
- ------------------------------------------------------------------------------------------------
Net loans charged off (72) (65) (149) (132)
Provision for loan losses 72 75 149 142
- ------------------------------------------------------------------------------------------------
Allowance for loan losses at end of period $ 900 $ 880 $ 900 $ 880
===== ===== ===== =====
- ------------------------------------------------------------------------------------------------
Net loan charge-offs to average loans .51% .52% .54% .54%
Allowance for loan losses to period end loans 1.56 1.70 1.56 1.70
Allowance for loan losses to nonperforming loans 240.64 236.56 240.64 236.56
- ------------------------------------------------------------------------------------------------
The Allowance at June 30, 1998, was $900 million, or 1.56% of loans, compared
with $880 million, or 1.70% of loans, at June 30, 1997. Included in the 1998 and
1997 Allowance was $23 million and $28 million, respectively, which was
specifically allocated for impaired loans. For a further discussion of impaired
loans see Note 6, Impaired Loans and Other Nonperforming Assets, on page 12. At
June 30, 1998, the Allowance was 240.64% of nonperforming loans, compared with
236.22% at December 31, 1997, and 236.56% at June 30, 1997. There have been no
significant changes in the allocation of the Allowance since year end.
The composition of nonperforming assets is shown in Figure 18. These assets
totaled $417 million at June 30, 1998, and represented .72% of loans, OREO and
other nonperforming assets compared with $431 million, or .81%, at year end 1997
and $433 million, or .84%, at June 30, 1997. The level of nonperforming assets
has remained consistent over the past six quarters, ranging from a high of $433
million at June 30, 1997, to a low of $411 million at September 30, 1997.
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FIGURE 18 SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS
June 30, December 31, June 30,
dollars in millions 1998 1997 1997
- -----------------------------------------------------------------------------------
Commercial, financial and agricultural $ 139 $ 162 $ 160
Real estate--commercial mortgage 93 88 82
Real estate--construction 18 21 9
Commercial lease financing 20 5 13
Real estate--residential mortgage 63 58 59
Consumer 41 47 49
- -----------------------------------------------------------------------------------
Total nonperforming loans(1) 374 381 372
OREO 62 66 68
Allowance for OREO losses (23) (21) (9)
- -----------------------------------------------------------------------------------
OREO, net of allowance 39 45 59
Other nonperforming assets 4 5 2
- -----------------------------------------------------------------------------------
Total nonperforming assets $ 417 $ 431 $ 433
===== ===== =====
- -----------------------------------------------------------------------------------
Accruing loans past due 90 days or more $ 156 $ 132 $ 128
- -----------------------------------------------------------------------------------
Nonperforming loans to period end loans .65% .71% .72%
Nonperforming assets to period end loans plus
OREO and other nonperforming assets .72 .81 .84
- -----------------------------------------------------------------------------------
1 Includes impaired loans of $200 million, $196 million and $188 million
at June 30, 1998, December 31, 1997 and June 30, 1997, respectively.
DEPOSITS AND OTHER SOURCES OF FUNDS
Core deposits, defined as domestic deposits other than certificates of deposit
of $100,000 or more, are Key's primary source of funding. During the second
quarter of 1998, these deposits averaged $36.8 billion and represented 56% of
Key's funds supporting earning assets, compared with $39.2 billion and 65%,
respectively, during the second quarter of 1997. Over the past year the decrease
in core deposits was due primarily to declines in the levels of savings
deposits, NOW accounts and time deposits. This resulted primarily from the sale
of KeyBank Wyoming in July 1997 and the divestiture of 122 other branch offices
since June 30, 1997. The divested branches (including KeyBank Wyoming) had
deposits of approximately $3.0 billion. Also contributing to both the decrease
and change in the mix of core deposits were investment alternatives pursued by
customers in response to the continued strength of the stock and bond markets.
The increase in money market deposit accounts over the past three quarters
reflects these customer preferences as well as actions taken by management to
reprice such deposits.
Purchased funds, which are comprised of large certificates of deposit, deposits
in foreign offices and short-term borrowings, averaged $19.1 billion during the
second quarter of 1998, up $2.6 billion, or 16%, from the comparable prior year
period. As illustrated in Figure 4, the increase was attributable to higher
levels of short-term borrowings and large certificates of deposit which rose by
$3.7 billion and $161 million, respectively. Purchased funds have been more
heavily relied upon to offset declines in the volume of core deposits and to
fund earning asset growth. This trend is expected to continue during the second
half of 1998 due in large part to the impact of planned bank and branch
divestitures which were completed in the second quarter.
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FIGURE 19 MATURITY DISTRIBUTION OF TIME DEPOSITS OF $100,000 OR MORE
June 30, 1998 DOMESTIC FOREIGN
in millions OFFICES OFFICES TOTAL
- ----------------------------------------------------------------------
Time remaining to maturity:
Three months or less $1,632 $1,565 $3,197
Over three through six months 652 -- 652
Over six through twelve months 555 -- 555
Over twelve months 453 -- 453
- ----------------------------------------------------------------------
Total $3,292 $1,565 $4,857
====== ====== ======
- ----------------------------------------------------------------------
LIQUIDITY
Key actively analyzes and manages its liquidity, which represents the
availability of funding to meet the needs of depositors, borrowers and creditors
at a reasonable cost on a timely basis and without adverse consequences. The
affiliate banks maintain liquidity in the form of short-term money market
investments, securities available for sale, anticipated prepayments and
maturities on securities, the maturity structure of their loan portfolios and
the ability to securitize and package loans for sale. Liquidity is also enhanced
by a sizable concentration of core deposits, previously discussed, which are
generated by 962 full-service KeyCenters in 13 states. The affiliate banks
monitor deposit flows and evaluate alternate pricing structures with respect to
their deposit base. This process is supported by Key's Funds & Investment
Management Group, which monitors the overall mix of funding sources in
conjunction with the affiliate banks' deposit pricing and in response to the
structure of the earning assets portfolio. In addition, the affiliate banks have
access to various sources of money market funding (such as Federal funds
purchased, securities sold under repurchase agreements and bank notes) and
borrowings from the Federal Reserve system for short-term liquidity requirements
should the need arise. One of the affiliate banks, KeyBank USA, has a line of
credit with the Federal Reserve, which provides for overnight borrowings of up
to $982 million and is secured by $1.4 billion of KeyBank USA's credit card
receivables at June 30, 1998. There were no borrowings outstanding under this
line of credit as of June 30, 1998.
During the first six months of 1998, Key's affiliate banks raised $6.2 billion
under Key's Bank Note Program, which provides for the issuance of up to $13
billion ($12 billion by KeyBank N.A. and $1 billion by KeyBank USA). Of the
notes issued during the first half of 1998, $2.6 billion have original
maturities in excess of one year and are included in long-term debt, while $3.6
billion have original maturities of one year or less and are included in
short-term borrowings. At June 30, 1998, the program had an unused capacity of
$6.1 billion.
Under Key's Euronote Program, the parent company, KeyBank N.A. and KeyBank USA
may issue both long- and short-term debt of up to $5 billion in the aggregate.
The notes will be offered exclusively to non-U.S. investors and can be
denominated in dollars and most European currencies. There was $1.4 billion of
borrowings outstanding under this facility as of June 30, 1998, $524 million of
which was issued during the first six months of this year.
The parent company has a commercial paper program and a four-year revolving
credit agreement; both facilities provide funding availability of $500 million.
The proceeds from the commercial paper program may be used for general corporate
purposes and have been used to fund certain non-prime automobile lending
activities in conjunction with securitizations. There were no borrowings
outstanding under either of these facilities as of June 30, 1998.
The parent company also has a universal shelf registration statement on file
with the SEC, which provides for the possible issuance of up to $1.3 billion of
debt and equity securities. At June 30, 1998, unused capacity under the shelf
registration totaled $1.3 billion, including $750 million reserved for future
issuance as medium-term notes. The proceeds from the issuances under the shelf
registration, the Bank Note Program and the Euronote Program described above may
be used for general corporate purposes, including acquisitions.
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The liquidity requirements of the parent company, primarily for dividends to
shareholders, servicing of debt and other corporate purposes are principally met
through regular dividends from affiliate banks. Excess funds are maintained in
short-term investments. The parent company has ready access to the capital
markets as a result of its favorable debt ratings which, at June 30, 1998, were
as follows:
Senior Subordinated
Commercial Long-Term Long-Term
Paper Debt Debt
------------------- -------------------- --------------------
Duff & D-1 A+ A
Phelps
Standard & A-2 A- BBB+
Poor's
Moody's P-1 A1 A2
Further information pertaining to Key's sources and uses of cash for the
six-month periods ended June 30, 1998 and 1997, is presented in the Consolidated
Statements of Cash Flow on page 6.
CAPITAL AND DIVIDENDS
Total shareholders' equity at June 30, 1998, was $5.5 billion, up $344 million,
or 7%, from the December 31, 1997, balance and $711 million, or 15%, from the
end of the second quarter of last year. The increase from the end of the prior
year and from the year-ago quarter was due primarily to retained net income,
offset in part by dividends paid to shareholders. Also contributing to the
increase in each of these periods were net unrealized gains on securities
available for sale and net reductions in the level of treasury stock. Other
factors contributing to the change in shareholders' equity during the first six
months of 1998 are shown in the Statement of Changes in Shareholders' Equity
presented on page 5.
In January 1998, the Board of Directors approved a share repurchase program
which authorized the repurchase from that date of up to 5,000,000 Common Shares
(10,000,000 shares on a post-split basis), with no expiration date for the
authority. Under the program, shares may be repurchased from time to time in the
open market or through negotiated transactions. No shares were repurchased under
this program during the first half of 1998. Under a separate authorization, Key
plans on repurchasing up to half of the estimated 17.7 million shares to be
issued in the acquisition of McDonald. During the second quarter of 1998, Key
repurchased 100,000 shares at an average of $35.06 per share under this separate
authorization. The 51,536,469 Treasury Shares at June 30, 1998, are expected to
be reissued over time in connection with employee stock purchase, 401(k), stock
option and dividend reinvestment plans and for other corporate purposes. During
the first half of 1998, Key reissued 2,388,481 Treasury Shares for employee
benefit and dividend reinvestment plans.
Capital adequacy is an important indicator of financial stability and
performance. Overall, Key's capital position remains strong with a ratio of
total shareholders' equity to total assets of 8.28% at June 30, 1998, compared
with 7.71% at December 31, 1997, and 7.63% at June 30, 1997. Excluding certain
capital securities receiving Tier 1 treatment, these ratios are 7.29%, 7.03% and
6.91%, respectively.
Banking industry regulators define minimum capital ratios for bank holding
companies and their banking subsidiaries. Based on risk-adjusted capital rules
and definitions prescribed by the banking regulators, Key's Tier 1 and total
risk-adjusted capital ratios at June 30, 1998, were 7.15% and 11.86%,
respectively. These compare favorably with the minimum requirements of 4.0% for
Tier 1 and 8.0% for total capital. The regulatory leverage ratio standard
prescribes a minimum ratio of 3.0%, although most banking organizations are
expected to maintain ratios of at least 100 to 200 basis points above the
minimum. At June 30, 1998, Key's leverage ratio was 7.04%, substantially higher
than the minimum requirement. Figure 20 presents the details of Key's regulatory
capital position at June 30, 1998, December 31, 1997, and June 30, 1997.
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FIGURE 20. CAPITAL COMPONENTS AND RISK-ADJUSTED ASSETS
June 30, December 31, June 30,
dollars in millions 1998 1997 1997
- --------------------------------------------------------------------------------------------
Tier 1 capital
Common shareholders' equity(1) $ 5,497 $ 5,170 $ 4,850
Qualifying capital securities 747 500 500
Less: Goodwill (1,028) (1,071) (795)
Other intangible assets(2) (79) (95) (108)
- --------------------------------------------------------------------------------------------
Total Tier 1 capital 5,137 4,504 4,447
- --------------------------------------------------------------------------------------------
Tier 2 capital
Allowance for loan losses(3) 898 847 779
Qualifying long-term debt 2,487 1,982 2,032
- --------------------------------------------------------------------------------------------
Total Tier 2 capital 3,385 2,829 2,811
- --------------------------------------------------------------------------------------------
Total capital $ 8,522 $ 7,333 $ 7,258
======== ======== ========
Risk-adjusted assets
Risk-adjusted assets on balance sheet $ 60,533 $ 58,412 $ 55,304
Risk-adjusted off-balance sheet exposure 12,267 10,501 7,949
Less: Goodwill (1,028) (1,071) (795)
Other intangible assets(2) (79) (95) (108)
Plus: Market risk-equivalent assets 171 -- --
- --------------------------------------------------------------------------------------------
Gross risk-adjusted assets 71,864 67,747 62,350
Less: Excess allowance for loan losses(3) (2) (53) (101)
- --------------------------------------------------------------------------------------------
Net risk-adjusted assets $ 71,862 $ 67,694 $ 62,249
======== ======== ========
Average quarterly total assets $ 74,066 $ 71,490 $ 67,778
======== ======== ========
Capital ratios
Tier 1 risk-adjusted capital ratio 7.15% 6.65% 7.14%
Total risk-adjusted capital ratio 11.86 10.83 11.66
Leverage ratio(4) 7.04 6.40 6.65
- --------------------------------------------------------------------------------------------
1 Common shareholders' equity excludes the impact of net unrealized
gains or losses on securities, except for net unrealized losses on
marketable equity securities.
2 Intangible assets (excluding goodwill and portions of purchased credit
card relationships) recorded after February 19, 1992, and deductible
portions of purchased mortgage servicing rights.
3 The allowance for loan losses included in Tier 2 capital is limited
to 1.25% of gross risk-adjusted assets.
4. Tier 1 capital as a percentage of average quarterly assets, less
goodwill and other non-qualifying intangible assets as defined in
2 above.
Under the Federal Deposit Insurance Act, the Federal bank regulators group
FDIC-insured depository institutions into five broad categories based on certain
capital ratios. The five categories are "well capitalized," "adequately
capitalized," "undercapitalized," "significantly undercapitalized" and
"critically undercapitalized." All of Key's affiliate banks qualify as "well
capitalized" at June 30, 1998, since they exceeded the well-capitalized
thresholds of 10%, 6% and 5% for the total capital, Tier 1 capital and leverage
ratios, respectively. Although these provisions are not directly applicable to
Key under existing laws and regulations, based upon its ratios Key would also
qualify as "well capitalized" at June 30, 1998. The FDIC-defined capital
categories may not constitute an accurate representation of the overall
financial condition or prospects of Key or its affiliate banks.
On January 15, 1998, Key announced a two-for-one stock split effected by means
of a 100% stock dividend payable March 6, 1998, to shareholders of record as of
February 18, 1998. All relevant Common Share amounts and per share data in this
report have been adjusted to reflect the split.
At the Annual Meeting of Shareholders held May 7, 1998, shareholders increased
the authorized number of Key Common Shares from 900,000,000 to 1,400,000,000
Common Shares. Additionally, on January 15,
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1998, the Board voted to cancel and retire all 1,400,000 authorized shares of
Key's 10% Cumulative Preferred Stock, Class A, none of which were outstanding.
PART OTHER INFORMATION
II.
Item 1. Legal Proceedings
-----------------
In the ordinary course of business, Key is subject to legal actions
which involve claims for substantial monetary relief. Based on
information presently available to management and Key's counsel,
management does not believe that any legal actions, individually or in
the aggregate, will have a material adverse effect on the consolidated
financial condition of Key.
Item 4. Submission of Matters to a Vote of Security Holders
---------------------------------------------------
At the 1998 Annual Meeting of Shareholders of KeyCorp held on May 7,
1998, six directors were elected for three-year terms expiring in
2001, and shareholders adopted resolutions to: (a) amend the Articles
of Incorporation of KeyCorp to increase the authorized number of
common shares from 900,000,000 to 1,400,000,000 shares, and to modify
the description of KeyCorp's Preferred Stock, and (b) to ratify the
appointment by the Board of Directors of Ernst & Young LLP as
independent auditors for KeyCorp for the fiscal year ending December
31, 1998. Shareholders defeated a shareholder proposal requesting
necessary steps to cause annual election of all directors. Director
nominees for terms expiring in 2001 were: Cecil D. Andrus, Thomas A.
Commes, Stephen R. Hardis, Douglas J. McGregor, Henry L. Meyer III,
and Peter G. Ten Eyck, II. Directors whose term in office as a
director continued after the Annual Meeting of Shareholders were:
William G. Bares, Albert C. Bersticker, Dr. Carol A. Cartwright,
Kenneth M. Curtis, John C. Dimmer, Robert W. Gillespie, Henry S.
Hemingway, Charles R. Hogan, Steven A. Minter, M. Thomas Moore,
Richard W. Pogue, Ronald B. Stafford, and Dennis W. Sullivan.
The vote on each issue was as follows:
For Against Abstain
-------------- -----------------------------------
Election of Directors:
Cecil D. Andrus 369,969,652 * 4,762,339
Thomas A. Commes 345,301,489 * 29,430,502
Stephen R. Hardis 370,498,664 * 4,233,387
Douglas J. McGregor 370,691,929 * 4,040,062
Henry L. Meyer III 370,506,392 * 4,225,599
Peter G. Ten Eyck, II 370,471,795 * 4,260,196
Resolution amending KeyCorp Articles
of Incorporation to increase the authorized
number of common shares and to modify
the description of Preferred Stock 334,003,177 38,770,433 1,958,198
Ratification of Ernst & Young as
independent auditors of KeyCorp 370,870,612 2,626,212 1,234,981
Shareholder proposal requesting
necessary steps to cause
annual election of all Directors 124,837,512 202,783,235 6,905,853
* Proxies provide that shareholders may either cast a vote for, or
abstain from voting for, directors.
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Item 6. Exhibits and Reports on Form 8-K
--------------------------------
(a) Exhibits
(10) KeyCorp Amended and Restated 1991 Equity Compensation Plan
amended as of May 6, 1998
(15) Acknowledgment Letter of Independent Auditors
(27) Financial Data Schedule (filed electronically only)
(b) Reports on Form 8-K
April 17, 1998 - Item 5. Other Events and Item 7. Financial Statements
and Exhibits. Reporting that on April 16, 1998, the Registrant issued
a press release announcing its earnings results for the three-month
period ended March 31, 1998.
June 15, 1998 - Item 5. Other Events and Item 7. Financial Statements
and Exhibits. Reporting that on June 15, 1998, the Registrant issued a
press release announcing that it signed a definitive agreement to
acquire McDonald, a full-service investment banking and securities
brokerage company headquartered in Cleveland, Ohio. Simultaneously,
McDonald issued to KeyCorp an option which under certain circumstances
would permit KeyCorp to purchase up to 19.9% of the outstanding shares
of McDonald at $30.8125 per share.
No other reports on Form 8-K were filed during the three-month period
ended June 30, 1998.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
KEYCORP
---------------------------------------
(Registrant)
Date: August 13, 1998 /s/ Lee Irving
---------------------------------------
By: Lee Irving
Executive Vice President
and Chief Accounting Officer
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