KeyBank 2006 Annual Report Download - page 29

29
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
In 2005, Other Segments generated net income of $67 million, compared
to $43 million for 2004, due to increases in net gains from principal
investing and net interest income.
RESULTS OF OPERATIONS
Net interest income
One of Key’s principal sources of earnings is net interest income. Net
interest income is the difference between interest income received on
earning assets (such as loans and securities) and loan-related fee income,
and interest expense paid on deposits and borrowings. There are several
factors that affect net interest income, including:
• the volume, pricing, mix and maturity of earning assets and interest-
bearing liabilities;
• the volume and value of net free funds, such as noninterest-bearing
deposits and capital;
• the use of derivative instruments to manage interest rate risk;
• interest rate fluctuations and competitive conditions within the
marketplace; and
• asset quality.
To make it easier to compare results among several periods and the yields
on various types of earning assets (some taxable, some not), we present
net interest income in this discussion on a “taxable-equivalent basis” (i.e.,
as if it were all taxable and at the same rate). For example, $100 of tax-
exempt income would be presented as $154, an amount that — if taxed
at the statutory federal income tax rate of 35% — would yield $100.
Figure 6, which spans pages 30 and 31, shows the various components
of Key’s balance sheet that affect interest income and expense, and their
respective yields or rates over the past six years. This figure also presents
areconciliation of taxable-equivalent net interest income for each of
those years to net interest income reported in accordance with GAAP.
Taxable-equivalent net interest income for 2006 was $2.9 billion,
representing a $141 million, or 5%, increase from 2005. The net
interest margin, which is an indicator of the profitability of the earning
assets portfolio, is calculated by dividing net interest income by average
earning assets. During 2006, Key’s net interest margin increased by 2
basis points to 3.67%. A basis point is equal to one one-hundredth of
apercentage point, meaning 2 basis points equals .02%.
The improvement in net interest income and the net interest margin was
attributable to 7% growth in average commercial loans and an 8%
increase in average core deposits, combined with a 9% rise in the
volume of noninterest-bearing funds. As a result of the rising interest rate
environment, noninterest-bearing funds were of significantly greater
value during 2006 as they added approximately 25 basis points to the net
interest margin. Key’s net interest margin also benefited from a slight asset-
sensitive interest rate risk position in a rising interest rate environment.
The increase in the net interest margin was offset in partby the sale of
certain assets that had higher yields and credit costs, but did not fit Key’s
relationship banking strategy.In addition, during 2006, Key experienced
atighter interest rate spread, which represents the difference between the
yield on average earning assets and the rate paid for interest-bearing funds.
As shown in Figure 6, Key’s interest rate spread narrowed by 23 basis
points from 2005 as a result of competitive pressure on loan and deposit
pricing, and a change in deposit mix, as consumers shifted funds from
money market deposit accounts to time deposits. Management expects
these conditions and the continuing flat-to-inverted yield curve to
maintain pressure on the net interest margin heading into 2007.
Average earning assets for 2006 totaled $79.5 billion, which was $3.5
billion, or 5%, higher than the 2005 level, due largely to the 7%
increase in commercial loans.
In 2005, taxable-equivalent net interest income was $2.8 billion,
representing a $227 million, or 9%, increase from 2004. The growth
reflected a 6% increase in average earning assets due to strong growth
in all major components of the commercial loan portfolio. Growth
in commercial lending, which was bolstered by the acquisitions of
EverTrust Financial Group, Inc. and American Express Business Finance
Corporation during the fourth quarter of 2004, and an increase in
loans held for sale more than offset declines in consumer loans and short-
term investments. The decline in consumer loans was due primarily to
loan sales. Net interest income for 2005 also benefited from a 3 basis
point improvement in the net interest margin to 3.65%.
Over the past two years, the growth and composition of Key’s earning
assets has been affected by the following loan sales, most of which came
from the held-for-sale portfolio:
• Key sold commercial mortgage loans of $2.6 billion during 2006
and $2.2 billion during 2005. Since some of these loans have been
sold with limited recourse (i.e., there is a risk that Key will be held
accountable for certain events or representations made in the sales
agreements), Key established and has maintained a loss reserve in an
amount estimated by management to be appropriate. More information
about the related recourse agreement is provided in Note 18
(“Commitments, Contingent Liabilities and Guarantees”) under the
heading “Recourse agreement with Federal National Mortgage
Association” on page 99.
•Key sold education loans of $1.4 billion ($1.1 billion through a
securitization) during 2006 and $1.2 billion ($937 million through a
securitization) during 2005. Key has used the securitization market for
education loans to diversify funding sources.
• Key sold other loans totaling $3.2 billion during 2006 and $2.7
billion during 2005. During the fourth quarter of 2006, Key sold the
$2.5 billion nonprime mortgage loan portfolio held by the Champion
Mortgage finance business. The Champion business no longer fits
strategically with Key’s longer-term business goals and continued
focus on Community Banking and relationship-oriented businesses.
• During the first quarter of 2005, Key completed the sale of $992
million of indirect automobile loans, representing the prime segment
of that portfolio. In April 2005, Key completed the sale of $635
million of automobile loans, representing the nonprime segment.
The decision to sell these loans was driven by management’s strategies
for improving Key’s returns and achieving better interest rate and
credit risk profiles.
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