KeyBank 2006 Annual Report Download - page 50

50
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Credit policy, approval and evaluation. Key manages credit risk
exposure through a multi-faceted program. Independent committees
approve both retail and commercial credit policies. These policies are
communicated throughout Key to foster a consistent approach to
granting credit.
The Credit Risk Management department performs credit approval.
Credit Risk Management is independent of Key’s lines of business and
comprises senior officers who have extensive experience in structuring
and approving loans. Only Credit Risk Management officers are
authorized to grant significant exceptions to credit policies. It is not
unusual to make exceptions to established policies when mitigating
circumstances dictate, but most major lending units have been assigned
specific thresholds to keep exceptions within a manageable level.
Key has a well-established process known as the quarterly Underwriting
Standards Review (“USR”) for monitoring compliance with credit
policies. The quarterly USR report provides data on all commercial loans
over $2 million at the time of their approval. Each quarter, the data is
analyzed to determine if lines of business have adhered to established
exception limits. Further, the USR report identifies grading trends of new
business, exceptions to internally established benchmarks for returns
on equity, transactions with higher risk and other pertinent lending
information. This process enables management to take timely action to
modify lending practices when necessary.
Credit Risk Management is responsible for assigning loan grades at the
time of origination and as the loans season. Most extensions of credit at
Key are subject to loan grading or scoring. This risk rating methodology
blends management’sjudgment and quantitative modeling. On the
commercial side, loans generally areassigned two internal risk ratings.
The first rating reflects the probability that the borrower will default on
an obligation; the second reflects expected recovery rates on the credit
facility.The assessment of default probability is based, among other
factors, on the financial strength of the borrower, an assessment of the
borrower’s management, the borrower’s competitive position within its
industrysector and an assessment of industryrisk within the context of
the general economic outlook. Types of exposureand transaction structure,
including credit risk mitigants, affect the expected recovery assessment.
Credit Risk Management uses externally- and internally-developed risk
models to evaluate consumer loans. These models (“scorecards”) forecast
probability of serious delinquency and default for an applicant. The
scorecards are embedded in Key’s application processing system, which
allows for real-time scoring and automated decisions for many of Key’s
products. Key periodically validates the loan grading and scoring processes.
Key maintains an active concentration management program to encourage
diversification in the credit portfolios. For exposures to individual
obligors, Key employs a sliding scale of exposure (“hold limits”), which
is dictated by the strength of the borrower. Key’s legal lending limit is well
in excess of $1 billion for any individual borrower. However, internal
hold limits generally restrict the largest exposures to less than half that
amount. As of December 31, 2006, Key had eight client relationships with
loan commitments of more than $200 million. The average amount
outstanding on these commitments at December 31 was $60 million. In
general, Key’s philosophy is to maintain a diverse portfolio with regard
to credit exposures.
Key manages industry concentrations using several methods. On smaller
portfolios, limits may be set according to a percentage of Key’s overall
loan portfolio. On larger, or higher risk portfolios, Key may establish a
specific dollar commitment level or a level of economic capital that
cannot be exceeded.
In addition, Key actively manages the overall loan portfolio in a manner
consistent with asset quality objectives. This process entails the use of
credit derivatives — primarily credit default swaps — to mitigate Key’s
credit risk. Credit default swaps enable Key to transfer a portion of the
credit risk associated with the underlying extension of credit to a third
party, and to manage portfolio concentration and correlation risks. At
December 31, 2006, credit default swaps with a notional amount of $989
million were used to manage the credit risk associated with specific
commercial lending obligations. Key also provides credit protection to
other lenders through the sale of credit default swaps. These transactions
may generate fee income and can diversify overall exposure to credit loss.
At December 31, 2006, the notional amount of credit default swaps sold
by Key was $25 million.
Credit default swaps are recorded on the balance sheet at fair value.
Related gains or losses, as well as the premium paid or received for credit
protection, are included in the trading income component of noninterest
income. These swaps did not have a significant effect on Key’s operating
results for 2006.
Other actions used to manage the loan portfolio include loan
securitizations, portfolio swaps, or bulk purchases and sales. The
overarching goal is to continually manage the loan portfolio within a
desirable range of asset quality.
Watch and criticized credits. Watch credits are troubled loans with
the potential for further deterioration in quality due to the client’s
current financial condition and possible inability to perform in accordance
with the terms of the loan. Criticized credits are troubled loans that show
additional signs of weakness that may lead to an interruption in scheduled
repayments from primarysources, potentially requiring Key to rely on
repayment from secondary sources, such as collateral liquidation.
At December 31, 2006, the level of watch commitments was higher
than that experienced a year earlier. This increase was attributable to
anumber of client segments across a range of loan portfolios; most
notably Commercial Floor Plan and Real Estate Capital. During
2006, the level of criticized commitments increased modestly, due to
anumber of offsetting changes across multiple portfolios. Increases in
the Commercial Floor Plan and Real Estate Capital portfolios were
substantially offset by decreases in a number of other portfolios.
Management continues to closely monitor fluctuations in Key’s watch
and criticized commitments.
Allowance for loan losses. The allowance for loan losses at December 31,
2006, was $944 million, or 1.43% of loans, compared to $966 million,
or 1.45%, at December 31, 2005. The allowance includes $14 million that
was specifically allocated for impaired loans of $34 million at December
31, 2006, compared to $6 million that was allocated for impaired loans
of $9 million one year ago. For more information about impaired loans,
see Note 9 (“Nonperforming Assets and Past Due Loans”) on page 85.
At December 31, 2006, the allowance for loan losses was 439.07% of
nonperforming loans, compared to 348.74% at December 31, 2005.
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