KeyBank 2007 Annual Report Download - page 24

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
offset the positive effect of a 4% increase in average earning assets,
due largely to solid commercial loan growth. Excluding the $25
million increase attributable to the sale of the McDonald Investments
branch network, Key’s noninterest income was up $77 million from
the 2006 level, reflecting strong performances from several fee-
based businesses and higher net gains from principal investing.
Additionally, 2007 results benefited from a $58 million increase in
gains related to the sale of MasterCard Incorporated shares and a $26
million gain from the settlement of the automobile residual value
insurance litigation. The increase in noninterest income was
moderated by the impact of continued volatility in the fixed income
markets on several of Key’s capital markets-driven businesses, and a
$49 million loss recorded in connection with the repositioning of the
securities portfolio.
• Key continued to strengthen its compliance and operations
infrastructure, which is designed to detect and prevent money
laundering in accordance with the requirements of the Bank Secrecy
Act (“BSA”). As a result of these efforts, during the second quarter,
the Office of the Comptroller of the Currency removed the October
2005 consent order concerning KeyBank’s BSA and anti-money
laundering compliance. At that same time, the Federal Reserve Bank
of Cleveland terminated its memorandum of understanding with
KeyCorp concerning BSA and other related matters.
• Key’s nonperforming assets rose by $491 million from the level
reported one year ago. The increase was attributable to the effect of
deteriorating market conditions on the residential properties segment
of the commercial real estate construction portfolio, with the majority
of the increase coming from nonperforming loans outstanding in
Florida and southern California. Outside of this portfolio, Key
experienced only modest increases in nonperforming loans during
2007. Net loan charge-offs for 2007 totaled $275 million, or .41%
of average total loans.
• Key continued to manage expenses effectively. Excluding the $121
million reduction caused by the sale of the McDonald Investments
branch network, a $64 million charge recorded in 2007 for the fair
value of Key’s potential liability to Visa Inc., a $42 million charge
recorded in 2007 for litigation, and 2007 separation expense of $25
million, total noninterest expense was up $89 million, or 3%, from
the 2006 level. This growth reflected increases in operating lease
expense, personnel expense, and business and franchise taxes. In
addition, Key recorded a $28 million provision for losses on lending-
related commitments, compared to a $6 million credit in 2006.
Further, Key continued to effectively manage equity capital by paying
dividends to shareholders, repurchasing shares and investing in its
businesses. During 2007, Key repurchased 16.0 million of its common
shares. At December 31, 2007, Key’s tangible equity to tangible assets
ratio was 6.46%.
The primary reasons that Key’s revenue and expense components changed
over the past three years are reviewed in greater detail throughout the
remainder of the Management’s Discussion & Analysis section.
Key’s results for 2007 were adversely affected by the need to record
additional loan loss reserves in response to deteriorating conditions
in the housing market, losses associated with volatility in the fixed
income markets and the strategic decision to exit certain business
activities. However, the increase in Key’s loan loss reserves was less
extensive than it would have been if management had not already
taken action to position Key for a potential downturn in the credit cycle.
Management moved two years ago to curtail Key’s Florida condominium
exposure, completed the sale of Key’s subprime mortgage lending
business during the fourth quarter of 2006, and in December 2007
announced decisions to exit dealer-originated home improvement
lending activities, cease conducting business with nonrelationship
homebuilders outside of Key’s Community Banking footprint and cease
offering Payroll Online services.
Financial outlook
During the fourth quarter of 2007, Key increased its provision for
loan losses significantly in response to deteriorating market conditions
in the commercial real estate loan portfolio. Also, since July 2007, the
fixed income markets have experienced extraordinary volatility, rapidly
widening credit spreads and significantly reduced liquidity. Key
participates in these markets through business conducted by its National
Banking group and through principal investing activities, and Key is also
impacted by activity in these markets in other important ways. Changes
in market conditions, including most significantly the widening of
credit spreads, can adversely affect the market values of Key’s loan and
securities portfolios held for sale or trading, resulting in the recognition
of both realized and unrealized losses. During 2007, Key recorded net
losses of $17 million from loan sales and write-downs, net gains of $17
million from dealer trading and derivatives, and net losses of $34
million from certain real estate-related investments, for a total of $34
million in net losses. This compares to net gains of $152 million from
these activities for 2006 and $171 million for 2005. Additionally, the
widening of credit spreads and the overall reduction in liquidity have
exerted pressure on Key’s net interest margin.
Management expects that in 2008 Key will experience:
• a net interest margin of around 3.30%;
• a low- to mid-single digit percentage increase in loans, excluding
acquired balances;
• a low single digit percentage increase in core deposits;
• net loan charge-offs in the range of .60% to .70% of average loans;
• a low single digit percentage increase in expenses, excluding the
2007 charges for Key’s liability to Visa and for losses on lending-
related commitments; and
• an effective tax rate of around 32% on a taxable-equivalent basis.