KeyBank 2007 Annual Report Download - page 53

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Credit risk management
Credit risk is the risk of loss arising from an obligor’s inability or
failure to meet contractual payment or performance terms. Like other
financial service institutions, Key makes loans, extends credit, purchases
securities and enters into financial derivative contracts, all of which
expose Key to credit risk.
Credit policy, approval and evaluation. Key manages credit risk
exposure through a multifaceted program. Independent committees
approve both retail and commercial credit policies. These policies are
communicated throughout Key to foster a consistent approach to
granting credit.
Credit Risk Management, which is responsible for credit approval, is
independent of Key’s lines of business and consists of 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 at 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’s judgment and quantitative modeling. Commercial
loans generally are assigned 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 industry
sector and an assessment of industry risk within the context of the
general economic outlook. Types of exposure and 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 the 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. KeyBank’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, 2007, Key
had eight client relationships with loan commitments of more than
$200 million. The average amount outstanding on these commitments
at December 31, 2007, was $117 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 maximum level of economic capital.
In addition to these localized precautions, 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 a
particular extension of credit to a third party, and to manage portfolio
concentration and correlation risks. At December 31, 2007, Key used
credit default swaps with a notional amount of $1.1 billion to manage
the credit risk associated with specific commercial lending obligations.
Occasionally, Key will provide 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, 2007, the notional amount of credit default swaps sold by Key was
$50 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 2007.
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 assets. Watch assets are troubled commercial
loans with the potential to deteriorate in quality due to the client’s current
financial condition and possible inability to perform in accordance
with the terms of the underlying contract. Criticized assets are troubled
loans and other assets that show additional signs of weakness that
may lead, or have led, to an interruption in scheduled repayments
from primary sources, potentially requiring Key to rely on repayment
from secondary sources, such as collateral liquidation.
At December 31, 2007, the levels of watch assets and criticized assets
were higher than they were a year earlier. Both watch and criticized levels
increased in most of the National Banking lines of business. The most
significant increase occurred in the Real Estate Capital line of business,
due principally to deteriorating market conditions in the residential
properties segment of Key’s commercial real estate construction portfolio.
The increase in criticized commitments was offset in part by the
favorable settlement of Key’s automobile residual value insurance
litigation, in which the related receivable was eliminated during the first
quarter of 2007. Management continues to closely monitor fluctuations
in Key’s watch assets and criticized assets.