KeyBank 2004 Annual Report Download - page 24

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Taxable-equivalent net interest income for 2004 was $2.7 billion,
representing a $65 million, or 2%, decrease from the prior year. This
reduction reflects the adverse effect of a lower net interest margin,
which decreased 16 basis points to 3.64%. A basis point is equal to one
one-hundredth of a percentage point, meaning 16 basis points equals
.16%. 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.
The combination of a soft economy and growth in core deposits have
affected the net interest margin, as well as the size and composition of
Key’s earning assets portfolio. Over the past twelve months, average core
deposits grew by $2.3 billion, or 5%, while average earning assets
increased by $1.5 billion, or 2%. Due to generally weak loan demand
during the first half of 2004, the excess funds from core deposits were
used primarily to reduce short-term borrowings or long-term debt.
The stronger demand for loans during the second half of the year has
helped to stabilize the net interest margin.
Specific factors that led to the decrease in Key’s net interest margin over
the past year are:
•During the first half of 2004, we repositioned our balance sheet in
anticipation of interest rate increases. We also allowed interest rate
swaps to mature without replacing them.
•During the third quarter of 2003, we experienced exceptionally high
levels of prepayments on our investment and consumer loan portfolios
as a result of the low interest rate environment.
•During 2003 and the first half of 2004, we did not reduce interest rates
on deposit accounts because of competitive market conditions and the
low interest rate environment.
•Although the demand for commercial loans strengthened during the
last half of 2004, the demand for commercial credit was weak during
the preceding eighteen-month period.
Average earning assets for 2004 totaled $75.0 billion, which was $1.5
billion, or 2%, higher than the 2003 level. Growth in commercial
lending and short-term investments more than offset declines in consumer
loans and securities available for sale. The decline in consumer loans was
due to loan sales and management’s efforts to exit certain credit-only
relationship portfolios.
In 2003, net interest income was $2.8 billion, representing a $73
million, or 3%, decrease from the prior year as the negative effect of
a lower net interest margin more than offset an increase in average
earning assets. Key’s net interest margin contracted 17 basis points to
3.80%, while average earning assets grew by $1.2 billion, or 2%, to
$73.5 million. Steady growth in our home equity lending (driven by the
low interest rate environment) and commercial lease financing, and an
increase in the securities available-for-sale portfolio drove the increase.
During the same period, the general economic slowdown contributed
to a decline in average commercial loans outstanding. Average
consumer loans, other than home equity loans, also declined during
2003. The largest reduction occurred in the indirect automobile
financing portfolio, primarily because, since 2001, Key has been scaling
back automobile lending and has allowed the automobile lease financing
portfolio to run off.
Over the past two years, the growth and composition of Key’s loan
portfolio has been affected by the following actions:
•During the fourth quarter of 2004, Key acquired EverTrust, in
Everett, Washington with a loan portfolio (primarily commercial
real estate loans) of approximately $685 million at the date of
acquisition. In the same quarter, Key acquired AEBF with a
commercial lease financing portfolio of approximately $1.5 billion,
thereby adding 75 offices to our network for small-ticket lease
solutions. During the first quarter of 2003, Key acquired a $311
million commercial lease financing portfolio and a $71 million
commercial loan portfolio from a Canadian financial institution.
The acquisition of these portfolios further diversified our asset base
and has generated additional equipment financing opportunities.
•Key sold commercial mortgage loans of $2.1 billion during 2004 and
$1.7 billion during 2003. 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), Key established
and has maintained a loss reserve of 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 83.
•Key sold education loans of $1.3 billion ($1.1 billion through
securitizations) during 2004 and $1.2 billion ($998 million through
securitizations) during 2003. Key has used the securitization market
for education loans as a cost effective means of diversifying its
funding sources.
•Key sold other loans (primarily home equity, residential real estate and
commercial loans) totaling $2.9 billion during 2004 and $1.8 billion
during 2003. In 2004, these transactions included the fourth quarter
sale of $978 million of broker-originated home equity loans. During
the same quarter, Key reclassified $1.7 billion of indirect automobile
loans to held-for-sale status in anticipation of their sale. The sales and
plans to sell these long-term, fixed-rate loans were driven by
management’s strategies for improving Key’s returns and achieving
desired interest rate and credit risk profiles.
•During the third quarter of 2003, Key consolidated an asset-backed
commercial paper conduit as a result of an accounting change. This
consolidation added approximately $200 million to Key’s commercial
loan portfolio. More information about this change, required by
Interpretation No. 46, “Consolidation of Variable Interest Entities,”
is provided in Note 8 (“Loan Securitizations, Servicing and Variable
Interest Entities”), which begins on page 67.
•During the second quarter of 2001, management announced that Key
would exit the automobile leasing business, de-emphasize indirect
prime automobile lending outside of Key’s primary geographic
markets and discontinue certain credit-only commercial relationships.
As of December 31, 2004, the affected portfolios, in the aggregate,
have declined by approximately $459 million since December 31,
2003, and $5.1 billion since the date of the announcement.
Figure 7 shows how the changes in yields or rates and average balances
from the prior year affected net interest income. The section entitled
“Financial Condition,” which begins on page 26, contains more
discussion about changes in earning assets and funding sources.
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