KeyBank 2007 Annual Report Download - page 20

18
MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Management continually assesses the risk profile of the loan portfolio
and adjusts the allowance for loan losses when appropriate. The
economic and business climate in any given industry or market is
difficult to gauge and can change rapidly, and the effects of those
changes can vary by borrower. However, since Key’s total loan portfolio
is well diversified in many respects, and the risk profile of certain
segments of the loan portfolio may be improving while the risk profile
of others is deteriorating, management may decide to change the level
of the allowance for one segment of the portfolio without changing it for
any other segment. As a result, changes in the level of the allowance for
different segments may offset each other.
In addition to adjusting the allowance for loan losses to reflect market
conditions, management also may adjust the allowance because of
unique events that cause actual losses to vary abruptly and significantly
from expected losses. For example, class action lawsuits brought against
an industry segment (e.g., one that utilized asbestos in its product)
can cause a precipitous deterioration in the risk profile of borrowers
doing business in that segment. Conversely, the dismissal of such
lawsuits can improve the risk profile. In either case, historical loss
rates for that industry segment would not have provided a precise
basis for determining the appropriate level of allowance.
Even minor changes in the level of estimated losses can significantly affect
management’s determination of the appropriate level of allowance
because those changes must be applied across a large portfolio. For
example, an increase in estimated losses equal to one-tenth of one
percent of Key’s December 31, 2007, consumer loan portfolio would
result in an $18 million increase in the level of allowance deemed
appropriate. The same level of increase in estimated losses for the
commercial loan portfolio would result in a $53 million increase in the
allowance. Such adjustments to the allowance for loan losses can
materially affect net income. Following the above examples, an $18
million increase in the allowance would have reduced Key’s net income
by approximately $11 million, or $.03 per share, and a $53 million
increase in the allowance would have reduced net income by
approximately $33 million, or $.08 per share.
In all of its decision-making regarding the allowance, management
benefits from a lengthy organizational history and experience with
credit decisions and related outcomes. Nonetheless, if management’s
underlying assumptions later prove to be inaccurate, the allowance
for loan losses would have to be adjusted, possibly having an adverse
effect on Key’s results of operations.
Our accounting policy related to the allowance is disclosed in Note 1
under the heading “Allowance for Loan Losses” on page 67.
Loan securitizations. Key securitizes education loans and accounts for
those transactions as sales when the criteria set forth in Statement of
Financial Accounting Standards (“SFAS”) No. 140, “Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities,” are met. If management were to subsequently determine that
the transactions did not meet the criteria prescribed by SFAS No. 140,
the loans would have to be brought back onto the balance sheet, which
could have an adverse effect on Key’s capital ratios and other unfavorable
financial implications.
Management must make assumptions to determine the gains or losses
resulting from securitization transactions and the subsequent carrying
amount of retained interests; the most significant of these are described
in Note 8 (“Loan Securitizations, Servicing and Variable Interest
Entities”), which begins on page 81. Note 8 also includes information
concerning the sensitivity of Key’s pre-tax earnings to immediate adverse
changes in important assumptions. The use of alternative assumptions
would change the amount of the initial gain or loss recognized and might
result in changes in the carrying amount of retained interests, with
related effects on results of operations. Key’s accounting policy related
to loan securitizations is disclosed in Note 1 under the heading “Loan
Securitizations” on page 67.
Contingent liabilities, guarantees and income taxes. Contingent
liabilities arising from litigation and from guarantees in various
agreements with third parties under which Key is a guarantor, and the
potential effects of these items on Key’s results of operations, are
summarized in Note 18 (“Commitments, Contingent Liabilities and
Guarantees”), which begins on page 97. In addition, it is not always
clear how the Internal Revenue Code and various state tax laws apply
to transactions that we undertake. In the normal course of business,
Key may record tax benefits related to transactions, and then find
those benefits contested by the IRS or state tax authorities. Key has
provided tax reserves that management believes are adequate to absorb
potential adjustments that such challenges may necessitate. However, if
management’s judgment later proves to be inaccurate, the tax reserves
may need to be adjusted, possibly having an adverse effect on Key’s
results of operations and capital. For further information on Key’s
accounting for income taxes, see Note 17 (“Income Taxes”), which
begins on page 95.
Key records a liability for the fair value of the obligation to stand
ready to perform over the term of a guarantee, but there is a risk that
Key’s actual future payments in the event of a default by a third party
could exceed the recorded amount. See Note 18 for a comparison of the
liability recorded and the maximum potential undiscounted future
payments for the various types of guarantees that Key had outstanding
at December 31, 2007.
Derivatives and related hedging activities. Key uses derivatives known
as interest rate swaps and caps to hedge interest rate risk for asset and
liability management purposes. These instruments modify the repricing
characteristics of specified on-balance sheet assets and liabilities. Key’s
accounting policies related to derivatives reflect the guidance in SFAS No.
133, “Accounting for Derivative Instruments and Hedging Activities,”
as revised and further interpreted by SFAS No. 149, “Amendment of
Statement 133 on Derivative Instruments and Hedging Activities,” and
other related accounting guidance. In accordance with this accounting
guidance, all derivatives are recognized as either assets or liabilities on
the balance sheet at fair value. Accounting for changes in the fair value
(i.e., gains or losses) of a particular derivative differs depending on
whether the derivative has been designated and qualifies as part of a
hedging relationship, and further, on the type of hedging relationship.