KeyBank 2007 Annual Report Download - page 29

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
Management continues to pursue opportunities to improve Key’s business
mix and credit risk profile, and to emphasize relationship businesses.
During the fourth quarter of 2007, management made the strategic
decision to exit dealer-originated home improvement lending activities,
which involve prime loans but are largely out-of-footprint. Key also
decided to cease offering Payroll Online services, which were not of
sufficient size to provide economies of scale to compete profitably. In 2006,
Key sold the subprime mortgage loan portfolio held by the Champion
Mortgage finance business, and in the first quarter of 2007 completed the
sale of Champion’s origination platform. As a result of these actions, Key
has applied discontinued operations accounting to this business. Further
information regarding the Champion divestiture is included in Note 3
(“Acquisitions and Divestitures”), which begins on page 74.
Over the past two years, Key also has completed two acquisitions that
expanded its market share positions and strengthened its business.
During 2007, Key acquired Tuition Management Systems, Inc., one of
the nation’s largest providers of outsourced tuition planning, billing and
related technology services. Headquartered in Warwick, Rhode Island,
Tuition Management Systems serves more than 700 colleges, universities,
elementary and secondary educational institutions. The combination
of the payment plan systems and technology in place at Tuition
Management Systems and the array of payment plan products offered
by Key’s Consumer Finance line of business created one of the largest
payment plan providers in the nation. In 2006, Key expanded the asset
management product line by acquiring Austin Capital Management, Ltd.,
an investment firm headquartered in Austin, Texas. Austin specializes in
selecting and managing hedge fund investments for its principally
institutional customer base.
Other Segments
Other Segments consists of Corporate Treasury and Key’s Principal
Investing unit. These segments generated net income of $83 million for
2007, compared to $42 million for 2006. The improvement was
attributable to an $81 million increase in net gains from principal
investing and a $24 million charge recorded in the fourth quarter of 2006
in connection with the redemption of certain trust preferred securities.
The increase resulting from these items was offset in part by the $49
million loss recorded in the first quarter of 2007 in connection with the
repositioning of Key’s securities portfolio.
In 2006, Other Segments generated net income of $42 million, compared
to $68 million for 2005. Net income declined because of a decrease in
net gains from principal investing and the $24 million charge recorded
in 2006 in connection with the redemption of trust preferred securities.
RESULTS OF OPERATIONS
Net interest income
One of Key’s principal sources of revenue is net interest income. Net
interest income is the difference between interest income received on
earning assets (such as loans and securities) and loan-related fee income,
and interest expense paid on deposits and borrowings. There are several
factors that affect net interest income, including:
• the volume, pricing, mix and maturity of earning assets and interest-
bearing liabilities;
• the volume and value of net free funds, such as noninterest-bearing
deposits and equity capital;
• the use of derivative instruments to manage interest rate risk;
• interest rate fluctuations and competitive conditions within the
marketplace; and
• asset quality.
To make it easier to compare results among several periods and the yields
on various types of earning assets (some taxable, some not), we present
net interest income in this discussion on a “taxable-equivalent basis” (i.e.,
as if it were all taxable and at the same rate). For example, $100 of tax-
exempt income would be presented as $154, an amount that — if taxed
at the statutory federal income tax rate of 35% — would yield $100.
Taxable-equivalent net interest income for 2007 was $2.9 billion,
representing a $50 million, or 2%, decrease from 2006. Figure 8,
which spans pages 28 and 29, shows the various components of Key’s
balance sheet that affect interest income and expense, and their respective
yields or rates over the past six years. This figure also presents a
reconciliation of taxable-equivalent net interest income for each of
those years to net interest income reported in accordance with GAAP.
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. During 2007, Key’s net interest margin declined
by 21 basis points to 3.46%. A basis point is equal to one one-hundredth
of a percentage point, meaning 21 basis points equal .21%. The decrease
in the net interest margin was moderated by the impact of a 5% rise in
the volume of noninterest-bearing funds. The growth in these funds
added approximately 15 basis points to the net interest margin.
The decline in net interest income and the reduction in the net interest
margin reflected tighter interest rate spreads on both loans and deposits,
caused by competitive pricing, client preferences for deposit products with
more attractive interest rates, and heavier reliance on short-term wholesale
borrowings to support earning asset growth during the second half of
2007. Additionally, as part of the February 2007 sale of the McDonald
Investments branch network, Key transferred approximately $1.3 billion
of NOW and money market deposit accounts to the buyer. McDonald
Investments’ NOW and money market deposit accounts averaged $1.5
billion for 2006.
Heading into 2008, management expects Key’s net interest margin to
remain under pressure due to strong competition for loans and deposits, the
effects of disruption in the fixed income markets and the significant increase
in nonperforming loans that occurred during the second half of 2007.
Average earning assets for 2007 totaled $82.9 billion, which was $3.4
billion, or 4%, higher than the 2006 level, due largely to a 5% increase
in commercial loans. This growth was due in part to the higher demand
for credit caused by the volatile capital markets environment.
In 2006, taxable-equivalent net interest income was $2.9 billion, representing
a $141 million, or 5%, increase from 2005. During 2006, Key’s net interest
margin rose by 2 basis points to 3.67%. The improvement in net interest
income and the net interest margin was attributable to 7% growth in
average commercial loans and an 8% increase in average core deposits,
combined with a 9% rise in the volume of noninterest-bearing funds.