KeyBank 2008 Annual Report Download - page 34

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MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES
The provision for loan losses rose by $1.159 billion from 2007, reflecting
deteriorating market conditions in the residential properties segment of
Key’s commercial real estate construction portfolio, and an additional
provision recorded in connection with the transfer of $3.284 billion of
education loans from held-for-sale status to the loan portfolio. National
Banking’s provision for loan losses exceeded net loan charge-offs by $561
million as Key continued to build reserves in a weak economy.
Noninterest expense grew by $459 million, or 34%, from 2007. During
the fourth quarter of 2008, Key’s annual testing for goodwill impairment
indicated that the estimated fair value of the National Banking reporting
unit was less than its carrying amount, reflecting unprecedented weakness
in the financial markets. As a result, National Banking recorded a
noncash accounting charge of $465 million. Additionally, personnel costs
rose by $18 million from the prior year. These factors were partially
offset by a $21 million credit for losses on lending-related commitments
in 2008, compared to a $26 million provision in 2007.
In 2007, the $372 million decline in income from continuing operations
resulted from a $110 million, or 11%, decrease in noninterest income,
a$402 million increase in the provision for loan losses, and a $108
million increase in noninterest expense. The adverse effects of these
changes were moderated by a $29 million, or 2%, increase in taxable-
equivalent net interest income.
Management continues to pursue opportunities to improve Key’s
business mix and credit risk profile, and to emphasize relationship
businesses. During the thirdquarter of 2008, management decided to exit
retail and floor-plan lending for marine and recreational vehicle products,
and to limit new education loans to those backed by government
guarantee. Additionally,management has determined that Key will
cease lending to homebuilders.
Other Segments
Other Segments consists of Corporate Treasury and Key’s Principal
Investing unit. These segments generated a net loss of $24 million for
2008, compared to net income of $84 million for 2007. These results
reflect net losses of $62 million from principal investing in 2008,
compared to net gains of $134 million for the prior year. Additionally,
during the fourth quarter of 2008, Key recorded net losses of $39
million related to the volatility associated with the hedge accounting
applied to debt instruments, compared to net gains of $3 million in
the year-ago quarter. The majority of the net losses are attributable to
the restructuring of certain cash collateral arrangements for hedges
that reduced exposure to counterparty risk and lowered the cost of
borrowings. The adverse effects from the above items were 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 2007, Other Segments generated net income of $84 million, up
from $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 improvement
resulting from these items was offset in part by the $49 million loss on
the securities portfolio recorded in 2007 as discussed above.
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.
Key’staxable-equivalent net interest income for 2008 was $1.955
billion, compared to $2.868 billion for the prior year. Figure 9, which
spans pages 34 and 35, 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 table 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 2008, Key’s net interest margin declined
by 130 basis points to 2.16%. (A basis point is equal to one one-
hundredth of a percentage point, meaning 130 basis points equal 1.30%.)
The decline in net interest income and the reduction in the net interest
margin wereattributable primarily to the 2008 leveraged lease tax
litigation charges discussed below. The net interest margin also declined
because of increases in the cost of deposits and borrowings caused by
wider spreads, a shift in the mix of deposits to higher cost categories,
tighter loan spreads caused by competitive pricing, and higher levels of
nonperforming assets and net loan charge-offs.
Approximately 98 basis points of the reduction in Key’s net interest
margin resulted from $890 million in charges to interest income recorded
during 2008 in connection with the leveraged lease tax litigation. As
previously reported, most of these charges were recorded during the
second quarter following an adverse federal courtdecision on Key’stax
treatment of a leveraged sale-leaseback transaction. In accordance with
the accounting guidance provided under FASB Staff Position No. 13-2,
“Accounting for a Change or Projected Change in the Timing of Cash