UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 2001 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From ______ To ______ Commission File Number 0-850 [LOGO] KEYCORP ------------------------------------------------------ (Exact name of registrant as specified in its charter) OHIO 34-6542451 - ---------------------------------------- --------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 127 PUBLIC SQUARE, CLEVELAND, OHIO 44114-1306 - --------------------------------------------- ------------------------------- (Address of principal executive offices) (Zip Code) (216) 689-6300 ------------------------------------------------------ (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Shares with a par value of $1 each 423,468,540 Shares - -------------------------------------------- ---------------------------------- (Title of class) (Outstanding at October 31, 2001)
KEYCORP TABLE OF CONTENTS PART I. FINANCIAL INFORMATION <TABLE> <CAPTION> Item 1. FINANCIAL STATEMENTS PAGE NUMBER -------------------- ----------- <S> <C> Consolidated Balance Sheets -- September 30, 2001, December 31, 2000 and September 30, 2000 3 Consolidated Statements of Income -- Three and nine months ended September 30, 2001 and 2000 4 Consolidated Statements of Changes in Shareholders' Equity -- Nine months ended September 30, 2001 and 2000 5 Consolidated Statements of Cash Flow -- Nine months ended September 30, 2001 and 2000 6 Notes to Consolidated Financial Statements 7 Independent Accountants' Review Report 27 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 28 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK 59 PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS 59 Item 5. OTHER INFORMATION 59 Item 6. EXHIBITS AND REPORTS ON FORM 8-K 59 Signature 60 </TABLE> 2
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2001 2000 2000 =================================================================================================================================== (UNAUDITED) (UNAUDITED) <S> <C> <C> <C> ASSETS Cash and due from banks $ 2,803 $ 3,189 $ 2,691 Short-term investments 1,792 1,884 1,570 Securities available for sale 6,471 7,329 6,664 Investment securities (fair value: $1,186, $1,208 and $1,262) 1,174 1,198 1,253 Loans, net of unearned income of $1,782, $1,789 and $1,756 64,506 66,905 66,299 Less: Allowance for loan losses 1,174 1,001 1,001 - -------------------------------------------------------------------------------------------------------------------- Net loans 63,332 65,904 65,298 Premises and equipment 682 717 711 Goodwill 1,121 1,324 1,339 Other intangible assets 34 44 48 Corporate-owned life insurance 2,289 2,215 2,185 Accrued income and other assets 4,721 3,466 3,741 - --------------------------------------------------------------------------------------------------------------------- Total assets $ 84,419 $ 87,270 $ 85,500 ======== ======== ======== LIABILITIES Deposits in domestic offices: Noninterest-bearing $ 8,643 $ 9,076 $ 8,386 Interest-bearing 33,526 35,519 35,016 Deposits in foreign office - interest-bearing 3,203 4,054 4,407 - --------------------------------------------------------------------------------------------------------------------- Total deposits 45,372 48,649 47,809 Federal funds purchased and securities sold under repurchase agreements 4,367 4,936 5,324 Bank notes and other short-term borrowings 6,040 6,957 6,407 Accrued expense and other liabilities 5,622 4,701 4,397 Long-term debt 15,114 14,161 13,800 Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely subordinated debentures of KeyCorp (See Note 9) 1,329 1,243 1,243 - --------------------------------------------------------------------------------------------------------------------- Total liabilities 77,844 80,647 78,980 SHAREHOLDERS' EQUITY Preferred stock, $1 par value; authorized 25,000,000 shares, none issued -- -- -- Common shares, $1 par value; authorized 1,400,000,000 shares; issued 491,888,780 shares 492 492 492 Capital surplus 1,393 1,402 1,402 Retained earnings 6,282 6,352 6,205 Loans to ESOP trustee -- (13) (13) Treasury stock, at cost (68,461,648, 68,634,881 and 64,628,931 shares) (1,599) (1,600) (1,502) Accumulated other comprehensive income (loss) 7 (10) (64) - --------------------------------------------------------------------------------------------------------------------- Total shareholders' equity 6,575 6,623 6,520 - --------------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 84,419 $ 87,270 $ 85,500 ======== ======== ======== - --------------------------------------------------------------------------------------------------------------------- </TABLE> See Notes to Consolidated Financial Statements (Unaudited) 3
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ----------------------- ------------------------ dollars in millions, except per share amounts 2001 2000 2001 2000 =================================================================================================================================== <S> <C> <C> <C> <C> INTEREST INCOME Loans $ 1,240 $ 1,460 $ 3,979 $ 4,204 Taxable investment securities 8 8 23 18 Tax-exempt investment securities 4 5 13 18 Securities available for sale 113 106 348 325 Short-term investments 15 17 54 60 - --------------------------------------------------------------------------------------------------------------------------------- Total interest income 1,380 1,596 4,417 4,625 INTEREST EXPENSE Deposits 343 462 1,191 1,275 Federal funds purchased and securities sold under repurchase agreements 52 88 174 194 Bank notes and other short-term borrowings 61 99 260 328 Long-term debt, including capital securities 200 263 667 800 - --------------------------------------------------------------------------------------------------------------------------------- Total interest expense 656 912 2,292 2,597 - --------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME 724 684 2,125 2,028 Provision for loan losses 116 131 627 382 - --------------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 608 553 1,498 1,646 NONINTEREST INCOME Trust and investment services income 140 148 413 458 Investment banking and capital markets income 46 91 183 278 Service charges on deposit accounts 107 85 281 256 Corporate-owned life insurance income 28 28 82 78 Letter of credit and loan fees 27 26 86 73 Net securities gains (losses) 2 (50) 36 (47) Gain from divestiture -- -- -- 332 Other income 104 77 226 258 - --------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 454 405 1,307 1,686 NONINTEREST EXPENSE Personnel 334 342 1,043 1,085 Net occupancy 60 55 173 168 Computer processing 62 59 187 178 Equipment 37 41 115 131 Marketing 31 29 87 82 Amortization of intangibles 22 26 222 76 Professional fees 26 30 63 70 Restructuring charges -- 102 (4) 109 Other expense 111 103 353 313 - --------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 683 787 2,239 2,212 INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGES 379 171 566 1,120 Income taxes 130 50 235 384 - --------------------------------------------------------------------------------------------------------------------------------- INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES 249 121 331 736 Cumulative effect of accounting changes, net of tax (see Note 1) -- -- (25) -- - --------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 249 $ 121 $ 306 $ 736 ========= ========= ========= ========= Per common share: Income before cumulative effect of accounting changes $ .59 $ .28 $ .78 $ 1.69 Net income .59 .28 .72 1.69 Income before cumulative effect of accounting changes - assuming dilution .58 .28 .77 1.69 Net income - assuming dilution .58 .28 .71 1.68 Weighted average common shares outstanding (000) 424,802 429,584 424,503 435,156 Weighted average common shares and potential common shares outstanding (000) 430,346 431,972 430,009 437,231 =================================================================================================================================== </TABLE> See Notes to Consolidated Financial Statements (Unaudited) 4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED) <TABLE> <CAPTION> LOANS TO TREASURY COMMON CAPITAL RETAINED ESOP STOCK, dollars in millions, except per share amounts SHARES SURPLUS EARNINGS TRUSTEE AT COST ========================================================================================================================== <S> <C> <C> <C> <C> <C> BALANCE AT DECEMBER 31, 1999 $492 $1,412 $5,833 $(24) $(1,197) Net income 736 Other comprehensive income (losses): Net unrealized gains on securities available for sale, net of income taxes of $41(a) Foreign currency translation adjustments Total comprehensive income Cash dividends on common shares ($.84 per share) (364) Issuance of common shares: Employee benefit and dividend reinvestment plans - 1,486,112 net shares (10) 35 Repurchase of common shares - 17,652,800 shares (340) ESOP transactions 11 - -------------------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2000 $492 $1,402 $6,205 $(13) $(1,502) ==== ====== ====== ==== ======= ========================================================================================================================== BALANCE AT DECEMBER 31, 2000 $492 $1,402 $6,352 $(13) $(1,600) Net income 306 Other comprehensive income (losses): Net unrealized gains on securities available for sale, net of income taxes of $25(a) Cumulative effect of change in accounting for derivative financial instruments, net of income taxes of ($12) Net unrealized losses on derivative financial instruments, net of income taxes of ($2) Foreign currency translation adjustments Total comprehensive income Cash dividends on common shares ($.885 per share) (376) Issuance of common shares: Employee benefit and dividend reinvestment plans-1,862,367 net shares (9) 51 Repurchase of common shares - 2,035,600 shares (50) ESOP transactions 13 - -------------------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2001 $492 $1,393 $6,282 -- $(1,599) ==== ====== ====== ======= ========================================================================================================================== <CAPTION> ACCUMULATED OTHER COMPREHENSIVE COMPREHENSIVE dollars in millions, except per share amounts INCOME (LOSS) INCOME (LOSS)(b) ============================================================================================== <S> <C> <C> BALANCE AT DECEMBER 31, 1999 $(127) Net income $736 Other comprehensive income (losses): Net unrealized gains on securities available for sale, net of income taxes of $41(a) 73 73 Foreign currency translation adjustments (10) (10) ---- Total comprehensive income $799 ==== Cash dividends on common shares ($.84 per share) Issuance of common shares: Employee benefit and dividend reinvestment plans - 1,486,112 net shares Repurchase of common shares - 17,652,800 shares ESOP transactions - --------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2000 $(64) ==== - --------------------------------------------------------------------- BALANCE AT DECEMBER 31, 2000 $(10) Net income $306 Other comprehensive income (losses): Net unrealized gains on securities available for sale, net of income taxes of $25(a) 37 37 Cumulative effect of change in accounting for derivative financial instruments, net of income taxes of ($12) (22) (22) Net unrealized losses on derivative financial instruments, net of income taxes of ($2) (3) (3) Foreign currency translation adjustments 5 5 ---- Total comprehensive income $323 ==== Cash dividends on common shares ($.885 per share) Issuance of common shares: Employee benefit and dividend reinvestment plans-1,862,367 net shares Repurchase of common shares - 2,035,600 shares ESOP transactions - --------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 2001 $ 7 ==== ===================================================================== (a) Net of reclassification adjustments. (b) For the three months ended September 30, 2001 and 2000, comprehensive income was $262 million and $205 million, respectively. </TABLE> See Notes to Consolidated Financial Statements (Unaudited) 5
CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- in millions 2001 2000 ============================================================================================================= <S> <C> <C> OPERATING ACTIVITIES Net income $ 306 $ 736 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 627 382 Cumulative effect of accounting changes, net of tax 25 -- Depreciation expense and software amortization 215 211 Amortization of intangibles 222 76 Net gain from divestiture -- (332) Net securities (gains) losses (36) 47 Net (gains) losses from venture capital investments 33 (55) Net gains from loan securitizations and sales (40) (26) Deferred income taxes 138 203 Net increase in mortgage loans held for sale (330) (448) Net (increase) decrease in trading account assets (101) 39 Net increase (decrease) in accrued restructuring charges (58) 48 Other operating activities, net (368) (456) - ------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES 633 425 INVESTING ACTIVITIES Net increase in loans, excluding acquisitions, sales and divestitures (1,665) (5,615) Purchases of loans (107) -- Proceeds from loan securitizations and sales 4,061 4,377 Purchases of investment securities (207) (276) Proceeds from sales of investment securities 39 32 Proceeds from prepayments and maturities of investment securities 169 127 Purchases of securities available for sale (3,321) (4,908) Proceeds from sales of securities available for sale 325 4,162 Proceeds from prepayments and maturities of securities available for sale 3,843 723 Net decrease in other short-term investments 193 251 Purchases of premises and equipment (82) (60) Proceeds from sales of premises and equipment 13 19 Proceeds from sales of other real estate owned 19 19 Cash used in acquisitions, net of cash acquired (3) (375) - ------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 3,277 (1,524) FINANCING ACTIVITIES Net increase (decrease) in deposits (3,277) 4,576 Net decrease in short-term borrowings (1,486) (885) Net proceeds from issuance of long-term debt, including capital securities 3,542 3,153 Payments on long-term debt, including capital securities (2,687) (5,217) Loan payments received from ESOP trustee 13 11 Purchases of treasury shares (50) (317) Net proceeds from issuance of common stock 25 17 Cash dividends (376) (364) - ------------------------------------------------------------------------------------------------------------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES (4,296) 974 - ------------------------------------------------------------------------------------------------------------- NET DECREASE IN CASH AND DUE FROM BANKS (386) (125) - ------------------------------------------------------------------------------------------------------------- CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,189 2,816 - ------------------------------------------------------------------------------------------------------------- CASH AND DUE FROM BANKS AT END OF PERIOD $ 2,803 $ 2,691 ======= ======= - ------------------------------------------------------------------------------------------------------------- Additional disclosures relative to cash flow: Interest paid $ 2,148 $ 2,560 Income taxes paid 95 83 Noncash items: Derivative assets resulting from adoption of new accounting standard $ 120 -- Derivative liabilities resulting from adoption of new accounting standard 152 -- ============================================================================================================ </TABLE> See Notes to Consolidated Financial Statements (Unaudited) 6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The unaudited condensed consolidated interim financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Management believes that the unaudited condensed consolidated interim financial statements reflect all adjustments of a normal recurring nature and disclosures which are necessary for a fair presentation of the results for the interim periods presented. Some previously reported results have been reclassified to conform to current reporting practices. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. When you read these financial statements, you should also look at the audited consolidated financial statements and related notes included in Key's 2000 Annual Report to Shareholders. As used in these Notes, KeyCorp refers solely to the parent company and Key refers to the consolidated entity consisting of KeyCorp and its subsidiaries. ACCOUNTING PRONOUNCEMENTS ADOPTED IN 2001 DERIVATIVES AND HEDGING ACTIVITIES. Effective January 1, 2001, Key adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133), which establishes accounting and reporting standards for derivative instruments ("derivatives") and for hedging activities. SFAS 133 requires that all derivatives be recognized as either assets or liabilities on the balance sheet at fair value. The accounting for changes in the fair value (i.e., gains or losses) of derivatives depends on whether they have been designated and qualify as part of a hedging relationship and further, on the type of hedging relationship. Derivatives that are designated and qualify as hedging instruments must be designated as either a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. Key does not have any derivatives that hedge net investments in foreign operations. Derivatives that are used to hedge changes in the fair value of existing assets, liabilities, and firm commitments against changes in interest rates or other economic factors are designated as fair value hedges. The gain or loss on the derivative as well as the related loss or gain on the hedged item attributable to the hedged risk are recognized in earnings during the period of the change in fair values. Derivatives that are used to hedge the variability of future cash flows against changes in interest rates or other economic factors are designated as cash flow hedges. The effective portion of a gain or loss on a derivative designated as a cash flow hedge is reported as a component of other comprehensive income or loss and reclassified into earnings in the same period or periods that the hedged transaction affects earnings. The ineffective portion of the derivative gain or loss, if any, is recognized in earnings during the current period. For derivatives not designated as hedging instruments, the gain or loss is recognized immediately in earnings. As a result of adopting SFAS 133, Key recorded a cumulative loss of $1 million in net income and a cumulative loss of $22 million in other comprehensive income (loss) during the first quarter of 2001. TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES. In September 2000, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (SFAS 140), which replaces SFAS 125. SFAS 140 retains most of the SFAS 125 provisions related to controlling interests and adds three significant new rules. These new rules: 7
- - prescribe the test that determines whether a special purpose entity ("SPE") is a "qualifying" SPE, and prescribe the amount and type of derivative instruments a qualifying SPE can hold and the activities it may pursue; - - provide more restrictive guidance regarding the circumstances under which a company that transfers assets to a qualifying SPE will be deemed to have relinquished control of such assets and may account for the transaction as a sale; and - - require extensive disclosures about collateral, assets securitized and accounted for as a sale, and retained interests in securitized assets. Effective April 1, 2001, Key adopted SFAS 140 which is effective for transactions entered into after March 31, 2001. The statement was effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Key included the disclosures required by SFAS 140 in the notes to its December 31, 2000, financial statements. RECOGNITION OF INTEREST INCOME AND IMPAIRMENT ON CERTAIN INVESTMENTS. In July 2000, the Emerging Issues Task Force ("EITF"), a standard-setting group under the auspices of the Financial Accounting Standards Board, reached a consensus in EITF 99-20 that provides guidance on how to record interest income and measure impairment on beneficial interests retained in a securitization transaction accounted for as a sale under SFAS 140 and on purchased beneficial interests in securitized financial assets. Assets subject to this accounting guidance are carried on the balance sheet as securities available for sale [see Note 5 ("Securities") starting on page 15] or as trading account assets. This accounting guidance is effective for fiscal quarters beginning after March 15, 2001. Key adopted this guidance on April 1, 2001. As a result, during the second quarter, Key recorded a cumulative loss of $24 million in net income. This loss is presented as a "cumulative effect of accounting change" on Key's income statement. ACCOUNTING PRONOUNCEMENTS PENDING ADOPTION BUSINESS COMBINATIONS. In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141, "Business Combinations" (SFAS 141), which replaces Accounting Principles Board Opinion No. 16. SFAS 141 eliminates the pooling-of-interests method of accounting for business combinations initiated after June 30, 2001. Subsequent to June 30, 2001, Key has not initiated any business combinations that would have qualified for the pooling-of-interest method of accounting. GOODWILL AND OTHER INTANGIBLE ASSETS. In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (SFAS 142), which takes effect for fiscal years beginning after December 15, 2001. SFAS 142 replaces Accounting Principles Board Opinion No. 17 and eliminates the amortization of goodwill and intangible assets deemed to have indefinite lives. Management anticipates that the elimination of the related amortization may reduce noninterest expense and increase net income by approximately $80 million for 2002. Under the new accounting standard, goodwill and certain intangible assets are subject to impairment tests, which must be conducted at least annually. The impairment tests will require Key to determine the fair value of its reporting units by using various valuation techniques recommended by the standard. If the carrying amount of any reporting unit exceeds its fair value, it will be necessary to determine the amount of any goodwill impairment by conducting a detailed fair value analysis of the assets (excluding goodwill) assigned to the unit. Impairment losses, if any, that result from the initial application of SFAS 142 would be accounted for as a "cumulative effect of accounting change" on Key's income statement. Transitional impairment tests conducted to determine the amount of any such losses must be completed as soon as possible after adoption of the new standard, but no later than December 31, 2002. However, transitional impairment losses related to 8
goodwill must be recognized in the first interim reporting period subsequent to adoption of the standard. As such, Key expects to complete the transitional goodwill impairment testing prior to March 31, 2002. Impairment losses incurred subsequent to those resulting from the transitional impairment test will be recorded as part of income from operations. Management is currently in the process of determining the valuation techniques that will be applied and the reporting units for which initial and subsequent tests will be performed. Therefore, the extent of any potential "transition impairment charge" has not yet been determined. Key will adopt SFAS 142 as of January 1, 2002. ASSET RETIREMENT OBLIGATIONS. In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 143, "Accounting for Asset Retirement Obligations" (SFAS 143), which takes effect for fiscal years beginning after June 15, 2002. SFAS 143 establishes the initial and subsequent accounting for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal operation of a long-lived asset. Key will adopt SFAS 143 as of January 1, 2003, and management is currently evaluating the extent to which it will impact Key's financial condition and results of operations. IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS. In October 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS 144), which replaces Statement of Financial Accounting Standards No. 121. The new standard provides an accounting model for the disposal of long-lived assets and significantly changes the criteria that would have to be met to classify such an asset as held for sale. SFAS 144 also broadens the extent to which dispositions will qualify for reporting as discontinued operations, and changes the manner in which expected future operating losses from such operations are to be reported. The new standard is effective for fiscal years beginning after December 15, 2001. Key will adopt SFAS 144 as of January 1, 2002, and management is currently evaluating the extent to which it will impact Key's financial condition and results of operations. ACCOUNTING GUIDANCE ISSUED DURING 2001 ACCOUNTING AND REPORTING FOR CERTAIN LOANS HELD FOR SALE. The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of Thrift Supervision, and the National Credit Union Administration issued Interagency Guidance in March 2001, instructing institutions and examiners about the appropriate accounting and reporting treatment for certain loans that are sold directly from the loan portfolio or transferred to a held for sale account. In accordance with the guidance, once a decision has been made to sell a nonperforming loan, normal credit evaluation procedures should continue until the loan is sold directly from the loan portfolio or transferred to a held for sale account. If the proceeds from the sale of a nonperforming loan held in the portfolio are less than its net carrying amount, the shortfall must be recorded as a loan charge-off unless it can be demonstrated that part or all of the shortfall was attributable to market-driven factors, such as changes in interest rates or foreign exchange rates. Market driven related losses must be reported in earnings, while credit risk related losses must be reported as charge-offs. Nonperforming loans transferred to a held for sale account must be revalued at each subsequent reporting date until sold and reported at the lower of their amortized cost or fair value. Changes in the carrying amounts of these loans must be reported in earnings. This guidance did not have a significant impact on Key during the first nine months of 2001, nor would it have had a significant impact on prior periods had it been issued earlier. Key has applied this guidance in subsequent sales of certain nonperforming consumer (primarily home equity) loans. The Securities and Exchange Commission has expressed views that support the Interagency Guidance. 9
2. EARNINGS PER COMMON SHARE The computation of Key's basic and diluted earnings per common share is as follows: <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------- ------------------------------- dollars in millions, except per share amounts 2001 2000 2001 2000 - -------------------------------------------------------------------------------------------------------------------------------- EARNINGS <S> <C> <C> <C> <C> Income before cumulative effect of accounting changes $ 249 $ 121 $ 331 $ 736 Net income 249 121 306 736 - -------------------------------------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE COMMON SHARES Weighted average common shares outstanding (000) 424,802 429,584 424,503 435,156 Effect of dilutive common stock options (000) 5,544 2,388 5,506 2,075 - -------------------------------------------------------------------------------------------------------------------------------- Weighted average common shares and potential common shares outstanding (000) 430,346 431,972 430,009 437,231 ======== ======= ======= ======= - -------------------------------------------------------------------------------------------------------------------------------- EARNINGS PER COMMON SHARE Income per common share before cumulative effect of accounting changes $.59 $.28 $.78 $1.69 Net income per common share .59 .28 .72 1.69 Income per common share before cumulative effect of accounting changes - assuming dilution .58 .28 .77 1.69 Net income per common share - assuming dilution .58 .28 .71 1.68 - -------------------------------------------------------------------------------------------------------------------------------- </TABLE> 3. ACQUISITIONS AND DIVESTITURE Business acquisitions and the divestiture that Key completed during 2000 and the first nine months of 2001 are summarized below. ACQUISITIONS THE WALLACH COMPANY INC. On January 2, 2001, Key purchased The Wallach Company, Inc., an investment banking firm headquartered in Denver, Colorado. The purchase price of approximately $11 million was paid partly in cash and partly in the form of 370,830 Key common shares. Goodwill of approximately $9 million was recorded and is currently being amortized using the straight-line method over a period of 10 years. NEWPORT MORTGAGE COMPANY L.P. On September 30, 2000, Key purchased certain net assets of Newport Mortgage Company L.P., a commercial mortgage company headquartered in Dallas, Texas. Goodwill of approximately $10 million was recorded and is currently being amortized using the straight-line method over a period of 10 years. NATIONAL REALTY FUNDING L.C. On January 31, 2000, Key purchased certain net assets of National Realty Funding L.C., a commercial finance company headquartered in Kansas City, Missouri. Goodwill of approximately $10 million was recorded and is currently being amortized using the straight-line method over a period of 15 years. DIVESTITURE - ----------- CREDIT CARD PORTFOLIO On January 31, 2000, Key sold its credit card portfolio of $1.3 billion in receivables and nearly 600,000 active VISA and MasterCard accounts to Associates National Bank (Delaware). Key recognized a gain of $332 million ($207 million after tax), which is included in "gain from divestiture" on the income statement. 10
4. LINE OF BUSINESS RESULTS Key's three major lines of business are Key Consumer Banking, Key Corporate Finance and Key Capital Partners. KEY CONSUMER BANKING RETAIL BANKING (A DIVISION OF KEY CONSUMER BANKING) - --------------------------------------------------- Retail Banking delivers a complete line of branch-based financial products and services to consumers through 911 KeyCenters (retail banking branches). These KeyCenters are operated by relationship managers supported by a 24-hour telephone banking call center services group, 2,401 ATMs that access 15 different networks (resulting in one of the largest ATM networks in the United States) and a leading-edge Internet banking service, Key.com(R). HOME EQUITY AND CONSUMER FINANCE (A DIVISION OF KEY CONSUMER BANKING) - --------------------------------------------------------------------- Home Equity and Consumer Finance provides indirect, non-branch-based consumer loan products, including automobile loans, home equity loans, education loans, and marine and recreational vehicle loans. As of December 31, 2000, based on the volume of loans generated, Home Equity and Consumer Finance was one of the foremost lenders for education, automobile purchases, and purchases of marine and recreational vehicles in the United States. KEY CORPORATE FINANCE Key Corporate Finance offers a complete range of financing, transaction processing, electronic commerce and financial advisory services to corporations nationwide. It operates one of the largest bank-affiliated equipment leasing companies in the world, with operations in the United States, Canada, Europe, Asia and the Pacific Rim. Key Corporate Finance also offers investment banking, capital markets, 401(k) and trust custody products in cooperation with Key Capital Partners. Key Corporate Finance is organized around five primary lines of businesses: commercial banking, commercial real estate, equipment finance, specialized industries, and global treasury management. Across Key's 13-state franchise, its commercial banking unit has a significant market share with middle market, small business and large corporate segment companies. Key Corporate Finance ranks among the top banks in providing financial services to media and telecommunications, commercial real estate and health care industries across the nation. Based on total transaction volume, it is also one of the nation's leading providers of cash management services. KEY CAPITAL PARTNERS Key Capital Partners provides asset management, employee benefits services, brokerage services, investment banking, and capital markets and insurance expertise. It also offers specialized services to high-net-worth clients through the wealth management and private banking businesses. Key Capital Partners employs a range of distribution outlets, including those of Key's other lines of business. The table that spans pages 13 and 14 shows selected financial data for each major line of business for the three- and nine-month periods ended September 30, 2001 and 2000. The financial information was derived from the internal profitability reporting system that management uses to monitor and manage Key's financial performance. The selected financial data are based on internal accounting policies designed to ensure that results are compiled on a consistent basis and reflect the underlying economics of Key's three major businesses. In accordance with these policies: 11
- - Net interest income for each line of business was determined by assigning a standard cost for funds used (or a standard credit for funds provided) to assets and liabilities based on their maturity, prepayment and/or repricing characteristics. The net effect of this funds transfer pricing is included in the "Treasury and Other" columns of the table. - - Indirect expenses, such as computer servicing costs and corporate overhead, were allocated based on the extent to which each line of business actually used the service. - - The provision for loan losses assigned to each line of business reflects credit quality expectations within each line over a normal business cycle. This "normalized provision for loan losses" does not necessarily coincide with actual net loan charge-offs at any given point in the cycle. The level of the consolidated provision is based upon the methodology that Key uses to estimate its consolidated allowance for loan losses. This methodology is described in Note 1 ("Summary of significant accounting policies") under the heading "Allowance for loan losses" on page 66 of Key's 2000 Annual Report to Shareholders. - - Income taxes were allocated based on the statutory Federal income tax rate of 35% (adjusted for tax-exempt income from corporate-owned life insurance, nondeductible goodwill amortization and tax credits associated with investments in low-income housing projects) and a blended state income tax rate (net of the Federal income tax benefit) of 2% for the periods presented. - - Capital was assigned to each line of business based on management's assessment of economic risk factors (primarily credit, operating and market risk). Developing and applying the methodologies that management follows to allocate items among Key's lines of business is a dynamic process. Accordingly, financial results may be revised periodically to reflect accounting enhancements, changes in the risk profile of a particular segment of Key's business or changes in Key's structure. The financial data for both 2001 and 2000 presented in the accompanying table reflects the following changes that occurred during the first nine months of 2001: - - A number of businesses have been reclassified. The Key Electronic Services unit moved from Treasury and Other to Retail Banking, the Small Business unit moved from Retail Banking to Key Corporate Finance, the Community Development unit moved from Key Corporate Finance to Retail Banking and the Principal Investing unit moved from Key Capital Partners to Treasury and Other. - - The methodology used to assign a provision for loan losses to each line of business was changed from one based primarily upon actual net charge-offs to a methodology based on the credit quality expectations within each line over a normal business cycle. Accounting principles generally accepted in the United States guide financial accounting, but there is no authoritative guidance for "management accounting"--the way management uses its judgment and experience to guide reporting decisions. Consequently, the line of business results Key reports cannot necessarily be compared with results presented by other companies. 12
NOTE 4. LINE OF BUSINESS <TABLE> <CAPTION> KEY CONSUMER BANKING ----------------------------------------------------------- HOME EQUITY AND THREE MONTHS ENDED SEPTEMBER 30, RETAIL BANKING CONSUMER FINANCE --------------------------- ----------------------------- <S> <C> <C> <C> <C> dollars in millions 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $233 $240 $150 $131 Noninterest income 116 97 4 5 Revenue sharing(a) 12 19 ___ ___ - --------------------------------------------------------------------------------------------------------------------------------- Total revenue(b) 361 356 154 136 Provision for loan losses 12 12 33 33 Depreciation and amortization expense 38 40 10 12 Noninterest expense 158 162 79 63 Expense sharing(a) 9 13 ___ ___ - --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting change 144 129 32 28 Allocated income taxes and taxable equivalent adjustments 56 50 13 12 - --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting change 88 79 19 16 Cumulative effect of accounting change ___ ___ ___ ___ - --------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 88 $ 79 $19 $16 ===== ===== ==== ==== Percent of consolidated net income 35% 65% 8% 13% Percent of total segments' net income 35 36 7 7 - --------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $7,735 $7,840 $15,586 $15,084 Total assets(b) 9,058 9,304 16,558 16,206 Deposits 30,892 32,188 213 164 - --------------------------------------------------------------------------------------------------------------------------------- <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, KEY CORPORATE FINANCE ------------------------------- <S> <C> <C> dollars in millions 2001 2000 - ---------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $351 $334 Noninterest income 76 67 Revenue sharing(a) 32 34 - ---------------------------------------------------------------------------------------------------------- Total revenue(b) 459 435 Provision for loan losses 52 50 Depreciation and amortization expense 20 20 Noninterest expense 164 160 Expense sharing(a) 18 21 - ---------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting change 205 184 Allocated income taxes and taxable equivalent adjustments 78 70 - ---------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting change 127 114 Cumulative effect of accounting change ___ ___ - ---------------------------------------------------------------------------------------------------------- Net income (loss) $127 $114 ==== ==== Percent of consolidated net income 51% 94% Percent of total segments' net income 50 51 - ---------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $35,545 $34,826 Total assets(b) 37,377 36,618 Deposits 6,637 6,482 - ---------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> KEY CONSUMER BANKING --------------------------------------------------------------- HOME EQUITY AND NINE MONTHS ENDED SEPTEMBER 30, RETAIL BANKING CONSUMER FINANCE ------------------------------- ----------------------------- dollars in millions 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS <S> <C> <C> <C> <C> Net interest income (taxable equivalent) $696 $700 $438 $384 Noninterest income 306 277 7 41 Revenue sharing(a) 38 53 2 2 - ---------------------------------------------------------------------------------------------------------------------------------- Total revenue(b) 1,040 1,030 447 427 Provision for loan losses 36 37 99 98 Depreciation and amortization expense 117 119 34 37 Noninterest expense 476 495 218 200 Expense sharing(a) 27 42 1 ___ - ---------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting changes 384 337 95 92 Allocated income taxes and taxable equivalent adjustments 150 132 40 40 - ---------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes 234 205 55 52 Cumulative effect of accounting changes -- -- (24) ___ - ---------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $234 $205 $31 $52 ===== ===== ==== ==== Percent of consolidated net income 76% 28% 10% 7% Percent of total segments' net income 34 30 5 8 - ---------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $7,773 $7,737 $15,742 $14,886 Total assets(b) 9,141 9,230 16,777 16,062 Deposits 31,815 31,374 164 139 - ---------------------------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, KEY CORPORATE FINANCE ------------------------------- dollars in millions 2001 2000 - --------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS <S> <C> <C> Net interest income (taxable equivalent) $1,040 $978 Noninterest income 231 215 Revenue sharing(a) 103 98 - --------------------------------------------------------------------------------------------------------- Total revenue(b) 1,374 1,291 Provision for loan losses 155 148 Depreciation and amortization expense 61 59 Noninterest expense 506 476 Expense sharing(a) 60 61 - --------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting changes 592 547 Allocated income taxes and taxable equivalent adjustments 226 210 - --------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes 366 337 Cumulative effect of accounting changes ___ ___ - --------------------------------------------------------------------------------------------------------- Net income (loss) $366 $337 ===== ===== Percent of consolidated net income 120% 46% Percent of total segments' net income 54 50 - --------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $35,693 $34,307 Total assets(b) 37,453 36,198 Deposits 6,542 6,327 - --------------------------------------------------------------------------------------------------------- </TABLE> (a) Represents the assignment of Key Capital Partners' revenue and expense to the lines of business principally responsible for maintaining the relationships with the clients that used Key Capital Partners' products and services. (b) Substantially all revenue generated by Key's major lines of business is derived from clients resident in the United States. Substantially all long-lived assets, including premises and equipment, capitalized software and goodwill, held by Key's major lines of business are located in the United States. (c) "Reconciling items" reflect certain nonrecurring items, the results of the divested credit card business and charges related to unallocated nonearning assets of corporate support functions. These latter charges are part of net interest income and are allocated to the business segments through noninterest expense. Noninterest income for the first nine months of 2001 includes a loss of $40 million ($25 million after tax) recorded in the second quarter in connection with the decline in leased vehicle residual values. Noninterest income in the first nine months of 2000 includes a gain of $332 million ($207 million after tax) from the January sale of Key's credit card business and $5 million ($3 million after tax) earned by the divested credit card business. This business also added $13 million ($8 million after tax) in the first nine months of 2000 to net interest income. 13
<TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, KEY CAPITAL PARTNERS TREASURY AND OTHER --------------------------- ----------------------------- dollars in millions 2001 2000 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS <S> <C> <C> <C> <C> Net interest income (taxable equivalent) $53 $54 $(30) $(29) Noninterest income 233 237 25 (1) Revenue sharing(a) (44) (53) ___ ___ - ----------------------------------------------------------------------------------------------------------------------------------- Total revenue(b) 242 238 (5) (30) Provision for loan losses 3 2 1 1 Depreciation and amortization expense 24 23 ___ ___ Noninterest expense 209 202 6 7 Expense sharing(a) (27) (34) ___ ___ - ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting change 33 45 (12) (38) Allocated income taxes and taxable equivalent adjustments 15 19 (15) (25) - ----------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting change 18 26 3 (13) Cumulative effect of accounting change ___ ___ ___ ___ - ----------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $18 $26 $ 3 $(13) === === === ==== Percent of consolidated net income 7% 21% 2% (11)% Percent of total segments' net income 7 12 1 (6) - ----------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $5,456 $5,424 $1,774 $2,226 Total assets(b) 9,195 8,945 11,488 11,347 Deposits 3,466 3,378 4,111 3,601 - ----------------------------------------------------------------------------------------------------------------------------------- <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, TOTAL SEGMENTS RECONCILING ITEMS ----------------------------- ------------------------------- dollars in millions 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------------------------------ SUMMARY OF OPERATIONS <S> <C> <C> <C> <C> Net interest income (taxable equivalent) $757 $730 $(27) $(39) Noninterest income 454 405 ___ ___ Revenue sharing(a) ___ ___ ___ ___ - ------------------------------------------------------------------------------------------------------------------------------------ Total revenue(b) 1,211 1,135 (27)(c) (39)(c) Provision for loan losses 101 98 15 33 Depreciation and amortization expense 92 95 1 1 Noninterest expense 616 594 (26) 97 (e) Expense sharing(a) ___ ___ ___ ___ - ------------------------------------------------------------------------------------------------------------------------------------ Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting change 402 348 (17) (170) Allocated income taxes and taxable equivalent adjustments 147 126 (11) (69) - ------------------------------------------------------------------------------------------------------------------------------------ Income (loss) before cumulative effect of accounting change 255 222 (6) (101) Cumulative effect of accounting change ___ ___ ___ ___ - ------------------------------------------------------------------------------------------------------------------------------------ Net income (loss) $255 $ 222 $(6) $(101) ===== ====== ==== ====== Percent of consolidated net income 103% 182% (3)% (82)% Percent of total segments' net income 100 100 N/A N/A - ------------------------------------------------------------------------------------------------------------------------------------ AVERAGE BALANCES Loans $66,096 $65,400 $ 102 $ 377 Total assets(b) 83,676 82,420 1,203 (f) 1,685 (f) Deposits 45,319 45,813 (86) 26 - ------------------------------------------------------------------------------------------------------------------------------------ <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, KEY ------------------------------- dollars in millions 2001 2000 - -------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS <S> <C> <C> Net interest income (taxable equivalent) $730 $691 Noninterest income 454 405 Revenue sharing(a) ___ ___ - -------------------------------------------------------------------------------------------------------- Total revenue(b) 1,184 1,096 Provision for loan losses 116 131 Depreciation and amortization expense 93 96 Noninterest expense 590 691 Expense sharing(a) ___ ___ - -------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting change 385 178 Allocated income taxes and taxable equivalent adjustments 136 57 - -------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting change 249 121 Cumulative effect of accounting change ___ ___ - -------------------------------------------------------------------------------------------------------- Net income (loss) $ 249 $121 ===== ==== Percent of consolidated net income 100% 100% Percent of total segments' net income N/A N/A - -------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $66,198 $65,777 Total assets(b) 84,879 84,105 Deposits 45,233 45,839 - -------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, KEY CAPITAL PARTNERS TREASURY AND OTHER ------------------------------ -------------------------------- dollars in millions 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $157 $155 $(100) $(70) Noninterest income 713 726 85 85 Revenue sharing(a) (143) (153) -- -- - --------------------------------------------------------------------------------------------------------------------------------- Total revenue(b) 727 728 (15) 15 Provision for loan losses 8 7 3 4 Depreciation and amortization expense 74 69 -- 1 Noninterest expense 651 648 19 23 Expense sharing(a) (88) (103) -- -- - --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting changes 82 107 (37) (13) Allocated income taxes and taxable equivalent adjustments 38 46 (46) (36) - --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes 44 61 9 23 Cumulative effect of accounting changes -- -- (1) -- - --------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $44 $ 61 $ 8 $ 23 === ==== ==== ==== Percent of consolidated net income 14% 8% 3% 3% Percent of total segments' net income 6 9 1 3 - --------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $5,501 $5,268 $1,912 $2,334 Total assets(b) 9,191 9,006 11,718 11,378 Deposits 3,728 3,377 3,557 3,679 - --------------------------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, TOTAL SEGMENTS RECONCILING ITEMS ---------------------------- -------------------------------- dollars in millions 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $2,231 $2,147 $(87) $ (98) Noninterest income 1,342 1,344 (35) 342 Revenue sharing(a) -- -- -- -- - --------------------------------------------------------------------------------------------------------------------------------- Total revenue(b) 3,573 3,491 (122)(c) 244(c) Provision for loan losses 301 294 326 (d) 88(d) Depreciation and amortization expense 286 285 151 (e) 2 Noninterest expense 1,870 1,842 (68)(e) 83(e) Expense sharing(a) -- -- -- -- - --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting changes 1,116 1,070 (531) 71 Allocated income taxes and taxable equivalent adjustments 408 392 (154) 13 - --------------------------------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes 708 678 (377) 58 Cumulative effect of accounting changes (25) -- -- -- - --------------------------------------------------------------------------------------------------------------------------------- Net income (loss) $683 $678 $(377) $ 58 ===== ===== ====== ===== Percent of consolidated net income 223% 92% (123)% 8% Percent of total segments' net income 100 100 N/A N/A - --------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $66,621 $64,532 $ 104 $344 Total assets(b) 84,280 81,874 1,444 (f) 1,694(f) Deposits 45,806 44,896 (56) 24 - --------------------------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, KEY ----------------------------------- dollars in millions 2001 2000 - ------------------------------------------------------------------------------------------------------- <S> <C> <C> SUMMARY OF OPERATIONS Net interest income (taxable equivalent) $2,144 $2,049 Noninterest income 1,307 1,686 Revenue sharing(a) -- -- - ------------------------------------------------------------------------------------------------------- Total revenue(b) 3,451 3,735 Provision for loan losses 627 382 Depreciation and amortization expense 437 287 Noninterest expense 1,802 1,925 Expense sharing(a) -- -- - ------------------------------------------------------------------------------------------------------- Income (loss) before income taxes (taxable equivalent) and cumulative effect of accounting changes 585 1,141 Allocated income taxes and taxable equivalent adjustments 254 405 - ------------------------------------------------------------------------------------------------------- Income (loss) before cumulative effect of accounting changes 331 736 Cumulative effect of accounting changes (25) -- - ------------------------------------------------------------------------------------------------------- Net income (loss) $ 306 $ 736 ===== ====== Percent of consolidated net income 100% 100% Percent of total segments' net income N/A N/A - ------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $66,725 $64,876 Total assets(b) 85,724 83,568 Deposits 45,750 44,920 - ------------------------------------------------------------------------------------------------------- </TABLE> (d) The first nine months of 2001 includes an additional provision for loan losses of $300 million ($189 million after tax) recorded during the second quarter in connection with Key's decision to discontinue certain nonrelationship credit-only commercial lending. In the first nine months of 2000, the provision for loan losses includes an additional first quarter provision of $121 million ($76 million after tax). This provision resulted from the implementation of an enhanced methodology for assessing credit risk particularly in the commercial loan portfolio. (e) Noninterest expense in the third quarter of 2000 includes $114 million ($72 million after tax) of nonrecurring charges recorded in connection with strategic actions being taken to improve Key's operating efficiency and profitability. Noninterest expense for the first nine months of 2001 includes a goodwill write-down of $150 million associated with Key's decision to downsize its automobile finance business, additional litigation reserves of $20 million ($13 million after tax) and $2 million ($1 million after tax) of nonrecurring charges recorded in connection with strategic actions being taken to improve Key's operating efficiency and profitability. All of these charges were recorded in the second quarter. For the first nine months of 2000, noninterest expense includes $130 million ($82 million after tax) of nonrecurring charges recorded in connection with strategic actions being taken to improve Key's operating efficiency and profitability and $7 million ($4 million after tax) incurred by the divested credit card business. (f) Total assets represent primarily the unallocated portion of nonearning assets of corporate support functions. N/A = Not Applicable 14
5. SECURITIES Key classifies its securities into three categories: trading, investment and available for sale. TRADING ACCOUNT SECURITIES. These are debt and equity securities that are purchased and held by Key with the intent of selling them in the near term. These securities are reported at fair value ($844 million, $743 million and $729 million at September 30, 2001, December 31, 2000 and September 30, 2000, respectively) and included in "short-term investments" on the balance sheet. Realized and unrealized gains and losses on trading account securities are reported in "investment banking and capital markets income" on the income statement. INVESTMENT SECURITIES. These include debt securities that Key has the intent and ability to hold until maturity and equity securities that do not have readily determinable fair values. The debt securities are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method. This method produces a constant rate of return on the basis of the adjusted carrying amount. SECURITIES AVAILABLE FOR SALE. These are debt and equity securities that Key has not classified as trading account securities or investment securities. Securities available for sale are reported at fair value with unrealized gains and losses (net of income taxes) recorded in shareholders' equity as a component of "accumulated other comprehensive income (loss)." Actual gains and losses on the sales of these securities are computed for each specific security sold and included in "net securities gains " on the income statement. When Key retains an interest in securitized loans, Key bears the risk that the loans will be prepaid (which results in less interest income) or not paid at all. Key's retained interests (which include both certificated and uncertificated interests) are accounted for like debt securities that are classified as securities available for sale or as trading account securities. The amortized cost, unrealized gains and losses, and approximate fair value of Key's investment securities and securities available for sale were as follows: <TABLE> <CAPTION> SEPTEMBER 30, 2001 -------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INVESTMENT SECURITIES States and political subdivisions $ 254 $12 -- $ 266 Other securities 920 -- -- 920 - ---------------------------------------------------------------------------------------------------------------- Total investment securities $1,174 $12 -- $1,186 ======= ==== ==== ======= SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 268 -- -- $ 268 States and political subdivisions 23 -- -- 23 Collateralized mortgage obligations 4,562 $117 $65 4,614 Other mortgage-backed securities 1,092 39 -- 1,131 Retained interests in securitizations 246 15 -- 261 Other securities 198 1 25 174 - ---------------------------------------------------------------------------------------------------------------- Total securities available for sale $6,389 $172 $90 $6,471 ======= ===== ==== ======= - ---------------------------------------------------------------------------------------------------------------- </TABLE> 15
<TABLE> <CAPTION> DECEMBER 31, 2000 -------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INVESTMENT SECURITIES States and political subdivisions $ 323 $10 -- $ 333 Other securities 875 -- -- 875 - ---------------------------------------------------------------------------------------------------------------- Total investment securities $1,198 $10 -- $1,208 ======= ==== ==== ======= SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 984 -- -- $ 984 States and political subdivisions 33 -- -- 33 Collateralized mortgage obligations 4,296 $63 $61 4,298 Other mortgage-backed securities 1,355 12 12 1,355 Retained interests in securitizations 334 -- 18 316 Other securities 307 42 6 343 - ---------------------------------------------------------------------------------------------------------------- Total securities available for sale $7,309 $117 $97 $7,329 ======= ===== ==== ======= - ---------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> SEPTEMBER 30, 2000 -------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INVESTMENT SECURITIES States and political subdivisions $ 364 $9 -- $ 373 Other securities 889 -- -- 889 - ---------------------------------------------------------------------------------------------------------------- Total investment securities $1,253 $9 -- $1,262 ====== ==== ===== ====== SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $2,105 -- -- $2,105 States and political subdivisions 48 -- -- 48 Collateralized mortgage obligations 2,561 $12 $99 2,474 Other mortgage-backed securities 1,425 6 23 1,408 Retained interests in securitizations 341 -- 15 326 Other securities 278 28 3 303 - ---------------------------------------------------------------------------------------------------------------- Total securities available for sale $6,758 $46 $140 $6,664 ======= ==== ===== ====== - ---------------------------------------------------------------------------------------------------------------- </TABLE> 16
6. LOANS Key's loans by category are summarized as follows: <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2001 2000 2000 - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Commercial, financial and agricultural $19,022 $20,100 $19,884 Real estate-- commercial mortgage 6,826 6,876 6,900 Real estate-- construction 6,014 5,154 5,019 Commercial lease financing 7,147 7,164 7,011 - --------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 39,009 39,294 38,814 Real estate-- residential mortgage 2,418 4,212 4,264 Home equity 10,826 9,908 9,344 Consumer-- direct 2,388 2,539 2,633 Consumer-- indirect lease financing 2,409 3,005 3,035 Consumer-- indirect other 5,408 5,718 5,891 - --------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 23,449 25,382 25,167 Real estate-- commercial mortgage 614 316 588 Real estate-- residential mortgage 74 42 54 Education 1,360 1,871 1,676 - --------------------------------------------------------------------------------------------------------------------------------- Total loans held for sale 2,048 2,229 2,318 - --------------------------------------------------------------------------------------------------------------------------------- Total loans $64,506 $66,905 $66,299 ======== ======== ======== - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> Key uses interest rate swaps to manage interest rate risk; these swaps modify the repricing and maturity characteristics of certain loans. For more information about such swaps at September 30, 2001, see Note 12 ("Derivatives and Hedging Activities"), which begins on page 24. Changes in the allowance for loan losses are summarized as follows: <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------------- ----------------------------------- in millions 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Balance at beginning of period $1,231 $ 979 $1,001 $ 930 Charge-offs (197) (129) (534) (387) Recoveries 24 25 81 81 - --------------------------------------------------------------------------------------------------------------------------------- Net charge-offs (173) (104) (453) (306) Allowance related to loans sold -- (5) (1) (5) Provision for loan losses 116 131 627 382 - --------------------------------------------------------------------------------------------------------------------------------- Balance at end of period $1,174 $1,001 $1,174 $1,001 ======= ======= ======= ======= - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> 17
7. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS At September 30, 2001, impaired loans totaled $546 million. This amount includes $325 million of impaired loans with a specifically allocated allowance for loan losses of $135 million, and $221 million of impaired loans that are carried at their estimated fair value without a specifically allocated allowance. At the end of 2000, impaired loans totaled $364 million, including $213 million of loans with a specifically allocated allowance of $102 million, and $151 million that were carried at their estimated fair value. The average investment in impaired loans for the third quarter of 2001 and 2000 was $462 million and $291 million, respectively. Key's nonperforming assets were as follows: <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 2001 2000 2000 - --------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Impaired loans $546 $364 $305 Other nonaccrual loans 339 283 287 - --------------------------------------------------------------------------------------------------------------- Total nonaccrual loans 885 647 592 Restructured loans(a) -- 3 -- - ------------------------------------------------------------------------------------------------------------------ Total nonperforming loans 885 650 592 OREO 26 23 26 Allowance for OREO losses (1) (1) (1) - --------------------------------------------------------------------------------------------------------------- OREO, net of allowance 25 22 25 Other nonperforming assets 3 -- -- - --------------------------------------------------------------------------------------------------------------- Total nonperforming assets $913 $672 $617 ===== ==== ===== - --------------------------------------------------------------------------------------------------------------- </TABLE> (a) Excludes restructured loans on nonaccrual status When appropriate, an impaired loan is assigned a specific allowance. Management calculates the extent of the impairment, which is the carrying amount of the loan less the estimated present value of future cash flows and the fair value of any existing collateral. When expected cash flow and/or collateral value does not justify the carrying amount of a loan, the amount that management deems uncollectible (the impaired amount) is charged against the allowance for loan losses. When collateral value or other sources of repayment appear sufficient, but management remains uncertain about whether the loan will be repaid in full, an amount is specifically allocated in the allowance for loan losses. Key does not perform a specific impairment valuation for smaller-balance, homogeneous, nonaccrual loans (shown in the preceding table as "Other nonaccrual loans"). Generally, this portfolio includes loans to finance residential mortgages, automobiles, recreational vehicles, boats and mobile homes. Management applies historical loss experience rates, which are adjusted based on assessments of emerging credit trends and other factors, to these loans and then allocates a portion of the allowance for loan losses to each loan type. 18
8. LONG-TERM DEBT The components of long-term debt, presented net of unamortized discount where applicable, were as follows: <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2001 2000 2000 - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Senior medium-term notes due through 2005(a) $ 1,171 $ 393 $ 303 Subordinated medium-term notes due through 2005(a) 85 103 103 Senior euro medium-term notes due through 2003(b) 50 -- -- 7.50% Subordinated notes due 2006(c) 250 250 250 6.75% Subordinated notes due 2006(c) 200 200 200 8.125% Subordinated notes due 2002(c) 200 199 199 8.00% Subordinated notes due 2004(c) 125 125 125 8.404% Notes due through 2001 -- 13 13 All other long-term debt(i) 22 -- 1 - ------------------------------------------------------------------------------------------------------------------------- Total parent company(j) 2,103 1,283 1,194 Senior medium-term bank notes due through 2039(d) 5,065 5,979 6,389 Senior euro medium-term bank notes due through 2007(e) 4,098 3,955 3,466 6.50 % Subordinated remarketable securities due 2027(f) 312 312 312 6.95% Subordinated notes due 2028(f) 300 300 300 7.125% Subordinated notes due 2006(f) 250 250 250 7.25% Subordinated notes due 2005(f) 200 200 200 6.75% Subordinated notes due 2003(f) 200 200 200 7.50% Subordinated notes due 2008(f) 165 165 165 7.00% Subordinated notes due 2011(f) 506 -- -- 7.30% Subordinated notes due 2011(f) 107 107 107 7.85% Subordinated notes due 2002(f) 93 93 93 7.55% Subordinated notes due 2006(f) 75 75 75 7.375% Subordinated notes due 2008(f) 70 70 70 Lease financing debt due through 2006(g) 545 581 588 Federal Home Loan Bank advances due through 2030(h) 756 452 249 All other long-term debt(i) 269 139 142 - -------------------------------------------------------------------------------------------------------------------------- Total subsidiaries 13,011 12,878 12,606 - ------------------------------------------------------------------------------------------------------------------------- Total long-term debt $15,114 $14,161 $13,800 ======= ======== ======== - ------------------------------------------------------------------------------------------------------------------------- </TABLE> Key uses interest rate swaps and caps, which modify the repricing and maturity characteristics of certain long-term debt, to manage interest rate risk. For more information about such financial instruments at September 30, 2001, see Note 12 ("Derivatives and Hedging Activities"),which begins on page 24. (a) At September 30, 2001, December 31, 2000 and September 30,2000, the senior medium-term notes had weighted average interest rates of 3.77%, 6.81% and 6.77%, respectively, and the subordinated medium-term notes had a weighted average interest rate of 7.42%, 7.32% and 7.32% at each respective date. These notes had a combination of fixed and floating interest rates. (b) Senior euro medium-term notes had a weighted average interest rate of 3.73% at September 30, 2001. These notes, which are obligations of KeyCorp, had a floating interest rate based on the three-month London Interbank Offered Rate (known as "LIBOR"). (c) The notes may not be redeemed or prepaid prior to maturity. (d) Senior medium-term bank notes of subsidiaries had weighted average interest rates of 3.71%, 6.72% and 6.68%, at September 30, 2001, December 31, 2000 and September 30, 2000, respectively. These notes had a combination of fixed and floating interest rates. 19
(e) Senior euro medium-term notes had weighted average interest rates of 4.10%, 6.89%, and 6.88%, at September 30, 2001, December 31, 2000 and September 30, 2000, respectively. These notes, which are obligations of KeyBank National Association, had fixed interest rates and floating interest rates based on LIBOR. (f) These notes and securities are all obligations of KeyBank National Association, with the exception of the 7.55% notes, which are obligations of Key Bank USA, National Association. None of the subordinated notes may be redeemed prior to their maturity dates. (g) Lease financing debt had weighted average interest rates of 7.93% at September 30, 2001, 7.80% at December 31, 2000 and 7.78% at September 30, 2000. This category of debt primarily comprises nonrecourse debt collateralized by leased equipment under operating, direct financing and sales type. (h) Long-term advances from the Federal Home Loan Bank had weighted average interest rates of 3.44% at September 30, 2001, 6.66% at December 31, 2000 and 6.56% at September 30, 2000. These advances, which had a combination of fixed and floating interest rates, were secured by $1 billion, $678 million, and $374 million of real estate loans and securities at September 30, 2001, December 31, 2000 and September 30, 2000, respectively. (i) Other long-term debt, comprising industrial revenue bonds, capital lease obligations, and various secured and unsecured obligations of corporate subsidiaries, had weighted average interest rates of 6.95%, 7.91%, and 7.84% at September 30, 2001, December 31, 2000 and September 30, 2000, respectively. (j) At September 30, 2001, unused capacity under KeyCorp's shelf registration totaled $394 million, all of which is reserved for issuance as medium-term notes. 9. CAPITAL SECURITIES Five subsidiary business trusts of KeyCorp (KeyCorp Institutional Capital A, KeyCorp Institutional Capital B, KeyCorp Capital I, KeyCorp Capital II and KeyCorp Capital III) have issued corporation-obligated mandatorily redeemable preferred capital securities ("capital securities"). As guarantor, KeyCorp unconditionally guarantees payment of: - - accrued and unpaid distributions required to be paid on the capital securities; - - the redemption price when a capital security is called for redemption; and - - amounts due if a trust is liquidated or terminated. KeyCorp owns all of the outstanding common stock of each of the five trusts. The trusts used the proceeds from the issuance of their capital securities and common stock to buy debentures issued by KeyCorp. These debentures are the trusts' only assets and the interest payments from the debentures finance the distributions paid on the capital securities. Key's financial statements do not reflect the debentures or the related income statement effects because they are eliminated in consolidation. The capital securities, common securities and related debentures are summarized as follows: <TABLE> <CAPTION> PRINCIPAL CAPITAL AMOUNT OF SECURITIES, COMMON DEBENTURES, dollars in millions NET OF DISCOUNT(a) SECURITIES NET OF DISCOUNT(b) - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> September 30, 2001 KeyCorp Institutional Capital A $384 $11 $ 361 KeyCorp Institutional Capital B 165 4 154 KeyCorp Capital I 247 8 255 KeyCorp Capital II 258 8 255 KeyCorp Capital III 275 8 257 - ------------------------------------------------------------------------------------------------------------- Total $1,329 $39 $1,282 ====== === ======= - ------------------------------------------------------------------------------------------------------------- December 31, 2000 $1,243 $39 $1,282 ====== === ======= - ------------------------------------------------------------------------------------------------------------- September 30, 2000 $1,243 $39 $1,282 ====== === ======= - ------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> INTEREST RATE MATURITY OF CAPITAL OF CAPITAL SECURITIES AND SECURITIES AND dollars in millions DEBENTURES (c) DEBENTURES - ---------------------------------------------------------------------------------------- <S> <C> <C> September 30, 2001 KeyCorp Institutional Capital A 7.826 % 2026 KeyCorp Institutional Capital B 8.250 2026 KeyCorp Capital I 4.530 2028 KeyCorp Capital II 6.875 2029 KeyCorp Capital III 7.750 2029 - ---------------------------------------------------------------------------------------- Total 7.066 % -- - ---------------------------------------------------------------------------------------- December 31, 2000 7.619 % -- - ---------------------------------------------------------------------------------------- September 30, 2000 7.612 % -- - ---------------------------------------------------------------------------------------- </TABLE> (a) The capital securities must be redeemed when the related debentures mature, or earlier if provided in the governing indenture. Each issue of capital securities carries an interest rate identical to that of the related debenture. The capital securities constitute minority interests in the equity accounts of KeyCorp's consolidated subsidiaries and, therefore, qualify as Tier 1 20
capital under Federal Reserve Board guidelines. Included in certain capital securities at September 30, 2001, are basis adjustments related to fair value hedges. (b) KeyCorp has the right to redeem its debentures: (i) in whole or in part, on or after December 1, 2006 (for debentures owned by Capital A), December 15, 2006 (for debentures owned by Capital B), July 1, 2008 (for debentures owned by Capital I), March 18, 1999 (for debentures owned by Capital II), and July 16, 1999 (for debentures owned by Capital III); and (ii) in whole at any time within 90 days after and during the continuation of a "tax event" or a "capital treatment event" (as defined in the applicable offering circular). If the debentures purchased by Capital A or Capital B are redeemed before they mature, the redemption price will be the principal amount, plus a premium, plus any accrued but unpaid interest. If the debentures purchased by Capital I are redeemed before they mature, the redemption price will be the principal amount, plus any accrued but unpaid interest. If the debentures purchased by Capital II or Capital III are redeemed before they mature, the redemption price will be the greater of: (i) the principal amount, plus any accrued but unpaid interest or (ii) the sum of the present values of principal and interest payments discounted at the Treasury Rate (as defined in the applicable offering circular), plus 20 basis points (25 basis points for Capital III), plus any accrued but unpaid interest. When debentures are redeemed in response to tax or capital treatment events, the redemption price is generally slightly more favorable to Key. (c)The interest rates for Capital A, Capital B, Capital II and Capital III are fixed. Capital I has a floating interest rate (which reprices quarterly) equal to three-month LIBOR plus 74 basis points. The rates shown as the total at September 30, 2001, December 31, 2000, and September 30, 2000, are weighted average rates. 10. RESTRUCTURING CHARGES During the first nine months of 2001, KeyCorp recorded a restructuring charge credit of $4 million ($2 million after tax) in connection with a three-year "competitiveness initiative" instituted in November 1999 to improve Key's operating efficiency and profitability. Restructuring charges previously accrued under this initiative totaled $104 million ($66 million after tax) in 2000 and $98 million ($62 million after tax) in 1999. In the first phase of the initiative, Key's primary strategic actions were outsourcing certain technology and other corporate support functions, consolidating sites in a number of Key's businesses and reducing the number of management layers. This phase was completed last year. The final phase, which started during the second half of 2000, is focusing on: - - simplifying Key's business structure by consolidating 22 business lines into 12; - - streamlining and automating business operations and processes; - - standardizing product offerings and internal processes; - - consolidating operating facilities and service centers; and - - outsourcing certain noncore activities. As a result of the competitiveness initiative, Key's workforce is to be reduced by approximately 4,000 positions from its November 1999 level. Those reductions are to occur at all levels throughout the organization. At September 30, 2001, nearly 3,500 positions have been eliminated. Key's management expects the remaining reductions (comprising both staffed and vacant positions) to occur near the end of 2001. Changes in the restructuring charge liability associated with the above actions are as follows: <TABLE> <CAPTION> DECEMBER 31, RESTRUCTURING CASH SEPTEMBER 30, in millions 2000 CHARGES PAYMENTS 2001 - -------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Severance $ 62 $(7) $24 $31 Site consolidations 60 3 30 33 Equipment and other 2 -- -- 2 - -------------------------------------------------------------------------------------------- Total $124 $(4) $54 $66 ===== ==== ==== === - -------------------------------------------------------------------------------------------- </TABLE> 21
11. LEGAL PROCEEDINGS In the ordinary course of business, Key is subject to legal actions that involve claims for substantial monetary relief. Based on information presently known to management and Key's counsel, management does not believe there is any legal action to which Key is a party, or involving any of its properties, that, individually or in the aggregate, will have a material adverse effect on Key's financial condition. RESIDUAL VALUE INSURANCE LITIGATION. Key Bank USA, National Association ("KeyBank") obtained two insurance policies from Reliance Insurance Company ("Reliance") insuring the residual value of certain automobiles leased through KeyBank. The two policies, the "4011 Policy" and the "4019 Policy", together covered the period January 1, 1997 to January 1, 2001. The 4019 Policy contains an endorsement stating that Swiss Reinsurance America Corporation ("Swiss Re") would assume and reinsure 100% of Reliance's obligations under the 4019 Policy in the event that Reliance Group Holdings' (Reliance's parent) claims paying ability fell below investment grade. KeyBank also entered into a letter agreement with Swiss Re and Reliance whereby Swiss Re agreed to issue a policy on the same terms and conditions as the 4011 Policy in the event that Reliance Group Holdings' financial condition fell below a certain level. Around May 2000, those conditions were met. Effective May 1, 2000, the 4011 Policy was terminated and replaced by a policy issued by North American Specialty Insurance Company (a subsidiary or affiliate of Swiss Re) (the "NAS Policy"). Tri-Arc Financial Services, Inc. ("Tri-Arc") acted as agent for Reliance, Swiss Re, and NAS with regard to the Policies. Since February 2000, KeyBank has been filing claims under the Policies, but Reliance, Swiss Re, NAS, and Tri-Arc (the "Insurance Parties") have not paid any of the claims submitted under the respective policies. In July 2000, KeyBank filed a claim for arbitration with the American Arbitration Association against the Insurance Parties seeking, among other things, a declaration of the scope of coverage under the Policies and for damages. On January 8, 2001, Reliance filed an action (the "Litigation") against KeyBank in Federal district court in Ohio seeking rescission of the 4019 and 4011 Policies because, according to Reliance, they do not reflect the intent of the parties as to the scope of coverage and how and when claims were to be paid. In the alternative, Reliance is seeking reformation of those policies. The other Insurance Parties have also joined in this suit; and Swiss Re and NAS are asserting claims similar to the Reliance claims. In response, KeyBank filed an answer and counterclaim in the Litigation, asserting claims under the Policies against the Insurance Parties. KeyBank is seeking, among other things, declaratory relief as to the scope of coverage under the Policies, damages for breach of contract and the Insurance Parties' failure to act in good faith, and punitive damages. By agreement of the parties to proceed in the Litigation, KeyBank subsequently dismissed the arbitration without prejudice. On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order placing Reliance in rehabilitation and purporting to stay all litigation pending against Reliance. Reliance subsequently petitioned the Federal district court in Ohio to stay the Litigation, which stay was granted on July 23, 2001. KeyBank filed a motion asking the court to lift and to amend the stay. On October 3, 2001, the court in Pennsylvania entered an order placing Reliance into liquidation. Management believes that KeyBank has valid insurance coverage for the residual value of automobiles leased during the four-year period ending January 1, 2001. Because the leases in question are 3 to 5 year leases, the terms of the leases will expire over time through 2006. Consequently, the eventual aggregate amount in dispute is not currently known and will be dependent upon the residual value of the automobiles at the end of the respective lease terms. 22
NSM LITIGATION. In March 1998, McDonald Investments Inc. ("McDonald"), now a subsidiary of KeyCorp, participated in an offering to institutional investors of certain securities of Nakornthai Strip Mill Public Company Ltd. ("NSM"), a Thailand public company, and certain NSM affiliates. The offering was part of the financing of an NSM steel mini-mill located in Chonburi, Thailand. McDonald served as a financial advisor to NSM and was an initial purchaser in connection with the offering (under Rule 144A of the Securities and Exchange Commission) of the approximately $452 million in NSM debt securities and related warrants. On December 24, 1998, holders of NSM securities gave a Notice of Default alleging a number of defaults under the terms of the securities. NSM is currently working to restructure its obligations, including obligations to holders of the securities and other creditors. Certain purchasers of the NSM securities have commenced litigation against McDonald and several other parties, claiming that McDonald, the other initial purchasers and certain other of NSM's third party service providers violated certain state and federal securities and other laws. The lawsuits are based on alleged misstatements and omissions in the Offering Memorandum for the securities, and on certain other information allegedly provided and oral statements allegedly made to potential investors. In each lawsuit the plaintiffs allege misrepresentations relating to (among other things) the physical facilities at the mill, the management of the mill, the supply of inputs to the mill and the use of the proceeds of the offering. Nine separate lawsuits have been brought against McDonald and others by purchasers of the NSM securities: two in Federal court in Minnesota; two in Federal court in New York; two in California; and one in each of Connecticut, Illinois and New Jersey. The aggregate amount of securities alleged to have been purchased by the plaintiffs in these nine lawsuits is at least $260 million. While the relief claimed in the lawsuits varies, generally the plaintiffs seek rescission of the sale of the securities, compensatory damages, punitive damages, pre- and post- judgment interest, legal fees and expenses. McDonald has filed responses to each complaint denying liability and has been vigorously defending these actions. In addition, McDonald has reached settlement agreements with the plaintiffs in the two lawsuits in California, the two lawsuits in New York, and the lawsuits in New Jersey and Connecticut, pursuant to which those plaintiffs' claims against McDonald are being dismissed. The terms of those settlement agreements, including the consideration paid by McDonald, are confidential. Key believes that it has insurance coverage (above certain self-insurance layers which have been exhausted and expensed) for the settlements that have been reached. The insurance companies in question have denied coverage and declaratory judgment actions have been filed. On August 2, 2001, the parties agreed to an informal stay of the lawsuits for a period of ninety days to pursue a consensual mediation of their dispute, and recently agreed to extend the mediation through November 30, 2001. 23
12. DERIVATIVES AND HEDGING ACTIVITIES Key, mainly through its lead bank (KeyBank National Association), is party to various derivative instruments. These derivatives are used for asset and liability management and trading purposes. Generally, these instruments help Key meet clients' financing needs and manage exposure to "market risk"--the possibility that economic value or net interest income will be adversely affected by changes in interest rates or other economic factors. However, like other financial instruments, these contain an element of "credit risk"--the possibility that Key will incur a loss because a counterparty fails to meet its contractual obligations. The primary derivatives that Key uses are interest rate swaps, caps and futures; and foreign exchange forward contracts. All of the foreign exchange forward contracts and interest rate swaps and caps held are over-the-counter instruments. ACCOUNTING TREATMENT AND VALUATION Effective January 1, 2001, Key adopted SFAS 133, which establishes accounting and reporting standards for derivatives and hedging activities. The new standards are summarized in Note 1 ("Basis of Presentation") under the heading "Derivatives and hedging activities," on page 7. As a result of adopting SFAS 133, Key recorded a cumulative loss of $1 million in net income and a cumulative loss of $22 million in other comprehensive income (loss) during the first quarter of 2001. Of the $22 million loss, an estimated $13 million will be reclassified to earnings during 2001. At September 30, 2001, Key had $376 million of derivative assets recorded in "accrued income and other assets" and $263 million of derivative liabilities recorded in "accrued expense and other liabilities" on the balance sheet. ASSET AND LIABILITY MANAGEMENT FAIR VALUE HEDGING STRATEGIES. Key enters into primarily receive fixed/pay variable interest rate swap contracts to modify its exposure to interest rate risk by converting specified fixed-rate deposits, short-term borrowings and long-term debt to variable rate obligations. These contracts involve the receipt of fixed-rate interest payments in exchange for variable rate payments over the life of the contracts without an exchange of the underlying notional amount. During the first nine months of 2001, the net loss recognized by Key in connection with the ineffective portion of its fair value hedging instruments was not significant. The ineffective portion of the hedge relationship was recorded in "other income" on the income statement. CASH FLOW HEDGING STRATEGIES. Key also enters into primarily pay fixed/receive variable interest rate swap contracts that effectively convert a portion of its floating-rate debt to fixed-rate, thereby reducing the potential adverse impact of interest rate increases on future interest expense. With these contracts, variable-rate interest payments are exchanged for fixed-rate payments over the life of the contracts without an exchange of the underlying notional amount. Similarly, Key has converted certain floating-rate commercial loans to fixed-rate by entering into receive fixed/pay variable interest rate swap contracts. With these contracts, Key receives fixed-rate interest payments in exchange for variable-rate payments over the life of the contracts. Key also uses pay fixed/receive variable interest rate swaps to manage the interest rate risk associated with anticipated sales/securitizations of certain commercial real estate loans. These swaps protect against a possible short-term decline in the value of the loans between the time they are originated and the time of the anticipated sale/securitization. Key's policy is to generally sell or securitize these loans within one year 24
of their origination and to hedge the related interest rate risk over the period during which the loans are held. As a result of the strategic actions announced in May, Key's anticipated future debt needs were revised. Consequently, during the second quarter of 2001, Key reclassified a $3 million gain from accumulated other comprehensive income (loss) to "other income" on the income statement. This reclassification relates to a cash flow hedge of a previously forecasted debt issuance which is no longer probable of occurring. During the first nine months of 2001, the net loss recognized by Key in connection with the ineffective portion of its cash flow hedging instruments was not significant. There was no impact on earnings during the first nine months of 2001 related to the exclusion of portions of hedging instruments from the assessment of hedge effectiveness. Any hedge ineffectiveness was recorded in "other income" on the income statement. The change in accumulated other comprehensive income (loss) resulting from cash flow hedges is as follows: <TABLE> <CAPTION> CUMULATIVE EFFECT DECEMBER 31, OF ADOPTING 2001 RECLASSIFICATION SEPTEMBER 30, in millions 2000 SFAS 133 HEDGING ACTIVITY TO EARNINGS 2001 - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> Accumulated other comprehensive income (loss) resulting from cash flow hedges -- $ (22) $ (20) $17 $ (25) - ------------------------------------------------------------------------------------------------------------------------------ </TABLE> At September 30, 2001, Key expects to reclassify approximately $3 million of net gains on derivative instruments from accumulated other comprehensive income (loss) to earnings during the next twelve months, coinciding with the income statement impact of the hedged item through the payment of variable-rate interest on debt, the receipt of variable-rate interest on commercial loans and the sale/securitization of commercial real estate loans. TRADING PORTFOLIO FUTURES CONTRACTS AND INTEREST RATE SWAPS, CAPS AND FLOORS. Key uses these instruments for dealer activities (which are generally limited to the banks' commercial loan clients), and enters into other positions with third parties to mitigate the interest rate risk of the client positions. The swaps entered into with clients are generally limited to conventional swaps. All of the futures contracts and interest rate swaps, caps and floors are recorded at their estimated fair values. Adjustments to fair value are included in "investment banking and capital markets income" on the income statement. FOREIGN EXCHANGE FORWARD CONTRACTS. Key uses these instruments to accommodate the business needs of clients and for proprietary trading purposes. Foreign exchange forward contracts provide for the delayed delivery or purchase of foreign currency. Key mitigates the associated foreign exchange risk by entering into other foreign exchange contracts with third parties. Adjustments to the fair value of all foreign exchange forward contracts are included in "investment banking and capital markets income" on the income statement. OPTIONS AND FUTURES. Key uses these instruments for proprietary trading purposes. Adjustments to the fair value of options are included in "investment banking and capital markets income" on the income statement. The following table shows trading income recognized on interest rate swap, foreign exchange forward, and option and futures contracts. 25
<TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ------------------------------ in millions 2001 2000 - -------------------------------------------------------------------------------------- <S> <C> <C> Interest rate swap contracts $14 $21 Foreign exchange forward contracts 31 27 Option and futures contracts ___ 2 - -------------------------------------------------------------------------------------- </TABLE> CREDIT RISK Swaps and caps present credit risk because the counterparty may not meet the terms of the contract. This risk is measured as the cost of replacing contracts--at current market rates-- that have generated unrealized gains. To mitigate credit risk, Key deals exclusively with counterparties that have high credit ratings. Key uses two additional precautions to manage exposure to credit risk on swap contracts. First, Key generally enters into bilateral collateral and master netting arrangements. These agreements include legal rights of setoff that provide for the net settlement of the subject contracts with the same counterparty in the event of default. Second, a credit committee monitors credit risk exposure to the counterparty on each interest rate swap to determine appropriate limits on Key's total credit exposure and the amount of collateral required, if any. At September 30, 2001, Key had 40 different counterparties to swaps, including swaps entered into to offset the risk of client swaps. Key had aggregate credit exposure of $148 million to 15 of these counterparties, with the largest credit exposure to an individual counterparty amounting to $24 million. As of the same date, Key's aggregate credit exposure on its interest rate caps totaled $33 million. Based on management's assessment, as of September 30, 2001, all counterparties were expected to meet their obligations. 26
INDEPENDENT ACCOUNTANTS' REVIEW REPORT SHAREHOLDERS AND BOARD OF DIRECTORS KEYCORP We have reviewed the unaudited condensed consolidated balance sheets of KeyCorp and subsidiaries ("Key") as of September 30, 2001 and 2000, and the related condensed consolidated statements of income for the three- and nine-month periods then ended, and the condensed consolidated statements of changes in shareholders' equity and cash flow for the nine-month periods ended September 30, 2001 and 2000. These financial statements are the responsibility of Key's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States, which will be performed for the full year with the objective of expressing an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States. We have previously audited, in accordance with auditing standards generally accepted in the United States, the consolidated balance sheet of Key as of December 31, 2000, and the related consolidated statements of income, changes in shareholders' equity, and cash flow for the year then ended (not presented herein) and in our report dated January 12, 2001, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2000, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ Ernst & Young LLP Cleveland, Ohio October 12, 2001 27
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION - ------------ This Management's Discussion and Analysis reviews the financial condition and results of operations of KeyCorp and its subsidiaries for the quarterly and year-to-date periods ended September 30, 2001 and 2000. Some tables may cover more than these periods to comply with Securities and Exchange Commission disclosure requirements or to illustrate trends over a longer period of time. When you read this discussion, you should also look at the consolidated financial statements and related notes that appear on pages 3 through 26. TERMINOLOGY This report contains some shortened names and industry-specific terms. We want to explain some of these terms at the outset so you can better understand the discussion that follows. - - KEYCORP refers solely to the parent company. - - KEY refers to the consolidated entity consisting of KeyCorp and its subsidiaries. - - A KEYCENTER is one of Key's full-service retail banking facilities or branches. - - Key engages in CAPITAL MARKETS ACTIVITIES, primarily through the Key Capital Partners line of business. These activities encompass a variety of services. Among other things, we trade securities as a dealer, enter into derivative contracts (both to accommodate clients' financing needs and for proprietary trading purposes), invest in privately held companies (also referred to as principal investing) and conduct transactions in foreign currencies (both to accommodate clients' needs and to benefit from fluctuations in exchange rates). - - CORE FINANCIAL RESULTS exclude the effects of significant nonrecurring items such as accounting changes, write-downs of certain assets in connection with the implementation of strategic actions, gains from divestitures and restructuring charges. - - When we want to draw your attention to a particular item in Key's Notes to Consolidated Financial Statements, we refer to NOTE ___, giving the particular number, name and starting page number. - - All earnings per share data included in this discussion are presented on a DILUTED basis, which takes into account all common shares outstanding and potential common shares that could result from the exercise of outstanding stock options. Some of the financial information tables also include BASIC earnings per share, which takes into account only common shares outstanding. - - For regulatory purposes, capital is divided into several classes. Federal regulations prescribe that at least half of a bank or bank holding company's TOTAL RISK-ADJUSTED CAPITAL must qualify as TIER 1. Both total and Tier 1 capital serve as bases for several measures of capital adequacy, which is an important indicator of financial stability and condition. You will find a more detailed explanation of total and Tier 1 capital and how they are calculated in the section entitled "Capital and dividends," which begins on page 57. OUR PROJECTIONS ARE NOT FOOLPROOF This report contains "forward-looking statements" about issues like anticipated cost savings and revenue growth, and the anticipated reduction in Key's employment base. Forward-looking statements by their nature are subject to assumptions, risks and uncertainties. For a variety of reasons, including the following, actual results could differ materially from those contained in or implied by the forward-looking statements. 28
- - Interest rates could change more quickly or more significantly than we expect, which may have an adverse effect on our financial results. - - If the economy or segments of the economy fail to rebound, the demand for new loans and the ability of borrowers to repay outstanding loans may decline. - - The stock and bond markets could suffer a disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities. - - It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all. - - Acquisitions and dispositions of assets, business units or affiliates could affect us in ways that management has not anticipated. - - We may become subject to new legal obligations, or the resolution of pending litigation may have a negative effect on our financial condition. - - Terrorist activities or military actions could further disrupt the economy, or business operations or activities, which may have an adverse effect on our financial results or condition and that of our borrowers. - - We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements. MAJOR ASPECTS OF KEY'S PERFORMANCE - ---------------------------------- FINANCIAL PERFORMANCE On May 17, concurrent with the election of Chief Executive Officer Henry L. Meyer III, as Chairman of the Board of Directors, we announced the implementation of strategic actions designed to sharpen our business focus and strengthen our financial performance. Specific actions include exiting the automobile leasing business, de-emphasizing indirect prime automobile lending and discontinuing certain nonrelationship, credit-only commercial lending. As a result of the above actions, we recorded several nonrecurring charges during the second quarter, which had a short-term adverse affect on Key's financial performance. These charges include a noncore $150 million write-down of goodwill and two large charges included in Key's core financial results. The core charges include an additional provision for loan losses of $300 million ($189 million after tax) and $40 million ($25 million after tax) for losses incurred on the residual values of leased vehicles. Each of these charges is discussed in greater detail in the remainder of this discussion. The primary measures of Key's core financial performance for the third quarter and first nine months of 2001 are summarized below. Year-to-date results for the current year reflect the core charges recorded during the second quarter. Comparable measures of performance on a reported basis are included in Figure 2 on page 31. - - Both core and reported net income were $249 million, or $.58 per common share, compared with core net income of $28 million, or $.07 per share, for the previous quarter and $245 million, or $.57 per share, for the third quarter of 2000. For the first nine months of the year, Key's core net income was $494 million, or $1.15 per common share, compared with $737 million, or $1.69 for the same period last year. - - Key's return on average equity was 15.20% for the third quarter of 2001 on both a core and reported basis. This result compares with core returns of 1.69% and 14.97% for the second quarter of 2001 and 29
the third quarter of 2000, respectively. For the first nine months of the year, Key's core return on average equity was 10.03%, compared with 15.15% for the same period last year. - - Key's third quarter return on average total assets was 1.16% on both a core and reported basis. This result is up from a core return of .13% for the previous quarter and equal to the core return of 1.16% for the year-ago quarter. For the first nine months of the year, Key's core return on average total assets was .77%, down from 1.18% for the comparable period in 2000. In both the current and prior year, Key's financial results have been affected by various nonrecurring items, including those related to the implementation of the strategic actions announced on May 17. The most significant of the noncore items and their impact on both earnings and primary financial ratios are summarized in Figure 1. FIGURE 1. SIGNIFICANT NONRECURRING ITEMS <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, dollars in millions, except per share amounts 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Net income as reported $249 $121 $306 $ 736 Nonrecurring items (net of tax): Goodwill write-down (automobile finance business) -- -- 150 -- Cumulative effect of accounting change - EITF 99-20 -- -- 24 -- Additional litigation reserves -- -- 13 -- Restructuring and other special charges -- 71 1 80 Gain from sale of credit card portfolio -- -- -- (207) Additional provisions for loan losses -- 17 -- 93 Net losses from reconfiguration of securities portfolio -- 32 -- 32 Other nonrecurring items -- 4 -- 3 - ------------------------------------------------------------------------------------------------------------------------ Net income - core $249 $245 $494 $ 737 ===== ===== ===== ===== Net income per diluted common share $.58 $.28 $.71 $1.68 Net income per diluted common share - core .58 .57 1.15 1.69 Return on average total assets 1.16% .57% .48% 1.18% Return on average total assets - core 1.16 1.16 .77 1.18 Return on average equity 15.20 7.39 6.21 15.12 Return on average equity - core 15.20 14.97 10.03 15.15 - ------------------------------------------------------------------------------------------------------------------------ </TABLE> The increase in Key's third quarter core net income from that reported a year ago was moderated by the significant, adverse effects of a sluggish economy, which weakened further after the events of September 11. The impact was particularly noticeable in our more capital markets-sensitive businesses, such as equity capital investing and brokerage, and in the erosion experienced in credit quality over the past twelve months. However, despite challenging economic conditions, Key's third quarter results reflect a number of encouraging developments. Relative to the second quarter, core revenue increased by 5 percent, even though loan demand fell and softness continued in the market-sensitive businesses. This growth was driven by an improved net interest margin, which produced record net interest income. At the same time, we have begun to see an increase in core noninterest income from the implementation of various revenue-generating ideas associated with PEG, the corporate-wide competitiveness initiative we began last fall. In addition, Key's core noninterest expense decreased for the third consecutive quarter, reflecting the disciplined expense management attributable to our competitiveness initiative. The decline in Key's year-to-date core net income from the first nine months of last year was due primarily to the impact of the weaker economy and the second quarter core charges recorded in connection with the implementation of the strategic actions announced in May. Figure 2 summarizes Key's financial performance on a reported basis for each of the past five quarters and the first nine months of 2001 and 2000. 30
FIGURE 2. SELECTED FINANCIAL DATA <TABLE> <CAPTION> 2001 2000 --------------------------------- ----------------------- dollars in millions, except per share amounts THIRD SECOND FIRST FOURTH THIRD ==================================================================================================================================== <S> <C> <C> <C> <C> <C> FOR THE PERIOD Interest income $ 1,380 $ 1,467 $ 1,570 $ 1,652 $ 1,596 Interest expense 656 754 882 950 912 Net interest income 724 713 688 702 684 Provision for loan losses 116 401 110 108 131 Noninterest income 454 398 455 508 405 Noninterest expense 683 858 698 705 787 Income (loss) before income taxes and cumulative effect of accounting changes 379 (148) 335 397 171 Income (loss) before cumulative effect of accounting changes 249 (136) 218 266 121 Net income (loss) 249 (160) 217 266 121 - ------------------------------------------------------------------------------------------------------------------------------------ PER COMMON SHARE Income (loss) before cumulative effect of accounting changes $ .59 $ (.32) $ .51 $ .63 $ .28 Income (loss) before cumulative effect of accounting changes -assuming dilution .58 (.32) .51 .62 .28 Net income (loss) .59 (.38) .51 .63 .28 Net income (loss)-assuming dilution .58 (.38) .51 .62 .28 Cash dividends .295 .295 .295 .28 .28 Book value at period end 15.53 15.22 15.79 15.65 15.26 Market price: High 28.15 26.43 27.58 28.50 27.06 Low 22.20 22.10 22.65 21.50 17.50 Close 24.14 26.05 25.80 28.00 25.31 Weighted average common shares (000) 424,802 424,675 424,024 425,054 429,584 Weighted average common shares and potential common shares (000) 430,346 424,675 429,917 430,634 431,972 - ------------------------------------------------------------------------------------------------------------------------------------ AT PERIOD END Loans $ 64,506 $ 66,693 $ 67,027 $ 66,905 $ 66,299 Earning assets 73,943 76,531 77,027 77,316 75,786 Total assets 84,419 85,838 86,457 87,270 85,500 Deposits 45,372 45,743 45,965 48,649 47,809 Long-term debt 15,114 14,675 14,495 14,161 13,800 Shareholders' equity 6,575 6,467 6,702 6,623 6,520 Full-time equivalent employees 21,297 21,742 21,882 22,142 22,457 Branches 911 926 922 922 932 - ------------------------------------------------------------------------------------------------------------------------------------ PERFORMANCE RATIOS Return on average total assets 1.16% (.75)% 1.02% 1.24% .57% Return on average equity 15.20 (9.67) 13.28 16.16 7.39 Net interest margin (taxable equivalent) 3.85 3.77 3.63 3.71 3.68 - ------------------------------------------------------------------------------------------------------------------------------------ CAPITAL RATIOS AT PERIOD END Equity to assets 7.79% 7.53% 7.75% 7.59% 7.63% Tangible equity to tangible assets 6.51 6.25 6.29 6.12 6.10 Tier 1 risk-adjusted capital 7.81 7.71 7.99 7.72 7.59 Total risk-adjusted capital 11.77 11.81 12.32 11.48 11.34 Leverage 7.90 7.68 7.79 7.71 7.76 ==================================================================================================================================== <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, ------------------------- dollars in millions, except per share amounts 2001 2000 ============================================================================================== <S> <C> <C> FOR THE PERIOD Interest income $ 4,417 $ 4,625 Interest expense 2,292 2,597 Net interest income 2,125 2,028 Provision for loan losses 627 382 Noninterest income 1,307 1,686 Noninterest expense 2,239 2,212 Income (loss) before income taxes and cumulative effect of accounting changes 566 1,120 Income (loss) before cumulative effect of accounting changes 331 736 Net income (loss) 306 736 - ---------------------------------------------------------------------------------------------- PER COMMON SHARE Income (loss) before cumulative effect of accounting changes $ .78 $ 1.69 Income (loss) before cumulative effect of accounting changes -assuming dilution .77 1.68 Net income (loss) .72 1.69 Net income (loss)-assuming dilution .71 1.68 Cash dividends .885 .84 Book value at period end 15.53 15.26 Market price: High 29.25 27.06 Low 22.10 15.56 Close 24.14 25.31 Weighted average common shares (000) 424,503 435,156 Weighted average common shares and potential common shares (000) 430,009 437,231 - ---------------------------------------------------------------------------------------------- AT PERIOD END Loans $ 64,506 $ 66,299 Earning assets 73,943 75,786 Total assets 84,419 85,500 Deposits 45,372 47,809 Long-term debt 15,114 13,800 Shareholders' equity 6,575 6,520 Full-time equivalent employees 21,297 22,457 Branches 911 932 - ---------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets .48% 1.18% Return on average equity 6.21 15.12 Net interest margin (taxable equivalent) 3.75 3.68 - ---------------------------------------------------------------------------------------------- CAPITAL RATIOS AT PERIOD END Equity to assets 7.79% 7.63% Tangible equity to tangible assets 6.51 6.10 Tier 1 risk-adjusted capital 7.81 7.59 Total risk-adjusted capital 11.77 11.34 Leverage 7.92 7.76 ============================================================================================== </TABLE> Key completed several acquisitions and a divestiture during the periods shown in this table. One or more of these transactions may have had a significant effect on Key's results, making it difficult to compare results from one period to the next. Note 3 ("Acquisitions and Divestiture") on page 10 has specific information about the acquisitions and divestiture that Key completed in the periods presented above to help you understand how those transactions impacted Key's financial condition and results of operations. CORPORATE STRATEGY Key's management reviews Key's business lines on an ongoing basis to identify opportunities to improve earnings by shifting capital from low-growth to high-growth businesses. We continue to focus on acquiring or developing businesses that we believe are capable of achieving above-average earnings growth rates, and selling portfolios and business units that have low anticipated growth rates or do not have a competitive advantage or significant market share. 31
Key's corporate strategy also reflects the growing importance of the Internet and related information technologies to all daily activities. In particular, the strategy calls for the continual and thoughtful application of such technologies to enhance Key's product and service offerings and to streamline our internal business practices. This long-standing strategy was supplemented in the fourth quarter of 1999 by a new three-year competitiveness initiative to improve profitability by reducing the costs of doing business, sharpening the focus on the most profitable growth businesses and enhancing revenues. More specific information on the status of this initiative is provided in the section below entitled "Status of three-year competitiveness initiative." Importantly, it is Key's plan to convert this competitiveness initiative into a continuous process in order to improve client service levels and to control expenses. PRINCIPAL STRATEGIC ACTIONS DURING THE FIRST NINE MONTHS OF 2001 - - Early in the first quarter, we acquired The Wallach Company, Inc., an investment-banking firm based in Denver, Colorado. We expect this acquisition to enhance our position in this fast-growth region and to provide additional expertise in the information technology and financial institutions sectors. - - During the second quarter, we announced strategic actions, discussed on page 29, which are designed to sharpen our business focus and strengthen our financial performance. These efforts are helping us build on progress already made in streamlining the company. - - In the third quarter, we sold approximately $1.4 billion of the residential mortgage loans generated by our private banking and community development businesses. These loans are originated as a customer and community accommodation and are sold periodically because they have relatively low net interest spreads that do not meet Key's internal profitability standards. STATUS OF THREE-YEAR COMPETITIVENESS INITIATIVE The initial phase of Key's three-year competitiveness initiative began in November 1999 and was completed last year. During this phase, we reduced our operating expenses by approximately $100 million by outsourcing certain nonstrategic support functions, consolidating sites in a number of our businesses and reducing management layers. Management expects that Key will achieve an annual savings rate of approximately $360 million from the overall initiative when actions are fully implemented before the end of 2002. Approximately $60 million of these savings will be reinvested to fund activities that will enhance Key's strategic competitive position, fuel higher growth and improve customer service. During the third quarter of 2000, we entered the second and final phase of the initiative. The final phase is focusing on: - - simplifying Key's business structure by consolidating 22 business lines into 12; - - streamlining and automating business operations and processes; - - standardizing product offerings and internal processes; - - consolidating operating facilities and service centers; and - - outsourcing additional noncore activities. As of September 30, 2001, almost 80% of the projects related to the final phase have been completed and we have achieved more than half of the net annual savings rate of $200 million expected from these projects. Management expects that the actions taken in the final phase will reduce Key's workforce by approximately 2,300 positions (comprising both staffed and vacant positions) near the end of 2001. This would bring workforce reductions to approximately 4,000 positions for the entire three-year initiative. At September 30, 2001, nearly 3,500 of these positions have been eliminated. In connection with the competitiveness initiative, we have recorded cumulative charges amounting to a net $279 million. During the first nine months of 2001, we reduced our related restructuring charges by $4 million, but this was offset by a $4 million increase in other special charges related to the initiative. The section entitled "Noninterest expense," which begins on page 45, and Note 10 ("Restructuring Charges"), on page 21, provide more information about Key's restructuring charges. 32
CASH BASIS FINANCIAL DATA The selected financial data presented in Figure 3 highlight Key's performance on a cash basis for each of the past five quarters and the first nine months of 2001 and 2000. We provide cash basis financial data because we believe it offers a useful tool for measuring Key's ability to support future growth, evaluating liquidity and assessing Key's ability to pay dividends and repurchase shares. When we apply "cash basis" accounting, the only adjustments that we make to get from the information in Figure 2 (which is presented on an accrual basis) to the comparable line items in Figure 3 are to exclude goodwill and other intangibles that do not qualify as Tier 1 capital, and to exclude the amortization of those assets. Figure 3 does not exclude the impact of other noncash items (such as depreciation and deferred taxes) and significant nonrecurring items. Key's goodwill and other intangibles that do not qualify as Tier 1 capital are the result of business combinations that Key recorded using the "purchase" method of accounting. Under the purchase method, assets and liabilities of acquired companies are recorded at their fair values and any amount paid in excess of the fair value of the net assets acquired is recorded as goodwill. (If the same transactions had qualified for accounting using the "pooling of interests" method, the acquired company's financial statements would simply have been combined with Key's.) After a combination using purchase accounting, Key must amortize goodwill and other intangibles by taking periodic charges against income, but those charges are only accounting entries, not actual cash expenses. Thus, from an investor's perspective, the economic effect of a transaction is the same whether we account for it as a purchase or a pooling. For the same reason, the amortization of intangibles does not impact Key's liquidity and funds management activities. In June 2001, new accounting standards were issued that eliminate the pooling-of-interests method of accounting for business combinations initiated after June 30, 2001. Effective January 1, 2002, the new standards also eliminate the amortization of goodwill and other intangible assets deemed to have indefinite lives. These changes will essentially eliminate the difference between Key's reported results and those presented on a cash basis in this section. For more information pertaining to the new accounting standards, see the section entitled "Accounting pronouncements pending adoption," included in Note 1 ("Basis of Presentation"), beginning on page 7. This is the only section of this Financial Review that discusses Key's financial results on a cash basis. FIGURE 3. CASH BASIS SELECTED FINANCIAL DATA <TABLE> <CAPTION> 2001 ------------------------------------ dollars in millions, except per share amounts THIRD SECOND FIRST - --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> FOR THE PERIOD Noninterest expense $ 661 $ 684 $ 672 Income before income taxes and cumulative effect of accounting changes 401 26 361 Income before cumulative effect of accounting changes 269 36 242 Net income 269 12 241 - --------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE Income before cumulative effect of accounting changes $ .63 $ .08 $ .57 Income before cumulative effect of accounting changes - assuming dilution .63 .08 .56 Net income .63 .03 .57 Net income - assuming dilution .63 .03 .56 Weighted average common shares (000) 424,802 424,675 424,024 Weighted average common shares and potential common shares (000) 430,346 429,760 429,917 - --------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets 1.27% .06% 1.15% Return on average equity 20.01 .90 18.57 - --------------------------------------------------------------------------------------------------------------------- GOODWILL AND NONQUALIFYING INTANGIBLES Goodwill average balance $ 1,131 $ 1,223 $ 1,323 Nonqualifying intangibles average balance 35 38 42 Goodwill amortization (after tax) 18 170 21 Nonqualifying intangibles amortization (after tax) 2 2 3 - --------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> NINE MONTHS ENDED 2000 SEPTEMBER 30, ------------------------- --------------------- dollars in millions, except per share amounts FOURTH THIRD 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- FOR THE PERIOD <S> <C> <C> <C> <C> Noninterest expense $ 679 $ 763 $ 2,017 $ 2,137 Income before income taxes and cumulative effect of accounting changes 423 195 788 1,195 Income before cumulative effect of accounting changes 290 143 546 804 Net income 290 143 521 804 - ----------------------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE Income before cumulative effect of accounting changes $ .68 $ .33 $ 1.29 $ 1.85 Income before cumulative effect of accounting changes - assuming dilution .67 .33 1.27 1.84 Net income .68 .33 1.23 1.85 Net income - assuming dilution .67 .33 1.21 1.84 Weighted average common shares (000) 425,054 429,584 424,503 435,156 Weighted average common shares and potential common shares (000) 430,634 431,972 430,009 437,231 - ----------------------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets 1.37% .69% .82% 1.31% Return on average equity 22.33 11.12 13.09 21.15 - ----------------------------------------------------------------------------------------------------------------------------------- GOODWILL AND NONQUALIFYING INTANGIBLES Goodwill average balance $ 1,335 $ 1,346 $ 1,225 $ 1,367 Nonqualifying intangibles average balance 46 50 39 54 Goodwill amortization (after tax) 21 20 209 61 Nonqualifying intangibles amortization (after tax) 3 2 6 7 - ----------------------------------------------------------------------------------------------------------------------------------- </TABLE> Key completed several acquisitions and a divestiture during the periods presented in this table. One or more of these transactions may have had a significant effect on Key's results, making it difficult to compare results from one period to the next. Note 3 ("Acquisitions and Divestiture") on page 10 has specific information about the acquisitions and divestiture that Key completed in the periods presented above to help you understand how those transactions impacted Key's financial condition and results of operations. 33
LINE OF BUSINESS RESULTS - ------------------------- Key has three major lines of business: KEY CONSUMER BANKING comprises two of Key's primary divisions: RETAIL BANKING, and HOME EQUITY AND CONSUMER FINANCE. - - RETAIL BANKING offers branch-based deposit, investment and credit products and personal financial services to consumers. - - HOME EQUITY AND CONSUMER FINANCE offers non-branch-based consumer loan products, such as education loans, home equity loans, automobile loans, and marine and recreational vehicle loans. KEY CORPORATE FINANCE offers financing and specialized services related to, among other things, transaction processing, corporate electronic commerce, financial advice and equipment leasing. It also serves the needs of Key's small business clients. KEY CAPITAL PARTNERS offers asset management, employee benefits services, brokerage services, investment banking, and capital markets and insurance expertise. It also provides specialized services to high-net-worth clients through the wealth management and private banking businesses. This section summarizes the financial performance of each line of business and related strategic developments. To better understand this discussion, see Note 4 ("Line of Business Results"), which begins on page 11 and discloses the activities and financial results of each line of business in greater detail. Figure 4 summarizes the contribution made by each major line of business to Key's net income for the three- and nine-month periods ended September 30, 2001 and 2000. FIGURE 4. NET INCOME BY LINE OF BUSINESS(A) <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, ------------------------------- ------------------------ --------------------------- DOLLARS IN MILLIONS 2001 2000 AMOUNT PERCENT 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Key Consumer Banking: Retail Banking $ 88 $ 79 $9 11.4 % $234 $205 Home Equity and Consumer Finance(b) 19 16 3 18.8 55 52 Key Corporate Finance 127 114 13 11.4 366 337 Key Capital Partners(c) 18 26 (8) (30.8) 44 61 Treasury and Other 3 (13) 16 N/M 8 23 - ----------------------------------------------------------------------------------------------------------------------------------- Total segments 255 222 33 14.9 707 678 Reconciling items(d) (6) (101) 95 N/M (401) 58 - ----------------------------------------------------------------------------------------------------------------------------------- Total net income $249 $121 $128 105.8 % $306 $736 ===== ===== ===== ===== ===== - ----------------------------------------------------------------------------------------------------------------------------------- <CAPTION> CHANGE ------------------------- DOLLARS IN MILLIONS AMOUNT PERCENT - -------------------------------------------------------------------- <S> <C> <C> Key Consumer Banking: Retail Banking $29 14.1 % Home Equity and Consumer Finance(b) 3 5.8 Key Corporate Finance 29 8.6 Key Capital Partners(c) (17) (27.9) Treasury and Other (15) (65.2) - --------------------------------------------------------------------- Total segments 29 4.3 Reconciling items(d) (459) N/M - -------------------------------------------------------------------- Total net income $(430) (58.4)% ====== - -------------------------------------------------------------------- </TABLE> (a) Key's management accounting system utilizes a methodology for loan loss provisioning by line of business that reflects credit quality expectations within each line of business over a normal business cycle. The "normalized provision for loan losses" assigned to each line as a result of this methodology does not necessarily coincide with the level of net loan charge-offs at any given point in the cycle. (b) Results for 2001 exclude a second quarter one-time cumulative charge of $39 million ($24 million after tax) resulting from a prescribed change, applicable to all companies, in the accounting for retained interests in securitized assets (See note (d) below). (c) Noninterest income and expense attributable to Key Capital Partners is assigned to Retail Banking, Home Equity and Consumer Finance or Key Corporate Finance if one of those businesses is principally responsible for maintaining the relationship with the client that used Key Capital Partners' products and services. Key Capital Partners had net income of $29 million and $38 million in the third quarter of 2001 and 2000, respectively, and $80 million and $93 million in the first nine months of 2001 and 2000, respectively, before its income and expense were reassigned. (d) Reconciling items include certain strategic and nonrecurring items. Among these items are the second quarter 2001 additional provision for loan losses recorded in connection with Key's decision to discontinue certain nonrelationship credit-only commercial lending and the write-down of goodwill associated with Key's decision to downsize its automobile finance business. Included in 2000 results is the gain from the January sale of Key's credit card business and nonrecurring charges recorded in connection with strategic actions being taken to improve Key's operating efficiency and profitability. Also included are charges related to unallocated nonearning assets of corporate support functions and the effect of the accounting change described in note (b) above. For more specific information regarding the above items, see notes (c), (d) and (e) to the table included in Note 4 ("Line of Business Results"), which begins on page 11. N/M= Not Meaningful 34
KEY CONSUMER BANKING RETAIL BANKING (A DIVISION OF KEY CONSUMER BANKING) - ---------------------------------------------------- Net income for Key Retail Banking totaled $88 million for the third quarter of 2001, up from $79 million for the same period last year. The increase in net income is primarily attributable to a decrease in noninterest expense, but also reflects an increase in total revenue. Noninterest expense decreased by 5% from the year-ago quarter, largely due to lower costs associated with personnel, capital markets activities and various indirect charges. The improvement in noninterest expense is also reflected in the efficiency ratio, which declined to 56.76% from 60.44% for the third quarter of 2000. Noninterest income rose by $12 million from the year-ago quarter. This growth was largely the result of higher income from service charges on deposit accounts, which resulted from the implementation of strategies developed under Key's competitiveness initiative. At the same time, net interest income decreased by $7 million due primarily to less favorable interest rate spreads used in determining the profit contribution from deposits generated by Retail Banking, and a 4% decrease in the level of average deposits. HOME EQUITY AND CONSUMER FINANCE (A DIVISION OF KEY CONSUMER BANKING) - --------------------------------------------------------------------- Net income for Home Equity and Consumer Finance totaled $19 million for the third quarter of 2001, up from $16 million for the same period last year. Total revenue rose significantly from the year-ago quarter, reflecting strong growth in net interest income, while noninterest income decreased slightly. The improvement in total revenue was substantially offset, however, by a rise in noninterest expense. Net interest income increased by $19 million from the year-ago quarter, largely due to the effects of improved interest rate spreads used in determining the profit contribution from loans generated by this line of business. The growth in net interest income also reflects a favorable change in the composition of earning assets stemming from our decision to cease securitizing and selling our home equity loans starting in 2000. These assets have an attractive risk/reward profile and retaining them was a significant factor in contributing to a 3% increase in average loans outstanding and a 15% increase in net interest income, despite a very challenging economic environment. Noninterest income declined by $1 million from the year-ago quarter, while noninterest expense was up 19%, due primarily to higher costs associated with marketing, collections and professional services. KEY CORPORATE FINANCE Net income for Key Corporate Finance was $127 million for the third quarter of 2001, up from $114 million for the same period last year. The improvement from the year-ago quarter was driven by revenue growth, offset in part by a slight increase in the normalized provision for loan losses. Noninterest expense was essentially unchanged. In comparison with the third quarter of 2000, net interest income increased by $17 million, or 5%. More favorable interest rate spreads and modest growth in both total average loans and deposits were the primary factors contributing to this improvement. The strongest growth in loans occurred in the commercial real estate, equipment leasing and business banking units. At the same time, noninterest income rose 7%, largely due to higher income from service charges on deposit accounts, which grew as a direct result of strategies implemented under Key's competitiveness initiative. 35
KEY CAPITAL PARTNERS Net income for Key Capital Partners was $18 million in the third quarter of 2001, compared with $26 million for the same period last year. Prior to assigning revenue and expense to other business lines whose clients use products and services offered by Key Capital Partners, net income was $29 million in the third quarter, compared with $38 million in the year-ago quarter. Total revenue for Key Capital Partners increased by $4 million, or 2%, (a decrease of $5 million, or 2%, prior to revenue sharing) from the third quarter of last year. Higher revenues were generated by fixed income products, derivatives, and foreign exchange, all of which benefited from unstable interest rates and favorable conditions in the fixed income securities markets. In the third quarter of 2001, Key Capital Partners also benefited from a net gain resulting from the sale of loans. However, weak conditions in the capital markets have adversely impacted Key Capital Partners' overall financial performance in 2001. As a result, income derived from the brokerage and investment banking business units declined by approximately $16 million from that reported for the third quarter of last year. Noninterest expense increased by $15 million, or 8%, ($8 million, or 4%, prior to expense sharing) from the third quarter of last year. Increases in various indirect support costs were partially offset by lower personnel costs, and other expense reductions related to a lower volume of business activity. TREASURY AND OTHER Treasury and Other includes the Treasury unit, the Principal Investing unit and the net effect of funds transfer pricing. In the third quarter of 2001, this segment generated net income of $3 million, compared with a net loss of $13 million in the same period last year. The improvement was primarily due to the fact that during the third quarter of 2001 the Treasury unit recorded net securities gains of $2 million ($1 million after tax) compared with net securities losses of $50 million ($32 million after tax) in the third quarter of 2000. The losses recorded last year were incurred in connection with the reconfiguration of Key's securities portfolio. The improvement related to securities transactions was partially offset, however, by the fact that the Principal Investing unit recorded net equity capital losses of $9 million ($6 million after tax), compared with net equity capital gains of $22 million ($14 million after tax) in the year-ago quarter. 36
RESULTS OF OPERATIONS - --------------------- NET INTEREST INCOME Key's principal source of earnings is net interest income, which comprises interest and loan-related fee income less interest expense. There are several factors that affect net interest income, including: - - the volume, pricing, mix and maturity of earning assets and interest-bearing liabilities; - - the use of off-balance sheet instruments to manage interest rate risk; - - interest rate fluctuations; and - - asset quality. To make it easier to compare results among several periods and the yields on various types of earning assets, we present all net interest income on a "taxable-equivalent basis." In other words, if we earn $100 of tax-exempt income, we present those earnings at a higher amount (specifically, $154) that--if taxed at the statutory Federal income tax rate of 35%--would yield $100. Figure 5 shows the various components of Key's balance sheet that affect interest income and expense, and their respective yields or rates over the past five quarters. Net interest income for the third quarter of 2001 was $730 million, representing a $39 million, or 6%, increase from the same period last year. Average earning assets rose by 1% to $75.7 billion, as increases in construction and home equity loans were substantially offset by declines in residential real estate and consumer installment loans. At the same time, the net interest margin rose from 3.68% in the third quarter of 2000 to 3.85% in the third quarter of 2001. For the first nine months of 2001, net interest income totaled $2.1 billion, up $95 million, or 5%, from the first nine months of last year. The year-to-date growth reflected an improved net interest margin, which increased 7 basis points to 3.75%, while the growth of commercial and home equity loans was the primary contributor to a 3% increase in average earning assets to $76.4 billion. NET INTEREST MARGIN. There are two primary reasons that the net interest margin improved over the past year: - - We benefited from declining short-term interest rates; and - - the profitability of our total loan portfolio improved as we continue to focus on those businesses, such as home equity lending, that typically generate higher net interest spreads. INTEREST EARNING ASSETS. Average earning assets for the third quarter totaled $75.7 billion, which was $978 million, or 1%, higher than the third quarter 2000 level. For the first nine months of the year, average earning assets rose $2.3 billion to $76.4 billion from same period last year. Both the quarterly and year-to-date increases came principally from the commercial and home equity loan portfolios. Key's loan growth has been affected by several strategic developments: - - During 2000, we sold $805 million of low interest spread commercial loans to a loan conduit. This arrangement allowed us to continue to originate loans to meet our customers' funding needs and to generate servicing revenue without having to retain these low interest spread assets on the balance sheet; 37
<TABLE> <CAPTION> FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES THIRD QUARTER 2001 ---------------------------------------------- AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Loans(a),(b) Commercial, financial and agricultural $19,338 $ 324 6.63% Real estate -- commercial mortgage 6,813 123 7.20 Real estate -- construction 5,859 101 6.87 Commercial lease financing 6,995 117 6.68 - ------------------------------------------------------------------------------------------------------------------- Total commercial loans 39,005 665 6.77 Real estate -- residential 3,826 71 7.42 Home equity 10,777 228 8.38 Consumer - direct 2,409 56 9.34 Consumer - indirect lease financing 2,557 54 8.30 Consumer - indirect other 5,494 132 9.60 - ------------------------------------------------------------------------------------------------------------------- Total consumer loans 25,063 541 8.58 Loans held for sale 2,130 38 7.17 - ------------------------------------------------------------------------------------------------------------------- Total loans 66,198 1,244 7.47 Taxable investment securities 925 8 3.44 Tax-exempt investment securities(a) 258 5 8.65 - ------------------------------------------------------------------------------------------------------------------- Total investment securities 1,183 13 4.57 Securities available for sale(a),(c) 6,565 114 6.99 Short-term investments 1,741 15 3.57 - ------------------------------------------------------------------------------------------------------------------- Total earning assets 75,687 1,386 7.29 Allowance for loan losses (1,204) Accrued income and other assets 10,396 - ------------------------------------------------------------------------------------------------------------------- $84,879 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $12,522 55 1.72 Savings deposits 1,936 5 1.01 NOW accounts 611 2 1.41 Certificates of deposit ($100,000 or more)(d) 4,800 67 5.53 Other time deposits 13,703 184 5.33 Deposits in foreign office 3,399 30 3.57 - ------------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 36,971 343 3.68 Federal funds purchased and securities sold under repurchase agreements 6,078 52 3.37 Bank notes and other short-term borrowings(d) 6,230 61 3.95 Long-term debt, including capital securities(d),(e) 15,991 200 4.97 - ------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 65,270 656 3.99 Noninterest-bearing deposits 8,262 Accrued expense and other liabilities 4,848 Common shareholders' equity 6,499 - ------------------------------------------------------------------------------------------------------------------- $84,879 ======= Interest rate spread (TE) 3.30 - ------------------------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $ 730 3.85% ===== ======== Capital securities $1,305 $ 21 Taxable-equivalent adjustment(a) 6 - ------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES SECOND QUARTER 2001 --------------------------------------------- AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Loans(a),(b) Commercial, financial and agricultural $20,030 $ 361 7.24% Real estate -- commercial mortgage 6,837 135 7.91 Real estate -- construction 5,504 108 7.81 Commercial lease financing 6,990 120 6.86 - ---------------------------------------------------------------------------------------------------------------- Total commercial loans 39,361 724 7.37 Real estate -- residential 4,065 79 7.81 Home equity 10,459 228 8.74 Consumer - direct 2,458 60 9.74 Consumer - indirect lease financing 2,778 57 8.27 Consumer - indirect other 5,593 134 9.61 - ---------------------------------------------------------------------------------------------------------------- Total consumer loans 25,353 558 8.83 Loans held for sale 2,240 43 7.69 - ---------------------------------------------------------------------------------------------------------------- Total loans 66,954 1,325 7.93 Taxable investment securities 911 8 3.41 Tax-exempt investment securities(a) 297 6 8.79 - ---------------------------------------------------------------------------------------------------------------- Total investment securities 1,208 14 4.74 Securities available for sale(a),(c) 6,572 115 6.99 Short-term investments 1,812 19 4.19 - ---------------------------------------------------------------------------------------------------------------- Total earning assets 76,546 1,473 7.71 Allowance for loan losses (988) Accrued income and other assets 10,429 - ---------------------------------------------------------------------------------------------------------------- $85,987 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $12,296 67 2.22 Savings deposits 1,969 5 1.06 NOW accounts 610 3 1.50 Certificates of deposit ($100,000 or more)(d) 5,571 81 5.85 Other time deposits 14,479 209 5.77 Deposits in foreign office 2,173 23 4.27 - ---------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 37,098 388 4.20 Federal funds purchased and securities sold under repurchase agreements 5,177 52 4.06 Bank notes and other short-term borrowings(d) 8,016 94 4.67 Long-term debt, including capital securities(d),(e) 16,068 220 5.49 - ---------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 66,359 754 4.56 Noninterest-bearing deposits 8,213 Accrued expense and other liabilities 4,779 Common shareholders' equity 6,636 - ---------------------------------------------------------------------------------------------------------------- $85,987 ======= Interest rate spread (TE) 3.15 - ---------------------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $719 3.77% ====== ====== Capital securities $1,292 $23 Taxable-equivalent adjustment(a) 6 - ---------------------------------------------------------------------------------------------------------------- </TABLE> (a) Interest income on tax-exempt securities and loans has been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%. (b) For purposes of these computations, nonaccrual loans are included in average loan balances. (c) Yield is calculated on the basis of amortized cost. (d) Rate calculation excludes basis adjustments related to fair value hedges. (e) Rate calculation excludes ESOP debt. TE = Taxable Equivalent 38
<TABLE> <CAPTION> FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES (CONTINUED) First Quarter 2001 ------------------------------------------ Average Yield/ dollars in millions Balance Interest Rate - ------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Loans(a),(b) Commercial, financial and agricultural $20,025 $ 406 8.22% Real estate -- commercial mortgage 6,897 147 8.63 Real estate -- construction 5,273 117 9.03 Commercial lease financing 7,102 125 7.07 - ------------------------------------------------------------------------------------------------- Total commercial loans 39,297 795 8.19 Real estate-- residential 4,172 81 7.74 Home equity 10,086 233 9.38 Consumer - direct 2,480 64 10.43 Consumer - indirect lease financing 2,936 59 8.02 Consumer - indirect other 5,673 136 9.58 - ------------------------------------------------------------------------------------------------- Total consumer loans 25,347 573 9.10 Loans held for sale 2,389 54 9.09 - ------------------------------------------------------------------------------------------------- Total loans 67,033 1,422 8.57 Taxable investment securities 892 7 3.24 Tax-exempt investment securities(a) 317 8 8.83 - ------------------------------------------------------------------------------------------------- Total investment securities 1,209 15 4.70 Securities available for sale(a),(c) 7,026 120 6.87 Short-term investments 1,604 20 5.00 - ------------------------------------------------------------------------------------------------- Total earning assets 76,872 1,577 8.28 Allowance for loan losses (1,006) Accrued income and other assets 10,458 - ------------------------------------------------------------------------------------------------- $86,324 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $12,070 95 3.17 Savings deposits 1,993 7 1.34 NOW accounts 602 2 1.54 Certificates of deposit ($100,000 or more)(d) 5,994 92 6.25 Other time deposits 15,011 224 6.06 Deposits in foreign office 2,869 40 5.64 - ------------------------------------------------------------------------------------------------- Total interest-bearing deposits 38,539 460 4.84 Federal funds purchased and securities sold under repurchase agreements 5,263 70 5.39 Bank notes and other short-term borrowings(d) 7,532 105 5.67 Long-term debt, including capital securities(d),(e) 15,412 247 6.58 - ------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 66,746 882 5.38 Noninterest-bearing deposits 8,185 Accrued expense and other liabilities 4,766 Common shareholders' equity 6,627 - ------------------------------------------------------------------------------------------------- $86,324 ======= Interest rate spread (TE) 2.90 - ------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $695 3.63% ==== ===== Capital securities $1,307 $24 Taxable-equivalent adjustment(a) 7 - ------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES (CONTINUED) Fourth Quarter 2000 ----------------------------------------- Average Yield/ dollars in millions Balance Interest Rate - --------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Loans(a),(b) Commercial, financial and agricultural $20,093 $ 451 8.92% Real estate -- commercial mortgage 6,855 162 9.42 Real estate -- construction 5,164 129 9.97 Commercial lease financing 6,965 125 7.20 - --------------------------------------------------------------------------------------------------- Total commercial loans 39,077 867 8.84 Real estate-- residential 4,232 81 7.68 Home equity 9,591 228 9.45 Consumer - direct 2,582 69 10.57 Consumer - indirect lease financing 3,023 62 8.16 Consumer - indirect other 5,813 141 9.72 - --------------------------------------------------------------------------------------------------- Total consumer loans 25,241 581 9.18 Loans held for sale 2,220 51 9.13 - --------------------------------------------------------------------------------------------------- Total loans 66,538 1,499 8.98 Taxable investment securities 898 8 3.73 Tax-exempt investment securities(a) 344 8 8.73 - --------------------------------------------------------------------------------------------------- Total investment securities 1,242 16 5.12 Securities available for sale(a),(c) 6,807 121 7.02 Short-term investments 1,449 23 6.20 - --------------------------------------------------------------------------------------------------- Total earning assets 76,036 1,659 8.69 Allowance for loan losses (989) Accrued income and other assets 10,380 - --------------------------------------------------------------------------------------------------- $85,427 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $11,873 103 3.44 Savings deposits 2,045 7 1.32 NOW accounts 600 2 1.55 Certificates of deposit ($100,000 or more)(d) 5,789 94 6.44 Other time deposits 15,037 232 6.15 Deposits in foreign office 3,265 54 6.60 - --------------------------------------------------------------------------------------------------- Total interest-bearing deposits 38,609 492 5.07 Federal funds purchased and securities sold under repurchase agreements 5,859 93 6.33 Bank notes and other short-term borrowings(d) 6,446 101 6.22 Long-term debt, including capital securities(d),(e) 15,235 264 6.91 - --------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 66,149 950 5.72 Noninterest-bearing deposits 8,363 Accrued expense and other liabilities 4,368 Common shareholders' equity 6,547 - --------------------------------------------------------------------------------------------------- $85,427 ======= Interest rate spread (TE) 2.97 - --------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $709 3.71% ==== ===== Capital securities $1,243 $24 Taxable-equivalent adjustment(a) 7 - --------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> FIGURE 5. AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND YIELDS/RATES (CONTINUED) Third Quarter 2000 ----------------------------------------------- Average Yield/ dollars in millions Balance Interest Rate - ---------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Loans(a),(b) Commercial, financial and agricultural $19,647 $ 434 8.87% Real estate -- commercial mortgage 6,932 160 9.29 Real estate -- construction 4,866 121 9.98 Commercial lease financing 6,861 122 7.14 - ---------------------------------------------------------------------------------------------------- Total commercial loans 38,306 837 8.78 Real estate-- residential 4,273 80 7.51 Home equity 9,095 219 9.68 Consumer - direct 2,595 68 10.50 Consumer - indirect lease financing 3,052 62 8.08 Consumer - indirect other 5,952 142 9.55 - ---------------------------------------------------------------------------------------------------- Total consumer loans 24,967 571 9.17 Loans held for sale 2,504 56 8.96 - ---------------------------------------------------------------------------------------------------- Total loans 65,777 1,464 8.93 Taxable investment securities 787 8 3.63 Tax-exempt investment securities(a) 369 7 8.12 - ---------------------------------------------------------------------------------------------------- Total investment securities 1,156 15 5.06 Securities available for sale(a),(c) 6,275 107 6.67 Short-term investments 1,501 17 4.76 - ---------------------------------------------------------------------------------------------------- Total earning assets 74,709 1,603 8.61 Allowance for loan losses (969) Accrued income and other assets 10,365 - ---------------------------------------------------------------------------------------------------- $84,105 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $11,956 102 3.43 Savings deposits 2,151 8 1.49 NOW accounts 592 2 1.59 Certificates of deposit ($100,000 or more)(d) 5,269 84 6.40 Other time deposits 14,634 218 6.01 Deposits in foreign office 2,860 48 6.70 - ---------------------------------------------------------------------------------------------------- Total interest-bearing deposits 37,462 462 4.96 Federal funds purchased and securities sold under repurchase agreements 5,746 88 6.17 Bank notes and other short-term borrowings(d) 6,403 99 6.19 Long-term debt, including capital securities(d),(e) 15,356 263 6.91 - ---------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 64,967 912 5.65 Noninterest-bearing deposits 8,377 Accrued expense and other liabilities 4,248 Common shareholders' equity 6,513 - ---------------------------------------------------------------------------------------------------- $84,105 ======= Interest rate spread (TE) 2.96 - ---------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $691 3.68% ==== ==== Capital securities $1,243 $24 Taxable-equivalent adjustment(a) 7 - ---------------------------------------------------------------------------------------------------- </TABLE> 39
- - during 2000 and the first nine months of 2001, Key sold without recourse $1.3 billion of its commercial mortgage loans. Our business of originating and servicing commercial mortgage loans is expected to grow as a result of Key's acquisitions of Newport Mortgage Company, L.P. and National Realty Funding L.C. last year; - - early in 2000, management announced that Key would de-emphasize the securitization and sale of home equity loans generated by our home equity finance affiliate. We have not effected any such transactions since the end of 1999. By retaining the assets attributable to this growing business on Key's balance sheet, we intend to replace over time the earnings formerly generated by the divested credit card business. We will continue, however, to consider securitizations of other portfolios as a source of alternative funding when conditions in the capital markets are favorable; - - during the second quarter of 2001, management announced that Key would exit the automobile leasing business, de-emphasize indirect prime automobile lending and discontinue certain nonrelationship credit-only commercial lending; and - - during the third quarter of 2001, we sold approximately $1.4 billion of the residential mortgage loans generated by our private banking and community development businesses. These loans are originated as a customer and community accommodation and are sold periodically because they have relatively low net interest spreads that do not meet Key's internal profitability standards. Figure 6 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 48, contains more discussion about changes in earning assets and funding sources. <TABLE> <CAPTION> FIGURE 6. COMPONENTS OF NET INTEREST INCOME CHANGES FROM THREE MONTHS ENDED SEPTEMBER 30, 2000 TO THREE MONTHS ENDED SEPTEMBER 30, 2001 ------------------------------------------------------- AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE - ----------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> INTEREST INCOME Loans $ 9 $(229) $(220) Taxable investment securities 1 (1) -- Tax-exempt investment securities (2) -- (2) Securities available for sale 5 2 7 Short-term investments 2 (4) (2) - ----------------------------------------------------------------------------------------------------------- Total interest income (taxable equivalent) 15 (232) (217) INTEREST EXPENSE Money market deposit accounts 5 (52) (47) Savings deposits (1) (2) (3) NOW accounts -- -- -- Certificates of deposit ($100,000 or more) (7) (10) (17) Other time deposits (13) (21) (34) Deposits in foreign office 8 (26) (18) - ----------------------------------------------------------------------------------------------------------- Total interest-bearing deposits (8) (111) (119) Federal funds purchased and securities sold under repurchase agreements 5 (41) (36) Bank notes and other short-term borrowings (3) (35) (38) Long-term debt, including capital securities 10 (73) (63) - ----------------------------------------------------------------------------------------------------------- Total interest expense 4 (260) (256) - ----------------------------------------------------------------------------------------------------------- Net interest income (taxable equivalent) $ 11 $ 28 $ 39 ==== ===== ===== - ----------------------------------------------------------------------------------------------------------- <CAPTION> FROM NINE MONTHS ENDED SEPTEMBER 30, 2000 TO NINE MONTHS ENDED SEPTEMBER 30, 2001 ------------------------------------------------------- AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE - ----------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> INTEREST INCOME Loans $118 $(343) $(225) Taxable investment securities 6 (1) 5 Tax-exempt investment securities (7) -- (7) Securities available for sale 21 2 23 Short-term investments (3) (3) (6) - ------------------------------------------------------------------------------------------------------- Total interest income (taxable equivalent) 135 (345) (210) INTEREST EXPENSE Money market deposit accounts (1) (93) (94) Savings deposits (3) (5) (8) NOW accounts -- (1) (1) Certificates of deposit ($100,000 or more) 1 (7) (6) Other time deposits 33 12 45 Deposits in foreign office 19 (39) (20) - ------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 49 (133) (84) Federal funds purchased and securities sold under repurchase agreements 33 (53) (20) Bank notes and other short-term borrowings (4) (64) (68) Long-term debt, including capital securities (2) (131) (133) - ------------------------------------------------------------------------------------------------------- Total interest expense 76 (381) (305) - ------------------------------------------------------------------------------------------------------- Net interest income (taxable equivalent) $ 59 $ 36 $ 95 ==== ===== ===== - ------------------------------------------------------------------------------------------------------- </TABLE> The change in interest not due solely to volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each. INTEREST RATE SWAPS AND CAPS. Key uses interest rate swaps and caps to help manage its interest rate sensitivity position. Interest rate swaps and caps are complicated instruments, but briefly: 40
- - INTEREST RATE SWAPS are contracts under which two parties agree to exchange interest payment streams that are calculated on agreed-upon amounts (known as "notional amounts"). For example, party A will pay interest at a fixed rate to, and receive interest at a variable rate from, party B. Key generally uses interest rate swaps to mitigate its exposure to interest rate risk on certain loans, securities, deposits, short-term borrowings and long-term debt. - - INTEREST RATE CAPS are contracts that provide for the holder to be compensated based on an agreed-upon notional amount when a benchmark interest rate exceeds a specified level (known as the "strike rate"). Key uses interest rate caps to manage the risk of adverse movements in interest rates on certain of our long-term debt and short-term borrowings. A cap limits Key's exposure to interest rate increases; caps do not have any impact if interest rates decline. For more information about how Key uses interest rate swaps and caps to manage its balance sheet, see the next section, entitled "Market risk management" and Note 12 ("Derivatives and Hedging Activities"), starting on page 24. MARKET RISK MANAGEMENT The values of some financial instruments vary with changes in external interest rates, foreign exchange rates, equity prices (the value of equity securities held as assets), or other market-driven rates or prices. For example, the value of a fixed-rate bond will decline if market interest rates increase because the bond will become a less attractive investment. Similarly, the value of the U.S. dollar regularly fluctuates in relation to other currencies. (Key is not affected in any material way by changes in foreign exchange rates or the prices of various equity securities held as assets.) The exposure that instruments tied to such external factors presents is called "market risk." ASSET AND LIABILITY MANAGEMENT Key's Asset/Liability Management Policy Committee has developed a program to measure and manage interest rate risk. This committee is also responsible for approving Key's asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing Key's interest rate sensitivity position. MEASUREMENT OF SHORT-TERM INTEREST RATE EXPOSURE. The primary tool that management uses to measure interest rate risk is a net interest income simulation model. These simulations estimate the impact that various changes in the overall level of interest rates over one- and two-year time horizons would have on net interest income. The results help Key develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments, interest rates, and on- and off-balance sheet management strategies. Management believes that both individually and in the aggregate the assumptions we make are reasonable. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure. Key's guidelines for risk management call for preventive measures if a gradual 200 basis point increase or decrease in short-term rates over the next twelve months would affect net interest income over the same period by more than 2%. Key has been operating well within these guidelines. As of September 30, 2001, based on the results of our simulation model, Key would expect net interest income to increase by approximately .21% if short-term interest rates gradually decrease by 200 basis points. Conversely, if short-term interest rates gradually increase by 200 basis points, net interest income would be expected to decrease by approximately .65%. MEASUREMENT OF LONG-TERM INTEREST RATE EXPOSURE. Key uses an economic value of equity model to complement short-term interest rate risk analysis. The benefit of this model is that it measures exposure to 41
interest rate changes over time frames longer than two years. The economic value of Key's equity is determined by aggregating the present value of projected future cash flows for asset, liability and derivative positions based on the current yield curve. Economic value analysis has several limitations. For example, the economic values of asset, liability and off-balance sheet positions do not represent the true fair values of the positions, since economic values do not consider factors like credit risk and liquidity. In addition, we must estimate cash flow for assets and liabilities with indeterminate maturities. Moreover, our present value calculations do not take into consideration future changes in the balance sheet that will likely result from ongoing loan and deposit activities conducted by Key's core businesses. Finally, the analysis requires assumptions about events that span several years. Despite its limitations, the economic value of equity model is a relatively sophisticated tool for evaluating the longer-term effect of possible interest rate movements. Key's guidelines for risk management call for preventive measures if an immediate 200 basis point increase or decrease in interest rates would reduce the economic value of equity by more than 15%. Key has been operating well within these guidelines. OTHER SOURCES OF INTEREST RATE EXPOSURE. Management uses the results of short-term and long-term interest rate exposure models to formulate strategies to improve balance sheet positioning, earnings, or both, within the bounds of Key's interest rate risk, liquidity and capital guidelines. We also periodically measure the risk to earnings and economic value arising from various other pro forma changes in the overall level of interest rates. The many interest rate scenarios modeled, and their potential impact on earnings and economic value, quantify the level of Key's interest rate exposure arising from option risk, basis risk and gap risk. - - A financial instrument presents "OPTION RISK" when one party can take advantage of changes in interest rates without penalty. For example, when interest rates decline, borrowers may choose to prepay fixed-rate loans by refinancing at a lower rate. Such a prepayment gives Key a return on its investment (the principal plus some interest), but unless there is a prepayment penalty, that return will not be as much as the loan would have generated had payments been received as originally scheduled. Floating rate loans that are capped against potential interest rate increases and deposits that can be withdrawn on demand also present option risk. - - One approach that Key follows to manage interest rate risk is to use floating-rate liabilities (such as borrowings) to fund floating-rate assets (such as loans). That way, as our interest expense increases, so will our interest income. We face "BASIS RISK" when our floating-rate assets and floating-rate liabilities reprice in response to different market factors or indices. Under those circumstances, even if equal amounts of assets and liabilities are repricing at the same time, interest expense and interest income may not change by the same amount. - - We often use an interest-bearing liability to provide funding for an interest-earning asset. For example, Key may sell certificates of deposit and use the proceeds to make loans. That strategy presents "GAP RISK" if the related liabilities and assets do not mature or reprice at the same time. MANAGEMENT OF INTEREST RATE EXPOSURE. Key manages interest rate risk by using portfolio swaps and caps, which modify the repricing or maturity characteristics of some of our assets and liabilities. The decision to use these instruments rather than securities, debt or other on-balance sheet alternatives depends on many factors, including the mix and cost of funding sources, liquidity and capital requirements. In addition, management considers interest rate implications when adding to Key's securities portfolio, issuing new debt and packaging loans for securitization. TRADING PORTFOLIO RISK MANAGEMENT Key's trading portfolio includes interest rate swap contracts entered into to accommodate the needs of clients, other positions with third parties that are intended to mitigate the interest rate risk of client 42
positions, foreign exchange contracts entered into to accommodate the needs of clients, and financial assets and liabilities (trading positions) included in "accrued income and other assets" and "accrued expense and other liabilities," respectively, on the balance sheet. For more information about these contracts, see Note 12 ("Derivatives and Hedging Activities"), that begins on page 24. Management uses a value at risk ("VAR") model to estimate the potential adverse effect of changes in interest and foreign exchange rates on the fair value of Key's trading portfolio. Using statistical methods, this model estimates the maximum potential one-day loss with 95% certainty. At September 30, 2001, Key's aggregate daily VAR was $1.3 million compared with $1.1 million at September 30, 2000. Aggregate daily VAR averaged $1.3 million for the first nine months of 2001, compared with an average of less than $1 million during the same period last year. VAR modeling augments other controls that Key uses to mitigate the market risk exposure of the trading portfolio. These controls include loss and portfolio size limits that are based on market liquidity and the level of activity and volatility of trading products. NONINTEREST INCOME Noninterest income for the third quarter of 2001 totaled $454 million, up $49 million, or 12%, from the same period last year. For the first nine months of the year, noninterest income was $1.3 billion, representing a decrease of $379 million, or 22%, from the first nine months of 2000. In both the current and prior year, noninterest income has been affected by various nonrecurring items. The most significant of these items, which are shown in Figure 7, is the $332 million gain from the January 2000 sale of Key's credit card business. For more information on this transaction, see Note 3 ("Acquisitions and Divestiture"), on page 10. Core noninterest income, which excludes significant nonrecurring items, was $454 million (39% of total core revenue), for the third quarter compared with $460 million (40% of total core revenue) for the same period last year. One of management's long-term objectives is to increase core noninterest income as a percentage of total core revenue to at least 50%. The decrease in core noninterest income from the year-ago quarter was attributable primarily to the effects of weaker conditions in the capital markets, which were further accentuated by the events of September 11. These adverse conditions led to declines in revenue derived from various capital markets activities; the impact was particularly noticeable in our equity capital investing. Key's core noninterest income for the first nine months of 2001 includes a $40 million second quarter charge (included in miscellaneous income) for losses incurred on the residual values of leased vehicles. Excluding this strategic charge, core noninterest income for the year-to-date period was $1.3 billion compared with $1.4 billion for the first nine months of 2000. The decrease in year-to-date results is also attributable to the effects of continued economic weakness on Key's capital markets-sensitive revenues, particularly those generated by our equity capital investing and brokerage businesses. Figure 7 shows the major components of Key's noninterest income. The discussion that follows provides additional information, such as the composition of certain components and the factors that caused them to change from the prior year. For detailed information about trust and investment services, and investment banking and capital markets income, see Figures 8 and 9, respectively. 43
<TABLE> <CAPTION> FIGURE 7. NONINTEREST INCOME THREE MONTHS ENDED SEPTEMBER 30, CHANGE --------------------------------- ----------------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Trust and investment services income $140 $148 $(8) (5.4)% Investment banking and capital markets income 46 91 (45) (49.5) Service charges on deposit accounts 107 85 22 25.9 Corporate-owned life insurance income 28 28 -- -- Letter of credit and loan fees 27 26 1 3.8 Net securities gains 2 -- 2 N/M Other income: Electronic banking fees 20 18 2 11.1 Insurance income 14 16 (2) (12.5) Loan securitization servicing fees 4 6 (2) (33.3) Net gains from loan securitizations and sales 27 10 17 170.0 Miscellaneous income 39 32 7 21.9 - ------------------------------------------------------------------------------------------------------------------------------------ Total other income 104 82 22 26.8 - ------------------------------------------------------------------------------------------------------------------------------------ Total core noninterest income 454 460 (6) (1.3) Gain from sale of credit card portfolio -- -- -- -- Net losses from reconfiguration of securities portfolio -- (50) 50 (100.0) Other nonrecurring items -- (5) 5 (100.0) - ------------------------------------------------------------------------------------------------------------------------------------ Total significant nonrecurring items -- (55) 55 (100.0) - ------------------------------------------------------------------------------------------------------------------------------------ Total noninterest income $454 $405 $ 49 12.1 % ==== ==== ==== - ------------------------------------------------------------------------------------------------------------------------------------ <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE -------------------------------- -------------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Trust and investment services income $ 413 $ 458 $ (45) (9.8)% Investment banking and capital markets income 183 278 (95) (34.2) Service charges on deposit accounts 281 256 25 9.8 Corporate-owned life insurance income 82 78 4 5.1 Letter of credit and loan fees 86 73 13 17.8 Net securities gains 36 3 33 N/M Other income: Electronic banking fees 55 50 5 10.0 Insurance income 40 47 (7) (14.9) Loan securitization servicing fees 13 19 (6) (31.6) Net gains from loan securitizations and sales 40 33 7 21.2 Miscellaneous income 78 116 (38) (32.8) - ---------------------------------------------------------------------------------------------------------------------------------- Total other income 226 265 (39) (14.7) - ---------------------------------------------------------------------------------------------------------------------------------- Total core noninterest income 1,307 1,411 (104) (7.4) Gain from sale of credit card portfolio -- 332 (332) (100.0) Net losses from reconfiguration of securities portfolio -- (50) 50 (100.0) Other nonrecurring items -- (7) 7 (100.0) - ---------------------------------------------------------------------------------------------------------------------------------- Total significant nonrecurring items -- 275 (275) (100.0) - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest income $1,307 $1,686 $(379) (22.5)% ====== ====== ===== - ---------------------------------------------------------------------------------------------------------------------------------- </TABLE> N/M = Not Meaningful <Table> <CAPTION> FIGURE 8. TRUST AND INVESTMENT SERVICES THREE MONTHS ENDED SEPTEMBER 30, CHANGE --------------------------- -------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - --------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Personal asset management and custody fees $ 44 $ 50 $ (6) (12.0)% Institutional asset management and custody fees 21 22 (1) (4.5) Bond services 10 7 3 42.9 Brokerage commission income 26 34 (8) (23.5) All other fees 39 35 4 11.4 - --------------------------------------------------------------------------------------------------------------- Total trust and investment services income $ 140 $ 148 $ (8) (5.4)% ===== ====== ====== dollars in billions - --------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, Discretionary trust assets $ 67 $ 68 $ (1) (1.5)% Nondiscretionary trust assets 52 55 (3) (5.5) - --------------------------------------------------------------------------------------------------------------- Total trust assets $ 119 $ 123 $ (4) (3.3)% ===== ====== ====== - --------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE ------------------------ ------------------------------ dollars in millions 2001 2000 AMOUNT PERCENT - --------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Personal asset management and custody fees $ 135 $ 143 $ (8) (5.6)% Institutional asset management and custody fees 65 70 (5) (7.1) Bond services 29 31 (2) (6.5) Brokerage commission income 73 113 (40) (35.4) All other fees 111 101 10 9.9 - --------------------------------------------------------------------------------------------------------------- Total trust and investment services income $ 413 $ 458 $ (45) (9.8)% ====== ====== ====== - --------------------------------------------------------------------------------------------------------------- <CAPTION> FIGURE 9. INVESTMENT BANKING AND CAPITAL MARKETS INCOME THREE MONTHS ENDED SEPTEMBER 30, CHANGE ------------------------------- -------------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Dealer trading and derivatives income $23 $34 $(11) (32.4)% Investment banking income 23 25 (2) (8.0) Equity capital gains (losses) (9) 22 (31) (140.9) Foreign exchange income 9 10 (1) (10.0) - ---------------------------------------------------------------------------------------------------------------------------------- Total investment banking and capital markets income $46 $91 $(45) (49.5)% === === ===== - ---------------------------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE ---------------------------- --------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Dealer trading and derivatives income $114 $118 $(4) (3.4)% Investment banking income 71 78 (7) (9.0) Equity capital gains (losses) (33) 55 (88) (160.0) Foreign exchange income 31 27 4 14.8 - ---------------------------------------------------------------------------------------------------------------------------- Total investment banking and capital markets income $183 $278 $(95) (34.2)% ==== ==== ==== - ---------------------------------------------------------------------------------------------------------------------------- </TABLE> TRUST AND INVESTMENT SERVICES. Trust and investment services provide Key's largest source of noninterest income. As shown in Figure 8, the decrease in revenue derived from these services was largely due to a decline in brokerage commission income, reflecting the impact of a weakening economy. The softer economic environment also resulted in a decrease in fee income that is based on the value of assets managed by Key for its clients. At September 30, 2001, Key's bank, trust and registered investment advisory subsidiaries had assets under discretionary management (excluding corporate trust assets) of $67 billion, compared with $68 billion at September 30, 2000. INVESTMENT BANKING AND CAPITAL MARKETS INCOME. The decrease in this revenue component also reflects the effects of a weakening economy. As shown in Figure 9, results for the current year include net equity capital losses, compared with net equity capital gains last year. The net equity capital losses in the current year are attributable to unrealized mark-to-market adjustments, which totaled $13 million in the third quarter and $57 million for the year-to-date period. The $88 million decrease in total equity investing results from the first nine months of 2000 was substantially offset by a $33 million increase in net realized gains from the sales of certain securities held in Key's available for sale portfolio discussed on page 45. 44
SERVICE CHARGES ON DEPOSIT ACCOUNTS. Service charges on deposit accounts reached a record quarterly high and accounted for the largest increase in fee income relative to the prior year. This improvement was attributable primarily to strategies implemented in connection with Key's competitiveness initiative. SECURITIES TRANSACTIONS. During the first nine months of 2001, Key realized $36 million of net securities gains from the sales of securities held in the available for sale portfolio, compared with core net gains of $3 million a year ago. Since the sales involved primarily equity securities issued by financial service companies, the sales will not have a significant adverse affect on Key's future net interest income. NONINTEREST EXPENSE Noninterest expense for the third quarter of 2001 totaled $683 million, down $104 million, or 13%, from the third quarter of 2000. For the first nine months of the year, noninterest expense was $2.2 billion, representing an increase of $27 million, or 1%, from the first nine months of last year. Items that hinder a direct comparison of results between reporting periods are shown in Figure 10. In the current year, these items include a $150 million write-down of goodwill associated with Key's decision to downsize its automobile finance business and additional litigation reserves of $20 million; both were recorded in the second quarter. In the prior year, these items include restructuring and other special charges recorded during the first and third quarters in connection with strategic actions that Key has been taking to improve operating efficiency and profitability. More information about these charges can be found under the heading "Restructuring and other special charges," on page 47. Core noninterest expense, which excludes significant nonrecurring items, increased by $11 million, or 2%, from the year-ago quarter, due primarily to increases in professional fees and net occupancy expense of $8 million and $5 million, respectively. For the year-to-date period, core noninterest expense improved by $19 million, or 1%, reflecting a $42 million decrease in personnel expense and a $16 million decrease in equipment expense. These reductions were partially offset by smaller increases in a number of other expense components. Although third quarter expenses were up slightly from the prior year, we continue to benefit from the disciplined expense management resulting from our competitiveness initiative; core noninterest expense decreased for the third consecutive quarter. Figure 10 shows the major components of Key's noninterest expense. The discussion that follows explains the composition of certain components and the factors that caused them to change from the prior year. 45
<TABLE> <CAPTION> FIGURE 10. NONINTEREST EXPENSE THREE MONTHS ENDED SEPTEMBER 30, CHANGE ----------------------- ---------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Personnel $ 334 $ 342 $ (8) (2.3)% Net occupancy 60 55 5 9.1 Computer processing 62 59 3 5.1 Equipment 37 41 (4) (9.8) Marketing 31 29 2 6.9 Amortization of intangibles 22 26 (4) (15.4) Professional fees 26 18 8 44.4 Other expense: Postage and delivery 16 15 1 6.7 Telecommunications 10 12 (2) (16.7) Equity- and gross receipts-based taxes 7 8 (1) (12.5) OREO expense, net 2 2 -- -- Miscellaneous expense 76 65 11 16.9 - -------------------------------------------------------------------------------------------------------------- Total other expense 111 102 9 8.8 - -------------------------------------------------------------------------------------------------------------- Total core noninterest expense 683 672 11 1.6 Goodwill write-down (automobile finance business) -- -- -- -- Additional litigation reserves -- -- -- -- Restructuring and other special charges -- 114 (114) (100.0) Other nonrecurring items -- 1 (1) (100.0) - -------------------------------------------------------------------------------------------------------------- Total significant nonrecurring items -- 115 (115) (100.0) - -------------------------------------------------------------------------------------------------------------- Total noninterest expense $ 683 $ 787 $ (104) (13.2)% ======== ======== ======== Full-time equivalent employees at period end 21,297 22,457 (1,160) (5.2)% - -------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE ----------------------- ------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Personnel $ 1,043 $ 1,085 $ (42) (3.9)% Net occupancy 173 168 5 3.0 Computer processing 187 178 9 5.1 Equipment 115 131 (16) (12.2) Marketing 87 82 5 6.1 Amortization of intangibles 72 76 (4) (5.3) Professional fees 63 58 5 8.6 Other expense: Postage and delivery 49 49 -- -- Telecommunications 33 39 (6) (15.4) Equity- and gross receipts- based taxes 22 24 (2) (8.3) OREO expense, net 6 5 1 20.0 Miscellaneous expense 217 191 26 13.6 - ---------------------------------------------------------------------------------------------------------------- Total other expense 327 308 19 6.2 - ---------------------------------------------------------------------------------------------------------------- Total core noninterest expense 2,067 2,086 (19) (.9) Goodwill write-down (automobile finance business) 150 -- 150 N/M Additional litigation reserves 20 -- 20 N/M Restructuring and other special charges 2 128 (126) (98.4) Other nonrecurring items -- (2) 2 (100.0) - ---------------------------------------------------------------------------------------------------------------- Total significant nonrecurring items 172 126 46 36.5 - ---------------------------------------------------------------------------------------------------------------- Total noninterest expense $ 2,239 $ 2,212 $ 27 1.2 % ======== ======== ======== Full-time equivalent employees at period end 21,297 22,457 (1,160) (5.2)% - ---------------------------------------------------------------------------------------------------------------- </TABLE> N/M= Not Meaningful PERSONNEL. Personnel expense, the largest category of Key's noninterest expense, posted decreases from the prior year for both the quarterly and year-to-date periods. The improvements are largely attributable to the effectiveness of our competitiveness initiative. Through this initiative we have improved efficiency, reduced the level of personnel required to conduct our business, and instilled a greater sense of awareness among all employees of the need to manage costs. Lower levels of incentive compensation also contributed to the year-to-date reduction in personnel expense. Revenues on which various incentive programs (including those related to investment banking and capital markets activities) are based were down from the prior year, due largely to the weaker economic conditions. Figure 11 shows the major components of Key's core personnel expense. FIGURE 11. CORE PERSONNEL EXPENSE <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, CHANGE ------------------------- --------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Salaries $ 212 $ 220 $ (8) (3.6)% Employee benefits 42 44 (2) (4.5) Incentive compensation 80 78 2 2.6 - ---------------------------------------------------------------------------------------------------------------- Total core personnel expense $ 334 $ 342 $ (8) (2.3)% ======== ======== ======== - ---------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE ------------------------ --------------------------- dollars in millions 2001 2000 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Salaries $ 637 $ 661 $ (24) (3.6)% Employee benefits 144 151 (7) (4.6) Incentive compensation 262 273 (11) (4.0) - ---------------------------------------------------------------------------------------------------------------- Total core personnel expense $ 1,043 $ 1,085 $ (42) (3.9)% ======== ======== ======== - ---------------------------------------------------------------------------------------------------------------- </TABLE> At September 30, 2001, the number of full-time equivalent employees was 21,297, compared with 22,142 at the end of 2000 and 22,457 a year ago. The decrease in the number of employees is primarily a result of Key's competitiveness initiative. EQUIPMENT. The decrease in equipment expense from the first nine months of 2000 was driven by reductions in depreciation, maintenance expense and rental expense stemming from cost management efforts and our competitiveness initiative. 46
RESTRUCTURING AND OTHER SPECIAL CHARGES. During the first nine months of last year, Key recorded net nonrecurring charges of $130 million (including net restructuring charges of $111 million) in connection with strategic actions related to the competitiveness initiative. For more information related to the actions being taken, anticipated cost savings and expected reductions to Key's workforce, see the section entitled "Status of three-year competitiveness initiative," on page 32. Additional information related to the restructuring charges can be found in Note 10 ("Restructuring Charges"), on page 21. Cash generated by Key's operations will fund the restructuring charge liability; none of the charges will have a material impact on Key's liquidity. INCOME TAXES The provision for income taxes for the third quarter of 2001, was $130 million, up from $50 million for the comparable period in 2000. The effective tax rate (which is the provision for income taxes as a percentage of income before income taxes) for the third quarter of 2001 was 34.3%, compared with 29.2% for the third quarter of 2000. The effective tax rate for the year-ago quarter was distorted by the impact of significant nonrecurring charges. These charges are summarized in Figure 1 on page 30. Excluding these charges and the related tax benefits, the effective tax rate for the third quarter of 2000 was 33.4%. The slight increase in the effective tax rate from the adjusted tax rate a year-ago is attributable primarily to lower levels of tax-exempt interest income, nontaxable income from corporate-owned life insurance and tax credits. For the first nine months of 2001, the provision for income taxes was $235 million compared with $384 million for the first nine months of last year. The effective tax rates for these periods were 41.5% and 34.3%, respectively. The effective tax rate for 2001 continues to be impacted by the $150 million nondeductible write-down of goodwill recorded in the second quarter in connection with Key's decision to downsize its automobile finance business. Excluding this charge, the effective tax rate for the first nine months of 2001 was approximately 32.8%. Proportionately higher levels of tax-exempt interest income, nontaxable income from corporate-owned life insurance and tax credits contributed to the decrease from the effective tax rate reported for the third quarter of last year. The effective income tax rate remains below Key's combined statutory Federal and state rate of 37%, primarily because we continue to invest in tax-advantaged assets (such as tax-exempt securities and corporate-owned life insurance) and to recognize credits associated with investments in low-income housing projects. 47
FINANCIAL CONDITION LOANS At September 30, 2001, total loans outstanding were $64.5 billion, compared with $66.9 billion at the end of 2000 and $66.3 billion a year ago. The composition of the loan portfolio at each of these respective dates is summarized in Note 6 ("Loans") on page 17. Among the factors that contributed to the 3% decrease in our loans over the past twelve months are: - - weaker loan demand stemming from the sluggish economy; - - our recently-announced decision to exit the automobile leasing business, de-emphasize indirect prime automobile lending and discontinue certain nonrelationship, credit-only commercial lending; and - - selective loan sales completed to improve the profitability of Key's overall portfolio, or to accommodate our funding needs. Because of Key's success in generating new loan volume, loan growth has outpaced deposit growth over the past several years. To mitigate this imbalance, we have used alternative funding sources like loan sales and securitizations so we can continue to capitalize on our lending opportunities. Management expects Newport Mortgage Company, L.P. and National Realty Funding L.C., which were acquired last year, to improve Key's ability to generate and securitize new loans, especially in the area of commercial real estate. In addition, early in 2000, we sold loans to a loan conduit. This arrangement allowed us to continue to meet our corporate customers' funding needs and to generate servicing revenue without having to retain certain low net interest spread assets on the balance sheet. Loans outstanding (excluding loans held for sale) would have grown by $1.9 billion, or 3%, over the past twelve months, if we had not sold $3.4 billion of loans during that time period. Excluding the impact of loan sales, commercial loans rose by $1.8 billion, or 5%, since September 30, 2000. Commercial real estate lending drove a portion of this loan growth. Our commercial real estate line of business focuses on larger developers in the real estate industry and is designed to be diversified by both product type and geography. Figure 12 shows the nonowner-occupied portion of Key's commercial real estate portfolio detailed by industry concentration and geographic region. FIGURE 12. COMMERCIAL REAL ESTATE LOANS (NONOWNER-OCCUPIED) <TABLE> <CAPTION> SEPTEMBER 30, 2001 GEOGRAPHIC REGION ---------------------------------------------- TOTAL PERCENT OF TOTAL dollars in millions EAST MIDWEST CENTRAL WEST AMOUNT NONOWNER-OCCUPIED - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Multi-family properties $ 611 $ 438 $ 693 $ 511 $2,253 27.1 % Retail properties 470 621 248 327 1,666 20.0 Office buildings 153 224 108 400 885 10.6 Residential properties 62 94 148 453 757 9.1 Health facilities 10 449 8 12 479 5.7 Warehouses 147 82 38 93 360 4.3 Manufacturing facilities 55 31 2 16 104 1.2 Hotels/Motels 22 6 7 13 48 .6 Other 466 610 284 420 1,780 21.4 - ----------------------------------------------------------------------------------------------------------------------------- Total nonowner-occupied $1,996 $2,555 $1,536 $2,245 $8,332 100.0% ====== ====== ====== ====== ====== ====== - ----------------------------------------------------------------------------------------------------------------------------- </TABLE> 48
Consumer loans rose (excluding loan sales) by $94 million, or less than 1%. Our home equity portfolio grew by $1.8 billion, largely as a result of our decision not to securitize and sell these loans starting in 2000. By retaining these assets, we intend to replace over time the revenue generated by our former credit card business, which was sold in January 2000. The growth of the home equity portfolio was substantially offset, however, by declines of $728 million in installment loans, $626 million in automobile lease financing receivables and $398 million in residential real estate mortgage loans. The declines in installment loans and lease financing receivables reflect our decision to exit the automobile leasing business and to de-emphasize indirect prime automobile lending. SALES, SECURITIZATIONS AND DIVESTITURES. During the past twelve months, Key sold $1.6 billion of commercial real estate loans, $1.4 billion of residential mortgage loans, $1.2 billion of education loans ($491 million through securitizations) and $408 million of other types of loans. Among the factors that Key considers in determining which loans to securitize are: - - whether the characteristics of a specific loan portfolio make it conducive to securitization; - - the relative cost of funds; - - the level of credit risk; and - - capital requirements. Figure 13 summarizes Key's loan sales (including securitizations) for the first nine months of 2001 and all of 2000. FIGURE 13. LOANS SOLD AND DIVESTED <TABLE> <CAPTION> COMMERCIAL RESIDENTIAL HOME CREDIT CARD in millions COMMERCIAL REAL ESTATE REAL ESTATE EQUITY RECEIVABLES EDUCATION TOTAL - ---------------------------------------------------------------------------------------------------------------------------------- 2001 - ------------------- <S> <C> <C> <C> <C> <C> <C> <C> Third quarter -- $ 93 $1,427 $ 269 -- $ 597 $2,386 Second quarter $ 44 577 20 59 -- 144 844 First quarter -- 327 1 14 -- 449 791 - ---------------------------------------------------------------------------------------------------------------------------------- Total $ 44 $ 997 $1,448 $ 342 -- $1,190 $4,021 ====== ====== ====== ====== ====== ====== ====== 2000 - -------------- Fourth quarter -- $ 560 -- $ 22 -- $ 13 $ 595 Third quarter $ 27 70 -- 72 -- 618 787 Second quarter 451 499 -- 23 -- 518 1,491 First quarter 354 6 -- 24 $1,339 29 1,752 - ---------------------------------------------------------------------------------------------------------------------------------- Total $ 832 $1,135 -- $ 141 $1,339 $1,178 $4,625 ====== ====== ====== ====== ====== ====== ====== - ---------------------------------------------------------------------------------------------------------------------------------- </TABLE> Figure 14 shows loans that are either administered or serviced by Key, but are not recorded on the balance sheet. This includes loans that have been both securitized and sold, or simply sold outright. Key derives income from two sources when we sell or securitize loans but retain the right to administer or service them. We earn noninterest income (recorded as "other income") from servicing or administering the loans, and we earn interest income from the securitized assets retained. 49
<TABLE> <CAPTION> FIGURE 14. LOANS ADMINISTERED OR SERVICED SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, in millions 2001 2001 2001 2000 2000 - -------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Education loans $4,604 $4,305 $4,428 $4,113 $3,946 Automobile loans 199 254 340 422 505 Home equity loans 890 965 1,085 1,176 1,266 Commercial real estate loans 7,873 7,549 6,549 5,322 4,071 Commercial loans 901 951 1,023 973 916 - -------------------------------------------------------------------------------------------------------------------------------- Total $14,467 $14,024 $13,425 $12,006 $10,704 ======= ======= ======= ======= ======= - -------------------------------------------------------------------------------------------------------------------------------- </TABLE> SECURITIES At September 30, 2001, the securities portfolio totaled $7.7 billion and included $6.5 billion of securities available for sale and $1.2 billion of investment securities. In comparison, the total portfolio at December 31, 2000, was $8.5 billion, including $7.3 billion of securities available for sale and $1.2 billion of investment securities. Figure 15 shows the composition, yields and remaining maturities of Key's securities available for sale. Figure 16 provides the same information about Key's investment securities. For more information about retained interests in securitizations and gross unrealized gains and losses by type of security, see Note 5 ("Securities"), which begins on page 15. <TABLE> <CAPTION> FIGURE 15. SECURITIES AVAILABLE FOR SALE OTHER U.S. TREASURY, STATES AND COLLATERALIZED MORTGAGE- AGENCIES AND POLITICAL MORTGAGE BACKED dollars in millions CORPORATIONS SUBDIVISIONS OBLIGATIONS(a) SECURITIES(a) - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SEPTEMBER 30, 2001 Remaining maturity: One year or less $251 $1 $ 123 $ 1 After one through five years 3 12 4,108 1,022 After five through ten years 5 10 209 91 After ten years 9 -- 174 17 - ------------------------------------------------------------------------------------------------------------------------------------ Fair value $268 $23 $4,614 $1,131 Amortized cost 268 23 4,562 1,092 Weighted average yield (b) 3.01 % 4.69 % 6.93 % 7.40 % Weighted average maturity 1.0 years 4.9 years 3.2 years 3.3 years - ------------------------------------------------------------------------------------------------------------------------------------ DECEMBER 31, 2000 Fair value $984 $33 $4,298 $1,355 Amortized cost 984 33 4,296 1,355 - ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 2000 Fair value $2,105 $48 $2,474 $1,408 Amortized cost 2,105 48 2,561 1,425 - ------------------------------------------------------------------------------------------------------------------------------------ <CAPTION> RETAINED WEIGHTED INTERESTS IN OTHER AVERAGE dollars in millions SECURITIZATIONS (a) SECURITIES TOTAL YIELD (b) - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SEPTEMBER 30, 2001 Remaining maturity: One year or less $26 $14 $ 416 4.59 % After one through five years 235 11 5,391 7.13 After five through ten years -- 9 324 8.14 After ten years -- 140 (c) 340 8.65 - ----------------------------------------------------------------------------------------------------------------------------------- Fair value $261 $174 $6,471 -- Amortized cost 246 198 6,389 7.07 % Weighted average yield (b) 12.97 % 6.44 % 7.07 % -- Weighted average maturity 3.6 years 10.9 years 3.4 years -- - ----------------------------------------------------------------------------------------------------------------------------------- DECEMBER 31, 2000 Fair value $316 $343 $7,329 -- Amortized cost 334 307 7,309 7.16 % - ----------------------------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 2000 Fair value $326 $303 $6,664 -- Amortized cost 341 278 6,758 7.25 % - ----------------------------------------------------------------------------------------------------------------------------------- </TABLE> (a) Maturity is based upon expected average lives rather than contractual terms. (b) Weighted average yields are calculated based on amortized cost and exclude equity securities that have no stated yield. Stated yields have been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%. (c) Includes equity securities with no stated maturity. 50
FIGURE 16. INVESTMENT SECURITIES <TABLE> <CAPTION> STATES AND WEIGHTED POLITICAL OTHER AVERAGE dollars in millions SUBDIVISIONS SECURITIES TOTAL YIELD (a) - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SEPTEMBER 30, 2001 Remaining maturity: One year or less $93 $ 6 $ 99 7.71 % After one through five years 112 -- 112 9.73 After five through ten years 47 39 86 7.87 After ten years 2 875(b) 877 4.95 - ------------------------------------------------------------------------------------------------------------- Amortized cost $254 $920 $1,174 7.67 % Fair value 266 920 1,186 -- Weighted average yield (a) 8.96 % 5.24 % 7.67 % -- Weighted average maturity 2.6 years 9.9 years 8.3 years -- - ------------------------------------------------------------------------------------------------------------- DECEMBER 31, 2000 Amortized cost $323 $875 $1,198 8.16 % Fair value 333 875 1,208 -- - ------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 2000 Amortized cost $364 $889 $1,253 8.22 % Fair value 373 889 1,262 -- - ------------------------------------------------------------------------------------------------------------- </TABLE> (a) Weighted average yields are calculated based on amortized cost and exclude equity securities that have no stated yield. Stated yields have been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%. (b) Includes equity securities with no stated maturity. ASSET QUALITY Key manages asset quality by following procedures that address the issue from many perspectives. Specifically, Key has professionals that: - - evaluate and monitor the level of risk in credit-related assets; - - formulate underwriting standards and guidelines for line management; - - develop commercial and consumer credit policies and systems; - - establish credit-related concentration limits; - - review loans, leases and other corporate assets to evaluate credit quality; and - - review the adequacy of the allowance for loan losses. ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses at September 30, was $1.2 billion, or 1.82% of loans. This compares with $1.0 billion, or 1.51%, at September 30, 2000. The allowance includes $135 million (for 2001) and $83 million (for 2000) that is specifically allocated for impaired loans. For more information about impaired loans, see Note 7 ("Impaired Loans and Other Nonperforming Assets") on page 18. At September 30, 2001, the allowance for loan losses was 132.66% of nonperforming loans, compared with 169.09% at September 30, 2000. Management estimates the appropriate level of the allowance for loan losses on a quarterly (and at times more frequent) basis using an iterative methodology. The methodology is described in Note 1 ("Summary of Significant Accounting Policies") under the heading "Allowance for Loan Losses," on page 66 of Key's 51
2000 Annual Report to Shareholders. Since the allowance is established through the provision for loan losses, this methodology also has a direct impact on the level of the provision that Key records. In the second quarter of 2001, Key recorded an additional provision for loan losses in connection with management's decision to eliminate nonrelationship lending in the leveraged financing and nationally syndicated lending businesses. The added provision will be used to exit and resolve approximately $2.7 billion in related commitments that were moved to a separate loan run-off portfolio. The vast majority of these commitments are performing in accordance with their contractual repayment terms. Approximately $2.0 billion of these commitments were remaining as of September 30, of which $1.176 billion were funded. As write-downs on the run-off portfolio occur over time, the related allowance will not be replenished. Figure 17 summarizes certain asset quality indicators, segregated between Key's continuing and run-off loan portfolios. In the prior year, Key's year-to-date provision for loan losses includes an additional noncore provision of $121 million recorded in the first quarter as a result of an enhancement in Key's methodology for assessing credit risk. FIGURE 17. ASSET QUALITY INDICATORS--CONTINUING AND RUNOFF LOAN PORTFOLIOS <TABLE> <CAPTION> Continuing Loan Portfolio Run-off Loan Portfolio Total Loan Portfolio ------------------------- ----------------------- ----------------------- dollars in millions 3Q01 2Q01 3Q01 2Q01 3Q01 2Q01 - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Loans outstanding $63,330 $65,270 $1,176 $1,423 $64,506 $66,693 Nonperforming loans at period end 652 555 233 242 885 797 Net loan charge-offs 116 100 57 71 173 171 Net loan charge-offs to average loans .71 % .61 % N/M N/M 1.04 % 1.02 % Allowance for loan losses $ 1,002 $ 1,002 $ 172 $ 229 $ 1,174 $ 1,231 Allowance for loan losses to period-end loans 1.58 % 1.54 % 14.63 % 16.09 % 1.82 % 1.85 % - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> N/M= Not Meaningful NET LOAN CHARGE-OFFS. Net loan charge-offs for the third quarter of 2001 were $173 million, or 1.04% of average loans, compared with $104 million, or .63%, for the same period last year. For the first nine months of 2001, net loan charge-offs totaled $453 million, or .91% of average loans, compared with $306 million, or .63%, for the first nine months of 2000. The composition of Key's loan charge-offs and recoveries by type of loan portfolio is shown in Figure 18. The increase in net charge-offs relative to the prior year was primarily due to aggressive efforts made to resolve credits within the commercial loan run-off portfolio. As shown in Figure 17, this portfolio accounted for $57 million of total net charge-offs recorded in the third quarter of 2001. In addition, net charge-offs within the home equity portfolio rose by $13 million, reflecting the growth of this portfolio, the accelerated disposition of certain nonperforming loans and the impact of continued weakness in the economy. 52
FIGURE 18. SUMMARY OF LOAN LOSS EXPERIENCE <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------- --------------------------------- dollars in millions 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Average loans outstanding during the period $66,198 $65,777 $66,725 $64,876 - --------------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at beginning of period $1,231 $979 $1,001 $930 Loans charged off: Commercial, financial and agricultural 66 60 210 131 Real estate-commercial mortgage 25 2 35 6 Commercial lease financing 20 2 33 9 - --------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 111 64 278 146 Real estate-residential mortgage 5 1 12 5 Home equity 16 3 48 14 Credit card -- -- -- 16 Consumer-direct 12 14 36 43 Consumer-indirect lease financing 7 2 20 13 Consumer-indirect other 46 45 140 150 - --------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 86 65 256 241 - --------------------------------------------------------------------------------------------------------------------------------- 197 129 534 387 Recoveries: Commercial, financial and agricultural 5 4 19 18 Real estate-commercial mortgage 1 -- 3 3 Commercial lease financing -- -- 4 2 - --------------------------------------------------------------------------------------------------------------------------------- Total commercial loans 6 4 26 23 Real estate-residential mortgage 1 1 4 3 Home equity -- -- 1 1 Credit card -- 1 -- 4 Consumer-direct 2 2 6 5 Consumer-indirect lease financing 3 -- 7 2 Consumer-indirect other 12 17 37 43 - --------------------------------------------------------------------------------------------------------------------------------- Total consumer loans 18 21 55 58 - --------------------------------------------------------------------------------------------------------------------------------- 24 25 81 81 - --------------------------------------------------------------------------------------------------------------------------------- Net loans charged off (173) (104) (453) (306) Provision for loan losses 116 131 627 382 Allowance related to loans sold, net -- (5) (1) (5) - --------------------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of period $1,174 $1,001 $1,174 $1,001 ====== ====== ====== ====== - --------------------------------------------------------------------------------------------------------------------------------- Net loan charge-offs to average loans 1.04 % .63 % .91 % .63 % Allowance for loan losses to period-end loans 1.82 1.51 1.82 1.51 Allowance for loan losses to nonperforming loans 132.66 169.09 132.66 169.09 - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> NONPERFORMING ASSETS. Figure 19 shows the composition of Key's nonperforming assets. These assets totaled $913 million at September 30, 2001, and represented 1.41% of loans, other real estate owned (known as "OREO") and other nonperforming assets, compared with $672 million, or 1.00%, at December 31, 2000, and $617 million, or .93%, at September 30, 2000. The increase in the level of nonperforming assets in general is attributable to a number of factors, including continued economic weakness. The economic slowdown can be expected to continue to impact Key's loan portfolio generally, although the erosion in credit quality that we have experienced is concentrated in several distinct commercial portfolios of limited size. Management continually assesses the adequacy of the allowance for loan losses in light of economic conditions, credit trends in Key's portfolio and other factors. At September 30, 2001, our 20 largest nonperforming loans totaled $288 million, representing 40% of Key's nonperforming commercial loans and 32% of total loans on nonperforming status. Of this amount, $100 million is concentrated in the healthcare portfolio and $81 million in the structured finance portfolio. These portfolios account for only 5% of Key's total loans. Additionally, our exposure to the three industry segments most affected by the events of September 11 (commercial airlines, property and casualty insurance carriers, and hotel/motel) is not significant. 53
As shown in Figure 17, the commercial loan run-off portfolio accounted for $233 million, or 26%, of Key's total nonperforming loans at September 30, 2001. <TABLE> <CAPTION> FIGURE 19. SUMMARY OF NONPERFORMING ASSETS AND PAST DUE LOANS SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2001 2000 2000 - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> Commercial, financial and agricultural $ 399 $ 301 $ 251 Real estate-- commercial mortgage 169 90 92 Real estate-- construction 70 28 28 Commercial lease financing 83 48 45 - ------------------------------------------------------------------------------------------------------------------------ Total commercial loans 721 467 416 Real estate-- residential mortgage 40 52 50 Home equity 77 80 71 Consumer-- direct 9 8 8 Consumer-- indirect lease financing 13 7 6 Consumer-- indirect other 25 36 41 - ------------------------------------------------------------------------------------------------------------------------ Total consumer loans 164 183 176 - ------------------------------------------------------------------------------------------------------------------------ Total nonperforming loans 885 650 592 OREO 26 23 26 Allowance for OREO losses (1) (1) (1) - ------------------------------------------------------------------------------------------------------------------------ OREO, net of allowance 25 22 25 Other nonperforming assets 3 -- -- - ------------------------------------------------------------------------------------------------------------------------ Total nonperforming assets $ 913 $ 672 $ 617 ====== ====== ======= - ------------------------------------------------------------------------------------------------------------------------ Accruing loans past due 90 days or more $ 332 $ 236 $ 252 Accruing loans past due 30 through 89 days 1,084 963 1,030 - ------------------------------------------------------------------------------------------------------------------------ Nonperforming loans to period-end loans 1.37 % .97 % .89 % Nonperforming assets to period-end loans plus OREO and other nonperforming assets 1.41 1.00 .93 - ------------------------------------------------------------------------------------------------------------------------ </TABLE> DEPOSITS AND OTHER SOURCES OF FUNDS "Core deposits" -- domestic deposits other than certificates of deposit of $100,000 or more -- are Key's primary source of funding. During the third quarter of 2001, core deposits averaged $37.0 billion, and represented 49% of the funds Key used to support earning assets, compared with $37.7 billion and 50%, respectively, during the same period last year. As shown in Figure 5 (which spans pages 38 and 39), the composition of Key's deposits has changed over the past twelve months. The most pronounced of the changes in Key's deposit mix has occurred over the past two quarters. Key's money market deposit accounts have grown, while the levels of savings deposits and consumer time deposits have declined. This shift is due in part to actions taken by management to aggressively reduce rates paid for deposits late in the first quarter and throughout the following two quarters. Due to competitive factors, the timing of our initial reductions in 2001 did not coincide with the rate reductions instituted by the Federal Reserve earlier in the first quarter. Lower interest rates, coupled with the prolonged weakness in the securities markets, have caused client preferences to turn to investments that provide higher levels of liquidity and stability. 54
Purchased funds, comprising large certificates of deposit, deposits in the foreign branch and short-term borrowings, averaged $20.5 billion during the third quarter of 2001, compared with $20.3 billion a year ago. As shown in Figure 5, over the past two quarters Key has relied more heavily on long-term debt to fund earning assets. In addition, Key continues to consider loan securitizations as a funding alternative when market conditions are favorable. During the first nine months of 2001, Key securitized and sold $491 million of its education loans, all of which occurred in the third quarter. LIQUIDITY "Liquidity" measures whether an entity has sufficient cash flow to meet its financial obligations when due. Key has sufficient liquidity when it can meet the needs of depositors, borrowers and creditors at a reasonable cost, on a timely basis, and without adverse consequences. KeyCorp, the parent company, has sufficient liquidity when it can pay dividends to shareholders, service its debt, and support customary corporate operations and activities, including acquisitions. LIQUIDITY FOR KEY. Management actively analyzes and manages Key's liquidity. In particular, Key's Funding and Investment Management Group monitors the overall mix of funding sources with the objective of maintaining an appropriate mix in light of the structure of the asset portfolios. We use several tools to maintain sufficient liquidity. - - We maintain portfolios of short-term money market investments and securities available for sale, substantially all of which could be converted to cash quickly at a small expense. - - Key's portfolio of investment securities generates prepayments (often at a premium) and payments at maturity. - - We try to structure the maturities of our loans so we receive a relatively consistent stream of payments from borrowers. We also selectively securitize and package loans for sale. - - Our 911 full-service KeyCenters in 13 states generate a sizable volume of core deposits. Key's Funding and Investment Management Group monitors deposit flows and considers alternate pricing structures to attract deposits when necessary. (For more information about core deposits, see the previous section entitled "Deposits and other sources of funds.") - - Key has access to various sources of money market funding (such as Federal funds purchased, securities sold under repurchase agreements, and bank notes) and also can borrow from the Federal Reserve Bank to meet short-term liquidity requirements. Key did not have any borrowings from the Federal Reserve outstanding as of September 30, 2001. LIQUIDITY FOR THE PARENT COMPANY. KeyCorp meets its liquidity requirements principally through regular dividends from affiliate banks. During the first nine months of 2001, affiliate banks paid KeyCorp a total of $238 million in dividends and KeyCorp also received a $700 million distribution of surplus in the form of cash from KeyBank National Association. As of September 30, 2001, the affiliate banks had an additional $889 million available to pay dividends without prior regulatory approval. The parent company generally maintains excess funds in short-term investments. ADDITIONAL SOURCES OF LIQUIDITY. Management has implemented several programs that enable Key and KeyCorp to raise money in the public and private markets when necessary. The proceeds from all of these programs can be used for general corporate purposes, including acquisitions. BANK NOTE PROGRAM. During the first nine months of 2001, Key's affiliate banks raised $4.0 billion under Key's bank note program. Of the notes issued during this period of time, $1.1 billion have original maturities in excess of one year and are included in long-term debt. The remaining notes have original maturities of one year or less and are included in short-term borrowings. Key's current bank note program provides for the issuance of both long- and short-term debt up to $20.0 billion ($19.0 billion by KeyBank 55
National Association and $1.0 billion by Key Bank USA, National Association). At September 30, 2001, Key Bank National Association had $10.0 billion of debt outstanding under this program. EURO NOTE PROGRAM. Under Key's euro note program, KeyCorp, KeyBank National Association and Key Bank USA, National Association may issue both long- and short-term debt of up to $10.0 billion in the aggregate. The notes are offered exclusively to non-U.S. investors and can be denominated in U.S. dollars and many foreign currencies. There were $4.1 billion of borrowings outstanding under this facility as of September 30, 2001, $340 million of which were issued during the current year. COMMERCIAL PAPER AND REVOLVING CREDIT. KeyCorp has a commercial paper program and a two-year revolving credit agreement that provide funding availability of up to $500 million and $400 million, respectively. As of September 30, 2001, $25 million of borrowings were outstanding under the commercial paper program; no amount was outstanding under the revolving credit agreement. OTHER PUBLICLY ISSUED SECURITIES. KeyCorp has a universal shelf registration statement on file with the Securities and Exchange Commission that provides for the possible issuance of up to $1.5 billion of debt and equity securities in addition to the unused capacity under a previous shelf registration. At September 30, 2001, unused capacity under the shelf registration totaled $394 million, all of which is reserved for issuance as medium-term notes. Key has favorable debt ratings, shown in Figure 20 below, and management believes that, under normal conditions in the capital markets, any eventual offering of securities would be well-received by investors at a competitive cost. FIGURE 20. DEBT RATINGS <TABLE> <CAPTION> SENIOR SUBORDINATED SHORT-TERM LONG-TERM LONG-TERM CAPITAL September 30, 2001 BORROWINGS DEBT DEBT SECURITIES - ------------------------------------------------------------------------------------------------------------------- KeyCorp - ------------------------------------- <S> <C> <C> <C> <C> Standard & Poor's A-2 A- BBB+ BBB Moody's P-1 A2 A3 "Baa1" KEYBANK NATIONAL ASSOCIATION - ------------------------------------- Standard & Poor's A-1 A A- N/A Moody's P-1 A1 A2 N/A - ------------------------------------------------------------------------------------------------------------------- </TABLE> N/A=Not Applicable For more information about Key's sources and uses of cash for the nine-month periods ended September 30, 2001 and 2000, see the Consolidated Statements of Cash Flow on page 6. 56
CAPITAL AND DIVIDENDS SHAREHOLDERS' EQUITY. Total shareholders' equity at September 30, 2001, was $6.6 billion, down $48 million from the balance at December 31, 2000. The decrease was due primarily to a lower level of retained earnings. Several nonrecurring charges recorded in the second quarter of 2001 associated with the implementation of recently-announced strategies caused the decline in retained earnings. Also contributing to the decrease in shareholders' equity was a reduction in capital resulting from the cumulative effect of a change in accounting for derivative financial instruments. Other factors contributing to the change in shareholders' equity during the first nine months of 2001 are shown in the Statement of Changes in Shareholders' Equity presented on page 5. SHARE REPURCHASES. In light of Key's earnings outlook and strong capital position, in September 2000 the Board of Directors authorized the repurchase of 25,000,000 common shares, including the 3,647,200 shares remaining at the time from an earlier repurchase program. These shares may be repurchased in the open market or through negotiated transactions. During the first nine months of 2001, Key repurchased a total of 2,035,600 shares of its common shares at an average price per share of $24.56. At September 30, 2001, a remaining balance of 16,764,400 shares may be repurchased under the September 2000 authorization. At September 30, 2001, Key had 68,461,648 treasury shares. Management expects to reissue those shares over time to support the employee stock purchase, 401(k), stock option, and dividend reinvestment plans, and for other corporate purposes. During the first nine months of 2001, Key reissued 1,862,367 treasury shares for employee benefit and dividend reinvestment plans. CAPITAL ADEQUACY. Capital adequacy is an important indicator of financial stability and performance. Overall, Key's capital position remains strong: the ratio of total shareholders' equity to total assets was 7.79% at September 30, 2001, compared with 7.59% at December 31, 2000, and 7.63% at September 30, 2000. Banking industry regulators prescribe minimum capital ratios for bank holding companies and their banking subsidiaries. Risk-based capital guidelines require a minimum level of capital as a percent of "risk-adjusted assets," which is total assets plus certain off-balance sheet items that are adjusted for predefined credit risk factors. Currently, banks and bank holding companies must maintain, at a minimum, Tier 1 capital as a percent of risk-adjusted assets of 4.0%, and total capital as a percent of risk-adjusted assets of 8.0%. As of September 30, 2001, Key's Tier 1 capital ratio was 7.81%, and its total capital ratio was 11.77%. The leverage ratio is Tier 1 capital as a percentage of average quarterly tangible assets. Leverage ratio requirements vary with the condition of the financial institution. Bank holding companies that either have the highest supervisory rating or have implemented the Federal Reserve's risk-adjusted measure for market risk--as KeyCorp has--must maintain a minimum leverage ratio of 3.0%. All other bank holding companies must maintain a minimum ratio of 4%. As of September 30, 2001, KeyCorp had a leverage ratio of 7.90%, which is substantially higher than the minimum requirement. Federal bank regulators group FDIC-insured depository institutions into the following five categories based on certain capital ratios: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Both of Key's affiliate banks qualified as "well capitalized" at September 30, 2001, since each exceeded the prescribed thresholds of 10% for total capital, 6% for Tier 1 capital and 5% for the leverage ratio. If these provisions applied to bank holding companies, KeyCorp would also qualify as "well capitalized" at September 30, 2001. The FDIC-defined capital categories serve a limited regulatory function. Investors should not treat them as a representation of the overall financial condition or prospects of Key or its affiliates. Figure 21 presents the details of Key's regulatory capital position at September 30, 2001, December 31, 2000 and September 30, 2000. 57
Figure 21. Capital Components and Risk-Adjusted Assets <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 2001 2000 2000 - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> TIER 1 CAPITAL Common shareholders' equity(a) $6,533 $6,609 $6,565 Qualifying capital securities 1,243 1,243 1,243 Less: Goodwill 1,121 1,324 1,339 Other assets(b) 39 44 48 - -------------------------------------------------------------------------------------------------------------------------- Total Tier 1 capital 6,616 6,484 6,421 - -------------------------------------------------------------------------------------------------------------------------- TIER 2 CAPITAL Allowance for loan losses(c) 1,053 1,001 1,001 Net unrealized holding gains(d) -- 16 13 Qualifying long-term debt 2,305 2,136 2,158 - -------------------------------------------------------------------------------------------------------------------------- Total Tier 2 capital 3,358 3,153 3,172 - -------------------------------------------------------------------------------------------------------------------------- Total capital $9,974 $9,637 $9,593 ======= ======= ======= RISK-ADJUSTED ASSETS Risk-adjusted assets on balance sheet $70,177 $71,326 $71,152 Risk-adjusted off-balance sheet exposure 15,616 13,776 14,636 Less: Goodwill 1,121 1,324 1,339 Other assets(b) 39 44 48 Plus: Market risk-equivalent assets 236 225 174 Net unrealized holding gains(d) -- 16 13 - -------------------------------------------------------------------------------------------------------------------------- Gross risk-adjusted assets 84,869 83,975 84,588 Less: Excess allowance for loan losses(c) 121 -- -- - -------------------------------------------------------------------------------------------------------------------------- Net risk-adjusted assets $84,748 $83,975 $84,588 ======= ======= ======= AVERAGE QUARTERLY TOTAL ASSETS $84,879 $85,427 $84,105 ======= ======= ======= CAPITAL RATIOS Tier 1 risk-adjusted capital ratio 7.81 % 7.72 % 7.59 % Total risk-adjusted capital ratio 11.77 11.48 11.34 Leverage ratio(e) 7.90 7.71 7.76 - -------------------------------------------------------------------------------------------------------------------------- </TABLE> (a) Common shareholders' equity excludes net unrealized gains or losses on securities (except for net unrealized losses on marketable equity securities) and net gains or losses on cash flow hedges. (b) Intangible assets (excluding goodwill) recorded after February 19, 1992, and deductible portions of purchased mortgage servicing rights. (c) The allowance for loan losses included in Tier 2 capital is limited by regulation to 1.25% of gross risk-adjusted assets, excluding those with low-level recourse. (d) Net unrealized holding gains included in Tier 2 capital are limited by regulation to 45% of net unrealized holding gains on available for sale equity securities with readily determinable fair values. (e) Tier 1 capital divided by average quarterly total assets less goodwill and other nonqualifying intangible assets as defined in footnote (b). 58
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK The information presented in the Market Risk Management section beginning on page 41 of the Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The information presented in Note 11 ("Legal Proceedings"), beginning on page 22, of the Notes to Consolidated Financial Statements is incorporated herein by reference. ITEM 5. OTHER INFORMATION FINANCIAL MODERNIZATION LEGISLATION. Effective in May of 2001, the Gramm-Leach-Bliley Act repealed the blanket exception of banks and savings associations from the definitions of "broker" and "dealer" under the Securities Exchange Act of 1934, and replaced this full exception with functional exceptions. Under the statute, these institutions that engage in securities activities either must conduct those activities through a broker-dealer or conform their securities activities to those which qualify for functional exceptions. The Securities and Exchange Commission issued interim final rules in May of 2001 which included exemptions providing these institutions with additional time within which to conform their securities activities to those permitted by the statute. In July of 2001, the Securities and Exchange Commission further extended this compliance deadline to May of 2002. SUBPRIME LENDING. In April of 2001, the Federal Banking agencies clarified that the guidance provided to examiners in connection with their examination of subprime lending programs was neither intended nor considered by the agencies to be a capital regulation, and that the guidance did not represent a change in policy by the agencies. Moreover, the agencies specifically indicated that examiners would not unilaterally require additional reserves or capital based upon the guidance, and that any determination made by an examiner that an institution's reserves or capital is deficient would be discussed with the institution's management and each agency's appropriate supervisory office before a final decision is made. Neither the Federal Reserve Board nor the Office of the Comptroller of the Currency has advised KeyCorp or any of its national bank subsidiaries of any such deficiency. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (15) Acknowledgment Letter of Independent Auditors (b) Reports on Form 8-K July 17, 2001 - Item 5. Other Events, Item 7. Financial Statements and Exhibits and Item 9. Regulation FD Disclosure. Reporting that on July 17, 2001, the Registrant issued a press release announcing its earnings results for the three-and six-month periods ended June 30, 2001, and providing a slide presentation reviewed in the related conference call/webcast. No other reports on Form 8-K were filed during the three-month period ended September 30, 2001. 59
SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KEYCORP ------------------------------------ (Registrant) Date: November 13, 2001 /s/ Lee Irving ------------------------------------ By: Lee Irving Executive Vice President and Chief Accounting Officer 60