1 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, 1999 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 [KEYCORP LOGO] -------------------------------------------------------- (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 447,305,858 Shares - ----------------------------------------- ----------------------------------- (Title of class) (Outstanding at October 29, 1999)
2 KEYCORP TABLE OF CONTENTS PART I. FINANCIAL INFORMATION <TABLE> <CAPTION> Item 1. Financial Statements Page Number -------------------- ----------- <S> <C> Consolidated Balance Sheets -- September 30, 1999, December 31, 1998 and September 30, 1998 3 Consolidated Statements of Income -- Three months and nine months ended September 30, 1999 and 1998 4 Consolidated Statements of Changes in Shareholders' Equity -- Nine months ended September 30, 1999 and 1998 5 Consolidated Statements of Cash Flow -- Nine months ended September 30, 1999 and 1998 6 Notes to Consolidated Financial Statements 7 Independent Accountants' Review Report 23 Item 2. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations 24 ------------------------- Item 3. Quantitative and Qualitative Disclosure of Market Risk 47 ------------------------------------------------------ PART II. OTHER INFORMATION Item 1. Legal Proceedings 48 ----------------- Item 5. Other Information 49 ----------------- Item 6. Exhibits and Reports on Form 8-K 49 -------------------------------- Signature 50 </TABLE> 2
3 <TABLE> <CAPTION> PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS KEYCORP AND SUBSIDIARIES - ------------------------------------------------------------------------------------------------------------------------------------ Consolidated Balance Sheets - ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 1999 1998 1998 - ------------------------------------------------------------------------------------------------------------------------------------ (Unaudited) (Unaudited) <S> <C> <C> <C> ASSETS Cash and due from banks $ 3,018 $ 3,296 $ 2,750 Short-term investments 2,094 1,974 2,212 Securities available for sale 6,567 5,278 5,928 Investment securities (fair value: $1,005, $1,004 and $1,015) 989 976 984 Loans, net of unearned income of $1,566, $1,533 and $1,404 63,181 62,012 59,444 Less: Allowance for loan losses 930 900 900 - ------------------------------------------------------------------------------------------------------------------------------------ Net loans 62,251 61,112 58,544 Premises and equipment 818 902 876 Goodwill 1,422 1,430 1,038 Other intangible assets 64 79 83 Corporate owned life insurance 2,080 2,008 1,974 Other assets 3,274 2,965 3,302 - ------------------------------------------------------------------------------------------------------------------------------------ Total assets $82,577 $80,020 $77,691 ======= ======= ======= LIABILITIES Deposits in domestic offices: Noninterest-bearing $ 9,050 $ 9,540 $ 8,732 Interest-bearing 34,029 32,091 31,841 Deposits in foreign office -- interest-bearing 387 952 2,024 - ------------------------------------------------------------------------------------------------------------------------------------ Total deposits 43,466 42,583 42,597 Federal funds purchased and securities sold under repurchase agreements 3,510 4,468 6,652 Bank notes and other short-term borrowings 8,551 9,728 7,576 Other liabilities 3,595 3,110 2,963 Long-term debt 15,815 12,967 11,353 Corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely debentures of the Corporation (See Note 9) 1,243 997 997 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities 76,180 73,853 72,138 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 1,412 1,412 1,283 Retained earnings 5,686 5,192 5,038 Loans to ESOP trustee (24) (34) (34) Treasury stock, at cost (43,064,912, 39,437,183 and 55,796,496 shares) (1,058) (923) (1,267) Accumulated other comprehensive (loss) income (111) 28 41 - ------------------------------------------------------------------------------------------------------------------------------------ Total shareholders' equity 6,397 6,167 5,553 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $82,577 $80,020 $77,691 ======= ======= ======= - ------------------------------------------------------------------------------------------------------------------------------------ See Notes to Consolidated Financial Statements (Unaudited). </TABLE> 3
4 <TABLE> <CAPTION> KEYCORP AND SUBSIDIARIES - ------------------------------------------------------------------------------------------------------------------------------------ Consolidated Statements of Income (Unaudited) - ------------------------------------------------------------------------------------------------------------------------------------ THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------- -------------------------------- dollars in millions, except per share amounts 1999 1998 1999 1998 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> INTEREST INCOME Loans $1,299 $1,274 $3,800 $3,657 Taxable investment securities 4 2 11 9 Tax-exempt investment securities 7 11 24 36 Securities available for sale 106 104 310 350 Short-term investments 17 24 61 62 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest income 1,433 1,415 4,206 4,114 INTEREST EXPENSE Deposits 331 339 955 1,032 Federal funds purchased and securities sold under repurchase agreements 51 99 168 281 Bank notes and other short-term borrowings 103 108 310 320 Long-term debt, including capital securities 248 188 691 484 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest expense 733 734 2,124 2,117 - ------------------------------------------------------------------------------------------------------------------------------------ NET INTEREST INCOME 700 681 2,082 1,997 Provision for loan losses 78 71 265 220 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income after provision for loan losses 622 610 1,817 1,777 NONINTEREST INCOME Trust and asset management income 112 82 328 239 Service charges on deposit accounts 83 77 246 230 Investment banking and capital markets income 77 62 243 159 Insurance and brokerage income 46 22 162 68 Corporate owned life insurance income 25 25 76 72 Credit card fees 16 18 47 50 Net loan securitization gains 32 7 82 7 Net securities gains 2 -- 26 4 Gains from branch divestitures -- -- -- 39 Gains from other divestitures 13 -- 161 23 Other income 83 99 253 237 - ------------------------------------------------------------------------------------------------------------------------------------ Total noninterest income 489 392 1,624 1,128 NONINTEREST EXPENSE Personnel 356 317 1,111 913 Net occupancy 58 58 175 170 Equipment 48 46 153 134 Computer processing 60 46 173 127 Marketing 35 25 84 81 Amortization of intangibles 25 22 79 67 Professional fees 18 14 50 46 Other expense 101 100 341 278 - ------------------------------------------------------------------------------------------------------------------------------------ Total noninterest expense 701 628 2,166 1,816 INCOME BEFORE INCOME TAXES 410 374 1,275 1,089 Income taxes 140 122 432 353 - ------------------------------------------------------------------------------------------------------------------------------------ NET INCOME $ 270 $ 252 $ 843 $ 736 ====== ====== ====== ====== Per Common Share: Net income $ .60 $ .57 $ 1.88 $ 1.68 Net Income - assuming dilution .60 .57 1.86 1.65 Weighted average Common Shares outstanding (000) 448,742 438,856 448,764 439,180 Weighted average Common Shares and potential Common Shares outstanding (000) 452,886 443,750 453,267 445,047 - ------------------------------------------------------------------------------------------------------------------------------------ See Notes to Consolidated Financial Statements (Unaudited). </TABLE> 4
5 <TABLE> <CAPTION> KEYCORP AND SUBSIDIARIES - ------------------------------------------------------------------------------------------------------------------------------------ Consolidated Statements of Changes in Shareholders' Equity (Unaudited) - ------------------------------------------------------------------------------------------------------------------------------------ ACCUMULATED LOANS TO TREASURY OTHER COMMON CAPITAL RETAINED ESOP STOCK, COMPREHENSIVE COMPREHENSIVE DOLLARS IN MILLIONS, EXCEPT PER SHARE AMOUNTS SHARES SURPLUS EARNINGS TRUSTEE AT COST (LOSS) INCOME INCOME (2) - ------------------------------------------------------------------------------------------------------------------- -------------- <S> <C> <C> <C> <C> <C> <C> <C> BALANCE AT DECEMBER 31, 1997 $492 $1,283 $4,611 $(42) $(1,174) $11 Net income 736 $736 Other comprehensive income: Net unrealized gains on securities available for sale, net of income taxes of $16(1) 30 30 ------------ Total comprehensive income $766 ==== Cash dividends on Common Shares ($.705 per share) (309) Issuance of Common Shares under employee benefit and dividend reinvestment plans-2,757,854 net shares 60 Repurchase of Common Shares-4,729,400 shares (153) ESOP transactions 8 - ------------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 1998 $492 $1,283 $5,038 $(34) $(1,267) $41 ==== ====== ====== ==== ======= ===== - ------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1998 $492 $1,412 $5,192 $(34) $ (923) $ 28 Net income 843 $843 Other comprehensive losses: Net unrealized losses on securities available for sale, net of income taxes of $(85)(1) (136) (136) Foreign currency translation adjustments (3) (3) ------------ Total comprehensive income $704 ==== Cash dividends on Common Shares ($.78 per share) (350) Issuance of Common Shares: Acquisition - 632,183 shares 6 15 Employee benefit and dividend reinvestment plans - 2,146,512 net shares (6) 52 Repurchase of Common Shares-6,406,424 shares (202) ESOP transactions 1 10 - ------------------------------------------------------------------------------------------------------------------- BALANCE AT SEPTEMBER 30, 1999 $492 $1,412 $5,686 $(24) $(1,058) $(111) ==== ====== ====== ==== ======= ===== - ------------------------------------------------------------------------------------------------------------------- (1) Net of reclassification adjustments. (2) For the three months ended September 30, 1999 and 1998, comprehensive income was $266 million and $265 million, respectively. See Notes to Consolidated Financial Statements (Unaudited). </TABLE> 5
6 <TABLE> <CAPTION> KEYCORP AND SUBSIDIARIES - ------------------------------------------------------------------------------------------------------------------------------------ Consolidated Statements of Cash Flow (Unaudited) - ------------------------------------------------------------------------------------------------------------------------------------ NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- in millions 1999 1998 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> OPERATING ACTIVITIES Net income $ 843 $ 736 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 265 220 Depreciation expense and software amortization 219 173 Amortization of intangibles 79 67 Net gains from divestitures (161) (62) Net securities gains (26) (4) Net gains from loan securitizations and sales (107) (51) Deferred income taxes 304 241 Net (increase) decrease in mortgage loans held for sale (13) 70 Net increase in trading account assets (326) (64) Decrease in accrued restructuring charge (2) (23) Other operating activities, net (324) (364) - ------------------------------------------------------------------------------------------------------------------------------------ NET CASH PROVIDED BY OPERATING ACTIVITIES 751 939 INVESTING ACTIVITIES Net increase in loans, excluding acquisitions, sales and divestitures (6,019) (6,554) Purchases of loans (7) (859) Proceeds from loan securitizations and sales 4,374 962 Purchases of investment securities (169) (83) Proceeds from sales of investment securities 9 44 Proceeds from prepayments and maturities of investment securities 192 310 Purchases of securities available for sale (4,241) (123) Proceeds from sales of securities available for sale 382 62 Proceeds from prepayments and maturities of securities available for sale 2,961 1,869 Net (increase) decrease in other short-term investments 206 (219) Purchases of premises and equipment (61) (55) Proceeds from sales of premises and equipment 23 27 Proceeds from sales of other real estate owned 10 8 Net cash paid in connection with divestitures - (433) - ------------------------------------------------------------------------------------------------------------------------------------ NET CASH USED IN INVESTING ACTIVITIES (2,340) (5,044) FINANCING ACTIVITIES Net increase (decrease) in deposits 883 (1,818) Net increase (decrease) in short-term borrowings (2,115) 1,284 Net proceeds from issuance of long-term debt, including capital securities 5,147 4,767 Payments on long-term debt, including capital securities (2,094) (614) Loan payment received from ESOP trustee 10 8 Purchases of treasury shares (202) (153) Net proceeds from issuance of common stock 32 39 Cash dividends (350) (309) - ------------------------------------------------------------------------------------------------------------------------------------ NET CASH PROVIDED BY FINANCING ACTIVITIES 1,311 3,204 - ------------------------------------------------------------------------------------------------------------------------------------ NET DECREASE IN CASH AND DUE FROM BANKS (278) (901) CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD 3,296 3,651 - ------------------------------------------------------------------------------------------------------------------------------------ CASH AND DUE FROM BANKS AT END OF PERIOD $3,018 $2,750 ====== ====== - ------------------------------------------------------------------------------------------------------------------------------------ Additional disclosures relative to cash flow: Interest paid $2,013 $1,965 Income taxes paid 170 84 Net amount received on portfolio swaps 8 22 Noncash items: Transfer of credit card receivables to loans held for sale $1,299 - Reclassification of financial instruments from loans to securities available for sale 374 - Fair value of Concord EFS, Inc. shares received 170 - Carrying amount of Electronic Payment Services, Inc. shares divested 36 - Assets sold - $165 Liabilities sold - 660 - ------------------------------------------------------------------------------------------------------------------------------------ See Notes to Consolidated Financial Statements (Unaudited). </TABLE> 6
7 - -------------------------------------------------------------------------------- Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- 1. BASIS OF PRESENTATION The unaudited condensed consolidated interim financial statements include the accounts of KeyCorp (the "parent company") and its subsidiaries (collectively referred to as "Key"). All significant intercompany accounts and transactions have been eliminated in consolidation. In the opinion of management, 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, and should be read in conjunction with the audited consolidated financial statements and related notes included in Key's 1998 Annual Report to Shareholders. In addition, certain reclassifications have been made to prior period amounts to conform to the current presentation. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. ACCOUNTING PRONOUNCEMENTS ADOPTED IN 1999 As of January 1, 1999, Key adopted Statement of Financial Accounting Standard ("SFAS") No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." SFAS No. 134 amends SFAS No. 65, "Accounting for Certain Mortgage Banking Activities" and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 134 requires an entity engaged in mortgage banking activities to classify mortgage-backed securities or other retained interests resulting from a mortgage loan securitization based on its ability and intent to sell or hold those assets. The statement conforms the accounting for securities and uncertificated interests retained after the securitization of mortgage loans to the accounting for securities and uncertificated interests retained after the securitization of other types of assets by a non-mortgage banking enterprise. To date, Key has retained only uncertificated interests resulting from mortgage loan securitizations. These retained interests are classified as either available-for-sale or trading securities. Since Key was in compliance with the standard at the date of adoption, SFAS No. 134 had minimal impact on Key's financial condition and results of operations. As of January 1, 1999, Key adopted Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This SOP provides guidance on accounting for such costs, including the characteristics to be considered in defining internal-use software and the circumstances under which related costs should be expensed or capitalized. The provisions of SOP 98-1 are substantially consistent with Key's prior accounting policy for internally developed software. As a result, the effect of prospective adoption did not have a material impact on Key's financial condition or results of operations. ACCOUNTING PRONOUNCEMENTS PENDING ADOPTION In July 1999, the Financial Accounting Standards Board ("FASB") issued SFAS No. 137, "Deferral of the Effective Date of SFAS No. 133," that delays the effective date of SFAS No. 133 until fiscal years beginning after June 15, 2000. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," establishes accounting and reporting standards for derivative instruments including certain derivative instruments embedded in other contracts (collectively "derivatives") and for hedging activities. It requires that all derivatives be recognized on the balance sheet at fair value. Changes in the fair value of all derivatives qualifying as hedges will be recognized currently in earnings or comprehensive income. Depending on the nature of the hedge, and the extent to which it is effective, the changes in fair value will be offset against the change in fair value of the hedged item (which also is recognized in earnings) or recorded in comprehensive income and subsequently recognized in earnings in the period the hedged item affects earnings. The portion of a hedge that is deemed ineffective and all changes in the fair value of derivatives not designated as hedges will be recognized immediately in earnings. Key will adopt the provisions of SFAS No. 133 as of January 1, 2001. Management is currently reviewing SFAS No. 133 to determine the extent to which the statement will alter Key's use of certain derivatives in the future and the impact on its financial condition and results of operations. 7
8 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 1999 1998 1999 1998 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> NET INCOME $ 270 $ 252 $ 843 $ 736 ===== ===== ===== ===== - ------------------------------------------------------------------------------------------------------------------------------------ WEIGHTED AVERAGE COMMON SHARES Weighted average Common Shares outstanding (000) 448,742 438,856 448,764 439,180 Potential addition to Common Shares (000)(1) 4,144 4,894 4,503 5,867 - ------------------------------------------------------------------------------------------------------------------------------------ Weighted average Common Shares and potential Common Shares outstanding (000) 452,886 443,750 453,267 445,047 ======= ======= ======= ======= - ------------------------------------------------------------------------------------------------------------------------------------ EARNINGS PER COMMON SHARE Net income per Common Share $ .60 $ .57 $1.88 $1.68 Net income per Common Share - assuming dilution .60 .57 1.86 1.65 - ------------------------------------------------------------------------------------------------------------------------------------ (1) Represents the effect of dilutive common stock options. </TABLE> 3. MERGERS, ACQUISITIONS AND DIVESTITURES Mergers, acquisitions and divestitures completed by Key during 1998 and the first nine months of 1999 are summarized below. COMPLETED MERGERS AND ACQUISITIONS MCDONALD & COMPANY INVESTMENTS, INC. On October 23, 1998, Key acquired McDonald & Company Investments, Inc. ("McDonald"), a full-service investment banking and securities brokerage company headquartered in Cleveland, Ohio, with assets of approximately $776 million at the time of the transaction. Under the terms of the agreement, 19,337,159 Common Shares, with a value of approximately $581 million, were issued in a transaction structured as a tax-free merger and accounted for as a purchase. Key recorded goodwill of $444 million, which is being amortized using the straight-line method over a period of 25 years. In addition, Key established a retention program for certain McDonald employees under which stock options for approximately 3.3 million Key Common Shares were granted and will vest over a three-year period, and approximately $30 million in cash may be paid over the three-year period. LEASETEC CORPORATION On July 1, 1997, Key acquired an 80% interest (with an option to purchase the remaining 20%) in Leasetec Corporation ("Leasetec"), an equipment leasing company headquartered in Boulder, Colorado, with assets of approximately $1.1 billion at the time of the transaction and operations in the United States and overseas. In connection with the transaction, which was accounted for as a purchase, Key recorded goodwill of approximately $126 million, which is being amortized using the straight-line method over a period of 25 years. On June 26, 1998, Key acquired the remaining 20% interest in Leasetec. This resulted in additional goodwill of approximately $26 million, which is being amortized over the remainder of the 25-year period which began July 1, 1997. In accordance with a confidentiality clause in the purchase agreement, the terms, which are not material, have not been publicly disclosed. COMPLETED DIVESTITURES COMPAQ CAPITAL EUROPE LLC AND COMPAQ CAPITAL ASIA PACIFIC LLC On July 28, 1999, Key sold to Compaq Capital Corporation ("Compaq") its 50% ownership interests in Compaq Capital Europe LLC and Compaq Capital Asia Pacific LLC. These companies were formed with Compaq in 1998 to provide customized equipment leasing and financing programs to Compaq's customers in the United Kingdom, Europe and Asia. Key recognized a gain of $13 million ($8 million after tax) which was recorded in gains from other divestitures on the income statement. 8
9 ELECTRONIC PAYMENT SERVICES, INC. On February 28, 1999, Electronic Payment Services, Inc. ("EPS"), an electronic funds transfer processor in which Key held a 20% ownership interest, merged with a wholly owned subsidiary of Concord EFS, Inc. ("Concord EFS"), a Delaware corporation. Key received 5,931,825 shares of Concord EFS and recognized a gain of $134 million ($85 million after tax). The gain was recorded in gains from other divestitures on the income statement. On June 17, 1999, Key sold the Concord EFS shares and recognized a gain of $15 million ($9 million after tax). The gain was recorded in net securities gains on the income statement. KEY MERCHANT SERVICES, LLC On January 21, 1998, Key sold to NOVA Information Systems, Inc. ("NOVA") a 51% interest in Key Merchant Services, LLC, a wholly owned subsidiary formed to provide merchant credit card processing services to businesses. Key recognized a $23 million gain ($14 million after tax) at the time of closing. Under the terms of the agreement with NOVA, Key was entitled to receive additional consideration if certain revenue-related performance targets were met. Accordingly, Key recognized a gain of $27 million ($17 million after tax) in the fourth quarter of 1998 and recorded a final gain of $14 million ($9 million after tax) during the first quarter of 1999. These gains were recorded in gains from other divestitures on the income statement. In accordance with a confidentiality clause in the agreement, the terms, which are not material, have not been disclosed. BRANCH DIVESTITURES During 1998, Key sold 46 branch offices ("KeyCenters") with deposits of approximately $658 million, resulting in aggregate gains of $39 million ($22 million after tax). The gains were recorded in gains from branch divestitures on the income statement. TRANSACTION PENDING AT SEPTEMBER 30, 1999 LONG ISLAND FRANCHISE On October 18, 1999, Key sold its Long Island franchise, which included 28 KeyCenters with approximately $1.3 billion in deposits and $505 million in loans, resulting in an aggregate gain of $196 million ($125 million after tax), subject to final post-closing adjustments. 4. LINE OF BUSINESS RESULTS Key's four major lines of business as described below are Key Corporate Capital, Key Consumer Finance, Key Community Bank and Key Capital Partners. KEY CORPORATE CAPITAL Key offers a complete range of financing, transaction processing and financial advisory services to corporations throughout the country through Key Corporate Capital. This line of business also operates one of the largest bank-affiliated equipment leasing companies with operations conducted both domestically and throughout Europe and Asia. Key Corporate Capital's business units are organized around the following specialized industry client segments: commercial real estate, lease financing, structured finance, healthcare and media/telecommunications. In serving these targeted segments, Key Corporate Capital provides a number of specialized services including international banking, corporate finance advisory services and, based on transaction volume, is a leading provider of cash management services. Key Corporate Capital also provides investment banking, capital markets, 401(k) and trust custody products through Key Capital Partners. KEY CONSUMER FINANCE Key Consumer Finance is responsible for Key's indirect, non-branch-based consumer loan products. This line of business specializes in automobile loans and leases, home equity loans, education loans, marine and recreational vehicle loans and credit cards. As of December 31, 1998, based on the volume of loans generated, Key Consumer Finance was one of the five largest education lenders in the nation, ranked in the top ten in retail automobile financing and was one of the leading providers of financing for consumer purchases of marine and recreational vehicles. 9
10 KEY COMMUNITY BANK Key Community Bank is responsible for delivering a complete line of branch-based financial products and services to small businesses, consumers, and commercial banking businesses. The delivery of these products and services is accomplished through 963 full-service banking offices ("Key Centers"), a 24-hour telephone banking call center services group, 2,565 automated teller machines ("ATMs") that access 14 different networks and comprise one of the largest ATM networks in the United States, and a core team of relationship management professionals. KEY CAPITAL PARTNERS Key Capital Partners provides clients with asset management, investment banking, capital markets, insurance and brokerage expertise. It also plays a major role in generating fee income through its broad range of investment choices and customized products. This line of business is comprised of two major business groups. One group, operating under the name "McDonald Investments", includes retail and institutional brokerage, equity and fixed income trading and underwriting, investment banking, capital markets products, loan syndication and trading, public finance and clearing operations. The second major business group includes asset management, mutual funds, institutional asset services, venture capital, mezzanine finance, alliance funds, wealth management and insurance. Leveraging Key's corporate and community banking distribution channels and client relationships is and will continue to be an essential factor in ensuring Key Capital Partners' future growth and success. Selected financial data for each major line of business for the three- and nine-month periods ended September 30, 1999 and 1998, is presented in the table beginning on page 11. The financial information was derived from the internal profitability reporting system used by management to monitor and manage the financial performance of Key. The selected financial data are based on internal management accounting policies which have been developed to ensure that results are compiled on a consistent basis and to reflect the underlying economics of the businesses. These policies address the methodologies applied in connection with funds transfer pricing as well as the allocation of certain costs and capital. Funds transfer pricing was used in the determination of net interest income 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 transfer pricing was allocated to the lines of business based upon their respective contributions to net interest income. Indirect expenses were allocated based on actual volume measurements and other criteria, as appropriate. The provision for loan losses was allocated in an amount based primarily upon the actual net charge-offs of each respective line of business, adjusted for loan growth and changes in risk profile. The level of the consolidated provision for loan losses was based upon the application of a methodology designed by management to assess the adequacy of the consolidated allowance by focusing on a number of specific factors. This methodology and the factors which influence it are more fully discussed in the Allowance for Loan Losses section of Note 1, Summary of Significant Accounting Policies, beginning on page 65 of Key's 1998 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 1.8% 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). The development and application of these methodologies is a dynamic process. Accordingly, financial results may be revised periodically to reflect management accounting enhancements, changes in risk profile or changes in the organization's structure. The financial data presented in the accompanying table for both the current and prior year reflects a number of revisions in Key's organization structure and funds transfer pricing methodology that occurred during the first quarter of 1999. Primary among the structural changes was the reclassification of the public sector, retail brokerage, wealth management, private banking and franchise trust businesses from Key Community Bank to Key Capital Partners and the reclassification of institutional asset services from Key Corporate Capital to Key Capital Partners. In addition, funds transfer pricing was enhanced by refining the methodology applied to the residential mortgage loan portfolio, certain deposit products with indeterminate maturities and medium-term notes. Unlike financial accounting, there is no authoritative guidance for management accounting similar to generally accepted accounting principles. Consequently, reported results are not necessarily comparable with those presented by other companies. 10
11 <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, KEY CORPORATE CAPITAL KEY CONSUMER FINANCE KEY COMMUNITY BANK ---------------------------- ---------------------------- -------------------------- dollars in millions 1999 1998 1999 1998 1999 1998 - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> SUMMARY OF OPERATIONS Net interest income (TE) $ 134 $ 122 $ 158 $ 151 $ 426 $ 427 Noninterest income 35 18 66 57 119 118 Revenue sharing(1) 7 8 1 2 36 56 - --------------------------------------------------------------------------------------------------------------------------------- Total revenue(2) 176 148 225 210 581 601 Provision for loan losses 11 10 43 41 34 26 Depreciation and amortization expense 6 5 13 11 55 50 Other noninterest expense 41 41 88 76 276 293 Expense sharing(1) 3 3 -- -- 25 31 - --------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 115 89 81 82 191 201 Allocated income taxes and TE adjustment 42 32 31 30 73 71 - --------------------------------------------------------------------------------------------------------------------------------- Net income $ 73 $ 57 $ 50 $ 52 $ 118 $ 130 ======= ======= ======= ======= ======= ======= Percent of consolidated net income 27 % 23 % 18 % 20 % 44 % 52 % Efficiency ratio(6) 28.41 33.11 44.89 41.43 61.49 62.23 - --------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $15,335 $13,194 $15,551 $15,010 $27,325 $26,397 Total assets(2) 16,236 13,808 16,965 16,375 36,625 36,126 Deposits 446 425 145 129 36,410 36,296 - --------------------------------------------------------------------------------------------------------------------------------- NINE MONTHS ENDED SEPTEMBER 30, KEY CORPORATE CAPITAL KEY CONSUMER FINANCE KEY COMMUNITY BANK ---------------------------- ---------------------------- -------------------------- dollars in millions 1999 1998 1999 1998 1999 1998 - --------------------------------------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ 388 $ 339 $ 477 $ 427 $ 1,263 $ 1,283 Noninterest income 85 58 185 128 365 355 Revenue sharing(1) 26 17 3 2 117 132 - --------------------------------------------------------------------------------------------------------------------------------- Total revenue(2) 499 414 665 557 1,745 1,770 Provision for loan losses 32 28 137 138 97 73 Depreciation and amortization expense 17 12 40 32 166 150 Other noninterest expense 116 113 250 226 825 852 Expense sharing(1) 11 7 -- -- 80 84 - --------------------------------------------------------------------------------------------------------------------------------- Income before income taxes (TE) 323 254 238 161 577 611 Allocated income taxes and TE adjustment 117 91 89 60 204 213 - --------------------------------------------------------------------------------------------------------------------------------- Net income $ 206 $ 163 $ 149 $ 101 $ 373 $ 398 ======= ======= ======= ======= ======= ======= Percent of consolidated net income 24 % 22 % 18 % 14 % 44 % 54 % Efficiency ratio(6) 28.86 31.88 43.61 46.32 62.30 61.49 - --------------------------------------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $14,899 $12,298 $15,651 $14,065 $26,983 $26,316 Total assets(2) 15,739 12,886 17,049 15,391 36,280 36,769 Deposits 444 420 124 122 36,092 36,879 - --------------------------------------------------------------------------------------------------------------------------------- </TABLE> (1) Represents the assignment of Key Capital Partners' revenue and expense to the lines of business principally responsible for maintaining the corresponding client relationships. (2) Substantially all revenue generated by Key's major lines of business is derived from external clients domiciled in the United States and substantially all long-lived assets held by such lines of business are located in the United States. Long-lived assets include premises and equipment, capitalized software and goodwill. (3) For the first nine months of both 1999 and 1998, noninterest income included gains from certain divestitures. These gains, all of which were recorded prior to the third quarter of each respective year, totaled $149 million ($94 million after tax) in 1999 and $39 million ($22 million after tax) in 1998. Net interest income is primarily comprised of the funding cost related to unallocated nonearning assets of corporate support functions. 11
12 <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, KEY CAPITAL PARTNERS TOTAL SEGMENTS -------------------------------- ----------------------------------- dollars in millions 1999 1998 1999 1998 - ------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> SUMMARY OF OPERATIONS Net interest income (TE) $ 36 $ 32 $ 754 $ 732 Noninterest income 249 185 469 378 Revenue sharing(1) (44) (66) -- -- - ------------------------------------------------------------------------------------------------------------------ Total revenue(2) 241 151 1,223 1,110 Provision for loan losses 1 1 89 78 Depreciation and amortization expense 23 13 97 79 Other noninterest expense 223 134 628 544 Expense sharing(1) (28) (34) -- -- - ------------------------------------------------------------------------------------------------------------------ Income before income taxes (TE) 22 37 409 409 Allocated income taxes and TE adjustment 7 13 153 146 - ------------------------------------------------------------------------------------------------------------------ Net income $ 15 $ 24 $ 256 $ 263 ====== ====== ======= ======= Percent of consolidated net income 6 % 10 % 95 % 105 % Efficiency ratio(6) 90.46 74.83 59.38 56.13 - ------------------------------------------------------------------------------------------------------------------ AVERAGE BALANCES Loans $4,377 $3,663 $62,588 $58,264 Total assets(2) 9,060 6,934 78,886 73,243 Deposits 3,222 2,806 40,223 39,656 - ------------------------------------------------------------------------------------------------------------------ NINE MONTHS ENDED SEPTEMBER 30, KEY CAPITAL PARTNERS TOTAL SEGMENTS -------------------------------- ----------------------------------- dollars in millions 1999 1998 1999 1998 - ------------------------------------------------------------------------------------------------------------------ SUMMARY OF OPERATIONS Net interest income (TE) $ 118 $ 92 $ 2,246 $ 2,141 Noninterest income 774 512 1,409 1,053 Revenue sharing(1) (146) (151) -- -- - ------------------------------------------------------------------------------------------------------------------ Total revenue(2) 746 453 3,655 3,194 Provision for loan losses 3 2 269 241 Depreciation and amortization expense 68 36 291 230 Other noninterest expense 661 383 1,852 1,574 Expense sharing(1) (91) (91) -- -- - ------------------------------------------------------------------------------------------------------------------ Income before income taxes (TE) 105 123 1,243 1,149 Allocated income taxes and TE adjustment 36 41 446 405 - ------------------------------------------------------------------------------------------------------------------ Net income $ 69 $ 82 $ 797 $ 744 ====== ====== ======= ======= Percent of consolidated net income 8 % 11 % 94 % 101 % Efficiency ratio(6) 85.52 72.41 59.05 56.55 - ------------------------------------------------------------------------------------------------------------------ AVERAGE BALANCES Loans $4,292 $3,415 $61,825 $56,094 Total assets(2) 8,876 6,490 77,944 71,536 Deposits 3,220 2,732 39,880 40,153 - ------------------------------------------------------------------------------------------------------------------ <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, RECONCILING ITEMS KEYCORP CONSOLIDATED ---------------------------------------------------------- dollars in millions 1999 1998 1999 1998 - ---------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SUMMARY OF OPERATIONS Net interest income (TE) $ (45) $ (43) $ 709 $ 689 Noninterest income 20 14 489 392 Revenue sharing(1) -- -- -- -- - ---------------------------------------------------------------------------------------------------- Total revenue(2) (25)(3) (29)(3) 1,198 1,081 Provision for loan losses (11) (7) 78 71 Depreciation and amortization expense 3 5 100 84 Other noninterest expense (27)(4) -- 601 544 Expense sharing(1) -- -- -- -- - ---------------------------------------------------------------------------------------------------- Income before income taxes (TE) 10 (27) 419 382 Allocated income taxes and TE adjustment (4) (16) 149 130 - ---------------------------------------------------------------------------------------------------- Net income $ 14 $ (11) $ 270 $ 252 ====== ====== ======= ====== Percent of consolidated net income 5 % (5)% 100 % 100 % Efficiency ratio(6) N/M N/M 58.61 58.09 - ---------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $ 211 $ 295 $62,799 $58,559 Total assets(2) 2,409(5) 2,643(5) 81,295 75,886 Deposits 2,240 1,208 42,463 40,864 - ---------------------------------------------------------------------------------------------------- NINE MONTHS ENDED SEPTEMBER 30, RECONCILING ITEMS KEYCORP CONSOLIDATED ------------------------- ----------------------------- dollars in millions 1999 1998 1999 1998 - ---------------------------------------------------------------------------------------------------- SUMMARY OF OPERATIONS Net interest income (TE) $ (140) $ (118) $ 2,106 $ 2,023 Noninterest income 215 75 1,624 1,128 Revenue sharing(1) -- -- -- -- - ---------------------------------------------------------------------------------------------------- Total revenue(2) 75(3) (43)(3) 3,730 3,151 Provision for loan losses (4) (21) 265 220 Depreciation and amortization expense 7 10 298 240 Other noninterest expense 16(4) 2 1,868 1,576 Expense sharing(1) -- -- -- -- - ---------------------------------------------------------------------------------------------------- Income before income taxes (TE) 56 (34) 1,299 1,115 Allocated income taxes and TE adjustment 10 (26) 456 379 - ---------------------------------------------------------------------------------------------------- Net income $ 46 $ (8) $ 843 $ 736 ====== ====== ======= ======= Percent of consolidated net income 6 % (1)% 100 % 100 % Efficiency ratio(6) N/M N/M 59.36 58.43 - ---------------------------------------------------------------------------------------------------- AVERAGE BALANCES Loans $ 211 $ 238 $62,036 $56,332 Total assets(2) 2,454(5) 2,503(5) 80,398 74,039 Deposits 1,910 1,127 41,790 41,280 - ---------------------------------------------------------------------------------------------------- </TABLE> (4) For the first nine months of 1999, noninterest expense included special contributions of $3 ($2 million after tax) and $20 million ($13 million after tax) made to the Key sponsored charitable foundation in the second and first quarters, respectively. Noninterest expense in 1999 also included $27 million ($17 million after tax ) of other nonrecurring charges recorded during the first quarter. (5) Total assets represent primarily the unallocated portion of nonearning assets of corporate support functions. (6) Calculated as noninterest expense (excluding certain nonrecurring charges) divided by taxable-equivalent net interest income plus noninterest income (excluding net securities transactions and gains from certain divestitures). TE=Taxable Equivalent N/M=Not Meaningful 12
13 5. SECURITIES Debt securities that Key has the positive intent and ability to hold to maturity are classified as securities held to maturity and carried at cost, adjusted for amortization of premiums and accretion of discounts using the level yield method. Securities held to maturity and equity securities that do not have readily determinable fair values (primarily equity capital investments) are presented as investment securities on the balance sheet. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading account assets, reported at fair value and included in short-term investments on the balance sheet. Realized and unrealized gains and losses on trading account assets are reported in other income on the income statement. Debt and equity securities that Key has not classified as investment securities or trading account assets are classified as securities available for sale and are reported at fair value, with unrealized gains and losses, net of income taxes, reported in shareholders' equity as a component of accumulated other comprehensive (loss) income. Gains and losses from sales of securities available for sale are computed using the specific identification method and included in net securities gains on the income statement. During the first quarter of 1999, Key reclassified approximately $374 million of collateralized mortgage obligations from the commercial mortgage loan portfolio to the securities available for sale portfolio. The amortized cost, unrealized gains and losses and approximate fair value of securities available for sale and investment securities were as follows: <TABLE> <CAPTION> SEPTEMBER 30, 1999 ----------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 128 $ 1 $ 1 $ 128 States and political subdivisions 61 1 1 61 Collateralized mortgage obligations 4,240 1 157 4,084 Other mortgage-backed securities 1,772 9 29 1,752 Retained interests in securitizations 365 - 14 351 Other securities 184 8 1 191 - ------------------------------------------------------------------------------------------------------------------- Total securities available for sale $6,750 $20 $203 $6,567 ====== === ==== ====== INVESTMENT SECURITIES States and political subdivisions $ 490 $16 - $ 506 Other securities 499 - - 499 - ------------------------------------------------------------------------------------------------------------------- Total investment securities $ 989 $16 - $1,005 ==== === ====== - ------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> <CAPTION> DECEMBER 31, 1998 ----------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 420 $ 2 - $ 422 States and political subdivisions 65 2 - 67 Collateralized mortgage obligations 2,191 21 $ 1 2,211 Other mortgage-backed securities 2,123 34 6 2,151 Retained interests in securitizations 345 - 17 328 Other securities 84 16 1 99 - ------------------------------------------------------------------------------------------------------------------- Total securities available for sale $5,228 $75 $25 $5,278 ====== === === ====== INVESTMENT SECURITIES States and political subdivisions $ 631 $28 - $ 659 Other securities 345 - - 345 - ------------------------------------------------------------------------------------------------------------------- Total investment securities $ 976 $28 - $1,004 ====== === ====== - ------------------------------------------------------------------------------------------------------------------- </TABLE> 13
14 <TABLE> <CAPTION> SEPTEMBER 30, 1998 ----------------------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR in millions COST GAINS LOSSES VALUE - ------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SECURITIES AVAILABLE FOR SALE U.S. Treasury, agencies and corporations $ 138 $ 2 - $ 140 States and political subdivisions 75 2 - 77 Collateralized mortgage obligations 2,743 32 $ 1 2,774 Other mortgage-backed securities 2,390 47 4 2,433 Retained interests in securitizations 421 - 19 402 Other securities 93 9 - 102 - ------------------------------------------------------------------------------------------------------------------- Total securities available for sale $5,860 $92 $24 $5,928 ====== === === ====== INVESTMENT SECURITIES States and political subdivisions $ 709 $31 - $ 740 Other securities 275 - - 275 - ------------------------------------------------------------------------------------------------------------------- Total investment securities $ 984 $31 - $1,015 ==== === ====== - ------------------------------------------------------------------------------------------------------------------- </TABLE> Trading account assets had a fair value of $1.2 billion, $877 million and $599 million at September 30, 1999, December 31, 1998 and September 30, 1998, respectively. At September 30, 1999, these assets included $101 million of retained interests in home equity loan securitizations. 6. LOANS At September 30, 1999, Key reclassified its credit card receivables to the held for sale portfolio as a result of its announced intention to sell those receivables. Loans are summarized as follows: <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 1999 1998 1998 - -------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Commercial, financial and agricultural $18,275 $17,038 $16,352 Real estate - commercial mortgage 6,831 7,309 7,168 Real estate - construction 4,298 3,450 3,234 Commercial lease financing 6,399 5,613 5,068 - -------------------------------------------------------------------------------------------------------- Total commercial loans 35,803 33,410 31,822 Real estate - residential mortgage 4,331 5,083 5,223 Home equity 7,502 7,301 6,452 Credit card - 1,425 1,398 Consumer-direct 2,566 2,342 2,073 Consumer-indirect lease financing 3,107 2,580 2,290 Consumer-indirect other 6,488 7,009 6,876 - -------------------------------------------------------------------------------------------------------- Total consumer loans 23,994 25,740 24,312 Real estate - commercial mortgage 152 86 174 Real estate - residential mortgage 58 111 108 Home equity 153 - 440 Credit card 1,299 - - Education 1,722 2,665 2,512 Automobile - - 76 - -------------------------------------------------------------------------------------------------------- Total loans held for sale 3,384 2,862 3,310 - -------------------------------------------------------------------------------------------------------- Total loans $63,181 $62,012 $59,444 ======= ======= ======= - -------------------------------------------------------------------------------------------------------- </TABLE> Portfolio interest rate swaps are used to manage interest rate risk by modifying the repricing and maturity characteristics of certain loans. Additional information pertaining to the notional amount, fair value and weighted average rate of such swaps as of September 30, 1999, is presented in Note 10, Financial Instruments with Off-Balance Sheet Risk, beginning on page 18. 14
15 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 1999 1998 1999 1998 - ---------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Balance at beginning of period $ 930 $ 900 $900 $900 Charge-offs (102) (91) (314) (288) Recoveries 24 20 79 68 - ---------------------------------------------------------------------------------------------------------------------------- Net charge-offs (78) (71) (235) (220) Provision for loan losses 78 71 265 220 - ---------------------------------------------------------------------------------------------------------------------------- Balance at end of period $ 930 $ 900 $930 $900 ===== ===== ==== ==== - ---------------------------------------------------------------------------------------------------------------------------- </TABLE> 7. IMPAIRED LOANS AND OTHER NONPERFORMING ASSETS At September 30, 1999, impaired loans totaled $219 million. Included in this amount are $107 million of impaired loans for which the specifically allocated allowance for loan losses is $47 million, and $112 million of impaired loans which are carried at their estimated fair value without a specifically allocated allowance for loan losses. At the end of the prior year, impaired loans totaled $193 million, of which $95 million had a specifically allocated allowance of $42 million and $98 million were carried at their estimated fair value. The average investment in impaired loans for the third quarter of 1999 and 1998 was $204 million and $194 million, respectively. Nonperforming assets were as follows: <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 1999 1998 1998 - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Impaired loans $219 $193 $193 Other nonaccrual loans 160 172 167 - ---------------------------------------------------------------------------------------------------------------- Total nonperforming loans 379 365 360 Other real estate owned ("OREO") 32 56 58 Allowance for OREO losses (8) (18) (19) - ---------------------------------------------------------------------------------------------------------------- OREO, net of allowance 24 38 39 Other nonperforming assets 4 1 3 - ---------------------------------------------------------------------------------------------------------------- Total nonperforming assets $407 $404 $402 ==== ==== ==== - ---------------------------------------------------------------------------------------------------------------- </TABLE> Impaired loans are evaluated individually. The fair value of any existing collateral or an estimate of the present value of the future cash flows on the loan is used to determine the extent of the impairment. When such amounts do not support the carrying amount of the loan, the amount which management deems uncollectible is charged to the allowance for loan losses. In instances where collateral or other sources of repayment are sufficient, yet uncertainty exists regarding the ultimate repayment, an allowance is specifically allocated for in the allowance for loan losses. Key excludes smaller-balance, homogeneous nonaccrual loans (shown in the preceding table as "Other nonaccrual loans") from impairment evaluation. Generally, this portfolio includes loans to finance residential mortgages, automobiles, recreational vehicles, boats and mobile homes. Key applies historical loss experience rates to these loans, adjusted based on management's assessment of emerging credit trends and other factors. The resulting loss estimates are specifically allocated for by loan type in the allowance for loan losses. 15
16 NOTE 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 1999 1998 1998 - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Senior medium-term notes due through 2005(1) $ 401 $ 419 $ 419 Subordinated medium-term notes due through 2005(1) 133 133 133 7.50% Subordinated notes due 2006(2) 250 250 250 6.75% Subordinated notes due 2006(2) 200 200 200 8.125% Subordinated notes due 2002(2) 199 199 199 8.00% Subordinated notes due 2004(2) 125 125 125 8.404% Notes due through 2001 24 34 34 8.40% Subordinated capital notes due 1999 - 75 75 All other long-term debt(8) 4 5 12 - ------------------------------------------------------------------------------------------------------------------------- Total parent company(9) 1,336 1,440 1,447 Senior medium-term bank notes due through 2004(3) 9,394 7,426 5,984 Senior euro medium-term bank notes due through 2007(4) 2,383 1,441 1,419 6.50 % Subordinated remarketable securities due 2027(5) 313 313 313 6.95% Subordinated notes due 2028(5) 300 300 300 7.125% Subordinated notes due 2006(5) 250 250 250 7.25% Subordinated notes due 2005(5) 200 200 200 6.75% Subordinated notes due 2003(5) 200 200 200 7.50% Subordinated notes due 2008(5) 165 165 165 7.30% Subordinated notes due 2011(5) 107 - - 7.85% Subordinated notes due 2002(5) 93 200 200 7.55% Subordinated notes due 2006(5) 75 75 75 7.375% Subordinated notes due 2008(5) 70 70 70 Lease financing debt due through 2004(6) 580 574 515 Federal Home Loan Bank advances due through 2029(7) 241 289 169 All other long-term debt(8) 108 24 46 - ------------------------------------------------------------------------------------------------------------------------- Total subsidiaries(10) 14,479 11,527 9,906 - ------------------------------------------------------------------------------------------------------------------------- Total long-term debt $15,815 $12,967 $11,353 ======= ======= ======= - ------------------------------------------------------------------------------------------------------------------------- Portfolio interest rate swaps, caps and floors are used to manage interest rate risk by modifying the repricing and maturity characteristics of certain long-term debt. Additional information pertaining to the notional amount, fair value and weighted average rate of such financial instruments as of September 30, 1999, is presented in Note 10, Financial Instruments with Off-Balance Sheet Risk, beginning on page 18. (1) At September 30, 1999, December 31, 1998 and September 30, 1998, the senior medium-term notes had weighted average interest rates of 6.54%, 6.55% and 6.68%, respectively, and the subordinated medium-term notes had weighted average interest rates of 7.09% at each respective date. These notes had a combination of both fixed and floating interest rates. (2) The 7.50%, 6.75%, 8.125% and 8.00% subordinated notes may not be redeemed or prepaid prior to maturity. (3) At September 30, 1999, December 31, 1998 and September 30, 1998, senior medium-term bank notes of subsidiaries had weighted average interest rates of 5.48%, 5.30% and 5.69%, respectively. These notes had a combination of both fixed and floating interest rates. (4) At September 30, 1999, December 31, 1998 and September 30, 1998, the senior euro medium-term bank notes had weighted average interest rates of 5.56%, 5.52% and 5.76%, respectively. These notes are obligations of KeyBank National Association ("KeyBank N.A.") issued under Key's $7.0 billion Euronote Program and had fixed and floating interest rates based on the three-month London Interbank Offered Rate ("LIBOR"). As of September 30, 1999, the Euronote Program had an unused capacity of $4.6 billion. </TABLE> 16
17 <TABLE> <S> <C> (5) The subordinated notes and securities are all obligations of KeyBank N.A., with the exception of the 7.55% notes which are obligations of Key Bank USA, National Association ("Key Bank USA"). These notes may not be redeemed prior to their respective maturity dates. The 7.30% notes were issued in exchange for a portion of the 7.85% notes during the first quarter of 1999. (6) At September 30, 1999, December 31, 1998 and September 30, 1998, lease financing debt had weighted average interest rates of 6.70%, 6.56% and 7.01%, respectively, and represented primarily nonrecourse debt collateralized by lease equipment under operating , direct financing and sales type leases. (7) At September 30, 1999, December 31, 1998 and September 30, 1998, long-term advances from the Federal Home Loan Bank ("FHLB") had weighted average interest rates of 5.43%, 5.39% and 5.77%, respectively. These advances had a combination of both fixed and floating interest rates. Real estate loans and securities of $361 million, $409 million and $241 million at September 30, 1999, December 31, 1998 and September 30, 1998, respectively, collateralize FHLB advances. (8) Other long-term debt at September 30, 1999, December 31, 1998 and September 30, 1998, consisted of industrial revenue bonds, capital lease obligations and various secured and unsecured obligations of corporate subsidiaries and had weighted average interest rates of 7.01%, 7.17% and 7.56%, respectively. (9) At September 30, 1999, unused capacity under the parent company's shelf registration totaled $1.3 billion, including $750 million reserved for future issuance as medium-term notes. (10) As of September 30, 1999, the Bank Note Program had an unused capacity of $8.9 billion. </TABLE> 9. CAPITAL SECURITIES The corporation-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely debentures of the Corporation ("capital securities") were issued by five separate business trusts, all of whose common securities are owned by the parent company. The proceeds from the issuances of the capital securities and common securities were used to purchase debentures of the parent company. All of the trusts hold solely junior subordinated deferrable interest debentures of the parent company. Both the debentures and related income statement effects are eliminated in Key's financial statements. The parent company has entered into contractual arrangements which, taken collectively, fully and unconditionally guarantee payment of: (i) accrued and unpaid distributions required to be paid on the capital securities; (ii) the redemption price with respect to any capital securities called for redemption by the trusts; and (iii) payments due upon a voluntary or involuntary liquidation, winding-up or termination of the trusts. The capital securities (net of discount), common securities and related debentures are summarized as follows: <TABLE> <CAPTION> PRINCIPAL INTEREST RATE MATURITY CAPITAL AMOUNT OF OF CAPITAL OF CAPITAL SECURITIES, COMMON DEBENTURES, SECURITIES AND SECURITIES AND dollars in millions NET OF DISCOUNT(1) SECURITIES NET OF DISCOUNT(2) DEBENTURES(3) DEBENTURES - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> September 30, 1999 KeyCorp Institutional Capital A $ 350 $11 $ 361 7.826 % 2026 KeyCorp Institutional Capital B 150 4 154 8.250 2026 KeyCorp Capital I 247 8 255 6.089 2028 KeyCorp Capital II 247 8 255 6.875 2029 KeyCorp Capital III 249 8 257 7.750 2029 - ---------------------------------------------------------------------------------------------------------------------------------- Total $1,243 $39 $1,282 7.328 % - ====== === ====== - ---------------------------------------------------------------------------------------------------------------------------------- December 31, 1998 $ 997 $31 $1,028 7.149 % - ====== === ====== - ---------------------------------------------------------------------------------------------------------------------------------- September 30, 1998 $ 997 $31 $1,028 7.242 % - ====== === ====== - ---------------------------------------------------------------------------------------------------------------------------------- </TABLE> (1) The capital securities are mandatorily redeemable upon the respective maturity dates of the debentures or upon earlier redemption as provided in the indenture. Each issue of capital securities carries an interest rate identical to that of the respective debenture. The capital securities issued by the trusts constitute minority interests in the equity accounts of consolidated subsidiaries and, therefore, qualify as Tier 1 capital under Federal Reserve Board guidelines. 17
18 (2) The parent company has the right to redeem the debentures purchased by Capital A, Capital B, Capital I, Capital II and Capital III: (i) in whole or in part, on or after December 1, 2006, December 15, 2006, July 1, 2008, March 18, 1999 and July 16, 1999, respectively; and (ii) in whole at any time within 90 days following the occurrence 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 prior to maturity, the redemption price will be expressed as a certain percentage of, or factor added to, the principal amount, plus any accrued but unpaid interest. If the debentures purchased by Capital I are redeemed prior to maturity, the redemption price will be equal to 100% of the principal amount of such debentures, plus any accrued but unpaid interest. If the debentures purchased by Capital II or Capital III are redeemed prior to maturity, the redemption price will be equal to the greater of: (i) 100% of 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. The price of redemptions that occur in response to tax or capital treatment events is generally slightly more favorable than that available under other circumstances described above. (3) The interest rates for Capital A, Capital B, Capital II and Capital III are fixed interest rates. The interest rate for Capital I is a floating interest rate equal to three-month LIBOR plus 74 basis points and is repriced quarterly. The rates shown as the total at September 30, 1999, December 31, 1998 and September 30, 1998, are weighted average rates. 10. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK Key, mainly through its lead bank (KeyBank N.A.), is party to various financial instruments with off-balance sheet risk. It uses these financial instruments in the normal course of business to meet the financing needs of its clients and to manage its exposure to market risk. Market risk includes the possibility that Key's net interest income will be adversely affected as a result of changes in interest rates or other economic factors. The primary financial instruments used include commitments to extend credit, standby and commercial letters of credit, interest rate swaps, caps and floors, futures and foreign exchange forward contracts. All of the interest rate swaps, caps and floors, and foreign exchange forward contracts held are over-the-counter instruments. These financial instruments may be used for lending-related, asset and liability management and trading purposes, as discussed in the remainder of this note. In addition to the market risk inherent in the use of these financial instruments, each contains an element of credit risk. Credit risk is the possibility that Key will incur a loss due to a counterparty's failure to meet its contractual obligations. FINANCIAL INSTRUMENTS HELD OR ISSUED FOR LENDING-RELATED PURPOSES These instruments involve, to varying degrees, credit risk in addition to amounts recognized in Key's balance sheet. Key mitigates its exposure to credit risk through internal controls over the extension of credit. These controls include the process of credit approval and review, the establishment of credit limits and, when deemed necessary, securing collateral. Key's commitments to extend credit are agreements with clients to provide financing at predetermined terms as long as the client continues to meet specified criteria. Loan commitments serve to meet the financing needs of clients and generally carry variable rates of interest, have fixed expiration dates or other termination clauses, and may require the payment of fees. Since the commitments may expire without being drawn upon, the total amount of the commitments does not necessarily represent the future cash outlay to be made by Key. The credit-worthiness of each client is evaluated on a case-by-case basis. The estimated fair values of these commitments and standby letters of credit discussed below are not material. Key does not have any significant concentrations of credit risk. Standby letters of credit enhance the credit-worthiness of Key's clients by assuring the clients' financial performance to third parties in connection with specified transactions. Amounts drawn under standby letters of credit generally carry variable rates of interest, and the credit risk involved is essentially the same as that involved in the extension of loan facilities. 18
19 The following is a summary of the contractual amount of each class of lending-related, off-balance sheet financial instrument outstanding wherein Key's maximum possible accounting loss equals the contractual amount of the instruments. <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 1999 1998 1998 - --------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Loan commitments: Credit card lines $ 6,776 $ 6,320 $ 6,756 Home equity 4,630 4,347 4,291 Commercial real estate and construction 1,778 2,046 1,640 Commercial and other 21,979 20,995 21,667 - --------------------------------------------------------------------------------------------------------------- Total loan commitments 35,163 33,708 34,354 Other commitments: Standby letters of credit 1,870 1,834 1,597 Commercial letters of credit 155 138 151 Loans sold with recourse 17 21 22 - --------------------------------------------------------------------------------------------------------------- Total loan and other commitments $37,205 $35,701 $36,124 ======= ======= ======= - --------------------------------------------------------------------------------------------------------------- </TABLE> FINANCIAL INSTRUMENTS HELD OR ISSUED FOR ASSET AND LIABILITY MANAGEMENT PURPOSES Key manages its exposure to interest rate risk, in part, by using off-balance sheet financial instruments, commonly referred to as derivatives. Instruments used for this purpose modify the repricing or maturity characteristics of specified on-balance sheet assets and liabilities. The instruments must be both effective at reducing the risk associated with the exposure being managed, and designated as a risk management transaction at the inception of the derivative contract. In addition, to be considered effective, a high degree of interest rate correlation must exist between the derivative and the specified assets or liabilities being managed at inception and over the life of the derivative contract. Primary among the financial instruments used by Key to manage exposure to interest rate risk are interest rate swaps, caps and floors, otherwise referred to as portfolio swaps, caps and floors. In addition, Key uses treasury-based interest rate locks to manage the risk associated with anticipated loan securitizations. The following table summarizes the notional amount, fair value, maturity, weighted average rate received and paid, and weighted average strike rate for the various types of portfolio swaps, caps and floors used by Key. <TABLE> <CAPTION> September 30, 1999 -------------------------------------------------------------------------- Notional Fair Maturity Weighted Average Rate --------------------------------------- dollars in millions Amount Value (Years) Receive Pay Strike - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Interest rate swaps: Received fixed/pay variable-indexed amortizing(1) $ 132 $ 1 .7 7.02 % 5.37 % N/A Received fixed/pay variable-conventional 5,962 (58) 5.6 6.15 5.42 N/A Pay fixed/receive variable-conventional 3,846 52 4.5 5.46 5.96 N/A Pay fixed/receive variable-forward starting 148 2 5.1 5.94 6.13 N/A Basis swaps 8,408 (3) 1.7 5.21 5.16 N/A - ------------------------------------------------------------------------------------------------------------------------------------ Total 18,496 (6) -- 5.58 % 5.42 % -- Interest rate caps, collars and corridors: Caps purchased - one- to three-month LIBOR-based(2) 2,115 5 .7 N/A N/A 5.88% Collar - one- to three-month LIBOR-based 250 -- 1.3 N/A N/A 4.75 and 6.50 Collar - thirty-year U.S. Treasury-based -- -- -- N/A N/A -- 1% payout corridor(3) 200 -- .1 N/A N/A 6.00 to 7.00 - ------------------------------------------------------------------------------------------------------------------------------------ Total 2,565 5 -- -- -- -- - ------------------------------------------------------------------------------------------------------------------------------------ Total $21,061 $(1) -- -- -- -- ======= - ------------------------------------------------------------------------------------------------------------------------------------ <CAPTION> December 31, 1998 -------------------------------- Notional Fair dollars in millions Amount Value - --------------------------------------------------------------------------------------------- <S> <C> <C> Interest rate swaps: Received fixed/pay variable-indexed amortizing(1) $ 311 $ 4 Received fixed/pay variable-conventional 4,325 223 Pay fixed/receive variable-conventional 4,872 (68) Pay fixed/receive variable-forward starting 10 -- Basis swaps 2,872 19 - --------------------------------------------------------------------------------------------- Total 12,390 178 Interest rate caps, collars and corridors: Caps purchased - one- to three-month LIBOR-based(2) 3,175 3 Collar - one- to three-month LIBOR-based 250 (1) Collar - thirty-year U.S. Treasury-based 250 (24) 1% payout corridor(3) 200 -- - --------------------------------------------------------------------------------------------- Total 3,875 (22) - --------------------------------------------------------------------------------------------- Total $16,265 $156 ======= ======== - --------------------------------------------------------------------------------------------- </TABLE> (1) Maturity is based upon expected average lives rather than contractual terms. (2) Includes $15 million and $200 million of forward-starting caps as of September 30, 1999 and December 31, 1998, respectively. (3) Payout is indexed to three-month LIBOR. N/A = Not Applicable 19
20 Interest rate swap contracts involve the exchange of interest payments calculated based on an agreed-upon amount (notional amount) and are generally used to mitigate Key's exposure to interest rate risk on certain loans, securities, deposits, short-term borrowings and long-term debt. Interest rate caps and floors involve the payment of a premium by the buyer to the seller for the right to receive an interest differential equal to the difference between the current interest rate and an agreed-upon interest rate ("strike rate") applied to a notional amount. Key generally purchases caps, enters into collars (a combination of simultaneously purchasing a cap and selling a floor), and enters into corridors (a combination of simultaneously purchasing a cap at a specified strike rate and selling a cap at a higher strike rate) to manage the risk of adverse movements in interest rates on specified long-term debt and short-term borrowings. The notional amount associated with the execution of swaps, caps and floors is significantly greater than the amount at risk. Credit risk on swaps, caps and floors results from the possibility that the counterparty will not meet the terms of the contract and is measured as the cost of replacing, at current market rates, contracts in an unrealized gain position. To mitigate this risk, Key deals exclusively with counterparties with high credit ratings. With regard to its swap contracts, 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. In addition, the credit risk exposure to the counterparty on each interest rate swap is monitored by a credit committee. Based upon credit reviews of the counterparties, limits on Key's total credit exposure with each counterparty and the amount of collateral required, if any, are determined. At September 30, 1999, Key had 38 different counterparties to portfolio swaps and swaps entered into to offset the risk of client swaps. Key had aggregate credit exposure of $167 million to 26 of these counterparties, with the largest credit exposure to an individual counterparty amounting to $25 million. As of the same date, Key's aggregate credit exposure on its interest rate caps and floors totaled $63 million. Based on management's assessment as of September 30, 1999, all counterparties were expected to meet their obligations. Portfolio swaps (including the impact of both the spread on the swap portfolio and the amortization of deferred gains and losses resulting from terminated swaps) and portfolio caps and floors increased net interest income by $5 million in the third quarter of 1999 and $2 million in the third quarter of 1998. Conventional interest rate swap contracts involve the receipt of amounts based on a fixed or variable rate in exchange for payments based on variable or fixed rates, without an exchange of the underlying notional amount. Under an indexed amortizing swap contract, the notional amount remains constant for a specified period of time after which, based upon the level of an index at each review date, the swap contract will mature, the notional amount will begin to amortize, or the swap will continue in effect until its contractual maturity. Otherwise, the characteristics of these swaps are similar to those of conventional swap contracts. At September 30, 1999, Key was party to $73 million and $59 million of indexed amortizing swaps that used a LIBOR index and a Constant Maturity Treasuries ("CMT") index, respectively, for the review date measurement. Under basis swap contracts, interest payments based on different floating indices are exchanged. Based on the weighted average rates in effect at September 30, 1999, the spread on portfolio swaps, excluding the amortization of net deferred gains on terminated swaps, provided a positive impact on net interest income (since the weighted average rate received exceeded the weighted average rate paid by 16 basis points). The aggregate fair value of ($6) million at the same date was derived through the use of discounted cash flow models, which contemplate interest rates using the applicable forward yield curve, and represents an estimate of the unrealized loss that would be recognized if the portfolio were to be liquidated at that date. 20
21 Interest from portfolio swaps is recognized on an accrual basis over the lives of the respective contracts as an adjustment of the interest income or expense of the asset or liability whose risk is being managed. Gains and losses realized upon the termination of interest rate swaps prior to maturity are deferred as an adjustment to the carrying amount of the asset or liability. The deferred gain or loss is amortized using the straight-line method over the shorter of the projected remaining life of the related contract at its termination or the underlying asset or liability. During the first nine months of 1999, swaps with a notional amount of $3.2 billion were terminated, resulting in a deferred gain of $12 million. During the same period last year, swaps with a notional amount of $568 million were terminated, resulting in a net deferred loss of $1 million. At September 30, 1999, Key had a net deferred swap gain of $21 million with a weighted average life of 4.8 years related to the management of debt and a net deferred loss of $1 million with a weighted average life of 7.5 years related to the management of loans. FINANCIAL INSTRUMENTS HELD OR ISSUED FOR TRADING PURPOSES Key also uses interest rate swaps, caps and floors, and futures contracts for dealer activities (which are generally limited to the banks' commercial loan clients) and enters into other positions with third parties that are intended to mitigate the interest rate risk of the client positions. Interest rate swap contracts entered into with clients are typically limited to conventional swaps, as previously described. The client swaps, caps and floors, and futures, as well as the third-party positions, are recorded at their estimated fair values, and adjustments to fair value are included in investment banking and capital markets income on the income statement. Foreign exchange forward contracts are used by Key to accommodate the business needs of its clients and for proprietary trading purposes. These contracts provide for the delayed delivery or purchase of foreign currency. The foreign exchange risk associated with such contracts is mitigated by entering into other foreign exchange contracts with third parties. Adjustments to the fair value of all such foreign exchange forward contracts are included in investment banking and capital markets income on the income statement. Key also enters into treasury options and treasury futures options for proprietary trading purposes. Adjustments to the fair value of all such options are included in investment banking and capital markets income on the income statement. At September 30, 1999, credit exposure from financial instruments held or issued for trading purposes was limited to the aggregate fair value of each contract with a positive fair value, or $507 million. The risk of counterparties defaulting on their obligations is monitored on an ongoing basis. Key contracts with counterparties with high credit ratings and enters into master netting agreements when possible in an effort to manage credit risk. Trading income recognized on interest rate, foreign exchange forward and treasury-based option contracts totaled $28 million, $21 million and $5 million, respectively, for the first nine months of 1999 and $49 million, $16 million and $3 million, respectively, for the first nine months of 1998. 21
22 A summary of the notional amount and the respective fair value of derivative financial instruments held or issued for trading purposes at September 30, 1999, and on average for the nine-month period then ended, is presented below. The positive fair values represent assets to Key and are recorded in other assets, while the negative fair values represent liabilities and are recorded in other liabilities on the balance sheet. The $24.6 billion notional amount of client interest rate swaps presented in the table includes $11.6 billion of client swaps that receive a fixed rate and pay a variable rate, $9.3 billion of client swaps that pay a fixed rate and receive a variable rate and $3.7 billion of basis swaps. As of September 30, 1999, the client swaps had an average expected life of 5.6 years, carried a weighted average rate received of 5.98% and had a weighted average rate paid of 5.97%. The securitization positions were executed in connection with the residual interests retained in the securitization of certain home equity loans and the securitization of certain education loans. <TABLE> <CAPTION> September 30, 1999 Nine months ended September 30, 1999 ---------------------------- ------------------------------------------- Notional Fair Average Average in millions Amount Value Notional Amount Fair Value - -------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Interest rate contracts - client positions: Swap assets $14,163 $307 $13,525 $284 Swap liabilities 10,471 (223) 9,551 (210) Caps and floors purchased 416 2 395 1 Caps and floors sold 527 (2) 515 (1) Futures purchased 860 (2) 591 (1) Futures sold 7,680 14 12,565 17 Interest rate contracts - securitization positions: Swap assets $ 1,275 $ 12 $ 807 $ 4 Caps purchased 1,273 57 806 25 Caps sold 2,273 (57) 1,056 (25) Foreign exchange forward contracts: Assets $ 1,583 $ 55 $ 1,424 $ 47 Liabilities 1,489 (47) 1,254 (41) Treasury-based option contracts: Options purchased $ 3,110 $ 60 $ 3,672 $ 65 Options sold 3,335 (29) 4,463 (45) - -------------------------------------------------------------------------------------------------------------------------------- </TABLE> 22
23 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, 1999 and 1998, 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, 1999 and 1998. 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 generally accepted auditing standards, 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 generally accepted accounting principles. We have previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheet of Key as of December 31, 1998, 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 14, 1999, 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, 1998, 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 15, 1999 23
24 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION This section of the report, including the highlights summarized below, provides a discussion and analysis of the financial condition and results of operations of Key for the periods presented. It should be read in conjunction with the unaudited consolidated financial statements and notes thereto, presented on pages 3 through 22. This report contains forward-looking statements that are subject to numerous assumptions, risks and uncertainties. Statements pertaining to future periods are subject to uncertainty because of the possibility of changes in underlying factors and assumptions. Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including: sharp and/or rapid changes in interest rates; significant changes in the economy that could materially change anticipated credit quality trends and the ability to generate loans; failure of the capital markets to function consistent with customary levels; significant delay in or inability to execute strategic initiatives designed to grow revenues and/or manage expenses; consummation of significant business combinations or divestitures; unforeseen business risks stemming from Year 2000 computer systems difficulties and related issues; and significant changes in accounting, tax, or regulatory practices or requirements. Key's earnings for the third quarter of 1999 benefited from continued growth in lending, particularly in the commercial, home equity and consumer lease financing portfolios. Excluding the impact of sales, annualized commercial loan growth exceeded 10% for the tenth consecutive quarter, while average loans outstanding in the home equity and consumer lease financing portfolios were up an annualized 39% and 23%, respectively, from the second quarter of 1999. At the same time, Key's asset quality remained stable as the level of net charge-offs was essentially unchanged and nonperforming assets declined for the second consecutive quarter. Bolstered by the McDonald acquisition, core noninterest income (noninterest income, excluding certain nonrecurring gains) rose 21% from the year-ago quarter and comprised 40% of Key's total core revenue (net interest income plus core noninterest income), up from 36% a year ago. This growth also reflected improvement in the performance of Key's retail banking unit, which has benefited from several profitability enhancement initiatives undertaken earlier this year. However, core noninterest income was 6% below that recorded in the prior quarter, as fees from the investment banking and capital markets businesses subsided from record levels due to less favorable conditions in the financial markets served by Key. One of management's long-term goals is for Key to generate 50% of its revenue from investment advisory and other noninterest income generating activities. Noninterest expense was up 12% from the year-ago quarter, due primarily to the McDonald acquisition; however, lower levels of incentive compensation contributed to a slight decline in noninterest expense relative to the second quarter of 1999. This was attributable in part to reductions in investment banking and capital markets income, and stock-based compensation. Key's corporate strategy for the past several years has featured continued reviews of business lines to identify opportunities to generate higher earnings growth. These reviews have led to an active program of selling portfolios and business units that management determines to be of low-return and/or low-growth potential, and have prompted Key to acquire businesses that management believes are capable of achieving double-digit earnings growth rates. The principal strategic actions taken by Key during the current year are summarized below. During the first quarter, Key introduced an initiative designed to strengthen the profitability of the retail banking unit within the Key Community Bank line of business. This initiative and the guiding strategies are discussed in more detail under the heading "Key Community Bank" on page 29. Management's long-term goal is to increase the annual earnings growth rate of the retail banking unit to at least 10% (the target growth rate for 1999 is 8%) by improving sales-generating capabilities and reducing operating costs. During the first nine months of 1999, the earnings contribution of the retail banking unit was up 9% from the same period last year. In the second quarter, Key entered into a definitive agreement to sell its Long Island, New York, business, including 28 KeyCenters with approximately $1.3 billion of deposits and $505 million of loans. Key's Long Island business, while profitable, had a very small share of the market for deposits and loans in the greater New York City-Long Island area, the competition for which has been dominated by major New York City-based financial institutions. This transaction was completed in October and the positive effects on Key's capital ratios will increase its flexibility to allocate more capital to higher growth opportunities and geographic markets. The terms of the Long Island transaction are more fully disclosed in Note 3, Mergers, Acquisitions and Divestitures, beginning on page 8. 24
25 During the third quarter, Key sold the 50% interest held by its Leasetec subsidiary in a joint venture formed with Compaq early in 1998. This joint venture had been established to provide customized equipment leasing and financing programs to Compaq's clients in the United Kingdom, Europe and Asia. In October, Key announced its intentions to sell its credit card portfolio as part of Key's overall efforts to enhance earnings. The size of the portfolio ($1.3 billion, or 2% of total loans outstanding at September 30, 1999) does not provide the scale necessary to allow Key to compete effectively in credit card lending with other credit card issuers whose portfolios are significantly larger in size. One side effect of Key's corporate strategy is that loan growth has accelerated without a corresponding increase in deposits. Among the alternatives that Key uses to generate additional cash to fund loan growth are securitizations. Securitizations enable Key to generate cash from the sale of securitized loans and by charging a fee for servicing the loans afterwards. During the third quarter of 1999, Key securitized an aggregate $1.1 billion of education and home equity loans, bringing the total principal amount of loans securitized in 1999 to $3.2 billion. These securitizations are discussed in greater detail in the Loans section beginning on page 40. Key's management is currently in the process of evaluating several initiatives designed to reduce Key's operating costs. Among these initiatives are the potential outsourcing of certain nonstrategic support functions (which may result in the write-off of selected assets, including certain software); the proposed sale of Key's credit card portfolio; site consolidations in a number of Key's businesses; and the potential sale and leaseback of most of Key's real estate holdings. It is possible that as a result of the evaluation, Key will incur a number of special charges; the amounts and timing of any such possible charges would be determined upon conclusion of the evaluation, although some may be incurred in the fourth quarter of 1999. The preceding items are reviewed in greater detail in the remainder of this discussion and in the notes to the consolidated financial statements. PERFORMANCE OVERVIEW The selected financial data set forth in Figure 1 presents certain information highlighting the financial performance of Key for each of the last five quarters and the year-to-date periods ended September 30, 1999 and 1998. Some of the items referred to in this performance overview and in Figure 1 are more fully described in the following discussion or in the notes to the consolidated financial statements presented on pages 7 through 22. Unless otherwise indicated, all earnings per share data included in this section and throughout the remainder of this discussion are presented on a diluted basis. Net income for the third quarter of 1999 was $270 million, or $.60 per Common Share, up from $252 million, or $.57, in the third quarter of 1998. On an annualized basis, the return on average equity for the third quarter of 1999 was 17.06%, compared with 18.14% for the same period last year. The annualized return on average total assets was 1.32% for the third quarter of both 1999 and 1998. The increase in earnings relative to the third quarter of 1998 resulted from growth in fee income and an increase in taxable-equivalent net interest income. Noninterest income for the third quarter of 1999 was $489 million, significantly higher than the $392 million recorded a year ago. Excluding a $13 million gain from the sale of Key's interest in a joint venture with Compaq and net securities gains recorded in the third quarter of 1999, core noninterest income grew by $82 million, or 21%. Compared with the same period last year, taxable-equivalent net interest income rose by $20 million as a $4.5 billion, or 7%, increase in average earning assets (primarily commercial and consumer loans) more than offset a 16 basis point reduction in the net interest margin to 3.92%. These positive factors were partially offset by a $73 million, or 12%, increase in noninterest expense and a $7 million, or 10%, increase in the provision for loan losses. Contributing to the growth in noninterest income and expense was the impact of the McDonald acquisition completed in October 1998. For the first nine months of 1999, earnings were $843 million, up 15% from $736 million for the same period last year. On a per Common Share basis, Key's 1999 year-to-date earnings were $1.86, representing a 13% increase from $1.65 for the first nine months of 1998. On an annualized basis, the return on average equity for the first nine months of 1999 was 18.21%, compared with 18.29% for the comparable year-ago period. The annualized returns on average total assets 25
26 were 1.40% and 1.33% for the first nine months of 1999 and 1998, respectively. Affecting comparative results was a $496 million increase in noninterest income (including a $123 million increase in nonrecurring gains). In the current year, these gains were comprised of $13 million from the sale of Key's interest in the Compaq joint venture, $15 million from the second quarter sale of Key's interest in Concord EFS and $134 million from the first quarter sale of Key's interest in EPS. In the first nine months of 1998, branch divestiture gains of $33 million and $6 million were recorded in the second and first quarters, respectively. Also contributing to the improvement in year-to-date earnings was an $83 million increase in taxable-equivalent net interest income. The increase in total revenue was moderated by a $350 million, or 19%, increase in noninterest expense. Included in noninterest expense in 1999 was $23 million of special contributions to a charitable foundation that Key sponsors that were made in light of the gains realized from the sales of Concord EFS and EPS. Excluding these contributions and $27 million of other nonrecurring charges, noninterest expense was up $300 million, or 17%, from the first nine months of last year. The year-to-date increases in both noninterest income and expense also reflected the impact of the McDonald acquisition. Another factor partially offsetting the growth in revenue was a higher provision for loan losses. In the first nine months of 1999, the provision exceeded the level of net loan charge-offs by $30 million and was $45 million higher than that of the comparable 1998 period. Figure 1 Selected Financial Data <TABLE> <CAPTION> 1999 1998 ---------------------------------------- -------------------------------- dollars in millions, except per share amounts Third Second First Fourth Third - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> FOR THE PERIOD Interest income $ 1,433 $ 1,392 $ 1,381 $ 1,411 $ 1,415 Interest expense 733 695 696 724 734 Net interest income 700 697 685 687 681 Provision for loan losses 78 76 111 77 71 Noninterest income 489 526 609 447 392 Noninterest expense 701 717 748 667 628 Income before income taxes 410 430 435 390 374 Net income 270 280 293 260 252 - ----------------------------------------------------------------------------------------------------------------------------------- PER COMMON SHARE Net income $ .60 $ .63 $ .65 $ .58 $ .57 Net income-assuming dilution .60 .62 .65 .57 .57 Cash dividends .26 .26 .26 .235 .235 Book value at period end 14.25 13.90 13.63 13.63 12.73 Market price: High 33.50 38.13 34.19 34.06 39.50 Low 25.19 29.13 29.69 23.38 24.75 Close 25.81 32.13 30.31 32.00 28.88 Weighted average Common Shares (000) 448,742 448,037 449,520 449,949 438,856 Weighted average Common Shares and potential Common Shares (000) 452,886 452,733 454,197 454,527 443,750 - ----------------------------------------------------------------------------------------------------------------------------------- AT PERIOD END Loans $63,181 $61,971 $61,045 $62,012 $59,444 Earning assets 72,831 71,097 70,458 70,240 68,568 Total assets 82,577 80,889 79,992 80,020 77,691 Deposits 43,466 43,016 41,323 42,583 42,597 Long-term debt 15,815 15,168 15,457 12,967 11,353 Shareholders' equity 6,397 6,235 6,105 6,167 5,553 Full-time equivalent employees 25,523 25,758 25,650 25,862 24,586 Full-service banking offices 963 965 969 968 961 - ----------------------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets 1.32 % 1.40 % 1.49 % 1.31 % 1.32 % Return on average equity 17.06 18.16 19.48 17.12 18.14 Efficiency(1) 58.61 59.26 60.22 58.66 58.09 Overhead(2) 30.18 29.97 33.19 32.37 34.25 Net interest margin (taxable equivalent) 3.92 3.97 3.95 3.99 4.08 - ----------------------------------------------------------------------------------------------------------------------------------- CAPITAL RATIOS AT PERIOD END Equity to assets 7.75 % 7.71 % 7.63 % 7.71 % 7.15 % Tangible equity to tangible assets 6.06 5.95 5.86 5.93 5.79 Tier 1 risk-adjusted capital 7.84 7.48 7.44 7.21 7.01 Total risk-adjusted capital 11.94 11.74 11.92 11.69 11.61 Leverage 7.85 7.41 7.21 6.95 6.88 - ----------------------------------------------------------------------------------------------------------------------------------- <CAPTION> Nine months ended September 30, -------------------------------- dollars in millions, except per share amounts 1999 1998 - ---------------------------------------------------------------------------------- <S> <C> <C> FOR THE PERIOD Interest income $ 4,206 $ 4,114 Interest expense 2,124 2,117 Net interest income 2,082 1,997 Provision for loan losses 265 220 Noninterest income 1,624 1,128 Noninterest expense 2,166 1,816 Income before income taxes 1,275 1,089 Net income 843 736 - ---------------------------------------------------------------------------------- PER COMMON SHARE Net income $ 1.88 $ 1.68 Net income-assuming dilution 1.86 1.65 Cash dividends .78 .705 Book value at period end 14.25 12.73 Market price: High 38.13 44.88 Low 25.19 24.75 Close 25.81 28.88 Weighted average Common Shares (000) 448,764 439,180 Weighted average Common Shares and potential Common Shares (000) 453,267 445,047 - ---------------------------------------------------------------------------------- AT PERIOD END Loans $63,181 $59,444 Earning assets 72,831 68,568 Total assets 82,577 77,691 Deposits 43,466 42,597 Long-term debt 15,815 11,353 Shareholders' equity 6,397 5,553 Full-time equivalent employees 25,523 24,586 Full-service banking offices 963 961 - ---------------------------------------------------------------------------------- PERFORMANCE RATIOS Return on average total assets 1.40 % 1.33 % Return on average equity 18.21 18.29 Efficiency(1) 59.36 58.43 Overhead(2) 31.10 36.13 Net interest margin (taxable equivalent) 3.95 4.11 - ---------------------------------------------------------------------------------- CAPITAL RATIOS AT PERIOD END Equity to assets 7.75 % 7.15 % Tangible equity to tangible assets 6.06 5.79 Tier 1 risk-adjusted capital 7.84 7.01 Total risk-adjusted capital 11.94 11.61 Leverage 7.85 6.88 - ---------------------------------------------------------------------------------- </TABLE> The comparability of the information presented above is affected by certain mergers, acquisitions and divestitures completed by Key in the time periods presented. For further information concerning these transactions, refer to Note 3, Mergers, Acquisitions and Divestitures, beginning on page 8. (1) Calculated as noninterest expense (excluding certain nonrecurring charges) divided by taxable-equivalent net interest income plus noninterest income (excluding net securities transactions and gains from certain divestitures). (2) Calculated as noninterest expense (excluding certain nonrecurring charges) less noninterest income (excluding net securities transactions and gains from certain divestitures) divided by taxable-equivalent net interest income. 26
27 CASH BASIS FINANCIAL DATA The selected financial data presented in Figure 2 highlights the performance of Key on a cash basis for each of the last five quarters and the year-to-date periods ended September 30, 1999 and 1998. Cash basis financial data provides a useful tool for evaluating liquidity and for measuring a company's ability to support future growth, pay dividends and repurchase shares. The data presented below has been adjusted to exclude goodwill, other intangibles and the amortization of these assets that do not qualify as Tier 1 capital. It does not exclude the impact of other noncash items such as depreciation and the provision for loan losses. Goodwill and other non-qualifying intangibles resulted from business combinations recorded by Key using the purchase method of accounting. Had these business combinations qualified for accounting using the pooling of interests method, no intangible assets would have been recorded. Since the amortization of goodwill and other non-qualifying intangibles does not result in a cash expense, from an investor's perspective the economic value under either accounting method is essentially the same. For the same reason, such amortization does not impact Key's liquidity and funds management activities. This is the only section of this report in which Key's financial results are discussed on a cash basis. Figure 2 Cash Basis Selected Financial Data <TABLE> <CAPTION> NINE MONTHS ENDED 1999 1998 SEPTEMBER 30, ---------------------------------- --------------------- --------------------- dollars in millions, except per share amounts THIRD SECOND FIRST FOURTH THIRD 1999 1998 ==================================================================================================================================== <S> <C> <C> <C> <C> <C> <C> <C> FOR THE PERIOD Noninterest expense $ 677 $ 693 $ 719 $ 644 $ 608 $ 2,089 $ 1,753 Income before income taxes 434 454 464 413 394 1,352 1,152 Net income 291 302 319 281 270 912 791 - ------------------------------------------------------------------------------------------------------------------------------------ PER COMMON SHARE Net income $ .65 $ .67 $ .71 $ .63 $ .61 $ 2.03 $ 1.80 Net income - assuming dilution .64 .66 .71 .62 .61 2.01 1.78 Weighted average Common Shares (000) 448,742 448,037 449,520 449,949 438,856 448,764 439,180 Weighted average Common Shares and potential Common Shares (000) 452,886 452,733 454,197 454,527 443,750 453,267 445,047 - ------------------------------------------------------------------------------------------------------------------------------------ PERFORMANCE RATIOS Return on average total assets 1.45% 1.54% 1.65% 1.44% 1.43% 1.55% 1.45% Return on average equity 24.13 25.89 28.14 24.02 24.43 26.01 24.96 Efficiency(1) 56.61 57.27 57.73 56.64 56.24 57.20 56.40 - ------------------------------------------------------------------------------------------------------------------------------------ GOODWILL AND NON-QUALIFYING INTANGIBLES Goodwill average balance $1,429 $1,437 $1,428 $1,303 $1,042 $1,431 $1,049 Non-qualifying intangibles average balance 66 69 74 81 85 70 95 Goodwill amortization (after tax) 20 20 21 18 15 61 46 Non-qualifying intangibles amortization (after tax) 1 2 5 3 3 8 9 ==================================================================================================================================== </TABLE> The comparability of the information presented above is affected by certain mergers, acquisitions and divestitures completed by Key in the time periods presented. For further information concerning these transactions, refer to Note 3, Mergers, Acquisitions and Divestitures, beginning on page 8. (1) Calculated as noninterest expense (excluding certain nonrecurring charges and the amortization of goodwill and non-qualifying intangibles) divided by taxable-equivalent net interest income plus noninterest income (excluding net securities transactions and gains from certain divestitures). 27
28 LINE OF BUSINESS RESULTS Presented below is a summary of the comparative financial performance of each of Key's major lines of business for the three- and nine-month periods ended September 30, 1999 and 1998, as well as a summary of significant strategic developments that occurred within those lines during the first nine months of 1999. It should be read in conjunction with Note 4, Line of Business Results, beginning on page 9. This note provides additional information pertaining to the basis of the financial results discussed and the nature of the business conducted by each line of business. Key's net income by line of business for the three-and nine-month periods ended September 30, 1999 and 1998, is shown in Figure 3. Figure 3 Net Income by Line of Business <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, CHANGE -------------------------- ----------------------- ------------------------ ----------------------- dollars in millions 1999 1998 AMOUNT PERCENT 1999 1998 AMOUNT PERCENT - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Key Corporate Capital $ 73 $ 57 $ 16 28.1 % $206 $163 $ 43 26.4 % Key Consumer Finance 50 52 (2) (3.8) 149 101 48 47.5 Key Community Bank 118 130 (12) (9.2) 373 398 (25) (6.3) Key Capital Partners(1) 15 24 (9) (37.5) 69 82 (13) (15.9) - ---------------------------------------------------------------------------------------------------------------------------------- Total segments 256 263 (7) (2.7) 797 744 53 7.1 Reconciling items 14 (11) 25 N/M 46 (8) 54 N/M - ---------------------------------------------------------------------------------------------------------------------------------- Total net income $270 $252 $ 18 7.1 % $843 $736 $107 14.5 % ==== ==== ==== ==== ==== ==== - ---------------------------------------------------------------------------------------------------------------------------------- </TABLE> (1) Prior to the assignment of income and expense to the other lines of business, as described under the following Key Capital Partners heading, net income was $26 million and $45 million in the third quarter of 1999 and 1998, respectively, and $105 million and $122 million in the first nine months of 1999 and 1998, respectively. N/M = Not Meaningful KEY CORPORATE CAPITAL During the first nine months of 1999, Key Corporate Capital contributed approximately 24% of Key's consolidated earnings with net income of $206 million. In the same period last year, net income was $163 million, or approximately 22% of Key's consolidated earnings. The increase in earnings relative to the prior year reflected higher net interest income resulting from a 21% increase in total average loans as growth occurred in almost all of Key Corporate Capital's major business units. Also contributing to the improved earnings was a $36 million rise in noninterest income. This included a $13 million gain recorded in the 1999 third quarter from the sale of Key's interest in a joint venture with Compaq. The remainder of the increase in noninterest income was led by higher income from various investment banking and capital markets activities, and increased loan fees. The $85 million increase in total revenue was partially offset by a $4 million increase in the provision for loan losses and a $12 million increase in noninterest expense. The latter was primarily attributable to growth in personnel expense, an increase in depreciation and amortization expense, and higher costs associated with investment banking and capital markets activities. KEY CONSUMER FINANCE During the first nine months of 1999, Key Consumer Finance generated net income of $149 million, or approximately 18% of Key's consolidated earnings, up from $101 million, or approximately 14%, for the same period last year. The improvement in earnings was driven by higher levels of net interest income and noninterest income, as well as a slight reduction in the provision for loan losses. These positive factors were partially offset by an increase in noninterest expense. Net interest income increased by $50 million as average loans outstanding rose 11% from the first nine months of 1998. The increase in loans reflected the continuation of strong growth in the home equity portfolio, as well as the April 1998 acquisition of an $805 million marine/recreational vehicle installment loan portfolio. Growth in average loans occurred despite the securitization and sale of an aggregate $3.6 billion of automobile, home equity and education loans since December 31, 1997, of which $3.2 billion occurred in 1999. Gains resulting from securitizations accounted for virtually all of the $58 million increase in noninterest income from the first nine months of 1998. The small decrease in the provision for loan losses relative to the prior year reflected improvement in consumer credit quality. Noninterest expense rose $32 million from the 1998 year-to-date period due in large part to increases in personnel expense, depreciation and amortization expense, and marketing costs incurred to expand the home equity business. 28
29 KEY COMMUNITY BANK Key Community Bank's primary operating units are commercial banking and retail banking. During 1999, strategic efforts have focused on strengthening sales-generating capabilities and on improving efficiencies in delivering branch-based services to support a 1999 goal of achieving at least 8% earnings growth in the retail unit of Key Community Bank; the long-term goal is to achieve an annual earnings growth rate of at least 10%. In the first nine months of 1999, strategies centered on cross-selling, streamlining deposit product offerings and improving the deposit pricing structure. As a result of these efforts and those taken to reduce costs, the earnings contribution of the retail banking unit was up 9% from the same period last year. Retail progress to date, however, has been modestly offset by other factors, primary among which are increased commercial loan net charge-offs and resulting increases in the provision for loan losses. In the first nine months of 1999, net income for Key Community Bank totaled $373 million, or approximately 44% of Key's consolidated earnings, compared with $398 million, or 54%, respectively, for the first nine months of 1998. The decrease in earnings relative to the prior year reflected declines in net interest income and noninterest income, coupled with an increase in the provision for loan losses. These factors were partially offset by a decrease in noninterest expense. Net interest income declined by $20 million as a moderate increase in average loans outstanding was more than offset by a lower net interest margin, due largely to increased reliance on higher-cost funding. The higher cost of funds reflected the reduction in core deposits stemming from the 1998 divestiture of 46 branch offices with average deposits of approximately $321 million during the first nine months of 1998. Noninterest income decreased by $5 million as the growth in service charges on deposit accounts and loan fees was more than offset by lower income from various investment banking and capital markets activities. The provision for loan losses rose by $24 million in response to a higher level of net charge-offs in the commercial banking unit of Key Community Bank. Noninterest expense decreased by $15 million from 1998 due primarily to lower personnel expense, including that related to incentive compensation. KEY CAPITAL PARTNERS During the first nine months of 1999, Key Capital Partners recorded net income of $69 million, or approximately 8% of Key's consolidated earnings, compared with $82 million, or approximately 11%, a year-ago. A significant portion of noninterest income and expense generated by Key Capital Partners is reported under either Key Corporate Capital or Key Community Bank. This reflects Key's management accounting practice of assigning such income and expense to the line of business principally responsible for maintaining the relationships with clients who use the products and services offered by Key Capital Partners. Prior to the aforementioned assignments, Key Capital Partner's net income totaled $105 million (representing 12% of Key's consolidated earnings) in the first nine months of 1999 and $122 million (representing 17% of Key's consolidated earnings) in the same period last year. During the first nine months of 1999, total revenue for Key Capital Partners rose by $293 million ($288 million prior to revenue sharing) from the same period a year ago. This was primarily due to the October 1998 acquisition of McDonald, but also reflected higher revenue from trust and asset management activities as a result of new business, the repricing of certain services and the strength of the securities markets. The overall increase in revenue relative to the prior year was moderated by weaker demand for derivative products and investment banking services in the markets served by Key. Noninterest expense was up $310 million (with or without expense sharing) from the first nine months of 1998, also due largely to the impact of the McDonald acquisition and the associated increases in expenses related to personnel, depreciation and amortization. RECONCILING ITEMS The impact on net income from reconciling items shown in Figure 3 is primarily the result of certain nonrecurring items, as well as charges related to unallocated nonearning assets of corporate support functions. For the first nine months of 1999, noninterest income included a $134 million ($85 million after tax) gain from the sale of Key's 20% interest in EPS and a $15 million ($9 million after tax) gain from the sale of Key's interest in Concord EFS. Included in noninterest income for the first nine months of last year were branch divestiture gains of $39 million ($22 million after tax). Noninterest expense for the 1999 year-to-date period included special contributions of $23 million ($15 million after tax) made to the charitable foundation that Key sponsors and $27 million ($17 million after tax) of other nonrecurring charges. 29
30 RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income, which is comprised of interest and loan-related fee income less interest expense, is the principal source of earnings for Key. Net interest income is affected by a number of factors including the level, pricing, mix and maturity of earning assets and interest-bearing liabilities (including off-balance sheet instruments described in Note 10, Financial Instruments with Off-Balance Sheet Risk, beginning on page 18), interest rate fluctuations and asset quality. To facilitate comparisons in the following discussion, net interest income is presented on a taxable-equivalent basis, which restates tax-exempt income to an amount that would yield the same after-tax income had the income been subject to taxation at the statutory Federal income tax rate. Various components of the balance sheet and their respective yields and rates which affect interest income and expense are illustrated in Figure 4. The information presented in Figure 5 provides a summary of the effect on net interest income of changes in yields/rates and average balances for the quarterly and year-to-date periods from the same periods in the prior year. A more in-depth discussion of changes in earning assets and funding sources is presented in the Financial Condition section beginning on page 40. In the first quarter of 1999, Key reclassified the distributions on its capital securities (tax-advantaged preferred securities) from noninterest expense to interest expense and restated prior quarters to conform to the current presentation. This was done to allow these instruments to continue to qualify for hedge accounting in accordance with new guidelines issued by the Securities and Exchange Commission in December 1998. As a result of the reclassification, the net interest margin for each of the 1998 quarters presented in Figure 4 was reduced by approximately 10 basis points from that previously reported; a corresponding reduction also occurred in noninterest expense. The capital securities are more fully described in Note 9, Capital Securities, beginning on page 17. As measured using the new classification, net interest income for the third quarter of 1999 was $700 million, up $19 million, or 3%, from the same period last year. This improvement reflected a 7% increase in average earning assets (primarily commercial and consumer loans) to $72.0 billion, that more than offset a 16 basis point reduction in the net interest margin to 3.92%. Compared with the second quarter of 1999, net interest income was up slightly as an annualized 6% increase in average earning assets was largely offset by a 5 basis point decline in the net interest margin. The net interest margin is computed by dividing annualized taxable-equivalent net interest income by average earning assets. The decrease in the margin from both the year-ago and previous quarters was primarily driven by the growth of loans at interest rate spreads narrower than the net interest margin in each of these prior quarters. The narrower spreads were largely the result of greater reliance placed on higher-cost funding to support the incremental increase in loan portfolios. Average earning assets for the third quarter totaled $72.0 billion, which was $4.5 billion, or 7%, higher than the third quarter 1998 level and $1.1 billion, or an annualized 6%, above that of the second quarter of 1999. The growth from the year-ago quarter reflected a $4.2 billion, or 7%, increase in loans with the largest growth coming from the commercial portfolio. The third quarter of 1999 marked the tenth consecutive quarter in which this portfolio has achieved annualized growth exceeding 10%. Also contributing to growth from the third quarter of 1998 were increases in the home equity and lease financing segments of the consumer loan portfolio. The growth in earning assets relative to the prior quarter was also attributable to continued strong commercial loan growth as well as increases in the home equity and consumer lease financing portfolios. Key's strategy with respect to its loan portfolio is discussed in greater detail in the Loans section beginning on page 40. Key uses portfolio interest rate swaps, caps and floors (as defined in Note 10, Financial Instruments with Off-Balance Sheet Risk, beginning on page 18) in the management of its interest rate sensitivity position. The notional amount of such swaps increased to $18.5 billion at September 30, 1999, from $12.4 billion at year-end 1998. Over the same period, the notional amount of interest rate caps and floors decreased by $1.3 billion to $2.6 billion. For the third quarter of 1999, interest rate swaps (including the impact of both the spread on the swap portfolio and the amortization of deferred gains and losses resulting from terminated swaps) and interest rate caps and floors contributed $5 million to net interest income and 3 basis points to the net interest margin. For the same period last year, these instruments increased net interest income by $2 million and the net interest margin by 1 basis point. The manner in which interest rate swaps, caps and floors are used in Key's overall program of asset and liability management is described in the following Market Risk Management section. 30
31 Figure 4 Average Balance Sheets, Net Interest Income and Yields/Rates <TABLE> <CAPTION> THIRD QUARTER 1999 SECOND QUARTER 1999 --------------------------------- ----------------------------------- AVERAGE YIELD/ AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> ASSETS Loans(1,2) Commercial, financial and agricultural $17,978 $ 348 7.66 % $17,479 $ 324 7.43 % Real estate -- commercial mortgage 6,784 141 8.25 7,007 144 8.27 Real estate -- construction 4,190 89 8.46 4,015 81 8.09 Commercial lease financing 6,261 113 7.16 5,889 109 7.39 - ------------------------------------------------------------------------------------------------------------------------------ Total commercial loans 35,213 691 7.78 34,390 658 7.67 Real estate -- residential 4,175 80 7.64 4,546 87 7.71 Credit card 1,302 54 16.45 1,322 49 14.93 Other consumer 19,656 430 8.69 19,232 421 8.77 - ------------------------------------------------------------------------------------------------------------------------------ Total consumer loans 25,133 564 8.92 25,100 557 8.90 Loans held for sale 2,453 50 8.00 2,114 39 7.35 - ------------------------------------------------------------------------------------------------------------------------------ Total loans 62,799 1,305 8.24 61,604 1,254 8.16 Taxable investment securities 471 4 3.47 424 3 3.25 Tax-exempt investment securities(1) 499 10 8.55 560 12 8.63 - ------------------------------------------------------------------------------------------------------------------------------ Total investment securities 970 14 6.09 984 15 6.31 Securities available for sale(1,3) 6,359 106 6.54 6,575 107 6.46 Interest-bearing deposits with banks 43 1 10.25 48 1 10.82 Federal funds sold and securities purchased under resale agreements 751 3 1.66 445 2 1.89 Trading account assets 1,042 13 4.97 1,232 20 6.34 - ------------------------------------------------------------------------------------------------------------------------------ Total short-term investments 1,836 17 3.74 1,725 23 5.32 - ------------------------------------------------------------------------------------------------------------------------------ Total earning assets 71,964 1,442 7.96 70,888 1,399 7.91 Allowance for loan losses (920) (919) Other assets 10,251 10,056 - ------------------------------------------------------------------------------------------------------------------------------ $81,295 $80,025 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $13,274 100 2.97 $13,145 96 2.93 Savings deposits 2,699 11 1.63 2,811 12 1.62 NOW accounts 610 1 1.37 743 3 1.45 Certificates of deposit ($100,000 or more) 4,475 59 5.22 3,737 47 5.07 Other time deposits 12,095 150 4.91 11,811 144 4.90 Deposits in foreign office 776 10 4.99 1,096 13 4.75 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing deposits 33,929 331 3.87 33,343 315 3.79 Federal funds purchased and securities sold under repurchase agreements 4,495 51 4.49 5,479 63 4.59 Bank notes and other short-term borrowings 7,428 103 5.50 6,786 88 5.22 Long-term debt, including capital securities(4) 17,069 248 5.79 16,530 229 5.57 - ------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing liabilities 62,921 733 4.62 62,138 695 4.48 Noninterest-bearing deposits 8,534 8,438 Other liabilities 3,561 3,264 Common shareholders' equity 6,279 6,185 - ------------------------------------------------------------------------------------------------------------------------------ $81,295 $80,025 ======= ======= Interest rate spread (TE) 3.34 3.43 - ------------------------------------------------------------------------------------------------------------------------------ Net interest income (TE) and net interest margin (TE) $ 709 3.92 % $704 3.97 % ====== ======== ==== ========== Capital securities $ 1,205 $ 22 $ 1,162 $ 21 Taxable-equivalent adjustment(1) 9 7 - ------------------------------------------------------------------------------------------------------------------------------ </TABLE> (1) 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%. (2) For purposes of these computations, nonaccrual loans are included in average loan balances. (3) Yield is calculated on the basis of amortized cost. (4) Rate calculation excludes ESOP debt. TE = Taxable Equivalent 31
32 Figure 4 Average Balance Sheets, Net Interest Income and Yields/Rates <TABLE> <CAPTION> FIRST QUARTER 1999 FOURTH QUARTER 1998 -------------------------------- ---------------------------------- AVERAGE YIELD/ AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE BALANCE INTEREST RATE - ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> ASSETS Loans (1,2) Commercial, financial and agricultural $16,994 $ 314 7.49 % $16,711 $ 326 7.74 % Real estate -- commercial mortgage 7,176 148 8.36 7,394 158 8.48 Real estate -- construction 3,651 73 8.11 3,355 71 8.40 Commercial lease financing 5,723 103 7.30 5,241 100 7.57 - ---------------------------------------------------------------------------------------------------------------------- Total commercial loans 33,544 638 7.71 32,701 655 7.95 Real estate -- residential 4,868 91 7.58 5,174 99 7.59 Credit card 1,377 49 14.43 1,388 52 14.86 Other consumer 19,485 432 8.99 18,682 421 8.94 - ---------------------------------------------------------------------------------------------------------------------- Total consumer loans 25,730 572 9.02 25,244 572 8.99 Loans held for sale 2,419 44 7.38 2,711 54 7.90 - ---------------------------------------------------------------------------------------------------------------------- Total loans 61,693 1,254 8.24 60,656 1,281 8.38 Taxable investment securities 375 4 4.33 334 2 3.53 Tax-exempt investment securities(1) 615 13 8.57 668 15 8.91 - ---------------------------------------------------------------------------------------------------------------------- Total investment securities 990 17 6.96 1,002 17 6.73 Securities available for sale(1,3) 6,004 97 6.58 6,066 99 6.47 Interest-bearing deposits with banks 22 1 14.13 25 -- 13.66 Federal funds sold and securities purchased under resale agreements 749 5 2.71 1,102 11 3.96 Trading account assets 1,204 15 5.05 620 11 7.04 - ---------------------------------------------------------------------------------------------------------------------- Total short-term investments 1,975 21 4.31 1,747 22 5.00 - ---------------------------------------------------------------------------------------------------------------------- Total earning assets 70,662 1,389 7.97 69,471 1,419 8.10 Allowance for loan losses (888) (888) Other assets 10,084 10,385 - ---------------------------------------------------------------------------------------------------------------------- $79,858 $78,968 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $12,540 94 3.04 $12,152 98 3.20 Savings deposits 2,899 12 1.68 2,983 11 1.46 NOW accounts 1,210 4 1.34 1,205 5 1.65 Certificates of deposit ($100,000 or more) 3,646 46 5.12 3,816 52 5.41 Other time deposits 11,814 147 5.05 11,916 156 5.19 Deposits in foreign office 509 6 4.78 366 5 5.01 - ---------------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 32,618 309 3.84 32,438 327 4.00 Federal funds purchased and securities sold under repurchase agreements 5,077 54 4.31 5,205 61 4.65 Bank notes and other short-term borrowings 9,208 119 5.24 10,171 140 5.46 Long-term debt, including capital securities(4) 15,172 214 5.73 13,262 196 5.86 - ---------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 62,075 696 4.55 61,076 724 4.70 Noninterest-bearing deposits 8,495 8,810 Other liabilities 3,188 3,057 Common shareholders' equity 6,100 6,025 - ---------------------------------------------------------------------------------------------------------------------- $79,858 $78,968 ======= ======= Interest rate spread (TE) 3.42 3.40 - ---------------------------------------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $ 693 3.95 % $ 695 3.99 % ===== ========= ===== ========= Capital securities $ 1,039 $ 19 $ 997 $ 18 Taxable-equivalent adjustment(1) 8 8 <CAPTION> THIRD QUARTER 1998 ----------------------------------- AVERAGE YIELD/ dollars in millions BALANCE INTEREST RATE - --------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Loans (1,2) Commercial, financial and agricultural $15,815 $ 328 8.23 % Real estate -- commercial mortgage 7,034 160 9.02 Real estate -- construction 3,052 69 8.97 Commercial lease financing 4,933 90 7.24 - --------------------------------------------------------------------------------------- Total commercial loans 30,834 647 8.32 Real estate -- residential 5,274 102 7.67 Credit card 1,432 53 14.68 Other consumer 17,423 399 9.09 - --------------------------------------------------------------------------------------- Total consumer loans 24,129 554 9.11 Loans held for sale 3,596 75 8.27 - --------------------------------------------------------------------------------------- Total loans 58,559 1,276 8.64 Taxable investment securities 269 3 4.05 Tax-exempt investment securities(1) 726 15 8.20 - --------------------------------------------------------------------------------------- Total investment securities 995 18 7.18 Securities available for sale(1,3) 6,175 105 6.75 Interest-bearing deposits with banks 35 1 14.32 Federal funds sold and securities purchased under resale agreements 951 12 5.01 Trading account assets 742 11 5.88 - --------------------------------------------------------------------------------------- Total short-term investments 1,728 24 5.51 - --------------------------------------------------------------------------------------- Total earning assets 67,457 1,423 8.37 Allowance for loan losses (888) Other assets 9,317 - --------------------------------------------------------------------------------------- $75,886 ======= LIABILITIES AND SHAREHOLDERS' EQUITY Money market deposit accounts $11,783 99 3.33 Savings deposits 3,118 14 1.78 NOW accounts 1,160 5 1.71 Certificates of deposit ($100,000 or more) 3,399 47 5.49 Other time deposits 11,965 161 5.34 Deposits in foreign office 954 13 5.41 - --------------------------------------------------------------------------------------- Total interest-bearing deposits 32,379 339 4.15 Federal funds purchased and securities sold under repurchase agreements 7,456 99 5.27 Bank notes and other short-term borrowings 7,305 108 5.87 Long-term debt, including capital securities(4) 12,026 188 6.20 - --------------------------------------------------------------------------------------- Total interest-bearing liabilities 59,166 734 4.92 Noninterest-bearing deposits 8,485 Other liabilities 2,724 Common shareholders' equity 5,511 - --------------------------------------------------------------------------------------- $75,886 Interest rate spread (TE) 3.45 - --------------------------------------------------------------------------------------- Net interest income (TE) and net interest margin (TE) $ 689 4.08 % ===== ==== Capital securities $ 997 $ 19 Taxable-equivalent adjustment(1) 8 - --------------------------------------------------------------------------------------- </TABLE> - -------------------------------------------------------------------------------- (1) 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%. (2) For purposes of these computations, nonaccrual loans are included in average loan balances. (3) Yield is calculated on the basis of amortized cost. (4) Rate calculation excludes ESOP debt. TE = Taxable Equivalent 32
33 Figure 5 Components of Net Interest Income Changes <TABLE> <CAPTION> FROM THREE MONTHS ENDED SEPTEMBER 30, 1998, FROM NINE MONTHS ENDED SEPTEMBER 30, 1998, TO THREE MONTHS ENDED SEPTEMBER 30, 1999 TO NINE MONTHS ENDED SEPTEMBER 30, 1999 ------------------------------------------- ------------------------------------------ AVERAGE YIELD/ NET AVERAGE YIELD/ NET in millions VOLUME RATE CHANGE VOLUME RATE CHANGE - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> INTEREST INCOME Loans $90 $(61) $29 $358 $(210) $148 Taxable investment securities 2 (1) 1 5 (4) 1 Tax-exempt investment securities (5) -- (5) (18) 1 (17) Securities available for sale 3 (2) 1 (24) (17) (41) Short-term investments 1 (8) (7) 13 (14) (1) - ------------------------------------------------------------------------------------------------------------------------------------ Total interest income (taxable equivalent) 91 (72) 19 334 (244) 90 INTEREST EXPENSE Money market deposit accounts 12 (11) 1 35 (29) 6 Savings deposits (2) (1) (3) (7) (6) (13) NOW accounts (2) (2) (4) (4) (3) (7) Certificates of deposit ($100,000 or more) 14 (2) 12 21 (11) 10 Other time deposits 2 (13) (11) (17) (40) (57) Deposits in foreign office (2) (1) (3) (11) (5) (16) - ------------------------------------------------------------------------------------------------------------------------------------ Total interest-bearing deposits 22 (30) (8) 17 (94) (77) Federal funds purchased and securities sold under repurchase agreements (35) (13) (48) (75) (38) (113) Bank notes and other short-term borrowings 2 (7) (5) 24 (34) (10) Long-term debt, including capital securities 74 (14) 60 249 (42) 207 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest expense 63 (64) (1) 215 (208) 7 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income (taxable equivalent) $28 $ (8) $20 $119 $ (36) $ 83 === ==== === ==== ===== ==== - ------------------------------------------------------------------------------------------------------------------------------------ </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. MARKET RISK MANAGEMENT Market risk is the exposure to economic loss that arises from changes in the values of certain market risk sensitive instruments. Types of market risk include interest rate, foreign exchange and equity price risk (the risk of economic loss related to equity securities held as assets). Foreign exchange and equity price risk are not material to Key. Asset and Liability Management - ------------------------------ Key manages its interest rate risk through an active program of asset and liability management pursuant to guidelines established by its Asset/Liability Management Policy Committee ("ALCO"). The ALCO has responsibility for approving the asset/liability management policies of Key, overseeing the formulation and implementation of strategies to improve balance sheet positioning and/or earnings, and reviewing Key's interest rate sensitivity position. Measurement of Short-term Interest Rate Exposure: The primary tool utilized by management to measure and manage interest rate risk is a net interest income simulation model. Use of the model to perform simulations of changes in interest rates over one- and two-year time horizons has enabled management to develop strategies for managing exposure to interest rate risk. In its simulations, management estimates the impact on net interest income of various pro forma changes in the overall level of interest rates. These estimates are based on a large number of assumptions related to loan and deposit growth, asset and liability prepayments, interest rates, on- and off-balance sheet management strategies and other factors. Management believes that both individually and in the aggregate these assumptions are reasonable, but the complexity of the simulation modeling process results in a sophisticated estimate, not a precise calculation of exposure. The ALCO guidelines provide that a gradual 200 basis point increase or decrease in short-term rates over the next twelve-month period should not result in more than a 2% impact on net interest income over the same period from what net interest income would have been if such interest rates did not change. As of September 30, 1999, based on the results of the simulation model using the ALCO guidelines, Key would expect its net interest income to increase by approximately $35 million if short-term interest rates gradually decrease. Conversely, if short-term interest rates gradually increase, net interest income would be expected to decrease by approximately $29 million. 33
34 Measurement of Long-term Interest Rate Exposure: Short-term interest rate risk analysis is complemented by an economic value of equity model. This model provides the added benefit of measuring exposure to interest rate changes outside the one- to two-year time frame measured by the simulation model. The economic value of Key's equity is determined by modeling the net present value of future cash flows for asset, liability and off-balance sheet positions based on the implied forward yield curve. Economic value analysis has several limitations including: the economic values of asset, liability and off-balance sheet positions do not represent the true fair values of the positions, since they do not consider factors such as credit risk and liquidity; the use of estimates of cash flows is necessary for assets and liabilities with indeterminate maturities; the future structure of the balance sheet derived from ongoing loan and deposit activity by Key's core businesses is not factored into present value calculations; and the analysis requires assumptions about events that span an even longer time frame than that used in the simulation model. Despite its limitations, the economic value of equity model does provide management with a relatively sophisticated tool for evaluating the longer term effect of possible interest rate movements. The ALCO guidelines provide that an immediate 200 basis point increase or decrease in interest rates should not result in more than a 1.75% change in the ratio of base case economic value of equity to the sum of base case economic value of assets and net fixed rate interest rate swaps, caps and floors. Key has been operating well within these guidelines. Other Sources of Interest Rate Exposure: Key utilizes the results of its short-term and long-term interest rate exposure models to formulate strategies to improve balance sheet positioning and/or earnings within interest rate risk, liquidity and capital guidelines established by the ALCO. In addition to the interest rate exposure measured using ALCO guidelines, the risk to earnings and economic value arising from various other pro forma changes in the overall level of interest rates is periodically measured. The variety of interest rate scenarios modeled, and their potential impact on earnings and economic value, quantifies the level of interest rate exposure arising from several sources, namely option risk, basis risk and gap risk. Option risk exists in the form of options (including caps and floors) embedded in certain products. These options permit the client (either a loan client or a depositor) to take advantage of changes in interest rates without penalty. Examples include floating-rate loans that contain an interest rate cap, fixed-rate loans that do not contain prepayment penalties and deposits that can be withdrawn on demand. Basis risk refers to floating-rate assets and floating-rate liabilities that reprice simultaneously, but are tied to different indices. Basis risk arises when one index does not move consistently with another. Gap risk is the risk that assets, liabilities or related interest rate swaps, caps and floors will mature or reprice in different time frames. For example, floating-rate loans that reprice monthly may be funded with fixed-rate certificates of deposit that mature in one year. Management of Interest Rate Exposure: To manage interest rate risk, management uses interest rate swaps, caps and floors to modify the repricing or maturity characteristics of specified on-balance sheet assets and liabilities. Instruments used for this purpose are designated as portfolio swaps, caps and floors. The decision to use these instruments versus on-balance sheet alternatives depends on various factors, including the mix and cost of funding sources, liquidity and capital requirements. Further details pertaining to portfolio swaps, caps and floors are included in Note 10, Financial Instruments with Off-Balance Sheet Risk, beginning on page 18. In addition, management strategically selects the interest sensitivity structure of additions to Key's securities portfolio, new debt issuances and loan securitizations in light of interest rate risk management objectives. Portfolio Swaps, Caps and Floors: As shown in Note 10, the estimated fair value of Key's portfolio swaps, caps and floors decreased to ($1) million at September 30, 1999, from a fair value of $156 million at December 31, 1998. The decrease in fair value over the past nine months reflected the combined impact of a number of factors, including the increase in interest rates, the steepening of the implied forward yield curve, and the fact that Key's receive fixed interest rate swap portfolio has a slightly longer average remaining maturity than the pay fixed portfolio. Swaps with a notional amount of $3.2 billion were terminated during the first nine months of 1999, resulting in a deferred gain of $12 million. Further information pertaining to the balance and remaining amortization period of Key's deferred swap gains and losses at September 30, 1999, is also presented in Note 10. Each swap termination was made in response to a unique set of circumstances and for various reasons; however, the decision to terminate any swap contract is integrated strategically with asset and liability management and other appropriate processes. Key from time to time uses portfolio caps in response to heavier reliance placed on variable rate funding to support earning asset growth. These instruments are used primarily to protect against the adverse impact that a future rise in interest rates could have on variable rate short-term borrowings, while having no impact in the event of a decline in rates. Portfolio swaps, caps and floors activity for the nine-month period ended September 30, 1999, is summarized in Figure 6. 34
35 Figure 6 Portfolio Swaps, Caps and Floors Activity <TABLE> <CAPTION> RECEIVE FIXED -------------------------------- PAY FIXED- INDEXED PAY FIXED- FORWARD- BASIS in millions AMORTIZING CONVENTIONAL CONVENTIONAL STARTING SWAPS - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> BALANCE AT DECEMBER 31, 1998 $311 $4,325 $4,872 $ 10 $2,872 Additions -- 3,821 1,004 882 7,237 Maturities -- 1,289 1,517 -- 700 Terminations -- 895 621 636 1,001 Forward-starting becoming effective -- -- 108 (108) -- Amortization 179 -- -- -- -- - ---------------------------------------------------------------------------------------------------------------------------------- BALANCE AT September 30, 1999 $132 $5,962 $3,846 $148 $8,408 ==== ====== ====== ==== ====== - ---------------------------------------------------------------------------------------------------------------------------------- <CAPTION> TOTAL CAPS PORTFOLIO AND in millions SWAPS FLOORS TOTAL - --------------------------------------------------------------------------------- <S> <C> <C> <C> BALANCE AT DECEMBER 31, 1998 $12,390 $3,875 $16,265 Additions 12,944 115 13,059 Maturities 3,506 1,425 4,931 Terminations 3,153 -- 3,153 Forward-starting becoming effective -- -- -- Amortization 179 -- 179 - --------------------------------------------------------------------------------- BALANCE AT September 30, 1999 $18,496 $2,565 $21,061 ======= ====== ======= - --------------------------------------------------------------------------------- </TABLE> A summary of the notional amount and fair values of portfolio swaps, caps and floors by interest rate management strategy is presented in Figure 7. The fair value at any given date represents the estimated income (if positive) or cost (if negative) that would be recognized if the portfolios were to be liquidated at that date. However, because these instruments are used to alter the repricing or maturity characteristics of specific assets and liabilities, the net unrealized gains and losses are not recognized in earnings. Interest from these swaps, caps and floors is recognized on an accrual basis as an adjustment of the interest income or expense from the asset or liability being managed. Figure 7 Portfolio Swaps, Caps and Floors by Interest Rate Management Strategy <TABLE> <CAPTION> SEPTEMBER 30, 1999 DECEMBER 31, 1998 SEPTEMBER 30, 1998 -------------------- --------------------- --------------------- NOTIONAL FAIR NOTIONAL FAIR NOTIONAL FAIR in millions AMOUNT VALUE AMOUNT VALUE AMOUNT VALUE - ------------------------------------------------------------------------------------------------------------- --------------------- <S> <C> <C> <C> <C> <C> <C> Convert variable rate loans to fixed $ 1,282 $(6) $ 1,526 $ 58 $ 2,182 $ 75 Convert fixed rate loans to variable 642 9 909 (38) 899 (52) Convert fixed rate securities to variable 322 11 -- -- -- -- Convert variable rate deposits and short-term borrowings to fixed 1,150 5 2,378 (24) 2,430 (37) Convert fixed rate deposits and short-term borrowings to variable 226 (3) 200 -- -- -- Convert variable rate long-term debt to fixed 1,880 29 1,595 (6) 700 (13) Convert fixed rate long-term debt to variable 4,586 (48) 2,910 169 2,410 205 Basis swaps - foreign currency denominated debt 321 (9) 304 19 304 19 Basis swaps - interest rate indices 8,087 6 2,568 -- 1,500 -- - ------------------------------------------------------------------------------------------------------------- --------------------- Total portfolio swaps 18,496 (6) 12,390 178 10,425 197 Modify characteristics of variable rate short-term borrowings 2,050 4 3,060 2 3,530 -- Modify characteristics of variable rate long-term debt 515 1 565 -- 565 -- Modify characteristics of capital securities remarketing -- -- 250 (24) 250 (26) - ------------------------------------------------------------------------------------------------------------- --------------------- Total portfolio caps and floors 2,565 5 3,875 (22) 4,345 (26) - ------------------------------------------------------------------------------------------------------------- --------------------- Total portfolio swaps, caps and floors $21,061 $(1) $16,265 $156 $14,770 $171 ======= === ======= ==== ======= ==== - ------------------------------------------------------------------------------------------------------------- --------------------- </TABLE> The expected average maturities of the portfolio swaps, caps and floors at September 30, 1999, are summarized in Figure 8. Figure 8 Expected Average Maturities of Portfolio Swaps, Caps and Floors <TABLE> <CAPTION> SEPTEMBER 30, 1999 RECEIVE FIXED ----------------------------- PAY FIXED- INDEXED PAY FIXED- FORWARD- BASIS in millions AMORTIZING CONVENTIONAL CONVENTIONAL STARTING SWAPS - ---------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Mature in one year or less $132 $1,940 $ 536 -- $4,505 Mature after one through five years -- 2,440 2,555 $108 3,903 Mature after five through ten years -- 982 379 1 -- Mature after ten years -- 600 376 39 -- - ---------------------------------------------------------------------------------------------------------------------------- Total portfolio swaps, caps and floors $132 $5,962 $3,846 $148 $8,408 ==== ====== ====== ==== ====== - ---------------------------------------------------------------------------------------------------------------------------- <CAPTION> September 30, 1999 TOTAL CAPS PORTFOLIO AND in millions SWAPS FLOORS TOTAL - -------------------------------------------------------------------------------------------- <S> <C> <C> <C> Mature in one year or less $ 7,113 $1,950 $ 9,063 Mature after one through five years 9,006 615 9,621 Mature after five through ten years 1,362 -- 1,362 Mature after ten years 1,015 -- 1,015 - -------------------------------------------------------------------------------------------- Total portfolio swaps, caps and floors $18,496 $2,565 $21,061 ======= ====== ======= - -------------------------------------------------------------------------------------------- </TABLE> Trading Portfolio Risk Management - --------------------------------- Key's trading portfolio includes interest rate swap contracts entered into to accommodate the needs of its clients, and other positions with third parties that are intended to mitigate the interest rate risk of the client positions, foreign exchange contracts entered into to accommodate the needs of its clients and financial assets and liabilities (trading positions) included in other assets and other liabilities, respectively, on the balance sheet. Further information pertaining 35
36 to off-balance sheet contracts is included in Note 10, Financial Instruments with Off-Balance Sheet Risk, beginning on page 18. Key uses a value at risk ("VAR") model to estimate the adverse effect of changes in interest and foreign exchange rates on the fair value of its trading portfolio. VAR uses statistical methods to estimate the maximum potential one-day loss with a 95% confidence level. At September 30, 1999, Key's aggregate daily VAR was $1 million and averaged $1.6 million for the first nine months of 1999. As of September 30, 1998, Key's aggregate daily VAR was $.3 million and averaged $.6 million for the first nine months of 1998. VAR augments other controls used by Key to mitigate the market risk exposure of its trading portfolio. These controls are established by Key's Financial Markets Committee and include, in addition to VAR, loss and position equivalent limits which are based on the level of activity and volatility of trading products and market liquidity. NONINTEREST INCOME As shown in Figure 9, noninterest income for the third quarter of 1999 totaled $489 million, up $97 million, or 25%, from the same period last year. Included in third quarter 1999 results was a $13 million gain from the sale of Key's interest in a joint venture with Compaq. Excluding this gain and net securities gains of $2 million in the current year, noninterest income increased by $82 million, or 21%, and comprised 40% of total revenue for the quarter, up from 36% a year-ago. Strong increases in income from trust and asset management (up $30 million) and insurance and brokerage (up $24 million) were principally due to the impact of the October 1998 acquisition of McDonald. Investment banking and capital markets income contributed $15 million to the increase from the year-ago quarter, but was $23 million below that reported for the second quarter of 1999, due to weaker conditions in the financial markets served by Key. Noninterest income for the third quarter of 1999 also benefited from $32 million of net loan securitization gains compared with $7 million for the same period last year. Approximately $16 million of the current year gains resulted from the securitization and sale of $743 million of education loans previously scheduled for the fourth quarter of 1999. Key accelerated the education loan securitizations as part of a strategy to reduce its need for funding transactions in the fourth quarter, when they could possibly be influenced by millenium-induced fears. The increase in noninterest income relative to the 1998 third quarter was moderated somewhat by a $21 million decline in loan sale gains, due in part to the increase in interest rates that has occurred over the past year. Additional detail pertaining to investment banking and capital markets income, and trust income and assets is presented in Figures 10 and 11, respectively. Figure 9 Noninterest Income <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, ---------------------- --------------------- ---------------------- dollars in millions 1999 1998 AMOUNT PERCENT 1999 1998 - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Trust and asset management income $112 $ 82 $30 36.6 % $ 328 $ 239 Service charges on deposit accounts 83 77 6 7.8 246 230 Investment banking and capital markets income 77 62 15 24.2 243 159 Insurance and brokerage income 46 22 24 109.1 162 68 Corporate owned life insurance income 25 25 -- N/M 76 72 Credit card fees 16 18 (2) (11.1) 47 50 Net loan securitization gains 32 7 25 357.1 82 7 Net securities gains 2 -- 2 N/M 26 4 Gains from branch divestitures -- -- -- -- -- 39 Gains from other divestitures 13 -- 13 N/M 161 23 Other income: Letter of credit and loan fees 25 20 5 25.0 69 51 Electronic banking fees 16 12 4 33.3 42 33 Loan securitization servicing fees 6 7 (1) (14.3) 21 25 Mortgage banking income -- 1 (1) (100.0) 2 4 Gains from sales of loans 3 24 (21) (87.5) 25 44 Miscellaneous income 33 35 (2) (5.7) 94 80 - ------------------------------------------------------------------------------------------------------------------------ Total other income 83 99 (16) (16.2) 253 237 - ------------------------------------------------------------------------------------------------------------------------ Total noninterest income $489 $392 $97 24.7 % $1,624 $1,128 ==== ==== === ====== ====== - ------------------------------------------------------------------------------------------------------------------------ <CAPTION> CHANGE ----------------------- dollars in millions AMOUNT PERCENT - --------------------------------------------------------------------- <S> <C> <C> Trust and asset management income $ 89 37.2 % Service charges on deposit accounts 16 7.0 Investment banking and capital markets income 84 52.8 Insurance and brokerage income 94 138.2 Corporate owned life insurance income 4 5.6 Credit card fees (3) (6.0) Net loan securitization gains 75 1,071.4 Net securities gains 22 550.0 Gains from branch divestitures (39) (100.0) Gains from other divestitures 138 600.0 Other income: Letter of credit and loan fees 18 35.3 Electronic banking fees 9 27.3 Loan securitization servicing fees (4) (16.0) Mortgage banking income (2) (50.0) Gains from sales of loans (19) (43.2) Miscellaneous income 14 17.5 - --------------------------------------------------------------------- Total other income 16 6.8 - --------------------------------------------------------------------- Total noninterest income $496 44.0 % ==== - --------------------------------------------------------------------- </TABLE> For the first nine months of 1999, noninterest income totaled $1.6 billion, up $496 million, or 44%, from the comparable 1998 period. Included in 1999 results were gains of $13 million from the third quarter sale of Key's interest in a joint venture with Compaq, $15 million from the second quarter sale of Key's interest in Concord EFS (included in net securities gains) and $134 million from the sale of Key's interest in EPS in the first quarter. Excluding these gains, branch divestiture gains of $39 million recorded during the first half of 1998 and net securities gains in both years, noninterest income grew by $366 million, or 34%. Bolstered by the McDonald acquisition, the year-to-date increase was due principally to the growth in income from insurance and brokerage (up $94 million), trust and asset management 36
37 (up $89 million) and investment banking and capital markets (up $84 million). The $75 million increase in net loan securitization gains resulted from the securitization and sale of $3.2 billion of consumer loans during the first nine months of 1999. The volume of securitizations reflected Key's desire to diversify its funding sources, as well as the acceleration of the education loan securitization originally planned for the fourth quarter. In addition, some securitizations previously planned for the 1998 fourth quarter had been delayed due to the volatility experienced in the capital markets at that time. Figure 10 Investment Banking and Capital Markets Income <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, CHANGE -------------------------- ----------------------- dollars in millions 1999 1998 AMOUNT PERCENT - ----------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Dealer trading and derivatives income $28 $17 $11 64.7 % Investment banking income 28 32 (4) (12.5) Equity capital income 13 7 6 85.7 Foreign exchange income 8 6 2 33.3 - ----------------------------------------------------------------------------------------------------------------------- Total investment banking and capital markets income $77 $62 $15 24.2 % === === === - ----------------------------------------------------------------------------------------------------------------------- <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE -------------------------- ------------------------ dollars in millions 1999 1998 AMOUNT PERCENT - -------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Dealer trading and derivatives income $ 99 $ 55 $44 80.0 % Investment banking income 92 47 45 95.7 Equity capital income 31 41 (10) (24.4) Foreign exchange income 21 16 5 31.3 - -------------------------------------------------------------------------------------------------------------------- Total investment banking and capital markets income $243 $159 $84 52.8 % ==== ==== === - -------------------------------------------------------------------------------------------------------------------- </TABLE> Figure 11 Trust and Asset Management <TABLE> <CAPTION> THREE MONTHS ENDED SEPTEMBER 30, CHANGE ------------------------------ -------------------------- dollars in millions 1999 1998 AMOUNT PERCENT - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Personal asset management and custody fees $ 48 $ 42 $ 6 14.3 % Institutional asset management and custody fees 22 23 (1) (4.3) Bond services 7 -- 7 N/M All other fees 35 17 18 105.9 - ------------------------------------------------------------------------------------------------------------------------------ Total trust and asset management income $112 $ 82 $30 36.6 % ==== ==== === dollars in billions - --------------------------------------------------------------------------------------------------------------------------- SEPTEMBER 30, Discretionary assets $ 67 $ 63 $ 4 6.3 % Non-discretionary assets 48 44 4 9.1 - --------------------------------------------------------------------------------------------------------------------------- Total trust assets $115 $107 $ 8 7.5 % ==== ==== === - ------------------------------------------------------------------------------------------------------------------------------ <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, CHANGE ------------------------------ ----------------------- dollars in millions 1999 1998 AMOUNT PERCENT - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Personal asset management and custody fees $141 $123 $18 14.6 % Institutional asset management and custody fees 70 66 4 6.1 Bond services 19 -- 19 N/M All other fees 98 50 48 96.0 - ------------------------------------------------------------------------------------------------------------------------ Total trust and asset management income $328 $239 $89 37.2 % ==== ==== === </TABLE> N/M=Not Meaningful NONINTEREST EXPENSE As shown in Figure 12, noninterest expense for the third quarter of 1999 totaled $701 million, compared with $628 million for the third quarter of 1998. During the first quarter of 1999, Key reclassified the distributions on its tax-advantaged preferred securities from noninterest expense to interest expense and restated prior quarters to conform to the current presentation. This was done to allow these instruments to continue to qualify for hedge accounting in accordance with new guidelines issued by the Securities and Exchange Commission in December 1998. The distributions on these securities totaled $22 million and $19 million in the third quarter of 1999 and 1998, respectively. The increase in total noninterest expense from the year-ago quarter came largely from a $39 million increase in personnel costs, due primarily to the McDonald acquisition completed in October 1998. Further information pertaining to the McDonald transaction is disclosed in Note 3, Mergers, Acquisitions and Divestitures, beginning on page 8. In addition, computer-processing expense rose by $14 million due principally to a higher level of computer software amortization and marketing expense was up $10 million as a result of higher advertising costs. The increase in personnel expense was moderated by a $21 million reduction in stock-based compensation as a result of the lower KeyCorp stock price. For the first nine months of 1999, noninterest expense totaled $2.2 billion, up $350 million, or 19%, from the same period last year. In light of the gains realized from the sales of Concord EFS and EPS, in 1999 Key made $23 million of special contributions to the charitable foundation that it sponsors. Excluding these contributions and $27 million of other nonrecurring charges recorded during the current year, noninterest expense grew by $300 million, or 17%. This reflected higher costs associated with personnel expense (up $194 million), computer processing expense (up $46 million), equipment expense (up $14 million) and intangibles amortization (up $12 million). Key's management is currently in the process of evaluating several initiatives designed to reduce Key's operating costs. Among these initiatives are the potential outsourcing of certain nonstrategic support functions (which may result in the write-off of selected assets, including certain software); the proposed sale of Key's credit card portfolio; site consolidations in a number of Key's businesses; and the potential sale and leaseback of most of Key's real estate holdings. It is possible 37
38 that as a result of the evaluation, Key will incur a number of special charges; the amounts and timing of any such possible charges would be determined upon conclusion of the evaluation, although some may be incurred in the fourth quarter of 1999. Included in noninterest expense for the third quarter of 1999 was $1 million ($5 million in the third quarter of 1998) of expense incurred in connection with efforts being undertaken by Key to modify computer information systems to be Year 2000 compliant. For the first nine months of the year, these expenses totaled $9 million ($17 million for the first nine months of 1998). Further information pertaining to the Year 2000 issue and the status of Key's efforts to address it is included under the "Year 2000" heading below. The efficiency ratio, which provides a measure of the extent to which recurring revenues are used to pay operating expenses, was 58.61% for the third quarter, compared with 59.26% for the second quarter of 1999 and 58.09% for the third quarter of 1998. The increase in the ratio over the past year was due primarily to the impact of the October 1998 acquisition of McDonald. This ratio has improved, however, for two consecutive quarters reflecting an increase in core revenue in the second quarter and the effective management of expenses. Included in other expense are equity- and gross receipts-based taxes that are assessed in lieu of an income tax in certain states in which Key operates. These taxes, which are shown in Figure 12, represented 75, 74 and 82 basis points of Key's efficiency ratio for the third quarter of 1999, the second quarter of 1999 and the third quarter of 1998, respectively. The extent to which such taxes impact the level of noninterest expense will vary among companies based on the geographic locations in which they conduct their business. Figure 12 Noninterest Expense <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, CHANGE SEPTEMBER 30, ------------------------- ----------------------- ------------------------- dollars in millions 1999 1998 AMOUNT PERCENT 1999 1998 - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Personnel $356 $317 $39 12.3 % $1,111 $ 913 Net occupancy 58 58 -- -- 175 170 Equipment 48 46 2 4.3 153 134 Computer processing 60 46 14 30.4 173 127 Marketing 35 25 10 40.0 84 81 Amortization of intangibles 25 22 3 13.6 79 67 Professional fees 18 14 4 28.6 50 46 Other expense: Postage and delivery 17 17 -- -- 54 54 Telecommunications 14 13 1 7.7 42 40 Equity- and gross receipts- based taxes 9 9 -- -- 26 27 Miscellaneous 61 61 -- -- 219 157 - ------------------------------------------------------------------------------------------------------------------------------------ Total other expense 101 100 1 1.0 341 278 - ------------------------------------------------------------------------------------------------------------------------------------ Total noninterest expense $701 $628 $73 11.6 % $2,166 $1,816 ==== ==== === ====== ====== Full-time equivalent employees at period end 25,523 24,586 25,523 24,586 Efficiency ratio(1) 58.61 % 58.09 % 59.36 % 58.43 % Overhead ratio(2) 30.18 34.25 31.10 36.13 - ------------------------------------------------------------------------------------------------------------------------------------ <CAPTION> CHANGE -------------------------- dollars in millions AMOUNT PERCENT - ------------------------------------------------------------------------------- <S> <C> <C> Personnel $198 21.7 % Net occupancy 5 2.9 Equipment 19 14.2 Computer processing 46 36.2 Marketing 3 3.7 Amortization of intangibles 12 17.9 Professional fees 4 8.7 Other expense: Postage and delivery -- -- Telecommunications 2 5.0 Equity- and gross receipts- based taxes (1) (3.7) Miscellaneous 62 39.5 - ------------------------------------------------------------------------------- Total other expense 63 22.7 - ------------------------------------------------------------------------------- Total noninterest expense $350 19.3 % ==== </TABLE> (1) Calculated as noninterest expense (excluding certain nonrecurring charges) divided by taxable-equivalent net interest income plus noninterest income (excluding net securities transactions and gains from certain divestitures). (2) Calculated as noninterest expense (excluding certain nonrecurring charges) less noninterest income (excluding net securities transactions and gains from certain divestitures) divided by taxable-equivalent net interest income. Year 2000 - --------- During the first nine months of 1999, Key continued its efforts to prepare its systems to be Year 2000 compliant. The Year 2000 issue refers to the fact that many computer systems were originally programmed using two digits rather than four digits to identify the applicable year. Therefore, when the year 2000 occurs, these systems could interpret the year as 1900 rather than 2000. Unless hardware, software and systems applications are corrected to be Year 2000 compliant, computers and the devices they control could generate miscalculations and create operational problems. Various systems could be affected ranging from complex computer systems to telephone systems, ATMs and elevators. To address this issue, Key developed an extensive plan in 1995, including the formation of a team consisting of internal resources and third-party experts. The plan has been in implementation since that time and consists of five major phases: awareness-ensuring a common understanding of the issue throughout Key; assessment-identifying and prioritizing the systems and third parties with whom Key has exposure to Year 2000 issues; renovation-enhancing, replacing or retiring hardware, software and systems applications; validation-testing modifications made; and 38
39 implementation-certifying Year 2000 compliance and user understanding and acceptance. At September 30, 1999, Key has completed all of the major phases (including readiness testing) and all other tasks for which regulatory deadlines have been established. As a financial institution, Key may experience increases in problem loans and credit losses in the event that borrowers fail to properly respond to this issue. In addition, financial institutions may incur higher funding costs if consumers react to publicity about the issue by withdrawing deposits. They also could be impacted if third parties they deal with in conducting their business, such as foreign banks, governmental agencies, clearing houses, telephone companies and other service providers fail to properly address this issue. Key formed a separate internal team charged with the task of identifying critical business interfaces; assessing potential problems relating to credit, liquidity and counterparty risk; and where appropriate, developing contingency plans. This team has been surveying significant credit clients to determine their Year 2000 readiness and to evaluate the level of potential credit risk to Key. Based on the information obtained, specific follow-up programs have been established and the adequacy of the allowance for loan losses is being assessed on an ongoing basis. The results of the assessment are being reflected in the assignment of an appropriate risk rating in Key's loan grading system. On an ongoing basis, Key is also contacting other significant parties with which it conducts business to determine the status of their Year 2000 compliance efforts. Despite the actions taken by Key, there can be no assurance that significant clients or other critical parties will adequately address their Year 2000 issues. Consequently, Key has developed contingency plans to help mitigate the risks associated with potential delays in completing the renovation, validation and implementation phases of its Year 2000 plan, as well as the potential failure of external parties to adequately address their Year 2000 issues. In accordance with regulatory guidelines, these plans had been completed as of June 30, 1999, and address primarily contingency solutions for Key's core systems and the identification of alternative business partners. As part of the contingency planning process, during the first nine months of 1999, Key increased its borrowing capacity with the Federal Reserve Bank to address the potential need for additional funding as the Year 2000 approaches. Because the Year 2000 issue has never occurred, it is not possible to foresee or quantify the possible overall financial and operational impact and/or to determine whether it will be material to the financial condition or operations of Key. As of September 30, 1999, Key had recognized approximately $48 million of its total estimated project cost of up to $50 million. It is currently expected that the estimated remaining cost of up to $2 million will be recognized in 1999 and the first half of 2000. The total cost of the project is being funded through operating cash flows. INCOME TAXES The provision for income taxes was $140 million for the three-month period ended September 30, 1999, up from $122 million for the same period in 1998. The effective tax rate (provision for income taxes as a percentage of income before income taxes) for the 1999 third quarter was 34.1% compared with 32.6% for the third quarter of 1998. For the first nine months of 1999, the provision for income taxes was $432 million compared with $353 million for the first nine months of last year. The effective tax rate for these year-to-date periods was 33.9% and 32.4%, respectively. Primary factors contributing to the increase in the effective tax rate for the quarterly period were lower tax-exempt income and higher levels of amortization related to non-deductible goodwill and certain investments in low-income housing projects. The increase in the year-to-date rate also reflected lower tax-exempt income, as well as a second quarter 1999 catch-up adjustment related to the amortization of certain investments in low-income housing projects. The effective income tax rate remains below the statutory Federal rate of 35% due primarily to continued investment in tax-advantaged assets (such as tax-exempt securities and corporate owned life insurance) and the recognition of credits associated with investments in low-income housing projects. 39
40 FINANCIAL CONDITION LOANS At September 30, 1999, total loans outstanding were $63.2 billion compared with $62.0 billion at December 31, 1998, and $59.4 billion at September 30, 1998. A summary of the various components of the loan portfolios at each of these dates is presented in Note 6, Loans, beginning on page 14. The $3.8 billion, or 6%, increase in loans outstanding from the September 30, 1998, level was due to internal growth, offset in part by the impact of loan sales. The sales and divestitures which occurred during 1999 and 1998 are summarized in Figure 13 and include the impact of branch divestitures in the first half of 1998, as well as the securitization and/or sale of education loans, automobile loans, certain non-prime home equity loans and certain other loans. Among the factors considered in determining the particular loans to be securitized are the extent to which the characteristics of the specific portfolio make it conducive to securitization, the relative cost of funds, the level of credit risk and capital requirements. Activity since September 30, 1998, included the sales of $1.8 billion of education loans (of which $1.5 billion was associated with securitizations), $1.3 billion of home equity loans (which $1.1 billion was associated with securitizations), $555 million of automobile loans (all of which were associated with securitizations), $247 million of commercial real estate loans and $500 million of residential real estate loans. Securitizations are considered an alternative funding source and the extent to which they are used is dependent upon whether conditions in the capital markets make them more attractive as a funding source than on-balance sheet alternatives. The higher volume of securitizations relative to the first nine months of 1998 reflected Key's desire to diversify its funding sources as well as a change in the timing of certain securitizations originally planned for the fourth quarter of 1998 and 1999. During the first quarter of 1999, Key benefited from a record high volume of loan securitizations ($1.8 billion) as some securitizations planned for the fourth quarter of 1998 were delayed due to the volatility of the capital markets at that time. In addition, Key accelerated $743 million of education loan securitizations into the third quarter of 1999 as part of a strategy to reduce its need for funding transactions in the fourth quarter of 1999 when they could possibly be impacted by millennium-induced fears. Management will continue to explore opportunities for sales and/or other arrangements with respect to certain loan portfolios, consistent with prudent asset/liability management practices. Accordingly, as of September 30, 1999, Key reclassified its credit card receivables to the held for sale portfolio as a result of its announced intention to sell those receivables. <TABLE> <CAPTION> Figure 13 Loans Sold and Divested COMMERCIAL RESIDENTIAL BRANCH in millions EDUCATION AUTOMOBILE HOME EQUITY REAL ESTATE REAL ESTATE DIVESTITURES TOTAL ======================================================================================================================== <S> <C> <C> <C> <C> <C> <C> <C> 1999 - --------------- Third Quarter $ 786 -- $ 359 $ 100 -- -- $1,245 Second quarter 132 -- 442 63 $ 292 -- 929 First quarter 818 $ 555 428 84 208 -- 2,093 - ------------------------------------------------------------------------------------------------------------------------ $1,736 $ 555 $1,229 $ 247 $ 500 -- $4,267 ====== ====== ====== ====== ====== ====== 1998 - --------------- Fourth quarter $ 29 -- $ 48 -- -- -- $ 77 Third quarter 201 -- 374 -- -- -- 575 Second quarter 45 -- 53 $ 167 -- $ 124 389 First quarter 71 -- -- -- -- 20 91 - ------------------------------------------------------------------------------------------------------------------------ Total $ 346 -- $ 475 $ 167 -- $ 144 $1,132 ====== ====== ====== ====== ====== ======================================================================================================================== </TABLE> 40
41 Excluding the impact of loan sales and the transfer of credit card receivables to the held for sale portfolio, loans (other than one-to-four family mortgage loans and loans held for sale) increased by $8.0 billion, or 16%, since September 30, 1998, and $4.8 billion, or an annualized 12%, from the 1998 year end. Key's policy regarding new originations of one-to-four family mortgage loans is to originate such loans as a client and community accommodation, but to retain few of such loans on the balance sheet due to their marginal returns. Over the past year, the largest growth in Key's loan portfolio came from commercial loans which rose by $4.3 billion, due primarily to a $1.9 billion increase in commercial, financial and agricultural loans and increases of $1.3 billion and $1.1 billion in the lease financing and real estate-construction portfolios, respectively. Additionally, consumer loans rose by $3.3 billion, and included increases of $2.3 billion and $817 million in the home equity and lease financing portfolios, respectively. The strong growth in loans over the past twelve months reflected a number of factors, including the continued strength of the economy, improving consumer credit, targeted efforts to increase the commercial and home equity portfolios and Key's success in leveraging its Leasetec operation. The $1.2 billion increase in loans from the December 31, 1998, level also reflected strong growth in loan portfolios other than one-to-four family mortgages and loans held for sale. Excluding the impact of the 1999 loan sales shown in Figure 13 and the credit card transfer, loans (other than one-to-four family mortgage loans and loans held for sale) grew by $4.8 billion, or an annualized 12%, during the first nine months of 1999. Commercial loans contributed $2.7 billion to the year-to-date increase due to a $1.2 billion increase in commercial, financial and agricultural loans and increases of $848 million and $786 million in the real estate-construction and lease financing portfolios, respectively. On the same basis, the aggregate annualized growth rate of average outstanding balances in the commercial loan portfolio was 10% for the third quarter of 1999, representing the tenth consecutive quarter of double-digit annualized commercial loan growth. Consumer loans accounted for $1.9 billion of the increase with the largest growth occurring in the home equity (up $1.4 billion) and lease financing (up $527 million) portfolios. Shown in Figure 14 are loans that have been securitized/sold and are either administered or serviced by Key, but not recorded on its balance sheet. Income recognized in connection with such transactions is derived from two sources. Noninterest income earned from servicing or administering the loans is recorded as other income, while income earned on assets retained in connection with securitizations and accounted for like investments in interest-only strip securities, is recorded as interest income on securities available for sale. The increase in these balances since the 1998 year end reflected the impact of securitizations, offset in part by loan repayments. Figure 14 Loans Securitized/Sold and Administered or Serviced <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, in millions 1999 1998 1998 =================================================================================== <S> <C> <C> <C> Education loans $3,377 $2,312 $2,363 Automobile loans 994 946 1,099 Home equity loans 1,627 744 813 - ------------------------------------------------------------------------------------ Total $5,998 $4,002 $4,275 ====== ====== ====== =================================================================================== </TABLE> SECURITIES At September 30, 1999, the securities portfolio totaled $7.6 billion and was comprised of $6.6 billion of securities available for sale and $989 million of investment securities. This compares with a total portfolio of $6.3 billion, including $5.3 billion of securities available for sale and $976 million of investment securities at December 31, 1998. Certain information pertaining to the composition, yields, and remaining maturities of the securities available for sale and investment securities portfolios is presented in Figures 15 and 16, respectively. Additional information pertaining to gross unrealized gains and losses by type of security is presented in Note 5, Securities, beginning on page 13. As shown in Note 5, the increase in securities available for sale from the December 31, 1998, level was primarily due to a higher level of collateralized mortgage obligations. This reflected the reinvestment of funds previously held in lower-yielding securities purchased under resale agreements, the reclassification of approximately $374 million of collateralized mortgage obligations from the commercial loan portfolio to the securities available for sale portfolio and additional securities purchased as collateral in connection with client pledging requirements. 41
42 <TABLE> <CAPTION> Figure 15 Securities Available for Sale OTHER U.S. TREASURY, STATES AND COLLATERALIZED MORTGAGE- RETAINED AGENCIES AND POLITICAL MORTGAGE BACKED INTERESTS IN dollars in millions CORPORATIONS SUBDIVISIONS OBLIGATIONS(1) SECURITIES(1) SECURITIZATIONS(1) - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> SEPTEMBER 30, 1999 Remaining maturity: One year or less $100 $ 1 $ 713 $ 2 -- After one through five years 4 20 3,084 1,444 $132 After five through ten years 6 39 116 268 219 After ten years 18 1 171 38 -- - ------------------------------------------------------------------------------------------------------------------------------------ Fair value $128 $61 $4,084 $1,752 $351 Amortized cost 128 61 4,240 1,772 365 Weighted average yield 5.33% 5.92% 6.48% 7.29% 9.15% Weighted average maturity 3.3 years 5.7 years 3.7 years 5.5 years 3.6 years - ------------------------------------------------------------------------------------------------------------------------------------ DECEMBER 31, 1998 Fair value $422 $67 $2,211 $2,151 $328 Amortized cost 420 65 2,191 2,123 345 - ------------------------------------------------------------------------------------------------------------------------------------ SEPTEMBER 30, 1998 Fair value $140 $77 $2,774 $2,433 $402 Amortized cost 138 75 2,743 2,390 421 - ------------------------------------------------------------------------------------------------------------------------------------ </TABLE> <TABLE> <CAPTION> WEIGHTED OTHER AVERAGE dollars in millions SECURITIES TOTAL YIELD(2) - --------------------------------------------------------------------------------------- <S> <C> <C> <C> SEPTEMBER 30, 1999 Remaining maturity: One year or less $ 7 $ 823 6.58% After one through five years 18 4,702 6.42 After five through ten years 4 652 9.10 After ten years 162(3) 390 7.39 - --------------------------------------------------------------------------------------- Fair value $191 $6,567 -- Amortized cost 184 6,750 6.78% Weighted average yield 5.32% 6.78% -- Weighted average maturity 9.5 years 4.3 years -- - --------------------------------------------------------------------------------------- DECEMBER 31, 1998 Fair value $ 99 $5,278 -- Amortized cost 84 5,228 6.69% - --------------------------------------------------------------------------------------- SEPTEMBER 30, 1998 Fair value $102 $5,928 -- Amortized cost 93 5,860 7.06 % - --------------------------------------------------------------------------------------- </TABLE> (1) Maturity is based upon expected average lives rather than contractual terms. (2) Weighted average yields are calculated on the basis of amortized cost. Such yields have been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%. (3) Includes equity securities with no stated maturity. <TABLE> <CAPTION> Figure 16 Investment Securities STATES AND WEIGHTED POLITICAL OTHER AVERAGE dollars in millions SUBDIVISIONS SECURITIES TOTAL YIELD(1) - ----------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> SEPTEMBER 30, 1999 Remaining maturity: One year or less $135 $ 1 $ 136 8.05% After one through five years 236 -- 236 9.21 After five through ten years 102 -- 102 9.51 After ten years 17 498(2) 515 3.92 - ----------------------------------------------------------------------------------------------------------- Amortized cost $490 $499 $ 989 6.32% Fair value 506 499 1,005 -- Weighted average yield 8.53% 3.72% 6.32% -- Weighted average maturity 3.2 years 10.1 years 6.7 years -- - ----------------------------------------------------------------------------------------------------------- DECEMBER 31, 1998 Amortized cost $631 $345 $ 976 7.13% Fair value 659 345 1,004 -- - ----------------------------------------------------------------------------------------------------------- SEPTEMBER 30, 1998 Amortized cost $709 $275 $ 984 7.50% Fair value 740 275 1,015 -- - ----------------------------------------------------------------------------------------------------------- (1) Weighted average yields are calculated on the basis of amortized cost. Such yields have been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%. (2) Includes equity securities with no stated maturity. </TABLE> ASSET QUALITY Key has groups dedicated to evaluating and monitoring the level of risk in its credit-related assets; formulating underwriting standards and guidelines for line management; developing commercial and consumer credit policies and systems; establishing credit-related concentration limits; reviewing loans, leases and other corporate assets to evaluate credit quality; and reviewing the adequacy of the allowance for loan losses ("Allowance"). Geographic diversity throughout Key is a significant factor in managing credit risk. 42
43 Management relies upon an iterative methodology to estimate the level of the Allowance on a quarterly and at times more frequent basis, as deemed necessary. This methodology is described in detail in the Allowance for Loan Losses section of Note 1, Summary of Significant Accounting Policies, beginning on page 65 of Key's 1998 Annual Report to Shareholders. As shown in Figure 17, net loan charge-offs for the third quarter of 1999 were $78 million, or .49% of average loans, compared with $71 million, or .48%, for the same period last year. Net charge-offs in the commercial loan portfolio rose by $8 million, including a $10 million increase in the commercial, financial and agricultural sector. This reflected the significant growth that has occurred in this portfolio over the past year. The level of consumer loan net charge-offs was essentially unchanged as increases in the home equity and installment portfolios were largely offset by a $5 million decline in the level of net charge-offs in the credit card sector. The increase in net charge-offs experienced in the home equity and installment portfolios reflected the growth in outstanding balances from the year-ago quarter, while net charge-offs in the credit card sector decreased primarily as a result of a lower volume of credit card receivables. <TABLE> <CAPTION> Figure 17 Summary of Loan Loss Experience THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, -------------------------------- ------------------------------- dollars in millions 1999 1998 1999 1998 ======================================================================================================================= <S> <C> <C> <C> <C> Average loans outstanding during the period $ 62,799 $ 58,559 $ 62,036 $ 56,332 - ----------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at beginning of period $ 930 $ 900 $ 900 $ 900 Loans charged off: Commercial, financial and agricultural 28 18 79 53 Real estate--commercial mortgage 2 4 2 12 Real estate--construction -- 1 -- 2 Commercial lease financing 4 4 13 6 - ----------------------------------------------------------------------------------------------------------------------- Total commercial loans 34 27 94 73 Real estate--residential mortgage 2 3 7 8 Home equity 2 2 7 5 Credit card 21 25 69 79 Consumer--direct 12 9 34 32 Consumer--indirect 31 25 103 91 - ----------------------------------------------------------------------------------------------------------------------- Total consumer loans 68 64 220 215 - ----------------------------------------------------------------------------------------------------------------------- 102 91 314 288 Recoveries: Commercial, financial and agricultural 6 6 21 20 Real estate--commercial mortgage 2 (1) 4 4 Real estate--construction -- 3 -- 3 Commercial lease financing -- 1 1 1 - ----------------------------------------------------------------------------------------------------------------------- Total commercial loans 8 9 26 28 Real estate--residential mortgage 1 1 4 3 Credit card 3 2 11 7 Consumer--direct 2 1 6 5 Consumer--indirect 10 7 32 25 - ----------------------------------------------------------------------------------------------------------------------- Total consumer loans 16 11 53 40 - ----------------------------------------------------------------------------------------------------------------------- 24 20 79 68 - ----------------------------------------------------------------------------------------------------------------------- Net loans charged off (78) (71) (235) (220) Provision for loan losses 78 71 265 220 - ----------------------------------------------------------------------------------------------------------------------- Allowance for loan losses at end of period $ 930 $ 900 $ 930 $ 900 ======== ======== ======== ======== - ----------------------------------------------------------------------------------------------------------------------- Net loan charge-offs to average loans .49% .48% .50% .52% Allowance for loan losses to period end loans 1.47 1.51 1.47 1.51 Allowance for loan losses to nonperforming loans 245.38 250.00 245.38 250.00 ======================================================================================================================= </TABLE> In light of the Retail Credit Policy issued by the Federal banking agencies last February (See Item 5 on page 49) it is possible that Key may accelerate certain consumer loan charge-offs for which an Allowance has already been provided. Although the definitive financial impact on Key is not presently known, based upon management's current estimates, it is anticipated that the implementation of the Retail Credit Policy will not have a material adverse effect on Key's financial condition and results of operations. In addition, with the advent of additional credit scoring capabilities, management continues to review and refine Key's Allowance for loan losses methodology. 43
44 The amount and timing of any possible changes in Key's provisioning or charge-offs that may result from methodology enhancements has not yet been determined. The Allowance at September 30, 1999, was $930 million, or 1.47% of loans, compared with $900 million, or 1.51%, at September 30, 1998. Included in the 1999 and 1998 Allowance was $47 million and $41 million, respectively, which was specifically allocated for impaired loans. For a further discussion of impaired loans see Note 7, Impaired Loans and Other Nonperforming Assets, on page 15. At September 30, 1999, the Allowance was 245.38% of nonperforming loans, compared with 250.00% at September 30, 1998. The composition of nonperforming assets is shown in Figure 18. These assets totaled $407 million at September 30, 1999, and represented .64% of loans, OREO and other nonperforming assets compared with $404 million, or .65%, at December 31, 1998. The $3 million rise in the level of nonperforming assets since the 1998 year end was primarily due to a higher level of nonperforming loans. Despite the strong growth that has occurred in the loan portfolio, the level of Key's nonperforming assets has remained relatively stable. Over the past two years, the level of nonperforming assets has ranged from a quarterly high of $431 million at December 31, 1997, to a low of $402 million at September 30, 1998. In addition, nonperforming assets have declined in each of the past two quarters and the nonperforming assets ratio posted as of September 30, 1999, was the best on record over the past three years. <TABLE> <CAPTION> Figure 18 Summary of Nonperforming Assets and Past Due Loans SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 1999 1998 1998 ================================================================================================== <S> <C> <C> <C> Commercial, financial and agricultural $ 146 $ 144 $ 132 Real estate--commercial mortgage 102 79 97 Real estate--construction 6 6 5 Commercial lease financing 31 29 22 Real estate--residential mortgage 50 60 61 Consumer 44 47 43 - -------------------------------------------------------------------------------------------------- Total nonperforming loans(1) 379 365 360 OREO 32 56 58 Allowance for OREO losses (8) (18) (19) - -------------------------------------------------------------------------------------------------- OREO, net of allowance 24 38 39 Other nonperforming assets 4 1 3 - -------------------------------------------------------------------------------------------------- Total nonperforming assets $ 407 $ 404 $ 402 ===== ===== ===== - -------------------------------------------------------------------------------------------------- Accruing loans past due 90 days or more $ 268 $ 178 $ 182 - -------------------------------------------------------------------------------------------------- Nonperforming loans to period end loans .60% .59% .61% Nonperforming assets to period end loans plus OREO and other nonperforming assets .64 .65 .68 ================================================================================================== </TABLE> (1) Includes impaired loans of $219 million, $193 million and $193 million at September 30, 1999, December 31, 1998 and September 30, 1998, respectively. DEPOSITS AND OTHER SOURCES OF FUNDS Core deposits, defined as domestic deposits other than certificates of deposit of $100,000 or more, are Key's primary source of funding. During the third quarter of 1999, these deposits averaged $37.2 billion and represented 52% of Key's funds supporting earning assets, compared with $36.5 billion and 54%, respectively, during the third quarter of 1998. As shown in Figure 4 beginning on page 31, the mix of core deposits changed over past year as decreases in the levels of savings deposits and NOW accounts were largely offset by substantial growth in money market deposit accounts. The consistent level and change in the mix of core deposits reflected the 1998 divestiture of 46 branches with deposits of approximately $658 million, and investment alternatives pursued by clients in response to the strength of the securities markets. The increase in money market deposit accounts that has now occurred over eight consecutive quarters reflects these client preferences as well as actions taken by management in 1998 to reprice such deposits. In October 1999, Key sold an additional 28 branches with deposits of approximately $1.3 billion. Further information pertaining to the sale of these branches is disclosed in Note 3, Mergers, Acquisitions and Divestitures, beginning on page 8. 44
45 Purchased funds, which are comprised of large certificates of deposit, deposits in the foreign office and short-term borrowings, averaged $17.2 billion during third quarter of 1999, compared with $17.1 billion during the prior quarter and $19.1 billion a year-ago. As shown in Figure 4, long-term debt, including capital securities, has been more heavily relied upon to fund earning asset growth. During the third quarter of 1999, these borrowings comprised 24% of Key's funds supporting earning assets, up from 18% in the year-ago quarter. This trend is expected to continue over the remainder of the year. In addition, Key continues to consider loan securitizations as a funding alternative, provided capital market conditions are conducive to such activity. During the first nine months of 1999, Key securitized and sold $3.2 billion of consumer loans, including $1.1 billion of education and home equity loans during the third quarter. LIQUIDITY Key actively analyzes and manages its liquidity, which represents the availability of funding to meet the needs of depositors, borrowers and creditors at a reasonable cost on a timely basis and without adverse consequences. Key maintains liquidity in the form of short-term money market investments, securities available for sale, anticipated prepayments and maturities on securities, the maturity structure of its loan portfolios and the ability to securitize and package loans for sale. Liquidity is also enhanced by a sizable concentration of core deposits, discussed in the preceding section, which are generated by 963 full-service KeyCenters in 13 states. Key monitors deposit flows and evaluates alternate pricing structures with respect to its deposit base. This process is managed by Key's Funding and Investment Management Group, which monitors the overall mix of funding sources in conjunction with deposit pricing and in response to the structure of the earning assets portfolio. In addition, Key has access to various sources of money market funding (such as Federal funds purchased, securities sold under repurchase agreements and bank notes) and borrowings from the Federal Reserve Bank for short-term liquidity requirements should the need arise. During 1999, KeyBank N.A. increased its overnight borrowing capacity at the Federal Reserve Bank Discount Window from approximately $975 million at December 31, 1998, to approximately $11.0 billion at September 30, 1999, by pledging approximately $15.1 billion of loans (primarily commercial) as collateral. This action was taken as a precautionary measure in connection with Key's Year 2000 contingency planning process. In addition, KeyBank USA has overnight borrowing capacity at the Federal Reserve Bank Discount Window which provides for borrowings of up to $1.0 billion and is secured by $1.3 billion of KeyBank USA's credit card receivables at September 30, 1999. Neither bank had borrowings outstanding under these facilities as of September 30, 1999. During the first nine months of 1999, Key's affiliate banks raised $9.6 billion under Key's Bank Note Program, which provides for the issuance of both long- and short-term debt of up to $20.0 billion ($19.0 billion by KeyBank N.A. and $1.0 billion by KeyBank USA) in the aggregate. Of the notes issued during the first nine months of 1999, $3.6 billion have original maturities in excess of one year and are included in long-term debt, while $6.0 billion have original maturities of one year or less and are included in short-term borrowings. At September 30, 1999, the program had an unused capacity of $8.9 billion. Under Key's Euronote Program, the parent company, KeyBank N.A. and KeyBank USA may issue both long- and short-term debt of up to $7.0 billion in the aggregate. The borrowing capacity under this program was increased from $5.0 billion during the second quarter of 1999. The notes are offered exclusively to non-U.S. investors and can be denominated in dollars and/or most European currencies. There were $2.4 billion of borrowings outstanding under this facility as of September 30,1999, $940 million of which were issued during the current year. The parent company has a commercial paper program and a four-year revolving credit agreement; each facility provides funding availability of up to $500 million. The proceeds from these facilities may be used for general corporate purposes. As of September 30, 1999, $95 million of borrowings were outstanding under the commercial paper program. The parent company also has a universal shelf registration statement on file with the Securities and Exchange Commission, which provides for the possible issuance of up to $1.3 billion of debt and equity securities. At September 30, 1999, unused capacity under the shelf registration totaled $1.3 billion, including $750 million reserved for issuance as medium-term notes. The proceeds from the issuances under the shelf registration, the Bank Note Program and the Euronote Program described above may be used for general corporate purposes, including acquisitions. 45
46 The liquidity requirements of the parent company, primarily for dividends to shareholders, servicing of debt and other corporate purposes are principally met through regular dividends from affiliate banks. Excess funds are maintained in short-term investments. In addition, the parent company has access to the capital markets as a result of its favorable debt ratings which, at September 30, 1999, were as follows: Senior Subordinated Commercial Long-Term Long-Term Paper Debt Debt -------------- -------------- ----------------- Duff & Phelps D-1 A+ A Standard & Poor's A-2 A- BBB+ Moody's P-1 A1 A2 Further information pertaining to Key's sources and uses of cash for the nine-month periods ended September 30, 1999 and 1998, is presented in the Consolidated Statements of Cash Flow on page 6. CAPITAL AND DIVIDENDS Total shareholders' equity at September 30, 1999, was $6.4 billion, up $230 million from the balance at December 31, 1998, and $844 million, or 15%, from September 30, 1998. During the first nine months of 1999, the increase provided by retained net income was substantially offset by a net increase in treasury stock, resulting from the share repurchases discussed below, and net unrealized losses on securities available for sale. The increase from the September 30, 1998, balance was due primarily to retained net income and the net decrease in treasury stock resulting from the shares issued in the McDonald acquisition, also discussed below. Other factors contributing to the change in shareholders' equity during the first nine months of 1999 are shown in the Consolidated Statements of Changes in Shareholders' Equity presented on page 5. During the first nine months of 1999, Key repurchased 6,406,424 of its Common Shares at an average price per share of $31.51. This included the repurchase of 3,869,761 shares remaining under the authorization by the Board of Directors to repurchase up to 60% of the 19,337,159 shares issued in the October 1998 acquisition of McDonald. The other 2,536,663 shares were repurchased under a separate repurchase program authorized in January 1998. That authority provides for the repurchase of up to 10,000,000 shares in open market or negotiated transactions and has no expiration date. At September 30, 1999, the number of shares remaining under that authority was 7,463,337. The 43,064,912 shares held in treasury at September 30, 1999, are expected to be reissued over time in connection with employee stock purchase, 401(k), stock option and dividend reinvestment plans and for other corporate purposes. During the first nine months of 1999, Key reissued 2,146,512 Treasury Shares for employee benefit and dividend reinvestment plans. Capital adequacy is an important indicator of financial stability and performance. Overall, Key's capital position remains strong with a ratio of total shareholders' equity to total assets of 7.75% at September 30, 1999, 7.71% at December 31, 1998, and 7.15% at September 30, 1998. Banking industry regulators define minimum capital ratios for bank holding companies and their banking subsidiaries. Based on risk-adjusted capital rules and definitions prescribed by the banking regulators, Key's Tier 1 and total risk-adjusted capital ratios at September 30, 1999, were 7.84% and 11.94%, respectively, compared with minimum regulatory requirements of 4.0% for Tier 1 and 8.0% for total capital. The regulatory leverage ratio standard prescribes a minimum ratio of 3.0% for bank holding companies (such as Key) that either have the highest supervisory rating or have implemented the Federal Reserve Board's risk-based capital measure for market risk. All other bank holding companies must maintain a minimum leverage ratio of at least 4%. At September 30, 1999, Key's leverage ratio was 7.85%, substantially higher than the minimum requirement. Figure 19 presents the details of Key's regulatory capital position at September 30, 1999, December 31, 1998, and September 30, 1998. Under the Federal Deposit Insurance Act, 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 qualify as "well capitalized" at September 30, 1999, since they exceeded the well-capitalized thresholds of 10%, 6% and 5% for the total capital, Tier 1 capital and leverage ratios, respectively. Although these provisions are not directly applicable to bank holding companies, Key would also qualify as "well capitalized" at September 30, 1999, if the same provisions were applied. The FDIC-defined capital categories may not constitute an accurate representation of the overall financial condition or prospects of Key or its affiliates. 46
47 <TABLE> <CAPTION> Figure 19 Capital Components and Risk-Adjusted Assets SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, dollars in millions 1999 1998 1998 ================================================================================================ <S> <C> <C> <C> TIER 1 CAPITAL Common shareholders' equity(1) $ 6,503 $ 6,137 $ 5,512 Qualifying capital securities 1,243 747 747 Less: Goodwill (1,422) (1,430) (1,038) Other intangible assets(2) (60) (71) (74) - ------------------------------------------------------------------------------------------------ Total Tier 1 capital 6,264 5,383 5,147 - ------------------------------------------------------------------------------------------------ TIER 2 CAPITAL Allowance for loan losses(3) 930 900 900 Net unrealized holding gains(4) 2 3 -- Qualifying long-term debt 2,350 2,445 2,474 - ------------------------------------------------------------------------------------------------ Total Tier 2 capital 3,282 3,348 3,374 - ------------------------------------------------------------------------------------------------ Total capital $ 9,546 $ 8,731 $ 8,521 ======== ======== ======== RISK-ADJUSTED ASSETS Risk-adjusted assets on balance sheet $ 67,342 $ 63,721 $ 62,422 Risk-adjusted off-balance sheet exposure 13,713 12,198 12,025 Less: Goodwill (1,422) (1,430) (1,038) Other intangible assets(2) (60) (71) (74) Plus: Market risk-equivalent assets 370 242 76 Net unrealized holding gains(4) 2 3 -- - ------------------------------------------------------------------------------------------------ Gross risk-adjusted assets 79,945 74,663 73,411 Less: Excess allowance for loan losses(3) -- -- -- - ------------------------------------------------------------------------------------------------ Net risk-adjusted assets $ 79,945 $ 74,663 $ 73,411 ======== ======== ======== AVERAGE QUARTERLY TOTAL ASSETS $ 81,295 $ 78,968 $ 75,886 ======== ======== ======== CAPITAL RATIOS Tier 1 risk-adjusted capital ratio 7.84 % 7.21 % 7.01 % Total risk-adjusted capital ratio 11.94 11.69 11.61 Leverage ratio(5) 7.85 6.95 6.88 - ------------------------------------------------------------------------------------------------ (1) Common shareholders' equity excludes the impact of net unrealized gains or losses on securities, except for net unrealized losses on marketable equity securities. (2) Intangible assets (excluding goodwill) recorded after February 19, 1992, and deductible portions of purchased mortgage servicing rights. (3) The allowance for loan losses included in Tier 2 capital is limited to 1.25% of gross risk-adjusted assets. (4) Net unrealized holding gains included in Tier 2 capital are limited to 45% of net unrealized holding gains on available for sale equity securities with readily determinable fair values. (5) Tier 1 capital as a percentage of average quarterly total assets, less goodwill and other non-qualifying intangible assets as defined in 2 above. </TABLE> ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK The information included in the Market Risk Management section beginning on page 33 of the Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference. 47
48 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In the ordinary course of business, Key is subject to legal actions which involve claims for substantial monetary relief. Based on information presently known to management and Key's counsel, management does not believe that there exists any legal action to which KeyCorp or any of its subsidiaries is a party, or of which their properties are the subject, that, individually or in the aggregate, will have a material adverse effect on the financial condition of Key. In March 1998, McDonald Investments Inc. ("McDonald"), now a subsidiary of the Corporation, participated as an initial purchaser 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, including $452 million in debt securities and related warrants (the "Securities"). 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 of approximately $44 million of the Securities. On December 24, 1998, holders of Securities gave a Notice of Default alleging a number of defaults under the terms of the Securities. At present, NSM is attempting to negotiate a restructuring of its obligations, including those owed to holders of the Securities and other creditors. Certain purchasers of Securities have commenced litigation against McDonald and other parties in California, Connecticut, Minnesota, New Jersey and New York, claiming that McDonald, the other initial purchasers and certain other third party service providers to NSM have 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 and oral statements allegedly provided 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. There are currently seven separate lawsuits pending against McDonald, as well as other defendants (two suits in Federal District Court in Minnesota; one suit in Federal District Court in New York; two suits in California; and one suit in each of Connecticut and New Jersey). Each of the lawsuits was commenced by a different group of purchasers of the Securities. The aggregate amount of Securities alleged to have been purchased by the plaintiffs in these seven lawsuits is at least $240 million. While the relief claimed in the lawsuits varies, generally speaking, the plaintiffs seek recision of the sale of the Securities, compensatory damages, legal fees, expenses, and in the case of the New Jersey action (which currently covers $107 million of Securities), treble damages consistent with applicable law, exemplary damages and civil penalties. McDonald is vigorously defending these actions and has filed, or will file, responses to each complaint denying liability. 48
49 ITEM 5. OTHER INFORMATION On February 10, 1999, the Federal banking agencies published their final Uniform Retail Credit Classification and Account Management Policy (the "Retail Credit Policy"), which revises their 1980 Uniform Policy for Classification of Consumer Installment Credit Based on Delinquency Status. The Retail Credit Policy applies to all financial institutions which file call reports or thrift financial reports with a Federal banking agency. In general, the Retail Credit Policy establishes a uniform charge-off policy at 120 and 180 days delinquency for closed-end and open-end credit, respectively, provides uniform guidance for loans affected by bankruptcy, fraud, and death, establishes guidelines for re-aging, extending, deferring, or rewriting past due accounts, classifies certain delinquent residential mortgage and home equity loans, and broadens recognition of partial payments that qualify as full payments. Changes made by the Retail Credit Policy which involve manual adjustments to an institution's policies and procedures were required to be implemented by June 30, 1999, while changes involving programming resources are required to be implemented by December 31, 2000. Key was not impacted by any changes involving manual adjustments to its policies and procedures at June 30, 1999. The definitive financial impact on Key from implementing the Retail Credit Policy is not presently known. However, based upon its estimate of the impact of applying the Retail Credit Policy against Key's existing retail portfolio, management anticipates that implementing the Retail Credit Policy at December 31, 2000, will not have a material adverse effect on Key's financial condition and results of operations, but will result in the acceleration of certain charge-offs for which an Allowance has already been provided. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (10.1) First Amendment to Form of Change of Control Agreement between KeyCorp and Certain Executive Officers (10.2) Second Amendment to Employment Agreement between KeyCorp and Henry Meyer III (10.3) KeyCorp Automatic Deferral Plan (10.4) First Amendment to the KeyCorp Excess Cash Balance Pension Plan (10.5) First Amendment to the KeyCorp Supplemental Retirement Plan (10.6) Third Amendment to the KeyCorp Supplemental Retirement Benefit Plan (10.7) Third Amendment to the KeyCorp Supplemental Retirement Benefit Plan for Key Executives (15) Acknowledgment Letter of Independent Auditors (27) Financial Data Schedule (filed electronically only) (b) Reports on Form 8-K July 16, 1999 - Item 5. Other Events and Item 7. Financial Statements and Exhibits. Reporting that on July 15, 1999, the Registrant issued a press release announcing its earnings results for the three- and six-month periods ended June 30, 1999. No other reports on Form 8-K were filed during the three-month period ended September 30, 1999. 49
50 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 10, 1999 /s/ Lee Irving ----------------------------- By: Lee Irving Executive Vice President And Chief Accounting Officer 50