KeyCorp (KEY) — Q3 2010 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2010. KeyCorp is a U.S. regional bank holding company with Community Banking and National Banking businesses. Interim statements are unaudited and were reviewed by the independent accounting firm, which reported no material modifications were needed for GAAP conformity.
Financial performance and position
| Metric | Q3 2010 / Sept. 30, 2010 | Comparable period / change |
|---|---|---|
| Net interest income | $640 million | $592 million in Q3 2009 |
| Noninterest income | $486 million | $382 million in Q3 2009 |
| Provision for loan losses | $94 million | $733 million in Q3 2009 |
| Noninterest expense | $736 million | $901 million in Q3 2009 |
| Net income attributable to Key common shareholders | $178 million; $0.20 per diluted share | Loss of $438 million; loss of $0.52 per diluted share in Q3 2009 |
| Net interest margin, continuing operations, taxable-equivalent | 3.35% | 2.80% in Q3 2009; 3.17% in Q2 2010 |
- For the first nine months, Key reported $111 million of net income attributable to common shareholders, versus a $1.364 billion loss in 2009. Continuing-operations common income was $121 million versus a $1.323 billion loss.
- Q3 pre-provision net revenue was $397 million, versus $80 million a year earlier. The earnings improvement chiefly reflected a lower credit-loss provision, reduced expenses and stronger fee income.
- Q3 noninterest income benefited from higher investment banking and capital-markets income, principal-investing gains, loan-sale gains and letter-of-credit and loan fees. Year-to-date noninterest income declined 9%, in part because 2009 included securities, Visa-share and capital-securities exchange gains.
- At September 30, total assets were $94.0 billion, total loans from continuing operations were $51.4 billion, deposits were $61.4 billion, long-term debt was $11.4 billion, and total shareholders’ equity was $11.4 billion. Continuing-operations loans fell from $62.2 billion a year earlier; deposits fell from $67.3 billion.
- Cash and due from banks was $823 million. For the first nine months, operating activities provided $1.969 billion, investing activities provided $1.553 billion, and financing activities used $3.170 billion.
- Capital ratios were strong: Tier 1 common equity 8.61%, Tier 1 risk-based capital 14.30%, total risk-based capital 18.22%, and leverage 12.53%. The common tangible-equity-to-tangible-assets ratio was 8.00%.
- The allowance for loan losses was $1.957 billion, 3.81% of continuing-operations loans and 142.6% of nonperforming loans. Q3 net charge-offs were $357 million, or 2.69% of average loans.
Material changes versus comparable periods
- Q3 returned to common-shareholder profitability from a substantial year-earlier loss. The loan-loss provision fell by $639 million year over year; noninterest expense fell by $165 million.
- Nonperforming loans declined to $1.372 billion from $2.290 billion at September 30, 2009; nonperforming assets fell to $1.801 billion from $2.799 billion. The allowance also declined from $2.485 billion a year earlier.
- Loan balances contracted substantially, reflecting weak demand, repayments, charge-offs, loan sales and runoff of exit portfolios. Available-for-sale securities increased to $21.2 billion from $15.4 billion a year earlier, reflecting liquidity management.
- Deposits shifted away from higher-cost time deposits toward transaction accounts and noninterest-bearing deposits. The consolidated loan-to-deposit ratio improved to 92% from 101% a year earlier.
- In January 2010, new consolidation rules required Key to consolidate its education-loan securitization trusts. This added about $2.8 billion of assets and liabilities and a $45 million after-tax adjustment to beginning retained earnings. The education lending business remains a discontinued operation; trust-related fair-value changes contributed to its nine-month loss.
Outlook, management commentary and risks
- Management expected Q4 2010 net interest margin of about 3.30%, citing continued low-cost deposit inflows being reinvested in lower-yielding assets. The long-term margin goal is above 3.50%.
- Management expected further allowance reductions during the remainder of 2010, based on anticipated lower charge-offs and nonperforming loans, while also expecting net charge-offs to remain elevated for the rest of 2010.
- Long-term goals include a 90%–100% loan-to-core-deposit ratio, net charge-offs of 40–50 basis points, noninterest income above 40% of revenue, return on average assets of 1.00%–1.25%, and $300–$375 million in Keyvolution run-rate savings by end-2012. At Q3, reported metrics included a 92% loan-to-deposit ratio, 2.69% net charge-offs to average loans, 42.9% noninterest income to revenue, 0.93% return on average assets and $224 million of implemented savings.
- Management described a slow and uncertain recovery, high unemployment and continued weakness in housing and commercial real estate. Further declines in commercial-property rents, occupancy or values could weaken repayment capacity, particularly in retail and office exposures. The filing also identifies double-dip recession, deflation, credit deterioration, liquidity, interest-rate and regulatory risks.
- Regulation E overdraft opt-in rules were expected to reduce deposit service-charge income by about $40 million annually. Key estimated approximately $75 million in annualized debit interchange revenue could be affected by future Dodd-Frank rules; the impact was not yet clear.
- On November 1, 2010, after quarter-end, Moody’s downgraded KeyBank’s short-term, senior long-term and subordinated debt ratings one notch. The downgrade could affect eligibility to hold $1.50–$1.85 billion of mortgage-servicing escrow balances and could trigger alternative investment requirements or impairment of mortgage-servicing assets. Management cited an $11.1 billion liquid-asset portfolio and stated it expected adequate liquidity.
- Potential contingencies include shareholder derivative and 401(k) fiduciary lawsuits, Madoff-related claims involving the wound-down Austin subsidiary, and guarantees with $14.481 billion of maximum potential undiscounted payments and $191 million recorded liability. Management assessed payment/performance risk for the listed guarantees as low. The DataTreasury matter was settled on terms described as not material.
- Dodd-Frank phases out most trust-preferred and cumulative preferred securities from Tier 1 capital beginning in 2013; management said its pro forma capital ratios would still meet current “well-capitalized” thresholds. Basel III rules were still developing.
Most important facts for investors to verify
- Whether lower provisions and improving nonperforming-asset measures persist, and whether credit costs remain elevated as management expected.
- Commercial real estate and exit-portfolio trends, including loan modifications, collateral values, charge-offs and the performance of restructured loans.
- Q4 net interest margin, deposit mix and loan/deposit trends versus management’s approximately 3.30% margin outlook.
- The effect of Regulation E, interchange regulation and Dodd-Frank on recurring fee income, capital treatment and compliance costs.
- Consequences of the November 2010 Moody’s downgrade, including any escrow actions, added collateral needs or mortgage-servicing-asset impairment.
- Capital and liquidity calculations, including the contribution and future regulatory treatment of trust-preferred securities and the parent company’s dependence on external funding.
- Assumptions and valuation sensitivity for consolidated education-loan trusts, principal investments, loan-loss reserves and other Level 3 fair-value measurements.