KeyCorp (KEY)

Cleveland-based KeyCorp (KEY), a bank-oriented financial service company, provides a wide range of products and services such as commercial and retail banking, commercial leasing, investment management, consumer finance, as well as investment banking products to individual, corporate, and institutional clients throughout the United States and, for certain businesses, internationally. The company operates mainly through two major business groups Community Banking (roughly 52% of total revenue from continuing operations in 2007) and National Banking (roughly 46%). As of March 31, 2008, KEY had $101.5 billion in total assets, $76.4 billion in loans, and $64.7 billion in deposits.

KEY has a network of nearly 985 "KeyCenters" (full-service retail banking branches), a telephone banking call center services group, and about 1,479 ATMs in 16 states. In addition to the customary banking services, KeyCorp's bank, its registered investment advisor, and its trust company subsidiaries offer personal and corporate trust services, personal financial services, access to mutual funds, cash management services, investment banking and capital markets products, as well as international banking services. KEY also provides other financial services, both within and beyond its primary banking markets, through non-bank subsidiaries. These services include accident, health and credit-life insurance on loans, principal investing, community development financing, securities underwriting and brokerage, as well as other financial services. The company is also an equity participant in a joint venture with Key Merchant Services, LCC, which provides merchant services.

KEY continues to reorganize its operations in order to improve its business mix by exiting the risky and unprofitable businesses and through strategic acquisitions. In 2006, it sold Champion Mortgage finance business (non-prime mortgage loan portfolio). During 2007, the company exited its out-of-footprint homebuilder portfolio, dealer originated home improvement lending, and payroll online services. KEY also continues to pursue opportunities to grow its franchise through targeted acquisitions. During 3Q07, the company acquired Tuition Management Systems, one of the leading providers of education-related financial services. With this addition, KEY will probably operate as the largest educational payment plan providers in the nation. In January 2008, the company acquired U.S.B. Holding Company. The acquisition added $3.0 billion in assets and 31 branches to KEY's Hudson Valley/Metro NY District. Management expects the deal to boost earnings by 2009. Management thus continues to focus on improving the risk profile and emphasizing areas of strength.

During 1Q08, fixed income markets remained extraordinary volatile, with credit spreads continuing to widen rapidly, which had a negative impact on market values of KEY's held-for-sale and trading portfolios. Management is taking actions to mitigate the effects of this future market volatility. These actions include the placement of hedges on its remaining previously unhedged commercial real estate mortgage loans held for sale to protect against declines in market values that may result from changes in credit spreads and other market-driven factors.

Credit quality metrics were weak during 1Q08. KEY's non-performing assets rose significantly during the quarter, due primarily to deteriorating market conditions in the residential properties segment of KEY's commercial real estate construction portfolio, principally in Florida and California. Net charge-offs as a percentage of average loans from continuing operations increased 40 bps from the prior-year quarter, though it remained unchanged sequentially. Although the company is reducing its exposure to the risky loans, its credit quality may suffer in the near future as the market slump is going to stay for a while.

NIM contraction is another area of concern for KEY. Though average earnings increased 12% year-over-year during 1Q08, NIM declined to 3.14% from 3.50% in the prior-year quarter. The margin reduction was due largely to both loan and deposit spreads, which remained under pressure due to the continuation of competitive pricing and a lease accounting adjustment related to certain leveraged lease transactions. The company experienced a slight growth (4% year-over-year) in average core deposits during the first quarter. However, the cost of these deposits continued to rise. Though KEY subsequently made adjustments in a number of its deposit rates according to the recent rate-cut by the Fed, the full amount of the adjustment has yet to be made in the rates paid for these funds. This normal lag effect on consumer deposit rates, increase in line utilization on the part of commercial customers, and higher levels of non-performing assets will continue to pressurize the NIM until wider credit spreads can work their way through the balance sheet. However, higher earning asset levels should offset the margin pressure impact on net interest income. We will keep an eye on this.

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