DBRS Comments on KeyCorp’s 4Q10 and 2010 Results; Sr. at BBB (high) Unchanged; Trend Stable

DBRS Inc. (DBRS) has today commented on the 4Q10 results of KeyCorp (Key or the Company). The Company reported net income available to common shareholders of $279 million (after $41 million in preferred dividends and amortization), compared to $178 million in the prior quarter and a loss position of $265 million in 4Q09. The stronger results were attributable to higher than expected release of loan loss provisions of $97 million. The favorable earnings results in the recent quarters have been largely driven by the positive momentum in credit quality and management anticipates credit trends to continue to improve into 2011. Fourth quarter also marked the lowest level of net loan charge-offs (NCOs) since 1Q08, and of nonperforming assets (NPAs) and new non-accrual loan inflows since 3Q08. DBRS views KeyCorp’s improved fourth quarter performance as being within expectations and therefore its ratings, including its Issuer & Senior Debt rating of BBB (high) and Stable trend remain unchanged.

KeyCorp’s results reflect the progress the Company has made in dealing with its significant asset quality challenges, nevertheless, DBRS sees consistent revenue generation and earnings growth as the Company’s primary challenges. Net interest income decreased 1.7%, or $11 million, in the quarter to $629 million. The decline was driven by a reduction in interest yields and the 1.9% contraction in earning assets. Average loans (excluding exit portfolios) declined 3.3% in 4Q10, at a slower pace than the prior quarter, however, continued to pressure net interest income. DBRS expects further pressure on net interest income from weak loan demand and a decline in the average loan balances projected from exit portfolios and discontinued operations somewhat offset by improved funding costs. Net interest margin (NIM) was up 27 bps from 4Q09, but contracted 4 bps from 3Q10 to 3.31%, impacted by hedge maturities and an earning asset yields decline of 17 bps from the prior quarter, partially offset by improvement in funding mix (with a 15 bps decline in yield on interest-bearing liabilities) as higher yielding CD’s matured or re-priced to lower-cost transaction deposits. Management anticipates NIM in 2011 to be in the range of 3.2% to 3.3%.

Fourth quarter noninterest income was up 8.2%, or $40 million, to $526 million and up 12.2%, or $57 million, from a year ago same quarter. Results reflected improved performance in investment banking and capital markets income primarily related to a reduction in customer derivative activity reserves and an increase in corporate-owned life insurance income. In the quarter, fee income also benefited from a $28 million gain from the sale of Tuition Management Systems and $12 million in net securities gains. Conversely, a $10 million sequential decline in letter of credit and loan fees, and the $6 million in losses from principal investing partially offset the positive variance. Included in the segment results for the quarter is the full impact of Regulation E, with deposit service charges down an additional $5 million on a linked quarter basis and $12 million from 4Q09 (full year impact of $40 to $70 million). DBRS anticipates the Company’s fee revenue to be further pressured as the Durbin Amendment, scheduled to take effect in the 2H11, could have a negative impact of approximately $75 million on Key’s $100 million interchange fees and underscores the revenue headwinds facing Key in 2011. In 4Q10, total noninterest income comprised 45% of total revenues.

Rising expense levels exert further pressure on revenue growth for KeyCorp. For the quarter, noninterest expense increased 1.1% or, $8 million, to $744 million from the prior quarter. The increase was due to a $15 million jump in business services and professional fees related to resolving non-performing credits, a $6 million increase in personnel expense due to higher incentive accruals, a $6 million increase in other real estate owned (OREO) expense, and an $8 million provision for losses on low income housing tax credit guaranteed funds largely offset by a decrease in operating lease expense and an increase in the credit for losses on lending-related commitments. Although reflecting some improvement with achieving $228 million in run-rate expense reduction toward its $300 million to $375 million goal by the end of 2012, Key’s expense and efficiency levels continue to lag peers and are improving at a slow pace. DBRS sees expense savings as a driver for achieving more normalized profitability.

Net charge-offs (NCOs) for the quarter signaled positive trends and totaled $256 million (2.00% of average loans) and decreased 28.3% ($101 million) sequentially, comparing favorably to 2.69% in the prior quarter and 4.64% at 4Q09. CRE-related loan NCOs continued to decline (34% on a linked-quarter basis) with improvements in CRE construction loans offset by the increase in the commercial mortgage NCOs over the quarter. CRE-related loans comprised 23% of its total loan portfolios, yet comprised 46% of total NPLs and 31% of total NCOs at 4Q10. The Company’s exit portfolio, at $5.4 billion, decreased approximately 8% over the quarter and accounted for 32%, or $81 million, of its total NCOs.

Credit quality improvements were evident in all 4Q10 metrics (including its exit loan portfolio). Fourth quarter results improved with nonperforming loans (NPLs) totaling $1.1 billion, a 22% ($304 million) decline from 3Q10 and represented 2.13% of period end loans, improving 54 bps from the prior quarter and 159 bps from 4Q09. OREO, net of allowance, decreased $34 million in the quarter while nonperforming loans held for sale declined $124 million sequentially to $106 million. DBRS notes that the decline in NPAs marks the fifth consecutive quarterly decline. Most of the quarterly reduction stemmed from commercial, financial, agricultural, and CRE-related portfolios. Key’s exit portfolio accounted for $210 million, or 15.7%, of total NPAs at 4Q10. Consumer NPLs grew 3.1% over the quarter, impacted by growth in residential mortgage and marine and other consumer NPLs.

DBRS notes that one of the few negative credit trends experienced was that 90 day past due but accruing loans increased 57% from 3Q10 to $239 million due to delays in loan renewal negotiations that have since cleared. Positively; however, near term delinquencies (30 to 89 days past due) declined 28% to $476 million in 4Q10.

Key’s $97 million release in loan loss provision in the quarter compared to loan loss provision of $94 million in 3Q10 reflects a significantly improved and healthier relationship between its adjusted income before taxes and provisions (IBPT) of $371 million, and credit costs. Reserve coverage also improved in the quarter to 150.2% of NPLs compared to 142.6% in the prior quarter, despite a $353 million reserve release. Allowance for loan losses was $1.6 billion, or 3.2% of total loans at 4Q10, compared to 3.8% in the prior quarter and 4.3% at 4Q09. Key’s reserve coverage is adequate in providing a solid layer of protection against potential losses in addition to strong capital levels.

The Company’s regulatory and tangible capital ratios also improved over the quarter from better earnings, lower risk assets, lower disallowed net deferred tax asset (for regulatory ratios), and from elimination of intangible assets associated with Tuition Management Systems. As a result, the Tier 1 risk-based capital ratio rose 80 bps sequentially to 15.1% and the Tier 1 Common equity ratio improved 70 bps to 9.31%. Importantly, the TCE ratio increased 19 bps in the quarter to 8.19%. DBRS believes Key’s capital levels remain solid and reflect positively on the Company’s careful capital management efforts while positioning the Company for the transition to Basel III. DBRS notes, however, that regulatory capital ratios include $2.5 billion in TARP preferred shares that contribute an estimated 3.13% to the Tier 1 capital ratio at December 31, 2010. Additionally, the Company had $1.8 billion of Trust Preferred Securities (corresponding to 229 bps of Tier 1 capital as of 12/31/10) qualifying as Tier 1 capital that will be phased out over a three year period in accordance with the financial reform legislation beginning in 2013.

Currently, KeyCorp is one of the 19 banks subject to a second round of Federal Reserve stress tests to ensure capital adequacy. The stress tests will test a bank’s ability to absorb losses over the next two years under at least two scenarios (baseline and adverse) and will take the proposed Basel III capital requirements into account as well as TARP repayment. Test results will also determine whether an institution may resume capital distributions (stock dividends and/or repurchases). The stress test results are expected to be communicated to BHCs (not publicly) no later than March 21, 2011.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Global Methodology for Rating Banks and Banking Organizations, Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the company documents, the Federal Deposit Insurance Corporation and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: William Schwartz
Initial Rating Date: 25 April 2003
Most Recent Rating Update: 26 March 2010

For additional information on this rating, please refer to the linking document below.