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KeyCorp (NYSE:KEY)

Q4 2007 Earnings Call

January 22, 2008 9:00 am ET

Executives

Henry L. Myer III – Chairman of the Board, President & Chief Executive Officer

Jeffrey B. Weeden – Chief Financial Officer

Charles S. Hyle – Executive Vice President, Chief Risk Officer

Beth E. Mooney – Vice Chairman

Thomas W. Bunn – Vice Chairman

Analysts

Terry McEnvoy – Oppenheimer & Company

Anthony Davis – Stifel Nicolaus

John Boland – Maple Capital Management

[David Kringle – Fells Point Research]

Operator

Good morning everyone and welcome to KeyCorp’s fourth quarter 2007 earnings results conference call. This call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to the Chairman and Chief Executive Officer of KeyCorp, Mrs. Henry Myer. Mr. Myer please go ahead sir.

Henry L. Myer III

Thank you Operator. Good morning and welcome to KeyCorp’s fourth quarter earnings conference call. We appreciate you talking time to be part of our discussion today. Joining me for today’s presentation is our CFO, Jeff Weeden. Also joining me for the Q&A portion of our call are our business leaders Tom and Beth, and our chief risk officer Chuck Hyle.

Slide Two is our forward-looking disclosure statement; it covers both our presentation and the Q&A portion that will follow. Before I discuss the strategic actions shown on Slide Three, I think it’s important to point out that Key has been positioning itself for a potential downturn in the credit markets. Specific actions include curtailment of our Florida condominium exposure, the sale of our sub-prime home mortgage lending business more than a year ago and our recent decision to access dealer originated home improvement lending and cease conducting business with non-relationship home builders outside of our footprint. Also and importantly we have no meaningful TLO, CDO, asset backed commercial paper or SIV exposure.

Slide Three highlights strategic actions that were previously announced on December 20th to bolster Keys’ loan loss reserve and manage our expense structure as we entered 2008. These actions include increasing our loan loss reserves with a provision that exceeded net charge-offs by $244 million and adding $25 million to the provisions for unfunded commitments. The additional loan loss provisions reflected deteriorating market conditions in the residential property segment of Keys commercial real estate construction portfolio. We also transferred approximately $1.1 billion of home builder related loans and $800 million of condominium exposure to our special asset management group. As we said in our earnings release today the majority of these credits are currently performing and expected to continue to perform. We announced our decision to exit several non-scale or out of footprint operations, specifically our non-relationship home builder lending outside of our 13 state community footprint, the pay roll on line services which were not of significant size to compete profitable, and the dealer originated home improvement lending which involves prime loans but is conducting largely out of footprint through keys national banking group. We will continue to offer home equity loan to customers within our community banking footprint and we initiated a proactive expense review in the fourth quarter of 2007 aimed at sustaining keys competitive position. As a result of this review Keys has or will eliminate 570 existing positions and 300 open positions. An additional 170 positions will be eliminated in 2008 as a result of our decision to exit the businesses I just mentioned.

We have also continued to focus on building our core relationship banking business. On January 1st we completed the acquisition of USB Holding Company, Inc., the holding company for Union State Bank headquartered in Orangeburg, New York. This acquisition doubles our branch penetration in the attractive lower Hudson Valley area. And finally our board of directors declared the 2008 first quarter quarterly cash dividends of $0.37.5 per common share. This represents a 2.7% increase over the prior quarterly dividend.

On Slide Four you can see our strong dividend tract record. This board action marks the 43rd consecutive year of dividend increases which places us among a very select group of companies in the S&P 500. S&P recognizes these companies with the designation of dividend aristocrat. This decision is also a strong signal from our board about their confidence in the underlying strength of our company. Now I’ll turn the call over to Jeff for a review of our financial results.

Henry L. Myer III

Thank you Henry. I’ll begin with financial summary shown on Slide Five. My comments today will be with respect to Keys results from continuing operations from the fourth quarter of 2007. In some cases I’ll comment on comparisons to both the fourth quarter of 2006 and the first quarter of 2007. Our earnings per share from the fourth quarter of 2007 were impacted by the actions we announced on December 20th to add to our reserve per loan losses and exit certain business activities as well as the market related charges we incurred in our health for sale portfolio. In addition the Visa accruals sweeping through the banking industry during the fourth adversely impacted our results. For the fourth quarter 2007 we are in $0.06 per share from continuing operations, compared to $0.76 per share from the same period one year ago and $0.57 in the third quarter of 2007. I’ll comment further on our fourth quarter results on our 2008 outlook as we review the remaining slides in our presentation.

Turning to Slide Six. The companies tax {inaudible} net interest income for the fourth quarter 2007 increased $38 million dollars from the third quarter and $6 million from the same period one year ago. For the fourth quarter 2007 our net interest margin increased 8 basis points to 3.48% from the third quarter level and was down 18 basis points from the same period one year ago. Our margin benefited in the fourth quarter 2007 from the lease accounting adjustment which increased taxable equipment net interest income by $18 million and added approximately 9 basis points to the net interest margin. The company experienced a similar adjustment in the fourth quarter of 2006. Excluding the fourth quarter of 2007 impact from the lease accounting adjustment our margin would have declined by approximately 1 basis point from the third quarter of 2007.

Our performance here was a little better than what we were expecting as we moved to re-price deposits with a general decline in short term market rates during the fourth quarter. As we’ve talked about in the past several quarters the competition for deposits remain strong in our markets and we believe will continue to pressure the margin into 2008. We would also notice that credit risks have widened for new lending arrangements in the upper ends of the middle market and in the large corporate lending segments. However, this same trend has not worked its way through other lending segments in which the competition for loans remain high. Given the continued strong competition in our markets and the elevated levels of non-performing assets we believe the margin will remain under some pressure in 2008. Our current expectations for the net interest margin in 2008 is for it to be in the 3.30% range.

Slide Seven highlights the changes in non-interest income between the fourth quarter of 2007 and the third quarter of 2007 and the fourth quarter of 2006. As we stated in our earnings release and in our earlier comments the fixed income markets continue to have an adverse impact on our fourth quarter non-interest income, however, when compared to the third quarter 2007 our results were significantly better. For the fourth quarter our non-interest income was up $50million from the third quarter and down $70 million from the same period one year ago. During the fourth quarter we experienced good growth in our trust and investment services fee income compared to the third quarter. Prior year comparisons are impacted by the first quarter 2007 divestiture of McDonald investments. Excluding the McDonalds results from the fourth quarter 2006 year-over-year trust and investment service fee income increased by $21 million or 19% driven by both personal and institutional asset management businesses. We also experienced good growth in our deposit service charges compared to both the prior quarter and the same period one year ago. Net losses from loan securitization and sales decreased in the fourth quarter compared to the third quarter due to smaller marks on our health for sale portfolio and the $28 million in gains realized from the sale of commercial leased financing receivables during the fourth quarter. Compared to the prior year, income from this line item was down $48 million. The current year negative marks on the health for sale portfolios compared to gains in the prior year and the securitization of student loans and commercial makes comparisons difficult. Due to market conditions we did not proceed with the securitization of our student loans in the fourth quarter of 2007. At this point in time we do not know when market conditions may improve to the point where we may wish to complete a securitization.

Turning to Slide Eight. We have prepared a similar comparison of the increase and decrease in non-interest expense between the fourth quarter 2007, the third quarter 2007 and the fourth quarter 2006. Several items impacted our overall non-interest expense during the fourth quarter. In the personnel area we recorded severance expense of 24 million compared to $4 million in the third quarter. We also increased our provision for non-unfunded commitments to $25 million from $5 million in the third quarter and we recorded a $64 million charge representing the estimated fair value of Keys liability to Visa Inc. in the fourth quarter. Comparisons to the fourth quarter 2006 are impacted by these same items plus the divestiture of the McDonald Investment branch network.

Turning to Slide Nine. Average loans from continuing operations increased $2 billion or 11.9% annualized from the third quarter 2007 and were up $4.1 billion or 6.3% compared to the fourth quarter of 2006. Average commercial loan balances were up 7.5% in the fourth quarter versus one year ago and up 15.3% annualized from the third quarter of 2007. Average consumer loans were up 3.1% from the same period one year ago and were up 2.7% annualized from the third quarter level. We experienced strong linked quarter growth in our C&I portfolio in our National Banking lines of business coming from real estate capital and the institutional banking areas. This growth was partially due to the disruptions we saw in the fixed income markets during the second half of 2007. Customers who may have financed there transactions in the capital markets in the past look to us and other banks to help them with their funding needs. For 2008, as a result of our continued deemphasize on our home builder and condo exposure, we expect to see commercial loan growth in the low single digit area for the year. Our outlook consumer loan growth is also in the low single digit area given our belief that consumers will be guarded with the respect to taking on additional debt until they get a better feel for the direction of the US economy and the value of their homes. In addition, our decision to exist the dealer originated home improvement lending area will also impact our growth.

These growth expectations do not include the balances which we acquired as part of the Union State Bank acquisition on January 1st 2008 which were approximately $900 million of commercial loans and $600 million in consumer loans as of the acquisition date.

Turning to Slide 10. I’ll speak briefly to the changes we experienced to our average for deposits in the fourth quarter versus the third quarter. Comparisons to the first quarter in prior periods has shown are impacted by the McDonalds investment branch network. The dotted line on this chart represents the year-over-year percentage growth comparison excluding the impact of the McDonalds deposits sold. Our core deposit balances were impacted in the fourth quarter by continued intense competitive pricing pressure. While we have talked in the past about the regional differences in pricing across the company with the Western half of the country being more rational we did not see this in the fourth quarter. Pricing for deposits has become just as competitive in the West as it is in the Eastern half of the United States. We believe that with the destruction in the capital markets and the ability to raise wholesale funds on the part of banks in general, many competitors chose to maintain or increase their deposits even while the Fed was cutting rates. We chose to remain competitive with our pricing and at the same time we reduced rates in many areas in response to the cuts in the targeted Fed funds rates. Within our Community Bank we saw average deposit growth of $0.5 billion or 4.5% annualized for the fourth quarter compared to the third quarter of 2007 with most of this growth coming in CD’s greater than $100,000. Core deposits were relatively flat with the third quarter versus the fourth quarter of 2006 average total deposits with community bank adjusted for the $1.6 billion deposits sold with the McDonald Investment branch network increased $1.5 billion or 3.4%. On the National Banking side average deposit balances for the fourth quarter were flat with the third quarter. In our real estate capital line of business, deposits were down approximately $0.3 billion as interim loan servicing and the related escrow balances declined in the fourth quarter. This was a result of fewer commercial mortgage loan balances being structured in the C&VS products in the fourth quarter. In addition, we reclassified approximately $3.4 billion of DDA balances to the MMDA category during the fourth quarter. This had an impact on our reported average as well as ending balances from both the DDA and the now MMDA categories. As of the end of the fourth quarter our commercial mortgage servicing portfolio stood at $135 billion and had $3.9 billion of escrow deposit balances associated with this business. Our expectation for 2008 is to see core deposits grow in the low single digit range.

Slide 11 shows our asset qualities summary. Consistent with our announcement on December 20th, net charge offs in the quarter were $119 million or 67 basis points compared to $59 million or 35 basis points in the third quarter and $54 million or 33 basis points for the same quarter one year ago. What I’m not showing on this slide our provision for loan losses was $363 million in the current quarter and exceeded net charge-offs by $244 million. Non-performing assets and the additional provision expense were primarily results of deteriorating market conditions in our commercial real estate construction portfolio.

As part of the actions taken in the fourth quarter we are also moving to exit approximately $1.1 billion and $.8 billion of condominium exposure located outside of our 13 state community banking footprint. The majority of the $1.9 billion in loans identified are in projects located in Florida and California. Outside of the commercial real estate construction portfolio we experienced a modest increase in our consumer non-performing loans during the current quarter. The reserve for loan losses at December 31, 2007 stood at 1.69% of total loans and our coverage ratio of our allowance to non-performing loans stood at 175%. Our current outlook for net charge offs for 2008 is in the 60 to 70 basis point range.

Looking at Slide 12; the company’s tangible capital to tangible asset ratio was 6.46% and our tier one capital ratio was 7.37% at December 31, 2007. Our targeted ranges for the tangible and tier one ratios are 6.35% to 6.75% and 7.50% to 8.0% respectively. During the fourth quarter we did not repurchase any of our common shares and reissue activity was limited at just 85,000 shares under employee benefit plans. At December 31, 2007 we had 14 million shares remaining under our current board repurchase authorization. We currently do not anticipate any share repurchase activity during the first quarter 2008 as we rebuild our tier one capital ratio to our targeted range.

Slide 13 is a summary of our current outlook for selected line items for calendar year 2008. As Henry mentioned in his comments, we closed the Union State Bank acquisition on January 1, 2008. This added approximately $1.5 billion of loans and $1.8 billion of deposits in the company as of that date. Also, we anticipate that with the actions taken in the fourth quarter to exit certain portfolios in the home builder area and the home improvement area, loan growth will be slower in 2008 than experienced in 2007. In addition, we are expecting held-for-sale loan balances to be lower in 2008 compared to 2007. Overall, we anticipate average earning asset growth in the low single digit range in 2008 compared to 2007.

We expect the margins to remain under some pressure due to the items previously discussed and to be in the 3.30% range for the year. With respect to credit costs we current expect net charge offs in the 60 to 70 basis point range for the year and provision will depend on specific facts and circumstances surrounding non-performing assets and the migration of credit up and down. With the actions taken in the fourth quarter to address our costs, excluding the Visa related charges and the reserve for unfunded commitments provision taken in the fourth quarter 2007, expense growth in 2008 will be well controlled and in the low single digit range. We also expect our effective tax rate to return to the 32 to 33% range.

That concludes our remarks and now I’ll turn the call back over to the operator who will provide instructions for the Q&A segment of our call.

Question-and-Answer Session

Operator

Our question and answer session will be conducted electronically. (Operator Instructions) Our first question of the morning will go to Terry McEnvoy at Oppenheimer & Company. Please go ahead.

Terry McEnvoy – Oppenheimer & Company

Could you just be a little more specific on the expenses recorded in Q4 associated with the expense review that’s going on? Then, looking on to 2008 within your guidance this morning does that include additional, call it one time expenses, as part of this review? Or, do you think they’ll be above and beyond your guidance today?

Henry L. Myer III

Well Terry, in the fourth quarter as far as the separation charges there were $24 million worth of severance. There were also some professional fees associated with the outplacement and other activities. That was primary in there. We also recorded a $5 million charges associated with the writing off of goodwill with the payroll online business and that’s in the other expense. As you recall, I think it’s identified clearly in the press release, the $64 million for Visa, the provision for unfunded commitments which for the year was around $28 million. Those particular items we would not anticipate at those levels obviously, in 2008. In the guidance we provided of low single digits excludes a number of those charges related to Visa and unfunded commitments. I think as you look at the separation charges there was also a reduction of incentive compensation accruals both in the third and fourth quarter of 2007. Those would probably be offset increases in 2008 against the separation charges we incurred in 2007.

Terry McEnvoy – Oppenheimer & Company

Could you talk about deposit relationships that KeyCorp has with some of your home builder clients? Particularly those that are out of footprint and those loans that were transfer to the special asset management group and also the quality of those deposits as well.

Thomas W. Bunn

One of the reasons we are exiting a number of those relationships is they weren’t really relationships they were more really opportunities in those regions, non-franchise and because they weren’t in our franchise footprint we did not have significant deposit relationships so you will not see a significant impact on our deposit relationships because of those being moved to the exit portfolios.

Operator

Our next question goes to Tony Davis at Stifel Nicolaus. Please go ahead.

Anthony Davis – Stifel Niclaus

Just a few more details here. Tom, keep going here, I wonder what you could tell me about what you’re seeing right now as loan syndication, as CMBS syndication volumes and kind of what your expectations are for the rest of the year?

Thomas W. Bunn

Regarding syndication we were pleased with the volume we had in the fourth quarter coming out of the institutional side of the bank both with institutional real estate as well as institutional corporate. Clearly, some of that is driven by M&A related activities which has slowed. Now, that said we did see some M&A activity in the fourth quarter slide to the first quarter which will close, which will provide financing opportunities. But, quite honestly, our outlook for the capital market side of the business is really going to be driven by how open those capital markets are. As Jeff said, we do not anticipate significant growth year-over-year in those businesses until we have a better view of those markets.

Anthony Davis – Stifel Niclaus

The question was CMBS?

Thomas W. Bunn

The CMBS pipeline has fallen off dramatically. The fourth quarter was estimated about 20% of normalized volume. We expect no better than 40 to 50% normalize volume this year. As Jeff mentioned, our interim financing has shown a significant slowing and again, we don’t see that growth improving until we get some calm in the markets and a better indication of rates to take outside.

Anthony Davis – Stifel Niclaus

What are you seeing Tom, on mortgage servicing pricing and what’s the likelihood you’ll be adding some this year?

Thomas W. Bunn

Interestingly enough we continue to see strong competition in the mortgage servicing pricing. We will continue to look to add there but we will not be stupid about paying for it.

Anthony Davis – Stifel Niclaus

Finally Beth, a question for you; I just wondered how many of the branches you’re looking to upgrade this year? And, what we can expect there in terms of incremental expense impact?

Beth E. Mooney

We currently have about 65 branches in flight for our branch modernization and updating and then we will be looking to do another 100 to 150 this year in our modernization program and we have accounted for that in our expectations for our 2008 non-interest expense. But, given most of that is capital it will not have a significant impact.

Operator

We’ll go next to John Boland at Maple Capital Management. Please go ahead.

John Boland – Maple Capital Management

I’m just trying to get a little more clarity on the reserve side and your methodology. The consensus is the next couple of quarters are certainly going to be a lot worse than what we’ve seen and you’re allowances seem to be going up at a much slower pace than your non-performing assets or your charge offs. Just looking for any kind of clarification.

Charles S. Hyle

I think our main focus clearly has been on the commercial real estate side. We took a very detailed look in December at our commercial real estate business. As we’ve indicated both looking at exit names as well as parts of the residential construction portfolio that has underperformed the last six months. We try to take quite a conservative few of that portfolio looking out into the future and that’s where the special reserves come from and while the majority of our exit names are still performing and we do expect them to continue to perform, it’s clearly weakness in specific parts particularly California and Florida. Our perspective on that was to increase our reserves to look through the next 12 months to be as adequately reserved for that part of the portfolio as we possibly could. The rest of the portfolio has continued to perform well. Our commercial and institutional businesses have continued to perform well and in line with expectations. Our consumer portfolios we started to see some modest migration starting four months ago. Through the fourth quarter we have seen some continued migration but, it has been relatively modest and we continue to view that part of the portfolio as well as our middle market portfolio to essentially perform in line with the economy. That’s our perspective.

John Boland – Maple Capital Management

Can you provide any granularity as far as geographic trends you might be seeing? You just mentioned California but within the core markets are you seeing any particular or do you have any breakdowns as to who’s really getting harder than others?

Charles S. Hyle

Are you speaking about real estate or broadly?

John Boland – Maple Capital Management

Primarily real estate.

Charles S. Hyle

Primarily California and Florida are the two weakest areas. Most of the rest of the geographies have performed relatively well. We’re seeing a little weakness in Nevada but, we’re not particularly exposed there. We’ve seen some weakness in Michigan but we are very underexposed in Michigan in real estate. The Pacific Northwest continues to perform well. Most of the northeast does. So, it’s really most of our focus on the negative side is just certain parts of California and certain parts of Florida.

John Boland – Maple Capital Management

Which are really non-core markets, correct?

Charles S. Hyle

Correct.

John Boland – Maple Capital Management

Just one last bit of information if you could; would you say you’re being very proactive in the modeling? It almost sounds like you’re letting the economy drive the reserves and I’m just wondering if you could shed any light on that.

Charles S. Hyle

Well, as I said I think we will perform in line with the economy but, as we look at the economy and our view of the economy changes it has an impact on the model. Our models are very sensitized to economic activity and we are certainly seeing some migration to a weakening economic environment and those do show up in the models we use.

Operator

(Operator Instructions) We’ll go next to David Kringle at Fells Point Research. Please go ahead sir.

[David Kringle – Fells Point Research]

Jeff, your guidance on the margin is that take into account the FED cut today?

Henry L. Myer III

Well, it was based on the Blue Chip forecast. Obviously, I haven’t had an opportunity to go back and remodel the margin for the most recent activity that happened today. But, directionally we were modeling for decreasing rates over the next 12 months. So, the guidance has a degree of decline in general interest rates over the next 12 months.

[David Kringle – Fells Point Research]

But, did it have the magnitude of the move today?

Henry L. Myer III

I don’t know if anybody did David, to be quite honest. If you were to look at People’s analysis – the way we’re positioned with the decrease in rates depend on how low the FEDs end up ultimately going obviously. Looking at competitive factors that are out there in the market place how fast will competitors respond also to this change in the overall rate environment.

Operator

Mr. Myer we have no other questions at this time. I’d like to turn the call back to you for any further comments.

Henry L. Myer III

Again, we thank all of you for taking the time from your schedule to participate in our call today. If you have any follow up questions on the items we discussed please don’t hesitate to call Vern Patterson in our investor relations department. I’m sure all of you have Vern’s number but I’ve got it too, it’s 216-689-0520. That concludes our remarks and we wish everyone to have a good day.

Operator

That does conclude the call. We do appreciate your participation. At this time you may disconnect. Thank you.

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