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Operator
Good morning, and welcome to the KeyCorp's fourth quarter earnings results conference call.
This conference is being recorded.
At this time, I would like to turn the call over to the Chairman and Chief Executive Officer, Mr. Henry Meyer.
Mr. Meyer, please go ahead, sir.
Henry L. Meyer III - Chairman and CEO
Thank you, operator, and good morning, and welcome, all of you, to KeyCorp's fourth quarter earnings conference call.
We appreciate you taking some time on what we know is a busy day to be a part of our discussion.
Joining me today for our presentation is CFO Jeff Weeden, and also available for our question and answer period are Lee Irving (ph), Kevin Blakeley (ph), Joe Veda (ph), and Vern Patterson (ph).
On slide two, you'll see our standard forward-looking disclosure statement.
It covers both our presentation and the Q&A that follows.
If you'll now turn to slide three, you can see some of the areas where I feel we've made very good progress against our four strategic priorities -- growing revenue, managing expenses, reducing our credit costs, and delivering consistent results.
Let me start with the financial results.
Key was able to hit its consensus number for the fourth consecutive quarter.
We are able to achieve this despite some fairly strong economic headwinds that we faced throughout the year.
Although our results fell short of our original plan, I believe that we had a very solid year, with a number of meaningful accomplishments.
On the revenue side, we've been working hard to grow deposits, align our businesses to better serve our customers, and build profitable relationships and improve our cross-sell ratio.
As you can see on this slide, our deposit initiatives gained strength in the fourth quarter as we aggressively competed for new business and continued to expand relationships with existing customers.
This included the rollout of free checking in all of our markets, and for our new checking customers, we had been successful in selling an additional 1.5 services, therefore totaling 2.5 services for each of those new customers.
Non-interest-bearing deposits were also up over 700 million in the quarter, primarily driven by our commercial business.
Progress was also made during the year on aligning our businesses around customer segments.
One example is the integration of our commercial and investment banking units to better serve our corporate customers.
We've also invested in our core businesses, such as retail, where we build eight new branches in 2002 and continued our program of refurbishing 10 percent of our existing facilities each year, and we've also continued to deliver on our commitments to downsize our non-relationship businesses, such as auto and the large corporate loans in our runoff portfolio.
Since we announced these initiatives in May of 2001, 3.5 billion of these low spread loans have been taken off our balance sheet.
Expense management has been a very positive story for us this year again.
As a result of PEG (ph) and our continuous improvement efforts, expenses in 20002 were at their lowest level since 1998 and have been basically flat for the past four years.
Improving credit quality remains one of our top priorities.
In the fourth quarter, non-performing loans declined 44 million, and our criticized and classified loans were also down compared to the previous quarter.
Overall, we remain cautious given the economy and the normal lag time before net charge-offs show improvement, but we are convinced that the right steps are being taken to improve credit quality, and that Key is very well positioned, with operating leverage on the upside when market sensitive revenues and the economy in general turn up.
And finally, we completed the acquisition of Union Bancshares in Denver, Colorado.
The acquisition strengthens our market share position and raises our profile in this very attractive market.
This move is consistent with the growth strategy that we have been pursuing on our retail business.
Now let me turn the call over to Jeff Weeden for a review of our quarter - Jeff.
Jeffrey B. Weeden - CFO
Thank you, Henry.
Turning to slide four, Key reported earnings of 57 cents in the fourth quarter.
Total revenue was up 26 million from the previous quarter as a result of a relatively stable net interest margin, a slight increase in average earning assets, and higher non-interest income.
Our non-performing loans declined 44 million or 4.5 percent from the level at the end of the third quarter, and our capital ratios remain strong, giving us the flexibility to repurchase 1.2 million shares in the quarter, leaving 13.8 million shares remaining under our -- under our current authorization.
At December 31, 2002, the company's tangible capital to asset ratio stood at 6.73 percent compared to 6.71 percent at the end of September, and 6.29 percent at one year ago.
Turning to slide five, the company's net interest income and the margin remained relatively stable during the fourth quarter.
The fourth quarter net interest margin was down one basis point from the third quarter to 3.98 percent.
The change in interest rates announced by the Fed in November will put pressure on net -- on the net interest margin going forward, as implied interest rate floors on certain consumer deposits have been reached (ph) to remain competitive in the marketplace.
In addition, soft loan demand in the current tepid economic environment, coupled with our strategic decision to exit certain businesses, will continue to put pressure on our ability to expand our earning asset base in the short run.
Average earnings assets from the current quarter were up 471 million, due to an increase in the securities portfolio.
Our securities portfolio still only represents approximately 13 percent of our earning assets.
And our sensitivity to rising rates remains very modest.
Approximately one-half of 1 percent of net interest income is at risk to a 200 basis point increase over the next 12 months.
Turning to slide six, you can see the primary drivers of the $14 million quarter to quarter increase in non-interest income.
Part of the increase was attributable to higher investment banking and capital markets revenue as we experience seasonable improvement from the low level we experienced in the third quarter.
On the other hand, trusted investment services income was down for the second consecutive quarter, reflecting just how difficult the market has been.
Slide seven shows that non-interest expense increased by $9 million in the fourth quarter to 668 million.
The largest increase was in professional fees, which were up $8 million during the quarter.
The increased professional fees were spread across many areas, and relate in part to increased volume for leasing, commercial real estate, and capital market transactions closed in the fourth quarter.
Personnel costs continued to decline during the fourth quarter, and stood at $354 million, down $4 million from the third quarter level.
Due to seasonable factors for such items as payroll taxes for FICA, FUDA (ph), and SUTA (ph) and increased medical and dental costs, as well as returning to the recording of an expense for pension in 2003, versus income in 2002, the company expects personnel costs to rise in the first quarter and for the year.
As previously announced, we will also begin expensing options in 2003.
The impact on 2003 earnings depends on the number of options granted, as well as the timing and valuation assumptions used.
On slide eight, you'll find information pertaining to loan charge-offs.
Focusing on the far right column, you'll see the total net charge-offs for the quarter were 186 million, basically unchanged from the level we experienced in the third quarter.
One hundred forty-seven million in net charge-offs came from the continuing portfolio and 39 million from the non-replenishable reserve.
In the continuing portfolio, commercial net charge-offs were unchanged from the third quarter, and consumer loan charge-offs were up $12 million in part due to normal seasonal factors.
Charge-offs to the non-replenishable reserve during the quarter declined $11 million to $39 million.
Slide nine covers our asset quality indicators.
Again, looking at the far right column, you'll see that total non-performing loans finished the quarter at $943 million, down 44 million or 4.5 percent from the prior quarter.
Non-performing loans now represent 1.51 percent of the overall loan portfolio, down six basis points from last quarter.
Total net charge-offs, at $186 million, represent 1.18 percent of loans, up two basis points from the third quarter.
Our loan loss reserve declined modestly to finish the quarter at approximately 1.45 billion or 2.32 percent of loans.
The ratio of reserves to non-performing loans improved three percent to end the quarter at 154 percent.
Slide 10 provides an update on the runoff portfolio that was set up during the second quarter of 2001.
We continue to have success in reducing the size of the runoff portfolio.
Commitments have declined to below 1 billion and outstandings have been reduced to 599 million.
The non-replenishable reserve against which runoff portfolio losses and loan sales are charged constitutes 48 million.
And non-performers in the pool are down to 85 million.
As of December 31, 2002, two-thirds of the remaining balances in the runoff portfolio are higher quality, single relationships credits, and we believe the non-replenishable reserve balance remains adequate to cover the risk in this portfolio.
With the progress that has been made on this portfolio, we anticipate ending separate reporting of this result in 2003.
Now turning to slide 11, which is our first quarter 2003 outlook.
As we stated in our press release, with all the uncertainties in the economy, we are limiting the majority of our comments to the next quarter.
We are continuing to see only modest improvement in the economy, and given where interest rates are, we expect the net interest margin to be under pressure and has become -- as it has become more difficult to move deposit costs down from their already low levels due to competitive reasons.
We also anticipate that our first quarter will be impacted by some seasonal factors, such as lower revenue from leasing and capital markets activities.
Until we see sustained improvement in market conditions, market-sensitive revenues will remain subdued.
As I mentioned earlier, personnel costs are expected to increase in the first quarter and in 2003 due to increased benefit costs surrounding medical, dental, and pension-related costs.
Non-personnel costs are expected to remain well controlled.
The credit outlook remains about the same with NPLs, net charge-offs, and watch lists stable to down next quarter.
As is typical for the company to experience, EPS is expected to be down from the fourth quarter level and is likely to be at the low end of the estimates posted on First Call of 54 cents to 59 cents.
As we look out in 2003, the weak economy continues to affect financial markets and financial companies such as Key.
Credit costs remain high, and market sensitive businesses continue to come under pressure.
That concludes our remarks, and now I'll turn the call back over to the operator to provide us with instructions for the Q&A portion of our call - operator.
Operator
Thank you.
A brief reminder - the question and answer session will be conducted electronically today.
Anyone wishing to ask a question may signal us by firmly pressing the star key, followed by the digit one on your touch-tone telephone.
We will take as many questions as time permits, and we'll proceed in the order that you signal us.
As a remainder, there may be callers holding to ask a question at one time.
We appreciate your patience.
And we'll be going to Jeff Davis with TN Securities.
Jeff Davis
Good morning.
How are you guys?
Henry L. Meyer III - Chairman and CEO
Good morning, Jeff.
Jeff Davis
A question for you, and Jeff, I guess you sort of touched on it.
As -- from -- as we think about Key's earnings and earning power going forward, what you've done with the runoff portfolio is -- and the difference between net charge-offs is relatively easy to see.
But as we go forward, are we going to see the charge-offs in '03 basically come down to match provision or -- and will draw down the reserve, or is that going to end here in the next couple of quarters?
Jeffrey B. Weeden - CFO
Well, we anticipate that we'll continue with the runoff portfolio for a period of time in 2003, and continue to make charge-offs to that.
On the continuing portfolio, our practice has been, in the past year, to match charge-offs and provision.
Henry L. Meyer III - Chairman and CEO
Jeff, a simple - it's Henry - a simple way to look at that is, there won't be a bigger difference than 48 million, which is what we have left in the runoff reserve.
So, you know, that's the most that we would miss that by.
We continue, as Jeff said, to have a policy of fully providing for the core charge-offs.
Jeff Davis
OK.
And then -- so, directionally for the year, should the 147 of losses on the core portfolio, as we look next year, should that be viewed as a high water mark, assuming the economy doesn't get down again?
Henry L. Meyer III - Chairman and CEO
It's somewhat difficult to project, you know, charge-offs throughout the entire year, Jeff, but -- you know, it's difficult to project charge-offs, I would say.
There could be other events that happen, as you know, so -- during the course of the year, just like what happened in 2002.
Jeff Davis
OK.
And one follow-up question, if I may.
Henry or Jeff, or anyone else sitting around the table, what are you guys seeing in the auto industry?
And maybe -- and how does your base of customers feel, say, maybe vis-a-vis three months ago when we saw Core America (ph) preannounce?
Kevin Blakeley
I would -- this is Kevin Blakeley.
I would have to say that, overall, while the auto industry isn't terrific, it's certainly not in awful condition either.
We are seeing basically stabilization in our overall manufacturing portfolio, which includes our auto exposure.
I would say that it's not getting tremendously better, but it's also not getting tremendously worse either.
Jeff Davis
OK, very good.
Thank you.
Operator
And we'll be taking our next question from Scott Siefers with Sandler O'Neill.
Scott Siefers
Good morning, everybody.
Just a couple of really quick questions.
First, I noticed just a bump up in the (inaudible) from third quarter.
Just wondering if you could tell us, is that an unfortunate incident, or did you put more on?
And then second, you noted the increase in home equity non-performers in the text of the press release.
I was just hoping you could talk generally about trends you're seeing in terms of consumer credit quality?
Joe Veda
This is Joe Veda.
I'll respond to the question on COLA (ph) income.
First of all, let me say that we have not added to that portfolio.
That was part of your question.
The increase in income during the fourth quarter is purely a result of the carriers making adjustments to the dividends that they provide during the fourth quarter.
And that typically happens during the fourth quarter of each year.
Henry L. Meyer III - Chairman and CEO
With regard to the home equity non-accruals and the consumer portfolio overall, I'd say that, with regards to the portfolio overall, year to over year, most of our delinquencies are down for almost all of our portfolios.
Quarter to quarter, sort of a mixed bag.
Some of them were up a little, some of them were down a little.
But what we're experiencing right now is sort of seasonality in the portfolio; typically in the fourth quarter of the year, we see delinquencies rise.
That extends into the first quarter of the year also.
So I would say that what you're seeing is sort of a normal trend.
We're not excessively concerned about what's going on.
Scott Siefers
OK.
Thank you very much.
Operator
We'll be taking our next question from Roger Lister at Morgan Stanley.
Roger Lister
Yes, good morning.
First of all, I wonder if you can give us a sense of the differences in the trends between sort of middle market direct kind of lending versus more of the asset-backed type lending out of your finance group.
Kevin Blakeley
Could I ask for a little clarification on that question?
Are you asking, are we doing more secured type lending?
Roger Lister
Well, yes, I guess - and some (ph) -- everybody is trying to figure out where our commercial lending is going.
I was trying to get a sense of the differences you are seeing between, you know, the more - you know, lines of credit directly to middle market versus the extent to which, you know, more asset-backed lending is growing.
Kevin Blakeley
Well, I guess what I can say is that, at this point in the economy, we don't see our customers exhibiting a whole lot of new demand for capital expenditure in the middle market area.
We do see a lot of stabilization going on in their balance sheets.
We are no longer seeing, you know, a lot of wholesale deterioration in the middle market sector.
The -- I will say that, as far as asset-based lending is concerned, I think in general the industry is looking for more and more collateral type collateral behind their loans.
If anybody comes in with leverage, there is typical an approach made on an asset-based lending rather than the -- you know, what we were seeing three or four years ago where you can do a lot of air ball lending.
I'm not sure if that addresses your question or not.
Roger Lister
No, that does get to exactly, I think, the point I was trying to understand, and, you know, the differences in the trends between the different types of lending.
Shifting (ph) to maybe a different direction, everybody is trying to understand what's going on with consumers.
To what extent do you see differences in trends and delinquencies and bankruptcies between the sort of more prime customers and subprime customers?
You know, as you think about customer base out of Champion versus, you know, maybe direct out of the branch (ph)?
I mean, is there this bifurcation that people are talking about between the two groups of customers?
Kevin Blakeley
Well, I would say that in just about any prime portfolio, it's obviously going to perform better than a non-prime or a subprime portfolio.
Overall, I believe that, in our largest portfolio, which is our direct home equity portfolio, delinquencies actually edged down a little bit during the quarter.
With regard to the near prime home equity businesses that we have, one of the portfolios, their delinquencies actually improved during the quarter.
The other portfolio, they actually declined slightly during the quarter -- I mean, they deteriorated slightly during the quarter.
So, overall, I have not seen a significant change quarter to quarter in the performance of the portfolios.
But yes, clearly there is a difference between the delinquencies of the prime portfolio and the near prime.
Roger Lister
Yeah.
I was thinking more about the trends rather than the absolutes of differentials, whether or not you saw a widening trend, (inaudible) what you're saying, they're moving about in the same direction?
Kevin Blakeley
Well, yes.
I mean, the direct portfolio was down slightly.
One of the near prime portfolios was down slightly.
One of the near prime portfolios was up slightly.
So I can't really say that there was a major difference between quarter to quarter.
Henry L. Meyer III - Chairman and CEO
Roger, this is Henry.
You know, another factor that's important to remember as it relates to Champion is that, in 2002, north of 80 percent of the loans that Champion did we filed first liens on -- i.e., customers came to us for a second mortgage reason, and because of rates, we were able to refinance that into a first lien position, and first lien positions, in all of consumer, are the highest quality position to be in.
So, while we, as Kevin said, haven't seen any significant deterioration -- one portfolio up a little, one portfolio down a little -- the Champion portfolio, we feel very, very comfortable with, given the characteristics of those loans.
And it's why, in case you missed it, Kevin referred to that as a near prime portfolio.
We really don't look at the C paper there as deep subprime, and consequently, it's followed the market trends much more than the low-quality trends.
Roger Lister
You know, I did notice that comment.
Could you -- just quickly, is there any sense of differences between the regions, say the Pacific Northwest and the more Midwest focus in terms of what's going on either on the business side or the consumer side?
Henry L. Meyer III - Chairman and CEO
No.
We really, in this past quarter, we looked at that anticipating the question, and also it's something that I want to know.
What we really have seen is that the Midwest, two years ago, dipped first, but we've seen the other regions slow down and catch up, but we haven't seen any particular regional movement in the fourth quarter, either from an improvement standpoint or a deterioration standpoint.
I think everyone knows that there are pockets of commercial real estate, some cities that are having what would be described as real regional declines.
But in terms of the consumer and in terms of Key's portfolio as it relates to commercial real estate, we're seeing a pretty steady across all four of the regions we look at, the Midwest, the Northeast, the Rockies, and the Northwest.
Roger Lister
Thank you.
Operator
And our next question will come from Nancy Bush at NAB Research.
Nancy Bush
Good morning.
A couple of questions for you.
If you could just sort of -- my clients -- and I'm sure you have heard this as well -- are concerned about commercial real estate increasingly at this point.
If you could just sort of size your exposure there and tell us what your experience has been, particularly in, you know, the last couple of quarters.
Secondly, I saw Jack Kaniski (ph) up in Boston in November, and he was talking about the sort of ongoing look at the retail branch system and some of the things that might be done there.
Can you just sort of give us an idea, you know, of any kind of major changes that may be coming in the retail branch system in '03?
Thanks.
Kevin Blakeley
Yeah.
This is Kevin Blakeley.
Let me address the commercial real estate issue first.
Overall, we have about -- I think the area that you're interested in, Nancy, is what we would describe as non-owner occupied.
We break that out to be around $6.8 billion as of the end of the year.
Overall, the quality of that portfolio is very, very good.
It's -- I think I saw that we had less than $2 million charged off in that portfolio for the fourth quarter.
The level of criticized (ph) is -- continues to be very low.
Yes, it's up slightly over the last several quarters.
But our level of charge-offs, our level of non-performings, are very high quality.
Henry L. Meyer III - Chairman and CEO
Nancy, it's Henry.
Let me take the branch question.
And there are no significant changes that we're going to make in our retail distribution portfolio.
We would like to do a couple of smaller acquisitions in 2003, a la Union Bancshares in Denver.
We are continuing to move out of the in-store supermarket branches.
We did about 10 or so of those in the Northeast.
We moved out in 2002, and we're continuing to review that.
But as I have said and Jack has said, since June of 2002, at least the six months at the end of last year, and for 2003, we planned to be net adders of branches as we continue to try to move in franchise into the higher-growing neighborhoods and demographically more attractive areas.
But the acquisitions that we would hope to get done would be in franchise additions to help our micro-market share.
And we aren't excluding the Northeast and the Midwest, but if we could find more opportunities like Denver, that would fit both lower share opportunities to grow and higher growth markets.
Nancy Bush
Henry, when would you anticipate -- because I asked Jack the perennial question about Alaska, and, you know, certainly got an indication that there might be in the future, you know, some looks at the outlying parts of the branch network and what you might want to do with those.
When would you anticipate some more -- -- I don't know, call it dramatic reshaping of the branch network?
Is that still several years down the road?
Henry L. Meyer III - Chairman and CEO
Nancy, right now we are very conscious of our loan to deposit ratio.
We have a flattened asset growth because of the decisions we made in May of 2001, and we're pushing on the deposit growth.
Alaska, because you mentioned it, is a funding source for us.
And while any pieces of our franchise could be used for funding a higher profitable or higher growth opportunity, either geographic or line of business, there are no current plans to exit any of the markets that we're in.
While I can make a case that we got a very good price for Long Island, it also exacerbated the loan to deposit issue.
So we have assets on our balance sheet that could be used for funding or transferring to other growth or profitable opportunities, but I doubt, even in the next couple of years, that I am going to singularly pair off an asset, especially one that's deposit rich.
Nancy Bush
OK.
If I could just -- since you brought up the loan to deposit ratio, do you have any goal or target where you would like to be at the end of '03?
Henry L. Meyer III - Chairman and CEO
Yes, better.
Nancy Bush
Like, how much?
Henry L. Meyer III - Chairman and CEO
We haven't -- we're in the process, Nancy, of putting some numbers together for the board and my team that will include short-term and longer-term goals, but I don't have those at this point.
Nancy Bush
OK.
Thank you.
Operator
We'll be taking our next question from John McDonald at UBS Warburg.
John McDonald
Good morning.
I was hoping Kevin could just clarify, on the charge-off fund for the consumer, what was the source of the increase in consumer charge-offs from the 51 million to the 63 million?
Kevin Blakeley
Actually, if you can give me one second, I can quote it for you.
John McDonald
Sure.
And then also, for Jeff or Henry, if you could comment on the capital levels right now, and how you're analyzing, you know, your ability and willingness to do buybacks.
You know, what's - obviously a weak economic environment.
Kevin Blakeley
John, this is Kevin.
With regard to the consumer charge-offs, it was pretty much scattered across the board.
The one area of the $12 million increase, I think $3 million of it was related to the marine (ph) portfolio, which is the largest single category.
The marine portfolio goes through a seasonal period in the fourth quarter and the first quarter.
That's where we typically see the charge-offs increase there.
Otherwise, it's sort of sprinkled about through the whole portfolio.
John McDonald
OK.
So when you talked about the seasonal impact in that overall number, you're really referring to the marine?
Kevin Blakeley
Well, the marine is particularly seasonal, but there are -- most of the consumer portfolios that are seasonal, and particularly in the fourth quarter, because of the holidays, people tend to take their money and buy, you know, gifts and stuff like that, instead of paying their loan.
But that's typical throughout the industry.
John McDonald
OK.
Jeffrey B. Weeden - CFO
John, with respect to the capital, our capital level attend of the year we had a tangible capital asset ratio of 673, basically unchanged from where we were at the end of the third quarter.
Our capital level does give us the flexibility, if you will, to look at acquisitions, to also, you know, pay our dividend, and also look at stock buybacks.
As far as repurchasing of shares we've been following, at least in 2002, and I would anticipate, as we look at 2003 that, we would buyback shares for any employee benefit plan increase.
So if you look at it year over year, we're relatively flat on the number of shares outstanding, and I think that's probably a good place to look for '03 at this point.
John McDonald
So you're a little bit more biased towards keeping the capital in a weak environment right now than taking the share count down on a net basis?
Jeffrey B. Weeden - CFO
From an aggressive standpoint, that's absolutely correct.
John McDonald
OK.
One more follow-up for Kevin.
If you could just give us a little bit more color on the watch list trends, what we saw this quarter, and the inflow into NPAs?
Kevin Blakeley
The inflow to NPAs was about -- the new inflow was about consistent with what we saw in the preceding quarter.
However, we saw a lot of pay downs during the fourth quarter.
We did some sales, we did some pay downs.
We had some improvements.
It's clear that the pipeline for overall problem credits is really slowing down.
And we were pleasantly surprised with the trends of criticized from classified assets, which precede the lagging indicators of non-performer and charge-offs.
So the pipeline is flowing.
I think we're starting to see a bend in the trend lines now.
John McDonald
OK.
One last thing, Kevin.
Could you just quantify your energy exposure?
Kevin Blakeley
Sure.
The total energy exposure is -- we have around what we would call energy categories of around -- commitments of around 1.7 billion, but it's not the type of energy that you're interested in there, John.
None of these are transmission companies.
They're all very highly rated companies.
As I'm scanning down the list here, I'd have the vast majority of them sitting in front of me here.
I don't see any of them that are even criticized.
Many of them -- most of them are investment grade.
John McDonald
OK.
How about the outstanding?
Kevin Blakeley
Outstanding is around $500 million.
John McDonald
Great.
Thanks a lot.
Operator
We'll take our next question from Jennifer Thompson at Putnam Lovell.
Jennifer Thompson
Good morning.
Could you just give us a little more color on the inflows into NPLs this quarter in terms of, are we seeing anything specific on the industry side?
I know assisted living was a particular issue last quarter.
Jeffrey B. Weeden - CFO
If -- my recollection is that we had some more structured finance credits go in, and that we had some from the middle market portfolio go in.
But those were probably the two biggest contributors.
Jennifer Thompson
And how is assisted living looking?
Jeffrey B. Weeden - CFO
Assisted living is actually beginning to turn around.
We -- I think I've described it before by saying that, you know, we are at the end of the tunnel with the healthcare portfolio, and in fact, I can now say that I think we're beginning to step out of the tunnel.
Structured finance, we've probably got another quarter or two to go.
Jennifer Thompson
Great.
And just one more question.
In terms of investment banking, how are you thinking about that, and what does the pipeline look like?
Henry L. Meyer III - Chairman and CEO
This is Henry.
Jennifer, we had a very good year in 2002.
Counter to maybe what some of the bigger firms, it was the second best year in our 79-year history with McDonald.
And the pipeline is good.
It really has firmed up.
Some of you will remember that we put out a press release in July of last year because we had a great first six months.
Then things just dried up.
But in the fourth quarter, as Jeff had reported, we closed a number of deals, and the pipeline is starting to look better.
So we're cautiously optimistic.
Again, so much depends on the assumptions one makes in terms of what the economic activity is going to be.
But our niche in terms of the middle market and the number of KeyBank commercial banking customers that are now using our investment banking services at McDonald is a real positive in terms of what other companies have done.
Jennifer Thompson
Thank you.
Operator
We'll go next to Jason Goldberg with Lehman Brothers.
Jason Goldberg
Thank you.
Good morning.
Though not a big contributor to your balance sheet, this is the second quarter in a row you opted to add leverage in the face of tough loan growth by putting on securities.
If you could just give us some more color in terms of what types of securities you're putting on, and your thoughts on how you managed the balance sheet in 2003?
Joe Veda
OK.
This is Joe.
I'll pick up on that question.
First of all, on the leverage part, once you recognize that we used the investment portfolio as a quote in our overall asset liability management process, including how we structure our desired rate risk profile.
So, within that, we're seeing a period of low loan growth and fixed rate deposit growth.
And as a way to balance our desired rate risk profile, we need to book some rates -- our rates are not rate sensitive assets.
We can do that either on or off the balance sheet, and given the strong capital ratios that we have, some modest leverage is the direction that we took.
Now, with then adding to the portfolio, these -- the portfolio's largely short-term, mortgage-backed securities, and this continues to be what we are purchasing.
And these are largely CMO pack size paper (ph) in the maturity range of two to four years.
Jason Goldberg
OK.
Thank you.
Then an unrelated question -- you know, service charges were down linked (ph) due to the rollout of the free checking.
Do you - remind us in terms of where you are, in terms of rolling that out, and how much more pressure on service charges you'd expect?
Henry L. Meyer III - Chairman and CEO
The rollout was completed in December, so it's throughout the entire company -- was obviously a process that started earlier in the year.
And it was completed in the month of - the first part of December.
Jason Goldberg
And in terms of how long you'd expect the (inaudible) on service charges, or are we done with that?
Henry L. Meyer III - Chairman and CEO
There may be some drag, if you will, looking at next year.
But there's also the opportunity then, too, for additional product sales and services to those customers that we are picking up as a result of that particular product.
Jason Goldberg
Great.
Thank you.
Operator
We'll be going next to Gerard Cassidy at RBC Capital Markets.
Gerard Cassidy
Thank you.
Good morning.
Getting back to the available for sale portfolio, can you share with us what the duration of that portfolio is?
And then the comments on the mortgage-backed securities, what kind of assumptions are you using for the prepayment fees for those mortgage-backed securities?
Joe Veda
Sure.
Let me -- this is Joe Veda again.
Let me give you the information on the portfolio.
First of all, let me point out that most of the bank's investment portfolio is characterized as available for sale.
And as I indicated earlier, a large component is agency CMO (ph) paper.
That's roughly 85 percent to 90 percent of the portfolio.
Prepayment within a mortgage portfolio is always something that is looked at quite closely.
This is both prepayment and maturity extension risk.
And you should be aware that all of those assumptions are run through our asset liability rate sensitivity models.
In the current environment, we did have some activity during the quarter to manage the portfolio dynamically, recognizing that there were some securities with a higher propensity to prepay.
We did sell out of some of those securities, and we added in what are more reflective of current mortgage rates so that the acquisitions that we made would be less sensitive to prepays unless there's a change in the future rate environment.
So it is actively managed, and we do consider the prepay, because extension risk in the rate sensitivity analysis that Jeff described earlier.
Gerard Cassidy
Now, let's assume the economy picks up, and we start seeing a 10-year at 5.25 percent or 5.5 percent this summer.
What happens to the duration which -- I don't know if you mentioned what the duration is now, but if you could get that number.
And then, what happens to that duration risk if the 10-year goes to the 5.5 percent?
Joe Veda
Sure.
We do model that out, and the duration would lengthen, as would be expected.
Again, it's modeled in our analyses.
The duration lengthening in itself is mitigated from the type of paper that we're buying.
Number one, we're dealing largely with underlying mortgage loans at 15 years, not 30.
So that in itself helps dampen the effect.
As I indicated earlier, this is largely short-traunched CMO paper, NPAC (ph) paper, which is more predictable by definition.
On the duration that you asked for, the average maturity of our agency CMO paper is 2.4 years.
That has moved in a range of roughly two years to three years in average duration over the past 12 months.
And that reflects the active management I described earlier.
Does that answer your question on duration?
Gerard Cassidy
Yes.
And then, if rates were to go up 100 to 150 basis points from here on the long end, what would that do to that 2.3 years?
Would that push it out ...
Joe Veda
... activity within 100 to 200 basis point move higher is estimated to be up about -- or out about a year or so in duration.
Gerard Cassidy
OK.
And one final question on this.
Since you guys have, like so many banks, grown this portfolio significantly over the last 12 months, and to us (ph), we're very focused on interest rate risk this year.
What would happen to the portfolio now is 8.5 billion, it looks like at the end of the period, what would happen to the value -- what kind of mark would you have to take to the equity section of the balance sheet if rates were up 150 basis points from here by, let's say, June?
Unidentified
That would be ...
Unidentified
... that in my head.
Joe Veda
Also -- I think we'd also be six months further out onto the maturity process.
So you would also, while you had some extension, you'd also be further along, if you will, on the ultimate maturity of it.
Unidentified
Let me add to what Jeff was saying.
Remember, we're using the portfolio not as a rate of return portfolio, but as a tool in our asset liability management process.
Gerard Cassidy
Right.
Unidentified
So in the spirit of trying to be relatively balanced, we shouldn't look at only one side of the gain/loss equation.
It's viewed more of a hedge to the overall rate risk, and there's an offsetting effect elsewhere on the balance sheet.
However, if you look at the portfolio, the current market, if you will, is about 152 million.
The portfolio is not all that changed from where it was at the end of last quarter.
And the increase in the market is up roughly, I believe, 30 million to 35 million.
So that gives you an idea, given the decline in rates that we've gone through, particularly on the short end, and the shape -- the change of the shape of the yield curve as the type of impact you might interpolate for a reversal in that yield change.
Gerard Cassidy
I see.
So the portfolio is about 180 million above order, is that correct?
Unidentified
About 150 million.
Gerard Cassidy
One hundred fifty.
OK.
Thank you very much.
Operator
We'll be taking our next question from David George at AG Edwards.
David George
Good morning.
My question has been answered.
Thank you.
Operator
We'll go to David Pringle with Fulcrum.
David Pringle
Good morning.
Henry L. Meyer III - Chairman and CEO
Hi, David.
David Pringle
A couple of questions.
One, last quarter you said the option cost had run about 4 cents to 6 cents a share in 2003.
Are you still sort of in that area?
Jeffrey B. Weeden - CFO
Well, the 4 cents to 6 cents that -- we put in the press release last time it was 4 cents.
And then, by fully implemented at the end of, you know, the three-year cycle, it was going to be 6 cents.
Based upon timing and number and valuation, the range should be anywhere from 2 cents to 4 cents would be the impact in 2003.
David Pringle
And how much is the swing on the pension year to year?
Jeffrey B. Weeden - CFO
The pension, we've gone from an income in 2002 of approximately one cent per share, and we would estimate it to be 3 cents to 4 cents in 2003.
Unidentified
Cost.
Jeffrey B. Weeden - CFO
Yeah.
So from an income to a cost.
David Pringle
Right.
And that's after-tax numbers?
Jeffrey B. Weeden - CFO
That is correct.
That's an EPS number I'm providing.
David Pringle
And then, assuming that nothing in the world changes, where does your margin sort of end up?
Jeffrey B. Weeden - CFO
Well, we're currently - again, what we discussed related to the rate environment that we're currently in, and rates, as you know, the most recent Fed cut has put pressure on the ability to lower consumer deposits.
We would anticipate that the margin, as we look forward into the first quarter, would be down from four to six basis points in that particular range.
David Pringle
And then would it just sit there if everything else was stable?
Jeffrey B. Weeden - CFO
Well, you know, it -- again, you have to look at what you have for your overall interest rate risk profile, what you have for hedges that are in place, and also what the consumer will do with respect to both deposit and the loan yields and also commercial credit as far as the growth, et cetera.
But I think margins will as the industry -- and I'll just speak for the industry as a whole -- margins have come under pressure.
I think margins came down for a number of institutions.
We declined one basis point in the first quarter.
Other institutions are also seeing decline in their margins, and the anticipation would be that the margin would decline in this rate environment going forward.
Eventually it does reach an equilibrium point, though, again, and I'm not in a position to predict what that would be at this stage.
David Pringle
Any activity in the principal investing portfolio in the fourth quarter?
Jeffrey B. Weeden - CFO
Yes.
In the principal investing portfolio in the fourth quarter, we recognized $13 million worth of losses.
David Pringle
No kidding.
And where does that portfolio stand now?
Jeffrey B. Weeden - CFO
The dollar amount of the portfolio, Lee - what, around 660?
Lee Irving
Close to $600 million.
Carried at fair value.
Jeffrey B. Weeden - CFO
At fair value.
David Pringle
And the 13 million on losses came through which income statement line?
Jeffrey B. Weeden - CFO
That would have come through the capital markets line.
And plus (ph) the banking and the capital markets on the income statement.
David Pringle
OK.
And could -- you know, not to beat a dead tax horse, but could you talk a little bit about the tax rate being down quarter to quarter, and where you think it should settle out, please?
Jeffrey B. Weeden - CFO
Well, I think on the tax rate being down quarter to quarter, what impacts that, obviously, is the amount of tax advantage income that's recognized in any given quarter.
In the fourth quarter, we did close a number of capital markets deals and had in there some low income housing tax credits that had a positive impact, if you will, but reduces the tax rate.
And then I think, as you saw, the Foley (ph) income was up also.
Those particular items don't receive a tax equivalent yield adjustment because of where they're reported on the income statement.
So that has an impact on the tax rate in any given quarter.
As you look forward, we basically would look at it, if you use a 33 percent tax rate on a go-forward basis, you know, we feel that that's a conservative rate.
David Pringle
And just last one -- sorry to be to be a hog here -- the $13 million of PIP losses, was there any kind of offset to that during the quarter?
Jeffrey B. Weeden - CFO
Well, that's a net -- that's a net number.
And again ...
David Pringle
Right, but I just - you know, you're looking at -- you know, revenues down in the non-interest income, I guess sort of down into the first quarter, yet you still had the 13 million, you know, loss that was buried in there.
Was there any offset in the quarter that would make you think that you got more than a 13 million offset going into first quarter of this year?
Jeffrey B. Weeden - CFO
I think you have to look at the overall capital markets line was very, very strong in the quarter.
We closed a number of deals in our commercial real estate area.
As you know, we're a large national player in that particular market.
And we do a lot of construction lending, and then when it comes time to term it out, we sell off the credit at that point in time.
So there are seasonal offsets.
I mean, the fourth quarter is a very strong fee income quarter for us.
David Pringle
Thank you.
Operator
We'll be going next to Steve Wharton at Loomis Sayles.
Steve Wharton
Good morning.
Henry L. Meyer III - Chairman and CEO
Good morning, Steve.
Steve Wharton
I just wanted to follow-up on the deposits and the growth this quarter.
I just wanted to get a better understanding of where it was coming from and the trends that you expect to persist into the quarter -- the first quarter and into 2003.
The only reason I bring it up is because, you know, on the average balance sheet for the aggregate, and you can clearly see the growth in MMDA (ph).
But then if you look at the line of business information on retail banking sequentially, and then also on the written comments at the beginning where you get a little table for each line of business, like, for the total consumer banking line of business, it's a little less clear.
So can you just maybe flesh that out a little bit more?
And then also, I don't know if you have the number to give us net new account growth as well that occurred in the quarter?
Unidentified
Well, Steve, I may not have the net new account growth numbers to provide you, but I can provide you with some of the details with respect to the consumer loan -- deposit growth, as well as the growth in the other lines of business.
On the consumer side for the quarter, core deposits overall were up about $900 million, or about 2.8 percent.
We did have growth in our transaction-related accounts.
They were up about 1,300,000,000.
We still have runoff that's happening in the CDs under 100,000.
So we end up with that.
Now, I'm talking -- when I'm looking here, I'm looking at kind of quarter end to quarter end, Steve.
So they may be a little different from the different balances for the entire quarter, but we did see some good growth in the consumer side.
On the commercial side, obviously in the rate environment that we're experiencing here, you continue to have commercial customers that have analyzed account balances that have a decision that they make, whether they're going to pay hard dollar fees or whether they're going to use balances and receive an earnings credit to offset those fees.
So on the commercial side we also had growth in the non-interest bearing accounts of about 13.5 percent end of quarter to quarter basis in there.
And then, on the Key capital partner side, we ended up also with good growth coming there, as we offered different alternatives for people for consumers, and they shifted from money market accounts in some cases over to FDIC-insured money market bank product instead of being in the capital market type of mutual fund money market account.
So those are kind of the areas where we had growth in the deposit side during the quarter.
Henry L. Meyer III - Chairman and CEO
And Jeff -- Steve, this is Henry.
We also -- we've made reference to this, but we closed Union Bancshares on December 12th.
So that average is not much in the quarter, but will come in in terms of mathematics in the first quarter of 2002.
And that's 450 million, plus or minus.
Jeffrey B. Weeden - CFO
It's about 300 million on the deposit side -- 330 million on the deposit side.
Steve Wharton
OK.
Thanks.
Operator
We'll be going to Mike Holton with T. Rowe Price.
Mike Holton
Yes.
I just wanted to ask one question with no follow-up.
In terms of the non-interest expense for all of 2003, given the factors you mentioned earlier, what type of growth are you targeting?
Jeffrey B. Weeden - CFO
For non-interest expense in 2003 -- we really aren't commenting on the overall, but if you remember, my comments that I made that non-interest expense, excluding what I had spoke with on personnel, will be well controlled.
I'll just leave it at that.
Operator
And having no further questions, I'd like to turn the call back over to Mr. Meyer for any additional or closing remarks.
Henry L. Meyer III - Chairman and CEO
I just want to thank everyone again for participating with us on this conference call.
And as always, Verne (ph) and his team, Lee, Jeff, are available to take any specific questions.
And with that, operator, we're going to sign off from the KeyCorp perspective.
Operator
Thank you.
Thank you for your participation in today's conference, and you may disconnect at this time.