KeyCorp (KEY) 2012 Q2 法說會逐字稿

Good day and welcome to the KeyCorp second-quarter earnings results conference call.

This call is being recorded.

At this time, I would like to turn the call over to the Chairman and Chief Executive Officer, Ms. Beth Mooney.

Ms. Mooney, please go ahead, ma'am.

Thank you, operator.

Good morning and welcome to KeyCorp's second-quarter 2012 earnings conference call.

Joining me for today's presentation is Jeff Weeden, our Chief Financial Officer, and available for the Q&A portion of the call are the leaders of Key Corporate Bank and Key Community Bank, Chris Gorman and Bill Koehler.

And also joining us for the Q&A discussion are our Treasurer, Joe Vayda, and our new Chief Risk Officer, Bill Hartmann.

Slide 2 is our forward-looking disclosures statement.

It covers our presentation materials and comments, as well as the question-and-answer segment of our call today.

Slide 3 highlights the significant events in the second quarter.

I will start with our earnings announcement this morning.

We reported second-quarter net income from continuing operations attributable to common shareholders of $221 million or $0.23 per common share.

This is an increase of 11% from the first quarter.

Our second-quarter results reflect another quarter of loan growth, continued improvement in credit quality, and disciplined expense control.

As Jeff will discuss in his remarks, our expenses this quarter included some costs related to our branch acquisition and our new efficiency initiative.

The increase in loan balances was driven by the fifth consecutive quarter of growth in C&I loans and our successful spring home equity lending campaign.

The improvement in credit quality was also noteworthy.

Non-performing assets declined for the 11th consecutive quarter, and net charge-offs were down to 63 basis points, which is the lowest level since the fourth quarter of 2007.

In order to maintain our momentum, especially in light of the weak recovery and ongoing regulatory changes, we announced a number of new Company-wide efficiency initiatives that I will discuss in a moment.

These initiatives build on the success of our Keyvolution program and will improve our competitive position by lowering our cost structure and aligning it with the current operating environment.

Last week, we also completed the acquisition of 37 branches in upstate New York, strengthening our market share in two very attractive markets and positioning us to acquire and grow client relationships.

The final few items on this slide highlight our continuing commitment to disciplined capital management.

In addition to leveraging our strong capital position through our acquisition, we've also continued to return capital to our shareholders by repurchasing stock and by increasing our common stock dividend from $0.03 to $0.05 per share in the second quarter.

On slide 4, we provide more detail on the areas we are targeting for our new efficiency initiative.

This is a proactive and purposeful response to the rapid changes that continue to take place in our industry.

In addition to plans designed to enhance and grow revenue, one of the most effective levers we have is to lower our cost base and create a more variable expense structure.

This will allow us to better serve our customers by enhancing our speed to market for new products and services and ensuring that our capabilities are fully aligned with our relationship strategies.

Areas of focus include strategic sourcing, branch rationalization, procurement, sales and service productivity, and occupying -- optimizing our occupancy spend.

They not only improve efficiency but also increase our flexibility, so we can adapt more readily to economic, regulatory, and competitive changes.

On the expense side, we are targeting reductions of $150 million to $200 million by December 2013, which we expect to be fully reflected in our run rate the following year.

A number of our efforts have already begun, and we would expect to make meaningful progress toward our goal this year.

Using our current levels of revenue and expense as a baseline, this is intended to move us to our long-term efficiency ratio target of 60% to 65%.

Turning to slide 5, I mentioned earlier we also completed the acquisition of 37 branches in upstate New York.

You can see on the map how this strengthens our market share in two attractive markets.

The liquidity provided by this acquisition allows us to be flexible with debt maturities and can be used to fund organic growth opportunities.

We also gained benefits and capabilities such as ATM check imaging that we can now leverage to deliver client-focused solutions and improve our client experience.

At the same time, we will be able to enhance our efficiency, because we can leverage our existing cost structure across a larger base.

And the conversion, by the way, went according to plan, and we received positive reaction from customers, employees, and the community.

On slide 6, let me make a few comments on shareholder value.

Since assuming the CEO role in May of 2011, we have continued to strengthen our balance sheet, de-risk the Company, and reposition our businesses to align more closely with our relationship-based customer strategy.

Though business conditions and regulatory changes have created challenges, we are gaining momentum, and we have made progress on our financial targets.

Looking ahead, we will continue to make investments for growth that align with our relationship strategy.

At the same time, we intend to develop a cost structure that is more efficient and more variable relative to our business flows.

And finally, one of our highest priorities remains disciplined capital management.

We are looking for and taking advantage of opportunities to invest and deploy capital for growth, such as our branch acquisition in upstate New York.

And in addition, we expect to continue returning a portion of our capital to shareholders.

Now let me turn our call over to Jeff for some further comments on the second quarter.

Jeff?

Thank you, Beth.

Slide 8 provides a summary of the Company's second-quarter 2012 results from continuing operations.

As we reported this morning, the Company earned a net profit from continuing operations of $0.23 per common share in the second quarter, compared to $0.21 in the first quarter of this year and $0.26 for the second quarter of 2011.

Turning to Slide 9, average total loans for the second quarter were relatively flat compared to the first quarter of this year.

We continued to experience good growth in our C&I loans and also had growth in our branch-based home equity loans.

Average balances of C&I loans increased during the second quarter compared to the first quarter of 2012 by approximately $500 million or 2.5% unannualized to $20.1 billion.

And average balances of our community bank home equity loans increased approximately $200 million or 2% unannualized as a result of our very successful spring home equity borrowing campaign.

Both of these loan categories also showed growth in period end balances compared to March 31, 2012, increasing 3% and 4.9% respectively unannualized.

In addition, we saw growth in total period end loans of approximately $400 million, and this was after approximately $500 million reduction in our exit loan portfolio during the second quarter.

The reduction in the exit loan portfolio was from normal amortization and the early termination of leveraged leases.

Continue to slide 10.

On the liability side of the balance sheet, our trend of improving deposit mix continued into the second quarter, where we experienced an increase in average balances of non-time deposits of approximately $2 billion or 4% unannualized.

Contributing to this increase were the movement of certain funds previously invested in our Victory money market mutual fund that we discussed last quarter and the movement of certain escrow balances back to Key as result of the arrangement that we entered into with Berkadia late in the first quarter.

The combination of these two events accounted for approximately $1 billion of the increase we experienced.

Average balances of time deposits declined approximately $600 million during the second quarter.

Noted on this slide under the highlights are the scheduled maturities of existing -- of the existing CD book at June 30, 2012.

Of note here is the approximately $2.5 billion of CDs maturing during the third quarter at an average cost of 2.23%.

New CDs on average booked during the first six months of 2012 have been at an average cost of approximately 30 basis points.

Turning to slide 11, credit quality continued its improvement again this quarter, with net charge-offs declining to $77 million or 63 basis points of average loan balances for the second quarter of 2012.

The primary reason for the improvement was driven by stronger recoveries on commercial loans.

Our non-performing loans declined to 1.32% of period end loans at June 30, 2012.

Non-performing home equity loans increased this quarter as a result of obtaining additional information on the past due status of first mortgages serviced by others where we hold the home equity loans.

This increased our non-performing home equity loans by approximately $36 million during the quarter.

We do not anticipate a similar increase going forward.

Other real estate owned declined by more than 50% during the second quarter through sales and valuation adjustments, and our remaining inventory stood at just $28 million at June 30.

Our reserve for loan losses represented 1.79% of period end loans and 135% coverage of non-performing loans at June 30.

On page 23 of the Appendix, we provide a long-term trend of past due and criticized loans, both of which continued to show improvement through June 30.

With respect to the second half of 2012, our outlook for credit quality remains consistent with our comments made earlier this year.

We continue to anticipate modest improvement in both asset quality and net charge-offs, with net charge-offs continuing to move closer to our long-term target of 40 to 50 basis points of average loans.

Turning to slide 12, for the second quarter of 2012, the Company's net interest margin was 3.06%, compared to 3.16% for the first quarter.

Taxable equivalent net interest income was $544 million for the second quarter, down from $559 million in the first quarter, primarily as a result of early termination of leveraged leases.

The impact of the leveraged leases on net interest income and the net interest margin for the second quarter was a reduction of $13 million and seven basis points, respectively.

Average earning assets were up $546 million to $71.9 billion for the second quarter compared to the first quarter, primarily as result of higher short-term investment balances in anticipation of scheduled debt maturities during the second quarter.

With the second quarter debt maturities of $1.4 billion, $1 billion of which occurred on June 15, the redemption of $707 million of trust preferred securities on July 12, and the scheduled maturities of higher costing CDs during the third quarter, we look for the net interest margin to increase to the 3.20% range and for average earning assets to remain in the $71 billion to $73 billion range for the second half of 2012.

Fee income was positively impacted from the gains that we realized from the early termination of certain leverage leases, and we anticipate additional early termination activities in the second half of 2012.

Turning to slide 13, non-interest expense for the second quarter of 2012 remained well controlled at $714 million, up $11 million from the first quarter.

Included in our expenses for the second quarter was approximately $5 million in costs related to our acquisition of branches in upstate New York, higher professional fees, partially related to our new efficiency initiatives, and an increase in marketing costs related to our successful spring home equity lending campaign.

In addition, the provision for losses on lending-related commitments was an expense of $6 million in the second quarter, compared to nothing in the first quarter of 2012 and a credit of $12 million for the same quarter last year.

As Beth commented earlier, we are taking another look at our costs and have set a target of taking $150 million to $200 million of expenses out by the end of next year, with the full run rate benefit in 2014.

This goal will require us to look at the structural nature of our costs and is necessary to address the changing economics that we and the industry are facing from pricing controls and the extended low rate environment.

We intend to make changes that will make us more nimble and able to scale up and down as necessary in response to changes in customer demand and preferences.

We also need to continue to make investments for future growth and to ensure that we can meet the ever-changing regulatory demands.

The changes to reach this goal will require difficult but necessary decisions to improve our efficiency and profitability over the long term.

We will have more to report on this effort as we proceed through the next several quarters.

And finally, turning to slide 14, our tangible common equity ratio and estimated Tier 1 common equity ratio both remained strong at June 30, 2012, at 10.4% and 11.7%, respectively, placing us in the top quartile of our peer group on these ratios.

During the second quarter, we repurchased 10.5 million shares of common stock at an average cost of $7.83 per share, and we will continue to execute on our share repurchase authorization during the third quarter.

As noted on this slide, we estimate our Basel III Tier 1 common equity ratio under the Federal Reserve's notice of proposed rulemaking as of June 30 at 10.9%, which we believe will place us in a strong capital position relative to our peers on this measure.

On slide 25 in the Appendix, we include the adjustments from our current Basel I Tier 1 common ratio to the estimated Basel III ratio.

This estimate is based on the proposed rules on a fully phased-in basis and remains subject to change until the rules become final.

That concludes our remarks, and now we will turn the call back over to the operator to provide instructions for the Q&A segment of our call.

Operator?

Thank you.

(Operator Instructions).

Let's begin with Steven Alexopoulos with JPMorgan.

Good morning, everyone.

Good morning.

Could you start by giving more color on the comments to rationalize the branch network?

Maybe specifically address plans to close or sell branches?

Steven, this is Bill Koehler.

How are you this morning?

In the face of the present environment, when we recognized the need to rationalize our branches while also repositioning them in a way that allows us to provide the right convenience for our customers where they are.

So as we think about rationalization, it takes two avenues.

The first is looking for stranded branches, branches in markets where they are not contributing to density or the client experience we are trying to create, and in doing so, we see a number of opportunities throughout our entire footprint.

We've already made or notified the OCC and some of our customers in 17 cases.

The other is continuing to invest in a very selective basis in our priority markets to a much lower focus on de novos and much higher focus than we've done in the past on relocations and consolidations, again, to position our branches more closely to our customers.

Okay.

Any high-level thoughts on what ultimate consolidation might look like for the branch network?

Overall, we are expecting over the next 18 months to take out as many as 5% of our branches.

Okay.

And just one maybe for Jeff.

Do you expect the magnitude of the pressure on loan yields we saw this quarter to continue going forward?

And is this just a function of the competitive environment?

Thanks.

Yes.

In terms of the overall pricing pressure on loans, I think it is -- part of it is a remixing of the portfolio so we continue to have some maturities that are coming off.

And I think we've worked through all of that at this point in time.

New volume yields have been relatively stable for the last three quarters.

So from that perspective, I didn't see a lot of overall change.

And I don't know if -- Chris, if you want to make any comments?

Sure, Steve.

I completely agree with Jeff.

While there's been on the margin a little bit of pressure over the last 18 months, it is basically holding in terms of structure and in terms of pricing.

The other thing, of course, to keep in mind as you think about our business in the Corporate Bank, we are driving about 54% of our revenues from non-interest income, so we actually feel pretty good about the competitive landscape right now.

I guess one last comment, Steve, I would make is that the leveraged lease impact hit the commercial loan overall yield.

So if we look at the -- from the margin analysis that was on page 18, adding back $13 million worth of the hit that took place for writing off fees associated with the origination of those particular leases impacted the overall margin by about -- on commercial loans about 15 basis points.

So on an adjusted basis, it would be closer to the 4.09% for the total portfolio versus the 3.94%.

But there is some -- as a remixing, there was some overall downward movement, even without that adjustment.

Okay.

Thanks for the color.

And we will go next to Steve Scinicariello with UBS.

Good morning, everyone.

Good morning.

Good morning.

Just a higher-level question for you, Beth.

First off, I thought the expense initiative announcement was excellent, and that's definitely going to increase your future run rate.

But on the other side of the question, on the revenue side, I was just kind of curious.

As you kind of look across the franchise broadly, where do you see the biggest potential revenue opportunities, whether it is by business line or geographic?

Just kind of interested on the revenue side for increased profitability, as well as the expense initiative that you announced.

Yes, Steve.

A number of things that we are looking at.

I mentioned that we continue to invest for growth, so we have several initiatives within the Company, such as how we are positioning ourselves in healthcare, work that we are doing in our enterprise commercial payment space.

We have done a number of things where we are enhancing product capabilities, adding to our sales force, and creating programs that we will believe will grow revenue over time.

We are also looking at the inherent productivity of our sales force and our product mix within it.

So that's another opportunity where we are going to spend a lot of time making sure we have the right people against the right products in the right market.

So we do look generally across our geographies and see opportunities there as well.

And then we continue see momentum in what we call our distinctive business model between the alignment of our Corporate Bank and our Community Bank to really across a continuum of businesses from $25 million in sales up to $1.5 billion.

We are offering more holistic products from lending, deposits, treasury management into the capital markets capability that we continue to win clients, be able to meet more holistic needs, and increase our revenue through the alignment of those two businesses.

So we have a variety of things where we are very optimistic about our initiatives and revenue.

Steve, I'd like to have maybe Chris talk about one of the other things, because we talked about Berkadia and the arrangement we have.

That hits both onto the cost side as well as some of the revenue capabilities that we have in the Company.

Sure, Jeff.

So, Berkadia is an interesting transaction that basically touches sort of both sides of the equation, both revenue and expense.

We have been through our third-party commercial loan servicing operation a large servicer of Moody's-rated deposits.

Moody's rates about 65% of the CMBS market.

The CMBS market at one point was close to $300 billion.

We think this year, it is going to be a $35 billion market.

So as we thought about our inability to bid on Moody's-rated CMBS projects, we entered into this JV, this agreement with Berkadia whereby we swapped deposits.

So, the net result of it was, we basically were able to garner deposits on the tune of $610 million.

And most importantly, it put us in a position to bid in the future on Moody's-related business.

We've been fortunate enough to win some of that business.

And then the other piece of it, Jeff, that you alluded to in your comments, is the variability of the cost structure.

So, by doing so, we were able to take out 80 positions, which was about 23% of the workforce, and variablize our cost structure in the event that the CMBS market doesn't return to the previously high levels.

Great.

Thanks so much.

Really appreciate that.

We will go next to Craig Siegenthaler with Credit Suisse.

Thanks.

Good morning, everyone.

Good morning.

Good morning.

First, just on the efficiency ratio goal of 60% to 65%, or 69% today, I'm wondering, how much of that improvement are you expecting from credit quality?

And then, are you expecting any spend that would offset the improvement from both credit quality and then your planned expense initiative of $150 million to $200 million?

Well, there is some remaining on the credit quality.

You see the -- in terms of what we have overall on other real estate expense, for example, this quarter is probably a good example.

It was $7 million.

The balances that are in other real estate now have come down dramatically, at $28 million at the end of the quarter.

And I think the overall level of non-performing loans continues to trend down, so your future prospects of having other real estate are going to go back to what I'd call a more normal level.

You are always going to have some.

You are always going to have some credit costs.

The reserve for unfunded commitments was up this particular quarter, and that will be a function of both migration of credit, as well as the overall level of commitments that are outstanding.

So that becomes a little bit choppier and more challenging to predict on that.

But we've already taken out a significant amount of cost associated with our workout area and have redeployed those individuals into other parts of the Company.

So there's some with credit, not a lot with credit.

This is really getting at other areas of the Company.

If we think about -- we did a lot with Keyvolution with backroom consolidation.

There's still more work that's being done on some of the consolidation efforts.

And then we get into some of the occupancy costs.

So as we go through and we have vacancy around the Company, what we are doing is really restacking and eliminating some of our occupancy overall.

If you think about every foot on average is $28 to $30 a foot, if you can take out 1 million square feet across the Company, that's a big run rate savings overall.

Those are the things that we are really focusing on, but I think as Beth talked about and as Chris talked about, we are also looking at what our reinvestments are into the future.

Bill talked a little bit about repositioning some of the branch network while coming down in total branches, doing some repositioning too, and then just looking at what we are doing on commercial payments side and some of our other initiatives.

We are using this too as an opportunity where we can make investments to grow revenue long term, but we do have to have that overall efficiency get down into our goal of 60% to 65%.

And just a follow-up there.

You pointed OREO expense and provisions -- they were only $13 million in the quarter, so, as you point out, very marginal improvement left there.

If I take the high end of your objective of $200 million, that's about 5% on the efficiency ratio on today's revenue.

That gets you from 69% to 64%.

I'm just wondering how, do you get from 64% to 60% to the lower end of your range?

I guess that's all -- is that all revenue improvement at that point?

Craig, it does have to have revenue overall improvement.

That is why we continue to make investments to grow the revenue and grow other parts of the Company.

So, we know we can't cut ourselves to prosperity, but we have to be leaner, and we have to be more efficient.

Got it.

All right.

Great.

Thanks for taking my questions.

We will go next to Josh Levin with Citi.

Good morning.

I wanted to ask more about the thought process behind these new cost savings initiatives and the branch rationalization.

It sounded a bit more strategic than -- as more of a strategic decision then just cost cutting.

Was it just the low rate environment, or were there other factors that sort of caused you go ahead with these initiatives?

Josh, this is Beth Mooney.

I will go ahead and take that question.

I think it is clear that we are, as an industry, operating in what all of us would concur, I believe, is a challenging rate environment, extended low interest rates, slow GDP, cautious sentiment among American businesses and then specifically in our client base.

And then you add the increasing cost of regulation that is impacting us as well.

And you put all those together, and it is clear, as I said, that we needed to be purposeful and proactive in addressing our cost base and our plans for revenue in light of those industry economics.

So yes, there is very much a strategic point of view that we are in an environment that should last for several years, call it a new normal, and that we should realign our business plans, strategies, and expenses to reflect that environment.

And then from there, we clearly need to be tactical in how we get there.

So we are in the process of planning, evaluating, and creating implementation plans that will help us create that path to those savings.

And as we think about a number of the initiatives, they are strategic.

They are strategic in how we can also grow revenue, deepen our client base, and acquire clients.

So it is a combination of both.

But this environment, we believe, will be extended and requires us to respond and be more proactive in our plans.

So my follow-up question would be, given your view that there's this extended new normal period, that is going to be a tough period for banks, would you consider shrinking the balance sheet, given this is in the last few years, maybe returning capital to shareholders and then, when the cycle ultimately does turn, then you can grow the balance sheet then?

Is that part of your thought process also?

Josh, this is Jeff Weeden.

We've already gone through a tremendous amount of balance sheet restructuring.

So if you look at where we are today at 86%, 87% loan-to-deposit ratio, we've been paying down our overall debt, so we saw another $1.4 billion of debt maturities in the first quarter.

We had $707 million of the trust prefereds that we retired -- deemed last week.

That's all part and parcel to it.

We brought on the deposits from the upstate New York branch acquisition we completed also last Friday.

It is a repositioning of the balance sheet.

We've got a much more what I'd call a productive balance sheet.

It's core funded, and we are really set for overall growth there.

Our capital ratios are already high.

And of course, returning capital is one of our targeted objectives here.

But it is something that we work in conjunction with our regulators and go through the CCAR process.

And we were pleased that we could return or have authorization to return $344 million in common share repurchases, plus the increase in the dividend that took effect last quarter.

Thank you so much.

We will go next to Matt O'Connor with Deutsche Bank.

Good morning.

Good morning.

If I could just follow up a bit on the timing of the cost savings.

Beth, you had said there would be -- I don't know if you said meaningful or material progress this year.

Just as we think about the $150 million to $200 million coming in over the next six quarters or so, should it be relatively steady, front-ended, back-ended?

Matt, this is Jeff Weeden.

So, we've spent a lot of time here in the last several quarters going through our expenses and setting forth initiatives, but these initiatives do take a period of time to fully implement.

So, we've started on some of the things.

We've already -- we are already doing.

So if you talked about the Berkadia transaction, variablizing some of our costs there, we have initiatives that are underway, and they will continue to gain momentum.

And I think you will see most of that in 2013.

There will be some savings here by the end of 2012, but I would frame it more in the $30 million to $50 million run rate.

And Matt, I would say one piece that I think is important is that we will give with this call each quarter updates on specific initiatives and run rate savings, so we will be continuing to report out on this.

Okay.

Yes, that would be helpful.

And then, just as we put all together on the expense side, let's hope revenue grows.

But just holding revenue constant, will we see expenses decline on a net basis?

You talked about some investments that still -- that you'll be making some reallocation of costs, but will expenses decline off of the 2Q level of 714?

Yes.

Okay.

Then separately, on the net interest margin, I think you said it would be 3.2% in the back half of this year.

In the range of 3.2%, that's correct.

Okay.

And then, does that include any of the leveraged lease hits?

Obviously, there is a hit to interest income and then a gain in fees, but would that include any of the early termination of the leases?

Matt, those are more choppy and difficult to predict.

So while we have opportunities that are out there, it does not.

So in other words, what we will do is we will identify what those leveraged lease items are, because I couldn't tell you specifically which ones may hit at this particular point in time.

They are different in terms of how much they have in terms of capitalized origination costs against them.

Okay.

Fair enough, thanks.

We will go next to Erika Penala with Bank of America Merrill Lynch.

Good morning.

Good morning.

My first question is on your -- again, yet again, your efficiency target.

If I look back at your presentation in terms of your targets in the first quarter and compare it to this quarter, the efficiency target hasn't changed.

It was always 60% to 65%.

I'm wondering if this cost initiative had always been something that you were planning to do over the next few years but just haven't detailed to the Street, or whether there was some downgrading of the revenue outlook over the past three months.

Erika, this is Beth.

We have been working -- and part of what we said in our comments, that we have been working on plans for several quarters now.

And I would tell you that this has been a culture of continuous improvement, and we recognized as part of our target of 60% to 65% that we would need to be more effective in our cost structure.

So, it is not necessarily new thinking.

We shared this morning our goals to make it clear how our path to 60% to 65% takes form and over what time as part of giving clarity and more insight into what our thinking and planning has been.

Got it.

That's clear.

And just a follow-up question for Jeff.

Thank you so much or giving us the volume of funding that's going to mature or reprice for the second half of the year.

But could you give us a sense of what the rates are of the debt and the TRUPS and the CDs that are rolling off and what your plan is for replacement from both a volume and a rate perspective?

Yes.

So, in terms of the TLGP debt that matured in -- on June 15, the $1 billion was at approximately one month LIBOR plus 200 to 210, in that range.

The trust prefereds we swapped back.

So of the $707 million that we redeemed on July 12, $139 million was at three-month LIBOR plus 79 on a swap basis, and $568 million, which would've been the capital tens that we had out there, they had an 8% coupon, but we had swapped those back to basically three-month LIBOR plus about 236, 240.

And then on the CDs I think we covered that earlier.

There's over $1 billion of the CDs that are out there that mature in the third quarter that are at about a 5.06%, 5.07% cost on them.

But that's reflected in that overall $2.5 billion blended rate at 2.23%.

Of course, on the asset side of the equation, we expect that we will have continuing cash flows coming off of our investment portfolio.

That's been running at about $1.5 billion a quarter or $500 million per month.

What's been coming off is around 3%, and the reinvestment rates are closer to 1.6% to 1.75%.

Got it.

Thank you so much for all that detail, and thanks for taking my questions.

Certainly.

We will go next to Paul Miller with FBR.

Hi, guys.

Good morning.

This is actually Thomas LeTourneau on behalf of Paul.

Just a couple questions from a modeling standpoint here.

I know credit has been improving.

I'm just trying to get a feel for where you guys feel comfortable from a reserves to loan standpoint going forward.

From a reserve to loan standpoint, of course, it's something we build up each and every quarter.

And it is really going to be dictated by our forward look also of the portfolio and the embedded risk that's in that portfolio.

And that has been with positive migration of credit.

And again, I will point you to the classified assets or criticized assets at the back of our investor deck that continues to show overall improvement along with non-performers, etcetera.

So, it is trending down.

Our coverage ratio, I think, on annualized second-quarter charge-offs were about 2.8 times right now in that particular range.

So I think if we continue on this path and we get down to that 40 to 50 basis point, you're going to see reserves continue to come down some, but not necessarily as dramatic as what they have in the past as we get closer and closer to that 40 to 50 basis point net charge off ratio.

Okay, that's helpful.

And one more question.

I know the mix on the branch deal is largely core deposits, but do you guys happen to have the rate on those deposits available?

Yes.

We would point you to our overall blended rate that we have in our portfolio.

We've identified what that is in our slides.

If you look at that, it's probably around 10 basis points on transaction accounts blended, so there's a mix of -- a good mix of savings accounts and NOW accounts and money market accounts in that particular portfolio.

Okay.

Thank you very much.

We will go next to Ken Usdin with Jefferies.

Hi, good morning.

This is actually Bryan Batory from Ken's team.

My first question is just on pre-provision net revenue.

Jeff, last quarter you had given a range of $290 million to $330 million, and on a reported basis, you guys were kind of right in the middle there this quarter.

Obviously, a lot of moving parts, but I was wondering if you could give an updated outlook just on where you expect PPNR to run for the remainder of the year.

Bryan, we really haven't changed our overall outlook for the remaining part of the year.

Last quarter, we gave a range of $290 million to $330 million.

I think that's a consistent range.

A number of the things that we have under our initiatives are intended to show overall improvement in that as we get into 2013 and beyond.

Okay.

One follow-up on credit.

It looked like non-performing inflows were up a little bit in the quarter.

I know you guys spoke to the home equity re-class on the call, but was there anything else driving that increase quarter over quarter?

Bryan, this is Bill Hartmann.

One of the things that we have seen happening is that there's a tremendous amount of liquidity that's been in the market that is looking for some of the opportunities in -- specifically in real estate loans.

We have had some performing but criticized loans where we've received some reverse inquiries from people who are really to purchase those at relatively close to par.

The accounting for that requires that since there is a slight discount to our carrying value, that we actually move those into non-performing in order to account for that discount.

That discount does flow through the net charge-offs, and then we could actually sell the assets.

So, as you look at the detail that's listed on page 26, you will also see that the payments have risen as well, reflecting the cash that's flowing through that.

And reflecting the fact that it is at a near-par discount, the absolute level of charge-offs has been going down.

It's page 26 of the earnings release.

Okay.

Thanks for taking my questions.

Certainly.

We will go next to Mike Turner with Compass Point.

Hi, good morning.

On the kind of following ups earlier, your average loan yield was around 4.26% this quarter, and keeping in mind, I know about probably 10 basis points or so of that is due to the lease termination.

Where do you see that normalizing in this interest rate environment, adjusting for mix and just the time of new lower yielding loans flowing through the balance sheet?

The overall yield and the leveraged leases impacted the commercial yield, so that's what I will focus in on.

Adjusted, that actually cost the commercial yields around 15 basis points in the current quarter.

And again, I know that we have to look at overall mix, and mix does have an impact.

And so, depending on how much is fixed rate versus variable rate, but a large portion of our overall portfolio is variable rate, and a large portion of that has already been repriced at this point in time.

So there could be additional pressure in those overall yields, and that's going to come from continuation of some repricing.

But for the most part, new credit has been holding very, very stable, I think, since the third quarter of last year, when they had the debt crisis and the European banks also started pulling out of the market here.

The other thing I would say, Mike, if I would, we think the fact that our spreads have held relatively firm is a strong indication of our relationship strategy and the strength and resonance of the market, in addition to what Chris talked about earlier, relating to our strong fee mix.

Okay.

Then I guess as a follow-up, it sounds like -- there doesn't sound like there will be a tremendous amount of pressure is what I'm hearing, some at the margin.

If I look out two years from now and you get the benefit accruing from CD repricing, redemption and repayment of TRUPS, basically the benefit on the liability side and flow through the impact of lower rates on the asset side and then flow in the $150 million to $200 million in savings, does this, if the environment stays in this -- where it is today, which is what I think you and everybody is expecting -- does that get you to the 60% to 65% efficiency ratio?

Or if we stay in this environment of sluggish growth, are there some other levers you've got to look at pulling?

Well, we are looking at the cost side more aggressively, because we do expect that this rate environment will be here for an extended time period.

So, we are not looking for the margin to continue a steady upward climb to our long-term target of 3.5%.

I think as you look at this particular environment, we have to look at the cost side.

That's the lever that we are looking at, and then also looking at where we will be strategic in our overall investments as a Company to grow other forms of revenue that we have.

And that may be investing in certain new verticals, people, etcetera, but we will be making investments in the future.

But as we said earlier, we have to take costs out of the organization.

Those are structural costs that we have to get out to get to that 65% efficiency, based upon no change, if we had no change in revenue, but we are not forecasting no change in revenue.

We are forecasting other forms of revenue that we will continue to grow in this Company.

And Mike, I would just add, because it was a two-year out sort of view to your question, as you sit here in this current environment, I think it is important to underscore that you've managed that which you can control.

And so some piece of our comments and what we are sharing around expenses today is to underscore out where we see a clear line of sight around what we can control.

Okay, that's very helpful.

Am I hearing that you think you can get there in this environment, or that will be tough?

I think what we've laid out here is how we get down into our particular operating environment of 65%.

Basically, I think it was said by an earlier caller, if you look at the $150 million to $200 million, it will take 4% to 5% off of the efficiency ratio, based on current revenues.

Okay.

Thank you.

And sorry, one more follow-up on a different topic.

Just hearing from other banks on the state of really commercial borrowers and really demand, have you seen any change quarter over quarter reflecting back three months?

Is there a little more uncertainty?

Or just maybe you could characterize how your commercial borrowers are feeling right now.

Sure, Mike.

It is Chris Gorman.

I would say there is a greater level of hesitancy out there on the part of our commercial borrowers that we've seen over the past six weeks.

I will tell you that while the businesses are performing well, while they are delevered and have plenty of cash, they feel pretty good about their business, but they are concerned about macro issues.

And those macro issues, depending on the day, the rank order changes, but is really kind of three issues.

One is the fiscal cliff, the second is the election, and the third is Europe.

And we have seen a more cautious attitude on the macro side of things from our clients in the last six weeks or so.

And we are out in the market a great deal, and I think that's pretty consistent.

Okay.

Thank you, everyone.

That's very helpful.

We will go next to Gerard Cassidy with RBC Capital Markets.

Good morning, this is actually Jake Civiello on for Gerard.

You mentioned that the early termination of leveraged leases will accelerate the reduction in the exit portfolio.

But does the reduction come entirely in the commercial lease financing category, and is the decline fully reflected in the second quarter results?

Well, the decline that's reflected in the second quarter results are just those that had early payout along with normal amortization.

So there's both in the press release as well as on page 22 of our slides that we have, you will see a breakout of that particular portfolio.

It is down to about $3.4 billion at the end of June.

We have a number of categories that are just going to have normal amortization associated with them.

So without any acceleration due to the early terminations of leveraged leases, I would expect that we would see that continue to go down $200 million to $250 million per quarter and continue to amortize on out.

And Jake, those leveraged leases that we reported on in our second quarter are in our exit loan portfolio under commercial lease financing.

Okay, great.

That's helpful.

Just one other question.

With respect to the branch rationalization focus, what percentage of all Key branches are currently profitable?

And how many of those branches reached their profitability targets?

Jake, this is Bill.

A substantial amount of -- a very substantial amount of our branches on a store level basis are profitable.

We are focused, though, on the opportunity cost here for those that are less profitable.

Where is our opportunity to take that same expense, redeploy it, either in that market or in a different market with different demographics, growth profile opportunity?

How do we redeploy that same expense in a way that is more impactful to our revenue and strategy in that market?

So that's really how we are thinking about the rationalization effort.

Okay, very good.

Thanks.

And in the interest of time, please limit yourself to one question.

We will go next to Andrew Marquardt with Evercore Partners.

Good morning, guys.

Just want to clarify on the question on PPNR, to 290 to 330 range that you had before.

It looks like this quarter if you strip out some of the one-time specials, you were closer to the lower end of that.

Are you saying you are still expecting that that range is achievable and maybe more so, given the expense initiative, and then maybe you can improve next year?

How should we think about that?

Well, we think that range is definitely achievable, because we had some of the leveraged lease gains, but we also had additional expenses associated in the current quarter with the expense initiative, which was around $4 million to $5 million worth of our overall costs, as well as what we had for the branch acquisition in upstate New York, which was approximately $5 million.

And then, other real estate expense was higher also this quarter, as we continued to liquidate out of that particular portfolio.

I think as we look forward into 2013, we will provide updated guidance as we get -- as we usually do in the first quarter of the year.

So in January, we would expect to get that as we continue to work through our overall expense plans going forward from this point.

Got it.

And then, just clarification on the expense initiative.

How should we think about it relative to Keyvolution?

Is this a continuation of Keyvolution?

Is this -- is there a named one for this?

You've done a good job.

If you go way back, you had the PEG initiative.

How do we think about this one?

Andrew, this is Beth.

It does build on the success of our Keyvolution initiative, and some of these are a continuation of items that we did under Keyvolution.

I think Jeff mentioned the consolidation of backroom operation.

How do we look at sourcing, how do we look at occupancy, how do we look at demand management, how do we generally try and get more efficient and effective?

So when we stopped reporting on Keyvolution a year ago, we said it created a muscle memory in this Company for continuous improvement.

So we believe it is a continuation of Keyvolution in terms of capabilities and focus.

It is not programmatic.

We don't have a name for it.

It is just a commitment to structurally reduce our costs through the levers that are available to us to become more effective and efficient and report out on those.

Just a last question on capital.

With the strong Basel III level almost 11%, how do you think about deployment of capital and the priorities near/medium term?

Our capital priorities continue to remain consistent, and we have always said that we feel like the most important thing we need to do with our capital is continue to use it to support our organic growth opportunities that are within our franchise and for our clients.

Second, we talk about dividends as a second priority for return of capital to shareholders.

Third, an important recognition and another form of return of capital to shareholders would be share repurchase.

And then fourth, make sure that we have adequate capital and appropriately deployed for opportunities for growth for the Company.

We will go next to Alan Straus with Schroders.

Thanks.

On the share repurchase, given what your stock price is, is there any notion of not spacing it out over the rest of the year and rather accelerating it over the next quarter or two?

Alan, this is Jeff Weeden.

We are following our plan that was submitted as part of our CCAR, and I think we've talked about that in prior calls and meetings.

And that is that we will continue on this pattern that calls for the $344 million of share repurchases, beginning in the second quarter, which we did, and continuing through the first quarter of 2013.

Okay, thanks.

And as a reminder, please limit yourself to one question.

We will go next to Nancy Bush with NAB Research, LLC.

Good morning, guys.

Good morning.

Just a quick question.

There's been so much talk about expense and the 60% to 65% targeted ratio, etcetera, etcetera.

I guess I would ask this.

Given that it is beginning to look like the new normal may be the forever new normal, I guess I would ask is 60%, even if you can get down to the lower part of that ratio, good enough?

I realize that you have special challenges due to sort of the far-flung nature of your branch network, etcetera, but are you going to feel a need to go beyond that if this stuff goes on?

Nancy, this is Beth.

I would tell you that our target, and we have been consistent with this for some time, is that 60% to 65% range.

And we have talked accurately about our far-flung nature of our branch network, but also the mix of our businesses will also help drive the efficiency ratio.

So we view this as an important for us to articulate our path of 60% to 65%, and I do think it is incumbent on all institutions and bank management teams to constantly reevaluate what is important and where is the right place for us to position our aspirations and our targets relative to our peers and performance within the industry.

So I think making steps to clarify our goal -- how we are going to reach our goals is important and know that we are constantly evaluating our business mix, our opportunities, and what are our appropriate financial targets.

Thank you.

We will go to Matthew Keating with Barclays.

Yes, thank you.

I just had a question on your effective tax rate.

It obviously fell considerably more than we were forecasting, or I'm not sure what your expectations were, but at least in our model this quarter.

And I was wondering if you could provide some forward-looking guidance on where you think the effective tax rate will run?

Matthew, this is Jeff Weeden.

What impacts it, and we put this in the financial highlights or the highlights of the quarter on the first page of the press release.

The fact that these leveraged lease transactions, the gains that we recognized on them are non-taxable under a prior agreement that we entered into with the IRS several years back.

So that's what's impacting the effective tax rate.

If we have more of these transactions, it can have a further impact on the overall effective tax rate.

But what we try to do is use a GAAP basis.

And if you look at it from a tax equivalent perspective, the effective tax rate for the year, based upon what we have through the first six months of the year, would probably be in a range of about 25% to 26%.

At this time, I'd like to turn it back to our speakers for any additional or closing remarks.

Thank you, operator.

And to all of you, thank you for taking time from your schedule to participate in our call today.

If you have any follow-up questions, you can direct them to our Investor Relations team, Vern Patterson or Kelly Lammers.

That number is 216-689-3133, and that concludes our remarks for today.

Thank you.

This does conclude today's conference.

We thank you for your participation.