KeyCorp (KEY) Earnings Call Transcript & Summary

Okay. All right. I think we'll go ahead and get started with the next session. We have KeyCorp. From Key, we have Chris Gorman, Chairman and CEO; and incoming CFO, Clark Khayat, who is also the Chief Strategy Officer for the bank currently. So first of all, Chris, Clark, thank you for joining us. And I think we'll kick it off with -- I know Chris has some opening remarks. So we'll kick -- I'll hand it over to you, Chris, and then we'll get into Q&A.

Perfect. I'll make a couple of brief remarks, and then we'll jump into Q&A. Thank you, Ebrahim. I'm joined on stage, as mentioned, Clark Khayat, who currently is our Chief Strategy Officer and will be our Chief Financial Officer, in the very near future. So it's great to be out on the road with Clark. On Slide 2, you'll find our statement on forward-looking disclosures and non-GAAP financial measures. This covers my remarks as well as the Q&A period. I'm now moving to Slide 3. We will spend most of our time this morning in the fireside chat, but I want to just make a few of these opening comments. We continue to operate in very uncertain times. We have volatile markets, and they're driven by a variety of things: elevated interest rates, the unprecedented unwinding of the Federal Reserve balance sheet, which, by the way, I don't think gets enough attention when people talk about deposits, tight labor market and clearly economy that is slowing. Despite these headwinds, I remain confident in the way we have positioned Key for the future and our ability to continue to serve our clients and deliver long-term value for our shareholders. It starts with having a strong foundation, including our balance sheet and interest rate positioning. We have been very deliberate and intentional in the manner we have managed our interest rate risk with a longer-term perspective, although the positioning is providing less current benefit, we have significant upside over the next 2 years as our swaps and short-term treasuries mature and reprice. We also have continued to benefit from our focus on relationship banking and primacy and think of primacy as having the operating account, which provides us with strong stable deposits and high-quality diverse revenue streams. Approximately 60% of our deposits are derived from consumer and low-cost escrow balances. Additionally, over 80, 8-0 percent, of our commercial deposits represent core operating accounts. This has allowed us to successfully manage deposit betas and our overall funding costs. Given our balance sheet and interest rate positioning, we expect our net interest income and our net interest margin to grow over the next 2 years. Next thing I'd like to comment on, simply, we are good risk managers. We have derisked our business over the past decade, and we will remain diligent in our underwriting practices. We've also demonstrated the ability and the need at times to walk away from business that does not fit our risk profile. Last quarter, we built our loan loss reserve. Despite strong credit metrics and an outlook for net charge-offs to remain near historically low levels again this year, using our 2023 charge-off outlook, our reserves now represent a full 5 years of coverage. We will continue to support our clients while maintaining our moderate risk profile, which positions the company to perform well through all business cycles. Lastly, we will continue to create capacity to make targeted investments in our businesses. Although expense management has been an ongoing area of focus, as we discussed on our fourth quarter earnings call, we are accelerating our cost takeout plans early in this year. We are pursuing cost opportunities across our company, including areas where we can leverage technology, leverage automation, process improvement, reduce redundancy, improve efficiency and enhance effectiveness. We will also continue to reduce occupancy cost as we adopt the hybrid work models and optimized space. Our 2023 targets represent a cost reduction of approximately 4% relative to our 2022 level. The acceleration of our expense plans will benefit us in a couple of different ways. First, you cannot grow if you're not investing. This will give us the capacity to drive our targeted scale strategy, investing in what are points of differentiation -- continue to invest, I should say. With the benefit of our cost takeout, we expect to hold expenses relatively stable this year compared to our full year 2022 results, which would have -- which would be a significant accomplishment given the environment that we all know everyone's operating in that's inflationary and also our continued commitment to invest in our business as we have done. Importantly, our differentiated business model focuses on targeted scale, provides us with clear strategic opportunities for sound and profitable growth. We have made a conscious decision to invest our resources in specific vital and growing sectors of the economy: health care, and that would include Laurel Road; technology; renewable energy; and affordable housing. All areas that have a big impact both on our clients and our communities. We are also -- we also have a leading position in targeted areas such as third-party commercial real estate loan servicing. Key services $620 billion, including $200 billion where we are the named special servicers. So all of this is our [indiscernible] loans that we service. This is a high-return business with national scale and provides us with unique insights on commercial real estate across all markets and all asset types. This unique perspective helps to inform our decision-making. As we look across our servicing portfolio today, we see elevated delinquency rates in areas such as retail, lodging and B and C class office space, all areas where Key has a very limited exposure. Conversely, our growth in real estate has been in multifamily, primarily affordable housing, where we are the second largest lender in the United States. Affordable housing is a large underserved market that will continue to receive bipartisan support. Another area where we have been investing is the health care sector, and we are seeing tangible results. We continue to grow relationships with significant health care providers and expand our Laurel Road business. Despite -- student loan payment holiday, we originated over $1.5 billion of Laurel Road loans and increased our member households by over 30% in 2022. Additionally, we expanded our offering to include nurses, added new products and capabilities and completed the acquisition of GradFin. Since acquisition, GradFin has held over 30,000 individual consultations for refinance and public service loan forgiveness. These consultations are with prequalified credential prospects all of whom are new to Key. GradFin is especially well positioned, given the intense focus around student loan forgiveness. More broadly, our differentiated business model and relationship-based strategy can be seen in both our consumer and our commercial businesses. Importantly and especially relevant in today's environment, we remain committed to serving and supporting our clients through all market conditions. For our commercial clients, we have built a business model to provide a full range of financing options, and that's both on and off balance sheet to serve our clients through various market environments, including times like the present where some markets are in various stages of dislocation. We will continue to drive growth through our investments in points of differentiation and remain at the forefront of delivering client-centric digital-first solutions across all of our businesses. I will close by reaffirming our commitment to deliver on each of our long-term targets, which are unchanged and shown at the bottom of the slide. I remain confident in our long-term outlook and our ability to create value for all of our stakeholders. With that, Ebrahim, I will turn it over to you for the fireside chat.

Thank you, and thanks for that rundown. It was pretty comprehensive. So I guess maybe just unpacking that a little bit. You start with the macro outlook. I think you mentioned $100 [ million ] of QT that's still ongoing. Maybe if you could start with, obviously, deposit liquidity and funding costs, a big issue when you talk to investors, like how do you think about, one, talk to us about the stickiness of your deposit base? I think you mentioned primacy of accounts. And then relative to how you've given expectations, I think it was like mid- to high 20s deposit beta. Like how do you see the risk that these -- it turned out to be worse than expected? Maybe we'll kick it off there.

Sure. Happy to do so. So first of all, I think broadly, I think -- and this is uncharted territory. When you talk about this $8.4 trillion balance sheet, $95 billion a month getting peeled off, all of which has to come out of the banking system. And then you've got money market rates at 4.1%. You've got 2-year treasuries at [ 4 4 ], something like that. So these are -- these are real issues and I can understand why all investors are focused on them. If you just step back, though, for a second. One thing that I think sometimes gets lost in the discussion is that these are complex relationships we have with our clients. And so -- and what I mean by that is when you talk about primacy, if you have the operating account, whether it's an individual or it's a commercial account, think about -- I'll use commercials -- think about $100 billion -- $100 million, I beg your pardon, commercial account, the person that's making the call on what money moves into what account when is probably the same person that owns the business, is probably the same person that has to recruit people, it's probably the same person has to go out and sell customers, it's probably the same person has to work on deals. And I say that only because I think for those of us in the financial world, we all think about people optimizing and maximizing every [ bip ]. That's probably true for Fortune 50 companies. It's not always true for mid-market companies. It's also not always true for individuals who -- if you have the primary operating account, people have to pay their mortgage, you have to pay tuition. So I'm just kind of broadly, there's -- behind all this there's living, breathing relationships. And that goes back to your other point where what does the makeup of ours look like -- our deposit base that is? And why do we think it's a solid deposit base? About 3 years ago, not 3 months ago, but 3 years ago, we started focusing on this notion of primacy. We have meetings with our whole team every week as we think about both loans and deposits. And that's when we were all wash in deposits. And we sort of made the strategic decision that deposits are going to matter and not all deposits are the same. And you need to know what kind of deposits you want, you need to know where the pricing is because we needed to develop those muscles because we knew we would get to a time like this. So we've been at it for like 3 years. As you mentioned, 60% of our deposits are either escrow, about $10 billion in escrow deposits, or basically sticky retail deposits. And then 80% of our commercial deposits or operating accounts. So that kind of gives you kind of a broad brush. Now you asked specifically about deposit betas. So deposit betas, the cumulative deposit beta for us through the third quarter was 9%. Through last year, it was 19%. And what we said when we reported our fourth quarter earnings, we said, not only is it 19%, but it had really picked up near the end of the quarter. We said that there had been a ramp-up in December, and that has continued. So there is obviously with the rates where they are today and the kind of prints we get today, whether it's CPI or anything else, that will continue. Where I think it -- I don't know where it ends up, Ebrahim, but I can tell you, based on everything that we've done and our focus around really managing deposits, which I don't think a lot of banks really do, I feel confident that we will be on a cumulative basis, below where we were last cycle. And that last cycle, it peaked at sort of 40-ish in terms of cumulative beta. I'm confident we'll end up below 40, but there's a lot of moving pieces. Does that answer your question?

It does. Yes, no, that's helpful. And I guess within that, you mentioned the quantitative tightening piece of it. Like you're right, it doesn't get talked about as much, but is there anything like -- because I think most people have a hard time connecting the dots of how that translates. Like what do you think that means if the Fed pauses sometime in the next few months, but we continue to have the $100 [ billion ] of QT, like does that again continue to manifest itself in terms of higher funding costs?

I think it does. And I think it does in that I think it continues to come out of the banking system. No one knows how this is going to play out because this is the great experiment. And no one knows going from $8.4 trillion to what? Did we go to $4 trillion, probably $3 trillion. So I do think it has upward pressure. And in addition to that, there's a lot of math around not only does it come out of the banking system, but it has the impact of rate increases to the tune of 25 to 50 basis points depending on whose math you're looking at.

Right. Understood. I guess, on the other side, I think Key is a little differentiated in terms of having a bit better NII defensibility, I think you mentioned the swaps and the treasuries. Just give us -- if you don't mind, I think you've talked about $1 billion of NII upside from that. One, the risk of like not being able to realize that? And like how do you think about -- is there a way you can monetize that by bringing it forward as opposed to just letting them run their cost?

So I'll let Clark touch on that because it's something we spend literally every day kind of thinking about. We are looking at every avenue to monetize our position, which we think is advantageous to the rest of the market. And obviously, when you have an inverted yield curve in kind of the 3-, 4-, 5-year range, you don't have as many options as you would like to have. Having said that, we have -- I think we purchased about $1 billion of forward starters in the fourth quarter. We've purchased $1 billion now. We're looking at a wide variety of alternatives. Do we come in right now and buy some floors out of the money, which is clearly an option. You could actually let the swaps roll and that would make you obviously more asset sensitive. And they -- I think we're going to -- I think we have like $14 billion that mature -- of swaps that mature. There's also a lot we can do with this short term -- with our $9 billion treasury portfolio. Clark, what would you add to that?

So I mean I think the short story there is just as a reminder, $6.2 billion of swaps this year, $7.5 billion in '24, a $9 billion treasury portfolio, about 10% of that will come off in the third and fourth quarter this year. So that treasury portfolio, as Chris says, lots of flexibility can be used for funding. And then the swap portfolio, again, we generally are in the 2- to 5-year part of the curve, just given our loan book that's not particularly attractive. So I think the short story is we will be measured as we always are, and it's not going to be one strategy. So we will let you will likely see a combination of whether it's forward starters, floors, floor spreads, a variety of different things that we'll do to ensure that we take advantage of that higher for longer curve.

Got it. And I guess just one last question on that count. The other side of it, I think you're also thinking about the Fed could be cutting 12 months from now interest rates, clearly hold, like how do you manage against that when you think about protecting the margin?

So again, I think that's where you can -- it's going to be some basket of things, right? So the challenges everybody has talked about is you go to a forward starter, you're locking in negative carry. So if you think today, when your forward starter for 2 years in the 350s, that's -- you're looking at 125 to 150 basis points of negative carry. That's not super attractive. So you're just managing that. And I think, as Chris said, we'll look at things that lock in maybe floors or floor spreads, so you can cheapen up a little bit of that. But there's an opportunity to, again, I think, put an array of strategies in place that create some certainty but also give us some flexibility to take advantage of even if curves coming down, are they coming down to 2.5%, 3% in the near term.

Right. And in terms of the securities book, is there an opportunity to restructure any piece of it and maybe take a capital hit? And I guess the math is about just how quickly can you earn that back? So is that attractive right now given where the market is?

I think historically, you don't love to burn those capital dollars. I think we continue to look at that, as Chris said. And if there's an opportunity to make an economically positive trade, we'll think about it. To date, it's been kind of a wash, but the curve is changing. And again, depending on how you think about the future, if you think it's higher for longer and the forward curve doesn't show that, there's some potential opportunities to monetize that. So we'll continue to look at that.

Understood. And just one last. I think Chris, you mentioned you expect deposit betas to be lower than the last cycle. But I guess that leaves room for maybe some lift higher relative to how you've talked about it for this year in terms of guidance. Is that fair?

Well, I just think there's a lot of...

And I appreciate the uncertainty...

Yes. I mean it's just -- there's a lot of uncertainty. It's played out to date the way we thought it would play out. But I just -- the point I was making was really more than commenting on a specific deposit beta data point -- it's just how much we've changed our business over the last 3 or 4 years. I think it will be interesting to watch the whole thing play out.

That's fair.

And I think I would just add one, we're 1 month into the year, so it's a little early. But just a couple of other data points. One, we don't -- while we're showing 6% to 9% or 6% to 8% loan growth year-over-year, point to point, it's still relatively low, $2 billion to $3 billion. So assuming that comes in as it is, we're not looking to add a lot of additional funding. We started at a lower kind of relative number. And then the third piece, and I think this is really important, and you can see it in any data set you get, we have focused other than checking accounts and operating deposits, we are focused on retention, not acquisitions. So if you look at acquisition betas relative to portfolio betas, they're significantly different and particularly in the consumer space, when you go out to acquire you basically made that available to your whole portfolio. So we have been much more focused on retaining great relationships, expanding those, identifying our most valuable deposit dollars and working to retain those.

Understood. I guess maybe just the other thing that you mentioned about, I think it was $600 [ billion ] in CRE servicing, something which, I guess, is significant, but it's also visibility in terms of giving the concern around CRE. Like -- how do you see that playing off within your own portfolio as we think about the evolution of credit losses within CRE, you mentioned Class B and C and some of the other subsectors. But -- like how does the CRE market? Do you think it can handle this 5%, 6% benchmark rates and refinancing at 7%, 8% potentially? Or should we begin to see some of these cracks get wider during the summer, into back half of the year?

Yes. I mean I think -- well, first of all, let me speak to our book, which is really focused on multifamily, and I don't need to tell this group as you see rents for a variety of reasons that we could talk about. Rents remain strong and vacancy rates remain minimal. In multifamily, broadly defined and specifically in affordable, where right now, we have about -- where we're the #2 player in the country, and there's about 1/3 of the number of front doors that you need, and there's a whole bunch of things that make it better credit because of the support that you get in terms of tax credits, et cetera. So we feel really good about our portfolio, and we're constantly looking at it because my view of the world is the base case is that we'll have a mild recession. And if you're going to have a mild recession, you better look at anything that's leveraged and you better look at real estate, to your point. Where I think it's going to be a rocky road is, as I mentioned, B and C class office space in central business districts. And the reason I say that is there's been some data that was pushed out recently. A lot of the developers are now saying 50% of the people are back in the office. Well, that's great. But 50% is kind of a tough go, right? And -- so I just -- I feel like B and C class office space in central business districts that are -- where the commute is difficult, and we're seeing it. We're seeing it in this third-party commercial loan servicing, but keep in mind, these are multi-tenant buildings. So it's not like it's going to happen all at once. So there's many, many tenants in these buildings. But over time, I just think we have just too much office, and I'll put it in the context of Key in terms of our business, not our lending business. We had said that we were going to take out 25% of our nonbranch non-op center real estate. And Ebrahim, we've already taken out the 25%, and we're going to get more and -- because we're changing how we do business. We've invested in areas with touchdown stations and people are used to not having their own office. I was in our office -- offices, I should say, yesterday here in New York and everyone was in the office, but we're -- even that were more densely positioned than we used to be because we have these touchdown stations. So I just -- I think that's a place to watch is the -- and of course, everyone knows the other area where we have a de minimis amount of exposure is retail. I mean, retail that's not a new story.

Got it. And I guess maybe when you connect the dots here in terms of your customer segment, like what are you seeing? So you mentioned loan growth point to point, obviously, much lower than some of the guidance, but are customers pulling back? Like do you see that same concern around the recession around the outlook translating into just weakening demand?

I think so. And when I think so, particularly, we obviously have a big advisory business, and as you think about people making strategic moves, people are pausing. And we're financing people, but if you just put it in the context again of banking, we know exactly what's in our book because we spend a lot of time, as you can tell, going through it. We'd be hard pressed right now at this point in the cycle to buy a depository because you don't know exactly what is in their book. And so I do think you see that pulling back. I think where we're going to continue to see loan growth is in areas where we've carved out unique niches. I mentioned affordable, mentioned renewable energy where these are -- they're voracious consumers of capital. We'll continue to do that. I think you'll continue to see utilization rates tick up. Basically, the supply chain issues are getting resolved and you combine supply chain issues being resolved with inflation and people are willing to sort of go long inventory, they've been burned by it before. The other area where we get loan growth is our business model is really differentiated from that of a lot of our peers in that we originate to distribute. So historically, we've only put 18% of the capital that we raised on our balance sheet. When these markets get into dislocation, we structure those deals so we can put them on our balance sheet. And I don't mean bridge loans, I mean structuring to hold them for the long term. And so whereas we typically would only hold 18%. Last year, we held 23%. And if you think about $136 billion of capital that we raised last year, 5% on $136 billion generated some of that loan growth you talked about. So it's kind of a mixed bag. I don't see people doing strategic things right now, but I do see people continuing to invest in inventory and run their business. And their businesses are doing pretty well.

And is reshoring a thing? Like you obviously heard a lot about. I'm just wondering, do you see it?

I think it's a big thing. And I think it will be a big opportunity for people like us that finance these mid-market companies, but it will take a long time. And reshoring is not something that happens in 24 months or even 5 years. I mean these supply lines were built over a long time. But keep in mind, a lot of these middle market companies were sort of dragged around the world by their biggest customers. And as the -- first, the largest customers will reshore and then the people that we're financing will have the luxury of reshoring.

Understood.

There'll be a world likely where reshoring looks like acquiring. Instead of actually reshoring, you just acquire a different plant in the States, right, to actually take that capacity. And to Chris' point, just on uncertainty, I think certainty in either direction, a stronger economy than we expect or a weaker economy than we expect with some certainty will drive some business because even if it's weaker, if it's certain people know then what are the rules under which I'm going to transact and they'll transact.

And by the way, there are certain deals that just have to be done. I mean there are certain strategic things that if the outlook is cloudy, you can defer. There are certain things like debt coming due that you can go -- we went through a period of time last year where there was very little done. Eventually, things have to be refinanced, reworked, et cetera.