KeyCorp (KEY) Earnings Call Transcript & Summary

Let us get started with our next afternoon fireside chat. With us today from KeyCorp is Don Kimble, Chief Financial Officer, and Clark Khayat, which I always mispronounce, so I apologize, Chief Strategy Officer, and soon to be CFO when Don retires in a couple of months. And so it's great to have both of them here. As some of you know, Don has been CFO at KeyCorp when he joined in 2013, prior to that, he was the CFO at Huntington Bancshares. Clark has been -- I got to get your bio here, I apologize, Clark -- there you are. So Clark came to Key back in 2012, originally joined in '12, left and returned in 2018, and has been heading up strategy since that time. And as I mentioned, he's now going to be the CFO. Just a couple of stats that we've been using with all of the banks. Key's asset size is about $190 billion in assets, $17 billion market cap. And then on our price to adjusted book value and adjusted tangible book where we add back the AOCI, Key trades at about 1.1x stated book and 1.3x tangible and has a forward PE of 8.5x. What we'd like to do is Clark is going to make some opening comments, and then we'll continue with the fireside chat. And with that, Clark, take it away.

Okay. Thanks, Gerard. Don and I appreciate the opportunity to be part of the conference. On Slide 2, you'll find our statement on forward-looking disclosures, which will cover my remarks as well as the Q&A. Moving to Slide 3, we'll spend most of our time on Q&A with Gerard, but I want to provide a few overview comments and cover our revised guidance that you'll find in the appendix of our presentation. Our guidance slide shows a reduction in net interest income, reflecting the competitive pricing environment driving higher-than-expected deposit betas. I'll comment more on our NII and deposit trends later in my presentation. Although the external environment remains uncertain, both our consumer and commercial businesses continue to add and expand relationships. Credit quality remains exceptionally strong and our capital levels remain well within our targeted range, enabling us to support our clients and return capital to shareholders. As we continue to execute on our relationship and targeted scale strategies, we expect to differentiate Key's financial performance in 3 ways: first, the positioning of our balance sheet and interest rate risk management strategy presents us with a unique and significant opportunity, more than $22 billion of short duration swaps and treasuries are set to mature and reprice over the next 2 years, providing a tailwind in net interest income through 2024 and beyond. While 2023 will be challenging, we expect to see this opportunity to build throughout the year. In anticipation of swap maturities we've taken a measured approach to replacement. While the inverted yield curve presents a challenge, we've been opportunistic employing a variety of structures and time frames to realize this opportunity. This includes forward-starting swaps, floor spreads and collars. The recent rise in rates has offered favorable market conditions. And through last week, we had executed $6.8 billion in hedges to offset maturities since 4Q '22. Overall, those hedges consist of $3.5 billion of forward-starting swaps, none of which begin before 1Q of '24. In fact, we've been increasingly pushing the start dates later into 2024 to allow the higher short-term rates to flow through to our income statement. The average rate on those forward-starting swaps is 3.4% with a total average maturity of 3.4 years. Additionally, starting in 2023, we've added $3.3 billion of floor spreads to provide downside rate protection without capping our rates. We use these structures to minimize negative carry while also reducing the cost of pure floors due to high volatility. Overall, the floor spreads is kicking at an average rate of 3.4%. We've also deployed some collar structures in the portfolio to manage the current rate environment. I would also reiterate that we have not replaced swaps maturing in 2023 with spot starting hedges and would not expect to do so this year. We'll continue to evaluate opportunities to protect and enhance net interest income with additional hedging, balance sheet management and the modification of existing positions while reserving capacity for the continued increase in interest rates. Second, we remain focused on rigorous expense management to increase efficiency and create capacity for strategic investments. This quarter, we've taken actions to accelerate cost savings, and we're well on our way to delivering relatively stable year-over-year expenses despite the obvious inflationary pressure existing in the market. We've acted on several substantial cost reduction opportunities. Our largest expense remains people, and we've taken steps to reduce that number. While that unfortunately includes valued teammates, it extends more broadly to contractors and professional service firms as well. These steps were never easy, will allow us to continue to evolve to more cross-functional teams, bringing us closer to our clients and prospects and improving speed to market and quality of service, all while enhancing our risk practices. Further, this allows us to continue to add client-facing bankers to our differentiated platform and expand our teams in digital analytics and technology. We'll focus our banker investments in targeted scale areas of high growth, such as renewables, affordable housing, healthcare and technology while continuing to in-source engineering talent. And as we adopt hybrid models and emerge into a post-COVID-19 work environment we're evaluating new areas for potential cost saves. Consequently, we've now met and expect to exceed our original 25% occupancy target in non-branch nonoperations real estate. As a result of these optimization efforts, we'll be able to self-fund our needed investments in areas of differentiation for Key, our relationship-based model and targeted scale strategy. Third, our credit quality remains exceptionally strong. Key has meaningfully derisked our balance sheet over the last decade. We reduced construction exposure and exited high-risk in direct businesses that do not align with our relationship strategy, while adding high-quality loans for businesses like Laurel Road. We also possess a distinct ability to distribute risk in the capital markets. Our leading position in third-party commercial real estate loan servicing provides us with a distinctive risk management capability in this area. The $620 billion that we service, including over $200 billion where we are the named special servicer, Key gains unique access to the market, driving sector insights, which inform what we put on our balance sheet. As a result, Key has very limited exposure to retail, lodging and Class B and C office space, all areas where we see elevated delinquency rates across our servicing portfolio today. Said, we're focused primarily on affordable housing. We're #2 in the U.S. in this space, a large market where demand for housing continues to outstrip supply and development continues to garner bipartisan support from the federal government. Our recent credit performance has demonstrated continued strength with NCOs and NPLs improving further in the fourth quarter at historically low levels. Despite our strong credit metrics and outlook for net charge-offs to remain near historically low levels this year, we increased our loan loss reserve. Using our 2023 net charge-off outlook, our reserve now stands at 5 years of coverage above our CECL day 1 levels. Finally, our underwriting practices remain disciplined and rigorous. We'll walk away from business that doesn't meet our risk profile, but we'll also stay committed to serving and supporting our clients through all market conditions. This is an approach which positions our company and our customers to perform well through all business cycles. As I mentioned at the outset, before I turn the call over to Q&A, let me make a few comments on our 2023 outlook. Included in the appendix is a full updated 2023 outlook and additional information on our hedging strategy. As we noted at fourth quarter earnings, the competitive pricing environment is very fluid and the step-up in deposit rates Key experienced late in Q4 continued as expected into January. This trend accelerated further in February, driving more pressure than we expected in interest-bearing deposit costs. Our cumulative deposit beta was in the mid-20s as of February 28, since the Fed first began raising rates in March of 2022. We originally forecasted betas to peak in the second quarter, however, given changes in the macro environment, we expect beta to rise throughout the year. Relative to our full year 2022 results, we now expect net interest income to be up 1% to 4%. Our outlook incorporates cumulative interest-bearing deposit beta in the mid- to high 30s, still below our historic levels. Obviously, the markets are dynamic and any additional changes to the macroeconomic environment could impact these assumptions. Other expectations, including our commitment to long-term targets, which are shown at the bottom of our outlook slide, remain unchanged. Our relationship-based model focused on targeted scale and clear strategic opportunities all make me confident in our long-term outlook and our ability to deliver sound profitable growth. With that, I'll turn it over to Gerard to lead us through Q&A.

Thank you, Clark. Maybe we could start off since you talked about the deposit betas and how it's changed. When you look through your deposit mix, is it coming more from the commercial side or the consumer side? What's the color there?

Yes. So the more recent changes are more consumer driven, and that's just a function of -- generally, the commercial book starts to move earlier in a cycle. Our clients tend to be investment grade, large corporate. They have people who wake up every day, job is to optimize interest earnings. So that commercial cycle starts a little bit earlier, the consumer book tends to follow largely based on competitive pressure. That doesn't mean all of the commercial book is sort of where it's going to end up, but certainly, the recent pressure feels more driven by consumer.

Got it. Possibly, you can share with us, you talked about, Clark, the outlook for the full year. How is the outlook shaping up for the first quarter? And then second, you talked about these gains that are coming over the next 48 or 24 months from the treasuries as well as the existing fixed received swap book maturing. Is there any chance of locking some of them in sooner? Or you just want to play it out?

Yes. So couple of questions in there.

May be go with the first one.

Let's try to answer the first 1 first. Q1 generally is lower quarter for us in any year for a variety of reasons. This year, the guidance change will certainly show up in Q1, but there's also 2 fewer days in the quarter. So that will hit NII, there are generally lower loan fees in the first quarter in the year. And then from an expense standpoint, we tend to see higher expenses from things like FICA and federal taxes. So we would expect Q1 to be the low point, again, all other things being equal. As it turns out, you said 48 months, we came back to 24. I actually think 48 is right because we will have a lot that's turning over in '24, which will on a run rate look good and we annualized post that time. So that's probably the right time frame. As it relates to swaps, what I mentioned is we're letting them roll off in 2023. We're not replacing those. We want kind of our natural floating rate book to pull through. And then what we're doing is replacing 24s, but with forward starters. Again, which is a little bit of a challenge given the inverted yield curve, and then those floors that allow us to capture the floating rate, but give us some protection. As it relates to other areas of the balance sheet, we've talked about our treasury book, which really is probably outside our core investment portfolio. We think of that as kind of $35 billion to $40 billion. The treasuries is additional. And we've looked at opportunities to pull that forward, make sure we lock that in. We view that as potentially alternate sources of funding, so we're doing the calculus now to figure out does that make sense on a total economic standpoint, in-year view and a payback period. So we just really want to understand what our options there. And if it makes economic sense, we're trying to make sure we do the best we can with the rate environment we have.

Got it. And Don, other than being a pretty face, I do want to get you [indiscernible], can you just share with us, you always use swaps and derivatives because what Clark just said, the nature of your commercial book is variable, so maybe just share with us just the history because now it's front and center for everybody. But you guys have always been there. I haven't you?

I know you're absolutely right. Our balance sheet goes on a variable basis very quickly organically, but about 70% of our loan book is floating, and so what we've done historically is to minimize that asset sensitivity and have a more neutral approach. And so we would use -- received fixed swaps to hedge out some of the loan book, which would have the effect of converting that loan book to be more like a 50% fixed and 50% floating, which is probably more consistent with a lot of our peers. So it would bring it back down, and that's what we've done historically. We would lean into our asset sensitivity or liability sensitivity, depending upon our outlook. We were leaning in to be an asset-sensitive before the rates exploded but we weren't nearly as asset sensitive as our peers. And this is giving us the opportunity as we think about the next 24 months, especially with those swaps that are maturing. And in the appendix of the deck that was posted to our website last night, you can see that we've got about $6.5 billion of swaps maturing this year and another $7.5 billion next year, and the received fixed rate for those swaps is fairly low compared to what the current rates would be, and that's what Clark talked about in doing as far as locking in some of that, and then also the U.S. Treasury is about $9 billion, where we're earning less than 50 basis points on that today. And you can turn around and invest close to 5% in this environment as a replacement. And so what we're trying to do is make sure that we're achieving those upside available to us as those mature and making sure that we're positioned to benefit from that. And so that's what we're trying to do is to see where we can lock it in and how we can protect that going forward.

Good. Clark, coming back to you, another 2-part question on deposit betas. Can you share with us the incremental deposit beta today, not necessarily the cumulative year-to-date number, but just what's happening today? And then second, tell us from your guys' experience once the Fed reaches terminal rate, and rates stop going up, what happens to the deposit betas after that?

Yes. So I'd say the real difference recently, we had been seeing deposits, first of all, start very late. I think you've been around the block for a while. I think you would have said last summer, you were surprised that they weren't moving sooner than they were, we sort of watched that. They started later, and there's, I think, now a little bit of a catch-up, which we saw late December, we expected. And we've sort of been in this view of, we have a spike and then it flattens and a spike and then it flattens and we've been tracking that and relatively comfortable with it. What's happened in the last 30 days is a Fed effective treasury rate that's jumping 50 to 60 basis points in the month, we're seeing competitors move aggressively on rates, because we are not in acquisition mode for deposits, but retention mode, what triggers our clients often is competitor rates. So when they see those we've seen our escalations really ramp up at a level we hadn't seen them. So what that's telling us is that's not going to stop. And with recent news this morning or yesterday, we're now seeing in last week, a Fed curve that was originally 1 hike and a cut late in the year, now it's 3 hikes and no cuts. So we're just going to see that persist throughout the year in a way that we weren't expecting. As it relates to kind of that lag, we could all use historic models. They haven't proven to be as effective as we'd hope. But generally, once the Fed plateaus, you'd expect kind of a 3- to 6-month lag as betas sort of continue to catch up. That's very different than if they come down. So what the industry has done us included, is a lot more indexed rates and what that will allow when the Fed does cut is those rates will come down faster. So that plateau versus a decline is actually an important distinction.

Got it. And tying into this, obviously, we all want to focus on deposits and funding costs and betas. But once we hit the plateau, and let's say it's 6 months later, and they're not cutting rates because maybe the [ Fed ] is higher for longer. Can you share with us what happens with the reinvestment of the securities portfolio as that -- not your treasury -- just share with us the opportunities there for higher revenues, obviously, because the yields will be higher.

Yes. So today, again, $35 billion to $40 billion produces just north of $1 billion of cash flow a quarter. We're taking that out at low 2 percentage, we're reinvesting it at 5.5%. So in that world, you're picking up a significant amount every quarter. And then that flows to other parts of the balance sheet. So once you see deposit costs stabilize a little bit, I would expect at some point, from an equilibrium standpoint to see loan yields tick up a little as well. We haven't seen as much of that. as you might expect. And so I think all people who've been around banking would say higher rates in sort of a stable environment is good for banks in the long run, it can be painful getting there.

Speaking of the loan yields, are you saying that all across the commercial loan book? Or is it just certain segments of the loan book where they're just not -- the spreads aren't widening as much as we all would have thought by now?

Yes. I think we've talked a lot about this counterintuitively, the larger corporates see things move faster. They get to their deposit rates faster and they see their loan spreads move faster because they have very good transparency to the capital markets. As you go down in the book, it just gets less transparent little bit harder to predict, and it becomes more of a competitive action. So you need 1 bank out of 10 to make a bid that a client wants and that's the market price. So there's a little bit of mixed message in that kind of middle market lower book.

Got it. You talked in your opening remarks about the servicing business that you folks have. I think you said over $620 billion of commercial mortgages and the special servicing is over 200. Can you tell us what you're seeing in the -- you mentioned retail and steers you away from these higher-risk areas. But has there yet been a real acceleration in the special servicing part of the segment? Or has there just been a steady flow of what you normally would see in terms of working out credits?

Yes. I think we've seen places that you would expect retail and lodging that have been stressed, that's still a COVID hangover, although I think it's maybe stabilized a little, the place that's really accelerating is that Class B and C office space. And I also talked about leaving some occupancy real estate, and that is going to continue. We're not necessarily leaving B&T space, but you see that people exiting that will take some time to work through the system. So you haven't seen that necessarily click into special servicing because people have leases, they're either paying the leases and then letting them lapse or they're paying termination fees to get out, but there's income coming in to cover the existing facilities. The question will be as those leases mature over time, is that when the stress hits the book.

Right. And can you share with us the difference between the revenues from just the normal servicing book versus special servicing, the normal book is pretty straightforward and the fees, I would assume we're lower than spend. Maybe just explore that with us.

Yes. I don't have them off the top of my head, but if you just think about standard servicing operation, collect the payment, distribute the principal interest, taxes and insurance, do the investor reporting. It's not easy, but it's a pretty routine operation. We do it very well. When you get into special servicing, you think of that as we are the workout agent for the facility. And often, those facilities will be CMBS or something capital markets-oriented where there's multiple parties and you're really -- you're doing a lot of heavy lifting to get that loan back either back on track or settled and the fees are commensurate with that sort of effort. So I don't have a kind of a multiple of the head, but they're pretty significant, and it's a nice countercyclical stream.

Sure. And shifting over to the commercial model you've built over the years combining the investment banking and the commercial businesses targeted scale is the expression you folks like to use. Can you tell us in those 7 verticals, where is there some growth opportunities in this uncertain environment? And where are you kind of just holding back a bit because of this uncertainty?

Yes. So I'd say the biggest natural opportunities are going to be affordable and renewable, which I mentioned, both huge demand on the borrower side, but significant government support. So those are places where we've been in renewables since 2007. We're the #2 in North America. We've been in affordable 7 or 8 years. We're #2 in the U.S. So places where we have strength that happened to line up very well with kind of extreme circumstances that are supporting that. So we'll see continued growth there. We're very excited about that. We feel really good about the quality of that book. I think in other places, we're just supporting clients and a place where we are looking and just being careful where we also have a lot of scale is healthcare and that's just -- it's a business that's continued to grow. We're incredibly committed to that over time. But there's always a little stress in cycles and some of that post-COVID kind of government reimbursement is creating a little bit of noise, and we're watching that closely.

Yes. Some of your peers have moved into the investment banking business in a bigger way in the last 5 years, let's say. You've been added, obviously, with the acquisition of McDonald & Company going back a number of years. Share with us how did you guys successfully integrate the investment banking products, teams, members with the corporate bankers, which are obviously different?

Decade ago when I joined Key, Chris Gorman is running that function for us. And Chris had a vision of really creating a relationship business and not just focus on just the iBank fees but combining that with the traditional commercial banking type of products and services. And so it required teams to start to work together that never had before, and many of them were skeptical that we could actually get it done. And Chris was able to see the value and the team was able to realize that. And I think that's the biggest difference as I think about how we go to market compared to a lot of our competitors. They tend to still have more of a silo approach where they're buying an investment banking boutique and they go out and continue to do what they do best and focus on either the M&A advisory or the debt issuance or what have you, but not look at the comprehensive relationship. But if you talk to bankers that are on our system today that are part of Cain Brothers or the part of the Pacific Crest Securities, I think they also saw the value of being able to be a one-stop shop and provide the entire financial needs to that customer and do it in a cohesive, coordinated way as opposed to kind of a disjointed way. And so we think that really is a differentiator for us and why our model is unique, and we continue to benefit from that.

Speaking of differentiation, Laurel Road is certainly another one that differentiates you. Maybe, Clark, you can give us an update if the student loan forbearance ends as it's scheduled to end sometime this year. What that might mean for increased loan demand from you guys? And just what's going on in that business today?

Sure. So just as a reminder, Laurel Road is a platform we bought in 2019. Actually, your RBC team represented them quite well. So that was at the time a digital student loan refinance originator. For us at the time, we were picking up a new product in student lending, a new platform, in digital lending and a national consumer business, which we didn't have at the time. So all 3, great. The idea was use our balance sheet to get as much of that high-quality lending as we can, and we did that right up until the moratorium hit of the holiday, but that was never the end goal. We thought that would be the fuel to help take Laurel Road into a fully built national digital affinity bank. And we're on that path. We're doing it without all the benefit of that loan refinance at the moment. But in March of 2021, we launched Laurel Road for Doctors. We built a full service consumer bank around that offering. We added nurses last year, another healthcare professionals. We're launching a hospital kind of employee benefit strategy here this year. And last week, we offered in connection with our GradFin acquisition a year ago, which is focused on loan consultation and the public service loan forgiveness platform. Last week, we offered an income-driven repayment product. So we're really covering the whole space not just doctor student loan refi, right?

Yes. Now when the moratorium ends, do you see an expected pickup of originations possibly? Or rates move too much where it may not make sense.

Yes. So the 2 things -- the 2 headwinds obviously have been that holiday kind of moratorium and rates, I would expect there would be some pent-up demand. It's hard to know exactly how much -- but the nice thing about student lending is every year the government puts out a tranche, they price it at the market rates and then that builds over time. So whether there's pent-up demand when the moratorium comes off, if it comes off because I think we're at [indiscernible], and we'll see what it is. But at some point, in the near future, those tranches will start to look attractive to refinance, and we're confident that we'll be around and ready to take that business when it is available.

You talked about the expansion to the nurses. Are there other professions that you can ever take Laurel Road to engineers or attorneys or research analysts?

Absolutely, all the help we can get.

Correct. You certainly could use that chassis to go to a lot of affinity places. I think the decision we've made at this point is let's get this 1 right because what you learn is running an affinity model is a full-time job and we think it's the way to win in national digital consumer banking, the general digital bank on a national basis is hard because every full-service bank has a digital offering, so it's hard to differentiate. The affinity angle is a source of differentiation, but it's not a set-and-forget a thing. It's a full-time job. So I think we're going to spend our time getting this 1 right. And if we get that right, then we'll come back and at this conference, we'll launch...

There you go. Shifting over to credit. You had some comments in your opening remarks on credit. It was interesting in the fourth quarter that you lifted up the provision as high as you did, maybe give us some color on the thinking on that and how you're thinking about it going forward? And then I got a follow-up question.

Sure. I can go ahead and take that. As we take a look at our reserves, we're using CECL and the foundation for that really is the economic outlook that we would use, which tends to be based initially on the Moody's consensus assessments. If you look at the third quarter of last year to the fourth quarter of last year, we saw a significant reduction in the expected GDP for 2023. We saw reductions in home price index and we saw a number of factors unemployment being higher as far as the expectation for the following year as well. And so with that, our model saw a deteriorating economic outlook, which would require reserves to be built. What we were surprised because we thought that was what CECL wanted us to do, very few of our peers had the same type of increase at that same time period. And so we think that the CECL is designed to make sure that you're recognizing those current losses in the period when you see those changes and economic outlook changes. And so that's why we built the reserve, the same time that was occurring, our nonperforming loans were flat. Our criticized loans were flat. Our net charge-offs were 14 basis points, well below our through-the-cycle type of reserve or outlook for net charge-offs. And even more importantly, our outlook for this year that we provided in January was still at 25 to 30 basis points, which is below the low end of our reserve or expected ranges. And so we feel very good about where credit quality is, but because of the change in the economic outlook is why we increased our reserve at that time.

One last question, and I know we're a little bit out of time. What if Moody's comes in because we're maybe getting a soft landing. Any -- have you guys thought about what could happen if Moody's economic outlook -- you said it very clearly, Don, third to fourth quarter was a step down, I kind of believe they're not going to have that same kind of step down in 1Q versus 4Q or I could be wrong.

Don't know yet. We still have 3 weeks ago before we'll see what the March 31 numbers are. But we would expect the same. We think that if anything, the economic outlook has probably improved slightly. But 1 of the factors we'll have to watch is just a home price index that is a critical assumption in our models as far as our reserves, especially on the consumer side. And so if we don't see improvement there, we might not see the kind of recovery or recapture of the reserves that normally might expect in this type of environment.

And certainly, we may not even see a big increase. I mean for you guys. But with that, we've run out of time. So fellows, thank you so much, and please join me in a round of applause for thanking Don and Clark.

And this will be Don's last formal presentation, and offering himself a retirement.

Thank you.