KeyCorp (KEY) Earnings Call Transcript & Summary

Started now with the next fireside chat, which is with KeyCorp. Clark Khayat, as many of you know, is the Chief Financial Officer. Clark became the CFO in a very timely period of last March, if I recall. So he's had a very interesting 12 months as a CFO. Everyone knows that KeyCorp is obviously based out of the Midwest. The company is our 16th largest commercial bank in the United States with about $188 billion in assets. The company has a strong CET1 ratio of 10% as of the fourth quarter. And I'd be remiss without acknowledging a retirement, Vern Patterson, who's up here, Vern, why don't you stand up, please? Because Vern is retiring March 1, and let's give him a round of applause. I should say retired since it's past March 1, but Vern has been in the position for 30 years with KeyCorp and we'll be seeing them driving around. I think in his Ford 250 pulling his air stream behind and please send me a postcard from some great places, but congratulations, Vern.

Maybe, Clark, we could start off. We were together visiting investors last week over in Europe and one of the areas that was coming up in conversation, of course, was multifamily. And KeyCorp is a player in the multifamily market. And so maybe you can give us some color on how you're approaching managing the multifamily portfolio and differentiating how you guys run the affordable portfolio versus some of the headlines we're seeing about the rent control market?

Sure. So I think as most people know, look, commercial real estate is an important business to Key. We've been in it a long time. I think we have a differentiated platform among many in that we distribute a significant amount of the capital we raise for clients. We can do that through agencies, life companies, CMBS, in a sort of normalized market, maybe we put 20% of what we originate on the balance sheet. That's very consistent across our commercial bank, but lines up for CRE as well. And then within CRE, a really important part of our book is multifamily. So that's been in the news lately. We continue to feel good about that book. And I would really split it in two kind of market rate and traditional, I think what people think about as multifamily. We tend to work with experienced operators who are not particularly aggressive. They're not trying to lever up. We're underwriting fairly conservatively. They tend to put a lot of equity in. We don't put a lot of positions beneath the senior debt. So it's a pretty clean capital stack and clients who know the business well. They've been in the markets for a long time and they stand by their credit, and we're seeing performance that we're very comfortable with. The other part of the book would be affordable, as you mentioned. By the way, market rate is about 5% of our loan book, affordable about 3%. Affordable is not the same as rent control necessarily or rent control in Manhattan. So I should have said in market rate, we have 0 exposure to New York City rent control. We have a little bit throughout the country, but as people have been following the news, the 2019 law in Manhattan is pretty onerous. Most markets do not really follow that. In affordable, if you think about it, huge demand, given the demand-supply imbalance in the country, very high occupancy rate, waiting list to get in pretty significant subsidies and tax credits that sit beneath it. And I think maybe the most important part of it is, generally, all of the capital is committed upfront, all of the rules are well understood. So you kind of know what your path of rents are going to be. You know what the capital stack is going to look like, you generally go in with a permanent execution committed to on the back end. And so there's not a lot of surprises about where the market is going to go and what things are going to look like. So -- and it's very well sort of managed and administered by the state. So again, pretty straightforward, not a lot of surprises, performed really well over the last couple of decades. Cumulative affordable losses in the U.S. are like 50 basis points in total. So very clean credit book. We love the business. And if you look at our construction book and exposure on the balance sheet, that's almost all affordable. So as I said, that's got a permanent exit. So we continue to feel really good about it. It's not -- we're not immune to some of the stress there. But overall, the way we run that business, we feel very comfortable with.

And because of your depth of knowledge of the affordable market, is there still a lot of demand as you guys look out -- to grow like this new affordable in the construction book? Is that an avenue of growth if the demand is there?

Yes. I mean, look, we -- it's one of the places we would lean in. You've sort of shared our view on targeted scale. I think affordable is a place where we believe we have it. And to the extent we have good operators that we have a relationship with, who will have a relationship with us, we'll continue to support them. And then the other piece, just I'd be remiss if I didn't just talk about the last piece of our commercial real estate platform, which is our loan servicing book, which is about $400 billion in primary servicing, $200-billion-plus in special servicing, gives us very good insight into what's happening off our balance sheet. And we continue to follow the industry that way. And that's been a great business for us, source of deposits, a source of good, high-quality fee revenue and obviously just good intelligence around the sector.

And if I recall correctly, you guys have indicated last year, special servicing had a record year in revenue. And what are those folks in that division telling you about their pipeline? I mean, is it cresting yet or can they see that?

Yes. I mean the servicing book is really kind of -- it sort of rolls, right? As you can imagine, if you go back to coming out of pandemic, retail was the issue, that was not a surprise. That sort of abated a bit. Office jumped up. Office, I don't think is growing at the rate it was growing, but it feels like it might just be a kind of a slow bleed over time as leases come up for renewal. The biggest kind of jump in the last year has been multifamily and some of the issues we've talked about, but what we've seen is it's largely in higher leverage deals in markets that are a little bit oversupplied. And as Chris has said a few times, we sort of backed away from some of those markets, maybe too early. But being too early, it's probably better than being too late. So we're feeling a little bit better about that position right now.

No, absolutely. And you touched on an office there just a moment ago, Clark. KeyCorp has distinguished itself from many of its peers on its very low exposure to office. Maybe you could just give us some color of what you have and the thinking behind that exposure being so low.

Yes. So it's about $800 million or maybe 70 basis points of the loan book in total. We've provided for it at about 6%, which we feel good. It's maybe a little bit lower than peers, but the mix -- we have a very small portion of that Class B and C and Central Business District, something like $112 million roughly. But that's a pretty small exposure. If we had to go to 8% to 10% or whatever where we look at maybe the top end of the group, that's -- you're talking about $30 million. So we don't think that is a huge risk. And again, we're seeing some stress in that book like everybody else, but that's just not a place historically where we think we've had as much strength. Multifamily, in some of the other areas and places, we really have made our bets in terms of supporting clients.

And when you say stress and the reason I like to talk to folks like yourself that don't have big exposures, you can give us a more candid view of what you're seeing. The stress you're seeing in the -- is it due to rates or vacancy rates going up, the refinancing risk?

I think the best view I can give you is just if you think about Key as a tenant.

Yes.

Right, we've reduced our corporate space by 1/3 over the last 3 years. And if you just think about Key Tower in Cleveland, which is a Class A building, we give a floor back in that building, somebody moves from a Class C or Class B. Building around the block and they move into that space. It's not clear that somebody is moving into the place they vacated. Right? And then that over time just becomes a quite question about are you going to be able to fill it. A lot of conversations in the industry around converting to multifamily, I think we're -- again, starting to see in certain markets some multifamily supply. So it's not clear that the deals pencil out at these rates with kind of more supply in the market and I just -- my view would be that the conversion process is not simple, right? Again, one of Chris' favorite comments is when he sits in an office building, looks around and says, if you were going to convert this to multifamily, how many bathrooms would we have to put in and that feels like a lot of work. And then you think about just cost of supplies, availability of labor, time frames, rates, right, all of that sort of goes in the mix to make those look a little bit harder to pencil out.

Sure. Speaking of Chris, I think he was quoted last week or the week before, about saying that zero Fed fund rate cuts in calendar year '24 would be a pretty good outcome for Key's performance. Can you walk us through that kind of thinking for the calendar year '24?

Sure. So one, you hit the key point, which is calendar year, right? We tend to kind of truncate some of the trends based on whatever the calendar says. I think the biggest takeaway here is like we're pretty close to neutral at the moment. So we think we can manage a variety of rate environments we've talked about, whether it's 6, six weeks ago, now it looks more like 2 or 3 and it could be 0, and we feel comfortable that we can manage the balance sheet within that range. The zero at this point really is a function of our view would be if cuts are coming, they're probably coming back half. If there's more, there's going to be more. But in the probably at the very end of the year, and you'll hit earning assets immediately, and it just takes time to get beta into the market. So it's really a timing thing in '24. I would say if you end '24 with 0 cuts versus 6 cuts, again, because of the relatively neutral balance sheet, it's manageable. I think entering '25, your balance sheet composition probably looks a little bit different.

In fact, looking out beyond calendar year '24, what's the best rate scenario if you had the ability to manipulate rates? What's the best one for Key?

Yes. So the good thing for us, as we've talked about swaps and treasuries maturing, is it really -- we get through the vast majority of that in '24. So we started to see rate cuts in '25 that doesn't have the same repricing risk as we'd have in the back half of '24. And I think some more cuts, I think, brings a little bit more loan activity, brings a little bit more capital markets activity, which, as you know, is an important driver for us. I think it takes some pressure off deposits in both rate and probably brings a little bit more balances back. So I think that becomes a more constructive environment. And then to me, the biggest piece long term is just can we get some version of a flat or slightly upward-sloping yield curve because, again, that just becomes the market in which I think we're all kind of most productive.

Sure. No doubt about it. Speaking of deposits, maybe if the Fed starts to cut rates. So now let's say, they're actually cutting starting in June maybe. What are you thinking about deposit betas as rates come down? How do you benefit from that in terms of cutting your deposit rates because of the Fed fund rates coming down?

Yes. So as you know, it's a piece -- it's some piece of knowing your book, the types of clients, the markets you're in, the products they're in, when are your CDs maturing or what is the composition of the book. And then the other piece is just competition, right? So in some cases, you only need one person in a market to need the deposits and that can set the price in some cases. But if we think about it, we've discussed sort of truncating and cutting out. Take our commercial book, which is 35% to 40% of our deposits. We've talked about 2/3 of those being contractually or behaviorally indexed and the index rate being sort of 60% to 70%. So if you take all that together, you should have sort of a mid-teens beta out of the gate just based on that dynamic, and that's for the whole book, probably mid-40s for the commercial book. Then you say, how do I activate that -- the rest of that commercial book and how actively can I get them moving? And then really, it comes down to the consumer book. And that's got a wealth piece that feels a little bit more indexed just given the sophistication of that client base. And then you get into markets, different deposit types, what's your MMDA promotional rate, what's your CD maturity profile looking like? And then how quickly can you get rates and terms into the market? So there's a lot in there, and it's a local business. So we're executing that kind of market by market. But I think there'll be a lag to some degree as there isn't any down. We saw it on the way up. So I think it's not expecting it on the way down might be a little aggressive. But if competitors move, we're certainly prepared to move. And what we're really actively doing is trying to get stuck with rates in the CD book, for example, that bridge into '25 that we can action in this year.

Right. Speaking -- because your geographies are different in the Northeast, of course, Pacific -- out in the back West, Pacific West and of course, Ohio. Are there different competitive features in those markets on deposits?

Yes. So we've -- if we think about kind of our Northeast market, our great Lakes or Midwest and our West, we tend to see -- and it just is largely demographics, right, a little bit older client base, a little bit wealthier client base, but less growth in the Northeast. And then the competitive set is pretty robust, but more anted towards credit unions, small community banks often who will be a little bit more aggressive on deposit rates. You can see some -- in certain markets kind of hyper-competitiveness. If you move to the Midwest, similar demographic probably, maybe not quite as wealthy, but similar growth profile. And then the competitive profile looks a little bit more like a regional mix. So the banks, in some cases, will be a little bit more rational overall. In some cases, they're defending really important clients to them. The difference also being that one goes kind of up the food chain a little bit because if you're competing with a credit union in Maine, as you know, they're not competing for your large corporate business, right? So that dynamic changes a little bit. And then out West, you tend to have younger clients, a lot of growth. Our 5 main states out there are 5 of the fastest-growing states in the U.S. And the competitive set is a little bit more of the bigger banks. And so you tend to see a little bit more rational kind of checking pricing with the one caveat being sometimes the CD rates can be a little bit more aggressive, but that's just kind of part of that strategy. So we really are, again, client by client, product by product, market by market and trying to balance each of those.

Got it. It sounds pretty positive, the net interest income outlook with 0 to 6 rate cuts, I mean you're managing that pretty well. At the same time, Key has expressed optimism in the past. Why is it different this time? And then you're nearing officially, I guess, 1 year CFO, but month-wise, you're there. What are the learnings and changes that you've put in place to manage risk going forward?

Yes. So the first part, again, just to go back to the current position of the balance sheet, we're basically neutral given the swaps and treasuries rolling off and given the underlying floating rate nature of the book. If we do nothing, we'll become asset-sensitive. So we will likely not -- do nothing, but time has helped as painful as it may have been. So we're kind of in a little bit of a reset and then it's how you're going to manage it going forward. So you have a little bit of opportunity to influence that. One, we brought in a new treasurer, came from Discover, very experienced, started his career as a Fed economist. So really, I think, appreciates the dynamism of some of these economic moves and kind of the view of the Fed as it pertains to rates. We've put in a lot more governance around how we manage the balance sheet, inclusive of what are the core assumptions going into it at a painfully detailed level because I think it's important to understand them at that level. Being clear about objectives of when we put positions on and when we take them off. So last year, we terminated the swaps for 2024. We talked about that. We also added some payer swaps really as insurance against higher rates to balance some of the AOCI or tangible capital ratio risk we saw. We entered that thinking time helps us. Every quarter, we get some -- pull the par on the AOCI and those ratios get better. So this isn't a portfolio we're putting on for years. We're putting it on for that objective. And when that objective is no longer served, then you make a decision to exit, and we're actively talking about that. So that's different than where we were 2 years ago, and we probably should have been talking about terminating swaps in 2022 and not waiting until 2023. So I think just a lot of some different personnel and different talent, a lot more governance and a lot more engagement around the right assumptions, the main objectives and sort of the entry-exit parameters. And then the last piece would just be around thoughts on the portfolio. As you and I were talking before we came up here, it's kind of some leak on liquidity rules coming in. I think expectations the industry is sort of in the horizontal liquidity review right now. We're getting good views on where the world is going. So I think liquidity after last year is obviously going to be an important point. If you think about objectives for the investment portfolio, and you could probably recite this after last week, but really a store of liquidity, a tool to manage interest rate risk and then an earnings generator in that order. And we can talk about the magnitude of difference between rank, but we weren't always consistently thinking about it that way and making sure that, that portfolio was positioned appropriately to sort of manage liquidity, capital and earnings.

Yes. We've talked a bit here about the net interest income outlook. Let's come over to fees. You're uniquely positioned amongst your peers with your capital markets business. Chris, was in there for a number of years, of course. And you've melded it together with corporate banking rather well. Maybe share with us what you're thinking for that business this year versus a year ago's numbers.

Yes. So I think if you go back to 2021, I think we now all appreciate the anomaly that, that was on a lot of fronts, but one of them was certainly capital markets. We printed our highest number ever something in the 940 range. Last year, kind of the flip side of that 541, I think we would view our kind of normal year 6, 625, 650, somewhere in that range. I think we are going to expect progression back to that this year, and we're seeing activity that would at least support that perspective. We guided fees for the year 5% plus over last year. The plus is really if we get a fully kind of normalized run on capital markets. Which I think probably requires a little bit of rate -- of rate cut in the back half of the year. So we're seeing good activity out of the starting point. We've seen some larger deals in the market that I think are across industry, across products. So that's a good sign to start the year. But as you know, things can change, but it's consistent with where we were. The other thing I'd step back and say on fees broadly is our view on fees for the year is pretty consistently positive across the categories, with one exception, and that would be corporate services, which for us is client derivatives and foreign exchange. That's not a bad year. It's just last year was a great year because of the SOFR LIBOR transition. So when that comes off, we'll sort of revert to our historic levels. And that will be the one fee category that's got some pressure on it, but the rest, I think, are looking -- not necessarily lights out in the way that we hope capital market is this year, but certainly some good sustainable strength.

Within the capital markets sleeve, what parts of the capital markets is most beneficial to come, meaning DCM or advisory or you've got one of the best originate to distribute models as you talk about and what you like to keep on your books? Can you share with us some color there?

Yes. I mean, we try to be one of the really differentiating pieces of the model, and the objective is to not want to lean to any particular product or solution. We want to give clients a range of the best options and make sure we execute there. That's why as we've tried to describe and you've pushed us on what is a normal market, we've tried to say, look, externally, it probably feels like loan growth in the GDP range. And internally, a place where we're putting kind of that 20-ish percent of what we're originating on the balance sheet. If you go back a year, first quarter, it was 30%. That, to me, is an indicator, like the markets are not functioning because 30% of the time, our balance sheet should not be the best answer. If you're at 10%, it probably feels like it's a little overheated. So 20% is -- high teens, low 20s really -- is a pretty good spot for us. if we had to pick one, often M&A advisory is the thing that sort of drives the truck because there's a syndicated loan that comes out of that, there might be some bond issuance that comes. So there's a bunch of pieces that come from that type of transaction. That make it a little bit more broad-based. But really, what we want to do is support all our client needs in the most appropriate way for them. And if we do that well, we'll maintain relationships and when the next product opportunity shows up, we'll be there to do it.

Yes. And within the 7 verticals that you guys focus on where do you sense there could be activity this year? Is it the real estate? Or is it health care or technology? What do you think?

I think there'll be activity in real estate. We don't know exactly what it is at the moment. But Look, there is an opportunity if we get some term rate reductions, and we saw a little bit of the activity pickup when rates rallied in November, and it's kind of lagged a little bit as we backed up a bit. But people will refi into the market. And my view would be likely into some capital market execution to refi off the balance sheet, which will allow us to, again, get back to recycling capital. We have seen, as I said, we have one of our largest deals ever in building products, right, which generally is a subsector of our industrial group. That's a pretty good indicator that things are going okay in the economy if you're getting a lot of lean into building products. We've seen some health care deals. I mean, again, it's been kind of cross markets, whether it's health care, whether it's real estate, whether it's industrial and products. So M&A, syndicated loans and IPOs. So we were a co-book runner, on IPO, a large IPO in the first quarter. So all of that sort of feels like some broader market return again, not full fledge, but definitely on the range of rebound.

Got it. Capital, obviously, your CET1 ratio is about -- is 10%, above your kind of targeted level of 9% to 9.5%. Can you share with us, are you comfortable with that level? And then at what point would you consider maybe starting buybacks again?

Yes. So -- very comfortable with it right now. The 9% to 9.5%, we basically said we're not going to make a change until we know exactly what the rules are. We didn't want to declare and then redeclare. So hopefully, we'll have a little bit more sense of where we land there. We have said, look, we're not going to buy shares back until we really know where that is and once we reset and see the path to getting to the right levels over time. So we'll revisit that as we know more. But look, given the composition of our portfolio, which generally we think is pretty conservative, we tend to lean into very high-quality borrowers. We don't have a lot of credit card exposure. Most of our consumers are very prime with residential real estate collateralized. So we're not a big credit risk taker, which is, again, kind of a result of coming out of the recession, out of the great financial crisis, saying we shouldn't do that again, let's reconstitute the portfolio. But again, given that -- the question is how much more capital do you need to sustain losses over time? And we feel good where we are, but we'll reset the boundaries when we have the rules, and we'll figure out exactly where we need to be.

Sure. And regional banks like your own will have the AOCI issue, which just doesn't look like that's going to be eliminated from Basel III phases in over 3 years and you're comfortable with the burn-off that you're...

Yes. I mean I think the phase-in piece was done thoughtfully for exactly the reason to not create stress. So if you follow that, I feel very good about that. If you say, look, at some point, when do you get to the fully marked number? We've talked about our AOCI burning off kind of 25% by the end of '24, 34% by the end of '25. That looks like 20% and 32% if rates are flat. So we're going to see some pretty good run down in that, we're hopefully building capital organically. We'll continue to optimize RWAs where we can, not through the loan reduction process that we had last year. But we'll put all those together, and I think you'll find we'll be comfortable with the path there.

Speaking of the RWA reduction last year, I think it was $14 billion, about half loans, half other assets. It's over, obviously, what does that mean for loans this year though on just a comparison basis?

Yes. So we've talked about for the year, down 5% to 7%. Remember, last year's average was 118, last year's ending point was just over 112, so a lot of that was out. And we've sort of said, look, we're going to come down in the first half because the ending resulting actions of that RWA reduction will come through in the first half, and then we think we'll start to build back to roughly where we ended the year. That will be a function of rates. So again, as you've heard me say this now 30 or so times in the last week. But if rates are -- if there's no cuts in rates, I think that translates to maybe a little less loan demand. If there are cuts and there's more cuts, I think you'll see loan demand pick up. So it's a little bit of what's out in the market and where can we consistently apply our relationship philosophy and get that full relationship client.

Yes. Talking about freeing up capital. We've seen some banks that execute the credit risk transfer transactions recently. Is that something that you guys would be open to? What's your thinking there?

Yes. I mean we've looked at these historically. I think in prior CRT, or credit risk transfer, is kind of the broader category we've looked historically more at things like credit default swaps. Given the Fed guidance last fall, the credit-linked notes have come back into vogue because there's just a little bit more regulatory support there. So we're understanding those. And again, in my view, which I don't think is particularly enlightening in this case, but you use those when you have really high-quality assets and borrowers and a really high-risk-weighted asset, right? So if you think about the current standard approach, you can have an investment-grade commercial loan and it's 100% risk weight. So that feels economically imbalanced, and this is a way to get some of that back. So we'll continue to look at that. And if you think at the -- what I said earlier to sort of the quality of our book. And then the regulatory risk weightings associated with that, there's probably some opportunity to lean into that one.

Maybe one that -- we're running out of time here, but I do want to touch on one other area, which is expenses. If you guys are able to hold the line on expenses, plus or minus slightly, it will be the fourth year in a row, which is pretty impressive. So maybe share with us what you're thinking on expenses for this year and how you're managing that.

Yes. So I think it's the third year because '21 would have had a lot of capital market incentive comp in there. So look, what we've been trying to do is just get ahead of both keeping the company operating the way we need to, which means you have to invest and generating organically the pool of investment. And we're really trying to do that by not making a lot of times people we've done this before. You just sort of say, everybody cut 5%, and you don't make the best decisions. We've been much more intentional about where you reduce and try to get out -- like, we're not going to be in that business, take 100% of that expense base out and let the franchise continue to lean in. So we've done that. I think we did that really well last year that freed up a fair amount of capital. We took investment capital. We did take out about 8% of the workforce. A lot of that was at higher levels, which allowed our business to be a little bit simpler. Simpler for employees to navigate, simpler for clients to operate with us and a little bit better risk manage because there's more transparency. So that simplification theme is something you'll hear from us a lot, and we think we have some ongoing opportunities to do that and continue to generate dollars to invest in the places we need to, which you can't run a bank of any size, but certainly, at this size, and not be invest in -- continue to invest in important areas.

Sure. With that, we've gone over a little bit, but I want to thank Clark for joining us this year. Thank you very much.