KeyCorp 10-Q
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
Form 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2006
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From                      To                     
Commission File Number 1-11302
(KEYCORP LOGO)
(Exact name of registrant as specified in its charter)
     
Ohio   34-6542451
     
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
     
127 Public Square, Cleveland, Ohio   44114-1306
     
(Address of principal executive offices)   (Zip Code)
(216) 689-6300
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
         
Large accelerated filer þ   Accelerated filer o   Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
     
Common Shares with a par value of $1 each   403,298,128 Shares
     
(Title of class)   (Outstanding at July 31, 2006)
 
 

 


 

KEYCORP
TABLE OF CONTENTS
             
PART I. FINANCIAL INFORMATION
 
           
        Page Number
  Financial Statements        
 
           
 
  Consolidated Balance Sheets ¾ June 30, 2006, December 31, 2005, and June 30, 2005     3  
 
           
 
  Consolidated Statements of Income ¾ Three and six months ended June 30, 2006 and 2005     4  
 
           
 
  Consolidated Statements of Changes in Shareholders’ Equity ¾ Six months ended June 30, 2006 and 2005     5  
 
           
 
  Consolidated Statements of Cash Flow ¾ Six months ended June 30, 2006 and 2005     6  
 
           
 
  Notes to Consolidated Financial Statements     7  
 
           
 
  Report of Independent Registered Public Accounting Firm     33  
 
           
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     34  
 
           
  Quantitative and Qualitative Disclosure about Market Risk     72  
 
           
  Controls and Procedures     72  
 
           

PART II. OTHER INFORMATION
       
 
           
  Legal Proceedings     72  
 
           
  Unregistered Sales of Equity Securities and Use of Proceeds     72  
 
           
  Submission of Matters to a Vote of Security Holders     72  
 
           
  Exhibits     73  
 
           
 
  Signature     74  
 
           
 
  Exhibits     75  
 EX-15
 EX-31.1
 EX-31.2
 EX-32.1
 EX-32.2

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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets
                             
      June 30,     December 31,     June 30,  
dollars in millions     2006     2005     2005  
      (Unaudited)               (Unaudited)  
ASSETS
                           
Cash and due from banks
    $ 2,814       $ 3,108     $ 2,968  
Short-term investments
      1,577         1,592       1,845  
Securities available for sale
      7,140         7,269       7,271  
Investment securities (fair value: $45, $92 and $61)
      44         91       59  
Other investments
      1,379         1,332       1,409  
Loans, net of unearned income of $2,078, $2,153 and $2,155
      67,408         66,478       64,690  
Less: Allowance for loan losses
      956         966       1,100  
             
Net loans
      66,452         65,512       63,590  
Loans held for sale
      4,189         3,381       3,274  
Premises and equipment
      557         575       576  
Goodwill
      1,372         1,355       1,342  
Other intangible assets
      132         125       101  
Corporate-owned life insurance
      2,732         2,690       2,639  
Derivative assets
      1,016         1,039       1,448  
Accrued income and other assets
      5,390         5,057       4,493  
             
Total assets
    $ 94,794       $ 93,126     $ 91,015  
 
                     
 
                           
LIABILITIES
                           
Deposits in domestic offices:
                           
NOW and money market deposit accounts
    $ 25,291       $ 24,241     $ 22,071  
Savings deposits
      1,751         1,840       2,022  
Certificates of deposit ($100,000 or more)
      5,224         5,156       5,094  
Other time deposits
      11,542         11,170       10,794  
             
Total interest-bearing
      43,808         42,407       39,981  
Noninterest-bearing
      13,268         13,335       12,158  
Deposits in foreign office ¾ interest-bearing
      3,762         3,023       5,924  
             
Total deposits
      60,838         58,765       58,063  
Federal funds purchased and securities sold under repurchase agreements
      3,654         4,835       2,824  
Bank notes and other short-term borrowings
      2,360         1,780       3,315  
Derivative liabilities
      1,156         1,060       1,241  
Accrued expense and other liabilities
      4,999         5,149       4,632  
Long-term debt
      14,050         13,939       13,588  
             
Total liabilities
      87,057         85,528       83,663  
 
                           
SHAREHOLDERS’ EQUITY
                           
Preferred stock, $1 par value; authorized 25,000,000 shares, none issued
                     
Common shares, $1 par value; authorized 1,400,000,000 shares; issued 491,888,780 shares
      492         492       492  
Capital surplus
      1,577         1,534       1,504  
Retained earnings
      8,199         7,882       7,574  
Treasury stock, at cost (89,217,117, 85,265,173 and 83,657,893 shares)
      (2,411 )       (2,204 )     (2,132 )
Accumulated other comprehensive loss
      (120 )       (106 )     (86 )
             
Total shareholders’ equity
      7,737         7,598       7,352  
             
Total liabilities and shareholders’ equity
    $ 94,794       $ 93,126     $ 91,015  
 
                     
             
                             
             
See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Income (Unaudited)
                                 
    Three months ended June 30,     Six months ended June 30,  
dollars in millions, except per share amounts   2006     2005     2006     2005  
 
INTEREST INCOME
                               
Loans
  $ 1,190     $ 946     $ 2,304     $ 1,831  
Loans held for sale
    73       53       141       134  
Investment securities
    1       1       1       2  
Securities available for sale
    84       80       167       160  
Short-term investments
    16       12       38       22  
Other investments
    17       24       42       32  
 
Total interest income
    1,381       1,116       2,693       2,181  
 
                               
INTEREST EXPENSE
                               
Deposits
    392       238       735       444  
Federal funds purchased and securities sold under repurchase agreements
    34       25       68       50  
Bank notes and other short-term borrowings
    27       19       51       36  
Long-term debt
    198       141       381       272  
 
Total interest expense
    651       423       1,235       802  
 
 
                               
NET INTEREST INCOME
    730       693       1,458       1,379  
Provision for loan losses
    24       20       63       64  
 
Net interest income after provision for loan losses
    706       673       1,395       1,315  
 
                               
NONINTEREST INCOME
                               
Trust and investment services income
    139       135       274       273  
Service charges on deposit accounts
    77       76       149       146  
Investment banking and capital markets income
    59       51       119       106  
Operating lease income
    56       48       108       94  
Letter of credit and loan fees
    45       47       85       87  
Corporate-owned life insurance income
    26       24       51       52  
Electronic banking fees
    27       24       51       46  
Net gains from loan securitizations and sales
    10       10       20       29  
Net securities gains (losses)
    4       1       5       (5 )
Other income
    104       70       166       158  
 
Total noninterest income
    547       486       1,028       986  
 
                               
NONINTEREST EXPENSE
                               
Personnel
    431       386       836       776  
Net occupancy
    61       55       124       146  
Computer processing
    49       50       105       101  
Operating lease expense
    45       40       86       78  
Professional fees
    40       30       73       58  
Marketing
    28       34       46       59  
Equipment
    26       28       52       56  
Other expense
    136       130       264       248  
 
Total noninterest expense
    816       753       1,586       1,522  
 
                               
INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE
    437       406       837       779  
Income taxes
    129       115       245       224  
 
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE
    308       291       592       555  
Cumulative effect of accounting change, net of tax (see Note 1)
                5        
 
NET INCOME
  $ 308     $ 291     $ 597     $ 555  
 
                       
 
                               
Per common share:
                               
Income before cumulative effect of accounting change
  $ .76     $ .71     $ 1.46     $ 1.36  
Net income
    .76       .71       1.47       1.36  
Income before cumulative effect of accounting change — assuming dilution
    .75       .70       1.44       1.34  
Net income — assuming dilution
    .75       .70       1.45       1.34  
Cash dividends declared
    .345       .325       .69       .65  
Weighted-average common shares outstanding (000)
    404,528       408,754       405,949       408,510  
Weighted-average common shares and potential common shares outstanding (000)
    410,559       414,309       411,842       414,037  
 
See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)
                                                         
                                            Accumulated        
                                    Treasury     Other        
    Common Shares     Common     Capital     Retained     Stock,     Comprehensive     Comprehensive  
dollars in millions, except per share amounts   Oustanding (000)     Shares     Surplus     Earnings     at Cost     Loss     Income  
BALANCE AT DECEMBER 31, 2004
    407,570     $ 492     $ 1,491     $ 7,284     $ (2,128 )   $ (22 )        
Net income
                            555                     $ 555  
Other comprehensive losses:
                                                       
Net unrealized losses on securities available for sale, net of income taxes of ($8)a
                                            (16 )     (16 )
Net unrealized losses on derivative financial instruments, net of income taxes of ($8)
                                            (14 )     (14 )
Foreign currency translation adjustments
                                            (33 )     (33 )
Minimum pension liability adjustment, net of income taxes of ($1)
                                            (1 )     (1 )
 
                                                     
Total comprehensive income
                                                  $ 491  
 
                                                     
Deferred compensation
                    26                                  
Cash dividends declared on common shares ($.65 per share)
                            (265 )                        
Issuance of common shares and stock options granted under employee benefit and dividend reinvestment plans
    3,161               (13 )             80                  
Repurchase of common shares
    (2,500 )                             (84 )                
         
 
                                                       
BALANCE AT JUNE 30, 2005
    408,231     $ 492     $ 1,504     $ 7,574     $ (2,132 )   $ (86 )        
 
                                           
         
BALANCE AT DECEMBER 31, 2005
    406,624     $ 492     $ 1,534     $ 7,882     $ (2,204 )   $ (106 )        
Net income
                            597                     $ 597  
Other comprehensive income (losses):
                                                       
Net unrealized losses on securities available for sale, net of income taxes of ($33)a
                                            (55 )     (55 )
Net unrealized gains on derivative financial instruments, net of income taxes of $5
                                            9       9  
Net unrealized losses on common investment funds held in employee welfare benefits trust, net of income taxes
                                            (1 )     (1 )
Foreign currency translation adjustments
                                            33       33  
 
                                                     
Total comprehensive income
                                                  $ 583  
 
                                                     
Deferred compensation
                    19                                  
Cash dividends declared on common shares ($.69 per share)
                            (280 )                        
Issuance of common shares and stock options granted under employee benefit and dividend reinvestment plans
    6,048               24               158                  
Repurchase of common shares
    (10,000 )                             (365 )                
         
BALANCE AT JUNE 30, 2006
    402,672     $ 492     $ 1,577     $ 8,199     $ (2,411 )   $ (120 )        
 
                                           
         
 
(a)   Net of reclassification adjustments.
See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Cash Flow (Unaudited)
                 
    Six months ended June 30,  
in millions   2006     2005  
 
OPERATING ACTIVITIES
               
Net income
  $ 597     $ 555  
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
               
Provision for loan losses
    63       64  
Depreciation and amortization expense
    192       174  
Net securities (gains) losses
    (5 )     5  
Net gains from principal investing
    (20 )     (11 )
Net gains from loan securitizations and sales
    (20 )     (29 )
Deferred income taxes
    (195 )     48  
Net (increase) decrease in loans held for sale
    (808 )     1,079  
Net decrease in trading account assets
    47       114  
Other operating activities, net
    (261 )     (413 )
 
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
    (410 )     1,586  
INVESTING ACTIVITIES
               
Cash used in acquisitions, net of cash acquired
    (34 )     (7 )
Net increase in other short-term investments
    (32 )     (487 )
Purchases of securities available for sale
    (1,760 )     (1,466 )
Proceeds from sales of securities available for sale
    71       57  
Proceeds from prepayments and maturities of securities available for sale
    1,735       1,547  
Purchases of investment securities
    (2 )      
Proceeds from prepayments and maturities of investment securities
    49       12  
Purchases of other investments
    (269 )     (209 )
Proceeds from sales of other investments
    103       168  
Proceeds from prepayments and maturities of other investments
    147       43  
Net increase in loans, excluding acquisitions, sales and divestitures
    (1,238 )     (3,478 )
Purchases of loans
    (60 )     (11 )
Proceeds from loan securitizations and sales
    229       2,061  
Purchases of premises and equipment
    (32 )     (27 )
Proceeds from sales of premises and equipment
    2       7  
Proceeds from sales of other real estate owned
    15       47  
 
NET CASH USED IN INVESTING ACTIVITIES
    (1,076 )     (1,743 )
FINANCING ACTIVITIES
               
Net increase in deposits
    2,084       227  
Net increase (decrease) in short-term borrowings
    (601 )     1,479  
Net proceeds from issuance of long-term debt
    1,345       1,752  
Payments on long-term debt
    (1,148 )     (2,495 )
Purchases of treasury shares
    (365 )     (84 )
Net proceeds from issuance of common stock
    138       57  
Tax benefits in excess of recognized compensation cost for stock-based awards
    19        
Cash dividends paid
    (280 )     (265 )
 
NET CASH PROVIDED BY FINANCING ACTIVITIES
    1,192       671  
 
NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS
    (294 )     514  
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD
    3,108       2,454  
 
CASH AND DUE FROM BANKS AT END OF PERIOD
  $ 2,814     $ 2,968  
 
           
 
 
               
Additional disclosures relative to cash flow:
               
Interest paid
  $ 1,283     $ 765  
Income taxes paid
    311       193  
Noncash items:
               
Loans transferred to other real estate owned
  $ 19     $ 32  
 
See Notes to Consolidated Financial Statements (Unaudited).

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Notes to Consolidated Financial Statements
1. Basis of Presentation
The unaudited condensed consolidated interim financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
As used in these Notes, KeyCorp refers solely to the parent company and Key refers to the consolidated entity consisting of KeyCorp and subsidiaries.
Key consolidates any voting rights entity in which it has a controlling financial interest. In accordance with Financial Accounting Standards Board (“FASB”) Revised Interpretation No. 46, “Consolidation of Variable Interest Entities,” a variable interest entity (“VIE”) is consolidated if Key has a variable interest in the entity and is exposed to the majority of its expected losses and/or residual returns (i.e., Key is considered to be the primary beneficiary). Variable interests can include equity interests, subordinated debt, derivative contracts, leases, service agreements, guarantees, standby letters of credit, loan commitments, and other contracts, agreements and financial instruments.
Key uses the equity method to account for unconsolidated investments in voting rights entities or VIEs in which it has significant influence over operating and financing decisions (usually defined as a voting or economic interest of 20% to 50%, but not a controlling interest). Unconsolidated investments in voting rights entities or VIEs in which Key has a voting or economic interest of less than 20% generally are carried at cost. Investments held by KeyCorp’s broker/dealer and investment company subsidiaries (primarily principal investments) are carried at estimated fair value.
Qualifying special purpose entities (“SPEs”), including securitization trusts, established by Key under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” are not consolidated. Information on SFAS No. 140 is included in Note 1 (“Summary of Significant Accounting Policies”) of Key’s 2005 Annual Report to Shareholders under the heading “Loan Securitizations” on page 59.
Management believes that the unaudited condensed consolidated interim financial statements reflect all adjustments of a normal recurring nature and disclosures that are necessary for a fair presentation of the results for the interim periods presented. Some previously reported results have been reclassified to conform to current reporting practices. During the first quarter of 2006, Key reclassified certain loans from the “commercial lease financing” portfolio to the “commercial, financial and agricultural” portfolio to more accurately reflect the nature of these receivables. Prior period balances were not reclassified as the historical data was not available. The reclassification did not have any effect on Key’s total loans or net income.
The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. When you read these financial statements, you should also look at the audited consolidated financial statements and related notes included in Key’s 2005 Annual Report to Shareholders.
Stock-Based Compensation
Prior to January 1, 2006, Key used the fair value method of accounting as outlined in SFAS No. 123, “Accounting for Stock-Based Compensation.” Key had voluntarily adopted this method of accounting effective January 1, 2003, and opted to apply the new rules prospectively to all awards using one of three alternative methods of transition permitted under SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure.”
Effective January 1, 2006, Key adopted SFAS No. 123R, “Share-Based Payment,” which replaces SFAS No. 123. SFAS No. 123R requires stock-based compensation to be measured using the fair value method of accounting and for the measured cost to be recognized over the period during which the recipient is required to provide service in exchange for the award. As of the effective date, Key did not have any

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nonvested awards outstanding that had not been previously accounted for using the fair value method. Consequently, the adoption of SFAS No. 123R did not have a significant impact on Key’s financial condition or results of operations. The adoption of the new accounting standard did, however, result in a cumulative after-tax adjustment as discussed below.
SFAS No. 123R changes the manner of accounting for forfeited stock-based awards. Under the new standard, companies are no longer permitted to account for forfeitures as they occur. Companies, such as Key, that have been expensing stock-based awards and using this alternative method of accounting for forfeitures must now estimate expected forfeitures at the date the awards are granted and record compensation expense only for those that are expected to vest. As of the effective date, companies must estimate the forfeitures they expect to occur and reduce their related compensation obligation for expense previously recognized in the financial statements. The after-tax amount of this reduction must also be presented on the income statement as a cumulative effect of a change in accounting principle. Key’s cumulative after-tax adjustment increased first quarter 2006 earnings by $5 million, or $.01 per diluted common share.
Mandatory deferred incentive compensation awards vest at the rate of 33-1/3% per year. Prior to the adoption of SFAS No. 123R, Key recognized total compensation cost for its stock-based, mandatory deferred incentive compensation awards in the plan year that the performance-related services necessary to earn the awards were rendered. Effective January 1, 2006, Key is recognizing compensation cost for these awards using the accelerated method of amortization over a period of approximately four years (the current year performance period and the three-year vesting period, which starts generally in the first quarter following the performance period). The impact of this change on Key’s earnings was not material.
Also, prior to the adoption of SFAS No. 123R, Key presented all tax benefits of deductions resulting from the exercise of stock options or the issuance of shares under other stock-based compensation programs as operating cash flows in the statement of cash flows. SFAS No. 123R requires the cash flows resulting from the tax benefits of deductions in excess of the compensation cost recognized for stock-based awards to be classified as financing cash flows.
Generally, employee stock options granted by Key become exercisable at the rate of 33-1/3% per year beginning one year from their grant date and expire no later than ten years from their grant date. Key recognizes stock-based compensation expense for stock options with graded vesting using an accelerated method of amortization.
Key uses shares repurchased from time to time in accordance with its authorized repurchase program (treasury shares) for share issuances under stock-based compensation programs, other than the discounted stock purchase plan. Shares issued under this plan are purchased on the open market.
Accounting Pronouncements Adopted in 2006
Consolidation of limited partnerships. In June 2005, the FASB ratified Emerging Issues Task Force Issue No. 04-5, “Determining Whether a General Partner, or the General Partners of a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.” Issue No. 04-5 was initially effective for all limited partnerships created or modified after June 29, 2005, and became effective for all other limited partnerships on January 1, 2006. Adoption of this guidance did not have a material effect on Key’s financial condition or results of operations.
Accounting changes and error corrections. In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” which addresses the accounting for and reporting of accounting changes and error corrections. This guidance requires retrospective application for the reporting of voluntary changes in accounting principles and changes required by an accounting pronouncement when transition provisions are not specified. SFAS No. 154 was effective for accounting changes and corrections of errors made after December 31, 2005. Adoption of this guidance did not have a material effect on Key’s financial condition or results of operations.

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Stock-based compensation. As discussed under the heading “Stock-Based Compensation” on page 7, effective January 1, 2006, Key adopted SFAS No. 123R, which replaced SFAS No. 123. This new accounting standard changes the way in which stock-based compensation must be measured and recognized in the financial statements, and the manner in which forfeited stock-based awards must be accounted for. It also requires additional disclosures pertaining to stock-based compensation plans. The required disclosures for Key are presented under the heading referred to above and in Note 10 (“Stock-Based Compensation”), which begins on page 22.
Accounting Pronouncements Pending Adoption
Accounting for uncertain tax positions. In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” which clarifies the application of SFAS No. 109, “Accounting for Income Taxes,” by defining the minimum threshold that a tax position must meet before any associated benefit may be recognized in a company’s financial statements. This interpretation also provides guidance on measurement and derecognition of tax benefits, and requires expanded disclosures. The interpretation will be effective at the beginning of the fiscal year beginning after December 15, 2006 (effective January 1, 2007, for Key). Management is currently evaluating the potential effect this guidance may have on Key’s financial condition or results of operations. Additional information relating to this interpretation is included in Note 12 (“Income Taxes”), which begins on page 26.
Accounting for leveraged leases. In July 2006, the FASB issued Staff Position No. 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction,” which provides additional guidance on the application of SFAS No. 13, “Accounting for Leases.” This guidance will affect when earnings from leveraged lease transactions would be recognized when there are changes or projected changes in the timing of cash flows, including changes due to or expected to be due to settlements of tax matters. This guidance will be effective at the beginning of the fiscal year beginning after December 15, 2006 (effective January 1, 2007, for Key). Management is currently evaluating the potential effect this guidance may have on Key’s financial condition or results of operations. Additional information relating to this guidance is included in Note 12 (“Income Taxes”), which begins on page 26.
Accounting for servicing of financial assets. In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” which requires that servicing assets and liabilities be initially measured at fair value, if practicable. SFAS No. 156 also requires the subsequent remeasurement of servicing assets and liabilities at each reporting date using one of two methods: amortization over the servicing period, or measurement at fair value. This guidance will be effective at the beginning of the fiscal year beginning after September 15, 2006 (effective January 1, 2007, for Key). Adoption of this guidance is not expected to have a material effect on Key’s financial condition or results of operations.
Accounting for certain hybrid financial instruments. In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments.” A hybrid financial instrument is one where a derivative is embedded in another financial instrument. SFAS No. 155 will permit fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. This guidance will also eliminate the prohibition on a qualifying SPE from holding certain derivative financial instruments. SFAS No. 155 will be effective for all financial instruments acquired or issued after the beginning of the fiscal year beginning after September 15, 2006 (effective January 1, 2007, for Key). Adoption of this guidance is not expected to have a material effect on Key’s financial condition or results of operations.

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2. Earnings Per Common Share
Key calculates its basic and diluted earnings per common share as follows:
                                 
    Three months ended June 30,     Six months ended June 30,  
dollars in millions, except per share amounts   2006     2005     2006     2005  
 
EARNINGS
                               
Income before cumulative effect of accounting change
  $ 308     $ 291     $ 592     $ 555  
Net income
    308       291       597       555  
 
WEIGHTED-AVERAGE COMMON SHARES
                               
Weighted-average common shares outstanding (000)
    404,528       408,754       405,949       408,510  
Effect of dilutive common stock options and other stock awards (000)
    6,031       5,555       5,893       5,527  
 
Weighted-average common shares and potential common shares outstanding (000)
    410,559       414,309       411,842       414,037  
 
                       
 
EARNINGS PER COMMON SHARE
                               
Income per common share before cumulative effect of accounting change
  $ .76     $ .71     $ 1.46     $ 1.36  
Net income per common share
    .76       .71       1.47       1.36  
Income per common share before cumulative effect of accounting change — assuming dilution
    .75       .70       1.44       1.34  
Net income per common share — assuming dilution
    .75       .70       1.45       1.34  
 
3. Acquisitions and Divestiture
Key completed the following acquisitions during 2005 and the first six months of 2006. In the case of each acquisition, the terms of the transaction were not material.
Austin Capital Management, Ltd.
On April 1, 2006, Key acquired Austin Capital Management, Ltd., an investment firm headquartered in Austin, Texas with approximately $900 million in assets under management at the date of acquisition.
ORIX Capital Markets, LLC
On December 8, 2005, Key acquired the commercial mortgage-backed securities servicing business of ORIX Capital Markets, LLC (“ORIX”), headquartered in Dallas, Texas. ORIX had a servicing portfolio of approximately $27 billion at the date of acquisition.
Malone Mortgage Company
On July 1, 2005, Key acquired Malone Mortgage Company, a mortgage company headquartered in Dallas, Texas that serviced approximately $1.3 billion in loans at the date of acquisition.
Subsequent Event
On August 1, 2006, Key announced that it is considering the sale of its Champion Mortgage finance business. Key has hired UBS Investment Bank to assist the Board of Directors and management with the possible sale of this business. There can be no assurance that any agreements will be executed or that any transactions will be approved or consummated.

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4. Line of Business Results
Community Banking
Regional Banking provides individuals with branch-based deposit and investment products, personal finance services and loans, including residential mortgages, home equity and various types of installment loans. This line of business also provides small businesses with deposit, investment and credit products, and business advisory services.
Through McDonald Financial Group, Regional Banking also offers financial, estate and retirement planning, and asset management services to assist high-net-worth clients with their banking, brokerage, trust, portfolio management, insurance, charitable giving and related needs.
Commercial Banking provides midsize businesses with products and services that include commercial lending, cash management, equipment leasing, investments and employee benefit programs, succession planning, capital markets, derivatives and foreign exchange.
National Banking
Real Estate Capital provides construction and interim lending, permanent debt placements and servicing, and equity and investment banking services to developers, brokers and owner-investors. This line of business deals exclusively with nonowner-occupied properties (i.e., generally properties in which the owner occupies less than 60% of the premises).
Equipment Finance meets the equipment leasing needs of companies worldwide and provides equipment manufacturers, distributors and resellers with financing options for their clients. Lease financing receivables and related revenues are assigned to other lines of business (primarily Institutional and Capital Markets, and Commercial Banking) if those businesses are principally responsible for maintaining the relationship with the client.
Institutional and Capital Markets provides products and services to large corporations, middle-market companies, financial institutions, government entities and not-for-profit organizations. These products and services include commercial lending, treasury management, investment banking, derivatives and foreign exchange, equity and debt underwriting and trading, and syndicated finance.
Through its Victory Capital Management unit, Institutional and Capital Markets also manages or gives advice regarding investment portfolios for a national client base, including corporations, labor unions, not-for-profit organizations, governments and individuals. These portfolios may be managed in separate accounts, common funds or the Victory family of mutual funds.
Consumer Finance includes Indirect Lending, Commercial Floor Plan Lending and National Home Equity.
Indirect Lending offers loans to consumers through dealers. This business unit also provides federal and private education loans to students and their parents and processes payments on loans that private schools make to parents.
Commercial Floor Plan Lending finances inventory for automobile and marine dealers.
National Home Equity provides both prime and nonprime mortgage and home equity loan products to individuals. This business unit also works with home improvement contractors to provide home equity and home improvement solutions.
Other Segments
Other Segments consist of Corporate Treasury and Key’s Principal Investing unit.

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Reconciling Items
Total assets included under “Reconciling Items” represent primarily the unallocated portion of nonearning assets of corporate support functions. Charges related to the funding of these assets are part of net interest income and are allocated to the business segments through noninterest expense. Reconciling Items also includes certain items that are not allocated to the business segments because they are not reflective of their normal operations.
The table that spans pages 13 and 14 shows selected financial data for each major business group for the three- and six-month periods ended June 30, 2006 and 2005. This table is accompanied by supplementary information for each of the lines of business that comprise these groups. The information was derived from the internal financial reporting system that management uses to monitor and manage Key’s financial performance. U.S. generally accepted accounting principles (“GAAP”) guide financial accounting, but there is no authoritative guidance for “management accounting”—the way management uses its judgment and experience to make reporting decisions. Consequently, the line of business results Key reports may not be comparable with line of business results presented by other companies.
The selected financial data are based on internal accounting policies designed to compile results on a consistent basis and in a manner that reflects the underlying economics of the businesses. According to our policies:
¨   Net interest income is determined by assigning a standard cost for funds used to assets or a standard credit for funds provided to liabilities based on their assumed maturity, prepayment and/or repricing characteristics. The net effect of this funds transfer pricing is charged to the lines of business based on the total loan and deposit balances of each line.
 
¨   Indirect expenses, such as computer servicing costs and corporate overhead, are allocated based on assumptions regarding the extent to which each line actually uses the services.
 
¨   Key’s consolidated provision for loan losses is allocated among the lines of business based primarily on their actual net charge-offs, adjusted periodically for loan growth and changes in risk profile. The level of the consolidated provision is based on the methodology that management uses to estimate Key’s consolidated allowance for loan losses. This methodology is described in Note 1 (“Summary of Significant Accounting Policies”) under the heading “Allowance for Loan Losses” on page 59 of Key’s 2005 Annual Report to Shareholders.
 
¨   Income taxes are allocated based on the statutory federal income tax rate of 35% (adjusted for tax-exempt interest income, income from corporate-owned life insurance and tax credits associated with investments in low-income housing projects) and a blended state income tax rate (net of the federal income tax benefit) of 2.5%.
 
¨   Capital is assigned based on management’s assessment of economic risk factors (primarily credit, operating and market risk) directly attributable to each line.
Developing and applying the methodologies that management uses to allocate items among Key’s lines of business is a dynamic process. Accordingly, financial results may be revised periodically to reflect accounting enhancements, changes in the risk profile of a particular business or changes in Key’s organizational structure. The financial data reported for all periods presented in the line of business tables reflect a number of changes that occurred during the first six months of 2006:
¨   Effective January 1, 2006, Key reorganized and renamed its major business groups and some of its lines of business. The Community Banking group now includes Key businesses which operate primarily within our KeyCenter (branch) network. This group’s activities are conducted through two primary lines of business: Regional Banking (including McDonald Financial Group) and Commercial Banking. Key’s other major business group, National Banking, includes those corporate and consumer business units that operate both within and outside of the branch network to serve customers across the country and internationally through four primary lines of business: Real Estate Capital, Equipment Finance, Institutional and Capital Markets, and Consumer Finance.

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Three months ended June 30,   Community Banking     National Banking     Other Segments  
dollars in millions   2006     2005     2006     2005     2006     2005  
 
SUMMARY OF OPERATIONS
                                               
Net interest income (TE)
  $ 436     $ 420     $ 372     $ 346     $ (28 )   $ (19 )
Noninterest income
    226       225       259       239       51       28  
 
Total revenue (TE)a
    662       645       631       585       23       9  
Provision for loan losses
    19       18       5       2              
Depreciation and amortization expense
    36       35       62       53              
Other noninterest expense
    439       403       284       274       7       8  
 
Income (loss) before income taxes (TE)
    168       189       280       256       16       1  
Allocated income taxes and TE adjustments
    63       71       105       96       (4 )     (9 )
 
Income before cummulative effect of accounting change
    105       118       175       160       20       10  
Cummulative effect of accounting change
                                   
 
Net income
  $ 105     $ 118     $ 175     $ 160     $ 20     $ 10  
 
                                   
 
 
                                               
Percent of consolidated net income
    34 %     41 %     57 %     55 %     6 %     3 %
Percent of total segments net income
    35       41       58       56       7       3  
 
AVERAGE BALANCES
                                               
Loans and leases
  $ 26,804     $ 27,038     $ 40,201     $ 36,842     $ 301     $ 407  
Total assetsa
    29,758       29,902       50,470       46,101       11,396       11,622  
Deposits
    46,683       43,719       10,638       7,535       3,140       5,121  
 
OTHER FINANCIAL DATA
                                               
Net loan charge-offs
  $ 24     $ 25     $ 10     $ 23              
Return on average allocated equity
    19.23 %     21.83 %     18.31 %     17.61 %     N/M       N/M  
Average full-time equivalent employees
    9,015       8,698       4,466       4,502       39       40  
 
                                                 
Six months ended June 30,   Community Banking     National Banking     Other Segments  
dollars in millions   2006     2005     2006     2005     2006     2005  
 
SUMMARY OF OPERATIONS
                                               
Net interest income (TE)
  $ 866     $ 831     $ 750     $ 705     $ (57 )   $ (55 )
Noninterest income
    439       437       506       471       74       77  
 
Total revenue (TE)a
    1,305       1,268       1,256       1,176       17       22  
Provision for loan losses
    47       47       16       17              
Depreciation and amortization expense
    73       69       119       105              
Other noninterest expense
    842       800       561       521       15       17  
 
Income (loss) before income taxes (TE)
    343       352       560       533       2       5  
Allocated income taxes and TE adjustments
    129       132       210       200       (19 )     (19 )
 
Income (loss) before cummulative effect of accounting change
    214       220       350       333       21       24  
Cummulative effect of accounting change
                                   
 
Net income (loss)
  $ 214     $ 220     $ 350     $ 333     $ 21     $ 24  
 
                                   
 
 
                                               
Percent of consolidated net income
    36 %     40 %     59 %     60 %     3 %     4 %
Percent of total segments net income
    37       38       60       58       3       4  
 
AVERAGE BALANCES
                                               
Loans and leases
  $ 26,772     $ 26,917     $ 39,870     $ 36,646     $ 312     $ 422  
Total assetsa
    29,707       29,805       50,046       46,578       11,433       11,802  
Deposits
    46,262       43,453       10,302       7,099       3,268       5,510  
 
OTHER FINANCIAL DATA
                                               
Net loan charge-offs
  $ 52     $ 58     $ 21     $ 44              
Return on average allocated equity
    19.71 %     20.46 %     18.42 %     18.16 %     N/M       N/M  
Average full-time equivalent employees
    8,944       8,762       4,461       4,546       39       39  
 
 
(a)   Substantially all revenue generated by Key’s major business groups is derived from clients resident in the United States. Substantially all long-lived assets, including premises and equipment, capitalized software and goodwill, held by Key’s major business groups are located in the United States.
 
(b) “Other noninterest expense” includes a $30 million ($19 million after tax) charge recorded during the first quarter of 2005 to adjust the accounting for rental expense associated with operating leases from an escalating to a straight-line basis.
 
TE = Taxable Equivalent, N/A = Not Applicable, N/M = Not Meaningful

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Total Segments     Reconciling Items     Key  
2006     2005     2006     2005     2006     2005  
 
                                             
$ 780     $ 747     $ (28 )   $ (24 )   $ 752     $ 723  
  536       492       11       (6 )     547       486  
 
  1,316       1,239       (17 )     (30 )     1,299       1,209  
  24       20                   24       20  
  98       88                   98       88  
  730       685       (12 )     (20 )     718       665  
 
  464       446       (5 )     (10 )     459       436  
                                             
  164       158       (13 )     (13 )     151       145  
 
                                             
  300       288       8       3       308       291  
                                             
                                 
 
$ 300     $ 288     $ 8     $ 3     $ 308     $ 291  
                                 
 
                                             
  97 %     99 %     3 %     1 %     100 %     100 %
  100       100       N/A       N/A       N/A       N/A  
 
                                             
$ 67,306     $ 64,287     $ 136     $ 204     $ 67,442     $ 64,491  
  91,624       87,625       2,237       2,290       93,861       89,915  
  60,461       56,375       (68 )     (239 )     60,393       56,136  
 
                                             
$ 34     $ 48                 $ 34     $ 48  
  18.63 %     18.51 %     N/M       N/M       16.11 %     16.15 %
                                             
  13,520       13,240       6,411       6,189       19,931       19,429  
 
                                             
Total Segments     Reconciling Items     Key  
2006     2005     2006     2005     2006     2005  
 
                                             
$ 1,559     $ 1,481     $ (51 )   $ (44 )   $ 1,508     $ 1,437  
  1,019       985       9       1       1,028       986  
 
  2,578       2,466       (42 )     (43 )     2,536       2,423  
  63       64                   63       64  
  192       174                   192       174  
  1,418       1,338       (24 )     10 b     1,394       1,348  
 
  905       890       (18 )     (53 )     887       837  
                                             
  320       313       (25 )     (31 )     295       282  
 
                                             
  585       577       7       (22 )     592       555  
                                             
              5             5        
 
$ 585     $ 577     $ 12     $ (22 )   $ 597     $ 555  
                                 
 
                                             
  98 %     104 %     2 %     (4 )%     100 %     100 %
  100       100       N/A       N/A       N/A       N/A  
 
                                             
$ 66,954     $ 63,985     $ 110     $ 151     $ 67,064     $ 64,136  
  91,186       88,185       2,204       2,249       93,390       90,434  
  59,832       56,062       (125 )     (215 )     59,707       55,847  
 
                                             
$ 73     $ 102                 $ 73     $ 102  
  18.29 %     18.49 %     N/M       N/M       15.80 %     15.63 %
                                             
  13,444       13,347       6,369       6,187       19,813       19,534  
 

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Supplementary information (Community Banking lines of business)
                                 
Three months ended June 30,   Regional Banking     Commercial Banking  
dollars in millions   2006     2005     2006     2005  
 
Total revenue (taxable equivalent)
  $ 563     $ 546     $ 99     $ 99  
Provision for loan losses
    14       19       5       (1 )
Noninterest expense
    423       388       52       50  
Net income
    79       87       26       31  
Average loans and leases
    18,771       19,114       8,033       7,924  
Average deposits
    43,091       40,421       3,592       3,298  
Net loan charge-offs
    21       21       3       4  
Return on average allocated equity
    21.37 %     23.64 %     14.75 %     17.97 %
Average full-time equivalent employees
    8,642       8,316       373       382  
 
                                 
Six months ended June 30,   Regional Banking     Commercial Banking  
dollars in millions   2006     2005     2006     2005  
 
Total revenue (taxable equivalent)
  $ 1,110     $ 1,081     $ 195     $ 187  
Provision for loan losses
    41       52       6       (5 )
Noninterest expense
    813       777       102       92  
Net income
    160       158       54       62  
Average loans and leases
    18,774       19,208       7,998       7,709  
Average deposits
    42,659       40,202       3,603       3,251  
Net loan charge-offs
    42       47       10       11  
Return on average allocated equity
    21.73 %     21.54 %     15.47 %     18.15 %
Average full-time equivalent employees
    8,581       8,366       363       396  
 
Supplementary information (National Banking lines of business)
                                                                 
Three months ended June 30,   Real Estate Capital     Equipment Finance     Institutional and Capital Markets     Consumer Finance  
dollars in millions   2006     2005     2006     2005     2006     2005     2006     2005  
 
Total revenue (taxable equivalent)
  $ 174     $ 138     $ 136     $ 127     $ 187     $ 168     $ 134     $ 152  
Provision for loan losses
    3       (5 )     8       7       (13 )     1       7       (1 )
Noninterest expense
    71       55       80       75       110       97       85       100  
Net income
    62       55       30       28       57       44       26       33  
Average loans and leases
    12,719       10,596       9,871       8,892       7,589       7,824       10,022       9,530  
Average deposits
    3,467       1,728       14       11       6,441       5,152       716       644  
Net loan charge-offs (recoveries)
    2       3       3       2       (1 )     7       6       11  
Return on average allocated equity
    22.84 %     23.32 %     14.73 %     14.82 %     21.82 %     16.79 %     11.86 %     14.87 %
Average full-time equivalent employees
    955       774       915       963       1,253       1,213       1,343       1,552  
 
                                                                 
Six months ended June 30,   Real Estate Capital     Equipment Finance     Institutional and Capital Markets     Consumer Finance  
dollars in millions   2006     2005     2006     2005     2006     2005     2006     2005  
 
Total revenue (taxable equivalent)
  $ 328     $ 241     $ 259     $ 253     $ 394     $ 346     $ 275     $ 336  
Provision for loan losses
    4       (3 )     16       2       (12 )           8       18  
Noninterest expense
    131       101       150       147       236       190       163       188  
Net income
    120       89       58       65       107       98       65       81  
Average loans and leases
    12,594       10,197       9,721       8,921       7,706       8,024       9,849       9,504  
Average deposits
    3,341       1,622       14       11       6,238       4,851       709       615  
Net loan charge-offs (recoveries)
    4       6       6       3       (5 )     10       16       25  
Return on average allocated equity
    22.36 %     18.91 %     14.40 %     17.34 %     20.39 %     18.57 %     14.90 %     17.60 %
Average full-time equivalent employees
    968       766       925       990       1,244       1,204       1,324       1,586  
 

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5. Securities
Key classifies each security held into one of four categories: trading, available for sale, investment or other investments.
Trading account securities. These are debt and equity securities that are purchased and held by Key with the intent of selling them in the near term. Trading account securities are reported at fair value ($803 million at June 30, 2006, $850 million at December 31, 2005, and $749 million at June 30, 2005) and are included in “short-term investments” on the balance sheet. Realized and unrealized gains and losses on trading account securities are reported in “investment banking and capital markets income” on the income statement.
Securities available for sale. These are securities that Key intends to hold for an indefinite period of time and that may be sold in response to changes in interest rates, prepayment risk, liquidity needs or other factors. Securities available for sale, which include debt and marketable equity securities with readily determinable fair values, are reported at fair value. Unrealized gains and losses (net of income taxes) deemed temporary are recorded in shareholders’ equity as a component of “accumulated other comprehensive loss” on the balance sheet. Unrealized losses on specific securities deemed to be “other-than-temporary” are included in “net securities gains (losses)” on the income statement, as are actual gains and losses resulting from the sales of specific securities.
When Key retains an interest in loans it securitizes, it bears risk that the loans will be prepaid (which would reduce expected interest income) or not paid at all. Key accounts for these retained interests as debt securities and classifies them as available for sale.
“Other securities” held in the available-for-sale portfolio are primarily marketable equity securities.
Investment securities. These are debt securities that Key has the intent and ability to hold until maturity. Debt securities are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method. This method produces a constant rate of return on the adjusted carrying amount. “Other securities” held in the investment securities portfolio are foreign bonds.
Other investments. Principal investments — investments in equity and mezzanine instruments made by Key’s Principal Investing unit — represent the majority of other investments. These securities include direct investments (investments made in a particular company), as well as indirect investments (investments made through funds that include other investors). Principal investments are predominantly made in privately held companies and are carried at fair value ($846 million at June 30, 2006, $800 million at December 31, 2005, and $814 million at June 30, 2005). Changes in estimated fair values and actual gains and losses on sales of principal investments are included in “other income” on the income statement.
In addition to principal investments, “other investments” include other equity and mezzanine instruments that do not have readily determinable fair values. These securities include certain real estate-related investments that are carried at estimated fair value, as well as other types of securities that generally are carried at cost. The carrying amount of the securities carried at cost is adjusted for declines in value that are considered to be other-than-temporary. These adjustments are included in “investment banking and capital markets income” on the income statement.
The amortized cost, unrealized gains and losses, and approximate fair value of Key’s investment securities and securities available for sale are presented in the following tables. Gross unrealized gains and losses are represented by the difference between the amortized cost and the fair values of securities on the balance sheet as of the dates indicated. Accordingly, the amount of these gains and losses may change in the future as market conditions improve or worsen.

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      June 30, 2006    
       
              Gross     Gross            
      Amortized     Unrealized     Unrealized     Fair      
in millions     Cost     Gains     Losses     Value      
           
SECURITIES AVAILABLE FOR SALE
                                     
U.S. Treasury, agencies and corporations
    $ 24                 $ 24      
States and political subdivisions
      17                   17      
Collateralized mortgage obligations
      6,772     $ 3     $ 217       6,558      
Other mortgage-backed securities
      202       2       6       198      
Retained interests in securitizations
      122       45             167      
Other securities
      170       6             176      
           
Total securities available for sale
    $ 7,307     $ 56     $ 223     $ 7,140      
 
                             
 
                                     
           
INVESTMENT SECURITIES
                                     
States and political subdivisions
    $ 29     $ 1           $ 30      
Other securities
      15                   15      
             
Total investment securities
    $ 44     $ 1           $ 45      
 
                             
           
 
                                     
      December 31, 2005      
 
            Gross     Gross              
 
    Amortized     Unrealized     Unrealized     Fair      
in millions
    Cost     Gains     Losses     Value      
           
SECURITIES AVAILABLE FOR SALE
                                     
U.S. Treasury, agencies and corporations
    $ 267     $ 1           $ 268      
States and political subdivisions
      17       1             18      
Collateralized mortgage obligations
      6,455       2     $ 159       6,298      
Other mortgage-backed securities
      233       5       4       234      
Retained interests in securitizations
      115       67             182      
Other securities
      261       8             269      
           
Total securities available for sale
    $ 7,348     $ 84     $ 163     $ 7,269      
 
                             
 
                                     
           
INVESTMENT SECURITIES
                                     
States and political subdivisions
    $ 35     $ 1           $ 36      
Other securities
      56                   56      
             
Total investment securities
    $ 91     $ 1           $ 92      
 
                             
           
 
                                     
      June 30, 2005      
 
            Gross     Gross              
 
    Amortized     Unrealized     Unrealized     Fair      
in millions
    Cost     Gains     Losses     Value      
           
SECURITIES AVAILABLE FOR SALE
                                     
U.S. Treasury, agencies and corporations
    $ 270                 $ 270      
States and political subdivisions
      19     $ 1             20      
Collateralized mortgage obligations
      6,498       3     $ 103       6,398      
Other mortgage-backed securities
      274       7       2       279      
Retained interests in securitizations
      97       80             177      
Other securities
      121       6             127      
             
Total securities available for sale
    $ 7,279     $ 97     $ 105     $ 7,271      
 
                             
 
                                     
           
 
                                     
INVESTMENT SECURITIES
                                     
States and political subdivisions
    $ 46     $ 2           $ 48      
Other securities
      13                   13      
             
Total investment securities
    $ 59     $ 2           $ 61      
 
                             
           
 
                                     
 
                                     
           

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6. Loans and Loans Held for Sale
Key’s loans by category are summarized as follows:
                         
    June 30,     December 31,     June 30,  
in millions   2006     2005     2005  
 
Commercial, financial and agriculturala
  $ 21,598     $ 20,579     $ 19,331  
Commercial real estate:
                       
Commercial mortgage
    7,994       8,360       8,507  
Construction
    7,767       7,109       6,236  
 
Total commercial real estate loans
    15,761       15,469       14,743  
Commercial lease financinga
    9,909       10,352       10,113  
 
Total commercial loans
    47,268       46,400       44,187  
Real estate — residential mortgage
    1,418       1,458       1,466  
Home equity
    13,509       13,488       13,921  
Consumer — direct
    1,670       1,794       1,793  
Consumer — indirect:
                       
Marine
    2,920       2,715       2,665  
Other
    623       623       658  
 
Total consumer — indirect loans
    3,543       3,338       3,323  
 
Total consumer loans
    20,140       20,078       20,503  
 
Total loans
  $ 67,408     $ 66,478     $ 64,690  
 
                 
 
Key uses interest rate swaps to manage interest rate risk; these swaps modify the repricing and maturity characteristics of certain loans. For more information about such swaps, see Note 19 (“Derivatives and Hedging Activities”), which begins on page 87 of Key’s 2005 Annual Report to Shareholders.
(a)   At March 31, 2006, Key reclassified $792 million of loans from the commercial lease financing component of the commercial loan portfolio to the commercial, financial and agricultural component to more accurately reflect the nature of these receivables. Balances presented for prior periods were not reclassified as the historical data was not available.
Key’s loans held for sale by category are summarized as follows:
                         
    June 30,     December 31,     June 30,  
in millions   2006     2005     2005  
 
Commercial, financial and agricultural
  $ 45     $ 85        
Real estate — commercial mortgage
    1,133       525     $ 519  
Real estate — residential mortgage
    27       11       23  
Real estate — construction
    36       51        
Home equity
    1             1  
Education
    2,929       2,687       2,586  
Automobile
    18       22       145  
 
Total loans held for sale
    $4,189     $ 3,381     $ 3,274  
 
                 
 
Changes in the allowance for loan losses are summarized as follows:
                                 
    Three months ended June 30,     Six months ended June 30,  
in millions   2006     2005     2006     2005  
 
Balance at beginning of period
  $ 966     $ 1,128     $ 966     $ 1,138  
Charge-offs
    (59 )     (75 )     (124 )     (153 )
Recoveries
    25       27       51       51  
 
Net loans charged off
    (34 )     (48 )     (73 )     (102 )
Provision for loan losses
    24       20       63       64  
 
Balance at end of period
  $ 956     $ 1,100     $ 956     $ 1,100  
 
                       
 

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Changes in the allowance for credit losses on lending-related commitments are summarized as follows:
                                 
    Three months ended
June 30,
    Six months ended
June 30,
 
in millions   2006     2005     2006     2005  
 
Balance at beginning of period
  $ 59     $ 55     $ 59     $ 66  
Provision (credit) for losses on lending-related commitments
          2             (9 )
 
Balance at end of period a
  $ 59     $ 57     $ 59     $ 57  
 
                       
 
(a)   Included in “accrued expense and other liabilities” on the consolidated balance sheet.
7. Variable Interest Entities
A VIE is a partnership, limited liability company, trust or other legal entity that meets any one of certain criteria specified in Revised Interpretation No. 46. This interpretation requires VIEs to be consolidated by the party who is exposed to the majority of the VIE’s expected losses and/or residual returns (i.e., the primary beneficiary).
Key’s VIEs, including those consolidated and those in which Key holds a significant interest, are summarized below. Key defines a “significant interest” in a VIE as a subordinated interest that exposes Key to a significant portion, but not the majority, of the VIE’s expected losses or residual returns.
                         
    Consolidated VIEs     Unconsolidated VIEs  
                    Maximum  
in millions   Total Assets     Total Assets     Exposure to Loss  
 
June 30, 2006
                       
Commercial paper conduit
  $ 314       N/A       N/A  
Low-income housing tax credit (“LIHTC”) funds
    362     $ 190        
LIHTC investments
    N/A       762     $ 224  
 
N/A = Not Applicable
The noncontrolling interests associated with the consolidated LIHTC guaranteed funds are considered mandatorily redeemable instruments and are recorded in “accrued expense and other liabilities” on the balance sheet. The FASB has indefinitely deferred the measurement and recognition provisions of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” for mandatorily redeemable noncontrolling interests associated with finite-lived subsidiaries, such as Key’s LIHTC guaranteed funds. Key currently accounts for these noncontrolling interests as minority interests and adjusts the financial statements each period for the investors’ share of the funds’ profits and losses. At June 30, 2006, the settlement value of these noncontrolling interests was estimated to be between $398 million and $474 million, while the recorded value, including reserves, totaled $352 million.
Key’s Principal Investing unit and the Real Estate Capital line of business make equity and mezzanine investments in entities, some of which are VIEs. These investments are held by nonregistered investment companies subject to the provisions of the American Institute of Certified Public Accountants (“AICPA”) Audit and Accounting Guide, “Audits of Investment Companies.” The FASB deferred the effective date of Revised Interpretation No. 46 for such nonregistered investment companies until the AICPA clarifies the scope of the Audit Guide. As a result, Key is not currently applying the accounting or disclosure provisions of Revised Interpretation No. 46 to its principal and real estate mezzanine and equity investments, which remain unconsolidated.

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Additional information pertaining to Revised Interpretation No. 46 and the activities of the specific VIEs with which Key is involved is provided in Note 8 (“Loan Securitizations, Servicing and Variable Interest Entities”) of Key’s 2005 Annual Report to Shareholders under the heading “Variable Interest Entities” on page 71.
8. Nonperforming Assets and Past Due Loans
Impaired loans totaled $120 million at June 30, 2006, compared to $105 million at December 31, 2005, and $88 million at June 30, 2005. Impaired loans averaged $121 million for the second quarter of 2006 and $99 million for the second quarter of 2005.
Key’s nonperforming assets and past due loans were as follows:
                         
    June 30,     December 31,     June 30,  
in millions   2006     2005     2005  
 
Impaired loans
  $ 120     $ 105     $ 88  
Other nonaccrual loans
    159       172       204  
 
Total nonperforming loans
    279       277       292  
 
                       
Nonperforming loans held for sale
    1       3       1  
 
                       
Other real estate owned (OREO)
    26       25       33  
Allowance for OREO losses
    (1 )     (2 )     (2 )
 
OREO, net of allowance
    25       23       31  
Other nonperforming assets
    3       4       14  
 
Total nonperforming assets
  $ 308     $ 307     $ 338  
 
                 
 
Impaired loans with a specifically allocated allowance
  $ 26     $ 9     $ 30  
Allowance for loan losses allocated to impaired loans
    8       6       8  
 
Accruing loans past due 90 days or more
  $ 119     $ 90     $ 74  
Accruing loans past due 30 through 89 days
    600       491       475  
 
At June 30, 2006, Key did not have any significant commitments to lend additional funds to borrowers with loans on nonperforming status.
Key evaluates the collectibility of most impaired loans individually as described in Note 1 (“Summary of Significant Accounting Policies”) under the heading “Allowance for Loan Losses” on page 59 of Key’s 2005 Annual Report to Shareholders. Key does not perform a loan-specific impairment valuation for smaller-balance, homogeneous, nonaccrual loans (shown in the preceding table as “Other nonaccrual loans”). These typically are smaller-balance commercial loans and consumer loans, including residential mortgages, home equity loans and various types of installment loans. Management applies historical loss experience rates to these loans, adjusted to reflect emerging credit trends and other factors, and then allocates a portion of the allowance for loan losses to each loan type.
9. Capital Securities Issued by Unconsolidated Subsidiaries
KeyCorp owns the outstanding common stock of business trusts that issued corporation-obligated mandatorily redeemable preferred capital securities (“capital securities”). The trusts used the proceeds from the issuance of their capital securities and common stock to buy debentures issued by KeyCorp. These debentures are the trusts’ only assets; the interest payments from the debentures finance the distributions paid on the capital securities.
The capital securities provide an attractive source of funds since they constitute Tier 1 capital for regulatory reporting purposes, but have the same tax advantages as debt for federal income tax purposes. During the first quarter of 2005, the Federal Reserve Board adopted a rule that allows bank holding companies to continue to treat capital securities as Tier 1 capital, but with stricter quantitative limits that take effect after a five-year transition period ending March 31, 2009. Management believes that the new rule will not have any material effect on Key’s financial condition.

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To the extent the trusts have funds available to make payments, KeyCorp continues to unconditionally guarantee payment of:
¨   required distributions on the capital securities;
 
¨   the redemption price when a capital security is redeemed; and
 
¨   amounts due if a trust is liquidated or terminated.
During the first six months of 2006, the business trusts did not repurchase any capital securities or related debentures. On June 20, 2006, $250 million of securities were issued by the KeyCorp Capital VIII trust.
The capital securities, common stock and related debentures are summarized as follows:
                                         
                    Principal     Interest Rate     Maturity  
    Capital             Amount of     of Capital     of Capital  
    Securities,     Common     Debentures,     Securities and     Securities and  
dollars in millions   Net of Discounta     Stock     Net of Discountb     Debenturesc     Debentures  
 
June 30, 2006
                                       
KeyCorp Institutional Capital A
  $ 364     $ 11     $ 361       7.826 %     2026  
KeyCorp Institutional Capital B
    156       4       154       8.250       2026  
KeyCorp Capital I
    197       8       205       5.730       2028  
KeyCorp Capital II
    165       8       165       6.875       2029  
KeyCorp Capital III
    211       8       197       7.750       2029  
KeyCorp Capital V
    158       5       180       5.875       2033  
KeyCorp Capital VI
    69       2       77       6.125       2033  
KeyCorp Capital VII
    210       8       258       5.700       2035  
KeyCorp Capital VIII
    242             250       7.000       2066  
 
Total
  $ 1,772     $ 54     $ 1,847       6.927 %      
 
                                 
 
December 31, 2005
  $ 1,617     $ 54     $ 1,597       6.794 %      
 
                                 
 
June 30, 2005
  $ 1,681     $ 54     $ 1,597       6.684 %      
 
                                 
 
(a)   The capital securities must be redeemed when the related debentures mature, or earlier if provided in the governing indenture. Each issue of capital securities carries an interest rate identical to that of the related debenture. Included in certain capital securities at June 30, 2006, December 31, 2005, and June 30, 2005, are basis adjustments of ($21) million, $74 million and $138 million, respectively, related to fair value hedges. See Note 19 (“Derivatives and Hedging Activities”), which begins on page 87 of Key’s 2005 Annual Report to Shareholders, for an explanation of fair value hedges .
 
(b)   KeyCorp has the right to redeem its debentures: (i) in whole or in part, on or after December 1, 2006 (for debentures owned by Capital A), December 15, 2006 (for debentures owned by Capital B), July 1, 2008 (for debentures owned by Capital I), March 18, 1999 (for debentures owned by Capital II), July 16, 1999 (for debentures owned by Capital III), July 21, 2008 (for debentures owned by Capital V), December 15, 2008 (for debentures owned by Capital VI), and June 15, 2011 (for debentures owned by Capital VIII); and, (ii) in whole at any time within 90 days after and during the continuation of a “tax event,” an “investment company event” or a “capital treatment event” (as defined in the applicable indenture). If the debentures purchased by Capital A or Capital B are redeemed before they mature, the redemption price will be the principal amount, plus a premium, plus any accrued but unpaid interest. If the debentures purchased by Capital I, Capital V, Capital VI, Capital VII or Capital VIII are redeemed before they mature, the redemption price will be the principal amount, plus any accrued but unpaid interest. If the debentures purchased by Capital II or Capital III are redeemed before they mature, the redemption price will be the greater of: (a) the principal amount, plus any accrued but unpaid interest or (b) the sum of the present values of principal and interest payments discounted at the Treasury Rate (as defined in the applicable indenture), plus 20 basis points (25 basis points for Capital III), plus any accrued but unpaid interest. When debentures are redeemed in response to tax or capital treatment events, the redemption price generally is slightly more favorable to KeyCorp .
 
(c)   The interest rates for Capital A, Capital B, Capital II, Capital III, Capital V, Capital VI, Capital VII and Capital VIII are fixed. Capital I has a floating interest rate equal to three-month LIBOR plus 74 basis points; it reprices quarterly. The rates shown as the total at June 30, 2006, December 31, 2005, and June 30, 2005, are weighted-average rates.

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10. Stock-Based Compensation
Key maintains several stock-based compensation plans, which are described below. Total compensation expense for these plans was $33 million for the six-month periods ended June 30, 2006 and 2005. The total income tax benefit recognized in the income statement for these plans was $12 million for the six-month periods ended June 30, 2006 and 2005. Stock-based compensation expense related to awards granted to employees is recorded in “personnel expense” on the income statement, whereas compensation expense related to awards granted to directors is recorded in “other expense.”
Key’s compensation plans allow KeyCorp to grant stock options, restricted stock, performance shares, discounted stock purchases and certain deferred compensation-related awards to eligible employees and directors. At June 30, 2006, KeyCorp had 74,070,085 common shares available for future grant under its compensation plans. In accordance with a resolution adopted by the Compensation and Organization Committee of Key’s Board of Directors, KeyCorp may not grant options to purchase common shares, restricted stock or other shares under its long-term compensation plans in an amount that exceeds 6% of KeyCorp’s outstanding common shares in any rolling three-year period.
Stock Option Plans
Stock options granted to employees and directors generally become exercisable at the rate of 33-1/3% per year beginning one year from their grant date and expire no later than ten years from their grant date. Exercise prices cannot be less than the fair value of Key’s common shares on the grant date. The exercise price is the average of the high and low price of Key’s common shares on the date of grant by the Compensation and Organization Committee. Management estimates the fair value of options granted using the Black-Scholes option-pricing model. This model was originally developed to estimate the fair value of exchange-traded equity options, which (unlike employee stock options) have no vesting period or transferability restrictions. Because of these differences, the Black-Scholes model is not a perfect indicator of the value of an employee stock option, but it is commonly used for this purpose. The model assumes that the estimated fair value of an option is amortized as compensation expense over the option’s vesting period.
The Black-Scholes model requires several assumptions, which management developed and updates based on historical trends and current market observations. The accuracy of these assumptions is critical to management’s ability to estimate the fair value of options accurately. The assumptions pertaining to options issued during the six-month periods ended June 30, 2006 and 2005, are shown in the following table.
                 
    Six months ended  
    June 30,  
    2006     2005  
 
Average option life
  5.2 years   6.0 years
Future dividend yield
    3.75 %     3.96 %
Historical share price volatility
    .196       .286  
Weighted-average risk-free interest rate
    4.9 %     4.0 %
 
Key’s annual stock option grant to its executives and certain other employees occurs in July, upon approval by the Compensation and Organization Committee. Consequently, in the first half of 2006, stock option grants were not significant.
The following table summarizes activity, pricing and other information for Key’s stock options for the six-month period ended June 30, 2006:
                                 
            Weighted-Average     Weighted-Average     Aggregate  
    Number of     Exercise Price     Remaining Life     Intrinsic  
dollars in millions, except per share amounts   Options     Per Option     (Years)     Valuea  
 
Outstanding at December 31, 2005
    37,265,859     $ 28.35                  
Granted
    154,500       36.90                  
Exercised
    (5,309,735 )     26.53                  
Lapsed or canceled
    (589,732 )     30.28                  
                 
Outstanding at June 30, 2006
    31,520,892     $ 28.67       6.0     $ 221  
 
                             
 
Expected to vest
    29,024,036     $ 28.63       6.3     $ 205  
 
Exercisable at June 30, 2006
    19,131,928     $ 27.25       5.2     $ 161  
 
(a)   The intrinsic value of a stock option is the amount by which the fair value of the underlying stock exceeds the exercise price of the option.

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The weighted-average grant-date fair value of options granted during the six-month periods ended June 30, 2006 and 2005, was $5.99 and $7.12, respectively. The total intrinsic value of options exercised during the six-month periods ended June 30, 2006 and 2005, was $51 million and $18 million, respectively. As of June 30, 2006, unrecognized compensation cost related to nonvested options expected to vest under the plans totaled $19 million. Management expects to recognize this cost over a weighted-average period of 2.0 years.
The actual tax benefit realized for the tax deductions from options exercised totaled $18 million and $6 million for the six-month periods ended June 30, 2006 and 2005, respectively.
Long-Term Incentive Compensation Program
Key’s Long-Term Incentive Compensation Program (“Program”) rewards senior executives who are critical to Key’s long-term financial success. The Program covers three-year performance cycles with a new cycle beginning each year. Awards under the Program are primarily in the form of time-lapsed restricted stock, performance-based restricted stock, and performance shares payable primarily in stock. The time-lapsed restricted stock generally vests after the end of the three-year cycle. The vesting of the performance-based restricted stock and performance shares is contingent upon the attainment of defined performance levels.
The following table summarizes activity and pricing information for the nonvested shares in the Program for the six-month period ended June 30, 2006:
                                 
                    Vesting Contingent on  
    Vesting Contingent on     Performance and  
    Service Conditions     Service Conditions  
            Weighted-             Weighted-  
    Number of     Average     Number of     Average  
    Nonvested     Grant-Date     Nonvested     Grant-Date  
    Shares     Fair Value     Shares     Fair Value  
 
Outstanding at December 31, 2005
    476,034     $ 31.43       1,190,458     $ 31.05  
Granted
    222,797       35.42       738,002       33.51  
Forfeited
    (22,316 )     31.98       (34,523 )     31.40  
 
Outstanding at June 30, 2006
    676,515     $ 32.73       1,893,937     $ 32.00  
 
                           
 
The compensation cost of time-lapsed restricted stock awards granted under the Program is measured based on the average of the high and low trading price of Key’s common shares on the grant date. The performance shares payable primarily in stock, unlike the time-lapsed and performance-based restricted stock, do not pay dividends during the vesting period. Consequently, the fair value of performance shares is measured by reducing the share price at the date of grant by the present value of estimated future dividends forgone during the vesting period, discounted at an appropriate risk-free interest rate. The weighted-average grant-date fair value of awards granted under the Program during the six-month periods ended June 30, 2006 and 2005, was $33.95 and $32.28, respectively. As of June 30, 2006, unrecognized compensation cost related to nonvested shares expected to vest under the Program totaled $27 million. Management expects to recognize this cost over a weighted-average period of 2.1 years. There were no shares scheduled to vest during the six-month periods ended June 30, 2006 and 2005.
Other Restricted Stock Awards
Key may also grant special time-lapsed restricted stock awards to certain executives and employees in recognition of high performance. These awards generally vest after three years of service.

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The following table summarizes activity and pricing information for the nonvested shares under these awards for the six-month period ended June 30, 2006:
                 
            Weighted-  
    Number of     Average  
    Nonvested     Grant-Date  
    Shares     Fair Value  
 
Outstanding at December 31, 2005
    243,748     $ 28.81  
Granted
    13,379       33.22  
Vested
    (29,350 )     25.58  
Forfeited
    (7,200 )     27.77  
 
Outstanding at June 30, 2006
    220,577     $ 29.51  
 
             
 
The weighted-average grant-date fair value of awards granted during the six-month periods ended June 30, 2006 and 2005, was $33.22 and $31.68, respectively. As of June 30, 2006, unrecognized compensation cost related to nonvested restricted stock expected to vest under these special awards totaled $2 million. Management expects to recognize this cost over a weighted-average period of 1.9 years. The total fair value of restricted stock vested during the six-month periods ended June 30, 2006 and 2005, was $1 million and $.1 million, respectively.
Deferred Compensation Plans
Key’s deferred compensation arrangements include voluntary and mandatory deferral programs, which award Key common shares to certain employees and directors. The mandatory deferral programs require that incentive compensation awards meeting specified criteria be automatically deferred. These deferred incentive awards, together with a 15% employer matching contribution, vest at the rate of 33-1/3% per year beginning one year after the deferral date. Deferrals under the voluntary programs, which include a nonqualified excess 401(k) savings plan, are immediately vested, except for any employer match. Key’s excess 401(k) savings plan permits certain employees to defer up to 6% of their eligible compensation, with the entire deferral eligible for an employee match in the form of Key common shares. All other voluntary deferral programs provide an employer match ranging from 6% to 15% of the deferral, depending on the plan. The employer match under all voluntary programs generally vests after three years of service.
Several of Key’s deferred compensation arrangements allow for deferrals to be redirected by participants into other investment elections outside of Key common shares, which provide for distributions payable in cash. Key accounts for these participant-directed deferred compensation arrangements as stock-based liabilities and remeasures the related compensation cost based on the most recent fair value of Key’s common shares. Stock-based liabilities of $1 million and $2 million were paid during the six-month periods ended June 30, 2006 and 2005, respectively. The compensation cost of all other nonparticipant-directed deferrals are measured based on the average of the high and low trading price of Key’s common shares on the deferral date.
The following table summarizes activity and pricing information for the nonvested shares in Key’s deferred compensation plans for the six-month period ended June 30, 2006:
                 
    Number of     Weighted-Average  
    Nonvested     Grant-Date  
    Shares     Fair Value  
 
Outstanding at December 31, 2005
    809,824     $ 31.74  
Granted
    610,500       36.34  
Dividend equivalents
    63,038       36.35  
Vested
    (475,494 )     32.06  
Forfeited
    (45,864 )     33.95  
     
Outstanding at June 30, 2006
    962,004     $ 34.70  
 
             
 
The weighted-average grant-date fair value of awards granted during the six-month periods ended June 30, 2006 and 2005, was $36.34 and $32.80, respectively. As of June 30, 2006, unrecognized compensation cost related to nonvested shares expected to vest under Key’s deferred compensation plans totaled $13 million. Management expects to recognize this cost over a weighted-average period of 2.7 years. The total fair value of shares vested during the six-month periods ended June 30, 2006 and 2005, was $18 million and $16 million, respectively.

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Discounted Stock Purchase Plan
Key’s Discounted Stock Purchase Plan provides employees the opportunity to purchase Key’s common shares at a 10% discount through payroll deductions or cash payments. Purchases are limited to $10,000 in any month and $50,000 in any calendar year and are immediately vested. To accommodate employee purchases, Key acquires shares on the open market on or around the fifteenth day of the month following the month of payment. During the six-month period ended June 30, 2006, Key issued 68,359 shares at a weighted-average cost of $35.55. During the six-month period ended June 30, 2005, Key issued 68,967 shares at a weighted-average cost of $32.79.
Information pertaining to Key’s method of accounting for stock-based compensation is included in Note 1 (“Basis of Presentation”) under the heading “Stock-Based Compensation” on page 7.
11. Employee Benefits
Pension Plans
Net pension cost for all funded and unfunded plans includes the following components:
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
in millions   2006     2005     2006     2005  
 
Service cost of benefits earned
  $ 12     $ 4     $ 24     $ 17  
Interest cost on projected benefit obligation
    14       6       28       21  
Expected return on plan assets
    (22 )     (7 )     (44 )     (31 )
Amortization of prior service benefit
                      (1 )
Amortization of losses
    8       2       15       8  
 
Net pension cost
  $ 12     $ 5     $ 23     $ 14  
 
                       
 
Other Postretirement Benefit Plans
Key sponsors a contributory postretirement healthcare plan that covers substantially all active and retired employees hired before 2001 who meet certain eligibility criteria. Key also sponsors life insurance plans covering certain grandfathered employees. These plans are principally noncontributory. Separate Voluntary Employee Beneficiary Association trusts are used to fund the healthcare plan and one of the life insurance plans.
Net postretirement benefit cost for these plans includes the following components:
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
in millions   2006     2005     2006     2005  
 
Service cost of benefits earned
  $ 2     $ 1     $ 3     $ 2  
Interest cost on accumulated postretirement benefit obligation
    2       2       4       4  
Expected return on plan assets
    (1 )     (1 )     (2 )     (2 )
Amortization of unrecognized transition obligation
    1       1       2       2  
Amortization of cumulative net loss
          1       1       2  
 
Net postretirement benefit cost
  $ 4     $ 4     $ 8     $ 8  
 
                       
 
On December 8, 2003, the “Medicare Prescription Drug, Improvement and Modernization Act of 2003” was signed into law. The Act, which became effective January 1, 2006, introduces a prescription drug benefit under Medicare, as well as a federal subsidy to sponsors of retiree healthcare benefit plans that offer “actuarially equivalent” prescription drug coverage to retirees.
Based on regulations regarding the manner in which actuarial equivalence must be determined, management has determined that the prescription drug coverage related to Key’s retiree healthcare benefit plan is actuarially equivalent, and that the subsidy will not have a material effect on Key’s accumulated postretirement benefit obligation and net postretirement benefit cost.

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12. Income Taxes
Lease Financing Transactions
In the ordinary course of business, Key’s equipment finance business unit (“KEF”) enters into various types of lease financing transactions. Between 1996 and 2004, KEF entered into certain lease financing transactions which may be characterized in three categories: Lease-In, Lease-Out (“LILO”) transactions; Qualified Technological Equipment Leases (“QTEs”); and Service Contract Leases.
LILO transactions are leveraged leasing transactions in which KEF leases property from an unrelated third party and then leases the property back to that party. The transaction is similar to a sale-leaseback, except that the property is leased by KEF, rather than purchased. QTE and Service Contract Leases are even more like sale-leaseback transactions as KEF is considered to be the purchaser of the equipment for tax purposes. KEF executed these three types of leasing transactions with both foreign and domestic customers that are primarily municipal authorities. LILO and Service Contract transactions involve commuter rail equipment, public utility facilities, and commercial aircraft. QTE transactions involve sophisticated high technology hardware and related software, such as telecommunications equipment. The terms of the leases range from ten to fifty years.
Like other forms of leasing transactions, LILO transactions generate income tax deductions for Key from net rental expense associated with the leased property, interest expense on nonrecourse debt incurred to fund the transaction, and transaction costs. QTE and Service Contract transactions generate rental income from the leasing of the property, as well as deductions from the depreciation of the property, interest expense on nonrecourse debt incurred to fund the transaction, and transaction costs.
LILO, QTE and Service Contract Leases were prevalent in the financial services industry and in certain other industries. The tax treatment that Key applied was based on applicable statutes, regulations, and judicial authority in effect at the time they were entered into. Subsequently, the Internal Revenue Service (“IRS”) has challenged the tax treatment of these transactions by a number of bank holding companies and other corporations.
The IRS has completed audits of Key’s income tax returns for the 1995 through 2000 tax years and has disallowed all deductions taken in tax years 1995 through 1997 pertaining to LILOs, and all deductions in tax years 1998 through 2000 that relate to LILOs, QTEs and Service Contract Leases. In addition, the IRS is currently conducting audits of Key’s income tax returns for the 2001 through 2003 tax years, and Key expects that the IRS will disallow all similar deductions taken by Key in those tax years.
Key had previously appealed the examination results for the tax years 1995 through 1997, which pertained to LILOs only, to the Appeals Division of the IRS. During the fourth quarter of 2005, ongoing discussions with the Appeals Division were discontinued without having reached a resolution. In April 2006, Key received a final assessment from the IRS disallowing all LILO deductions taken in those tax years. The assessment, which relates principally to the 1997 tax year, consists of federal tax, interest and a penalty. Key paid the assessment and filed a refund claim for the total amount. Key has also filed an appeal with the Appeals Division of the IRS with regard to the proposed disallowance of LILO, QTE and Service Contract Lease deductions taken in the 1998 through 2000 tax years.
The payment of the 1997 tax year assessment did not impact Key’s earnings since the taxes had been included in previously recorded deferred taxes as required under GAAP. The payment of the interest and penalty did not materially impact Key’s earnings, in part due to Key’s tax reserves, and also because Key is recording a receivable on its balance sheet for amounts that are not charged to Key’s tax reserve.
Management believes that these LILO, QTE and Service Contract Lease transactions were entered into in conformity with the tax laws in effect at the time, and Key intends to vigorously pursue the IRS appeals process and its litigation alternatives. Key cannot currently estimate the financial outcome of the appeals process and any ensuing litigation; however, if Key were not to prevail in these efforts or were to enter into a settlement agreement with the IRS, in addition to previously accrued tax amounts that would be due to the IRS, Key would owe interest and possibly penalties, which could be material in amount and could have a material adverse effect on Key’s results of operations in the period recorded.

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Tax-Related Accounting Pronouncements Pending Adoption
In July 2006, the FASB issued Staff Position No. 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction,” which provides additional guidance on the application of SFAS No. 13, “Accounting for Leases.” This guidance will affect when earnings from leveraged lease transactions would be recognized when there are changes or projected changes in the timing of cash flows, including changes due to or expected to be due to settlements of tax matters. Previously, leveraged lease transactions were required to be recalculated only when a change in the total cash flows occurred. The impact of any changes or projected changes to the cash flows resulting from adoption of this new guidance will be recorded as an adjustment to retained earnings. In the event of an adjustment, future earnings would be expected to increase over the remaining term of the affected leases by a similar amount. This guidance will be effective at the beginning of the fiscal year beginning after December 15, 2006 (effective January 1, 2007, for Key). Management is currently evaluating the potential effect this guidance may have on Key’s financial condition or results of operations.
In July 2006, the FASB also issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” which clarifies the application of SFAS No. 109, “Accounting for Income Taxes,” by defining the minimum threshold that a tax position must meet before any associated benefit may be recognized in a company’s financial statements. In accordance with this guidance, a company may recognize the benefit if management concludes that the tax position, based solely on its technical merits, is “more likely than not” to be sustained upon examination. If such a conclusion is reached, the tax benefit is to be measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. This interpretation also provides guidance on measurement and derecognition of tax benefits, and requires expanded disclosures. The interpretation will be effective at the beginning of the fiscal year beginning after December 15, 2006 (effective January 1, 2007, for Key). Management is currently evaluating the potential effect this guidance may have on Key’s financial condition or results of operations.
13. Contingent Liabilities and Guarantees
Legal Proceedings
Residual value insurance litigation. Key Bank USA obtained two insurance policies from Reliance Insurance Company (“Reliance”) insuring the residual value of certain automobiles leased through Key Bank USA. The two policies (the “Policies”), the “4011 Policy” and the “4019 Policy,” together covered leases entered into during the period from January 1, 1997, to January 1, 2001.
The 4019 Policy contains an endorsement (“REINS-1 Endorsement”) stating that Swiss Reinsurance America Corporation (“Swiss Re”) will assume and reinsure 100% of Reliance’s obligations under the 4019 Policy in the event Reliance Group Holdings’ (“Reliance’s parent”) so-called “claims-paying ability” were to fall below investment grade. Key Bank USA also entered into an agreement (“Letter Agreement”) with Swiss Re and Reliance whereby Swiss Re agreed to issue to Key Bank USA an insurance policy on the same terms and conditions as the 4011 Policy in the event the financial condition of Reliance Group Holdings fell below a certain level. Around May 2000, the conditions under both the 4019 Policy and the Letter Agreement were triggered.
The 4011 Policy was canceled and replaced as of May 1, 2000, by a policy issued by North American Specialty Insurance Company (a subsidiary or affiliate of Swiss Re) (“the NAS Policy”). Tri-Arc Financial Services, Inc. (“Tri-Arc”) acted as agent for Reliance, Swiss Re and NAS. From February 2000 through September 2004, Key Bank USA filed claims, and since October 2004, KeyBank National Association (“KBNA”) (successor to Key Bank USA) has been filing claims under the Policies, but none of these claims has been paid.
In July 2000, Key Bank USA filed a claim for arbitration against Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, a declaration of the scope of coverage under the Policies and for damages. On January 8, 2001, Reliance filed an action (litigation) against Key Bank USA in Federal District Court in

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Ohio seeking rescission or reformation of the Policies because they allegedly do not reflect the intent of the parties with respect to the scope of coverage and how and when claims were to be paid. Key filed an answer and counterclaim against Reliance, Swiss Re, NAS and Tri-Arc seeking, among other things, declaratory relief as to the scope of coverage under the Policies, damages for breach of contract and failure to act in good faith, and punitive damages. The parties agreed to proceed with this court action and to dismiss the arbitration without prejudice.
On May 29, 2001, the Commonwealth Court of Pennsylvania entered an order placing Reliance in a court supervised “rehabilitation” and purporting to stay all litigation against Reliance. On July 23, 2001, the Federal District Court in Ohio stayed the litigation to allow the rehabilitator to complete her task. On October 3, 2001, the court in Pennsylvania entered an order placing Reliance into liquidation and canceling all Reliance insurance policies as of November 2, 2001. On November 20, 2001, the Federal District Court in Ohio entered an order that, among other things, required Reliance to report to the Court on the progress of the liquidation. On January 15, 2002, Reliance filed a status report requesting the continuance of the stay for an indefinite period. On February 20, 2002, Key Bank USA asked the Court to allow the case to proceed against the parties other than Reliance, and the Court granted that motion on May 17, 2002. As of February 19, 2003, all claims against Tri-Arc were dismissed through a combination of court action and voluntary dismissal by Key Bank USA.
On August 4, 2004, the Court ruled on Key’s and Swiss Re’s motions for summary judgment on issues related to liability. In its written decision, which is publicly available, the Court held as a matter of law that Swiss Re breached its Letter Agreement with Key by not issuing a replacement policy covering the leases insured under Key’s 4011 Policy that were booked between October 1, 1998, and April 30, 2000. With respect to Key’s claims under the 4019 Policy, the Court held that Swiss Re is not entitled to judgment as a matter of law on Key’s claim that Swiss Re authorized Tri-Arc to issue the REINS-1 Endorsement. The Court also held that Swiss Re is not entitled to judgment as a matter of law on Key’s claim that Swiss Re acted in bad faith. On March 21, 2005, the Court, in response to the parties’ joint motion and related agreement to allow more time for the completion of the damages discovery process, entered an order establishing a new damages discovery schedule, including an extension of the deadline for submitting summary judgment motions on issues related to damages to December 9, 2005. On August 26, 2005, the Court entered an order modifying certain deadlines in the expert discovery phase of the case and extending the December 9, 2005, deadline to February 9, 2006. The parties completed the process of submitting briefs relating to the summary judgment motions on damages issues in June 2006.
Management believes that KBNA (successor to Key Bank USA) has valid insurance coverage or claims for damages relating to the residual value of automobiles leased through Key Bank USA during the four-year period ending January 1, 2001. With respect to each individual lease, however, it is not until the lease expires and the vehicle is sold that the existence and amount of any actual loss (i.e., the difference between the residual value provided for in the lease agreement and the vehicle’s actual market value at lease expiration) can be determined.
Accordingly, the total expected loss on the portfolio for which KBNA (and Key Bank USA) will have filed claims cannot be determined with certainty at this time. Claims filed through June 30, 2006, totaled approximately $385 million, and management currently estimates that approximately $.1 million of additional claims may be filed through year-end 2006. During the litigation, Key has carefully analyzed its claims, both internally and with the assistance of outside expert consultants. Based on the analysis completed through April 30, 2005, Key currently expects to seek recovery of insured residual value losses in the range of approximately $342 million to $357 million, in addition to interest and other damages attributable to Swiss Re’s denial of coverage.
Key is filing insurance claims for its losses and has recorded as a receivable on its balance sheet a portion of the amount of the insurance claims. Management believes the amount being recorded as a receivable due from the insurance carriers is appropriate to reflect the collectibility risk associated with the insurance litigation; however, litigation is inherently not without risk, and any actual recovery from the litigation may be more or less than the receivable. While management does not expect an adverse decision, if a court were to make an adverse final determination, such result would cause Key to record a material one-time expense

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during the period when such determination is made. An adverse determination would not have a material effect on Key’s financial condition, but could have a material adverse effect on Key’s results of operations in the quarter it occurs.
Other litigation. In the ordinary course of business, Key is subject to legal actions that involve claims for substantial monetary relief. Based on information presently known to management, management does not believe there is any legal action to which KeyCorp or any of its subsidiaries is a party, or involving any of their properties, that, individually or in the aggregate, could reasonably be expected to have a material adverse effect on Key’s financial condition.
Tax Contingency
In the ordinary course of business, Key enters into certain transactions that have tax consequences. On occasion, the IRS may challenge a particular tax position taken by Key. The IRS has completed its review of Key’s tax returns for the 1995 through 2000 tax years and has disallowed all LILO deductions taken in the 1995 through 1997 tax years and all deductions taken in the 1998 through 2000 tax years that relate to certain lease financing transactions. In addition, the IRS is currently conducting audits of the 2001 through 2003 tax years. Key expects that the IRS will disallow all similar deductions taken in those years. Further information on Key’s position on these matters and on the potential implications is included in Note 12 (“Income Taxes”) under the heading “Lease Financing Transactions” on page 26.
Guarantees
Key is a guarantor in various agreements with third parties. The following table shows the types of guarantees that Key had outstanding at June 30, 2006. Information pertaining to the basis for determining the liabilities recorded in connection with these guarantees is included in Note 1 (“Summary of Significant Accounting Policies”) under the heading “Guarantees” on page 61 of Key’s 2005 Annual Report to Shareholders.
                 
    Maximum Potential        
    Undiscounted     Liability  
in millions   Future Payments     Recorded  
 
Financial Guarantees:
               
Standby letters of credit
  $ 12,561     $ 37  
Credit enhancement for asset-backed commercial paper conduit
    28        
Recourse agreement with FNMA
    647       9  
Return guarantee agreement with LIHTC investors
    474       38  
Default guarantees
    9       1  
Written interest rate capsa
    68       11  
 
Total
  $ 13,787     $ 96  
 
           
 
(a)   As of June 30, 2006, the weighted-average interest rate of written interest rate caps was 5.0%, and the weighted-average strike rate was 5.0%. Maximum potential undiscounted future payments were calculated assuming a 10% interest rate.
Standby letters of credit. These instruments, issued on behalf of clients, obligate Key to pay a specified third party when a client fails to repay an outstanding loan or debt instrument, or fails to perform some contractual nonfinancial obligation. Standby letters of credit are issued by many of Key’s lines of business to address clients’ financing needs. Any amounts drawn under standby letters of credit are treated as loans; they bear interest (generally at variable rates) and pose the same credit risk to Key as a loan. At June 30, 2006, Key’s standby letters of credit had a remaining weighted-average life of 2.6 years, with remaining actual lives ranging from less than one year to as many as twelve years.
Credit enhancement for asset-backed commercial paper conduit. Key provides credit enhancement in the form of a committed facility to ensure the continuing operations of an asset-backed commercial paper conduit that is owned by a third party and administered by an unaffiliated financial institution. The commitment to provide credit enhancement extends until September 22, 2006, and specifies that in the event of default by certain borrowers whose loans are held by the conduit, Key will provide financial relief to the conduit in an amount that is based on defined criteria that consider the level of credit risk involved and other factors.

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At June 30, 2006, Key’s maximum potential funding requirement under the credit enhancement facility totaled $28 million. However, there were no drawdowns under the facility during the six-month period ended June 30, 2006. Key has no recourse or other collateral available to offset any amounts that may be funded under this credit enhancement facility. Management periodically evaluates Key’s commitment to provide credit enhancement to the conduit.
Recourse agreement with Federal National Mortgage Association. KBNA participates as a lender in the Federal National Mortgage Association (“FNMA”) Delegated Underwriting and Servicing (“DUS”) program. As a condition to FNMA’s delegation of responsibility for originating, underwriting and servicing mortgages, KBNA has agreed to assume a limited portion of the risk of loss during the remaining term on each commercial mortgage loan sold to FNMA. Accordingly, KBNA maintains a reserve for such potential losses in an amount estimated by management to approximate the fair value of KBNA’s liability. At June 30, 2006, the outstanding commercial mortgage loans in this program had a weighted-average remaining term of 8.4 years, and the unpaid principal balance outstanding of loans sold by KBNA as a participant in this program was approximately $2.0 billion. The maximum potential amount of undiscounted future payments that may be required under this program is generally equal to one-third of the principal balance of loans outstanding at June 30, 2006. If payment is required under this program, Key would have an interest in the collateral underlying the commercial mortgage loan on which the loss occurred.
Return guarantee agreement with LIHTC investors. Key Affordable Housing Corporation (“KAHC”), a subsidiary of KBNA, offered limited partnership interests to qualified investors. Partnerships formed by KAHC invested in low-income residential rental properties that qualify for federal LIHTCs under Section 42 of the Internal Revenue Code. In certain partnerships, investors pay a fee to KAHC for a guaranteed return that is based on the financial performance of the property and the property’s confirmed LIHTC status throughout a fifteen-year compliance period. If KAHC defaults on its obligation, Key is obligated to make any necessary payments to investors to provide the guaranteed return. In October 2003, management elected to discontinue new partnerships under this program.
No recourse or collateral is available to offset the guarantee obligation other than the underlying income stream from the properties. These guarantees have expiration dates that extend through 2018. Key meets its obligations pertaining to the guaranteed returns generally through the distribution of tax credits and deductions associated with the specific properties.
As shown in the table on page 29, KAHC maintained a reserve in the amount of $38 million at June 30, 2006, which management believes will be sufficient to cover estimated future obligations under the guarantees. The maximum exposure to loss reflected in the preceding table represents undiscounted future payments due to investors for the return on and of their investments. In accordance with Interpretation No. 45, the amount of all fees received in consideration for any return guarantee agreements entered into or modified with LIHTC investors on or after January 1, 2003, has been recognized in the liability recorded.
Various types of default guarantees. Some lines of business provide or participate in guarantees that obligate Key to perform if the debtor fails to satisfy all of its payment obligations to third parties. Key generally undertakes these guarantees to support or protect its underlying investment or where the risk profile of the debtor should provide an investment return. The terms of these default guarantees range from less than one year to as many as sixteen years. Although no collateral is held, Key would have recourse against the debtor for any payments made under a default guarantee.
Written interest rate caps. In the ordinary course of business, Key “writes” interest rate caps for commercial loan clients that have variable rate loans with Key and wish to limit their exposure to interest rate increases. At June 30, 2006, these caps had a weighted-average life of 2.8 years.
Key is obligated to pay the client if the applicable benchmark interest rate exceeds a specified level (known as the “strike rate”). These instruments are accounted for as derivatives. Key’s potential amount of future payments under these obligations is mitigated by offsetting positions with third parties.

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Other Off-Balance Sheet Risk
Other off-balance sheet risk stems from financial instruments that do not meet the definition of a guarantee as specified in Interpretation No. 45 and from other relationships.
Liquidity facility that supports asset-backed commercial paper conduit. Key provides liquidity to an asset-backed commercial paper conduit that is owned by a third party and administered by an unaffiliated financial institution. This liquidity facility obligates Key through November 5, 2008, to provide funding of up to $1.0 billion if required as a result of a disruption in credit markets or other factors that preclude the issuance of commercial paper by the conduit. The amount available to be drawn, which is based on the amount of current commitments to borrowers in the conduit, was $286 million at June 30, 2006, but there were no drawdowns under this committed facility at that time. Key’s commitment to provide liquidity is periodically evaluated by management.
Indemnifications provided in the ordinary course of business. Key provides certain indemnifications primarily through representations and warranties in contracts that are entered into in the ordinary course of business in connection with loan sales and other ongoing activities, as well as in connection with purchases and sales of businesses. Management’s past experience with these indemnifications has been that the amounts paid, if any, have not had a significant effect on Key’s financial condition or results of operations.
Intercompany guarantees. KeyCorp and certain other Key affiliates are parties to various guarantees that facilitate the ongoing business activities of other Key affiliates. These business activities encompass debt issuance, certain lease and insurance obligations, investments and securities, and certain leasing transactions involving clients.
14. Derivatives and Hedging Activities
Key, mainly through its subsidiary bank, KBNA, is party to various derivative instruments which are used for asset and liability management, credit risk management and trading purposes. The primary derivatives that Key uses are interest rate swaps, caps and futures, and foreign exchange forward contracts. All foreign exchange forward contracts, and interest rate swaps and caps held are over-the-counter instruments. Generally, these instruments help Key meet clients’ financing needs, manage exposure to “market risk"—the possibility that economic value or net interest income will be adversely affected by changes in interest rates or other economic factors, and mitigate the credit risk inherent in our loan portfolio.
At June 30, 2006, Key had $112 million of derivative assets and $297 million of derivative liabilities on its balance sheet that arose from derivatives that were being used for hedging purposes. As of the same date, derivative assets and liabilities classified as trading derivatives totaled $904 million and $859 million, respectively. Derivative assets and liabilities are recorded at fair value on the balance sheet.
Counterparty Credit Risk
Like other financial instruments, derivatives contain an element of “credit risk"—the possibility that Key will incur a loss because a counterparty, which may be a bank or a broker/dealer, may fail to meet its contractual obligations. This risk is measured as the expected positive replacement value of contracts. To mitigate credit risk when managing its asset, liability and trading positions, Key deals exclusively with counterparties that have high credit ratings.
Key uses two additional means to manage exposure to credit risk on swap contracts. First, Key generally enters into bilateral collateral and master netting arrangements. These agreements provide for the net settlement of all contracts with a single counterparty in the event of default. Second, Key’s Credit Administration department monitors credit risk exposure to the counterparty on each interest rate swap to determine appropriate limits on Key’s total credit exposure and decide whether to demand collateral. If Key determines that collateral is required, it is generally collected immediately. Key generally holds collateral in the form of cash and highly rated treasury and agency-issued securities.

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At June 30, 2006, Key was party to interest rate swaps and caps with 51 different counterparties. Among these were swaps and caps entered into to offset the risk of client exposure. Key had aggregate exposure of $225 million on these instruments to 24 of the 51 counterparties. However, at June 30, 2006, Key held approximately $96 million in collateral to mitigate its credit exposure, resulting in net exposure of $129 million. The largest exposure to an individual counterparty was approximately $50 million, of which Key secured approximately $32 million in collateral.
Asset and Liability Management
Key uses a fair value hedging strategy to manage its exposure to interest rate risk and a cash flow hedging strategy to reduce the potential adverse impact of interest rate increases on future interest expense. For more information about these asset and liability management strategies, see Note 19 (“Derivatives and Hedging Activities”), which begins on page 87 of Key’s 2005 Annual Report to Shareholders.
The change in “accumulated other comprehensive loss” resulting from cash flow hedges is as follows:
                                 
                    Reclassification        
    December 31,     2006     of Gains to     June 30,  
in millions   2005     Hedging Activity     Net Income     2006  
 
Accumulated other comprehensive loss resulting from cash flow hedges
  $ (31 )   $ 20     $ (11 )   $ (22 )
 
Reclassifications of gains and losses from “accumulated other comprehensive loss” to earnings coincide with the income statement impact of the hedged item through the payment of variable-rate interest on debt, the receipt of variable-rate interest on commercial loans and the sale or securitization of commercial real estate loans. Key expects to reclassify an estimated $16 million of net gains on derivative instruments from “accumulated other comprehensive loss” to earnings during the next twelve months.
Credit Risk Management
Key uses credit derivatives, primarily credit default swaps, to mitigate our credit risk by transferring a portion of the risk associated with the underlying extension of credit to a third party. These derivatives are recorded on the balance sheet at fair value, which is based on the creditworthiness of the borrowers. Related gains or losses, as well as the premium paid for the protection, are included in the trading income component of noninterest income. At June 30, 2006, the notional amount of credit default swaps purchased by Key was $672 million. Key does not apply hedge accounting to credit derivatives.
Trading Portfolio
Key’s trading portfolio includes:
¨   interest rate swap contracts entered into to accommodate the needs of clients;
 
¨   positions with third parties that are intended to offset or mitigate the interest rate risk of client positions;
 
¨   foreign exchange forward contracts entered into to accommodate the needs of clients; and
 
¨   proprietary trading positions in financial assets and liabilities.
The fair values of these trading portfolio items are included in “accrued income and other assets” or “accrued expense and other liabilities” on the balance sheet. Adjustments to the fair values are included in “investment banking and capital markets income” on the income statement. Key has established a reserve in the amount of $13 million at June 30, 2006, which management believes will be sufficient to cover estimated future losses on the trading portfolio in the event of client default. Additional information pertaining to Key’s trading portfolio is summarized in Note 19 of Key’s 2005 Annual Report to Shareholders.

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Report of Independent Registered Public Accounting Firm
Shareholders and Board of Directors
KeyCorp
We have reviewed the condensed consolidated balance sheets of KeyCorp and subsidiaries (“Key”) as of June 30, 2006 and 2005, and the related condensed consolidated statements of income for the three-month and six-month periods then ended, and the condensed consolidated statements of changes in shareholders’ equity and cash flow for the six-month periods ended June 30, 2006 and 2005. These financial statements are the responsibility of Key’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures, and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated interim financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Key as of December 31, 2005, and the related consolidated statements of income, changes in shareholders’ equity, and cash flow for the year then ended not presented herein, and in our report dated February 24, 2006, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2005, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ Ernst & Young LLP
Cleveland, Ohio
August 2, 2006

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
This section generally reviews the financial condition and results of operations of KeyCorp and its subsidiaries for the quarterly and year-to-date periods ended June 30, 2006 and 2005. Some tables may include additional periods to comply with disclosure requirements or to illustrate trends in greater depth. When you read this discussion, you should also refer to the consolidated financial statements and related notes that appear on pages 3 through 32. A description of Key’s business is included under the heading “Description of Business” on page 12 of Key’s 2005 Annual Report to Shareholders. This description does not reflect the reorganization and renaming of Key’s major business groups and some of its lines of business that took effect January 1, 2006. For a description of these changes, see Note 4 (“Line of Business Results”), which begins on page 11.
Terminology
This report contains some shortened names and industry-specific terms. We want to explain some of these terms at the outset so you can better understand the discussion that follows.
¨   KeyCorp refers solely to the parent holding company.
 
¨   KBNA refers to Key’s lead bank, KeyBank National Association.
 
¨   Key refers to the consolidated entity consisting of KeyCorp and its subsidiaries.
 
¨   A KeyCenter is one of Key’s full-service retail banking facilities or branches.
 
¨   Key engages in capital markets activities. These activities encompass a variety of products and services. Among other things, we trade securities as a dealer, enter into derivative contracts (both to accommodate clients’ financing needs and for proprietary trading purposes), and conduct transactions in foreign currencies (both to accommodate clients’ needs and to benefit from fluctuations in exchange rates).
 
¨   All earnings per share data included in this discussion are presented on a diluted basis, which takes into account all common shares outstanding as well as potential common shares that could result from the exercise of outstanding stock options and other stock awards. Some of the financial information tables also include basic earnings per share, which takes into account only common shares outstanding.
 
¨   For regulatory purposes, capital is divided into two classes. Federal regulations prescribe that at least one-half of a bank or bank holding company’s total risk-based capital must qualify as Tier 1. Both total and Tier 1 capital serve as bases for several measures of capital adequacy, which is an important indicator of financial stability and condition. You will find a more detailed explanation of total and Tier 1 capital and how they are calculated in the section entitled “Capital,” which begins on page 57.
Long-term goals
Key’s long-term goals are to achieve an annual return on average equity in the range of 16% to 18% and to grow earnings per common share at an annual rate of 8% to 10%. Our strategy for achieving these goals is described under the heading “Corporate Strategy” on page 14 of Key’s 2005 Annual Report to Shareholders.
Key’s earnings per common share for the first six months of 2006 grew by 8% relative to the same period last year. This improvement was accomplished by growing revenue faster than expenses. The growth in earnings also reflected a slight reduction in the provision for loan losses, and a prescribed change in

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accounting for forfeited stock-based awards that took effect on January 1, 2006. In addition, capital that exceeds internal guidelines and minimum requirements prescribed by the regulators can be used to repurchase common shares in the open market. As a result of such repurchases, Key’s weighted-average fully-diluted common shares decreased to 411,842,244 shares for the first six months of 2006 from 414,036,968 shares for the first half of 2005. A lower share count can contribute to both earnings per share growth and improved returns on average equity. The change in the number of shares attributable to net share repurchase activity did not have a material effect on either of these profitability measures in either the current or prior periods.
Forward-looking statements
This report may contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements about our long-term goals, financial condition, results of operations, earnings, levels of net loan charge-offs and nonperforming assets, interest rate exposure and profitability. These statements usually can be identified by the use of forward-looking language such as “our goal,” “our objective,” “our plan,” “will likely result,” “expects,” “plans,” “anticipates,” “intends,” “projects,” “believes,” “estimates” or other similar words or expressions or conditional verbs such as “will,” “would,” “could,” and “should.”
Forward-looking statements express management’s current expectations, forecasts of future events or long-term goals and, by their nature, are subject to assumptions, risks and uncertainties. Although management believes that the expectations, forecasts and goals reflected in these forward-looking statements are reasonable, actual results could differ materially for a variety of reasons, including the following factors.
¨   Interest rates could change more quickly or more significantly than we expect, which may have an adverse effect on our financial results.
 
¨   Trade, monetary and fiscal policies of various governmental bodies may affect the economic environment in which we operate, as well as our financial condition and results of operations.
 
¨   Adversity in general economic conditions, or in the condition of the local economies or industries in which we have significant operations or assets, could, among other things, materially impact credit quality trends and our ability to generate loans.
 
¨   Increased competitive pressure among financial services companies may adversely affect our ability to market our products and services.
 
¨   It could take us longer than we anticipate to implement strategic initiatives designed to grow revenue or manage expenses; we may be unable to implement certain initiatives; or the initiatives may be unsuccessful.
 
¨   Acquisitions and dispositions of assets, business units or affiliates could adversely affect us in ways that management has not anticipated.
 
¨   We may experience operational or risk management failures due to technological or other factors.
 
¨   We may continue to become subject to heightened regulatory practices, requirements or expectations.
 
¨   We may become subject to new legal obligations or liabilities, or the unfavorable resolution of pending litigation may have an adverse effect on our financial results.
 
¨   Changes in the stock markets, public debt markets and other capital markets could adversely affect our ability to raise capital or other funding for liquidity and business purposes, as well as our revenues from client-based underwriting, investment banking and other capital markets businesses.
 
¨   Terrorist activities or military actions could disrupt the economy and the general business climate, which may have an adverse effect on our financial results or condition and that of our borrowers.
 
¨   We may become subject to new accounting, tax or regulatory practices or requirements.

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Critical accounting policies and estimates
Key’s business is dynamic and complex. Consequently, management must exercise judgment in choosing and applying accounting policies and methodologies in many areas. These choices are important; not only are they necessary to comply with U.S. generally accepted accounting principles (“GAAP”), they also reflect management’s view of the most appropriate manner in which to record and report Key’s overall financial performance. All accounting policies are important, and all policies described in Note 1 (“Summary of Significant Accounting Policies”), which begins on page 57 of Key’s 2005 Annual Report to Shareholders, should be reviewed for a greater understanding of how Key’s financial performance is recorded and reported.
In management’s opinion, some accounting policies are more likely than others to have a significant effect on Key’s financial results and to expose those results to potentially greater volatility. These policies apply to areas of relatively greater business importance or require management to make assumptions and estimates that affect amounts reported in the financial statements. Because these assumptions and estimates are based on current circumstances, they may change over time or prove to be inaccurate. Key relies heavily on the use of assumptions and estimates in several areas, including accounting for the allowance for loan losses; loan securitizations; contingent liabilities, guarantees and income taxes; principal investments; goodwill; and pension and other postretirement obligations. A brief discussion of each of these areas appears on pages 14 through 16 of Key’s 2005 Annual Report to Shareholders.
During the first six months of 2006, there were no significant changes in the manner in which Key’s critical accounting policies were applied or in which related assumptions and estimates were developed. Additionally, no new critical accounting policies were adopted.
Highlights of Key’s Performance
Financial performance
The primary measures of Key’s financial performance for the three-month periods ended June 30, 2006, March 31, 2006, and June 30, 2005, and for the six-month periods ended June 30, 2006 and 2005, are summarized below.
¨   Net income for the second quarter of 2006 was $308 million, or $.75 per common share, compared to $289 million, or $.70 per share, for the previous quarter and $291 million, or $.70 per share, for the second quarter of 2005. For the first six months of 2006, net income was $597 million, or $1.45 per common share, compared to $555 million, or $1.34 per share, for the first half of 2005.
 
¨   Key’s return on average equity was 16.11% for the second quarter of 2006, compared to a return of 15.48% for the prior quarter and 16.15% for the year-ago quarter. For the first six months of 2006, Key’s return on average equity was 15.80%, compared to 15.63% for the first six months of 2005.
 
¨   Key’s second quarter 2006 return on average total assets was 1.32%, compared to a return of 1.26% for the previous quarter and 1.30% for the second quarter of 2005. For the first six months of 2006, Key’s return on average total assets was 1.29%, compared to 1.24% for the same period last year.
Key’s top four priorities for 2006 are to profitably grow revenue, institutionalize a culture of compliance and accountability, maintain a strong credit culture and improve operating leverage so that revenue growth outpaces expense growth. During the second quarter:
¨   Total revenue rose by $98 million from the second quarter of 2005, due largely to solid commercial loan growth, higher income from our fee-based businesses and growth in core deposits, which increased 10% from the second quarter of 2005. The growth in our commercial loan portfolio was geographically broad-based and spread among a number of industry sectors. The increase in fee income was attributable to a variety of revenue components and included increases in trust and

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    investment services income, investment banking fees, income from operating leases, and net gains from both principal investing and the share redemption by MasterCard Incorporated as part of its initial public offering in May 2006.
 
¨   We continued to make progress in strengthening our compliance and operations infrastructure designed, pursuant to the Bank Secrecy Act, to detect and prevent money laundering.
 
¨   Asset quality remained solid. Both nonperforming loans and net loan charge-offs were down from both the prior and year-ago quarters. For the second quarter of 2006, net loan charge-offs represented .21% of Key’s average total loans.
 
¨   The level of our noninterest expense grew by $63 million from the second quarter of 2005, due primarily to higher personnel costs and an increase in professional fees associated with our efforts to strengthen Key’s compliance controls.
Further, we continue to effectively manage our capital through dividends paid to shareholders, share repurchases, and investing in our higher-growth businesses. During the second quarter, Key repurchased 4,000,000 of its common shares. At June 30, 2006, Key’s tangible equity to tangible assets ratio was 6.68%, which is within our targeted range of 6.25% to 6.75%.
Considering recent trends, we expect Key’s earnings to be in the range of $.70 to $.74 per share for the third quarter of 2006 and $2.85 to $2.95 per share for the full year.
The primary reasons that Key’s revenue and expense components changed from those reported for the three- and six-month periods ended June 30, 2005, are reviewed in greater detail throughout the remainder of the Management’s Discussion & Analysis section.
Strategic developments
Our financial performance has improved due in part to a number of specific actions taken during 2005 and 2006 that have strengthened our market share positions and support our corporate strategy.
¨   On April 1, 2006, we broadened our asset management product line by acquiring Austin Capital Management, Ltd. (“Austin”), an investment firm headquartered in Austin, Texas with approximately $900 million in assets under management at the date of acquisition.
 
¨   On December 8, 2005, we acquired the commercial mortgage-backed servicing business of ORIX Capital Markets, LLC (“ORIX”), headquartered in Dallas, Texas. The acquisition increased our commercial mortgage servicing portfolio from $44 billion at September 30, 2005, to more than $70 billion at December 31, 2005. This is the sixth commercial real estate acquisition we have made since January 31, 2000, as part of our ongoing strategy to expand Key’s commercial mortgage finance and servicing capabilities.
 
¨   On July 1, 2005, we expanded our Federal Housing Administration (“FHA”) financing and servicing capabilities by acquiring Malone Mortgage Company, based in Dallas, Texas.
 
¨   During the first quarter of 2005, we completed the sale of $992 million of indirect automobile loans, representing the prime segment of that portfolio. In April 2005, we completed the sale of $635 million of loans, representing the nonprime segment. The decision to sell these loans was driven by management’s strategies for improving Key’s returns and achieving desired interest rate and credit risk profiles.
Figure 1 summarizes Key’s financial performance for each of the past five quarters.

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Figure 1. Selected Financial Data
                                                         
    2006     2005     Six months ended June 30,  
dollars in millions, except per share amounts   Second     First     Fourth     Third     Second     2006     2005  
 
FOR THE PERIOD
                                                       
Interest income
  $ 1,381     $ 1,312     $ 1,262     $ 1,174     $ 1,116     $ 2,693     $ 2,181  
Interest expense
    651       584       544       481       423       1,235       802  
Net interest income
    730       728       718       693       693       1,458       1,379  
Provision for loan losses
    24       39       36       43       20       63       64  
Noninterest income
    547       481       561       531       486       1,028       986  
Noninterest expense
    816       770       834       781       753       1,586       1,522  
Income before income taxes and cumulative effect of accounting change
    437       400       409       400       406       837       779  
Income before cumulative effect of accounting change
    308       284       296       278       291       592       555  
Net income
    308       289       296       278       291       597       555  
 
PER COMMON SHARE
                                                       
Income before cumulative effect of accounting change
  $ .76     $ .70     $ .72     $ .68     $ .71     $ 1.46     $ 1.36  
Net income
    .76       .71       .72       .68       .71       1.47       1.36  
Income before cumulative effect of accounting change — assuming dilution
    .75       .69       .72       .67       .70       1.44       1.34  
Net income — assuming dilution
    .75       .70       .72       .67       .70       1.45       1.34  
Cash dividends declared
    .345       .345       .325       .325       .325       .69       .65  
Book value at period end
    19.21       18.85       18.69       18.41       18.01       19.21       18.01  
Market price:
                                                       
High
    38.31       37.67       34.05       35.00       33.80       38.31       34.07  
Low
    34.24       32.68       30.10       31.65       31.52       32.68       31.00  
Close
    35.68       36.80       32.93       32.25       33.15       35.68       33.15  
Weighted-average common shares outstanding (000)
    404,528       407,386       408,431       410,456       408,754       405,949       408,510  
Weighted-average common shares and potential common shares outstanding (000)
    410,559       413,140       412,542       415,441       414,309       411,842       414,037  
 
AT PERIOD END
                                                       
Loans
  $ 67,408     $ 66,980     $ 66,478     $ 65,575     $ 64,690     $ 67,408     $ 64,690  
Earning assets
    81,737       81,087       80,143       80,096       78,548       81,737       78,548  
Total assets
    94,794       93,391       93,126       92,323       91,015       94,794       91,015  
Deposits
    60,838       59,402       58,765       58,071       58,063       60,838       58,063  
Long-term debt
    14,050       14,032       13,939       14,037       13,588       14,050       13,588  
Shareholders’ equity
    7,737       7,638       7,598       7,522       7,352       7,737       7,352  
 
PERFORMANCE RATIOS
                                                       
Return on average total assets
    1.32 %     1.26 %     1.27 %     1.22 %     1.30 %     1.29 %     1.24 %
Return on average equity
    16.11       15.48       15.59       14.84       16.15       15.80       15.63  
Net interest margin (taxable equivalent)
    3.69       3.77       3.71       3.67       3.71       3.73       3.69  
 
CAPITAL RATIOS AT PERIOD END
                                                       
Equity to assets
    8.16 %     8.18 %     8.16 %     8.15 %     8.08 %     8.16 %     8.08 %
Tangible equity to tangible assets
    6.68       6.71       6.68       6.68       6.60       6.68       6.60  
Tier 1 risk-based capital
    7.90       7.64       7.59       7.72       7.68       7.90       7.68  
Total risk-based capital
    12.08       11.91       11.47       11.83       11.72       12.08       11.72  
Leverage
    8.82       8.52       8.53       8.60       8.49       8.82       8.49  
 
TRUST AND BROKERAGE ASSETS
                                                       
Assets under management
  $ 80,349     $ 79,558     $ 77,144     $ 76,341     $ 76,807     $ 80,349     $ 76,807  
Nonmanaged and brokerage assets
    57,682       56,944       56,509       57,313       57,006       57,682       57,006  
 
OTHER DATA
                                                       
Average full-time equivalent employees
    19,931       19,694       19,417       19,456       19,429       19,813       19,534  
KeyCenters
    946       945       947       946       945       946       945  
 

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Line of Business Results
This section summarizes the financial performance and related strategic developments of Key’s two major business groups: Community Banking and National Banking. To better understand this discussion, see Note 4 (“Line of Business Results”), which begins on page 11. Note 4 includes a brief description of the products and services offered by each of the two major business groups, more detailed financial information pertaining to the groups and their respective lines of business, and explanations of “Other Segments” and “Reconciling Items.”
Figure 2 summarizes the contribution made by each major business group to Key’s taxable-equivalent revenue and net income for the three- and six-month periods ended June 30, 2006 and 2005. Key’s line of business results for all periods presented reflect a new organizational structure that took effect January 1, 2006. For a description of this change, see Note 4.
Figure 2. Major Business Groups — Taxable-Equivalent Revenue and Net Income
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Revenue (taxable equivalent)
                                                               
Community Banking
  $ 662     $ 645     $ 17       2.6 %   $ 1,305     $ 1,268     $ 37       2.9 %
National Banking
    631       585       46       7.9       1,256       1,176       80       6.8  
Other Segments
    23       9       14       155.6       17       22       (5 )     (22.7 )
 
Total segments
    1,316       1,239       77       6.2       2,578       2,466       112       4.5  
Reconciling items
    (17 )     (30 )     13       43.3       (42 )     (43 )     1       2.3  
 
Total
  $ 1,299     $ 1,209     $ 90       7.4 %   $ 2,536     $ 2,423     $ 113       4.7 %
 
                                                   
 
                                                               
Net income (loss)
                                                               
Community Banking
  $ 105     $ 118     $ (13 )     (11.0 )%   $ 214     $ 220     $ (6 )     (2.7 )%
National Banking
    175       160       15       9.4       350       333       17       5.1  
Other Segments
    20       10       10       100.0       21       24       (3 )     (12.5 )
 
Total segments
    300       288       12       4.2       585       577       8       1.4  
Reconciling items
    8       3       5       166.7       12       (22 ) a     34       N/M  
 
Total
  $ 308     $ 291     $ 17       5.8 %   $ 597     $ 555     $ 42       7.6 %
 
                                                   
 
(a)   Includes a $30 million ($19 million after tax) charge recorded during the first quarter of 2005 to adjust the accounting for rental expense associated with operating leases from an escalating to a straight-line basis.
N/M = Not Meaningful
Community Banking
As shown in Figure 3, net income for Community Banking was $105 million for the second quarter of 2006, down from $118 million for the year-ago quarter. An increase in noninterest expense drove the decline and more than offset growth in net interest income. Noninterest income and the provision for loan losses were essentially unchanged.
Noninterest expense grew by $37 million, or 8%, from the second quarter of 2005, due primarily to a rise in personnel expense and increases in various indirect charges.
Taxable-equivalent net interest income increased by $16 million, or 4%, due to growth in average core deposits, which also experienced a more favorable interest rate spread. The positive effect of these factors was offset in part by a tighter interest rate spread on average earning assets.

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Figure 3. Community Banking
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Summary of operations
                                                               
Net interest income (TE)
  $ 436     $ 420     $ 16       3.8 %   $ 866     $ 831     $ 35       4.2 %
Noninterest income
    226       225       1       .4       439       437       2       .5  
 
Total revenue (TE)
    662       645       17       2.6       1,305       1,268       37       2.9  
Provision for loan losses
    19       18       1       5.6       47       47              
Noninterest expense
    475       438       37       8.4       915       869       46       5.3  
 
Income before income taxes (TE)
    168       189       (21 )     (11.1 )     343       352       (9 )     (2.6 )
Allocated income taxes and TE adjustments
    63       71       (8 )     (11.3 )     129       132       (3 )     (2.3 )
 
Net income
  $ 105     $ 118     $ (13 )     (11.0 )%   $ 214     $ 220     $ (6 )     (2.7 )%
 
                                                   
 
                                                               
Percent of consolidated net income
    34 %     41 %     N/A       N/A       36 %     40 %     N/A       N/A  
 
                                                               
Average balances
                                                               
Loans and leases
  $ 26,804     $ 27,038     $ (234 )     (.9 )%   $ 26,772     $ 26,917     $ (145 )     (.5 )%
Total assets
    29,758       29,902       (144 )     (.5 )     29,707       29,805       (98 )     (.3 )
Deposits
    46,683       43,719       2,964       6.8       46,262       43,453       2,809       6.5  
 
TE = Taxable Equivalent, N/A = Not Applicable
Additional Community Banking Data
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Average deposits outstanding
                                                               
Noninterest-bearing
  $ 8,086     $ 8,092     $ (6 )     (.1 )%   $ 8,095     $ 8,014     $ 81       1.0 %
Money market and other savings
    22,523       20,932       1,591       7.6       22,252       20,894       1,358       6.5  
Time
    16,074       14,695       1,379       9.4       15,915       14,545       1,370       9.4  
 
Total deposits
  $ 46,683     $ 43,719     $ 2,964       6.8 %   $ 46,262     $ 43,453     $ 2,809       6.5 %
 
                                                   
 
Home equity loans
                                                               
Average balance
  $ 10,107     $ 10,398                                                  
Average loan-to-value ratio
    70 %     71 %                                                
Percent first lien positions
    60       61                                                  
                                                   
Other data
                                                               
On-line households / household penetration
    639,444/52 %     595,411/47 %                                                
KeyCenters
    946       945                                                  
Automated teller machines
    2,120       2,205                                                  
                                                   
National Banking
As shown in Figure 4, net income for National Banking was $175 million for the second quarter of 2006, up from $160 million for the same period last year. Growth in both net interest income and noninterest income more than offset increases in noninterest expense and the provision for loan losses.
Taxable-equivalent net interest income grew by $26 million, or 8%, from the second quarter of 2005, reflecting strong growth in average loans and leases, as well as deposits. Average loans and leases rose by $3.4 billion, or 9%, with most of the growth coming from the Real Estate Capital line of business. The positive effect of these factors was moderated by a tighter interest rate spread on average earning assets in the Consumer Finance line of business.
Noninterest income rose by $20 million, or 8%. Contributing to the improved performance were increases in income from trust and investment services, investment banking activities and operating leases.
Noninterest expense increased by $19 million, or 6%, reflecting higher costs associated with personnel and various indirect charges.
Since the second quarter of 2005, we have completed two acquisitions that have helped us to build upon our success in commercial mortgage origination and servicing. In the fourth quarter of 2005, we continued the expansion of our commercial mortgage servicing business by acquiring the commercial mortgage-backed servicing business of ORIX Capital Markets, LLC, headquartered in Dallas, Texas. In the third quarter, we expanded our FHA financing and servicing capabilities by acquiring Malone Mortgage Company, also based in Dallas.

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In addition, during the second quarter of 2006 we expanded our asset management product line by acquiring Austin Capital Management, Ltd., an investment firm headquartered in Austin, Texas.
Figure 4. National Banking
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Summary of operations
                                                               
Net interest income (TE)
  $ 372     $ 346     $ 26       7.5 %   $ 750     $ 705     $ 45       6.4 %
Noninterest income
    259       239       20       8.4       506       471       35       7.4  
 
Total revenue (TE)
    631       585       46       7.9       1,256       1,176       80       6.8  
Provision for loan losses
    5       2       3       150.0       16       17       (1 )     (5.9 )
Noninterest expense
    346       327       19       5.8       680       626       54       8.6  
 
Income before income taxes (TE)
    280       256       24       9.4       560       533       27       5.1  
Allocated income taxes and TE adjustments
    105       96       9       9.4       210       200       10       5.0  
 
Net income
  $ 175     $ 160     $ 15       9.4 %   $ 350     $ 333     $ 17       5.1 %
 
                                                   
 
                                                               
Percent of consolidated net income
    57 %     55 %     N/A       N/A       59 %     60 %     N/A       N/A  
 
                                                               
Average balances
                                                               
Loans and leases
  $ 40,201     $ 36,842     $ 3,359       9.1 %   $ 39,870     $ 36,646     $ 3,224       8.8 %
Total assets
    50,470       46,101       4,369       9.5       50,046       46,578       3,468       7.4  
Deposits
    10,638       7,535       3,103       41.2       10,302       7,099       3,203       45.1  
 
TE = Taxable Equivalent, N/A = Not Applicable
                 
Additional National Banking Data   Three months ended June 30,  
dollars in millions   2006     2005  
 
Home equity loans
               
Average balance
  $ 3,333     $ 3,498  
Average loan-to-value ratio
    70 %     71 %
Percent first lien positions
    61       67  
 
Other Segments
Other segments consist of Corporate Treasury and Key’s Principal Investing unit. These segments generated net income of $20 million for the second quarter of 2006, compared to $10 million for the same period last year.

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Results of Operations
Net interest income
One of Key’s principal sources of earnings is net interest income. Net interest income is the difference between interest income received on earning assets (such as loans and securities) and loan-related fee income, and interest expense paid on deposits and borrowings. There are several factors that affect net interest income, including:
¨   the volume, pricing, mix and maturity of earning assets and interest-bearing liabilities;
 
¨   the volume of net free funds, such as noninterest-bearing deposits and capital;
 
¨   the use of derivative instruments to manage interest rate risk;
 
¨   interest rate fluctuations and competitive conditions within the marketplace; and
 
¨   asset quality.
To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), we present net interest income in this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable and at the same rate). For example, $100 of tax-exempt income would be presented as $154, an amount that—if taxed at the statutory federal income tax rate of 35%—would yield $100.
Figure 5, which spans pages 44 and 45, shows the various components of Key’s balance sheet that affect interest income and expense, and their respective yields or rates over the past five quarters. This figure also presents a reconciliation of taxable-equivalent net interest income for each of those quarters to net interest income reported in accordance with GAAP.
Taxable-equivalent net interest income for the second quarter of 2006 was $752 million, representing a $29 million, or 4%, increase from the year-ago quarter. The positive effects of a 4% increase in average earning assets, a 10% increase in average core deposits and an 11% rise in average noninterest-bearing funds, more than offset the effect of lower net interest margin, which decreased 2 basis points to 3.69%. (A basis point is equal to one one-hundredth of a percentage point, meaning 2 basis points equals .02%).
The net interest margin, which is an indicator of the profitability of the earning assets portfolio, is calculated by dividing net interest income by average earning assets and annualizing the result. The decline in the net interest margin reflected the effect of a tighter interest rate spread, which represents the difference between the yield on average earning assets and the rate paid for interest-bearing funds. As shown in Figure 5, Key’s interest rate spread narrowed by 26 basis points from the second quarter of 2005 as a result of competitive pressure on loan and deposit pricing caused by rising interest rates. In addition, the net interest margin for the second quarter of 2005 benefited from a principal investing distribution of $15 million received in the form of dividends and interest. This distribution added approximately 8 basis points to the net interest margin for the year-ago quarter. The decrease in the net interest margin caused by the above factors was substantially offset, however, by the positive effect of an increase in the level of noninterest-bearing funds.
Average earning assets for the second quarter of 2006 totaled $81.5 billion, which was $3.4 billion, or 4%, higher than the second quarter 2005 level. Increases in commercial loans and loans held for sale drove the increase, but were partially offset by a decline in consumer loans.

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Since December 31, 2004, the growth and composition of Key’s loan portfolio has been affected by the following loan sales, most of which came from the held-for-sale portfolio:
¨   Key sold commercial mortgage loans of $889 million during the first six months of 2006 and $2.2 billion during all of 2005. Since some of these loans have been sold with limited recourse (i.e., there is a risk that Key will be held accountable for certain events or representations made in the sales), Key established and has maintained a loss reserve in an amount estimated by management to be appropriate. More information about the related recourse agreement is provided in Note 13 (“Contingent Liabilities and Guarantees”) under the heading “Recourse agreement with Federal National Mortgage Association” on page 30.
 
¨   Key sold education loans of $282 million ($84 million through securitizations) during the first half of 2006 and $1.2 billion ($937 million through securitizations) during all of 2005. Key has used the securitization market for education loans as a means of diversifying our funding sources.
 
¨   Key sold other loans totaling $360 million during the first six months of 2006 and $2.7 billion during all of 2005. During the first quarter of 2005, Key completed the sale of $992 million of indirect automobile loans, representing the prime segment of that portfolio. In April 2005, Key completed the sale of $635 million of loans, representing the nonprime segment. The decision to sell these loans was driven by management’s strategies for improving Key’s returns and achieving desired interest rate and credit risk profiles.

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Figure 5. Average Balance Sheets, Net Interest Income and Yields/Rates
                                                 
    Second Quarter 2006     First Quarter 2006  
    Average             Yield/     Average             Yield/  
dollars in millions   Balance     Interest     Rate     Balance     Interest     Rate  
 
ASSETS
                                               
Loansa,b
                                               
Commercial, financial and agricultural c
  $ 21,970     $ 390       7.12 %   $ 21,720     $ 357       6.66 %
Real estate — commercial mortgage
    8,071       153       7.59       8,089       144       7.23  
Real estate — construction
    7,570       152       8.07       7,312       138       7.66  
Commercial lease financing c
    9,764       148       6.05       9,581       143       5.98  
 
Total commercial loans
    47,375       843       7.13       46,702       782       6.78  
Real estate — residential
    1,430       24       6.54       1,450       23       6.33  
Home equity
    13,449       247       7.36       13,433       238       7.19  
Consumer — direct
    1,685       41       9.64       1,730       41       9.66  
Consumer — indirect
    3,503       57       6.66       3,367       57       6.66  
 
Total consumer loans
    20,067       369       7.37       19,980       359       7.26  
 
Total loans
    67,442       1,212       7.20       66,682       1,141       6.92  
Loans held for sale
    3,844       73       7.64       3,692       68       7.44  
Investment securitiesa
    46       1       8.01       61       1       6.34  
Securities available for saled
    7,075       84       4.71       7,148       83       4.61  
Short-term investments
    1,678       16       3.89       1,753       22       5.10  
Other investmentsd
    1,398       17       4.60       1,336       25       7.13  
 
Total earning assets
    81,483       1,403       6.89       80,672       1,340       6.70  
Allowance for loan losses
    (963 )                     (963 )                
Accrued income and other assets
    13,341                       13,206                  
 
 
                                               
Total assets
  $ 93,861                     $ 92,915                  
 
                                           
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                               
NOW and money market deposit accounts
  $ 25,347       173       2.75     $ 24,452       145       2.40  
Savings deposits
    1,752       1       .20       1,812       1       .32  
Certificates of deposit ($100,000 or more)e
    5,382       61       4.54       5,407       58       4.34  
Other time deposits
    11,456       115       4.02       11,282       104       3.73  
Deposits in foreign office
    3,429       42       4.88       3,354       35       4.29  
 
Total interest-bearing deposits
    47,366       392       3.32       46,307       343       3.00  
Federal funds purchased and securities sold under repurchase agreements
    3,005       34       4.60       3,349       34       4.06  
Bank notes and other short-term borrowings
    2,497       27       4.17       2,550       24       3.89  
Long-term debte
    14,088       198       5.59       13,991       183       5.27  
 
Total interest-bearing liabilities
    66,956       651       3.89       66,197       584       3.57  
Noninterest-bearing deposits
    13,027                       12,707                  
Accrued expense and other liabilities
    6,211                       6,438                  
Shareholders’ equity
    7,667                       7,573                  
 
 
                                               
Total liabilities and shareholders’ equity
  $ 93,861                     $ 92,915                  
 
                                           
 
                                               
Interest rate spread (TE)
                    3.00 %                     3.13 %
 
Net interest income (TE) and net interest margin (TE)
            752       3.69 %             756       3.77 %
 
                                           
TE adjustmenta
            22                       28          
 
Net interest income, GAAP basis
          $ 730                     $ 728          
 
                                           
 
 
(a)   Interest income on tax-exempt securities and loans has been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%.
 
(b)   For purposes of these computations, nonaccrual loans are included in average loan balances.
 
(c)   During the first quarter of 2006, Key reclassified $760 million of average loans and related interest income from the commercial lease financing component of the commercial loan portfolio to the commercial, financial and agricultural component to more accurately reflect the nature of these receivables. Balances presented for prior periods were not reclassified as the historical data was not available.
 
(d)   Yield is calculated on the basis of amortized cost.
 
(e)   Rate calculation excludes basis adjustments related to fair value hedges. See Note 19 (“Derivatives and Hedging Activities”), which begins on page 87 of Key’s 2005 Annual Report to Shareholders, for an explanation of fair value hedges.
TE = Taxable Equivalent

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Figure 5. Average Balance Sheets, Net Interest Income and Yields/Rates (Continued)
                                                                 
Fourth Quarter 2005   Third Quarter 2005     Second Quarter 2005  
Average             Yield/   Average             Yield/     Average             Yield/  
Balance     Interest     Rate   Balance     Interest     Rate     Balance     Interest     Rate  
 
               
 
                                               
               
 
                                               
               
 
                                               
$ 19,992     $ 315    
6.25%
  $ 19,249     $ 280       5.78 %   $ 19,477     $ 258       5.31 %
  8,580       151    
6.98
    8,467       136       6.42       8,373       129       6.13  
  6,896       129    
7.42
    6,388       110       6.81       6,117       98       6.45  
  10,285       154    
6.01
    10,161       158       6.19       9,984       158       6.33  
 
  45,753       749    
6.51
    44,265       684       6.15       43,951       643       5.86  
  1,460       23    
6.22
    1,472       23       6.13       1,477       21       6.04  
  13,767       242    
7.00
    13,888       236       6.72       13,904       225       6.49  
  1,785       44    
9.68
    1,794       40       8.96       1,831       36       7.93  
  3,340       56    
6.71
    3,339       56       6.67       3,328       51       6.15  
 
  20,352       365    
7.13
    20,493       355       6.86       20,540       333       6.53  
 
  66,105       1,114    
6.70
    64,758       1,039       6.37       64,491       976       6.07  
  3,592       64    
7.05
    3,521       56       6.43       3,169       53       6.61  
  95       1    
5.81
    76       1       7.00       65       1       8.42  
  7,034       84    
4.77
    7,131       84       4.65       7,081       80       4.54  
  2,091       19    
3.53
    1,972       15       3.15       1,799       12       2.58  
  1,297       10    
3.09
    1,342       12       3.25       1,455       24       6.42  
 
  80,214       1,292    
6.40
    78,800       1,207       6.08       78,060       1,146       5.88  
  (1,085 )          
 
    (1,095 )                     (1,124 )                
  13,077            
 
    12,918                       12,979                  
 
               
 
                                               
$ 92,206            
 
  $ 90,623                     $ 89,915                  
             
 
                                           
               
 
                                               
               
 
                                               
               
 
                                               
$ 23,947       127    
2.11
  $ 22,886       101       1.75     $ 22,301       77       1.39  
  1,858       1    
.27
    1,952       2       .29       1,999       1       .26  
               
 
                                               
  5,006       51    
4.06
    4,928       48       3.85       4,999       46       3.70  
  10,951       96    
3.46
    10,805       87       3.21       10,806       82       3.05  
  3,316       34    
4.03
    4,048       35       3.46       4,314       32       2.96  
 
  45,078       309    
2.72
    44,619       273       2.43       44,419       238       2.16  
               
 
                                               
  4,309       40    
3.72
    3,674       31       3.28       3,830       25       2.67  
               
 
                                               
  2,607       24    
3.67
    2,841       22       3.04       2,792       19       2.72  
  13,860       171    
4.89
    13,814       155       4.50       13,929       141       4.11  
 
  65,854       544    
3.28
    64,948       481       2.94       64,970       423       2.62  
  12,594            
 
    12,215                       11,717                  
  6,224            
 
    6,027                       6,000                  
  7,534            
 
    7,433                       7,228                  
 
 
               
 
                                               
$ 92,206            
 
  $ 90,623                     $ 89,915                  
             
 
                                           
               
 
                                               
               
3.12%
                    3.14 %                     3.26 %
 
               
 
                                               
          748    
3.71%
            726       3.67 %             723       3.71 %
               
 
                                           
          30    
 
            33                       30          
 
        $ 718    
 
          $ 693                     $ 693          
             
 
                                           
 

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Figure 6 shows how the changes in yields or rates and average balances from the prior year affected net interest income. The section entitled “Financial Condition,” which begins on page 52, contains more discussion about changes in earning assets and funding sources.
Figure 6. Components of Net Interest Income Changes
                                                 
    From three months ended June 30, 2005     From six months ended June 30, 2005  
    to three months ended June 30, 2006     to six months ended June 30, 2006  
    Average     Yield/     Net     Average     Yield/     Net  
in millions   Volume     Rate     Change     Volume     Rate     Change  
 
INTEREST INCOME
                                               
Loans
  $ 46     $ 190     $ 236     $ 89     $ 376     $ 465  
Loans held for sale
    12       8       20       2       5       7  
Investment securities
                            (1 )     (1 )
Securities available for sale
          4       4       (1 )     8       7  
Short-term investments
    (1 )     5       4             16       16  
Other investments
    (1 )     (6 )     (7 )     (2 )     12       10  
 
Total interest income (taxable equivalent)
    56       201       257       88       416       504  
 
                                               
INTEREST EXPENSE
                                               
NOW and money market deposit accounts
    12       84       96       20       166       186  
Certificates of deposit ($100,000 or more)
    4       11       15       9       20       29  
Other time deposits
    5       28       33       10       51       61  
Deposits in foreign office
    (8 )     18       10       (20 )     35       15  
 
Total interest-bearing deposits
    13       141       154       19       272       291  
Federal funds purchased and securities sold under repurchase agreements
    (6 )     15       9       (14 )     32       18  
Bank notes and other short-term borrowings
    (2 )     10       8       (5 )     20       15  
Long-term debt
    1       56       57       (6 )     115       109  
 
Total interest expense
    6       222       228       (6 )     439       433  
 
Net interest income (taxable equivalent)
  $ 50     $ (21 )   $ 29     $ 94     $ (23 )   $ 71  
 
                                   
 
The change in interest not due solely to volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each.
Noninterest income
Noninterest income for the second quarter of 2006 was $547 million, compared to $486 million for the same period last year. For the first six months of the year, noninterest income was $1.0 billion, representing an increase of $42 million, or 4%, from the first half of 2005.
As shown in Figure 7, the growth in noninterest income from the year-ago quarter reflected net gains of $23 million from principal investing in the current year, compared to net losses of $1 million one year ago, and a $9 million gain recorded in miscellaneous income that resulted from the share redemption by MasterCard Incorporated as part of its initial public offering in May 2006. Also contributing to the improved performance were increases in income from trust and investment services, investment banking activities, insurance products and operating leases.
For the year-to-date period, the growth in noninterest income from the same period last year reflected a $14 million increase in operating lease income, a $13 million increase in income from investment banking and capital markets activities, a $9 million increase in net gains from principal investing, and net gains of $5 million from the sales of securities in the current year, compared to net losses of $5 million recorded one year ago.

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Figure 7. Noninterest Income
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Trust and investment services income
  $ 139     $ 135     $ 4       3.0 %   $ 274     $ 273     $ 1       .4 %
Service charges on deposit accounts
    77       76       1       1.3       149       146       3       2.1  
Investment banking and capital markets income
    59       51       8       15.7       119       106       13       12.3  
Operating lease income
    56       48       8       16.7       108       94       14       14.9  
Letter of credit and loan fees
    45       47       (2 )     (4.3 )     85       87       (2 )     (2.3 )
Corporate-owned life insurance income
    26       24       2       8.3       51       52       (1 )     (1.9 )
Electronic banking fees
    27       24       3       12.5       51       46       5       10.9  
Net gains from loan securitizations and sales
    10       10                   20       29       (9 )     (31.0 )
Net securities gains (losses)
    4       1       3       300.0       5       (5 )     10       N/M  
Other income:
                                                               
Insurance income
    17       11       6       54.5       31       22       9       40.9  
Loan securitization servicing fees
    5       5                   10       10              
Credit card fees
    3       5       (2 )     (40.0 )     6       8       (2 )     (25.0 )
Net gains (losses) from principal investing
    23       (1 )     24       N/M       20       11       9       81.8  
Miscellaneous income
    56       50       6       12.0       99       107       (8 )     (7.5 )
 
Total other income
    104       70       34       48.6       166       158       8       5.1  
 
Total noninterest income
  $ 547     $ 486     $ 61       12.6 %   $ 1,028     $ 986     $ 42       4.3 %
 
                                                   
 
N/M = Not Meaningful
The following discussion explains the composition of certain components of Key’s noninterest income and the factors that caused those components to change.
Trust and investment services income. Trust and investment services is Key’s largest source of noninterest income. The primary components of revenue generated by these services are shown in Figure 8.
Figure 8. Trust and Investment Services Income
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Brokerage commissions and fee income
  $ 59     $ 62     $ (3 )     (4.8 )%   $ 121     $ 125     $ (4 )     (3.2 )%
Personal asset management and custody fees
    38       38                   77       76       1       1.3  
Institutional asset management and custody fees
    42       35       7       20.0       76       72       4       5.6  
 
Total trust and investment services income
  $ 139     $ 135     $ 4       3.0 %   $ 274     $ 273     $ 1       .4 %
 
                                                   
 
A significant portion of Key’s trust and investment services income depends on the value and mix of assets under management. At June 30, 2006, Key’s bank, trust and registered investment advisory subsidiaries had assets under management of $80.3 billion, representing a 5% increase from $76.8 billion at June 30, 2005. As shown in Figure 9, most of the increase was evenly divided between Key’s equity portfolio and securities lending business. When clients’ securities are lent to a borrower, the borrower must provide Key with cash collateral, which is invested during the term of the loan. The difference between the revenue generated from the investment and the cost of the collateral is then shared with the client. This business, although profitable, generates a significantly lower rate of return (commensurate with the lower level of risk inherent in the business) than other types of assets under management. The growth of the securities lending business and the increase in equity securities under management more than offset decreases in the levels of assets managed within the fixed income and money market portfolios. This trend reflects recent improvement in the equity markets in general, and the acquisition of Austin Capital Management, Ltd. on April 1, 2006.

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Figure 9. Assets Under Management
                                         
    2006     2005  
in millions   Second     First     Fourth     Third     Second  
 
Assets under management by investment type:
                                       
Equity
  $ 37,290     $ 36,405     $ 35,370     $ 34,912     $ 34,959  
Securities lending
    22,827       22,985       20,938       20,702       20,536  
Fixed income
    10,742       10,882       11,264       11,492       11,957  
Money market
    8,590       9,286       9,572       9,235       9,355  
Hedge funds
    900                          
 
Total
  $ 80,349     $ 79,558     $ 77,144     $ 76,341     $ 76,807  
 
                             
 
                                       
Proprietary mutual funds included in assets under management:
                                       
Money market
  $ 7,014     $ 7,606     $ 7,884     $ 7,549     $ 7,758  
Equity
    5,039       5,063       4,594       4,331       3,911  
Fixed income
    653       703       722       738       767  
 
Total
  $ 12,706     $ 13,372     $ 13,200     $ 12,618     $ 12,436  
 
                             
 
Service charges on deposit accounts. Service charges on deposit accounts were up slightly from the prior year, but have been on a downward trend over the past few years, due primarily to reductions in the levels of overdraft and maintenance fees charged to clients. The downward trend in overdraft fees reflects enhanced capabilities such as “real time” posting that allow clients to better manage their accounts. Maintenance fees have been lower because a higher proportion of Key’s clients have elected to use Key’s free checking products. In addition, as interest rates increase, commercial clients are able to cover a larger portion of their service charges with credits earned on compensating balances.
Investment banking and capital markets income. As shown in Figure 10, the increase in income from investment banking and capital markets activities compared to the second quarter of 2005, was due primarily to higher income from investment banking transactions.
The increase from the first six months of last year was attributable largely to growth in income from both investment banking transactions and other investments. Included in income from other investments in the current year is a $25 million gain that resulted from the initial public offering completed by the New York Stock Exchange in March 2006. The favorable effect of this gain was offset in part during the second quarter by a $5 million write-down to fair value of the shares obtained in the transaction. The growth in investment banking and capital markets income was moderated by a decline in income from dealer trading and derivatives. Results for the first six months of 2005 included $11 million of derivative income recorded during the first quarter in connection with the sale of Key’s indirect automobile loan portfolio.
Figure 10. Investment Banking and Capital Markets Income
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Investment banking income
  $ 26     $ 19     $ 7       36.8 %   $ 48     $ 36     $ 12       33.3 %
Dealer trading and derivatives income
    11       10       1       10.0       18       29       (11 )     (37.9 )
Income from other investments
    11       13       (2 )     (15.4 )     32       23       9       39.1  
Foreign exchange income
    11       9       2       22.2       21       18       3       16.7  
 
Total investment banking and capital markets income
  $ 59     $ 51     $ 8       15.7 %   $ 119     $ 106     $ 13       12.3 %
 
                                                   
 
Net gains from loan securitizations and sales. Key sells or securitizes loans to achieve desired interest rate and credit risk profiles, to improve the profitability of the overall loan portfolio or to diversify funding sources. During the first quarter of 2005, Key completed the sale of the prime segment of the indirect automobile loan portfolio, resulting in a gain of $19 million. However, this gain was partially offset by a $9 million impairment charge in the education lending business recorded during the same quarter. The types of loans sold during 2005 and the first six months of 2006 are presented in Figure 15 on page 54.

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Net gains (losses) from principal investing. Key’s principal investing income is susceptible to volatility since most of it is derived from mezzanine debt and equity investments in small to medium-sized businesses. Principal investments consist of direct and indirect investments in predominantly privately held companies. These investments are carried on the balance sheet at fair value ($846 million at June 30, 2006, and $814 million at June 30, 2005). Thus, the net gains and losses presented in Figure 7 stem from changes in estimated fair values as well as actual gains and losses on sales of principal investments. As discussed earlier, during the second quarter of 2005, Key received a $15 million distribution in the form of dividends and interest from principal investing activities. This revenue was recorded in net interest income.
Noninterest expense
Noninterest expense for the second quarter of 2006 was $816 million, compared to $753 million for the second quarter of 2005. For the first six months of the year, noninterest expense was $1.6 billion, compared to $1.5 billion for the first half of last year.
As shown in Figure 11, personnel expense rose by $45 million, and nonpersonnel expense increased by $18 million from the year-ago quarter. The increase in nonpersonnel expense included a $10 million rise in professional fees and a $6 million increase in net occupancy expense.
For the year-to-date period, personnel expense grew by $60 million, and nonpersonnel expense rose by $4 million from the first six months of 2005. The increase in nonpersonnel expense was attributable to a $15 million rise in professional fees, an $8 million increase in operating lease expense and smaller increases in several other expense components. In addition, results for the first six months of 2005 included a $9 million credit to the provision for losses on lending-related commitments. These increases were substantially offset by reductions in net occupancy expense and marketing expense.
Figure 11. Noninterest Expense
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Personnel
  $ 431     $ 386     $ 45       11.7 %   $ 836     $ 776     $ 60       7.7 %
Net occupancy
    61       55       6       10.9       124       146  a     (22 )     (15.1 )
Computer processing
    49       50       (1 )     (2.0 )     105       101       4       4.0  
Operating lease expense
    45       40       5       12.5       86       78       8       10.3  
Professional fees
    40       30       10       33.3       73       58       15       25.9  
Marketing
    28       34       (6 )     (17.6 )     46       59       (13 )     (22.0 )
Equipment
    26       28       (2 )     (7.1 )     52       56       (4 )     (7.1 )
Other expense:
                                                               
Postage and delivery
    12       12                   25       25              
Franchise and business taxes
    10       9       1       11.1       20       17       3       17.6  
Telecommunications
    7       8       (1 )     (12.5 )     14       15       (1 )     (6.7 )
OREO expense, net
    1       2       (1 )     (50.0 )     2       4       (2 )     (50.0 )
Provision (credit) for losses on lending-related commitments
          2       (2 )     (100.0 )           (9 )     9       100.0  
Miscellaneous expense
    106       97       9       9.3       203       196       7       3.6  
 
Total other expense
    136       130       6       4.6       264       248       16       6.5  
 
Total noninterest expense
  $ 816     $ 753     $ 63       8.4 %   $ 1,586     $ 1,522     $ 64       4.2 %
 
                                                   
 
                                                               
Average full-time equivalent employees
    19,931       19,429       502       2.6 %     19,813       19,534       279       1.4 %
 
(a)   Includes a charge of $30 million recorded during the first quarter of 2005 to adjust the accounting for rental expense associated with operating leases from an escalating to a straight-line basis.
The following discussion explains the composition of certain components of Key’s noninterest expense and the factors that caused those components to change.

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Personnel. As shown in Figure 12, personnel expense, the largest category of Key’s noninterest expense, rose by $60 million, or 8%, from the first six months of 2005. This growth was due to additional costs incurred in connection with business expansion, an increase in employee benefits expense and higher incentive compensation accruals.
Figure 12. Personnel Expense
                                                                 
    Three months ended June 30,     Change     Six months ended June 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Salaries
  $ 235     $ 218     $ 17       7.8 %   $ 466     $ 435     $ 31       7.1 %
Incentive compensation
    100       88       12       13.6       179       163       16       9.8  
Employee benefits
    76       64       12       18.8       157       138       19       13.8  
Stock-based compensation a
    18       14       4       28.6       32       32              
Severance
    2       2                   2       8       (6 )     (75.0 )
 
Total personnel expense
  $ 431     $ 386     $ 45       11.7 %   $ 836     $ 776     $ 60       7.7 %
 
                                                   
 
(a)   Excludes directors’ stock-based compensation of $.3 million and $.4 million for the three-month periods ended June 30, 2006 and 2005 respectively, and $.6 million and $.8 million for the six-month periods ended June 30, 2006 and 2005, respectively. Directors’ stock-based compensation is included in the “miscellaneous expense” component shown in Figure 11.
Effective January 1, 2006, Key adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment.” SFAS No. 123R changed the manner in which forfeited stock-based awards must be accounted for and reduced Key’s stock-based compensation expense for the first half of 2006 by $4 million. Additional information pertaining to this accounting change is presented in Note 1 (“Basis of Presentation”) under the heading “Stock-Based Compensation” on page 7.
For the second quarter of 2006, the average number of full-time equivalent employees was 19,931, compared to 19,694 for the first quarter of 2006 and 19,429 for the year-ago quarter.
Net occupancy. During the first quarter of 2005, the Securities and Exchange Commission issued interpretive guidance, applicable to all publicly held companies, related to the accounting for operating leases. As a result of this guidance, Key recorded a net occupancy charge of $30 million during the first quarter of last year to adjust the accounting for rental expense associated with such leases from an escalating to a straight-line basis.
Professional fees. The $15 million, or 26%, increase in professional fees from the first six months of 2005 was due in part to higher costs associated with Key’s efforts to strengthen its compliance controls.
Income taxes
The provision for income taxes was $129 million for the second quarter of 2006, compared to $115 million for the comparable period in 2005. The effective tax rate, which is the provision for income taxes as a percentage of income before income taxes, was 29.5% for the second quarter of 2006, compared to 28.3% for the year-ago quarter. For the first six months of 2006, the provision for income taxes was $245 million, compared to $224 million for the first half of 2005. The effective tax rates for these periods were 29.3% and 28.8%, respectively.
The effective tax rates for both the current and prior year are substantially below Key’s combined federal and state tax rate of 37.5%, due primarily to income from investments in tax-advantaged assets such as corporate-owned life insurance, credits associated with investments in low-income housing projects and tax deductions associated with dividends paid on Key common shares held in Key’s 401(k) savings plan. In addition, a lower tax rate is applied to portions of the equipment lease portfolio that are managed by a foreign subsidiary in a lower tax jurisdiction. Since Key intends to permanently reinvest the earnings of this foreign subsidiary overseas, no deferred income taxes are recorded on those earnings in accordance with SFAS No. 109, “Accounting for Income Taxes.”

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In the ordinary course of business, Key enters into certain transactions that have tax consequences. On occasion, the Internal Revenue Service (“IRS”) may challenge a particular tax position taken by Key. The IRS has completed its review of Key’s tax returns for the 1995 through 2000 tax years and has disallowed all LILO deductions taken in the 1995 through 1997 tax years and all deductions taken in the 1998 through 2000 tax years that relate to certain lease financing transactions. In addition, the IRS is currently conducting audits of the 2001 through 2003 tax years. Key expects that the IRS will disallow all similar deductions taken in those years. Further information on Key’s position on these matters and on the potential implications is included in Note 12 (“Income Taxes”) under the heading “Lease Financing Transactions” on page 26.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued new guidance that will change the manner in which income from a leveraged lease is accounted for when there is either a change or projected change in the timing of cash flows relating to income taxes generated by the lease. In addition, the FASB concurrently issued new guidance related to the accounting for uncertain tax positions. The new guidance related to each of these matters is summarized in Note 12 under the heading “Tax-Related Accounting Pronouncements Pending Adoption” on page 27.

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Financial Condition
Loans and loans held for sale
At June 30, 2006, total loans outstanding were $67.4 billion, compared to $66.5 billion at December 31, 2005, and $64.7 billion at June 30, 2005. The composition of Key’s loan portfolio at each of these dates is presented in Note 6 (“Loans and Loans Held for Sale”), which begins on page 18. The growth in our loans over the past twelve months was attributable largely to stronger demand for commercial loans in an improving economy.
Commercial loan portfolio. Commercial loans outstanding increased by $3.1 billion, or 7%, from one year ago, reflecting improvement in the economy. The overall growth in the commercial loan portfolio was broad-based and spread among a number of industry sectors.
Commercial real estate loans for both owner- and nonowner-occupied properties constitute one of the largest segments of Key’s commercial loan portfolio. At June 30, 2006, Key’s commercial real estate portfolio included mortgage loans of $8.0 billion and construction loans of $7.8 billion. The average size of a mortgage loan was $.6 million, and the largest mortgage loan had a balance of $150 million. The average size of a construction loan commitment was $5.6 million. The largest construction loan commitment was $125 million, of which $92 million was outstanding.
Key conducts its commercial real estate lending business through two primary sources: a thirteen-state banking franchise and Real Estate Capital, a national line of business that cultivates relationships both within and beyond the branch system. Real Estate Capital deals exclusively with nonowner-occupied properties (generally properties in which the owner occupies less than 60% of the premises) and accounted for approximately 61% of Key’s total average commercial real estate loans during the second quarter of 2006. Our commercial real estate business as a whole focuses on larger real estate developers and, as shown in Figure 13, is diversified by both industry type and geographic location of the underlying collateral.
Figure 13. Commercial Real Estate Loans
                                                                 
June 30, 2006   Geographic Region             Percent of  
dollars in millions   Northeast     Southeast     Southwest     Midwest     Central     West     Total     Total  
 
Nonowner-occupied:
                                                               
Residential properties
  $ 349     $ 1,675     $ 171     $ 172     $ 483     $ 1,315     $ 4,165       26.4 %
Multi-family properties
    252       281       125       283       493       478       1,912       12.1  
Retail properties
    93       157       68       432       244       255       1,249       7.9  
Land and development
    48       249       101       96       132       117       743       4.7  
Office buildings
    67       165       8       227       59       143       669       4.3  
Warehouses
    90       71       25       127       50       156       519       3.3  
Health facilities
                18       51             27       96       .6  
Manufacturing facilities
    4       1       11       24       4       19       63       .4  
Hotels/Motels
    7       8             2       1       2       20       .1  
Other
    234       152       1       249       25       132       793       5.1  
 
 
    1,144       2,759       528       1,663       1,491       2,644       10,229       64.9  
Owner-occupied
    719       564       94       1,455       515       2,185       5,532       35.1  
 
Total
  $ 1,863     $ 3,323     $ 622     $ 3,118     $ 2,006     $ 4,829     $ 15,761       100.0 %
 
                                               
 
Nonowner-occupied:
                                                               
Nonperforming loans
  $ 4                 $ 3     $ 3           $ 10       N/M  
Accruing loans past due 90 days or more
    2                   1                   3       N/M  
Accruing loans past due 30 through 89 days
    55     $ 46             6       35     $ 17       159       N/M  
 
         
Northeast
    Connecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont
Southeast
    Alabama, Delaware, Florida, Georgia, Kentucky, Louisiana, Maryland, Mississippi, North Carolina, South Carolina, Tennessee, Virginia, Washington D.C. and West Virginia
Southwest
    Arizona, Nevada and New Mexico
Midwest
    Idaho, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota and Wisconsin
Central
    Arkansas, Colorado, Oklahoma, Texas and Utah
West
    Alaska, California, Hawaii, Montana, Oregon, Washington and Wyoming
N/M = Not Meaningful

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In the last half of 2005, we continued to expand our FHA financing and mortgage servicing capabilities by acquiring Malone Mortgage Company and the commercial mortgage-backed securities servicing business of ORIX, both headquartered in Dallas, Texas. These acquisitions added more than $28 billion to our commercial mortgage servicing portfolio and are just two in a series of acquisitions that we have initiated over the past several years to build upon our success in the commercial mortgage business.
Management believes Key has both the scale and array of products to compete on a world-wide basis in the specialty of equipment lease financing. This business is conducted through the Equipment Finance line of business and continues to benefit from the fourth quarter 2004 acquisition of American Express Business Finance Corporation (“AEBF”), the equipment leasing unit of American Express’ small business division. AEBF had commercial loan and lease financing receivables of approximately $1.5 billion at the date of acquisition. During the first quarter of 2006, Key reclassified $792 million of loans from the commercial lease financing portfolio to the commercial, financial and agricultural portfolio to more accurately reflect the nature of these receivables. Prior period balances were not reclassified as the historical data was not available.
Consumer loan portfolio. Consumer loans outstanding decreased by $363 million, or 2%, from one year ago. The decline was largely attributable to the sale of $267 million of home equity loans within Key’s National Home Equity unit, as well as a general slowdown in the level of home equity loan originations over the past year. Excluding loan sales and acquisitions, consumer loans would have decreased by $186 million, or 1%, during the past twelve months.
The home equity portfolio is by far the largest segment of Key’s consumer loan portfolio. Key’s home equity portfolio is derived primarily from our Regional Banking line of business (responsible for 75% of the home equity portfolio at June 30, 2006) and the National Home Equity unit within our Consumer Finance line of business. The National Home Equity unit has two components: Champion Mortgage, a home equity finance business, and Key Home Equity Services, which works with home improvement contractors to provide home equity and home improvement solutions. On August 1, 2006, Key announced that it is considering the sale of its Champion Mortgage business. Key has hired UBS Investment Bank to assist the Board of Directors and management with the possible sale of this business. There can be no assurance that any agreements will be executed or that any transactions will be approved or consummated.
Figure 14 summarizes Key’s home equity loan portfolio at the end of each of the last five quarters, as well as certain asset quality statistics and yields on the portfolio as a whole.
Figure 14. Home Equity Loans
                                         
    2006     2005  
dollars in millions   Second     First     Fourth     Third     Second  
 
SOURCES OF LOANS OUTSTANDING AT PERIOD END
                                       
Regional Banking
  $ 10,122     $ 10,100     $ 10,232     $ 10,345     $ 10,404  
 
                                       
Champion Mortgage
    2,458       2,483       2,465       2,770       2,824  
Key Home Equity Services
    929       846       791       757       693  
 
National Home Equity unit
    3,387       3,329       3,256       3,527       3,517  
 
Total
  $ 13,509     $ 13,429     $ 13,488     $ 13,872     $ 13,921  
 
                             
 
Nonperforming loans at period end
  $ 90     $ 97     $ 79     $ 75     $ 74  
Net charge-offs for the period
    7       6       5       6       5  
Yield for the period
    7.36 %     7.19 %     7.00 %     6.72 %     6.49 %
 
Loans held for sale. As shown in Note 6, Key’s loans held for sale rose to $4.2 billion at June 30, 2006, from $3.4 billion at December 31, 2005, and $3.3 billion at June 30, 2005, due primarily to originations in the education, commercial mortgage, and commercial, financial and agricultural loan portfolios.

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Sales and securitizations. We have continued to use alternative funding sources like loan sales and securitizations to support our loan origination capabilities. In addition, over the past several years, several acquisitions have improved our ability to originate and sell new loans, and to securitize and service loans generated by others, especially in the area of commercial real estate.
During the past twelve months, Key sold $2.4 billion of commercial real estate loans, $1.2 billion of education loans ($909 million through securitizations), $403 million of commercial loans and leases, $345 million of residential real estate loans, $267 million of home equity loans and $111 million of indirect consumer loans. Most of these sales came from the held-for-sale portfolio.
Among the factors that Key considers in determining which loans to sell or securitize are:
¨   whether particular lending businesses meet our performance standards or fit with our relationship banking strategy;
 
¨   our asset/liability management needs;
 
¨   whether the characteristics of a specific loan portfolio make it conducive to securitization;
 
¨   the relative cost of funds;
 
¨   the level of credit risk; and
 
¨   capital requirements.
Figure 15 summarizes Key’s loan sales (including securitizations) for the first half of 2006 and all of 2005.
Figure 15. Loans Sold (Including Loans Held for Sale)
                                                                 
            Commercial     Commercial     Residential     Home     Consumer              
in millions   Commercial     Real Estate     Lease Financing     Real Estate     Equity     —Indirect     Education     Total  
 
2006
                                                               
Second quarter
  $ 64     $ 483           $ 97                 $ 110     $ 754  
First quarter
    40       406     $ 105       54                   172       777  
 
Total
  $ 104     $ 889     $ 105     $ 151                 $ 282     $ 1,531  
 
                                               
 
2005
                                                               
Fourth quarter
  $ 44     $ 792     $ 110     $ 95     $ 264           $ 834     $ 2,139  
Third quarter
    40       710             99       3     $ 111       48       1,011  
Second quarter
    21       336             99             635       128       1,219  
First quarter
    18       389             98       31       992       208       1,736  
 
Total
  $ 123     $ 2,227     $ 110     $ 391     $ 298     $ 1,738     $ 1,218     $ 6,105  
 
                                               
 
Figure 16 shows loans that are either administered or serviced by Key, but not recorded on its balance sheet. Included are loans that have been both securitized and sold, or simply sold outright. As discussed previously, the acquisitions of Malone Mortgage Company and the commercial mortgage-backed securities servicing business of ORIX added more than $28 billion to our commercial mortgage servicing portfolio during the last half of 2005.
Figure 16. Loans Administered or Serviced
                                         
    June 30,     March 31,     December 31,     September 30,     June 30,  
in millions   2006     2006     2005     2005     2005  
 
Commercial real estate loans
  $ 78,348     $ 76,123     $ 72,902     $ 43,555     $ 38,630  
Education loans
    4,806       4,992       5,083       4,518       4,708  
Commercial loans
    255       247       242       233       222  
Home equity loans
    4       5       59       85       96  
Commercial lease financing securitized
          21       25       29       35  
 
Total
  $ 83,413     $ 81,388     $ 78,311     $ 48,420     $ 43,691  
 
                             
 

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In the event of default, Key is subject to recourse with respect to approximately $647 million of the $83.4 billion of loans administered or serviced at June 30, 2006. Additional information about this recourse arrangement is included in Note 13 (“Contingent Liabilities and Guarantees”) under the heading “Recourse agreement with Federal National Mortgage Association” on page 30.
Key derives income from several sources when we sell or securitize loans but retain the right to administer or service them. We earn noninterest income (recorded as “other income”) from servicing or administering the loans, and we earn interest income from any securitized assets we retain, and from the investment of funds generated by escrow deposits collected in connection with the servicing of commercial real estate loans. These deposits have contributed to the growth in Key’s average noninterest-bearing deposits over the past twelve months.
Securities
At June 30, 2006, the securities portfolio totaled $8.6 billion and included $7.1 billion of securities available for sale, $44 million of investment securities and $1.4 billion of other investments (primarily principal investments). In comparison, the total portfolio at December 31, 2005, was $8.7 billion, including $7.3 billion of securities available for sale, $91 million of investment securities and $1.3 billion of other investments. At June 30, 2005, the securities portfolio totaled $8.7 billion and included $7.3 billion of securities available for sale, $59 million of investment securities and $1.4 billion of other investments.
Securities available for sale. The majority of Key’s securities available-for-sale portfolio consists of collateralized mortgage obligations (“CMO”). A CMO is a debt security that is secured by a pool of mortgages or mortgage-backed securities. Key’s CMOs generate interest income and serve as collateral to support certain pledging agreements. At June 30, 2006, Key had $6.8 billion invested in CMOs and other mortgage-backed securities, compared to $6.5 billion at December 31, 2005 and $6.7 billion at June 30, 2005. Substantially all of Key’s mortgage-backed securities are issued or backed by federal agencies. The CMO securities held by Key are shorter-duration class bonds that are structured to have more predictable cash flows than longer-term class bonds.
The weighted-average maturity of Key’s securities available-for-sale portfolio was 2.6 years at June 30, 2006, compared to 2.4 years at December 31, 2005 and 2.2 years at June 30, 2005.
The size and composition of Key’s securities available-for-sale portfolio depend largely on management’s assessment of current economic conditions, including the interest rate environment, and our needs for liquidity, as well as the extent to which we are required (or elect) to hold these assets as collateral to secure public funds and trust deposits. Although debt securities are generally used for this purpose, other assets, such as securities purchased under resale agreements, may be used temporarily when they provide more favorable yields or risks.
Figure 17 shows the composition, yields and remaining maturities of Key’s securities available for sale. For more information about securities, including gross unrealized gains and losses by type of security, see Note 5 (“Securities”), which begins on page 16.

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Figure 17. Securities Available for Sale
                                                                 
                            Other                              
    U.S. Treasury,     States and     Collateralized     Mortgage-     Retained                     Weighted-  
    Agencies and     Political     Mortgage     Backed     Interests in     Other             Average  
dollars in millions   Corporations     Subdivisions     Obligations a     Securities a     Securitizations a     Securities b     Total     Yield c  
 
JUNE 30, 2006
                                                               
Remaining maturity:
                                                               
One year or less
  $ 13     $ 1     $ 315     $ 8     $ 11     $ 62     $ 410       5.05 %
After one through five years
    5       3       6,228       140       88       109       6,573       4.48  
After five through ten years
    4       6       13       38       68       2       131       9.71  
After ten years
    2       7       2       12             3       26       7.20  
 
Fair value
  $ 24     $ 17     $ 6,558     $ 198     $ 167     $ 176     $ 7,140        
Amortized cost
    24       17       6,772       202       122       170       7,307       4.62 %
Weighted-average yield c
    4.58 %     6.95 %     4.25 %     5.69 %     23.17 %     5.48% d     4.62% d      
Weighted-average maturity
  3.3 years   11.2 years   2.5 years   4.5 years   5.5 years   3.7 years   2.6 years      
 
DECEMBER 31, 2005
                                                               
Fair value
  $ 268     $ 18     $ 6,298     $ 234     $ 182     $ 269     $ 7,269        
Amortized cost
    267       17       6,455       233       115       261       7,348       4.42 %
 
JUNE 30, 2005
                                                               
Fair value
  $ 270     $ 20     $ 6,398     $ 279     $ 177     $ 127     $ 7,271        
Amortized cost
    270       19       6,498       274       97       121       7,279       4.36 %
 
(a)   Maturity is based upon expected average lives rather than contractual terms.
 
(b)   Includes primarily marketable equity securities.
 
(c)   Weighted-average yields are calculated based on amortized cost. Such yields have been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%.
 
(d)   Excludes securities of $141 million at June 30, 2006, that have no stated yield.
Investment securities. Securities issued by states and political subdivisions constitute most of Key’s investment securities. Figure 18 shows the composition, yields and remaining maturities of these securities.
Figure 18. Investment Securities
                                 
    States and                     Weighted-  
    Political     Other             Average  
dollars in millions   Subdivisions     Securities     Total     Yield a  
 
JUNE 30, 2006
                               
Remaining maturity:
                               
One year or less
  $ 10     $ 2     $ 12       8.52 %
After one through five years
    18       13       31       6.65  
After five through ten years
    1             1       9.50  
 
Amortized cost
  $ 29     $ 15     $ 44       7.23 %
Fair value
    30       15       45        
Weighted-average maturity
  1.8 years     2.1 years     1.9 years        
 
DECEMBER 31, 2005
                               
Amortized cost
  $ 35     $ 56     $ 91       5.25 %
Fair value
    36       56       92        
 
JUNE 30, 2005
                               
Amortized cost
  $ 46     $ 13     $ 59       7.60 %
Fair value
    48       13       61        
 
(a)   Weighted-average yields are calculated based on amortized cost. Such yields have been adjusted to a taxable-equivalent basis using the statutory federal income tax rate of 35%.
Other investments. Principal investments – investments in equity and mezzanine instruments made by Key’s Principal Investing unit ___are carried at fair value, which aggregated $846 million at June 30, 2006, $800 million at December 31, 2005, and $814 million at June 30, 2005. Principal investments represent approximately 61% of “other investments” at June 30, 2006. These investments include direct and indirect investments ___predominantly in privately held companies. Direct investments are those made in a particular company, while indirect investments are made through funds that include other investors.

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In addition to principal investments, “other investments” include other equity and mezzanine instruments that do not have readily determinable fair values. These securities include certain real estate-related investments that are carried at estimated fair value, as well as other types of securities that generally are carried at cost. Neither these securities nor principal investments have stated maturities.
Deposits and other sources of funds
“Core deposits” ___ domestic deposits other than certificates of deposit of $100,000 or more ___ are Key’s primary source of funding. These deposits generally are stable, have a relatively low cost and typically react more slowly to changes in interest rates than market-based deposits. During the second quarter of 2006, core deposits averaged $51.6 billion and represented 63% of the funds Key used to support earning assets, compared to $46.8 billion and 60%, respectively, during the same quarter in 2005. The composition of Key’s deposits is shown in Figure 5, which spans pages 44 and 45.
The increase in the level of Key’s average core deposits during the past twelve months was due to higher levels of money market deposit accounts, time deposits and noninterest-bearing deposits. These results reflect client preferences for investments that provide high levels of liquidity in a changing interest rate environment. The growth in money market deposit accounts also benefited from the introduction of new products in 2005 and 2006. Average noninterest-bearing deposits also increased because we intensified our cross-selling efforts, focused sales and marketing efforts on our free checking products, and collected more escrow deposits associated with the servicing of commercial real estate loans.
Purchased funds, comprising large certificates of deposit, deposits in the foreign branch and short-term borrowings, averaged $14.3 billion in the second quarter of 2006, compared to $15.9 billion during the year-ago quarter. The decrease was attributable primarily to lower levels of foreign branch deposits, and federal funds purchased and securities sold under repurchase agreements. The need for this funding source has diminished as a result of strong core deposit growth, a higher level of capital and other interest-free funds, and loan sales.
We continue to consider loan sales and securitizations as a funding alternative when market conditions are favorable.
Capital
Shareholders’ equity. Total shareholders’ equity at June 30, 2006, was $7.7 billion, up $139 million from December 31, 2005. Factors contributing to the change in shareholders’ equity during the first half of 2006 are shown in the Consolidated Statements of Changes in Shareholders’ Equity presented on page 5.
Changes in common shares outstanding. Figure 19 shows activities that caused the change in Key’s outstanding common shares over the past five quarters.
Figure 19. Changes in Common Shares Outstanding
                                         
in thousands   2Q06     1Q06     4Q05     3Q05     2Q05  
 
Shares outstanding at beginning of period
    405,273       406,624       408,542       408,231       407,297  
Issuance of shares under employee benefit and dividend reinvestment plans
    1,399       4,649       1,332       1,561       934  
Repurchase of common shares
    (4,000 )     (6,000 )     (3,250 )     (1,250 )      
 
Shares outstanding at end of period
  $ 402,672     $ 405,273     $ 406,624     $ 408,542     $ 408,231  
 
                             
 
Key repurchases its common shares periodically under a repurchase program authorized by Key’s Board of Directors (“Board”). Key’s repurchase activity for each of the three months in the quarter ended June 30, 2006, is summarized in Figure 20.

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Figure 20. Share Repurchases
                                 
                    Number of     Remaining Number  
                    Shares Purchased     of Shares that may  
    Number of     Average     under a Publicly     be Purchased Under  
    Shares     Price Paid     Announced     the Program as  
in thousands, except per share data   Purchased     per Share     Program a     of each Month-End a  
 
April 1-30, 2006
    1,950     $ 36.68       1,950       14,511  
May 1-31, 2006
    2,050       37.27       2,050       12,461  
June 1-30, 2006
                      12,461  
 
Total
    4,000     $ 36.98       4,000          
 
                           
 
(a)   In July 2004, the Board authorized the repurchase of 25,000,000 common shares, in addition to the shares remaining from a repurchase program authorized in September 2003. This action brought the total repurchase authorization to 31,961,248 shares. These shares may be repurchased in the open market or through negotiated transactions. The program does not have an expiration date.
At June 30, 2006, Key had 89,217,117 treasury shares. Management expects to reissue those shares from time-to-time to support the employee stock purchase, stock option and dividend reinvestment plans, and for other corporate purposes. During the first half of 2006, Key reissued 6,048,056 treasury shares.
Capital adequacy. Capital adequacy is an important indicator of financial stability and performance. Overall, Key’s capital position remains strong: the ratio of total shareholders’ equity to total assets was 8.16% at June 30, 2006, and December 31, 2005, compared to 8.08% at June 30, 2005. Key’s ratio of tangible equity to tangible assets was 6.68% at June 30, 2006, and is within our targeted range of 6.25% to 6.75%. Management believes that Key’s capital position provides the flexibility to take advantage of investment opportunities, to repurchase shares when appropriate and to pay dividends.
Banking industry regulators prescribe minimum capital ratios for bank holding companies and their banking subsidiaries. Note 14 (“Shareholders’ Equity”), which begins on page 76 of Key’s 2005 Annual Report to Shareholders, explains the implications of failing to meet specific capital requirements imposed by the banking regulators. Risk-based capital guidelines require a minimum level of capital as a percent of “risk-weighted assets,” which is total assets plus certain off-balance sheet items, both adjusted for predefined credit risk factors. Currently, banks and bank holding companies must maintain, at a minimum, Tier 1 capital as a percent of risk-weighted assets of 4.00%, and total capital as a percent of risk-weighted assets of 8.00%. As of June 30, 2006, Key’s Tier 1 capital ratio was 7.90%, and its total capital ratio was 12.08%.
Another indicator of capital adequacy, the leverage ratio, is defined as Tier 1 capital as a percentage of average quarterly tangible assets. Leverage ratio requirements vary with the condition of the financial institution. Bank holding companies that either have the highest supervisory rating or have implemented the Federal Reserve’s risk-adjusted measure for market risk-as KeyCorp has-must maintain a minimum leverage ratio of 3.00%. All other bank holding companies must maintain a minimum ratio of 4.00%. As of June 30, 2006, Key had a leverage ratio of 8.82%.
Federal bank regulators group FDIC-insured depository institutions into five categories, ranging from “critically undercapitalized” to “well capitalized.” Key’s affiliate bank, KBNA, qualified as “well capitalized” at June 30, 2006, since it exceeded the prescribed thresholds of 10.00% for total capital, 6.00% for Tier 1 capital and 5.00% for the leverage ratio. If these provisions applied to bank holding companies, Key would also qualify as “well capitalized” at June 30, 2006. The FDIC-defined capital categories serve a limited supervisory function. Investors should not treat them as a representation of the overall financial condition or prospects of KeyCorp or KBNA.
Figure 21 presents the details of Key’s regulatory capital position at June 30, 2006, December 31, 2005, and June 30, 2005.

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Figure 21. Capital Components and Risk-Weighted Assets
                         
    June 30,     December 31,     June 30,  
dollars in millions   2006     2005     2005  
 
TIER 1 CAPITAL
                       
Common shareholders’ equitya
  $ 7,862     $ 7,678     $ 7,406  
Qualifying capital securities
    1,792       1,542       1,542  
Less: Goodwill
    1,372       1,355       1,342  
Other assetsb
    182       178       151  
 
Total Tier 1 capital
    8,100       7,687       7,455  
 
TIER 2 CAPITAL
                       
Allowance for losses on loans and lending-related commitments
    1,015       1,025       1,157  
Net unrealized gains on equity securities available for sale
    3       4       3  
Qualifying long-term debt
    3,276       2,899       2,764  
 
Total Tier 2 capital
    4,294       3,928       3,924  
 
Total risk-based capital
  $ 12,394     $ 11,615     $ 11,379  
 
                 
 
                       
RISK-WEIGHTED ASSETS
                       
Risk-weighted assets on balance sheet
  $ 78,928     $ 76,724     $ 74,153  
Risk-weighted off-balance sheet exposure
    24,895       25,619       24,280  
Less: Goodwill
    1,372       1,355       1,342  
Other assetsb
    761       785       714  
Plus: Market risk-equivalent assets
    899       1,064       675  
 
Risk-weighted assets
  $ 102,589     $ 101,267     $ 97,052  
 
                 
 
                       
AVERAGE QUARTERLY TOTAL ASSETS
  $ 93,861     $ 92,206     $ 89,915  
 
                 
 
                       
CAPITAL RATIOS
                       
Tier 1 risk-based capital ratio
    7.90 %     7.59 %     7.68 %
Total risk-based capital ratio
    12.08       11.47       11.72  
Leverage ratioc
    8.82       8.53       8.49  
 
(a)   Common shareholders’ equity does not include net unrealized gains or losses on securities available for sale (except for net unrealized losses on marketable equity securities) or net gains or losses on cash flow hedges.
 
(b)   Other assets deducted from Tier 1 capital and risk-weighted assets consist of intangible assets (excluding goodwill) recorded after February 19, 1992, deductible portions of purchased mortgage servicing rights and deductible portions of nonfinancial equity investments.
 
(c)   This ratio is Tier 1 capital divided by average quarterly total assets less goodwill, the nonqualifying intangible assets described in footnote (b), deductible portions of nonfinancial equity investments and net unrealized gains or losses on securities available for sale.

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Risk Management
Overview
Certain risks are inherent in the business activities that financial services companies conduct. The ability to properly and effectively identify, measure, monitor and report such risks is essential to maintaining safety and soundness and to maximizing profitability. Management believes that the most significant risks to which Key is exposed are market risk, credit risk, liquidity risk and operational risk. Each type of risk is defined and discussed in greater detail in the remainder of this section.
Key’s Board has established and follows a corporate governance program that serves as the foundation for managing and mitigating risk. In accordance with this program, the Board focuses on the interests of shareholders, encourages strong internal controls, demands management accountability, mandates adherence to Key’s code of ethics and administers an annual self-assessment process. The Board has established Audit and Finance committees whose appointed members play an integral role in helping the Board meet its risk oversight responsibilities. Those committees meet jointly, as appropriate, to discuss matters that relate to each committee’s responsibilities. The responsibilities of these two committees are summarized on page 38 of Key’s 2005 Annual Report to Shareholders.
Market risk management
The values of some financial instruments vary not only with changes in market interest rates, but also with changes in foreign exchange rates, factors influencing valuations in the equity securities markets and other market-driven rates or prices. For example, the value of a fixed-rate bond will decline if market interest rates increase. Similarly, the value of the U.S. dollar regularly fluctuates in relation to other currencies. When the value of an instrument is tied to such external factors, the holder faces “market risk.” Most of Key’s market risk is derived from interest rate fluctuations.
Interest rate risk management
Key’s Asset/Liability Management Policy Committee (“ALCO”) has developed a program to measure and manage interest rate risk. This senior management committee is also responsible for approving Key’s asset/liability management (“A/LM”) policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing Key’s sensitivity to changes in interest rates.
Factors contributing to interest rate exposure. Key uses interest rate exposure models to quantify the potential impact that a variety of possible interest rate scenarios may have on earnings and the economic value of equity. The various scenarios estimate the level of Key’s interest rate exposure arising from gap risk, option risk and basis risk. Each of these types of risk is defined in the discussion of market risk management, which begins on page 38 of Key’s 2005 Annual Report to Shareholders.