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 September 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   (I.R.S. Employer
incorporation or organization)   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
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   401,580,774 Shares
     
(Title of class)   (Outstanding at October 31, 2006)
 
 

 


 

KEYCORP
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
         
    Page Number
       
 
       
    3  
 
       
    4  
 
       
    5  
 
       
    6  
 
       
    7  
 
       
    34  
 
       
    35  
 
       
    73  
 
       
    73  
 
       
PART II. OTHER INFORMATION
 
       
    73  
 
       
    73  
 
       
    73  
 
       
    74  
 
       
Exhibits
    75  
 EX-10.1
 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
                         
    September 30,     December 31,     September 30,  
dollars in millions   2006     2005     2005  
    (Unaudited)             (Unaudited)  
ASSETS
                       
Cash and due from banks
  $ 2,957     $ 3,108     $ 2,660  
Short-term investments
    1,582       1,592       2,394  
Securities available for sale
    7,441       7,269       7,124  
Investment securities (fair value: $42, $92 and $99)
    41       91       98  
Other investments
    1,367       1,332       1,310  
Loans, net of unearned income of $2,075, $2,153 and $2,188
    65,551       66,478       65,575  
Less: Allowance for loan losses
    944       966       1,093  
 
Net loans
    64,607       65,512       64,482  
Loans held for sale
    7,150       3,381       3,595  
Premises and equipment
    567       575       593  
Goodwill
    1,372       1,355       1,344  
Other intangible assets
    127       125       109  
Corporate-owned life insurance
    2,754       2,690       2,658  
Derivative assets
    915       1,039       1,132  
Accrued income and other assets
    5,275       5,057       4,824  
 
Total assets
  $ 96,155     $ 93,126     $ 92,323  
 
                 
 
                       
LIABILITIES
                       
Deposits in domestic offices:
                       
NOW and money market deposit accounts
  $ 25,150     $ 24,241     $ 23,541  
Savings deposits
    1,672       1,840       1,922  
Certificates of deposit ($100,000 or more)
    5,734       5,156       4,783  
Other time deposits
    11,848       11,170       10,804  
 
Total interest-bearing
    44,404       42,407       41,050  
Noninterest-bearing
    13,396       13,335       12,202  
Deposits in foreign office — interest-bearing
    3,629       3,023       4,819  
 
Total deposits
    61,429       58,765       58,071  
Federal funds purchased and securities sold under repurchase agreements
    4,701       4,835       3,444  
Bank notes and other short-term borrowings
    2,594       1,780       3,001  
Derivative liabilities
    844       1,060       1,075  
Accrued expense and other liabilities
    4,986       5,149       5,173  
Long-term debt
    13,654       13,939       14,037  
 
Total liabilities
    88,208       85,528       84,801  
 
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
    1,588       1,534       1,517  
Retained earnings
    8,371       7,882       7,719  
Treasury stock, at cost (89,140,338, 85,265,173 and 83,346,435 shares)
    (2,434 )     (2,204 )     (2,133 )
Accumulated other comprehensive loss
    (70 )     (106 )     (73 )
 
Total shareholders’ equity
    7,947       7,598       7,522  
 
Total liabilities and shareholders’ equity
  $ 96,155     $ 93,126     $ 92,323  
 
                 
 
See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Income (Unaudited)
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
dollars in millions, except per share amounts   2006     2005     2006     2005  
 
INTEREST INCOME
                               
Loans
  $ 1,196     $ 1,006     $ 3,500     $ 2,837  
Loans held for sale
    131       56       272       190  
Investment securities
    1       1       2       3  
Securities available for sale
    84       84       251       244  
Short-term investments
    16       15       54       37  
Other investments
    16       12       58       44  
 
Total interest income
    1,444       1,174       4,137       3,355  
 
INTEREST EXPENSE
                               
Deposits
    443       273       1,178       717  
Federal funds purchased and securities sold under repurchase agreements
    45       31       113       81  
Bank notes and other short-term borrowings
    24       22       75       58  
Long-term debt
    202       155       583       427  
 
Total interest expense
    714       481       1,949       1,283  
 
NET INTEREST INCOME
    730       693       2,188       2,072  
Provision for loan losses
    31       43       94       107  
 
Net interest income after provision for loan losses
    699       650       2,094       1,965  
 
NONINTEREST INCOME
                               
Trust and investment services income
    137       135       411       408  
Service charges on deposit accounts
    78       82       227       228  
Investment banking and capital markets income
    44       62       163       168  
Operating lease income
    58       47       166       141  
Letter of credit and loan fees
    48       46       133       133  
Corporate-owned life insurance income
    23       26       74       78  
Electronic banking fees
    27       24       78       70  
Net gains from loan securitizations and sales
    14       12       34       41  
Net securities gains (losses)
    (7 )     3       (2 )     (2 )
Other income
    121       94       287       252  
 
Total noninterest income
    543       531       1,571       1,517  
 
NONINTEREST EXPENSE
                               
Personnel
    422       414       1,258       1,190  
Net occupancy
    63       66       187       212  
Computer processing
    52       54       157       155  
Operating lease expense
    48       40       134       118  
Professional fees
    29       29       102       87  
Marketing
    37       29       83       88  
Equipment
    26       28       78       84  
Other expense
    131       121       395       369  
 
Total noninterest expense
    808       781       2,394       2,303  
 
INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE
    434       400       1,271       1,179  
Income taxes
    122       122       367       346  
 
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE
    312       278       904       833  
Cumulative effect of accounting change, net of tax (see Note 1)
                5        
 
NET INCOME
  $ 312     $ 278     $ 909     $ 833  
 
                       
 
                               
Per common share:
                               
Income before cumulative effect of accounting change
  $ .77     $ .68     $ 2.23     $ 2.04  
Net income
    .77       .68       2.24       2.04  
Income before cumulative effect of accounting change — assuming dilution
    .76       .67       2.20       2.01  
Net income — assuming dilution
    .76       .67       2.21       2.01  
Cash dividends declared
    .345       .325       1.035       .975  
Weighted-average common shares outstanding (000)
    403,780       410,456       405,218       409,166  
Weighted-average common shares and potential common shares outstanding (000)
    409,428       415,441       411,029       414,510  
 
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
                            833                     $ 833  
Other comprehensive income (losses):
                                                       
Net unrealized losses on securities available for sale, net of income taxes of ($21)a
                                            (36 )     (36 )
Net unrealized gains on derivative financial instruments, net of income taxes of $4
                                            8       8  
Foreign currency translation adjustments
                                            (22 )     (22 )
Minimum pension liability adjustment, net of income taxes of ($1)
                                            (1 )     (1 )
 
                                                     
Total comprehensive income
                                                  $ 782  
 
                                                     
Deferred compensation
                    27                                  
Cash dividends declared on common shares ($.975 per share)
                            (398 )                        
Issuance of common shares and stock options granted under employee benefit and dividend reinvestment plans
    4,722               (1 )             119                  
Repurchase of common shares
    (3,750 )                             (124 )                
         
BALANCE AT SEPTEMBER 30, 2005
    408,542     $ 492     $ 1,517     $ 7,719     $ (2,133 )   $ (73 )        
 
                                           
         
BALANCE AT DECEMBER 31, 2005
    406,624     $ 492     $ 1,534     $ 7,882     $ (2,204 )   $ (106 )        
Net income
                            909                     $ 909  
Other comprehensive income:
                                                       
Net unrealized gains on securities available for sale, net of income taxes of $5a
                                            6       6  
Net unrealized gains on derivative financial instruments, net of income taxes
                                            1       1  
Net unrealized losses on common investment funds held in employee welfare benefits trust, net of income taxes
                                            (1 )     (1 )
Foreign currency translation adjustments
                                            30       30  
 
                                                     
Total comprehensive income
                                                  $ 945  
 
                                                     
Deferred compensation
                    21                                  
Cash dividends declared on common shares ($1.035 per share)
                            (420 )                        
Issuance of common shares and stock options granted under employee benefit and dividend reinvestment plans
    8,624               33               227                  
Repurchase of common shares
    (12,500 )                             (457 )                
         
BALANCE AT SEPTEMBER 30, 2006
    402,748     $ 492     $ 1,588     $ 8,371     $ (2,434 )   $ (70 )        
 
                                           
         
(a) Net of reclassification adjustments.
See Notes to Consolidated Financial Statements (Unaudited).

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Consolidated Statements of Cash Flow (Unaudited)
                 
    Nine months ended
September 30,
in millions   2006     2005  
 
OPERATING ACTIVITIES
               
Net income
  $ 909     $ 833  
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
               
Provision for loan losses
    94       107  
Depreciation and amortization expense
    292       265  
Net securities losses
    2       2  
Net gains from principal investing
    (48 )     (40 )
Net gains from loan securitizations and sales
    (34 )     (41 )
Deferred income taxes
    (230 )     137  
Net (increase) decrease in loans held for sale
    (1,295 )     758  
Net (increase) decrease in trading account assets
    33       (255 )
Other operating activities, net
    (232 )     (306 )
 
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
    (509 )     1,460  
INVESTING ACTIVITIES
               
Cash used in acquisitions, net of cash acquired
    (34 )     (32 )
Net increase in other short-term investments
    (23 )     (667 )
Purchases of securities available for sale
    (2,730 )     (2,623 )
Proceeds from sales of securities available for sale
    154       128  
Proceeds from prepayments and maturities of securities available for sale
    2,421       2,707  
Purchases of investment securities
    (2 )      
Proceeds from prepayments and maturities of investment securities
    53       17  
Purchases of other investments
    (401 )     (326 )
Proceeds from sales of other investments
    189       226  
Proceeds from prepayments and maturities of other investments
    209       199  
Net increase in loans, excluding acquisitions, sales and transfer
    (1,990 )     (2,492 )
Purchases of loans
    (64 )     (19 )
Proceeds from loan securitizations and sales
    298       154  
Purchases of premises and equipment
    (68 )     (67 )
Proceeds from sales of premises and equipment
    4       8  
Proceeds from sales of other real estate owned
    20       58  
 
NET CASH USED IN INVESTING ACTIVITIES
    (1,964 )     (2,729 )
FINANCING ACTIVITIES
               
Net increase in deposits
    2,674       244  
Net increase in short-term borrowings
    680       1,785  
Net proceeds from issuance of long-term debt
    1,609       2,504  
Payments on long-term debt
    (1,997 )     (2,633 )
Purchases of treasury shares
    (457 )     (124 )
Net proceeds from issuance of common stock
    207       97  
Tax benefits in excess of recognized compensation cost for stock-based awards
    26        
Cash dividends paid
    (420 )     (398 )
 
NET CASH PROVIDED BY FINANCING ACTIVITIES
    2,322       1,475  
 
NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS
    (151 )     206  
CASH AND DUE FROM BANKS AT BEGINNING OF PERIOD
    3,108       2,454  
 
CASH AND DUE FROM BANKS AT END OF PERIOD
  $ 2,957     $ 2,660  
 
           
 
 
Additional disclosures relative to cash flow:
               
Interest paid
  $ 2,042     $ 1,266  
Income taxes paid
    328       193  
Noncash items:
               
Loans transferred from portfolio to held for sale
  $ 2,474        
Loans transferred to other real estate owned
    52     $ 40  
Assets acquired
          15  
Liabilities assumed
          7  
 
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 23.
Accounting Pronouncements Pending Adoption
Employers’ accounting for defined benefit pension and other postretirement plans. In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires an employer to recognize an asset or liability for the overfunded or underfunded status, respectively, of its defined benefit plans. The overfunded or underfunded status is to be measured solely as the difference between the fair value of plan assets and the projected benefit obligation. In addition, any change in a plan’s funded status must be recognized in comprehensive income in the year in which it occurs. Most requirements of SFAS No. 158 will be effective for fiscal years ending after December 15, 2006 (effective December 31, 2006, for Key). However, the requirement to measure plan assets and liabilities as of the end of an employer’s fiscal year will not be effective until fiscal years ending after December 15, 2008 (effective December 31, 2008, for Key). Management estimates that Key will record an after-tax charge of approximately $145 million to the accumulated other comprehensive loss component of shareholders’ equity as a result of adopting this guidance for the year ending December 31, 2006. For more information about Key’s defined benefit plans, see Note 16 (“Employee Benefits”), which begins on page 78 of Key’s 2005 Annual Report to Shareholders.
Fair value measurements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 provides guidance on how to measure fair value when it is permitted or required under other accounting pronouncements. As such, this guidance does not expand the use of fair value measurements. SFAS No. 157 will be effective for fiscal years beginning after November 15, 2007 (effective January 1, 2008, for Key). Management is currently evaluating the potential effect this guidance may have on Key’s financial condition or results of operations.
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 for fiscal years 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 27.
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. Previously, leveraged lease transactions were required to be recalculated only when a change in the total cash flows occurred. This guidance will be effective for fiscal years beginning after December 15, 2006 (effective January 1, 2007, for Key). Management currently estimates that the adoption of this guidance will result in a cumulative after-tax charge to Key’s retained earnings in the range of $50 million to $65 million. However, future earnings are expected to increase over the remaining term of the affected leases by a similar amount.
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

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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 for fiscal years 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 in fiscal years 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.
2. Earnings Per Common Share
Key calculates its basic and diluted earnings per common share as follows:
                                 
    Three months ended
September 30,
  Nine months ended
September 30,
dollars in millions, except per share amounts   2006     2005     2006     2005  
 
EARNINGS
                               
Income before cumulative effect of accounting change
  $ 312     $ 278     $ 904     $ 833  
Net income
    312       278       909       833  
 
WEIGHTED-AVERAGE COMMON SHARES
                               
Weighted-average common shares outstanding (000)
    403,780       410,456       405,218       409,166  
Effect of dilutive common stock options and other stock awards (000)
    5,648       4,985       5,811       5,344  
 
Weighted-average common shares and potential common shares outstanding (000)
    409,428       415,441       411,029       414,510  
 
                       
 
EARNINGS PER COMMON SHARE
                               
Income per common share before cumulative effect of accounting change
  $ .77     $ .68     $ 2.23     $ 2.04  
Net income per common share
    .77       .68       2.24       2.04  
Income per common share before cumulative effect of accounting change — assuming dilution
    .76       .67       2.20       2.01  
Net income per common share — assuming dilution
    .76       .67       2.21       2.01  
 
3. Acquisitions and Divestitures
Acquisitions completed and divestitures announced by Key during 2005 and the first nine months of 2006 are summarized below. In the case of each acquisition or divestiture, the terms of the transaction either were not or are not expected to be material.
Acquisitions
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, 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.

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Divestitures Pending as of September 30, 2006
McDonald Investments branch network
On September 6, 2006, Key announced that it has agreed to sell its McDonald Investments branch network, which includes approximately 340 financial advisors in addition to field support staff and certain fixed assets, to UBS Financial Services Inc., a subsidiary of UBS AG. Key will retain its Private Banking, Wealth Management and Trust businesses. Key will also retain its Investment Services business, which offers products such as mutual funds and annuities through its KeyCenters. The sale is expected to be completed in the first quarter of 2007.
Champion Mortgage
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 a possible sale of this business. There is no assurance that Key will enter into an agreement regarding, or consummate the sale of, this business.

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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.
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 financing 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 intercompany eliminations and certain items that are not allocated to the business segments because they are not reflective of their normal operations.
The table that spans pages 14 and 15 shows selected financial data for each major business group for the three- and nine-month periods ended September 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:
w   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.
 
w   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.
 
w   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.
 
w   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%.
 
w   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.
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. These changes are reflected in the financial data reported for all periods presented in the line of business tables.

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Three months ended September 30,   Community Banking     National Banking     Other Segments  
dollars in millions   2006     2005     2006     2005     2006     2005  
 
SUMMARY OF OPERATIONS
                                               
Net interest income (TE)
  $ 443     $ 432     $ 375     $ 348     $ (31 )   $ (28 )
Noninterest income
    228       227       256       253       56       53  
 
Total revenue (TE)a
    671       659       631       601       25       25  
Provision for loan losses
    22       26       9       17              
Depreciation and amortization expense
    36       36       64       54              
Other noninterest expense
    434       419       276       272       7       7  
 
Income (loss) before income taxes (TE)
    179       178       282       258       18       18  
Allocated income taxes and TE adjustments
    67       67       106       97       (2 )     (3 )
 
Income (loss) before cumulative effect of accounting change
    112       111       176       161       20       21  
Cumulative effect of accounting change
                                   
 
Net income (loss)
  $ 112     $ 111     $ 176     $ 161     $ 20     $ 21  
 
                                   
 
 
                                               
Percent of consolidated net income
    36 %     40 %     57 %     58 %     6 %     7 %
Percent of total segments net income
    36       38       57       55       7       7  
 
AVERAGE BALANCES
                                               
Loans and leases
  $ 26,737     $ 27,131     $ 38,767     $ 37,072     $ 282     $ 377  
Total assetsa
    29,718       30,026       51,347       46,708       11,503       11,645  
Deposits
    46,987       44,705       11,068       7,785       3,543       4,589  
 
OTHER FINANCIAL DATA
                                               
Net loan charge-offs
  $ 22     $ 25     $ 21     $ 24              
Return on average allocated equity
    19.20 %     19.10 %     17.52 %     17.10 %     N/M       N/M  
Average full-time equivalent employees
    9,080       8,743       4,573       4,418       41       40  
 
                                                 
Nine months ended September 30,   Community Banking     National Banking     Other Segments  
dollars in millions   2006     2005     2006     2005     2006     2005  
 
SUMMARY OF OPERATIONS
                                               
Net interest income (TE)
  $ 1,311     $ 1,260     $ 1,126     $ 1,051     $ (91 )   $ (77 )
Noninterest income
    667       663       761       724       130       130  
 
Total revenue (TE)a
    1,978       1,923       1,887       1,775       39       53  
Provision for loan losses
    71       77       23       30              
Depreciation and amortization expense
    110       106       182       159              
Other noninterest expense
    1,276       1,220       836       792       21       24  
 
Income (loss) before income taxes (TE)
    521       520       846       794       18       29  
Allocated income taxes and TE adjustments
    195       195       317       298       (21 )     (19 )
 
Income (loss) before cumulative effect of accounting change
    326       325       529       496       39       48  
Cumulative effect of accounting change
                                   
 
Net income (loss)
  $ 326     $ 325     $ 529     $ 496     $ 39     $ 48  
 
                                   
 
 
                                               
Percent of consolidated net income
    36 %     39 %     58 %     59 %     4 %     6 %
Percent of total segments net income
    37       37       59       57       4       6  
 
AVERAGE BALANCES
                                               
Loans and leases
  $ 26,760     $ 26,987     $ 39,498     $ 36,790     $ 302     $ 407  
Total assetsa
    29,736       29,916       50,463       46,585       11,456       11,749  
Deposits
    46,506       43,875       10,560       7,330       3,361       5,200  
 
OTHER FINANCIAL DATA
                                               
Net loan charge-offs
  $ 74     $ 83     $ 42     $ 68              
Return on average allocated equity
    18.88 %     18.92 %     17.93 %     17.63 %     N/M       N/M  
Average full-time equivalent employees
    8,961       8,705       4,507       4,502       40       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  
 
 
$ 787     $ 752     $ (36 )   $ (26 )   $ 751     $ 726  
  540       533       3       (2 )     543       531  
 
  1,327       1,285       (33 )     (28 )     1,294       1,257  
  31       43                   31       43  
  100       90                   100       90  
  717       698       (9 )     (7 )     708       691  
 
  479       454       (24 )     (21 )     455       433  
 
  171       161       (28 )     (6 )     143       155  
 
 
  308       293       4       (15 )     312       278  
                                 
 
$ 308     $ 293     $ 4     $ (15 )   $ 312     $ 278  
                                 
 
                                             
  99 %     105 %     1 %     (5 )%     100 %     100 %
  100       100       N/A       N/A       N/A       N/A  
 
                                             
$ 65,786     $ 64,580     $ 224     $ 178     $ 66,010     $ 64,758  
  92,568       88,379       2,350       2,244       94,918       90,623  
  61,598       57,079       (227 )     (245 )     61,371       56,834  
 
                                             
$ 43     $ 49                 $ 43     $ 49  
  18.13 %     17.96 %     N/M       N/M       15.88 %     14.84 %
 
  13,694       13,201       6,570       6,255       20,264       19,456  
 
                                             
Total Segments     Reconciling Items     Key  
2006     2005     2006     2005     2006     2005  
 
 
$ 2,346     $ 2,234     $ (87 )   $ (71 )   $ 2,259     $ 2,163  
  1,558       1,517       13             1,571       1,517  
 
  3,904       3,751       (74 )     (71 )     3,830       3,680  
  94       107                   94       107  
  292       265                   292       265  
  2,133       2,036       (31 )     2 b     2,102       2,038  
 
  1,385       1,343       (43 )     (73 )     1,342       1,270  
 
  491       474       (53 )     (37 )     438       437  
 
 
  894       869       10       (36 )     904       833  
              5             5        
 
$ 894     $ 869     $ 15     $ (36 )   $ 909     $ 833  
                                 
 
                                             
  98 %     104 %     2 %     (4 )%     100 %     100 %
  100       100       N/A       N/A       N/A       N/A  
 
                                             
$ 66,560     $ 64,184     $ 149     $ 162     $ 66,709     $ 64,346  
  91,655       88,250       2,250       2,248       93,905       90,498  
  60,427       56,405       (159 )     (224 )     60,268       56,181  
 
                                             
$ 116     $ 151                 $ 116     $ 151  
  17.87 %     17.91 %     N/M       N/M       15.82 %     15.36 %
 
  13,508       13,246       6,466       6,262       19,974       19,508  
 

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Supplementary information (Community Banking lines of business)
                                 
Three months ended September 30,   Regional Banking     Commercial Banking  
dollars in millions   2006     2005     2006     2005  
 
Total revenue (TE)
  $ 570     $ 556     $ 101     $ 103  
Provision for loan losses
    27       19       (5 )     7  
Noninterest expense
    420       406       50       49  
Net income
    77       82       35       29  
Average loans and leases
    18,722       19,093       8,015       8,038  
Average deposits
    43,405       41,126       3,582       3,579  
Net loan charge-offs
    19       23       3       2  
Return on average allocated equity
    19.15 %     20.55 %     19.31 %     15.91 %
Average full-time equivalent employees
    8,761       8,420       319       323  
 
                                 
Nine months ended September 30,   Regional Banking     Commercial Banking  
dollars in millions   2006     2005     2006     2005  
 
Total revenue (TE)
  $ 1,681     $ 1,634     $ 297     $ 289  
Provision for loan losses
    73       70       (2 )     7  
Noninterest expense
    1,235       1,187       151       139  
Net income
    233       235       93       90  
Average loans and leases
    18,756       19,169       8,004       7,818  
Average deposits
    42,910       40,514       3,596       3,361  
Net loan charge-offs
    61       70       13       13  
Return on average allocated equity
    19.62 %     19.84 %     17.25 %     16.88 %
Average full-time equivalent employees
    8,642       8,385       319       320  
 
Supplementary information (National Banking lines of business)
                                                                 
Three months ended September 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 (TE)
  $ 169     $ 148     $ 137     $ 122     $ 188     $ 180     $ 137     $ 151  
Provision for loan losses
    14       4       4       5       (3 )     (5 )     (6 )     13  
Noninterest expense
    70       64       82       72       110       109       78       81  
Net income
    53       50       32       28       50       48       41       35  
Average loans and leasesa
    12,854       11,265       10,108       9,133       7,377       7,316       8,428       9,358  
Average loans held for salea
    1,022       603       6             455             4,709       2,908  
Average deposits
    3,598       2,100       19       14       6,704       4,986       747       685  
Net loan charge-offs (recoveries)
                12       11       (1 )           10       13  
Return on average allocated equity
    18.64 %     19.60 %     14.73 %     14.32 %     18.10 %     18.03 %     18.09 %     15.58 %
Average full-time equivalent employees
    970       812       927       966       1,305       1,255       1,371       1,385  
 
                                                                 
Nine months ended September 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 (TE)
  $ 498     $ 389     $ 397     $ 375     $ 578     $ 524     $ 414     $ 487  
Provision for loan losses
    28       4       25       6       (34 )     (16 )     4       36  
Noninterest expense
    207       166       240       220       330       298       241       267  
Net income
    164       137       83       93       176       151       106       115  
Average loans and leasesa
    12,682       10,557       9,851       8,993       7,595       7,785       9,370       9,455  
Average loans held for salea
    765       432       16             237             3,563       3,213  
Average deposits
    3,428       1,783       16       12       6,394       4,896       722       639  
Net loan charge-offs (recoveries)
    4       7       18       14       (6 )     9       26       38  
Return on average allocated equity
    19.65 %     18.67 %     13.16 %     16.09 %     21.69 %     18.73 %     15.73 %     16.55 %
Average full-time equivalent employees
    977       781       926       982       1,264       1,221       1,340       1,518  
 
(a)   On August 1, 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business. This transfer reduced average home equity loans and increased average loans held for sale by approximately $1.6 billion for the third quarter of 2006 and approximately $550 million for the first nine months of 2006.
TE = Taxable Equivalent

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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 ($817 million at September 30, 2006, $850 million at December 31, 2005, and $1.1 billion at September 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 ¾ investments in equity and mezzanine instruments made by Key’s Principal Investing unit ¾ 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 ($843 million at September 30, 2006, and $800 million at December 31, 2005, and September 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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    September 30, 2006  
            Gross     Gross        
    Amortized     Unrealized     Unrealized     Fair  
in millions   Cost     Gains     Losses     Value  
 
SECURITIES AVAILABLE FOR SALE
                               
U.S. Treasury, agencies and corporations
  $ 220                 $ 220  
States and political subdivisions
    16     $ 1             17  
Collateralized mortgage obligations
    6,762       13     $ 125       6,650  
Other mortgage-backed securities
    210       2       3       209  
Retained interests in securitizations
    122       35             157  
Other securities
    179       9             188  
 
Total securities available for sale
  $ 7,509     $ 60     $ 128     $ 7,441  
 
                       
 
                               
 
INVESTMENT SECURITIES
                               
States and political subdivisions
  $ 26     $ 1           $ 27  
Other securities
    15                   15  
 
Total investment securities
  $ 41     $ 1           $ 42  
 
                         
 
                               
 
                                 
    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  
 
                         
 
                               
 
                                 
    September 30, 2005  
            Gross     Gross        
    Amortized     Unrealized     Unrealized     Fair  
in millions   Cost     Gains     Losses     Value  
 
SECURITIES AVAILABLE FOR SALE
                               
U.S. Treasury, agencies and corporations
  $ 283                 $ 283  
States and political subdivisions
    19                   19  
Collateralized mortgage obligations
    6,390     $ 1     $ 125       6,266  
Other mortgage-backed securities
    255       6       3       258  
Retained interests in securitizations
    98       73             171  
Other securities
    120       7             127  
 
Total securities available for sale
  $ 7,165     $ 87     $ 128     $ 7,124  
 
                       
 
                               
 
INVESTMENT SECURITIES
                               
States and political subdivisions
  $ 42     $ 1           $ 43  
Other securities
    56                   56  
 
Total investment securities
  $ 98     $ 1           $ 99  
 
                         
 
                               
 

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6. Loans and Loans Held for Sale
Key’s loans by category are summarized as follows:
                         
    September 30,     December 31,     September 30,  
in millions   2006     2005     2005  
 
Commercial, financial and agricultural a
  $ 21,556     $ 20,579     $ 19,451  
Commercial real estate:
                       
Commercial mortgage
    8,266       8,360       8,618  
Construction
    8,272       7,109       6,700  
 
Total commercial real estate loans
    16,538       15,469       15,318  
Commercial lease financing a
    9,860       10,352       10,339  
 
Total commercial loans
    47,954       46,400       45,108  
Real estate — residential mortgage
    1,407       1,458       1,476  
Home equity b
    10,988       13,488       13,872  
Consumer — direct
    1,576       1,794       1,792  
Consumer — indirect:
                       
Marine
    2,982       2,715       2,676  
Other
    644       623       651  
 
Total consumer — indirect loans
    3,626       3,338       3,327  
 
Total consumer loans
    17,597       20,078       20,467  
 
Total loans
  $ 65,551     $ 66,478     $ 65,575  
 
                 
 
                       
 
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.
 
(b)   On August 1, 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business.
Key’s loans held for sale by category are summarized as follows:
                         
    September 30,     December 31,     September 30,  
in millions   2006     2005     2005  
 
Commercial, financial and agricultural
  $ 219     $ 85        
Real estate — commercial mortgage
    1,062       525     $ 416  
Real estate — construction
    198       51       5  
Commercial lease financing
    2              
Real estate — residential mortgage
    21       11       21  
Home equity a
    2,485             1  
Education
    3,147       2,687       3,123  
Automobile
    16       22       29  
 
Total loans held for sale
  $ 7,150     $ 3,381     $ 3,595  
 
                 
 
                       
 
(a)   On August 1, 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business.

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Changes in the allowance for loan losses are summarized as follows:
                                 
    Three months ended
September 30,
    Nine months ended
September 30,
 
in millions   2006     2005     2006     2005  
 
Balance at beginning of period
  $ 956     $ 1,100     $ 966     $ 1,138  
Charge-offs
    (70 )     (69 )     (194 )     (222 )
Recoveries
    27       20       78       71  
 
Net loans charged off
    (43 )     (49 )     (116 )     (151 )
Provision for loan losses
    31       43       94       107  
Foreign currency translation adjustment
          (1 )           (1 )
 
Balance at end of period
  $ 944     $ 1,093     $ 944     $ 1,093  
 
                       
 
                               
 
Changes in the allowance for credit losses on lending-related commitments are summarized as follows:
                                 
    Three months ended
September 30,
    Nine months ended
September 30,
 
in millions   2006     2005     2006     2005  
 
Balance at beginning of period
  $ 59     $ 57     $ 59     $ 66  
Provision (credit) for losses on lending-related commitments
          2             (7 )
 
Balance at end of period a
  $ 59     $ 59     $ 59     $ 59  
 
                       
 
                               
 
(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  
 
September 30, 2006
                       
Commercial paper conduit
  $ 190       N/A       N/A  
Low-income housing tax credit (“LIHTC”) funds
    353     $ 190        
LIHTC investments
    N/A       741     $ 219  
 
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 September 30, 2006, the settlement value of these noncontrolling interests was estimated to be between $377 million and $448 million, while the recorded value, including reserves, totaled $346 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”)

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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.
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 $122 million at September 30, 2006, compared to $105 million at December 31, 2005, and $194 million at September 30, 2005. Impaired loans averaged $121 million for the third quarter of 2006 and $141 million for the third quarter of 2005.
Key’s nonperforming assets and past due loans were as follows:
                         
    September 30,     December 31,     September 30,  
in millions   2006     2005     2005  
 
Impaired loans
  $ 122     $ 105     $ 194  
Other nonaccrual loans a
    101       172       166  
 
Total nonperforming loans
    223       277       360  
 
                       
Nonperforming loans held for sale a
    56       3       2  
 
                       
Other real estate owned (“OREO”)
    52       25       29  
Allowance for OREO losses
    (3 )     (2 )     (3 )
 
OREO, net of allowance
    49       23       26  
Other nonperforming assets
    1       4       5  
 
Total nonperforming assets
  $ 329     $ 307     $ 393  
 
                 
 
                       
 
Impaired loans with a specifically allocated allowance
  $ 27     $ 9     $ 8  
Allowance for loan losses allocated to impaired loans
    12       6       4  
 
Accruing loans past due 90 days or more
  $ 125     $ 90     $ 94  
Accruing loans past due 30 through 89 days
    715       491       550  
 
                       
 
(a)   On August 1, 2006, Key transferred approximately $55 million of home equity loans from nonperforming loans to nonperforming loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business.
At September 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

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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.
To the extent the trusts have funds available to make payments, KeyCorp continues to unconditionally guarantee payment of:
w   required distributions on the capital securities;
 
w   the redemption price when a capital security is redeemed; and
 
w   amounts due if a trust is liquidated or terminated.
During the first nine 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 debentures held by the KeyCorp Institutional Capital A and KeyCorp Institutional Capital B trusts are redeemable at the option of KeyCorp, at a premium, on or after December 1, 2006, and December 15, 2006, respectively. The capital securities are subject to mandatory redemption upon repayment of the debentures. KeyCorp intends to exercise its option to redeem the debentures held by the Capital A and Capital B trusts as soon as possible in order to minimize interest expense. Management has determined that KeyCorp will remain well-capitalized following the redemptions.
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  
 
September 30, 2006
                                       
KeyCorp Institutional Capital A
  $ 364     $ 11     $ 361       7.826 %     2026  
KeyCorp Institutional Capital B
    157       4       154       8.250       2026  
KeyCorp Capital I
    197       8       205       6.248       2028  
KeyCorp Capital II
    176       8       165       6.875       2029  
KeyCorp Capital III
    225       8       197       7.750       2029  
KeyCorp Capital V
    161       5       180       5.875       2033  
KeyCorp Capital VI
    72       2       77       6.125       2033  
KeyCorp Capital VII
    226       8       258       5.700       2035  
KeyCorp Capital VIII
    252             250       7.000       2066  
 
Total
  $ 1,830     $ 54     $ 1,847       6.977 %      
 
                                 
 
December 31, 2005
  $ 1,617     $ 54     $ 1,597       6.794 %      
 
                                 
 
September 30, 2005
  $ 1,633     $ 54     $ 1,597       6.729 %      
 
                                 
 
(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 September 30, 2006, December 31, 2005, and September 30, 2005, are basis adjustments of $37 million, $74 million and $90 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 September 30, 2006, December 31, 2005, and September 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 $48 million and $57 million for the nine-month periods ended September 30, 2006 and 2005, respectively. The total income tax benefit recognized in the income statement for these plans was $18 million and $21 million for the nine-month periods ended September 30, 2006 and 2005, respectively. 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 September 30, 2006, KeyCorp had 67,945,891 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 market 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 nine-month periods ended September 30, 2006 and 2005, are shown in the following table.
                 
    Nine months ended September 30,  
    2006     2005  
 
Average option life
  6.0 years     5.0 years  
Future dividend yield
    3.79 %     3.79 %
Historical share price volatility
    .199       .274  
Weighted-average risk-free interest rate
    5.0 %     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.
The following table summarizes activity, pricing and other information for Key’s stock options for the nine-month period ended September 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)     Value a  
 
Outstanding at December 31, 2005
    37,265,859     $ 28.35                  
Granted
    6,570,364       36.38                  
Exercised
    (7,928,899 )     26.90                  
Lapsed or canceled
    (889,383 )     31.49                  
                 
Outstanding at September 30, 2006
    35,017,941     $ 30.11       6.6     $ 257  
 
                             
 
Expected to vest
    31,582,749     $ 29.80       6.7     $ 241  
 
Exercisable at September 30, 2006
    22,103,729     $ 27.82       5.7     $ 213  
 
(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 nine-month periods ended September 30, 2006 and 2005, was $6.32 and $6.92, respectively. The total intrinsic value of options exercised during the nine-month periods ended September 30, 2006 and 2005, was $76 million and $30 million, respectively. As of September 30, 2006, unrecognized compensation cost related to nonvested options expected to vest under the plans totaled $37 million. Management expects to recognize this cost over a weighted-average period of 2.4 years.
The actual tax benefit realized for the tax deductions from options exercised totaled $24 million and $9 million for the nine-month periods ended September 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 nine-month period ended September 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  
 
Oustanding at December 31, 2005
    476,034     $ 31.43       1,190,458     $ 31.05  
Granted
    222,797       35.42       738,002       33.51  
Vested
    (2,653 )     33.73       (180 )     35.42  
Forfeited
    (49,648 )     32.93       (85,116 )     31.79  
 
Outstanding at September 30, 2006
    646,530     $ 32.68       1,843,164     $ 31.99  
 
                           
 
                               
 
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 nine-month periods ended September 30, 2006 and 2005, was $33.95 and $32.28, respectively. As of September 30, 2006, unrecognized compensation cost related to nonvested shares expected to vest under the Program totaled $21 million. Management expects to recognize this cost over a weighted-average period of 1.9 years. The total fair value of shares vested during the nine-month period ended September 30, 2006, was $.1 million. There were no shares scheduled to vest during the nine-month period ended September 30, 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.
The following table summarizes activity and pricing information for the nonvested shares under these awards for the nine-month period ended September 30, 2006:
                 
            Weighted-  
    Number of     Average  
    Nonvested     Grant-Date  
    Shares     Fair Value  
 
Outstanding at December 31, 2005
    250,948     $ 28.78  
Granted
    13,379       33.22  
Vested
    (50,801 )     27.45  
Forfeited
    (7,200 )     27.77  
 
Outstanding at September 30, 2006
    206,326     $ 29.49  
 
             
 
               
 

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The weighted-average grant-date fair value of awards granted during the nine-month periods ended September 30, 2006 and 2005, was $33.22 and $31.68, respectively. As of September 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 1.8 years. The total fair value of restricted stock vested during the nine-month periods ended September 30, 2006 and 2005, was $2 million and $.4 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 $2 million were paid during the nine-month periods ended September 30, 2006 and 2005. 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 nine-month period ended September 30, 2006:
                 
    Number of     Weighted-Average  
    Nonvested     Grant-Date  
    Shares     Fair Value  
 
Outstanding at December 31, 2005
    809,824     $ 31.74  
Granted
    687,217       36.37  
Dividend equivalents
    94,729       36.62  
Vested
    (580,818 )     32.72  
Forfeited
    (53,900 )     33.29  
 
Outstanding at September 30, 2006
    957,052     $ 34.87  
 
             
 
               
 
The weighted-average grant-date fair value of awards granted during the nine-month periods ended September 30, 2006 and 2005, was $36.37 and $32.92, respectively. As of September 30, 2006, unrecognized compensation cost related to nonvested shares expected to vest under Key’s deferred compensation plans totaled $12 million. Management expects to recognize this cost over a weighted-average period of 2.4 years. The total fair value of shares vested during the nine-month periods ended September 30, 2006 and 2005, was $21 million and $20 million, respectively.
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 nine-month period ended September 30, 2006, Key issued 102,458 shares at a weighted-average cost of $35.86. During the nine-month period ended September 30, 2005, Key issued 107,898 shares at a weighted-average cost of $33.07.
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.

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11. Employee Benefits
Pension Plans
Net pension cost for all funded and unfunded plans includes the following components:
                                 
    Three months ended     Nine months ended  
    September 30,     September 30,  
in millions   2006     2005     2006     2005  
 
Service cost of benefits earned
  $ 12     $ 20     $ 36     $ 37  
Interest cost on projected benefit obligation
    13       22       41       43  
Expected return on plan assets
    (22 )     (39 )     (66 )     (70 )
Amortization of prior service benefit
                      (1 )
Amortization of losses
    8       9       23       17  
 
Net pension cost
  $ 11     $ 12     $ 34     $ 26  
 
                       
 
                               
 
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     Nine months ended  
    September 30,     September 30,  
in millions   2006     2005     2006     2005  
 
Service cost of benefits earned
  $ 1     $ 1     $ 4     $ 3  
Interest cost on accumulated postretirement benefit obligation
    2       2       6       6  
Expected return on plan assets
    (1 )     (1 )     (3 )     (3 )
Amortization of unrecognized transition obligation
    1       1       3       3  
Amortization of cumulative net loss
    1             2       2  
 
Net postretirement benefit cost
  $ 4     $ 3     $ 12     $ 11  
 
                       
 
                               
 
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.
Employee Benefits-Related Accounting Pronouncement Pending Adoption
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires an employer to recognize an asset or liability for the overfunded or underfunded status, respectively, of its defined benefit plans. The overfunded or underfunded status is to be measured solely as the difference between the fair value of plan assets and the projected benefit obligation. In addition, any change in a plan’s funded status must be recognized in comprehensive income in the year in which it occurs. Most requirements of SFAS No. 158 will be effective for fiscal years ending after December 15, 2006 (effective December 31, 2006, for Key). However, the requirement to measure plan assets and liabilities as of the end of an employer’s fiscal year will not be effective until fiscal years ending after December 15, 2008 (effective December 31, 2008, for Key). Management estimates that Key will record an after-tax charge of approximately $145 million to the accumulated other comprehensive loss component of shareholders’ equity as a result of adopting this guidance for the year ending December 31, 2006. For more information about Key’s defined benefit plans, see Note 16 (“Employee Benefits”), which begins on page 78 of Key’s 2005 Annual Report to Shareholders.

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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 Key entered into these transactions. 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. Such an outcome 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 period it occurs.

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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. This guidance will be effective for fiscal years beginning after December 15, 2006 (effective January 1, 2007, for Key). Management currently estimates that the adoption of this guidance will result in a cumulative after-tax charge to Key’s retained earnings in the range of $50 million to $65 million. However, future earnings are expected to increase over the remaining term of the affected leases by a similar amount.
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 filed 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 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

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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 September 29, 2006, the Court ruled on Key’s and Swiss Re’s motions for summary judgment on damages and other issues. In its written decision, which is publicly available, the Court dismissed Swiss Re’s affirmative defenses that Key had failed to mitigate its damages and that Key had committed fraud in its submission of claims. The Court also substantially upheld Key’s damages claims for losses under the Policies, previously estimated by Key to be in the range of approximately $342 million to $357 million.
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. Key has completed the process of submitting insurance claims for its losses to Swiss Re.
In addition to seeking recovery of residual value losses under the Policies, Key expects to seek recovery of interest, damages on Key’s claim that Swiss Re acted in bad faith, and other damages attributable to Swiss Re’s denial of coverage. The precise amount of those damages will be determined through further legal proceedings.
As previously reported, Key has recorded on its balance sheet a portion of the amount of the insurance claims as a receivable. Management continues to believe 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 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 period 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, would reasonably be expected to have a material adverse effect on Key’s financial condition.

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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 to Key is included in Note 12 (“Income Taxes”) under the heading “Lease Financing Transactions” on page 27.
Guarantees
Key is a guarantor in various agreements with third parties. The following table shows the types of guarantees that Key had outstanding at September 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
  $ 12,944     $ 34  
Credit enhancement for asset-backed commercial paper conduit
    28        
Recourse agreement with FNMA
    630       8  
Return guarantee agreement with LIHTC investors
    448       41  
Default guarantees
    11       1  
Written interest rate capsa
    71       7  
 
Total
  $ 14,132     $ 91  
 
           
 
(a)   As of September 30, 2006, the weighted-average interest rate of written interest rate caps was 5.1%, and the weighted-average strike rate was 5.2%. 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 September 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 21, 2007, 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.
At September 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 nine-month period ended September 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

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losses in an amount estimated by management to approximate the fair value of KBNA’s liability. At September 30, 2006, the outstanding commercial mortgage loans in this program had a weighted-average remaining term of 8.2 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 September 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 30, KAHC maintained a reserve in the amount of $41 million at September 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 FASB 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 September 30, 2006, these caps had a weighted-average life of 2.4 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.
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 FASB Interpretation No. 45 and from other relationships.
Significant liquidity facilities that support asset-backed commercial paper conduits. Key provides liquidity to two asset-backed commercial paper conduits that are separately owned by third parties and administered by unaffiliated financial institutions. These liquidity facilities obligate Key through November 5, 2008, and September 27, 2007, to provide funding of up to $1.0 billion and $287 million, respectively, if required as a result of a disruption in credit markets or other factors that preclude the issuance of

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commercial paper by the conduits. The amounts available to be drawn, which are based on the amount of current commitments to borrowers in each of the conduits, were $296 million and $284 million, respectively, at September 30, 2006, but there were no drawdowns under these committed facilities at that time. Key’s commitments to provide liquidity are 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 interest rate swaps and caps, and foreign exchange forward contracts held are over-the-counter instruments. Generally, these instruments help Key manage exposure to market risk, mitigate the credit risk inherent in our loan portfolio and meet client’s financing needs. Market risk represents the possibility that economic value or net interest income will be adversely affected by changes in interest rates or other economic factors.
At September 30, 2006, Key had $111 million of derivative assets and $80 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 $804 million and $764 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.
At September 30, 2006, Key was party to derivative contracts with 53 different counterparties. These derivatives include interest rate swaps and caps, credit derivatives, energy derivatives and foreign exchange contracts. Among these were contracts entered into to offset the risk of client exposure. Key had aggregate exposure of $173 million on these instruments to 24 of the 53 counterparties. However, at September 30, 2006, Key held approximately $83 million in pooled collateral to mitigate the credit exposure associated with all of its derivative contracts, resulting in net exposure of $90 million. The largest exposure to an individual counterparty was approximately $37 million, of which Key secured approximately $17 million in collateral.

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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     September 30,  
in millions   2005     Hedging Activity     Net Income     2006  
 
Accumulated other comprehensive loss resulting from cash flow hedges
  $ (31 )   $ 2     $ (1 )   $ (30 )
 
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 $9 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. At September 30, 2006, the notional amount of credit default swaps purchased by Key was $904 million. Key also provides credit protection through the sale of credit default swaps. These transactions generate fee income and can also be used to diversify overall exposure to credit loss. At September 30, 2006, the notional amount of credit default swaps sold by Key was $25 million.
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 or received for the protection, are included in the trading income component of noninterest income. 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 $14 million at September 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 September 30, 2006 and 2005, and the related condensed consolidated statements of income for the three-month and nine-month periods then ended, and the condensed consolidated statements of changes in shareholders’ equity and cash flow for the nine-month periods ended September 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
November 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 September 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 33. 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 12.
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 58.
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 nine months of 2006 grew by 10% relative to the same period last year. This improvement was accomplished by growing revenue faster than expenses. The growth in earnings also reflected a 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. 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 411,028,805 shares for the first nine months of 2006 from 414,510,144 shares for the first nine months 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 year 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, 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 nine 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. However, as described in the section entitled “Allowance for loan losses,” which begins on page 65, during the third quarter of 2006, Key revised its methodology for allocating the allowance for loan losses by loan type within each of its specific lines of business. No new critical accounting policies were adopted during the current year.
Highlights of Key’s Performance
Financial performance
The primary measures of Key’s financial performance for the three-month periods ended September 30, 2006, June 30, 2006, and September 30, 2005, and for the nine-month periods ended September 30, 2006 and 2005, are summarized below.
     
¨
  Net income for the third quarter of 2006 was $312 million, or $.76 per common share, compared to $308 million, or $.75 per share, for the previous quarter and $278 million, or $.67 per share, for the third quarter of 2005. For the first nine months of 2006, net income was $909 million, or $2.21 per common share, compared to $833 million, or $2.01 per share, for the first nine months of 2005.
 
   
¨
  Key’s return on average equity was 15.88% for the third quarter of 2006, compared to a return of 16.11% for the prior quarter and 14.84% for the year-ago quarter. For the first nine months of 2006, Key’s return on average equity was 15.82%, compared to 15.36% for the first nine months of 2005.
 
   
¨
  Key’s third quarter 2006 return on average total assets was 1.30%, compared to a return of 1.32% for the previous quarter and 1.22% for the third quarter of 2005. For the first nine months of 2006, Key’s return on average total assets was 1.29%, compared to 1.23% 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 third quarter:
     
¨
  Total revenue rose by $49 million from the third quarter of 2005, due largely to solid commercial loan growth, higher income from our fee-based businesses and growth in average core deposits, which increased 8% from the third quarter of 2005. The growth in our commercial loan portfolio was

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  geographically broad-based and spread among a number of industry sectors. The increase in fee income was attributable to a variety of sources, including trust and investment services income, income from operating leases, electronic banking fees, credit card fees and several other revenue components.
 
   
¨
  We continued to make progress in strengthening our compliance and operations infrastructure designed to detect and prevent money laundering in accordance with the requirements of the Bank Secrecy Act.
 
   
¨
  Asset quality remained solid. Both nonperforming assets and net loan charge-offs were down from the year-ago quarter. For the third quarter of 2006, net loan charge-offs represented .25% of Key’s average total loans.
 
   
¨
  Our noninterest expense grew by $27 million from the third quarter of 2005, due primarily to higher personnel costs, increases in marketing and operating lease expense, and a $10 million contribution made to Key Foundation during the third quarter of 2006.
Further, we continue to effectively manage our capital through dividends paid to shareholders, share repurchases, and investing in our higher-growth businesses. During the third quarter, Key repurchased 2,500,000 of its common shares. At September 30, 2006, Key’s tangible equity to tangible assets ratio was 6.81%.
Considering recent trends, we expect Key’s earnings to be in the range of $.72 to $.76 per share for the fourth quarter of 2006.
The primary reasons that Key’s revenue and expense components changed from those reported for the three- and nine-month periods ended September 30, 2005, are reviewed in greater detail throughout the remainder of the Management’s Discussion & Analysis section.
Strategic developments
Key’s 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 September 6, 2006, we entered into an agreement to sell our McDonald Investments branch network to UBS Financial Services Inc., a subsidiary of UBS AG. This network includes approximately 340 financial advisors in addition to the field support staff who work in fourteen states. The sale is expected to be completed in the first quarter of 2007.
 
   
¨
  On August 1, 2006, we announced our intention to pursue a sale of the Champion Mortgage finance business.
 
   
¨
  On April 1, 2006, we broadened our asset management product line by acquiring Austin Capital Management, Ltd., 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, 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.

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Figure 1 summarizes Key’s financial performance for each of the past five quarters.
Figure 1. Selected Financial Data
                                                         
                                               
    2006     2005     Nine months ended
September 30,
 
dollars in millions, except per share amounts   Third     Second     First     Fourth     Third     2006     2005  
 
FOR THE PERIOD
                                                       
Interest income
  $ 1,444     $ 1,381     $ 1,312     $ 1,262     $ 1,174     $ 4,137     $ 3,355  
Interest expense
    714       651       584       544       481       1,949       1,283  
Net interest income
    730       730       728       718       693       2,188       2,072  
Provision for loan losses
    31       24       39       36       43       94       107  
Noninterest income
    543       547       481       561       531       1,571       1,517  
Noninterest expense
    808       816       770       834       781       2,394       2,303  
Income before income taxes and cumulative effect of accounting change
    434       437       400       409       400       1,271       1,179  
Income before cumulative effect of accounting change
    312       308       284       296       278       904       833  
Net income
    312       308       289       296       278       909       833  
 
PER COMMON SHARE
                                                       
Income before cumulative effect of accounting change
  $ .77     $ .76     $ .70     $ .72     $ .68     $ 2.23     $ 2.04  
Net income
    .77       .76       .71       .72       .68       2.24       2.04  
Income before cumulative effect of accounting change — assuming dilution
    .76       .75       .69       .72       .67       2.20       2.01  
Net income — assuming dilution
    .76       .75       .70       .72       .67       2.21       2.01  
Cash dividends declared
    .345       .345       .345       .325       .325       1.035       .975  
Book value at period end
    19.73       19.21       18.85       18.69       18.41       19.73       18.41  
Market price:
                                                       
High
    38.15       38.31       37.67       34.05       35.00       38.31       35.00  
Low
    34.48       34.24       32.68       30.10       31.65       32.68       31.00  
Close
    37.44       35.68       36.80       32.93       32.25       37.44       32.25  
Weighted-average common shares outstanding (000)
    403,780       404,528       407,386       408,431       410,456       405,218       409,166  
Weighted-average common shares and potential common shares outstanding (000)
    409,428       410,559       413,140       412,542       415,441       411,029       414,510  
 
AT PERIOD END
                                                       
Loans
  $ 65,551     $ 67,408     $ 66,980     $ 66,478     $ 65,575     $ 65,551     $ 65,575  
Earning assets
    83,132       81,737       81,087       80,143       80,096       83,132       80,096  
Total assets
    96,155       94,794       93,391       93,126       92,323       96,155       92,323  
Deposits
    61,429       60,838       59,402       58,765       58,071       61,429       58,071  
Long-term debt
    13,654       14,050       14,032       13,939       14,037       13,654       14,037  
Shareholders’ equity
    7,947       7,737       7,638       7,598       7,522       7,947       7,522  
 
PERFORMANCE RATIOS
                                                       
Return on average total assets
    1.30 %     1.32 %     1.26 %     1.27 %     1.22 %     1.29 %     1.23 %
Return on average equity
    15.88       16.11       15.48       15.59       14.84       15.82       15.36  
Net interest margin (taxable equivalent)
    3.63       3.69       3.77       3.71       3.67       3.69       3.68  
 
CAPITAL RATIOS AT PERIOD END
                                                       
Equity to assets
    8.26 %     8.16 %     8.18 %     8.16 %     8.15 %     8.26 %     8.15 %
Tangible equity to tangible assets
    6.81       6.68       6.71       6.68       6.68       6.81       6.68  
Tier 1 risk-based capital
    8.02       7.90       7.64       7.59       7.72       8.02       7.72  
Total risk-based capital
    12.13       12.08       11.91       11.47       11.83       12.13       11.83  
Leverage
    8.89       8.82       8.52       8.53       8.60       8.89       8.60  
 
TRUST AND BROKERAGE ASSETS
                                                       
Assets under management
  $ 84,060     $ 80,349     $ 79,558     $ 77,144     $ 76,341     $ 84,060     $ 76,341  
Nonmanaged and brokerage assets
    55,221       57,682       56,944       56,509       57,313       55,221       57,313  
 
OTHER DATA
                                                       
Average full-time equivalent employees
    20,264       19,931       19,694       19,417       19,456       19,974       19,508  
KeyCenters
    949       946       945       947       946       949       946  
 

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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 12. 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 nine-month periods ended September 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                     Nine months ended        
    September 30,     Change     September 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Revenue (taxable equivalent)
                                                               
Community Banking
  $ 671     $ 659     $ 12       1.8 %   $ 1,978     $ 1,923     $ 55       2.9 %
National Banking
    631       601       30       5.0       1,887       1,775       112       6.3  
Other Segments
    25       25                   39       53       (14 )     (26.4 )
 
Total segments
    1,327       1,285       42       3.3       3,904       3,751       153       4.1  
Reconciling items
    (33 )     (28 )     (5 )     (17.9 )     (74 )     (71 )     (3 )     (4.2 )
 
Total
  $ 1,294     $ 1,257     $ 37       2.9 %   $ 3,830     $ 3,680     $ 150       4.1 %
 
                                                   
Net income (loss)
                                                               
Community Banking
  $ 112     $ 111     $ 1       .9 %   $ 326     $ 325     $ 1       .3 %
National Banking
    176       161       15       9.3       529       496       33       6.7  
Other Segments
    20       21       (1 )     (4.8 )     39       48       (9 )     (18.8 )
 
Total segments
    308       293       15       5.1       894       869       25       2.9  
Reconciling items
    4       (15 )     19       N/M       15       (36 )a     51       N/M  
 
Total
  $ 312     $ 278     $ 34       12.2 %   $ 909     $ 833     $ 76       9.1 %
 
                                                   
 
(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 $112 million for the third quarter of 2006, up slightly from $111 million for the year-ago quarter. Growth in net interest income, a decrease in the provision for loan losses and a slight rise in noninterest income were substantially offset by an increase in noninterest expense.
Taxable-equivalent net interest income increased by $11 million, or 3%, from the third quarter of 2005, due to growth in average deposits, which also experienced a more favorable interest rate spread. The positive effects of these factors were moderated by a reduction in, and a tighter interest rate spread on, earning assets.
The provision for loan losses decreased by $4 million, or 15%, as a result of an improved credit risk profile.
Noninterest expense rose by $15 million, or 3%. Increases in personnel expense and various indirect charges caused the rise.

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During the third quarter of 2006, Key entered into an agreement to sell the McDonald Investments branch network to UBS Financial Services Inc., a subsidiary of UBS AG. This network includes approximately 340 financial advisors in addition to the field support staff who work in fourteen states. The sale is expected to be completed in the first quarter of 2007.
Figure 3. Community Banking
                                                                 
                                   
    Three months ended
September 30,
    Change     Nine months ended
September 30,
    Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Summary of operations
                                                               
Net interest income (TE)
  $ 443     $ 432     $ 11       2.5 %   $ 1,311     $ 1,260     $ 51       4.0 %
Noninterest income
    228       227       1       .4       667       663       4       .6  
 
Total revenue (TE)
    671       659       12       1.8       1,978       1,923       55       2.9  
Provision for loan losses
    22       26       (4 )     (15.4 )     71       77       (6 )     (7.8 )
Noninterest expense
    470       455       15       3.3       1,386       1,326       60       4.5  
 
Income before income taxes (TE)
    179       178       1       .6       521       520       1       .2  
Allocated income taxes and TE adjustments
    67       67                   195       195              
 
Net income
  $ 112     $ 111     $ 1       .9 %   $ 326     $ 325     $ 1       .3 %
 
                                                   
 
                                                               
Percent of consolidated net income
    36 %     40 %     N/A       N/A       36 %     39 %     N/A       N/A  
 
                                                               
Average balances
                                                               
Loans and leases
  $ 26,737     $ 27,131     $ (394 )     (1.5 )%   $ 26,760     $ 26,987     $ (227 )     (.8 )%
Total assets
    29,718       30,026       (308 )     (1.0 )     29,736       29,916       (180 )     (.6 )
Deposits
    46,987       44,705       2,282       5.1       46,506       43,875       2,631       6.0  
 
TE = Taxable Equivalent, N/A = Not Applicable
Additional Community Banking Data
                                                                 
                               
    Three months ended
September 30,
    Change     Nine months ended
September 30,
    Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Average deposits outstanding
                                                               
Noninterest-bearing
  $ 8,111     $ 8,411     $ (300 )     (3.6 )%   $ 8,100     $ 8,148     $ (48 )     (.6 )%
Money market and other savings
    22,390       21,448       942       4.4       22,299       21,080       1,219       5.8  
Time
    16,486       14,846       1,640       11.0       16,107       14,647       1,460       10.0  
 
Total deposits
  $ 46,987     $ 44,705     $ 2,282       5.1 %   $ 46,506     $ 43,875     $ 2,631       6.0 %
 
                                                   
 
                                                               
 
Home equity loans
                                                               
Average balance
  $ 10,048     $ 10,365                                                  
Weighted-average loan-to-value ratio
    70 %     71 %                                                
Percent first lien positions
    60       61                                                  
                                                 
Other data
                                                               
On-line households / household penetration
    646,993 / 52 %     607,127 / 49 %                                                
KeyCenters
    949       946                                                  
Automated teller machines
    2,099       2,185                                                  
                                                 
National Banking
As shown in Figure 4, net income for National Banking was $176 million for the third quarter of 2006, up from $161 million for the same period last year. The improvement was due primarily to higher net interest income and a decrease in the provision for loan losses, offset in part by a rise in the level of noninterest expense.
Taxable-equivalent net interest income grew by $27 million, or 8%, from the third quarter of 2005, reflecting strong growth in deposits, as well as average loans and leases. Deposits rose by $3.3 billion, or 42%, from the third quarter of 2005. Average loans and leases grew by $1.7 billion, or 5%, due largely to increases in the Real Estate Capital and Equipment Finance lines of business. The positive effects of these factors were moderated by tighter interest rate spreads on average earning assets in the Equipment Finance and Consumer Finance lines.
Noninterest income rose by $3 million, or 1%. Higher income from operating leases, trust and investment services, and a number of other fee-based services were moderated by reductions in income from dealer trading and derivatives, and other investments. In addition, Key recorded net losses from the sales of securities, compared to net gains in the same period one year ago.

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The provision for loan losses decreased by $8 million, or 47%, as a result of an improved credit risk profile.
Noninterest expense increased by $14 million, or 4%, reflecting higher costs associated with operating leases and various indirect charges.
In the current year, we have continued to take actions to improve our business mix and to support our focus on relationship businesses. During the third quarter, we announced our plans to pursue a sale of the Champion Mortgage finance business, and during the prior quarter, we expanded our asset management product line by acquiring Austin Capital Management, Ltd., an investment firm headquartered in Austin, Texas.
In addition, during the second half of 2005, we 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.
Figure 4. National Banking
                                                                 
    Three months ended                     Nine months ended        
    September 30,     Change     September 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Summary of operations
                                                               
Net interest income (TE)
  $ 375     $ 348     $ 27       7.8 %   $ 1,126     $ 1,051     $ 75       7.1 %
Noninterest income
    256       253       3       1.2       761       724       37       5.1  
 
Total revenue (TE)
    631       601       30       5.0       1,887       1,775       112       6.3  
Provision for loan losses
    9       17       (8 )     (47.1 )     23       30       (7 )     (23.3 )
Noninterest expense
    340       326       14       4.3       1,018       951       67       7.0  
 
Income before income taxes (TE)
    282       258       24       9.3       846       794       52       6.5  
Allocated income taxes and TE adjustments
    106       97       9       9.3       317       298       19       6.4  
 
Net income
  $ 176     $ 161     $ 15       9.3 %   $ 529     $ 496     $ 33       6.7 %
 
                                                   
 
                                                               
Percent of consolidated net income
    57 %     58 %     N/A       N/A       58 %     59 %     N/A       N/A  
 
                                                               
Average balances
                                                               
Loans and leasesa
  $ 38,767     $ 37,072     $ 1,695       4.6 %   $ 39,498     $ 36,790     $ 2,708       7.4 %
Loans held for salea
    6,192       3,511       2,681       76.4       4,581       3,645       936       25.7  
Total assets
    51,347       46,708       4,639       9.9       50,463       46,585       3,878       8.3  
Deposits
    11,068       7,785       3,283       42.2       10,560       7,330       3,230       44.1  
 
(a)   On August 1, 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business. This transfer reduced average home equity loans and increased average loans held for sale by approximately $1.6 billion for the third quarter of 2006 and approximately $550 million for the first nine months of 2006.
TE = Taxable Equivalent, N/A = Not Applicable
Other Segments
Other segments consist of Corporate Treasury and Key’s Principal Investing unit. These segments generated net income of $20 million for the third quarter of 2006, compared to $21 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 45 and 46, 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 third quarter of 2006 was $751 million, representing a $25 million, or 3%, increase from the year-ago quarter. The positive effects of a 5% increase in average earning assets, an 8% increase in average core deposits and a 4% rise in average noninterest-bearing funds, more than offset the effect of lower net interest margin, which decreased 4 basis points to 3.63%. (A basis point is equal to one one-hundredth of a percentage point, meaning 4 basis points equals .04%).
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 25 basis points from the third quarter of 2005 as a result of competitive pressure on loan and deposit pricing, and a change in deposit mix caused by a shift in consumer funds from money market deposit accounts to time deposits. Management expects these conditions and continuation of the flat-to-inverted yield curve to maintain pressure on the net interest margin. 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 third quarter of 2006 totaled $82.4 billion, which was $3.6 billion, or 5%, higher than the third quarter 2005 level, due primarily to a 7% rise in commercial 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 $1.6 billion during the first nine 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 $425 million ($90 million through securitizations) during the first nine months 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 $524 million during the first nine 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. In addition to these completed transactions, during the third quarter of 2006 Key announced its intention to pursue a sale of the Champion Mortgage finance business.

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Figure 5. Average Balance Sheets, Net Interest Income and Yields/Rates
                                                 
    Third Quarter 2006     Second Quarter 2006  
    Average           Yield/     Average             Yield/  
dollars in millions   Balance     Interest     Rate     Balance     Interest     Rate  
 
ASSETS
                                               
Loans a,b
                                               
Commercial, financial and agricultural c
  $ 21,648     $ 400       7.34 %   $ 21,970     $ 390       7.12 %
Real estate — commercial mortgage
    8,106       164       8.04       8,071       153       7.59  
Real estate — construction
    7,965       171       8.51       7,570       152       8.07  
Commercial lease financingc
    9,850       144       5.83       9,764       148       6.05  
 
Total commercial loans
    47,569       879       7.34       47,375       843       7.13  
Real estate — residential
    1,415       23       6.49       1,430       24       6.54  
Home equity d
    11,847       218       7.32       13,449       247       7.36  
Consumer — direct
    1,585       36       9.07       1,685       41       9.64  
Consumer — indirect
    3,594       61       6.83       3,503       57       6.66  
 
Total consumer loans
    18,441       338       7.31       20,067       369       7.37  
 
Total loans
    66,010       1,217       7.33       67,442       1,212       7.20  
Loans held for sale d
    6,201       131       8.40       3,844       73       7.64  
Investment securities a
    42       1       8.12       46       1       8.01  
Securities available for sale e
    7,216       84       4.61       7,075       84       4.71  
Short-term investments
    1,588       16       3.78       1,678       16       3.89  
Other investments e
    1,363       16       4.67       1,398       17       4.60  
 
Total earning assets
    82,420       1,465       7.06       81,483       1,403       6.89  
Allowance for loan losses
    (954 )                     (963 )                
Accrued income and other assets
    13,452                       13,341                  
 
 
                                               
Total assets
  $ 94,918                     $ 93,861                  
 
                                           
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                               
NOW and money market deposit accounts
  $ 25,230       194       3.05     $ 25,347       173       2.75  
Savings deposits
    1,700       1       .19       1,752       1       .20  
Certificates of deposit ($100,000 or more) f
    5,517       67       4.82       5,382       61       4.54  
Other time deposits
    11,700       127       4.29       11,456       115       4.02  
Deposits in foreign office
    4,139       54       5.22       3,429       42       4.88  
 
Total interest-bearing deposits
    48,286       443       3.64       47,366       392       3.32  
Federal funds purchased and securities sold under repurchase agreements
    3,634       45       4.88       3,005       34       4.60  
Bank notes and other short-term borrowings
    2,285       24       4.29       2,497       27       4.17  
Long-term debt f
    13,763       202       5.83       14,088       198       5.59  
 
Total interest-bearing liabilities
    67,968       714       4.17       66,956       651       3.89  
Noninterest-bearing deposits
    13,085                       13,027                  
Accrued expense and other liabilities
    6,068                       6,211                  
Shareholders’ equity
    7,797                       7,667                  
 
 
                                               
Total liabilities and shareholders’ equity
  $ 94,918                     $ 93,861                  
 
                                           
Interest rate spread (TE)
                    2.89 %                     3.00 %
 
Net interest income (TE) and net interest margin (TE)
            751       3.63 %             752       3.69 %
 
                                           
TE adjustment a
            21                       22          
 
Net interest income, GAAP basis
          $ 730                     $ 730          
 
                                           
 
(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)   On August 1, 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business. This transfer reduced average home equity loans and increased average loans held for sale by approximately $1.6 billion for the third quarter of 2006.
 
(e)   Yield is calculated on the basis of amortized cost.
 
(f)   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)

                                                                     
First Quarter 2006     Fourth Quarter 2005     Third Quarter 2005  
Average           Yield/     Average           Yield/     Average           Yield/  
Balance     Interest     Rate     Balance     Interest     Rate     Balance     Interest     Rate  
 
 
 
 
$ 21,720     $ 357       6.66 %   $ 19,992     $ 315       6.25 %   $ 19,249     $ 280       5.78 %
  8,089       144       7.23       8,580       151       6.98       8,467       136       6.42  
  7,312       138       7.66       6,896       129       7.42       6,388       110       6.81  
  9,581       143       5.98       10,285       154       6.01       10,161       158       6.19  
 
  46,702       782       6.78       45,753       749       6.51       44,265       684       6.15  
  1,450       23       6.33       1,460       23       6.22       1,472       23       6.13  
  13,433       238       7.19       13,767       242       7.00       13,888       236       6.72  
  1,730       41       9.66       1,785       44       9.68       1,794       40       8.96  
  3,367       57       6.66       3,340       56       6.71       3,339       56       6.67  
 
  19,980       359       7.26       20,352       365       7.13       20,493       355       6.86  
 
  66,682       1,141       6.92       66,105       1,114       6.70       64,758       1,039       6.37  
  3,692       68       7.44       3,592       64       7.05       3,521       56       6.43  
  61       1       6.34       95       1       5.81       76       1       7.00  
  7,148       83       4.61       7,034       84       4.77       7,131       84       4.65  
  1,753       22       5.10       2,091       19       3.53       1,972       15       3.15  
  1,336       25       7.13       1,297       10       3.09       1,342       12       3.25  
 
  80,672       1,340       6.70       80,214       1,292       6.40       78,800       1,207       6.08  
  (963 )                     (1,085 )                     (1,095 )                
  13,206                       13,077                       12,918                  
 
                                                                     
$ 92,915                     $ 92,206                     $ 90,623                  
                                                               
                                                                     
 
 
 
$ 24,452       145       2.40     $ 23,947       127       2.11     $ 22,886       101       1.75  
  1,812       1       .32       1,858       1       .27       1,952       2       .29  
                                                                     
  5,407       58       4.34       5,006       51       4.06       4,928       48       3.85  
  11,282       104       3.73       10,951       96       3.46       10,805       87       3.21  
  3,354       35       4.29       3,316       34       4.03       4,048       35       3.46  
 
  46,307       343       3.00       45,078       309       2.72       44,619       273       2.43  
                                                                     
  3,349       34       4.06       4,309       40       3.72       3,674       31       3.28  
 
  2,550       24       3.89       2,607       24       3.67       2,841       22       3.04  
  13,991       183       5.27       13,860       171       4.89       13,814       155       4.50  
 
  66,197       584       3.57       65,854       544       3.28       64,948       481       2.94  
  12,707                       12,594                       12,215                  
  6,438                       6,224                       6,027                  
  7,573                       7,534                       7,433                  
 
 
                                                                     
$ 92,915                     $ 92,206                     $ 90,623                  
                                                               
                  3.13 %                     3.12 %                     3.14 %
 
                                                                     
          756       3.77 %             748       3.71 %             726       3.67 %
                                                               
          28                       30                       33          
 
        $ 728                     $ 718                     $ 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 53, contains more discussion about changes in earning assets and funding sources.
Figure 6. Components of Net Interest Income Changes
                                                 
    From three months ended September 30, 2005     From nine months ended September 30, 2005  
    to three months ended September 30, 2006     to nine months ended September 30, 2006  
    Average     Yield/     Net     Average     Yield/     Net  
in millions   Volume     Rate     Change     Volume     Rate     Change  
 
INTEREST INCOME
                                               
Loans
  $ 21     $ 157     $ 178     $ 111     $ 533     $ 644  
Loans held for sale
    52       23       75       53       29       82  
Investment securities
    (1 )     1             (1 )     (1 )     (2 )
Securities available for sale
    1       (1 )                 7       7  
Short-term investments
    (3 )     4       1       (3 )     20       17  
Other investments
          4       4       (1 )     15       14  
 
Total interest income (taxable equivalent)
    70       188       258       159       603       762  
 
                                               
INTEREST EXPENSE
                                               
NOW and money market deposit accounts
    11       82       93       31       248       279  
Savings deposits
          (1 )     (1 )           (1 )     (1 )
Certificates of deposit ($100,000 or more)
    6       13       19       15       33       48  
Other time deposits
    8       32       40       18       82       100  
Deposits in foreign office
    1       18       19       (20 )     55       35  
 
Total interest-bearing deposits
    26       144       170       44       417       461  
Federal funds purchased and securities sold under repurchase agreements
          14       14       (15 )     47       32  
Bank notes and other short-term borrowings
    (5 )     7       2       (9 )     26       17  
Long-term debt
    (1 )     48       47       (7 )     163       156  
 
Total interest expense
    20       213       233       13       653       666  
 
Net interest income (taxable equivalent)
  $ 50     $ (25 )   $ 25     $ 146     $ (50 )   $ 96  
 
                                   
 
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 third quarter of 2006 was $543 million, compared to $531 million for the same period last year. For the first nine months of the year, noninterest income was $1.6 billion, representing an increase of $54 million, or 4%, from the first nine months of 2005.
As shown in Figure 7, the growth in noninterest income from the year-ago quarter was attributable to higher income from several of Key’s fee-based businesses and a $21 million increase in miscellaneous income, which resulted from a variety of factors. The overall increase in noninterest income was offset in part by reductions in income from dealer trading and derivatives, and other investments, both of which are included in investment banking and capital markets income. In addition, Key recorded net losses from the sales of securities, compared to net gains in the same period one year ago.
For the year-to-date period, the growth in noninterest income from the same period last year included increases of $25 million in operating lease income, $12 million in insurance income, $8 million in both electronic banking fees and net gains from principal investing, and a $13 million increase in miscellaneous income. These positive results were moderated by a $7 million reduction in net gains from the sales of securities and a $5 million decrease in investment banking and capital markets income.

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Figure 7. Noninterest Income
                                                                 
                                   
    Three months ended
September 30,
    Change     Nine months ended
September 30,
    Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Trust and investment services income
  $ 137     $ 135     $ 2       1.5 %   $ 411     $ 408     $ 3       .7 %
Service charges on deposit accounts
    78       82       (4 )     (4.9 )     227       228       (1 )     (.4 )
Investment banking and capital markets income
    44       62       (18 )     (29.0 )     163       168       (5 )     (3.0 )
Operating lease income
    58       47       11       23.4       166       141       25       17.7  
Letter of credit and loan fees
    48       46       2       4.3       133       133              
Corporate-owned life insurance income
    23       26       (3 )     (11.5 )     74       78       (4 )     (5.1 )
Electronic banking fees
    27       24       3       12.5       78       70       8       11.4  
Net gains from loan securitizations and sales
    14       12       2       16.7       34       41       (7 )     (17.1 )
Net securities gains (losses)
    (7 )     3       (10 )     N/M       (2 )     (2 )            
Other income:
                                                               
Insurance income
    18       15       3       20.0       49       37       12       32.4  
Loan securitization servicing fees
    5       5                   15       15              
Credit card fees
    8       4       4       100.0       14       12       2       16.7  
Net gains from principal investing
    28       29       (1 )     (3.4 )     48       40       8       20.0  
Miscellaneous income
    62       41       21       51.2       161       148       13       8.8  
 
Total other income
    121       94       27       28.7       287       252       35       13.9  
 
Total noninterest income
  $ 543     $ 531     $ 12       2.3 %   $ 1,571     $ 1,517     $ 54       3.6 %
 
                                                   
 
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                     Nine months ended        
    September 30,     Change     September 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Brokerage commissions and fee income
  $ 56     $ 61     $ (5 )     (8.2 )%   $ 177     $ 186     $ (9 )     (4.8 )%
Personal asset management and custody fees
    39       39                   116       115       1       .9  
Institutional asset management and custody fees
    42       35       7       20.0       118       107       11       10.3  
 
Total trust and investment services income
  $ 137     $ 135     $ 2       1.5 %   $ 411     $ 408     $ 3       .7 %
 
                                                   
 
A significant portion of Key’s trust and investment services income depends on the value and mix of assets under management. At September 30, 2006, Key’s bank, trust and registered investment advisory subsidiaries had assets under management of $84.1 billion, representing a 10% increase from $76.3 billion at September 30, 2005. As shown in Figure 9, the increase was due primarily to Key’s equity portfolio, reflecting improvement in the equity markets in general. Key’s securities lending business and the hedge funds obtained in the acquisition of Austin Capital Management, Ltd. on April 1, 2006, also contributed to the increase.
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.

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Figure 9. Assets Under Management
                                         
    2006     2005  
in millions   Third     Second     First     Fourth     Third  
 
Assets under management by investment type:
                                       
Equity
  $ 39,831     $ 37,290     $ 36,405     $ 35,370     $ 34,912  
Securities lending
    22,699       22,827       22,985       20,938       20,702  
Fixed income
    11,311       10,742       10,882       11,264       11,492  
Money market
    9,298       8,590       9,286       9,572       9,235  
Hedge funds
    921       900                    
 
Total
  $ 84,060     $ 80,349     $ 79,558     $ 77,144     $ 76,341  
 
                             
 
                                       
Proprietary mutual funds included in assets under management:
                                       
Money market
  $ 7,520     $ 7,014     $ 7,606     $ 7,884     $ 7,549  
Equity
    5,250       5,039       5,063       4,594       4,331  
Fixed income
    639       653       703       722       738  
 
Total
  $ 13,409     $ 12,706     $ 13,372     $ 13,200     $ 12,618  
 
                             
 
Service charges on deposit accounts. Service charges on deposit accounts decreased from the prior year, due primarily to reductions in the levels of maintenance fees and fees charged to commercial clients for cash management services. Maintenance fees decreased 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 decrease in income from investment banking and capital markets activities compared to the third quarter of 2005, was due to lower income from dealer trading and derivatives, and other investments.
The decrease from the first nine months of last year was attributable to a reduction in income from dealer trading and derivatives. Results for the first nine 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. This reduction was offset in part by growth in income from investment banking activities. 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 and third quarters by an aggregate $4 million write-down to fair value of the shares obtained in the transaction.
Figure 10. Investment Banking and Capital Markets Income
                                                                 
    Three months ended                     Nine months ended        
    September 30,     Change     September 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Investment banking income
  $ 21     $ 21                 $ 69     $ 57     $ 12       21.1 %
Dealer trading and derivatives income
    7       16     $ (9 )     (56.3 )%     25       45       (20 )     (44.4 )
Income from other investments
    5       14       (9 )     (64.3 )     37       37              
Foreign exchange income
    11       11                   32       29       3       10.3  
 
Total investment banking and capital markets income
  $ 44     $ 62     $ (18 )     (29.0 )%   $ 163     $ 168     $ (5 )     (3.0 )%
 
                                                   
 
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 nine months of 2006 are presented in Figure 15 on page 55.

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Net gains 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 ($843 million at September 30, 2006, and $800 million at September 30, 2005). Thus, the net gains presented in Figure 7 stem from changes in estimated fair values as well as actual gains on sales of principal investments. 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 third quarter of 2006 was $808 million, compared to $781 million for the third quarter of 2005. For the first nine months of the year, noninterest expense was $2.4 billion, compared to $2.3 billion for the first nine months of last year.
As shown in Figure 11, personnel expense rose by $8 million, due primarily to higher costs incurred in connection with business expansion. Nonpersonnel expense grew by $19 million, reflecting increases of $8 million in both marketing and operating lease expense. In addition, miscellaneous expense included a $10 million contribution made to Key Foundation during the third quarter of 2006.
For the year-to-date period, personnel expense grew by $68 million, and nonpersonnel expense rose by $23 million from the first nine months of 2005. The increase in nonpersonnel expense was attributable primarily to a $16 million increase in operating lease expense and a $15 million rise in professional fees. In addition, results for the first nine months of 2005 included a $7 million credit to the provision for losses on lending-related commitments. These increases were substantially offset by a $25 million reduction in net occupancy expense.
Figure 11. Noninterest Expense
                                                                 
    Three months ended                     Nine months ended        
    September 30,     Change     September 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Personnel
  $ 422     $ 414     $ 8       1.9 %   $ 1,258     $ 1,190     $ 68       5.7 %
Net occupancy
    63       66       (3 )     (4.5 )     187       212  a     (25 )     (11.8 )
Computer processing
    52       54       (2 )     (3.7 )     157       155       2       1.3  
Operating lease expense
    48       40       8       20.0       134       118       16       13.6  
Professional fees
    29       29                   102       87       15       17.2  
Marketing
    37       29       8       27.6       83       88       (5 )     (5.7 )
Equipment
    26       28       (2 )     (7.1 )     78       84       (6 )     (7.1 )
Other expense:
                                                               
Postage and delivery
    13       12       1       8.3       38       37       1       2.7  
Franchise and business taxes
    9       8       1       12.5       29       25       4       16.0  
Telecommunications
    7       8       (1 )     (12.5 )     21       23       (2 )     (8.7 )
OREO expense, net
    2       2                   4       6       (2 )     (33.3 )
Provision (credit) for losses on lending-related commitments
          2       (2 )     (100.0 )           (7 )     7       100.0  
Miscellaneous expense
    100       89       11       12.4       303       285       18       6.3  
 
Total other expense
    131       121       10       8.3       395       369       26       7.0  
 
Total noninterest expense
  $ 808     $ 781     $ 27       3.5 %   $ 2,394     $ 2,303     $ 91       4.0 %
 
                                                   
 
                                                               
Average full-time equivalent employees
    20,264       19,456       808       4.2 %     19,974       19,508       466       2.4 %
 
(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 $68 million, or 6%, from the first nine months of 2005. This growth was due to additional costs incurred in connection with business expansion, offset in part by reductions in stock-based compensation and severance expense.
Figure 12. Personnel Expense
                                                                 
    Three months ended                     Nine months ended        
    September 30,     Change     September 30,     Change  
dollars in millions   2006     2005     Amount     Percent     2006     2005     Amount     Percent  
 
Salaries
  $ 241     $ 222     $ 19       8.6 %   $ 706     $ 657     $ 49       7.5 %
Incentive compensation
    95       99       (4 )     (4.0 )     274       262       12       4.6  
Employee benefits
    68       66       2       3.0       226       204       22       10.8  
Stock-based compensation a
    15       23       (8 )     (34.8 )     47       55       (8 )     (14.5 )
Severance
    3       4       (1 )     (25.0 )     5       12       (7 )     (58.3 )
 
Total personnel expense
  $ 422     $ 414     $ 8       1.9 %   $ 1,258     $ 1,190     $ 68       5.7 %
 
                                                   
 
(a)   Excludes directors’ stock-based compensation of $.3 million and $.4 million for the three-month periods ended September 30, 2006 and 2005, respectively, and $.9 million and $1.2 million for the nine-month periods ended September 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 nine months of 2006 by $5 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 third quarter of 2006, the average number of full-time equivalent employees was 20,264, compared to 19,931 for the second quarter of 2006 and 19,456 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 17%, increase in professional fees from the first nine 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 $122 million for the third quarter of 2006, unchanged from 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 28.1% for the third quarter of 2006, compared to 30.5% for the year-ago quarter. For the first nine months of 2006, the provision for income taxes was $367 million, compared to $346 million for the first nine months of 2005. The effective tax rates for these periods were 28.9% and 29.3%, 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 audits 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 27.
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 and the anticipated effect on Key’s financial results are summarized in Note 12 under the heading “Tax-Related Accounting Pronouncements Pending Adoption” on page 28.

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Financial Condition
Loans and loans held for sale
Total loans outstanding were $65.6 billion at September 30, 2006 and 2005, compared to $66.5 billion at December 31, 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 19. Growth in our commercial loan portfolio over the past twelve months was substantially offset by a third quarter 2006 transfer of home equity loans to loans held for sale in connection with our intention to pursue a sale of the Champion Mortgage finance business.
Commercial loan portfolio. Commercial loans outstanding increased by $2.8 billion, or 6%, from one year ago, reflecting improvement in the economy. The overall growth in the commercial loan portfolio was geographically 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 September 30, 2006, Key’s commercial real estate portfolio included mortgage loans of $8.3 billion and construction loans of $8.3 billion. The average size of a mortgage loan was $.6 million, and the largest mortgage loan had a balance of $70 million. The average size of a construction loan commitment was $5.8 million. The largest construction loan commitment was $107 million, of which $106 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 third 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
                                                                 
September 30, 2006   Geographic Region             Percent of  
dollars in millions   Northeast     Southeast     Southwest     Midwest     Central     West     Total     Total  
 
Nonowner-occupied:
                                                               
Residential properties
  $ 319     $ 1,544     $ 209     $ 160     $ 522     $ 1,671     $ 4,425       26.8 %
Multi-family properties
    223       270       166       260       491       487       1,897       11.5  
Retail properties
    102       286       88       410       287       300       1,473       8.9  
Land and development
    51       216       134       71       185       178       835       5.0  
Office buildings
    58       101       33       84       126       246       648       3.9  
Warehouses
    96       62       56       145       56       164       579       3.5  
Health facilities
    49       91             47       24       77       288       1.7  
Manufacturing facilities
    9       1       12       25       6       26       79       .5  
Hotels/Motels
    1       10             2       12       2       27       .2  
Other
    184       82       3       233       46       159       707       4.3  
 
 
    1,092       2,663       701       1,437       1,755       3,310       10,958       66.3  
Owner-occupied
    1,128       99       50       1,872       514       1,917       5,580       33.7  
 
Total
  $ 2,220     $ 2,762     $ 751     $ 3,309     $ 2,269     $ 5,227     $ 16,538       100.0 %
 
                                               
 
Nonowner-occupied:
                                                               
Nonperforming loans
        $ 28           $ 3     $ 1           $ 32       N/M  
Accruing loans past due 90 days or more
          24                   7             31       N/M  
Accruing loans past due 30 through 89 days
  $ 1       43     $ 2       12       5     $ 19       82       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 second 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 Capital Markets, LLC, 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 $2.9 billion, or 14%, from one year ago. The decline was largely attributable to the third quarter 2006 transfer of $2.5 billion of home equity loans to loans held for sale in connection with our intention to pursue a sale of Champion Mortgage discussed below. Home equity loan sales of $266 million 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, also contributed to the decline. Excluding loan sales, acquisitions and the transfer to loans held for sale, consumer loans would have decreased by $217 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 91% of the home equity portfolio at September 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 financing solutions. On August 1, 2006, Key announced that it is considering a 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 is no assurance that Key will enter into an agreement regarding, or consummate the sale of, this business.
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   Third     Second     First     Fourth     Third  
 
SOURCES OF LOANS OUTSTANDING AT PERIOD END
                                       
Regional Banking
  $ 9,990     $ 10,122     $ 10,100     $ 10,232     $ 10,345  
 
Champion Mortgage a
          2,458       2,483       2,465       2,770  
Key Home Equity Services
    998       929       846       791       757  
 
National Home Equity unit
    998       3,387       3,329       3,256       3,527  
 
Total
  $ 10,988     $ 13,509     $ 13,429     $ 13,488     $ 13,872  
 
                             
 
Nonperforming loans at period end a
  $ 46     $ 90     $ 97     $ 79     $ 75  
Net charge-offs for the period
    4       7       6       5       6  
Yield for the period
    7.32 %     7.36 %     7.19 %     7.00 %     6.72 %
 
(a)   On August 1, 2006, Key transferred $2.5 billion of home equity loans from the loan portfolio to loans held for sale and approximately $55 million of home equity loans from nonperforming loans to nonperforming loans held for sale in connection with its intention to pursue a sale of the Champion Mortgage finance business.

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Loans held for sale. As shown in Note 6, Key’s loans held for sale rose to $7.2 billion at September 30, 2006, from $3.4 billion at December 31, 2005, and $3.6 billion at September 30, 2005, due primarily to the third quarter 2006 transfer of home equity loans to loans held for sale. Originations in the commercial mortgage; commercial, financial and agricultural; and construction loan portfolios also contributed to the increase.
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, $1.3 billion of education loans ($904 million through securitizations), $416 million of commercial loans and leases, $355 million of residential real estate loans and $266 million of home equity 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 nine months 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
                                                               
Third quarter
  $ 37     $ 679     $ 16     $ 109     $ 2           $ 143     $ 986  
Second quarter
    64       483             97                   110       754  
First quarter
    40       406       105       54                   172       777  
                 
Total
  $ 141     $ 1,568     $ 121     $ 260     $ 2           $ 425     $ 2,517  
 
                                                 
 
 
                                                               
                 
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 Capital Markets, LLC added more than $28 billion to our commercial mortgage servicing portfolio during the second half of 2005.

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Figure 16. Loans Administered or Serviced
                                         
    September 30,     June 30,     March 31,     December 31,     September 30,  
in millions   2006     2006     2006     2005     2005  
 
Commercial real estate loans
  $ 81,873     $ 78,348     $ 76,123     $ 72,902     $ 43,555  
Education loans
    4,640       4,806       4,992       5,083       4,518  
Commercial lease financing
    513       479       422       354       251  
Commercial loans
    252       255       247       242       233  
Home equity loans
    4       4       5       59       85  
 
Total
  $ 87,282     $ 83,892     $ 81,789     $ 78,640     $ 48,642  
 
                             
 
In the event of default, Key is subject to recourse with respect to approximately $656 million of the $87.3 billion of loans administered or serviced at September 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 September 30, 2006, the securities portfolio totaled $8.8 billion and included $7.4 billion of securities available for sale, $41 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 September 30, 2005, the securities portfolio totaled $8.5 billion and included $7.1 billion of securities available for sale, $98 million of investment securities and $1.3 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 September 30, 2006, Key had $6.9 billion invested in CMOs and other mortgage-backed securities, compared to $6.5 billion at December 31, 2005, and September 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 2.5 years at September 30, 2006, compared to 2.4 years at December 31, 2005, and 2.2 years at September 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 17.

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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  
 
SEPTEMBER 30, 2006
                                                               
Remaining maturity:
                                                               
One year or less
  $ 209     $ 1     $ 473     $ 4     $ 10     $ 66     $ 763       4.48 %
After one through five years
    5       4       6,175       160       77       110       6,531       4.53  
After five through ten years
    3       5       2       34       70       2       116       10.40  
After ten years
    3       7             11             10       31       6.55  
 
Fair value
  $ 220     $ 17     $ 6,650     $ 209     $ 157     $ 188     $ 7,441        
Amortized cost
    220       16       6,762       210       122       179       7,509       4.62 %
Weighted-average yield c
    5.05 %     7.25 %     4.30 %     5.47 %     19.54 %     5.70 %d     4.62 %d      
Weighted-average maturity
  .4 years     10.3 years     2.4 years     4.9 years     5.2 years     4.2 years     2.5 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 %
 
SEPTEMBER 30, 2005
                                                               
Fair value
  $ 283     $ 19     $ 6,266     $ 258     $ 171     $ 127     $ 7,124        
Amortized cost
    283       19       6,390       255       98       120       7,165       4.39 %
 
(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 $166 million at September 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  
 
SEPTEMBER 30, 2006
                               
Remaining maturity:
                               
One year or less
  $ 9     $ 2     $ 11       8.45 %
After one through five years
    16       13       29       6.52  
After five through ten years
    1             1       8.23  
 
Amortized cost
  $ 26     $ 15     $ 41       7.07 %
Fair value
    27       15       42        
Weighted-average maturity
  1.6 years   1.9 years     1.7 years        
 
DECEMBER 31, 2005
                               
Amortized cost
  $ 35     $ 56     $ 91       5.25 %
Fair value
    36       56       92        
 
SEPTEMBER 30, 2005
                               
Amortized cost
  $ 42     $ 56     $ 98       5.39 %
Fair value
    43       56       99        
 
(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 $843 million at September 30, 2006, and $800 million at December 31, 2005, and September 30, 2005. Principal investments represent approximately 62% of “other investments” at September 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 of $193 million at September 30, 2006, $209 million at December 31, 2005, and $233 million at September 30, 2005. The remaining securities consist primarily of Federal Reserve and Federal Home Loan Bank stock. This stock, which is carried at cost, totaled $192 million at September 30, 2006, $187 million at December 31, 2005, and $182 million at September 30, 2005. 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 third quarter of 2006, core deposits averaged $51.7 billion and represented 63% of the funds Key used to support earning assets, compared to $47.9 billion and 61%, respectively, during the same quarter in 2005. The composition of Key’s deposits is shown in Figure 5, which spans pages 45 and 46.
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 $15.6 billion in the third quarter of 2006, compared to $15.5 billion during the year-ago quarter. The increase was attributable to growth in large certificates of deposits, offset in part by a decrease in bank notes and other short-term borrowings. The need for purchased funds 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 September 30, 2006, was $7.9 billion, up $349 million from December 31, 2005. Factors contributing to the change in shareholders’ equity during the first nine months 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   3Q06     2Q06     1Q06     4Q05     3Q05  
           
Shares outstanding at beginning of period
    402,672       405,273       406,624       408,542       408,231  
Issuance of shares under employee benefit and dividend reinvestment plans
    2,576       1,399       4,649       1,332       1,561  
Repurchase of common shares
    (2,500 )     (4,000 )     (6,000 )     (3,250 )     (1,250 )
           
Shares outstanding at end of period
    402,748       402,672       405,273       406,624       408,542  
 
                             
           
Key repurchases its common shares periodically under a repurchase program authorized by Key’s Board of Directors. Key’s repurchase activity for each of the three months in the quarter ended September 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  
   
July 1-31, 2006
                      12,461  
August 1-31, 2006
    2,000     $ 37.28       2,000       10,461  
September 1-30, 2006
    500       36.74       500       9,961  
   
Total
    2,500     $ 37.17       2,500          
 
                           
   
(a)   In July 2004, the Board of Directors 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 September 30, 2006, Key had 89,140,338 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 nine months of 2006, Key reissued 8,624,835 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 8.26% at September 30, 2006, compared to 8.16% at December 31, 2005, and 8.15% at September 30, 2005. Key’s ratio of tangible equity to tangible assets was 6.81% at September 30, 2006, slightly above 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 September 30, 2006, Key’s Tier 1 capital ratio was 8.02%, and its total capital ratio was 12.13%.
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 September 30, 2006, Key had a leverage ratio of 8.89%.
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 September 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 September 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 September 30, 2006, December 31, 2005, and September 30, 2005.

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Figure 21. Capital Components and Risk-Weighted Assets
                         
    September 30,     December 31,     September 30,  
dollars in millions   2006     2005     2005  
 
TIER 1 CAPITAL
                       
Common shareholders’ equity a
  $ 8,019     $ 7,678     $ 7,578  
Qualifying capital securities
    1,792       1,542       1,542  
Less: Goodwill
    1,372       1,355       1,344  
Other assets b
    179       178       162  
 
Total Tier 1 capital
    8,260       7,687       7,614  
 
TIER 2 CAPITAL
                       
Allowance for losses on loans and lending-related commitments
    1,003       1,025       1,152  
Net unrealized gains on equity securities available for sale
    4       4       3  
Qualifying long-term debt
    3,229       2,899       2,899  
 
Total Tier 2 capital
    4,236       3,928       4,054  
 
Total risk-based capital
  $ 12,496     $ 11,615     $ 11,668  
 
                 
RISK-WEIGHTED ASSETS
                       
Risk-weighted assets on balance sheet
  $ 79,764     $ 76,724     $ 75,594  
Risk-weighted off-balance sheet exposure
    24,463       25,619       24,212  
Less: Goodwill
    1,372       1,355       1,344  
Other assets b
    778       785       769  
Plus: Market risk-equivalent assets
    941       1,064       945  
 
Risk-weighted assets
  $ 103,018     $ 101,267     $ 98,638  
 
                 
AVERAGE QUARTERLY TOTAL ASSETS
  $ 94,918     $ 92,206     $ 90,623  
 
                 
CAPITAL RATIOS
                       
Tier 1 risk-based capital ratio
    8.02 %     7.59 %     7.72 %
Total risk-based capital ratio
    12.13       11.47       11.83  
Leverage ratioc
    8.89       8.53       8.60  
 
(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 of Directors 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.
Measurement of short-term interest rate exposure. Key uses a simulation model to measure interest rate risk. The model estimates the impact that various changes in the overall level of market interest rates would have on net interest income over one- and two-year time periods. The results help Key develop strategies for managing exposure to interest rate risk.
Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions and judgments. Primary among these for Key are those related to loan and deposit growth, asset and liability prepayments, interest rate variations, product pricing, and on- and off-balance sheet management strategies. Management believes its assumptions are reasonable. Nevertheless, simulation modeling produces only a sophisticated estimate, not a precise calculation of exposure.

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Key’s risk management guidelines call for preventive measures to be taken if simulation modeling demonstrates that a gradual 200 basis point increase or decrease in short-term rates over the next twelve months, defined as a stressed interest rate scenario, would adversely affect net interest income over the same period by more than 2%. Key is operating within these guidelines.
When an increase in short-term interest rates is expected to generate lower net interest income, the balance sheet is said to be “liability-sensitive,” meaning that rates paid on deposits and other liabilities respond more quickly to market forces than yields on loans and other assets. Conversely, when an increase in short-term interest rates is expected to generate greater net interest income, the balance sheet is said to be “asset-sensitive,” meaning that yields on loans and other assets respond more quickly to market forces than rates paid on deposits and other liabilities. Key has historically maintained a modest liability-sensitive position to increasing interest rates under our “standard” risk assessment. However, since mid-2004, Key has been operating with a relatively neutral, to slight asset-sensitive, position. Management actively monitors the risk of changes in interest rates and takes preventive actions, when deemed necessary, with the objective of assuring that net interest income at risk does not exceed internal guidelines. In addition, since rising rates typically reflect an improving economy, management expects that Key’s lines of business could increase their portfolios of market-rate loans and deposits, which would mitigate the effect of rising rates on Key’s interest expense.
As discussed above, since mid-2004, Key has been operating with a relatively neutral, to slight asset-sensitive, position. Deposit growth, sales of fixed-rate consumer loans, and a smaller portfolio of receive fixed A/LM interest rate swaps have contributed to this position. Additionally, management has refined simulation model assumptions to address anticipated changes in deposit pricing on select products in a very competitive marketplace. Key manages interest rate risk with a long-term perspective. Although our rate risk guidelines currently call for a relatively neutral position, our bias is to be modestly liability-sensitive in the long run.
For purposes of simulation modeling, we estimate net interest income starting with current market interest rates, and assume that those rates will not change in future periods. Then we measure the amount of net interest income at risk by assuming a gradual 200 basis point increase or decrease in the Federal Funds target rate over the next twelve months. At the same time, we adjust other market interest rates, such as U.S. Treasury, LIBOR, and interest rate swap rates, but not as dramatically. These market interest rate assumptions form the basis for our “standard” risk assessment in a stressed period for interest rate changes. We also assess rate risk assuming that market interest rates move faster or slower, and that the magnitude of change results in “steeper” or “flatter” yield curves. (The yield curve depicts the relationship between the yield on a particular type of security and its term to maturity.)
In addition to modeling interest rates as described above, Key models the balance sheet in three distinct ways to forecast changes over different periods and under different conditions. Our initial simulation of net interest income assumes that the composition of the balance sheet will not change over the next year. In other words, current levels of loans, deposits, investments, and other related assets and liabilities are held constant, and loans, deposits and investments that are assumed to mature or prepay are replaced with like amounts. Interest rate swaps and investments used for A/LM purposes, and term debt used for liquidity management purposes are allowed to mature without replacement. In this simulation, we are simplistically capturing the effect of hypothetical changes in interest rates on future net interest income volatility. Additionally, growth in floating-rate loans and fixed-rate deposits, which naturally reduces the amount of net interest income at risk when interest rates are rising, is not captured in this simulation.
Another simulation, using Key’s “most likely balance sheet,” assumes that the balance sheet will grow at levels consistent with consensus economic forecasts. Investments used for A/LM purposes will be allowed to mature without replacement, and term debt used for liquidity management purposes will be incorporated to ensure a prudent level of liquidity. Forecasted loan, security, and deposit growth in the simulation model produces incremental risks, such as gap risk, option risk and basis risk, which may increase interest rate risk. To mitigate these risks, management makes assumptions about future on- and off-balance sheet management strategies. In this simulation, we are testing the sensitivity of net interest income to future

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balance sheet volume changes while simultaneously capturing the effect of hypothetical changes in interest rates on future net interest income volatility. As of September 30, 2006, based on the results of our simulation model, and assuming that management does not take action to alter the outcome, Key would expect net interest income to decrease by approximately .12% if short-term interest rates gradually increase by 200 basis points over the next twelve months. Conversely, if short-term interest rates gradually decrease by 200 basis points over the next twelve months, net interest income would be expected to increase by approximately .90% over the next year.
The results of the “most likely balance sheet” simulation form the basis for our “standard” risk assessment that is performed monthly and reported to Key’s risk governance committees in accordance with ALCO policy. There are a variety of factors that can influence the results of the simulation. Assumptions we make about loan and deposit growth strongly influence funding, liquidity, and interest rate sensitivity. Figure 26 (“Net Interest Income Volatility”) on page 40 of Key’s 2005 Annual Report to Shareholders illustrates the variability of the simulation results that can arise from changing certain major assumptions.
As of September 30, 2006, based on the results of a model in which we simulate the effect of a gradual 200 basis point increase in short-term interest rates only in the second year of a two-year time horizon, using the “most likely balance sheet,” and assuming that management does not take action to alter the outcome, Key would expect net interest income in the second year to decrease by approximately .57%. Conversely, if short-term interest rates gradually decrease by 200 basis points in the second year but remain unchanged in the first year, net interest income would be expected to increase by approximately 1.62% during the second year.
The results of the above second year scenarios reflect management’s intention to gradually move to a slight liability-sensitive position to rising interest rates. Given the current expectations for unchanged-to-lower short-term interest rates, we currently plan to add moderate amounts of receive fixed/pay variable interest rate swaps during the next two quarters i