KeyCorp Q3 2022 Earnings Call Transcript

Quartr
Provided by Quartr
October 20, 2022

There are 13 speakers on the call.

Operator

Good morning, and welcome to KeyCorp's Third Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to the Chairman and CEO, Chris Gorman. Please go ahead.

Speaker 1

Well, thank you for joining us for KeyCorp's Q3 2022 earnings conference call. Joining me on the call today are Don Kimball, our Chief Financial Officer Clark Kiet, our Chief Strategy Officer and Mark Mitkiff, our Chief Risk Officer. On Slide 2, you will find our statement on forward looking disclosure And non GAAP financial measures. It covers our presentation materials and comments as well as the question and answer segment of our call. I am now moving to Slide 3.

Speaker 1

This morning, we reported earnings of $513,000,000 or $0.55 Our results included $0.06 per share of additional loan loss provision in excess of net charge offs. Revenue was up 5% relative to the 2nd quarter, driven by higher net interest income, with a 13 basis point increase In our net interest margin, one thing that sets Key apart is our approach to managing interest rate risk. We have been very deliberate and intentional in managing with a long term perspective. While our net interest income is expected to be up Double digits this year, our balance sheet positioning presents a unique and significant upside for Key over the next 2 years. Even in the event that rates remain at current levels, we will experience a meaningful benefit as our securities and swaps reprice.

Speaker 1

If we were to reprice our existing short term treasuries and swaps at today's interest rates, We would have an annualized net interest income benefit of over $1,200,000,000 Our balance sheet benefits from our strong stable deposit base. Approximately 60% of our deposits are in stable, Low cost retail and escrow balances. In our commercial businesses, approximately 85% of our deposits Our growth came from both our commercial and our consumer businesses. We remain diligent in our underwriting practices And have walked away from business that does not meet our moderate risk profile. Our fee based businesses Continue to reflect current market conditions.

Speaker 1

Investment Banking and Debt Placement fees were up $5,000,000 from the prior quarter, But down meaningfully from the year ago period, reflecting the slowdown in the capital markets. The new issue equity market is virtually non existent and the M and A market is currently engaged in price discovery. Our pipelines remain solid, particularly in M and A. However, the pull through rate continues to be adversely impacted by market uncertainty. We continue to see more activity moving on to our balance sheet.

Speaker 1

In the Q3, we raised a record $39,000,000,000 for our clients, of which 23% was retained on our balance sheet, Well above our long term average of 18%. We will continue to do what is best for our clients, including offering on and off balance sheet solutions. Importantly, we continue to make progress with respect to our targeted scale sectors, which are not only high growth opportunities for key, but areas that matter to both our country And our economy. We have made a conscious decision to invest and focus our resources in certain vital growing sectors, including healthcare, renewable energy and affordable housing that impact both our clients and our communities. Both renewable energy and affordable housing are areas of investment in recently passed federal legislation.

Speaker 1

Combined, Inflation Reduction Act and the Bipartisan Infrastructure Bill have allocated over $300,000,000,000 for energy transition. In healthcare, we are growing relationships with significant healthcare providers and expanding our Laurel Grove business, including our recent market extension to include nurses. We are also very pleased with the early results From our May 2022 acquisition of Gradfin. Since the Gradfin team joined Key, they have held over 14,000 individual consultations For refinance and public service loan forgiveness, these consultations are with prequalified credentialed prospects, all new to Key. We continue to balance expense discipline with investments for the future.

Speaker 1

Credit quality remained Strong this quarter with net charge offs as a percentage of average loans of 15 basis points. Non performing loans declined from the prior quarter. We remain committed to delivering sound profitable growth by maintaining our discipline with respect to risk. We will continue to support our clients while maintaining our moderate risk profile, which positions the company to perform well through all business cycles. Our capital remains a strength, providing us with sufficient capacity to support our clients and return capital to our shareholders.

Speaker 1

Our Q4 guidance keeps us on a path to deliver positive operating leverage again in 2022 and concurrently make progress against each of our long term goals. We also continue to make Tangible progress against the 3 commitments we announced earlier this year at our Investor Day. These goals for 2025 are as follows: Growing relationship households in our consumer business by 20%, growing our senior bankers by 25% And growing our Laurel Road member households to 250,000 from 50,000. We are on pace to achieve all three measures. We have grown consumer households and Laurel Road members as well as the number of our senior bankers.

Speaker 1

Although, Our senior banker hires have been slower in the back half of this year, reflecting current market conditions. Overall, Key delivered another solid quarter. I remain confident in our future and our ability to create value for all of our stakeholders. With that, I will turn it over to Don to provide more details On the results of the quarter and our outlook. John?

Speaker 2

Thanks, Chris. I'm now on Slide 5. For the Q3, net income from continuing operations was $0.55 For comment share, up $0.01 from the prior quarter and down $0.10 from last year. Our results in the current quarter reflect strong core operating performance With a 5% increase in revenue driven by loan growth and by the way that we positioned our balance sheet to benefit from higher interest rates. Our results also reflect our ongoing focus on expense management and our strong risk profile.

Speaker 2

Turning to Slide 6, Average loans for the quarter were $114,000,000,000 up 14% from the year ago period and up 5% from the prior quarter. We continue to add and deepen client relationships across our franchise, which drove loan growth in both our commercial and consumer businesses. Commercial loans increased 5% from last quarter, reflecting broad based growth across our industry verticals. Our consumer business continued to be strong continued with its strong performance As we saw residential real estate originations of $1,900,000,000 consistent with our focus on healthcare segment, 30% of our consumer mortgage originations were to healthcare professionals. Laurel Road originated approximately $200,000,000 of loans this quarter, reflecting the ongoing federal student loan payment holiday as well as the impact of interest rates.

Speaker 2

Continuing on the Slide 7, Average deposits totaled $144,000,000,000 for the Q3 of 2022, down $3,000,000,000 or 2% compared to both the prior quarter and the year ago period. Year over year, we saw a decline in non operating commercial deposit balances, partially offset by an increase in retail deposits. The decline from the prior quarter reflected lower commercial and consumer balances. Both areas were impacted by a reduction in stimulus related funds. Interest bearing deposit costs increased 17 basis points from the prior quarter.

Speaker 2

This resulted in a cumulative deposit beta of 9%. We continue to have a strong stable core deposit base with consumer deposits accounting for approximately 60% of our total deposit mix. In addition, 85 percent of our commercial deposits are from core operating accounts. Turning to Slide 8. Taxable equivalent net interest income was $1,200,000,000 for the 3rd quarter compared to $1,000,000,000 in the year ago quarter and $1,100,000,000 in the prior quarter.

Speaker 2

Our net interest margin was 2.74 percent for the 3rd quarter compared to 2.47% for the same period last year And 2.61 percent for the prior quarter. Year over year net interest income benefited from higher earning asset balances and a favorable balance sheet mix as well as the benefit of higher interest rates. Quarter over quarter net interest income and margin benefited from higher interest rates and loan growth, Partially offset by higher interest bearing deposit costs. Both net interest income and net interest margin reflect lower loan fees related to PPP loan forgiveness as well as the impact of the sale of our indirect auto portfolio in the Q3 of 2021. Included in the appendix is additional detail on our investment portfolio and asset As Chris mentioned, we have intentionally positioned Key to continue to benefit from higher interest rates over the next few years.

Speaker 2

For example, if we were to reprice our existing $9,000,000,000 in short term treasuries and $26,000,000,000 of swaps to today's interest rates, We would have an annualized net interest income benefit of over $1,200,000,000 This positions us to continue to grow net interest income And the net interest margin over each of the next few years, even if rates do not increase. Moving to Slide 9, Non interest income was $683,000,000 for the Q3 of 2022 compared to $797,000,000 for the year ago period and $688,000,000 in the 2nd quarter. Our fee businesses continue to be impacted by the slowdown in capital markets. Investment banking and debt placement fees were $154,000,000 for the quarter, Up $5,000,000 from last quarter, but down $81,000,000 year over year. Compared to last year, in addition to lower investment banking fees, Cards and payments income was $20,000,000 lower driven by lower prepaid card revenue, which was partially offset by core growth.

Speaker 2

Consumer mortgage income was also lower reflecting lower gain on sale margins. Strength in corporate services income from higher derivatives income partially offset these declines. Quarter over quarter fees were down $5,000,000 Trust and Investment Services income declined reflecting lower commercial brokerage commissions. Operating lease income was lower due to lease terminations in the quarter. Increases in cards and payments income and the $5,000,000 increase in investment banking fees Partially offset these declines.

Speaker 2

Despite the increase in other income, this line also reflects a $9,000,000 reduction related to the Visa's litigation settlement. This quarter, we also reclassified certain customer related derivative income items from our other income line to corporate services income. This change was reflected in the current period as well as reclassified in prior periods for comparability. I'm now on Slide 10. Total non interest expense for the quarter was $1,100,000,000 relatively stable with last year and up $28,000,000 from last quarter.

Speaker 2

Our expenses reflect our ongoing investments in digital analytics and our teammates. Compared to the year ago quarter, our expenses are down $6,000,000 We saw declines across most non personnel line items, including business services and professional fees. Higher personnel costs Partially offset these declines related to an increase in salaries expense. This increase included $8,000,000 of lower deferred costs from slower loan originations And $10,000,000 of higher contract labor related to technology initiatives. Compared to the prior quarter, Nodges expenses up $28,000,000 Higher personnel costs drove this increase.

Speaker 2

This increase was caused by higher salaries related to seasonal staffing and $10,000,000 of lower deferred costs In addition, higher incentive and stock based compensation was driven by a $12,000,000 increase related to the relative stock price change on incentive compensation. Partially offsetting these increases were declines across most non personnel line items, including occupancy and business services and professional fees. Now moving on to Slide 11. Overall credit quality remains strong. For the 3rd quarter, net charge offs $43,000,000 or 15 basis points of average loans.

Speaker 2

Non performing loans were $390,000,000 this quarter or 34 basis points of period end loans, A decline of $39,000,000 from the prior quarter. We did see a very slight increase in our 30 to 89 day delinquencies and criticized loans this quarter, although both remain near historic lows. Our provision for credit losses was $109,000,000 for the quarter, up from $45,000,000 in the second quarter And exceeding net charge offs by $66,000,000 The increase in the provision was driven by the change in economic outlook. Now on to Slide 12. We ended the 3rd quarter with a common equity Tier 1 ratio of 9.1%, within our targeted range of 9% to 9.5%.

Speaker 2

This provides us with sufficient capacity, continued to support our customers and their borrowing needs and return capital to our shareholders. We will continue to manage our capital consistent with our capital priorities. First, supporting organic growth of our businesses. 2nd, paying dividends. And as we've mentioned before, our Board of Directors will evaluate a dividend increase in the 4th quarter And 3rd, repurchasing shares.

Speaker 2

During the quarter, our Board of Directors approved an extension of our share repurchase authorization $790,000,000 which is now in place through the Q3 of 2023. We did not complete any share repurchases in the current period. As we have in prior years, we have updated Slide 13 to show our 4th quarter outlook relative to our Q3 results. Using the midpoint of our guidance ranges would support Chris' comments about delivering another year of positive operating leverage in 2022. We expect average loans will be up between 2% 4% and average deposits up 1% to 3%.

Speaker 2

Net interest income is Expected to be up between 4% 6%, reflecting growth in average loan balances and higher interest rates. Our guidance is based on the forward curve assuming a Fed funds rate of 4.25% by the end of 2022. Non interest income is expected to be up between 1% and 3%. This reflects an expected seasonal pickup in investment banking and debt placement So we would expect the Q4 of 'twenty two to be well below the Q4 'twenty one results. This also For the implementation of our new NSFOD fee structure, which will decrease service charges on deposit accounts by approximately $25,000,000 this quarter.

Speaker 2

The higher interest rate environment will also impact the earnings credit in our commercial businesses and is expected to further pressure this line item. We expect non interest expense to be up between 1% and 3% for the 4th quarter, reflecting higher incentive compensation relative to fee production As well as $20,000,000 of one time charges in the 4th quarter, including a pension settlement charge, which will flow through other expense. For the quarter, we expect credit quality remains strong and net charge offs to be at the lower end of our 15 basis points to 25 basis point range. Our guidance for the GAAP tax rate remains the same at approximately 19%. Finally, shown at the bottom of the slide are our long term targets, which remain unchanged.

Speaker 2

We expect to continue to make progress on these targets by maintaining our moderate risk profile and improving our productivity and efficiency, which will drive returns. Overall, it was a solid quarter and we remain confident in our ability to grow and deliver on our commitments. With that, I'll now turn the call back over to the operator for instructions of

Operator

Our first question is from Alex Alexopoulos with JPMorgan. Please go ahead.

Speaker 3

Good morning, everybody. Good morning.

Speaker 2

Did you change your name? Yes.

Speaker 3

So I want to start on the deposit side. So if we look at the $4,000,000,000 decline in the non interest bearing rate, you're appropriately calling out The decline in non operating deposits, if you look at the $47,000,000,000 where you ended the quarter, how much Of that, it's still non operational and at risk to see outflows.

Speaker 2

I would say that at the end of the quarter, when we Look at our commercial balances, it's still in that 85% range. And we do believe that Part of that decline to be honest is that we were a little stingy on some of our deposit rates and that's part of our outlook for the Q4 of Showing deposits increase. We really have 2 factors. 1 is seasonal changes and then also 2 is to use some of that deposit beta and maybe Retain or attract additional customer relationships that are non operating.

Speaker 3

Okay. That's helpful commentary, Don. Follow-up. So if we look at the interest bearing deposit costs in only 25 basis points and the 3 month T Bills now at 4%, Why aren't deposit costs going to materially ramp in the quarters ahead? For you guys and really for everybody.

Speaker 3

I know that historically retail was sleepy, right, the money that moved, but it's a different era today. What gives you confidence that You could continue to see NIM expansion, which you clearly are signaling with the commentary on treasuries and swaps. Can you really flush that out for us? Thanks.

Speaker 1

So Steve, it's Chris. A couple of things. 1, when we were awash in liquidity, we were pretty disciplined about How what deposits we kept and what deposits we pushed out. So our starting point is a bit differentiated from where it's been in other cycles. The other thing to keep in mind is that 65% or 60% of our deposits are both consumer deposits and our escrow business, which has Significant deposits and we've been really focused on our pillars have been focused on four things, one of which has been primacy for some time.

Speaker 1

So I think we're in A little bit different position than we've ever been in as the cycle changes. What we're seeing is that our cumulative beta is 9% Through the 1st three quarters, we think our cumulative beta will be 15% for the year. We're projecting an endpoint on a spot basis Just above 30. So we are anticipating a fairly significant ramp, but not the kind of experience that we've had before Based on all the work we did prior to the interest the rise in interest rates.

Speaker 3

Okay. So is it safe to say most banks are guiding that NIMs are going to peak in the first half then probably of next year and then trend down the second half? Are you guys confident you'll see NIM

Speaker 2

We'll provide more on the 2023 outlook in January, but you're right. As we look at We're positioned with the benefit that Chris and I both referred to as far as just the short term swaps and the short term treasuries and those rollovers We do believe that we're going to grow net interest income and margin even beyond that first half of twenty twenty three. And so even with this Increased deposit beta. And so that was intentional on our part to have more of a long term focus as far as how we manage interest rate risk. And we think that while it's costing us a little bit on a relative basis now, we think that we'll be recouping that throughout the later periods of 'twenty three and 'twenty four.

Speaker 2

Okay. Thanks for all the color.

Operator

Thank you. Next, we go to the line of Erika Najarian with UBS. Please go ahead.

Speaker 4

Hi, good morning.

Speaker 2

Good morning, Erica.

Speaker 4

You mentioned, Chris, the $1,200,000,000 benefit over time Early on in your prepared remarks, and Don, you mentioned it again. So I guess let me ask the question. Number 1, your C and I loan beta was 53% this quarter. Is that essentially the impact from the And should we expect a similar loan beta, as the Fed continues to raise rates? And as we think about that $1,200,000,000 benefit Coming back, how much of that is coming from the swap book versus the securities book?

Speaker 4

And over what period of time Do you realize that $1,200,000,000 back into your net interest income?

Speaker 2

Sure. Maybe I can go ahead and take a crack at that, Erica. I don't have it broken out for C and I, but for total commercial, the swap impact for commercial yields cost us 43 basis points on a linked quarter basis. And so Instead of the increase that you're seeing for commercial yields that just the actual loan itself would have And so this quarter, we did see that kind of relative change on that category as far as the impact from swaps. As far as that $1,200,000,000 that it really relates to the swap book and the maturities and also the short Those treasuries which total about $9,000,000,000 really mature throughout late 'twenty three and throughout 'twenty four.

Speaker 2

The swap book between now and the end of 'twenty three, we've got $7,300,000,000 of swap maturities and another $7,500,000,000 in 'twenty four. And so If we just look at that time period for the next 2 years and using that same math as far as the repricing, we We'll have $900,000,000 of that $2,000,000,000 annualized net income pickup occur in that 2 year time period. 1.2. Of the $1,200,000,000 I'm sorry, yes, dollars 900,000,000 out of the $1,200,000,000 occur in that 2 year time period.

Speaker 4

Got it. And my follow-up question is on expenses. I think that Key has always been very good at managing expenses, particularly relative to fees. And I think that, it probably surprised The Street in terms of the personnel costs relative What happened on the fee side especially. And I'm wondering given that you called out some of the 12,000,000 And the $10,000,000 in your slides, how should we think about the $655,000,000 going forward?

Speaker 4

And I guess my other question, and I'm sorry, I'm not getting this out quickly, is Is this just something that even though the capital markets remain dislocated, inflation and the Competition for talent will continue to push this up pressure this upward.

Speaker 2

A couple of things. One, our expenses were higher than what we had guided to for this quarter and for the second half of the year. If you Look at the components of what drove that change and I'll get to your question as part of this is that There are 3 items that really caused our outlook for all of 2022 to be higher than what we previously expected. One is more one time items. We've got a pension settlement loss projected in the 4th quarter and also some branch consolidation, not branch or building type of costs associated with that and those two combined to $20,000,000 Outside of Personnel, but within our operating losses, during the Q2, we were seeing our operating losses from the prepaid card product Come down through the Q2 and we expected that to continue through the 3rd Q4 and what we actually saw was those costs actually go up.

Speaker 2

And so it wasn't a huge increase, but compared to what our relative positioning was and expectation was for that category, It's about a $30,000,000 increase to the second half of the year expense structure for us. And the good thing about that is that we have taken action to address that and We'll start to see that over time. But the other good thing is it has a limited life to it. These are related to funds that were distributed as part of the Stimulus programs and they're winding down and so we don't think that will have an ongoing impact with. The 3rd component, Erica, really is deferred loan origination costs and that cost is about $20,000,000 and most of that is with our Reset of our consumer loan originations and the cost that gets deferred associated with that.

Speaker 2

And so we will see Increases from that continue for some time period because we're not seeing a return of the previous origination levels. So that will be there. For the Q4, we expect to see our capital markets revenues pick up. And as we've said before, the incentive compensation expense It tends to be correlated to the tune of about $0.30 on the dollar. So for every dollar of investment banking and debt placement fee increase, we will see that come through incentives.

Speaker 2

As far as where we see for other salary and personnel costs, I would say just looking at the year over year Adjusting for some of these items I talked about for the deferred loan origination costs and things, Our total salary dollars are up about 10% and headcount is up about 5%. Now some of that includes some of the smaller acquisitions we've done throughout the year. And so that does imply a 4% to 5% inflationary impact for some of those salaries. Some of that is because of the lower end of the pay scale continue to have increases. Some of it's market pressure and we'll be working through that as we Our expectation for merit increases for 'twenty three and beyond.

Speaker 2

And I think that the important thing here, Erica, also is We're very focused on driving positive operating leverage. We expect to do that this year and we haven't given guidance for 'twenty three or beyond yet, but we expect to continue that through the Several years as well.

Operator

Thank you.

Speaker 5

Thank you.

Operator

Next, we go to John Pancari with Evercore. Please go ahead.

Speaker 6

Good morning.

Speaker 2

Good morning.

Speaker 6

Related to your last comment there On the operating leverage, I mean, your cash efficiency ratio is running at about 60% year to date. And just Wondering how you can if you could help us think how you're thinking about that for 2023. And if not, maybe if you could help us with the magnitude of pause off for leverage That we could see in 'twenty three. And then separately, your long term target, you maintain that at 54% to 56%. How should we think about What you need to see to be able to achieve that level?

Speaker 6

Thanks.

Speaker 1

So John, it's Chris. Good morning. So I think our efficiency ratio for the quarter we just printed was right around 58%. It's not We do aspire to get to 54% to 56%, but as Don mentioned, what we're really focused on is positive operating leverage. And if you think about our Capital Markets business coming back, if you think about some of the many investments that we continue to make Coming to fruition and you think about the trajectory that Don described from an NII perspective, obviously, that continues to move us That long term target that you referenced of 54% to 56%.

Speaker 6

Okay. All right. Thanks, Chris. And then separately, in terms of Deposit growth expectations, I appreciate the color you gave near term. Wanted to get a little bit of color on how you think about Deposit growth as you look into 2023, maybe if you could talk about the mix shift Non interest bearing towards interest bearing and then overall growth levels, do you think incremental declines are possible as we look into the early part of 'twenty three?

Speaker 6

Thanks.

Speaker 1

Well, I mean, we're really kind of going into a bit of uncharted territory. I will tell you this though, we have been pretty consistent And that our non interest bearing have been right around 32% and that hasn't moved. And I don't anticipate That moving a lot as we go forward. And as I mentioned earlier, this deposit book has been pretty well scrubbed over a period of time. Having said all that, as interest rates continue to rise, some deposits that previously were deemed to be not Interest rate sensitive will in fact be interest rate sensitive.

Speaker 1

And we saw some of that movement in the Q3 where some of our public sector Customers that are more interest rate sensitive move. So we're obviously watching it very closely and It's certainly an interesting dynamic, particularly as the Fed unwinds their balance sheet concurrently.

Speaker 5

Okay. Thanks for taking my question.

Operator

Next, we go to the line of Gerard Cassidy with RBC. Please go ahead.

Speaker 7

Good morning, Chris. Good morning, Don.

Speaker 5

Good morning, George.

Speaker 7

Chris, you talked about the strength in the commercial sheet rather than going to the capital markets. A couple of questions. One, can you share with us what percentage of that Portfolio is considered leveraged loans. And then also in that same kind of vein, how big is your syndicated loan portfolio? And did that impact

Speaker 1

So a couple of things. Our leverage book, Gerard, It's been pretty consistent at about 2.5% of total loans. And what's interesting about that It's been 2.5% even when we were a much smaller company. So that portfolio has a lot of velocity. It's In our it's in the segments in which we focus.

Speaker 1

There's been some talk about some of the deals that are hung lately. We've just had just a de minimis mark over the last 6 months in that book. So we feel really, really good about that. Most of the growth that you're seeing conversely is really an investment grade credit. And the market was dislocated enough and our clients were trying to do things in an expeditious manner and we have really grown the percentage of our C and I book that's investment grade as we brought More on to the balance sheet.

Speaker 1

Right now, our C and I book is about 50% investment grade, which is a bit of an outlier for a bank of our size.

Speaker 7

And when you underwrite the new originations, Do you guys I assume you always do this, but are you stressing it for 200 or 300 basis points higher rates just so that you're Protected if rates are to go quite a bit higher from here?

Speaker 1

For sure. I mean, our first stress that we always run is actually 300 basis points And we run a lot of stress other stresses. And when you get into anything that's leveraged, we stress EBITDA and we stress interest rates because that's the danger of anything that's leveraged as you have the concurrent decline of EBITDA And the increase in borrowing costs, we do a lot of stressing with respect to those credits.

Speaker 7

Very good. And then as a follow-up question, Your credit quality obviously is superb like many of your peers and I know that's going to be a defining moment for you folks through the cycle. So the question I have is on the consumer loan portfolio with the FICO scores, I think you showed it averages out to 772. Have you guys there's been some chatter that FICO scores like I think college grades have been inflated. Are you guys seeing anything where these FICO scores, if you compare them to 5 years ago, they are inflated or is that really not the case?

Speaker 1

I haven't personally done the analysis, but just because we look at this stuff all the time, I think there's probably a lot of Like they teach the SAT, I think there's some instruction on how to get your FICO score up. Having said that, if you think about the super prime customers that We're focused on doctors, dentists, which for example were 30% of our mortgage originations last quarter. We feel really, really good about our consumer book, as we look kind of across all the metrics.

Speaker 2

And Gerard, you're right. There actually was Some technical change in some of the FICO scores and I don't know if it was by law or what if they had to exclude certain Medical related costs or loans or expenses. And so if you would adjust for that, I think Today's FICO score is probably 10 to 15 basis points higher than the same would be several years ago. And so Instead of our 772, it might be a 760, which is still super prime even on historic standards.

Speaker 7

Very good. Thank you, Don. Thank you, Chris.

Speaker 2

Thank you, Gerard.

Operator

Next, we go to the line of Ebrahim Poonawala with Bank of America. Please go ahead.

Speaker 8

Good morning.

Speaker 2

Good morning. Good morning, Ebrahim.

Speaker 8

I guess, Tom, just wanted to follow-up on the swap and the treasury securities portfolio. So I get in terms of how this should help NII, that's obviously assuming that rates stay high for the next 12 to 18 months. Is there anything that you plan to do ahead of time to lock in that upside or Just give us a sense of because what I worry is if we get through the next 3 to 6 months rates flow lower, do we start losing some of that benefit that you would have otherwise had?

Speaker 2

We're continuing to review that on a regular basis. I would say that our ALCO committee as we Together, we tend to think that we're going to see rates higher for longer just given what we've experienced in the current marketplace. But even with that, You've seen a little bit of a tick up again as far as our forward starting swaps and that's exactly the purpose of that Ebrahim is that we're looking to put on swaps that actually kick And as some of these will mature and start to lock in some of that forward benefit for us as well. And we're not ready to do a wholesale type of Positioning to achieve that, but we do expect to continue to use that tool over the next several quarters to help

Speaker 8

That's fair. And I guess just a separate question following up on credit, less to do with your portfolio, but you have a lens into sort of the middle market commercial CRE. Like how stressed do you expect that customer base? Are you seeing areas where you've kind of pulled back given The rapid rise in Fed interest rates and what we're seeing in the markets in terms of spread widening, like what are the areas where you're seeing pain where you pulled back as a bank? And where do you like do you actually start seeing a 4%, 4.5% Fed Funds as most certainly creating pressure for a subset of that segment?

Speaker 1

Sure. I'll take that one. Clearly, I mean, last year and our view for some time has been that these that inflation would be And that rates would have to be higher for longer. And if you go back to a year ago in September, When we exited indirect auto, dollars 3,300,000,000 portfolio, that was an area that we thought And I still believe we'll be under intense stress in the market that we're entering. The other thing that I always look for is any place that there's Leverage and Gerard Cassidy had just asked a question about leverage loans.

Speaker 1

That's an area that we pay a lot of attention to. Another area that we pay a lot of attention to It's just real estate broadly. And by strategy, we're focused on apartments, multifamily and industrial. Interestingly, those values are up significantly from pre pandemic levels, respect 15% and 39%, respectively. The other area where I think that there's going to be a lot of dislocation is in office, Particularly B and C Class Office because those buildings are leveraged and obviously people have changed the way they work.

Speaker 1

That's not a business that we're in, in any significant way, although we do have a $600,000,000,000 3rd party commercial loan servicing portfolio, which is debt that's off us. And now the 2nd largest category Below retail where you would expect that starting to go into active special servicing are these B and C class offices In Central Business Districts. Those are a few of the places that I bring to your attention.

Speaker 8

And just on the office, do you think It's a cliff event just given the nature of the leases or is it going to be more like what we've seen with big box retail malls where it's Played out over the last decade as opposed to in any given quarter or any given year?

Speaker 1

Yes. I think I don't think it's a cliff event. I think it's Slow burn because if you think about these B and C class office space, they have many, many tenants with varying termination dates on their leases. I think it will be a slow but consistent burn.

Speaker 8

Thanks for taking my questions.

Speaker 1

Sure.

Operator

Next, we go to the line of Scott Siefers with Piper Sandler. Please go ahead.

Speaker 5

Good morning, guys. Thanks for taking the question. Maybe Chris, I was hoping you could sort of walk through the investment banking pipelines and pull through. I think we can all see what's happening in the industry, but Some companies are noting that there's still enough activity taking place at sort of the smaller end of the segment, middle market and below that it's keeping Sort of activity going, enough to prop up numbers. So where are you seeing healthier activity versus what's still slow?

Speaker 5

And Just given your background, do you think there's a point where we will say get price discovery and then increased activity despite higher rates and a weaker Economic backdrop?

Speaker 1

So I do. So where the activity has remained strong and we had a very good quarter in this area, it was Areas like syndicated finance. So that area continues to be strong. The areas that are really challenged is the public equity market and that's a market unlike the debt market where it's binary either you can issue equity or you can't basically And right now, you clearly can't. The M and A markets, I'm confident, will come back.

Speaker 1

We are involved in a lot of these Strategic discussions and what's happening Scott is if you're a buyer, you basically have sort of a free option. There's no huge impetus To close, everyone is looking out over the horizon and predicting a downturn. And so if you have a deal locked up, you sort of drag your feet and wait and see What the downturn is going to look like? Our pipelines remain strong in that business. We continue to selectively hire people.

Speaker 1

It will come back. I don't think it's going to come back. I don't see any significant market change in the Q4 by the way, but I do think that the business will come back. Having said that, I've been doing this for a long time. There's an inverse relationship Between the amount of time you've been working on the deal and the probability that it's actually going to close.

Speaker 1

And so I throw that out as a watch point.

Speaker 5

Perfect. Okay, that's good color. Thank you. And then maybe Don, this notion of AOC Imarks and the Tangible book and TCE hits has gotten a lot more attention. A lot of companies have begun to move pretty substantial amounts of their Curious portfolios to help to maturity.

Speaker 5

So in a sense, you can sort of make the TCE tangible book issue go away with the wave of a hand, So to speak. So maybe just some thoughts on why you guys are keeping mostly available for sale? To what degree does TCE matter in your eyes? Does it govern any of your capital management thinking or things like that?

Speaker 2

Sure. As we look at our future security purchases, we're starting to put a portion of those into held maturity whereas it used to be primarily only into the available for sale. And so we're just separating somewhere we might want to have bullet maturities where we can do some End of life type of swaps attached to it that we need to keep those in available for sale as opposed to Move them into held to maturity. The TCE ratio isn't a high priority for Our main capital ratio that we focus on is the common equity Tier 1 ratio and some of the other regulatory ratios whether it's Tier 1 or total. And so that's why you saw us take action in the Q3 with a preferred stock issuance and also a sub debt issuance.

Speaker 2

We feel very good about how we're positioned across that capital spectrum. The other thing to think about too as far as the TCE ratio, if you would just back out the AOCI Impact for TCE that would take our ratio up by 3.30 basis points. And so on that adjusted basis, Which will all come back over time because we don't have risk of those investments not being paid off because they're all agencies or U. Treasuries, we're going to see that realized and so that's more of the area of focus for us as well.

Speaker 5

Perfect. Okay, good. Thank you guys for taking the questions.

Operator

Next, we go to the line of Matt O'Connor with Deutsche Bank. Please go ahead.

Speaker 9

Good morning. Just wondering what you're seeing in loan pricing trends, specifically in commercial. Obviously, the absolute yield is going up because Higher rates, but are you seeing any improvement in spreads given we see widening in the marketplace in public markets that is?

Speaker 2

It's a great question, Matt. And what's ironic about this is to date what we've seen is credit spreads widen out for the investment grade companies that we serve And because we're seeing that in the capital markets for the middle market space because of the competition there tends to be more local, we haven't seen the Commercial spreads widened that much yet. We would expect that to pick up over time here, but near term spreads are holding in, but not

Speaker 9

And any way to quantify on the investment grade as you mentioned, you're overweight Great. But others, so that's probably a positive for you?

Speaker 2

Well, it is for us. And I would say that on the credit Spread widening, we've probably seen a good 20 basis points of widening generally on pricing reflective of credit spreads in the market.

Speaker 9

Okay. Thank you

Speaker 5

very much.

Operator

Next, we have a question from Mike Mayo with Wells Fargo Securities. Please go ahead.

Speaker 9

Hi. One negative, one positive. The negative is the personnel expense up so much quarter to quarter and I get One time items, 8% just versus How the one time items seem to repeat and therefore maybe they aren't so one time? I mean, I guess you said Q4 might have some more Next year, do you expect more one time items or when do we get more core expense numbers because that seem to come in a little higher than expected? And on the positive side, as far as your outlook for NII and the NIM, I mean, your NIM of 2.7%, A decade ago, it was close to 3.7%.

Speaker 9

Conceptually, we've had almost 14 years of 0 interest rates. And Now that we're getting out of that, could you potentially get all the way back to 3.7%? Or what are some of the ins and outs since the global financial crisis that could help or hurt that?

Speaker 2

Sure. As far as personnel, a couple of things that we've talked about as being one time Or just different one is the pension settlement loss that we'll have in the 4th quarter. The good thing there is that with rates being higher, the threshold is higher for us to be in a position to have to realize the Losses in the future and so we do think this truly is more one time and as long as rates remain where they're at or even go a little higher, We shouldn't see that come through as far as a charge. The one thing that you will see Mike is that a good portion of our long term incentive Sensation is tied to our stock price and we want our employees to be shareholders and have a consistent objective To what our shareholders have as well. And so part of that incentive compensation expense does You will see the incentive compensation expense increase with that as well.

Speaker 2

Beyond that Mike that I would say for the current Quarter versus a year ago, as I mentioned before, the core salary line item is up about 10% with about 5 And we had about a 4% kind of merit increase impact to that as well throughout the year and that reflects some of the experience we had for rightsizing the lower salaries, But also the market pressure that we're seeing. And so near term, I think we'll probably see a little higher than our typical 2% as far as wage inflation Going forward, but I think we'll see that settle down. And as Chris has said, that we'll continue to make investments And talent and especially in our frontline bankers and also in the technology space to continue to grow our business. But With that, we'll be holding the people accountable. They're making sure that we're getting the appropriate returns on those investments and showing the growth going forward.

Speaker 1

Yes. Tom, the only thing I would add to that is on the technology There has been a transition as we think about full stack engineers from some contract labor To people that are part of our headcount, we just think it's important as we continue to become the digital bank that we are, That we control that talent. And so that's a piece of what you're seeing there, Mike. And

Speaker 2

then Mike, as far as the margin I don't want people to start thinking that we're going to be at a 3.7% margin because our risk profile is much Different than what it was historically and so it is relationship based but we do see significant growth from that. And so one and just a simple After that would be taking a look at our full year net interest income and if you just layered on top of that the $1,200,000,000 that we've talked about for the repricing of the swaps and the treasuries That clearly gets you into the mid-3s and maybe not to the 3.7% range, but we would see some meaningful lift

Speaker 9

And then just one follow-up on that comment about technology. So Less consultants and more full time tech employees so that you can better control your tech destiny. Is that the idea of this? And what was

Speaker 1

The tipping point was as we were in the pandemic And everybody was short on talent. We were getting more turnover from some of our contractors than frankly we wanted to get. And We wanted to be able to literally have the continuity and we wanted to drive our strategy in a consistent way with leadership. And so we made the decision in certain areas to dial back contract labor and to hire When I say it's Fullstack Engineers and the nice thing is with some of the acquisitions we've made, Mike, we have the kind of leaders that can attract the

Operator

And our next question is from Ken Usdin with Jefferies. Please go ahead.

Speaker 10

Thanks a lot. Good morning. Don, just one more follow-up on the balance sheet mix. So the securities portfolio has been hanging around $50,000,000,000 And just want to understand with that plan runoff Good slide you have in the back about the maturities. Do you expect to keep the securities portfolio around this size from here?

Speaker 10

And then just I'm trying to understand how that gets funded incrementally given that you're still expecting decent loan growth.

Speaker 2

Yes. There's really two pieces of our investment portfolio. One is the core book, which is about $40,000,000,000 and the other is the U. S. Treasuries, which are about $9,000,000,000 I think near term and our outlook would suggest that we think that core portfolio will hang in there around the $40,000,000,000 level.

Speaker 2

And so We think that's appropriate just from a liquidity perspective and a balance sheet mix for the U. S. Treasury portion of the portfolio. We'll make some assessments as that maturities Those maturities come through and we'll get the benefit whether we use that for future funding or we just go ahead and roll that into the core portfolio. And so Yet to be determined how that plays out, but I would say that there's probably less certainty on that $9,000,000,000 short term treasury portfolio.

Speaker 10

And just following on to that then, so the 1.2 benefit, would this adding contemplate like any type of delta in Sizing of both the securities book and the overall swaps book as you get to those out years?

Speaker 2

The swap book assumes that it would Stay the same. And then on the treasury portfolio, it has either the assumed impact of rolling that over More 1 year treasuries or using that for funding and it adds the same net bottom line impact at this point in time.

Speaker 10

Okay. And then just sorry, one more follow-up. Just do you have an understanding or can you help us understand just when the near term swaps The detriment just from the natural higher rates kind of gets to its bottom and then you start to get this that incremental benefit Rate of change starts to happen. I guess it sounds like that's in next year, but do you have an understanding of kind of when that pivot happens?

Speaker 2

I would say that a couple of things we'd have to know for that. When do short term rates peak because that's going to be the main driver as So when that negative impact happens for the existing portfolio and then as we have the rollovers of that book, we'll be picking up over 4 Over 300 basis points on the swaps as they would roll over and so That will help offset that, but it'd probably sometime in 2023 that we start to see that peak and move the other direction.

Speaker 10

Okay. Got it. Thanks, Don.

Speaker 2

Thank you.

Operator

And our next question is from Betsy Graseck with Morgan Stanley. Please go ahead.

Speaker 11

Hi, good morning. Good morning. A couple of questions. One, I just wanted to understand what kind of loan growth you've got baked into your outlook And what is your expectation for how you're going to fund that loan growth?

Speaker 1

So what we on the loan growth We would not see the same trajectory of loan growth that we've experienced in the last couple of quarters. Our guidance For Q4 is 2% to 4%, Betsy. And we've had a lot of lift from on the consumer side Over the last several quarters, I don't see the same level of lift that so I think you're going to see we haven't given guidance yet for 2023, but With respect to loan growth, we're targeting 2% to 4% in the 4th quarter.

Speaker 2

And just to fund that, our guidance for the 4th quarter is also a 1% to 3% increase in Our deposits and if you go through the math, it's a pretty close match there as far as the midpoints of both are around that $3,000,000,000 kind of range. And so it's we think we'll be fairly close to funding that through just the core balance sheet growth. We have used other wholesale funding to help fill that gap in the last couple of quarters, but expect

Speaker 11

And if the deposits don't come through for whatever reason, can you just give us your Hierarchy of how you would go about funding it, is it securities roll off or you first go to the wholesale funding piece?

Speaker 2

Near term, we've been using FHLB advances and locking those into sub maturities or term maturities. So We would probably continue that. And then as I mentioned before, we're still yet undecided as far as the roll off of the U. S. Treasuries when they start coming through next year and then 2024 as So how we use those proceeds.

Speaker 11

And then just lastly, I know the forward curve is looking for the Fed to be done in early 2023, but If they end up extending with the rate hike cycle going further into 2023, how should we expect that impacts the I know you mentioned that you've got the benefit of the short term of the swaps rolling off that should help, but I'm just wondering is there any timing

Speaker 2

Yes. I don't think there's any cliff or any events there that we still view the rates going up. We'll still have a net positive even with deposit betas being higher than what they've been before. And then just the repricing of the swaps The treasuries will be additive for us. And so we think that we still will be able to grow net interest income and margin throughout the next couple of years Rates do go beyond the current outlook.

Speaker 8

Got it. Okay.

Speaker 11

And then just last question going back to the quarter in mortgage for the quarter, very Strong results here with I just wanted to understand what the main driver that was and the Hey, all the legs on that type of increase. Thanks.

Speaker 1

Sure. So for us, it was Driven really by purchase, 87% of our originations were purchased And this is a relationship based business, 30% were medical professionals. So ours will Basically, refinance business, Betsy, has completely dried up. I would envision from here that purchase mortgage continues to decline in this Environment as we believe we're in for a cycle that's higher for longer.

Speaker 11

Right. So this is reflecting And loans that had probably started a quarter or 2 ago, so we should expect that should tail off. And are these 30 year fixed you're putting on or 15 year or arm floaters, can you give us a sense of the construct?

Speaker 2

It tends to be more arms and 15 year. We do have some 30 year fixed in some of our Doctor. Dennis program that we've had, but I'd say it's a mix of those and We would expect to see the 4th quarter origination levels be lower than what the Q3 was. It still is a core product for us and something that we had underweighted in the past. So we I think there is room for some modest growth in the balance sheet there.

Speaker 11

Okay, great. Thank you.

Speaker 5

Thank you.

Operator

And our final question will come from Bill Carcache with Wolfe Research. Please go ahead.

Speaker 12

Hey, good morning, Chris and Don. I wanted to follow-up on your comments around the modest increase in the reserve rate due to the economic outlook. Can you give a little bit more detail on what kind of unemployment Is it implicit in that reserve and what you'd expect the reserve rate to go to if unemployment were to increase to say the 5% to 5.5% range?

Speaker 2

Yes. As far as what we use as our baseline for our CECL reserves, we tend to start with the consensus assessments from Moody's and so we did See a shift in that from last year to this year. I would say that Moody's unemployment levels are Using about a 4% unemployment level for 2023 and I don't know off the top of my head what the impact We've seen that going to 5% because we'd have to have the other components of the economic outlook. But I would say that if we Look at where our reserves were back at January 1, 2020, I would say that the unemployment levels and economic outlook Was a little worse than what we're seeing now today and our reserve levels there were about 10 basis points or 15 basis Higher than what they are today for us. So it's a lot of moving parts and pieces, but I think that It's not going to be a huge change, but still would be reflective in our reserve.

Speaker 12

That's helpful. Thank you. And Separately, it seems intuitive that the cohort that you're targeting with your Laurel Road products would perform relatively well in a downturn. But is there Less credit history for this asset class? And if so, can you give a little bit of color on the kind of data and analytics that you're using to underwrite potential customers?

Speaker 12

And what's the approval rate of customers seeking a loan through Laurel Road and actually those that actually receive 1?

Speaker 2

I would say that we do have data for doctors and dentists programs both on the residential mortgage side and also for Student loans, that history is continuing to be built out. We are using that insight in order to inform our credit underwriting decision. I don't have the exact approval rate for loans, but you would probably assume that it's Fairly high given the nature of the doctor that we're approaching who is going from $80,000 a year in compensation to $300,000 plus and has a firm commitment and a new assignment with A large hospital, so it's I would assume that it could be a fairly high approval rate.

Speaker 12

Understood. Thank you for taking my questions.

Operator

Thank you. Ladies and gentlemen, that does conclude your conference for today.

Speaker 1

Again, thank you for participating in our call today. If you have any questions, you can direct them to our Investor Relations team,

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Earnings Conference Call
KeyCorp Q3 2022
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