Taxable-equivalent net interest income for 2003 was $2.8 billion, representing a $73 million, or 3%, decrease from the prior year. This decrease resulted from a lower net interest margin, which contracted 17 basis points to 3.80%. A basis point is equal to one one-hundredth of a percentage point (e.g., 17 basis points equals .17%). 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. During 2003, average earning assets grew by 2% to $73.5 billion. 

The combination of a soft economy and significant growth in core deposits have affected the net interest margin, as well as the size and composition of Key’s earning assets portfolio. Over the past twelve months, average core deposits have grown by more than 10%, while average earning assets increased slightly. Due to generally weak loan demand, the excess funds have been either invested in securities or used to reduce wholesale funding. These actions improved Key’s liquidity; however, combined with the Federal Reserve Board’s reduction in interest rates in June 2003, they have placed downward pressure on net interest income. 

Key’s net interest margin decreased over the past year, primarily because: 

• higher-yielding securities matured and we experienced exceptionally high levels of prepayments on our investment and consumer loan portfolios as a result of the low interest rate environment; 

• we invested more heavily in securities available for sale since opportunities to originate commercial loans, which typically have higher interest rate spreads, had been adversely affected by the soft economy; and 

• competitive market conditions precluded us from reducing interest rates on deposit accounts to compensate for the full amount of the Federal Reserve Board’s reductions in interest rates. 

Average earning assets for 2003 totaled $73.5 billion, which was $1.2 billion, or 2%, higher than the 2002 level. Steady growth in our home equity lending (driven by the low interest rate environment) and commercial lease financing, and an increase in the securities available-for- sale portfolio drove the increase. During the same period, the general economic slowdown contributed to a decline in average commercial loans outstanding. Average consumer loans, other than home equity loans, also declined during 2003. The largest reduction occurred in the indirect automobile financing portfolio, primarily as a direct result of management’s May 2001 decision to scale back automobile lending and exit automobile lease financing. 

In 2002, net interest income was $2.9 billion, essentially unchanged from the prior year as the positive effect of an improved net interest margin was offset by a decrease in average earning assets. Key’s net interest margin rose by 16 basis points in 2002 to 3.97%, while average earning assets decreased by $3.1 billion, or 4%, to $72.3 million. This decrease came principally from the loan portfolio and was attributable to a number of factors, including Key’s strategic decision to scale back or exit certain types of lending. Another factor was loan sales, including the September 2001 sale of $1.4 billion of residential mortgage loans. 

Weak loan demand resulting from the general economic conditions at the time also contributed to the net decline in loans. 

Over the past two years, the growth and composition of Key’s loan portfolio has been affected by several actions: 

• During the third quarter of 2003, Key consolidated an asset-backed commercial paper conduit as a result of an accounting change. This consolidation added approximately $200 million to Key’s commercial loan portfolio. More information about this change, required by Interpretation No. 46, “Consolidation of Variable Interest Entities,” is provided in Note 8 (“Loan Securitizations and Variable Interest Entities”), which begins on page 63. 

• During the first quarter of 2003, Key acquired a $311 million commercial lease financing portfolio and a $71 million commercial loan portfolio from a Canadian financial institution. The acquisition of these portfolios further diversified our asset base and has generated additional equipment financing opportunities. 

•K ey sold commercial mortgage loans of $1.7 billion during 2003 and $1.4 billion during 2002. Since some of these loans have been sold with limited recourse (i.e., the risk that Key will be held accountable for certain events or representations made), Key established a loss reserve of an amount estimated by management to be appropriate to reflect the recourse risk. More information about the related recourse agreement is provided in Note 18 (“Commitments, Contingent Liabilities and Guarantees”) under the section entitled “Recourse agreement with Federal National Mortgage Association” on page 79. Our business of originating and servicing commercial mortgage loans has grown in part as a result of acquiring Conning Asset Management in the second quarter of 2002 and both Newport Mortgage Company, L.P. and National Realty Funding L.C. in 2000. 

• Key sold education loans of $1.2 billion ($998 million through securitizations) during 2003 and $1.1 billion ($750 million through securitizations) during 2002. Key has used the securitization market for education loans as a cost effective means of diversifying its funding sources. 

• Key sold other loans (primarily home equity and residential mortgage loans) totaling $1.8 billion during 2003 and $835 million during 2002. 

• During the second quarter of 2001, management announced that Key would exit the automobile leasing business, de-emphasize indirect prime automobile lending outside of Key’s primary geographic markets and discontinue certain credit-only commercial relationships. As of December 31, 2003, the affected portfolios, in the aggregate, have declined by approximately $4.6 billion since the date of the announcement. 

Figure 7 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 25, contains more discussion about changes in earning assets and funding sources. 

