historical loss rates for that industry segment would not have provided a precise basis for determining the appropriate level of allowance for the segment. appropriate methods 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 50, should be reviewed for a greater understanding of how Key’s financial performance is recorded and reported. Because Key’s loan portfolio is large, even minor changes in estimated loss rates can significantly affect management’s determination of the appropriate level of allowance. For example, a one-tenth of one percent change in the loss rate assumed for Key’s December 31, 2003, consumer loan portfolio would result in a $24 million change in the level of allowance deemed appropriate. The same percentage change in the loss rate assumed for the commercial loan portfolio would result in a $36 million change. Management estimates the appropriate level of Key’s allowance by conducting a detailed review of a significant number of much smaller portfolio segments that comprise the consumer and commercial loan portfolios. It should be noted that Key’s total loan portfolio is well diversified in many respects, and a change in the level of the allowance for any one segment of the portfolio does not necessarily mean that a change is appropriate for any other segment. Also, the risk profile of certain segments of the loan portfolio may be improving, while the risk profile of others may be deteriorating. As a result, changes in the appropriate level of the allowance for different segments may offset. Thus, the difference between actual and expected losses in any particular segment does not necessarily require a change in the level of the total allowance. Our accounting policy related to the allowance is disclosed in Note 1 under the heading “Allowance for Loan Losses” on page 51. Loan securitizations. Key securitizes certain types of loans, and accounts for those transactions as sales when the criteria set forth in Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,” are met. If future events were to preclude accounting for such transactions as sales, the loans would have to be placed back on Key’s balance sheet, which could have an adverse effect on Key’s capital ratios and other unfavorable financial implications. In addition, management must make assumptions to determine the gain or loss resulting from securitization transactions and the subsequent carrying amount of retained interests; the most significant of these are described in Note 8 (“Loan Securitizations and Variable Interest Entities”), which begins on page 63. Note 8 also includes information concerning the sensitivity of Key’s pre-tax earnings to immediate adverse changes in important assumptions. The use of alternative assumptions would change the amount of the initial gain or loss recognized and might result in changes in the carrying amount of retained interests, with related effects on results of operations. Our accounting policy related to loan securitizations is disclosed in Note 1 under the heading “Loan Securitizations” on page 52. Contingent liabilities and guarantees. Contingent liabilities arising from litigation, guarantees in various agreements with third parties in which Key is a guarantor, and the potential effects of all of these items on Key’s results of operations are summarized in Note 18 (“Commitments, Contingent Liabilities and Guarantees”), which begins on page 77. Adjustments to the allowance for loan losses can materially affect net income. Such adjustments may result from events that cause actual losses to vary abruptly from expected losses by tens or even hundreds of millions of dollars. For example, class action lawsuits brought against an industry segment (e.g., one that utilized asbestos in its product) can bring about a precipitous deterioration in the risk profile of that segment. Conversely, the dismissal of such lawsuits can bring about a precipitous improvement in the risk profile. In either case, Management estimates the appropriate level of Key’s allowance for loan losses by separately evaluating impaired and nonimpaired loans. A specific allowance is assigned to an impaired loan when expected cash flows or collateral do not justify the carrying amount of the loan. The methodology used to assign an allowance to a nonimpaired loan is much more subjective. Generally, the allowance assigned to nonimpaired loans is determined by applying historical loss rates to existing loans with similar risk characteristics and by exercising judgment to assess the impact of factors such as changes in economic conditions, changes in credit policies or underwriting standards, and changes in the level of credit risk associated with specific industries and markets. Because the economic and business climate in any given industry or market, and its impact on any given borrower, can change rapidly, the risk profile of the loan portfolio is continually assessed and adjusted when appropriate. Notwithstanding these procedures, there still exists the possibility that management’s assessment could prove to be significantly incorrect and that an immediate adjustment to the allowance for loan losses would be required. Allowance for loan losses. The loan portfolio is the largest category of assets on Key’s balance sheet. Management determines probable losses inherent in Key’s loan portfolio and establishes an allowance that is sufficient to absorb those losses by considering factors including historical loss rates, expected cash flows and estimated collateral values. In assessing these factors, management benefits from a lengthy organizational history and experience with credit decisions and related outcomes. Nonetheless, if management’s underlying assumptions later prove to be inaccurate, the allowance for loan losses would have to be adjusted. 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 and guarantees, principal investments, goodwill, and pension and other postretirement obligations. A brief discussion of each of these areas appears below. 10 NEXT PAGE PREVIOUS PAGE SEARCH BACK TO CONTENTS MANAGEMENTGLYPH<213>S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS KEYCORP AND SUBSIDIARIES