July 22 (Bloomberg) -- KeyCorp, Ohio's third-largest bank, reported its first unprofitable quarter since 2001 as the lender lost a tax case tied to leasing and set aside more money to cover bad loans to builders.

The second-quarter net loss was $1.13 billion, or $2.70 a share, compared with a profit of $334 million, or 84 cents, a year earlier, the Cleveland-based bank said in a statement today. While the cost of the tax case was less than the bank forecast, the cost of uncollectible debt was higher than expected, said Jeff Davis, an analyst with FTN Midwest Securities.

``More important is going to be what happens to credit quality,'' Davis said in an interview today. ``It's about asset quality, and where does capital stand at this point in time.''

Chief Executive Officer Henry Meyer has stopped lending to builders in places where the bank has no community banking operations after defaults in states including Florida and California that prospered during the housing boom. KeyCorp raised more than $1.7 billion in the quarter selling convertible and common stock and halved its dividend after losing the tax case.

KeyCorp gained 49 cents, or 4.3 percent, to $11.99 at 4:02 p.m. in New York Stock Exchange composite trading, reversing an earlier decline of 15 percent after Vice Chairman Thomas Bunn said the only customers leaving KeyCorp are clients the bank no longer wants because they are at risk of not paying back loans.

The lender's stock has declined 49 percent this year, compared with the 73 percent slide at National City Corp., Ohio's largest bank, and the 41 percent plunge at No. 2 Fifth Third Bancorp.

``If the economy goes into full-blown recession, there's no way any of these banks have hit the bottom on credit,'' said RBC Capital Markets analyst Gerard Cassidy in an interview before results were announced.

Bad Loans

KeyCorp took a $1.01 billion second-quarter charge on the tax case tied to so-called lease-in, lease-out transactions, and said it planned to appeal. LILOs and similar service-in, lease- out transactions, or SILOs, aim to give buyers the right to asset-related deductions such as depreciation without technically owning the asset. The lender had forecast a charge of $1.1 billion to $1.2 billion.

The lender said loans it doesn't expect to be repaid climbed tenfold to $524 million, or 2.75 percent of average loans. KeyCorp in May doubled its forecast of uncollectible debt for the year to as high as 1.3 percent of average loans. Second- and third-quarter net charge-offs could run even higher, KeyCorp said in a regulatory filing on May 27.

KeyCorp ``moved to reduce our exposure in the residential homebuilder portfolio through the planned sale of certain assets,'' Meyer said in the statement.

Construction Lending

KeyCorp said it has sold $44 million in construction loans that weren't paying interest, and expects to sell an additional $340 million of such debt in the third quarter. Total loans for which KeyCorp is no longer collecting interest rose to $814 million from $276 million the same period a year earlier.

The bank set aside $647 million to cover bad debts, up from $53 million during second quarter of 2007.

The lender said its Tier 1 capital ratio at the end of the quarter was 8.49 percent, up from 8.14 percent a year earlier. Banks must have at least a 6 percent ratio to be considered ``well capitalized'' by regulators.

To contact the reporter on this story: Linda Shen in New York at lshen21@bloomberg.net

Last Updated: July 22, 2008 16:16 EDT