1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the Quarterly Period Ended September 30, 1998. or [ ] 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: 0-25188 Washington Mutual, Inc. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Washington 91-1653725 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1201 Third Avenue, Seattle, Washington 98101 (Address of principal executive offices) (Zip Code) (206) 461-2000 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) 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 [X] No [ ] The number of shares outstanding of the issuer's classes of common stock as of October 31, 1998. Common Stock - 593,252,788
2 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1998 TABLE OF CONTENTS <TABLE> <CAPTION> Page ---- <S> <C> <C> PART I Item 1. Financial Statements: Consolidated Statements of Income-- Three and nine months ended September 30, 1998 and 1997.............. 2 Consolidated Statements of Financial Position-- September 30, 1998 and December 31, 1997............................. 3 Consolidated Statements of Stockholders' Equity-- Nine months ended September 30, 1998 and 1997........................ 4 Consolidated Statements of Cash Flows-- Nine months ended September 30, 1998 and 1997........................ 5 Notes to Consolidated Financial Statements............................. 7 Item 2. Management's Discussion and Analysis of Financial Position and Results of Operations: General............................................................ 10 Results of Operations.............................................. 10 Review of Financial Position....................................... 15 Asset Quality...................................................... 18 Market Risk and Asset/Liability Management......................... 21 Liquidity.......................................................... 22 Capital Adequacy................................................... 23 PART II Item 1. Legal Proceedings...................................................... 24 Item 4. Submission of Matters to a Vote of Security Holders.................... 24 Item 6. Exhibits and Reports on Form 8-K....................................... 24 </TABLE> i
3 PART I ITEM 1. FINANCIAL STATEMENTS In the opinion of management, the accompanying balance sheets and related interim statements of income and cash flows reflect all adjustments (which include reclassifications and normal recurring adjustments) that are necessary for a fair presentation in conformity with generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the financial statements. Certain reclassifications have been made to the 1997 financial statements to conform to the 1998 presentation. All significant intercompany transactions and balances have been eliminated. When Washington Mutual, Inc. ("Washington Mutual" or the "Company") acquires a company through a material pooling of interests, current and prior period financial statements are restated to include the accounts of merged companies. Previously reported balances of the merged companies have been reclassified to conform to the Company's presentation and restated to give effect to the mergers. The financial information of Washington Mutual contained herein has not been restated for the merger with H.F. Ahmanson & Company ("Ahmanson"), which was effective on October 1, 1998. The information included in this Form 10-Q should be read in conjunction with Washington Mutual's 1997 Annual Report to the Securities and Exchange Commission on Form 10-K. Interim results are not necessarily indicative of results for a full year. 1
4 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------ ------------------------ 1998 1997 1998 1997 ----------- ----------- ----------- ----------- (dollars in thousands, except per share amounts) <S> <C> <C> <C> <C> INTEREST INCOME Loans $1,407,008 $1,320,754 $4,154,969 $3,826,055 Available-for-sale securities 256,724 230,337 710,358 773,559 Held-to-maturity securities 216,426 136,027 678,558 305,084 Cash equivalents and other 31,669 41,435 95,331 109,620 ---------- ---------- ---------- ---------- Total interest income 1,911,827 1,728,553 5,639,216 5,014,318 ---------- ---------- ---------- ---------- INTEREST EXPENSE Deposits 512,662 547,798 1,540,445 1,629,078 Borrowings 683,024 525,104 1,943,285 1,416,662 ---------- ---------- ---------- ---------- Total interest expense 1,195,686 1,072,902 3,483,730 3,045,740 ---------- ---------- ---------- ---------- Net interest income 716,141 655,651 2,155,486 1,968,578 Provision for loan losses 35,250 52,131 126,998 155,940 ---------- ---------- ---------- ---------- Net interest income after provision for loan losses 680,891 603,520 2,028,488 1,812,638 ---------- ---------- ---------- ---------- OTHER INCOME Depositor and other retail banking fees 121,082 92,431 319,042 267,409 Loan servicing income 16,283 22,066 49,729 65,150 Loan related income 17,679 14,431 52,106 38,663 Securities fees and commissions 39,135 39,988 118,155 116,132 Insurance fees and commissions 12,497 13,356 36,349 40,270 Mortgage banking gains (losses) 26,551 (89,173) 69,644 (76,707) Gain on sale of other assets 8,455 6,691 25,318 17,697 Write down of loans securitized and retained (8,234) (7,744) (18,371) (20,166) Other operating income 13,238 19,067 38,360 39,063 ---------- ---------- ---------- ---------- Total other income 246,686 111,113 690,332 487,511 ---------- ---------- ---------- ---------- OTHER EXPENSE Salaries and employee benefits 205,444 198,038 600,444 598,417 Occupancy and equipment 76,047 80,871 227,260 239,718 Telecommunications and outsourced information services 51,141 40,137 153,114 126,210 Regulatory assessments 9,102 8,822 27,457 26,026 Transaction-related expense 20,465 366,860 53,588 424,886 Amortization of intangible assets arising from acquisitions 13,733 16,387 40,761 47,833 Foreclosed asset (income) expense (9,546) 5,166 (5,945) 9,710 Other operating expense 122,996 109,685 337,577 320,454 ---------- ---------- ---------- ---------- Total other expense 489,382 825,966 1,434,256 1,793,254 ---------- ---------- ---------- ---------- Income (loss) before income taxes 438,195 (111,333) 1,284,564 506,895 Income taxes 159,911 11,313 480,564 250,093 Provision for payments in lieu of taxes 3,987 4,308 11,961 12,924 ---------- ---------- ---------- ---------- NET INCOME (LOSS) $ 274,297 $ (126,954) $ 792,039 $ 243,878 ========== ========== ========== ========== Net income (loss) attributable to common stock $ 273,028 $ (132,883) $ 788,096 $ 226,091 ========== ========== ========== ========== Net income (loss) per common share: Basic $0.73 $(0.36) $2.10 $0.62 Diluted 0.73 (0.36) 2.10 0.62 </TABLE> See Notes to Consolidated Financial Statements 2
5 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (Unaudited) <TABLE> <CAPTION> September 30, December 31, 1998 1997 ------------- ------------- (dollars in thousands) <S> <C> <C> ASSETS Cash $ 1,313,409 $ 1,285,222 Cash equivalents 40,750 275,668 Investments: Trading securities 38,452 23,364 Available-for-sale securities, amortized cost $18,284,691 and $11,258,232: Mortgage-backed securities ("MBS") 17,899,773 10,188,107 Investment securities 556,209 1,185,815 Held-to-maturity securities, fair value $11,240,535 and $12,699,653: MBS 11,283,139 12,659,217 Investment securities 130,790 120,397 ------------- ------------- Total investments 29,908,363 24,176,900 ------------- ------------- Loans: Loans held in portfolio 72,010,875 67,124,935 Loans held for sale 1,083,435 685,716 Reserve for loan losses (686,156) (670,494) ------------- ------------- Total loans 72,408,154 67,140,157 ------------- ------------- Investment in Federal Home Loan Banks ("FHLBs") 1,408,871 1,059,491 Foreclosed assets 157,500 205,272 Premises and equipment 1,077,958 937,198 Intangible assets arising from acquisitions 316,398 356,650 Mortgage servicing rights 262,340 215,360 Other assets 1,465,323 1,329,181 ------------- ------------- Total assets $ 108,359,066 $ 96,981,099 ============= ============= LIABILITIES Deposits: Checking accounts $ 8,133,689 $ 7,914,375 Savings accounts and money market deposit accounts 17,033,630 14,940,045 Time deposit accounts 25,391,716 28,131,597 ------------- ------------- Total deposits 50,559,035 50,986,017 ------------- ------------- Federal funds purchased and commercial paper 4,448,523 2,928,282 Securities sold under agreements to repurchase ("reverse repurchase agreements") 13,991,989 12,279,040 Advances from FHLBs 26,795,229 20,301,963 Other borrowings 3,288,679 3,489,362 Other liabilities 3,474,624 1,687,364 ------------- ------------- Total liabilities 102,558,079 91,672,028 ------------- ------------- STOCKHOLDERS' EQUITY Preferred stock, no par value, liquidation preference, 10,000,000 shares authorized - none and 4,722,500 shares issued and outstanding -- 118,063 Common stock, no par value, 1,600,000,000 shares authorized - 387,599,422 and 386,340,027 shares issued and outstanding -- -- Capital surplus - common stock 1,975,074 1,943,294 Accumulated other comprehensive income 159,488 134,610 Retained earnings 3,666,425 3,113,104 ------------- ------------- Total stockholders' equity 5,800,987 5,309,071 ------------- ------------- Total liabilities and stockholders' equity $ 108,359,066 $ 96,981,099 ============= ============= </TABLE> See Notes to Consolidated Financial Statements 3
6 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------- 1998 1997 ----------- ----------- (dollars in thousands) <S> <C> <C> PREFERRED STOCK Balance, beginning of period $ 118,063 $ 283,063 Redemption of Preferred Stock, Series C (68,813) -- Redemption of Preferred Stock, Series E (49,250) -- ----------- ----------- Balance, end of period -- 283,063 CAPITAL SURPLUS - COMMON STOCK Balance, beginning of period 1,943,294 1,664,870 Common stock issued through stock options, restricted stock grants and employee stock plans, including tax benefits 31,546 311,278 Common stock issued under dividend reinvestment plan 234 847 Common stock acquired -- (32,016) ----------- ----------- Balance, end of period 1,975,074 1,944,979 ACCUMULATED OTHER COMPREHENSIVE INCOME Balance, beginning of period 134,610 118,625 Other comprehensive income 24,878 47,638 ----------- ----------- Balance, end of period 159,488 166,263 RETAINED EARNINGS Balance, beginning of period 3,113,104 2,926,530 Net income 792,039 243,878 Minimum pension liability adjustment (2,504) -- Cash dividends declared on preferred stock (3,943) (17,787) Cash dividends declared on common stock (232,271) (201,722) Common stock issued and other miscellaneous transactions -- (8,099) ----------- ----------- Balance, end of period 3,666,425 2,942,800 ----------- ----------- Total stockholders' equity $ 5,800,987 $ 5,337,105 =========== =========== </TABLE> <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------- 1998 1997 ----------- ----------- (number of shares in thousands) <S> <C> <C> PREFERRED STOCK Balance, beginning of period 4,723 5,383 Redemption of Preferred Stock, Series C (2,753) -- Redemption of Preferred Stock, Series E (1,970) -- ----------- ----------- Balance, end of period -- 5,383 =========== =========== COMMON STOCK Balance, beginning of period 386,340 250,231 Common stock issued through stock options, restricted stock grants and employee stock plans, including tax benefits 1,254 7,833 Common stock issued under dividend reinvestment plan 5 20 Common stock acquired -- (908) ----------- ----------- Balance, end of period 387,599 257,176 =========== =========== </TABLE> See Notes to Consolidated Financial Statements 4
7 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------- 1998 1997 ----------- ----------- (dollars in thousands) <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 792,039 $ 243,878 Adjustments to operating activities: Provision for loan losses 126,998 155,940 Mortgage banking (gains) losses (69,644) 76,707 Gain on sale of other assets (25,318) (17,697) Depreciation and amortization 89,345 133,182 Stock dividends from FHLBs (58,179) (46,686) Transaction-related (accrual reversal) expense (37,448) 278,751 Decrease in trading securities 96,978 1,647 Origination of loans held for sale (5,840,878) (2,719,142) Proceeds from sales of loans held for sale 8,786,241 3,248,089 Increase in other assets (74,181) (183,746) Decrease in other liabilities (370,257) (269,261) ----------- ----------- Net cash provided by operating activities 3,415,696 901,662 CASH FLOWS FROM INVESTING ACTIVITIES Purchases of available-for-sale securities (9,301,106) (2,004,161) Principal payments and maturities of available-for-sale securities 2,718,765 1,754,288 Sales of available-for-sale securities 1,373,072 1,963,165 Purchases of held-to-maturity securities (13,079) (27,550) Principal payments and maturities of held-to-maturity securities 2,006,193 285,827 Increase in loans (9,225,283) (10,666,115) Proceeds from sale of foreclosed assets 248,610 292,537 Purchases of premises and equipment, net (204,409) (83,605) ----------- ----------- Net cash used by investing activities (12,397,237) (8,485,614) CASH FLOWS FROM FINANCING ACTIVITIES Decrease in deposits (426,982) (1,374,097) Increase in annuities -- 5,956 Increase in federal funds purchased and commercial paper 1,520,241 2,093,792 Increase (decrease) in short-term reverse repurchase agreements 1,783,804 (3,125,862) Proceeds from long-term reverse repurchase agreements 1,146,205 7,195,188 Repayments on long-term reverse repurchase agreements (1,215,591) (4,408,407) Proceeds from FHLBs advances 39,871,933 39,443,154 Repayments on FHLBs advances (33,379,116) (32,813,109) (Repayments on) proceeds from other borrowings (200,683) 90,035 Cash dividends paid (236,214) (219,509) Redemption of preferred stock (118,063) -- Common stock repurchased -- (32,016) Other capital transactions 29,276 304,026 ----------- ----------- Net cash provided by financing activities 8,774,810 7,159,151 ----------- ----------- Decrease in cash and cash equivalents (206,731) (424,801) Cash and cash equivalents, beginning of period 1,560,890 1,665,355 ----------- ----------- Cash and cash equivalents, end of period $ 1,354,159 $ 1,240,554 =========== =========== </TABLE> See Notes to Consolidated Financial Statements 5
8 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------- 1998 1997 ----------- ----------- (dollars in thousands) <S> <C> <C> NONCASH INVESTING ACTIVITIES Loans held for sale originated to refinance existing loans $ 3,273,438 $ 760,817 Trade date purchases not yet settled 2,178,226 703,088 Loans held in portfolio originated to refinance existing loans 1,402,902 326,064 Loans exchanged for MBS 647,020 2,710,300 Trade date sales not yet settled 272,589 157,207 Real estate acquired through foreclosure 242,220 336,325 Loans exchanged for trading securities 107,544 -- Loans originated to facilitate the sale of foreclosed assets 41,382 64,862 Reserves transferred to contingent liability 833 2,747 Transfer to held-to-maturity securities -- 4,359,814 Loans transferred to loans held for sale -- 1,236,796 Reserves transferred to MBS impairment -- 16,505 CASH PAID DURING THE PERIOD FOR Interest on borrowings 1,736,201 1,347,919 Interest on deposits 1,527,974 1,623,707 Income taxes 543,017 194,866 </TABLE> See Notes to Consolidated Financial Statements 6
9 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1: EARNINGS PER SHARE ("EPS") Basic EPS excludes dilution and is computed by dividing income attributable to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Information used to calculate EPS was as follows: <TABLE> <CAPTION> Three Months Ended September 30, ----------------------------------------------------------------------------------- 1998 1997 ----------------------------------------- ---------------------------------------- Income Shares Per Share Income Shares Per Share (numerator) (denominator) Amounts (numerator) (denominator) Amounts ------------- ----------- --------- ----------- ------------- --------- (dollars in thousands, except per share amounts) <S> <C> <C> <C> <C> <C> <C> Basic EPS: Net income (loss) $ 274,297 $ (126,954) Less: preferred stock dividends (1,269) (5,929) ------------- ------------- Income (loss) attributable to common shareholders 273,028 375,361,082 $0.73 (132,883) 370,959,425 $ (0.36) Diluted EPS: Effect of dilutive securities: Stock options -- 1,015,334 -- 1,529,020 ------------- ----------- ------------- ----------- Income (loss) attributable to common shareholders and assumed conversions $ 273,028 376,376,416 $0.73 $ (132,883) 372,488,445 $ (0.36) ============= =========== ============= =========== </TABLE> <TABLE> <CAPTION> Nine Months Ended September 30, -------------------------------------------------------------------------------------- 1998 1997 --------------------------------------- ------------------------------------------- Income Shares Per Share Income Shares Per Share (numerator) (denominator) Amounts (numerator) (denominator) Amounts ----------- ------------ --------- ------------- ------------- --------- (dollars in thousands, except per share amounts) <S> <C> <C> <C> <C> <C> <C> Basic EPS: Net income $ 792,039 $ 243,878 Less: preferred stock dividends (3,943) (17,787) ---------- ------------- Income attributable to common shareholders 788,096 374,879,413 $ 2.10 226,091 365,854,485 $0.62 Diluted EPS: Effect of dilutive securities: Stock options -- 1,237,622 -- 1,369,254 ---------- ----------- ------------- ------------- Income attributable to common shareholders and assumed conversions $ 788,096 376,117,035 $ 2.10 $ 226,091 367,223,739 $0.62 ========== =========== ============= ============= </TABLE> 7
10 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) NOTE 2: COMPREHENSIVE INCOME Washington Mutual adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," effective January 1, 1998. The standard requires that comprehensive income and its components be disclosed in the financial statements. The Company's comprehensive income includes all items which comprise net income plus the unrealized holding gains on available-for-sale securities. For the three and nine months ended September 30, 1998 and 1997, the Company's comprehensive income (loss) was as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------ ------------------------- 1998 1997 1998 1997 ----------- ----------- ----------- ------------ (dollars in thousands) <S> <C> <C> <C> <C> Net income (loss) $274,297 $(126,954) $792,039 $243,878 Other comprehensive income 15,317 85,277 24,878 47,638 -------- --------- -------- -------- Total comprehensive income (loss) $289,614 $ (41,677) $816,917 $291,516 ======== ========= ======== ======== </TABLE> NOTE 3: THE AHMANSON MERGER On March 17, 1998, Washington Mutual and Ahmanson announced the signing of a definitive merger agreement. The merger was approved by the shareholders of both companies at special meetings held on August 28, 1998. Holders of Washington Mutual common stock and holders of Washington Mutual preferred stock also approved an amendment to Washington Mutual's Articles of Incorporation to increase the number of authorized shares of common stock from 800,000,000 shares to 1,600,000,000 shares. The merger was approved by the Office of Thrift Supervision in September 1998. The merger was effective on October 1, 1998 and was accounted for as a pooling of interests. Each share of Ahmanson common stock was converted into the right to receive 1.68 shares of Washington Mutual common stock with cash paid in lieu of fractional shares. In connection with the merger, approximately 205,582,840 shares of Washington Mutual common stock were issued. On October 3, 1998, the Company merged Ahmanson's banking subsidiary, Home Savings of America, FSB, into Washington Mutual Bank, FA. NOTE 4: STOCKHOLDERS' EQUITY On September 16, 1998, the Company redeemed its Series E preferred stock at a price equal to $25 per share plus accrued and unpaid dividends. The preferred issue carried a dividend rate of 7.6% and was issued in September 1993. NOTE 5: OTHER BORROWINGS Other borrowings included Company-obligated mandatorily redeemable capital securities of the Company's subsidiary trusts holding solely $800.0 million aggregate principal amount of subordinated deferrable interest debentures of the Company as of September 30, 1998 and December 31, 1997. NOTE 6: IMPACT OF RECENTLY ISSUED OR ADOPTED ACCOUNTING STANDARDS SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," was issued in June 1997 and redefined how operating segments are determined. SFAS No. 131 requires disclosure of certain financial and descriptive information about a company's operating segments. This statement was adopted by the Company on January 1, 1998. Provisions of this statement require annual disclosure in the year of adoption and interim reporting for periods thereafter. This statement does not affect the results of operations or financial position of the Company. SFAS No. 132, "Employers' Disclosure about Pensions and Other Postretirement Benefits," was issued in February 1998 and standardizes the annual disclosure requirements for pensions and other postretirement benefits. This statement does not affect the results of operations or financial position of the Company. SFAS No. 132 was adopted by the Company as of January 1, 1998. 8
11 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued in June 1998 and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The statement is effective for all fiscal years beginning after June 15, 1999. The impact of the adoption of the provisions of this statement on the results of operations or the financial position of the Company has not yet been determined. SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise," was issued in October 1998. Prior to issuance of SFAS No. 134, when a mortgage banking company securitized loans held for sale but did not sell the security in the secondary market, the security was classified as trading. SFAS No. 134 requires that the security be classified in accordance with SFAS No. 115 as either trading, available for sale or held to maturity according to the Company's intent unless the Company has already committed to sell the security before or during the securitization process. The statement is effective for all fiscal years beginning after December 15, 1998. This statement is not expected to have a material impact on the results of operations or financial position of the Company. 9
12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL POSITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements. GENERAL Washington Mutual, Inc. ("Washington Mutual" or the "Company") is a financial services company committed to serving consumers and small and mid-sized businesses. The Company's banking subsidiaries, Washington Mutual Bank, FA ("WMBFA"), Washington Mutual Bank ("WMB") and Washington Mutual Bank fsb ("WMBfsb"), accept deposits from the general public, make residential loans, consumer loans, and commercial real estate loans (primarily loans secured by multi-family properties) and engage in certain commercial banking activities. The Company's consumer finance operations provide direct installment loans and related credit insurance services and purchase retail installment contracts. Washington Mutual also markets annuities and other insurance products, offers full service securities brokerage, and acts as the investment advisor to and the distributor of mutual funds. THE KEYSTONE TRANSACTION. In December 1996, Keystone Holdings, Inc. ("Keystone Holdings") merged with and into Washington Mutual and all of the subsidiaries of Keystone Holdings, including American Savings Bank, F.A. ("ASB"), became subsidiaries of the Company. THE GREAT WESTERN MERGER. On July 1, 1997, Great Western Financial Corporation ("GWFC") merged with and into New American Capital, Inc. ("NACI"), a wholly-owned subsidiary of the Company, and all of the subsidiaries of GWFC, including Great Western Bank, a Federal Savings Bank ("GWB") and Aristar, Inc. ("Aristar") became subsidiaries of NACI. On October 1, 1997, GWB was merged with and into ASB; simultaneously, the name of ASB was changed to Washington Mutual Bank, FA. THE AHMANSON MERGER. On October 1, 1998, H.F. Ahmanson & Company ("Ahmanson") merged with and into Washington Mutual. On October 3, 1998, Ahmanson's banking subsidiary, Home Savings of America, FSB, was merged with and into WMBFA. RESULTS OF OPERATIONS OVERVIEW. The Company's net income for the third quarter of 1998 was $274.3 million, compared with a net loss of $127.0 million for the third quarter of 1997. For the nine months ended September 30, 1998, net income was $792.0 million, compared with $243.9 million for the nine months ended September 30, 1997. Net income for the periods in both years was reduced by transaction-related expenses in connection with the GWFC merger and the results for 1998 also included transaction-related expenses for the Ahmanson merger. For the third quarter of 1998 and 1997, pretax charges for transaction-related expenses totaled $20.5 million and $366.9 million. For the nine months ended September 30, 1998 and 1997, pretax charges for transaction-related expenses totaled $53.6 million and $424.9 million. NET INTEREST INCOME. Net interest income for the third quarter of 1998 was $716.1 million, a 9% increase from $655.7 million in the third quarter of 1997. The increase was due to a 12% rise in average interest-earning assets to $100.54 billion from $89.97 billion in the third quarter of 1997. The net interest spread, however, declined to 2.70% in the third quarter of 1998 from 2.76% in the third quarter of 1997. The 9% increase in net interest income for the nine months ended September 30, 1998 to $2.16 billion was also due to a rise in average interest-earning assets. The net interest spread declined to 2.74% in the nine months ended September 30, 1998 from 2.83% in the nine months ended September 30, 1997. To a certain extent, the Company's net interest spread is affected by changes in the yield curve. During the third quarter of 1998, the difference between the yield on a three-month U.S. Treasury bill and a 10-year U.S. Government note averaged 26 basis points, compared with 106 basis points for the same period a year earlier. During the nine months ended September 30, 1998, the difference between the yield on a three-month U.S. Treasury bill and a 10-year U.S. Government note averaged 39 basis points, compared with 132 basis points for the same period a year earlier. 10
13 Selected average financial balances and the net interest spread and margin were as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------- -------------------------- 1998 1997 1998 1997 ------------ ------------ ------------ ------------- (dollars in thousands) <S> <C> <C> <C> <C> Selected Average Balances: Loans $ 71,417,642 $67,037,118 $ 69,809,714 $64,647,077 Investments 29,124,944 22,935,483 28,466,636 22,428,951 ------------ ----------- ------------ ----------- Total interest-earning assets 100,542,586 89,972,601 98,276,350 87,076,028 Deposits 50,407,583 51,670,233 50,738,940 52,004,850 Borrowings 46,360,159 35,061,690 44,083,025 31,904,807 ------------ ----------- ------------ ----------- Total interest-bearing liabilities 96,767,742 86,731,923 94,821,965 83,909,657 Total assets 103,944,145 93,764,401 101,845,313 90,386,754 Stockholders' equity 5,719,128 5,358,598 5,528,083 5,161,239 Weighted Average Interest Rates: Yield on loan portfolio 7.87% 7.86% 7.94% 7.89% Yield on investment portfolio 6.93 7.11 6.95 7.06 Yield on interest-earning assets 7.60 7.67 7.65 7.68 Cost of deposits 4.03 4.21 4.06 4.19 Cost of borrowings 5.85 5.94 5.89 5.94 Cost of interest-bearing liabilities 4.90 4.91 4.91 4.85 Net interest spread 2.70 2.76 2.74 2.83 Net interest margin 2.88 2.94 2.92 3.00 </TABLE> The net interest spread is the difference between the Company's yield on its loan and investment portfolios and its cost of deposits and borrowings. The net interest margin measures the Company's annualized net interest income as a percentage of average interest-earning assets. OTHER INCOME. Other income was $246.7 million and $690.3 million for the three and nine months ended September 30, 1998 compared with $111.1 million and $487.5 million for the same periods in 1997. Depositor and other retail banking fees of $121.1 million and $319.0 million for the three and nine months ended September 30, 1998 increased from $92.4 million and $267.4 million for the same periods in 1997. The increase reflected an increase in the volume of nonsufficient funds charges and overdraft protection charges on checking accounts and money market deposit accounts ("MMDAs"). There was also an increase in the number of such accounts since September 1997. Contributing to the decline in loan servicing income for the three and nine months ended September 30, 1998 was an increase in the amortization of mortgage servicing rights. The increased amortization was related to the higher rate of prepayments in the loan servicing portfolio. The amortization of mortgage servicing rights increased from $28.3 million for the nine months ended September 30, 1997 to $42.3 million for the same period in 1998. Higher prepayment activity generated by the declining interest-rate environment also resulted in an increase in prepayment fees, which are included in loan related income. Mortgage banking gains during the three and nine months ended September 30, 1998 were $26.6 million and $69.6 million, compared with net losses of $89.2 million and $76.7 million for the same periods in 1997. The Company's strategy is to sell the majority of its fixed-rate loan originations in the secondary market and during the three and nine months ended September 30, 1998, $2.65 billion and $8.72 billion of fixed-rate loans were sold. The relatively low interest-rate environment led to fixed-rate single family residential ("SFR") loan originations of $7.56 billion and $23.05 billion for the three and nine months ended September 30, 1998. Included in the third quarter and year-to-date losses during 1997 was a $100.0 million write down of loans securitized and held in the trading portfolio. 11
14 The sale of other assets resulted in net gains of $8.5 million and $25.3 million for the three and nine months ended September 30, 1998, compared with $6.7 million and $17.7 million for the same periods in 1997. The increases in the 1998 periods were due to sales and calls of mortgage-backed and investment securities, as well as an increase in 1998 of $4.5 million in the valuation of securities held in the trading portfolio compared with the write down in 1997 discussed above. The first nine months of 1997 included a $4.2 million gain associated with the sale of branch premises at GWB. OTHER EXPENSE. Other expense totaled $489.4 million and $1.43 billion for the three and nine months ended September 30, 1998, compared with $826.0 million and $1.79 billion for the same periods in 1997. Salaries and employee benefits increased to $205.4 million and $600.4 million for the three and nine months ended September 30, 1998, compared with $198.0 million and $598.4 million for the three and nine months ended September 30, 1997, as a result of increased incentive compensation due to expanded loan originations. Full-time equivalent employees ("FTEs") were 19,499 at September 30, 1998, compared with 19,954 at September 30, 1997. The decrease in FTEs was primarily due to staff reductions in connection with the GWFC merger and restructuring plan. However, this decrease was partially offset by increased staffing levels throughout the Company to support its growth. As a result of merger activity, the Company recorded transaction-related expense of $20.5 million and $53.6 million for the three and nine months ended September 30, 1998, compared with $366.9 million and $424.9 million for the same periods in 1997. For the three and nine months ended September 30, 1998, the majority of the charges were for one-time nonrecurring incremental costs associated with combining entities, which are being expensed as incurred. These transaction-related charges were partially offset by reductions in the estimates of contract cancellation fees of $13.6 million, severance of $8.0 million and other accruals of $3.0 million, and from gains on the disposition of surplus real estate of $12.8 million during the first nine months of 1998. The reduction in estimates for contract cancellation fees was largely a result of maintaining certain contracts in place for longer periods than originally anticipated, thereby reducing the cancellation penalties. The reduction in severance estimates was primarily the result of more employees voluntarily terminating without severance than was originally estimated. All staff reductions related to the Keystone Holdings and GWFC mergers have been completed. The remaining severance accruals relate to installment payments to employees that have already departed. The gains from the disposition of surplus real estate were a result of the value of excess branch properties being higher than originally estimated due to increases in real estate values in Southern California. 12
15 Reconciliation of the transaction-related expense and accrual activity was as follows: <TABLE> <CAPTION> Three Months Three Months Three Months Ended Ended Ended June 30, September 30, September 30, September 30, September 30, 1998 1998 1998 1998 1997 Accrued Activity Charged Accrued Period Period Balance Against Accrual(1) Balance Costs(2) Costs --------- ------------------ -------------- -------------- ------------- (dollars in thousands) <S> <C> <C> <C> <C> <C> Severance ................... $ 50,146 $(13,074) $37,072 $ 1,705 $122,933 Premises and equipment ..... 46,891 (14,095) 32,796 (9,539) 146,286 Legal, underwriting and other direct transaction costs .. 111 (35) 76 721 55,288 Contract cancellation costs . 18,744 (17,091) 1,653 1,155 33,207 Other ....................... 6,738 (2,830) 3,908 26,423 9,146 --------- -------- ------- --------- -------- $ 122,630 $(47,125) $75,505 $ 20,465 $366,860 ========= ======== ======= ========= ======== </TABLE> <TABLE> <CAPTION> Nine Months Nine Months Nine Months Ended Ended Ended December 31, September 30, September 30, September 30, September 30, 1997 1998 1998 1998 1997 Accrued Activity Charged Accrued Period Period Balance Against Accrual(1) Balance Costs(2) Costs ------------ ------------------ -------------- -------------- ------------- (dollars in thousands) <S> <C> <C> <C> <C> <C> Severance ................... $ 93,104 $ (56,032) $37,072 $ (3,923) $122,933 Premises and equipment ...... 57,304 (24,508) 32,796 (12,789) 146,286 Legal, underwriting and other direct transaction costs .. 742 (666) 76 7,413 113,314 Contract cancellation costs . 33,699 (32,046) 1,653 (11,527) 33,207 Other ....................... 11,243 (7,335) 3,908 74,414 9,146 --------- --------- ------- --------- -------- $ 196,092 $(120,587) $75,505 $ 53,588 $424,886 ========= ========= ======= ========= ======== </TABLE> - ---------- (1) Amounts include activity charged against the accrual, additional accruals and reversals of excess accruals. (2) Amounts include reversals of excess accruals. Telecommunications and outsourced information services expense of $51.1 million and $153.1 million for the three and nine months ended September 30, 1998 was up from $40.1 million and $126.2 million for the same periods in 1997. This change resulted from increased volume and usage. Foreclosed assets generated net income of $9.5 million and $5.9 million for the three and nine months ended September 30, 1998 compared with net expenses of $5.2 million and $9.7 million for the same periods in 1997. During the third quarter of 1998, the Company reversed $3.1 million in excess reserves on foreclosed assets and recorded a gain of $4.2 million on the sale of two foreclosed commercial properties. 13
16 Other operating expense consisted of the following: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ----------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- (dollars in thousands) <S> <C> <C> <C> <C> Other operating expense: Advertising and promotion $ 23,380 $ 22,638 $ 70,776 $ 62,747 Operating losses and settlements 21,946 13,909 45,904 37,481 Postage 14,011 12,049 39,835 37,333 Professional fees 11,585 13,944 31,517 40,913 Office supplies 6,510 3,899 17,196 14,249 Other expense 45,564 43,246 132,349 127,731 -------- -------- -------- -------- Total other operating expense $122,996 $109,685 $337,577 $320,454 ======== ======== ======== ======== </TABLE> Operating losses and settlements refer primarily to uncollected overdrafts and other deposit-related activity. As the volume of checking accounts increased, so did losses associated with these accounts. Management closely monitors these losses, especially in light of the growth in checking accounts. Included in the other category listed above are such expenses as travel and training, security services, outside printing, insurance expenses, and other operating costs. TAXATION. Income taxes include federal and applicable state income taxes and payments in lieu of taxes. The provision for income taxes was $163.9 million for the third quarter of 1998, compared with $15.6 million for the third quarter of 1997. The 1997 third quarter pretax loss of $111.3 million included transaction-related expenses which were not deductible for tax purposes. For the nine months ended September 30, 1998, the provision was $492.5 million, which represented an effective tax rate of 38.3%, compared with a 51.9% effective tax rate for the nine months ended September 30, 1997. The change in the tax rate resulted from a reduction in the tax valuation allowance in 1998 and nondeductible merger costs in 1997. CONSUMER FINANCE OPERATIONS. During the three and nine months ended September 30, 1998, Aristar had net income of $14.8 million and $41.4 million, up from $10.2 million and $34.3 million for the same periods in 1997. The 1997 third quarter net income had been reduced as a result of a pretax interest accrual reversal of $4.2 million. The improvement in net interest income was due to the growth in the loan portfolio. The increase in the loan loss provision reflected, in part, this growth of the loan portfolio and the credit risk inherent in consumer finance lending. <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ----------------------- 1998 1997 1998 1997 ---------- ---------- ---------- ---------- (dollars in thousands) <S> <C> <C> <C> <C> Consumer finance operations: Net interest income $ 71,791 $ 58,474 $ 206,655 $180,790 Provision for loan losses (21,800) (16,200) (58,100) (47,200) Other income 7,844 6,592 20,110 19,647 Other expense (33,322) (31,821) (100,174) (96,585) -------- -------- --------- -------- Income before income taxes 24,513 17,045 68,491 56,652 Income taxes (9,700) (6,800) (27,100) (22,400) -------- -------- --------- -------- Net income $ 14,813 $ 10,245 $ 41,391 $ 34,252 ======== ======== ========= ======== </TABLE> 14
17 REVIEW OF FINANCIAL POSITION ASSETS. At September 30, 1998, the Company's assets were $108.36 billion, an increase of 12% from $96.98 billion at December 31, 1997. The growth during the nine months ended September 30, 1998 resulted primarily from the purchase of agency and high quality MBS in the secondary market and the retention of adjustable-rate mortgage ("ARM") loan originations. Despite record loan originations during the nine months ended September 30, 1998, asset growth was hampered by increases in principal payments and sales of a majority of the Company's fixed-rate loan production. SECURITIES. The Company's securities portfolio increased by $5.73 billion to $29.91 billion during the nine months ended September 30, 1998 primarily due to the purchase of agency and high quality MBS in the secondary market. At September 30, 1998, 72% of MBS in the Company's securities portfolio were adjustable rate. This was down from 84% at June 30, 1998 primarily due to the purchase of fixed-rate securities with short durations. Of the securities indexed to an adjustable rate, 70% were indexed to the Cost of Funds Index of the Federal Home Loan Bank ("FHLB") Eleventh District ("COFI"), 20% were indexed to U.S. Treasury indices, and 10% were indexed to the London Interbank Offering Rate. The remaining 28% of MBS were fixed rate. LOANS. Total loans at September 30, 1998 were $72.41 billion, up from $67.14 billion at December 31, 1997. Changes in total loans for the nine months ended September 30, 1998 were as follows: <TABLE> <CAPTION> Nine Months Ended September 30, 1998 ---------------------------------------------- Cash Basis Noncash Items Total Change ------------ ------------- ------------- (dollars in thousands) <S> <C> <C> <C> Loans held in portfolio and reserve for loan losses: Loans originated (1) $ 18,591,332 $ 1,402,902 $ 19,994,234 Loans originated to facilitate the sale of foreclosed assets -- 41,382 41,382 Loans purchased 1,687,830 -- 1,687,830 Loans securitized -- (754,564) (754,564) Real estate acquired through foreclosure -- (242,220) (242,220) Proceeds from loans sold (24,574) -- (24,574) Loan payments and other (1) (11,139,808) (4,676,340) (15,816,148) Change in loan loss reserve 110,503 (126,165) (15,662) ------------ ----------- ------------ Change in loans held in portfolio and reserve for loan losses 9,225,283 (4,355,005) 4,870,278 Loans held for sale: Loans originated (1) 5,840,878 3,273,438 9,114,316 Proceeds from loans sold (8,786,241) -- (8,786,241) Mortgage banking gains 69,644 -- 69,644 ------------ ------------ ------------ Change in loans held for sale (2,875,719) 3,273,438 397,719 ------------ ------------ ------------ Total change in loans $ 6,349,564 $(1,081,567) $ 5,267,997 ============ ============ ============ </TABLE> - ---------- (1) Noncash items include loans originated to refinance existing loans. 15
18 Loans (exclusive of the reserve for loan losses) consisted of the following: <TABLE> <CAPTION> September 30, December 31, 1998 1997 ------------- ------------ (dollars in thousands) <S> <C> <C> Real estate loans: SFR $58,103,428 $53,431,451 SFR construction 973,669 877,449 Apartment buildings 4,109,321 4,187,580 Other commercial real estate 2,332,706 2,425,961 ----------- ----------- 65,519,124 60,922,441 Manufactured housing 1,097,766 1,081,193 Second mortgage and other consumer 3,069,575 2,725,144 Consumer finance 2,433,183 2,309,407 Commercial business 974,662 772,466 ----------- ----------- $73,094,310 $67,810,651 =========== =========== </TABLE> Real estate loans (exclusive of the reserve for loan losses) by product type were as follows: <TABLE> <CAPTION> September 30, 1998 December 31, 1997 ------------------------------- -------------------------------- Percent of Percent of Total Real Total Real Amount Estate Loans Amount Estate Loans ----------- ------------ ----------- ------------ (dollars in thousands) <S> <C> <C> <C> <C> Short-term ARMs: COFI $27,965,445 43% $32,108,461 53% Moving Treasury Average ("MTA") 6,261,732 9 1,602,123 3 Constant Maturity Treasury ("CMT") 3,098,686 5 3,800,156 6 Other 3,125,165 5 4,553,499 7 ----------- --- ----------- --- 40,451,028 62 42,064,239 69 Medium-term ARMs: MTA 5,347,763 8 2,880,587 5 CMT 3,220,619 5 4,135,947 7 COFI 903,228 1 1,244,357 2 Other 2,658,495 4 -- -- ----------- --- ----------- --- 12,130,105 18 8,260,891 14 Fixed-rate mortgages 12,937,991 20 10,597,311 17 ----------- --- ----------- --- $65,519,124 100% $60,922,441 100% =========== === =========== === Number of real estate loans 516,432 513,417 </TABLE> Short-term ARMs reprice within a year or less. Medium-term ARMs have an initial fixed rate for more than one year and then convert to short-term ARMs. 16
19 Loan originations were as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- 1998 1997 1998 1997 ------------- ------------- ------------- ------------- (dollars in thousands) <S> <C> <C> <C> <C> Real estate loans: SFR: Adjustable rate $3,905,075 $4,084,265 $11,299,226 $11,359,513 Fixed rate 3,654,218 1,770,245 11,750,052 4,632,757 ---------- ---------- ----------- ----------- 7,559,293 5,854,510 23,049,278 15,992,270 SFR construction: Custom 310,045 235,814 755,459 642,527 Builder 184,819 122,353 546,826 430,398 ---------- ---------- ----------- ----------- 494,864 358,167 1,302,285 1,072,925 Apartment buildings 149,585 212,071 424,489 524,912 Other commercial real estate 97,557 159,256 306,575 364,730 ---------- ---------- ----------- ----------- 8,301,299 6,584,004 25,082,627 17,954,837 Manufactured housing 83,815 96,515 221,273 247,670 Second mortgage and other consumer 469,258 495,257 1,404,452 1,420,495 Consumer finance 724,966 531,835 1,806,937 1,508,541 Commercial business 186,272 149,046 634,643 474,256 ---------- ---------- ----------- ----------- $9,765,610 $7,856,657 $29,149,932 $21,605,799 ========== ========== =========== =========== </TABLE> SFR originations by product type were as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, 1998 September 30, 1998 ---------------------------------- --------------------------------- Percent Percent Percent Percent of of of of Amount Category Total Amount Category Total ---------- -------- ------- ----------- -------- ------- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Short-term ARMs: MTA $1,679,415 94% 22% $ 4,616,572 85% 20% COFI 99,787 5 2 619,675 11 3 CMT 13,354 1 * 165,197 3 1 Other 1,210 * * 38,779 1 * ---------- --- --- ----------- --- --- 1,793,766 100% 24 5,440,223 100% 24 === === Medium-term ARMs: MTA 2,034,873 96% 27 5,189,960 89% 22 CMT 19,262 1 * 429,467 7 2 COFI 57,174 3 1 57,174 1 * Other -- -- -- 182,402 3 1 ---------- --- --- ----------- --- --- 2,111,309 100% 28 5,859,003 100% 25 === === Fixed-rate mortgages 3,654,218 48 11,750,052 51 ---------- --- ----------- --- $7,559,293 100% $23,049,278 100% ========== === =========== === </TABLE> - ---------- * Less than one percent 17
20 The strong housing market and lower interest rates led to strong loan production which included a significant amount of refinance activity during the nine months ended September 30, 1998. The low interest-rate environment also led to an increase in borrower preference for fixed-rate mortgages. Fixed-rate loan production accounted for 48% of total SFR originations in the third quarter of 1998, up from 30% in the third quarter of 1997, and 51% of total SFR originations during the nine months ended September 30, 1998, compared with 29% during the nine months ended September 30, 1997. INTEREST-BEARING LIABILITIES. The Company uses customer deposits and wholesale borrowings to fund its operations. Due to increased market competition for customer deposits, the Company has increasingly relied upon wholesale borrowings to fund its asset growth. The slight decrease in deposits from $50.99 billion as of December 31, 1997 to $50.56 billion as of September 30, 1998 reflected the competitive environment of banking institutions and the wide array of investment opportunities available to consumers. While time deposit accounts have declined as a percentage of total deposits, savings accounts, MMDAs and checking accounts have increased as a percentage of total deposits to 50% at September 30, 1998 compared with 45% at year-end 1997. These latter three products generally carry lower interest costs to the Company compared with time deposit accounts. Even though savings accounts, MMDAs and checking accounts are liquid, they are considered by the Company to be the core relationship with its customers. In the aggregate, the Company views these core accounts to be a more stable source of long-term funding. The Company's asset growth was funded by borrowings that primarily take the form of federal funds purchased, securities sold under agreements to repurchase ("reverse repurchase agreements") and advances from the FHLBs of Seattle and San Francisco. The exact mix at any given time is dependent upon the market pricing of the individual borrowing sources. ASSET QUALITY NONPERFORMING ASSETS. Assets considered to be nonperforming include nonaccrual loans and securities, foreclosed assets and real estate held for investment purposes that do not generate sufficient income to meet return on investment criteria. When loans securitized or sold with recourse provisions become nonperforming, they are included in nonaccrual loans. Management's classification of a loan as nonaccrual does not necessarily indicate that the principal of the loan is uncollectible in whole or in part. Loans are generally placed on nonaccrual status when they are four payments or more past due. Nonperforming assets were $748.5 million or 0.69% of total assets at September 30, 1998, compared with $806.6 million or 0.83% of total assets at December 31, 1997. Nonperforming assets consisted of the following: <TABLE> <CAPTION> September 30, December 31, 1998 1997 ------------- ------------- (dollars in thousands) <S> <C> <C> Nonaccrual loans: Real estate loans: SFR $471,714 $469,127 SFR construction 10,955 10,413 Apartment buildings 10,971 17,296 Other commercial real estate 7,484 25,825 -------- -------- 501,124 522,661 Manufactured housing 12,313 11,127 Second mortgage and other consumer 19,558 14,071 Consumer finance 55,050 50,930 Commercial business 2,974 2,585 -------- -------- 591,019 601,374 Foreclosed assets 157,500 205,272 -------- -------- $748,519 $806,646 ======== ======== Nonperforming assets as a percentage of total assets 0.69% 0.83% </TABLE> The decrease in foreclosed assets was primarily attributable to the decline in residential foreclosures. During the nine months ended September 30, 1998, sales of existing foreclosed assets exceeded acquisitions, resulting in a net decrease in the inventory. The Company also sold two foreclosed commercial properties during the third quarter of 1998. The two properties had a combined basis of $13.7 million and their sale generated a gain of $4.2 million. 18
21 PROVISION FOR LOAN LOSSES AND RESERVE FOR LOAN LOSSES. The provision for loan losses is based upon management's estimate of the amount necessary to maintain adequate reserves for loan losses inherent in the Company's loan portfolio. The Company's process to determine the level of the reserve and the related provision for loan losses includes consideration of various factors, such as current and anticipated economic conditions, the underlying quality of the loan portfolio, prior loan loss experience, the Company's credit administration and asset management philosophy and procedures, and regulatory requirements. Changes in the reserve for loan losses were as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------- ------------------------- 1998 1997 1998 1997 ----------- ----------- ----------- ----------- (dollars in thousands) <S> <C> <C> <C> <C> Balance, beginning of period $684,436 $666,057 $ 670,494 $ 677,141 Provision for loan losses 35,250 52,131 126,998 155,940 Reserves added through business combinations - - - 10,908 Reserves transferred to MBS impairment - - - (16,505) Reserves transferred to contingent liability (833) - (833) (2,747) Loans charged off: SFR (8,389) (22,438) (33,453) (78,624) SFR construction (108) (12) (470) (12) Commercial real estate (1,077) (4,869) (7,332) (19,148) Manufactured housing, second mortgage and other consumer (4,961) (4,422) (17,056) (13,674) Consumer finance (21,917) (19,683) (65,610) (58,336) Commercial business (819) (781) (2,734) (1,087) ------- ------- -------- -------- (37,271) (52,205) (126,655) (170,881) Recoveries of loans previously charged off: SFR 62 327 795 875 SFR construction - 5 - 74 Commercial real estate 125 1,302 923 2,169 Manufactured housing, second mortgage and other consumer 490 409 1,399 2,507 Consumer finance 3,761 3,754 12,703 12,214 Commercial business 136 89 332 174 -------- -------- --------- --------- 4,574 5,886 16,152 18,013 -------- -------- --------- --------- Net charge offs (32,697) (46,319) (110,503) (152,868) -------- -------- --------- --------- Balance, end of period $686,156 $671,869 $ 686,156 $ 671,869 ======== ======== ========= ========= </TABLE> An analysis of the reserve for loan losses was as follows: <TABLE> <CAPTION> September 30, December 31, 1998 1997 ------------- ------------ (dollars in thousands) <S> <C> <C> Specific and allocated reserves: Commercial real estate $ 76,073 $ 84,969 Commercial business 8,993 3,277 Builder construction 852 2,207 -------- -------- 85,918 90,453 Unallocated reserves 600,238 580,041 -------- -------- $686,156 $670,494 ======== ======== Total reserve for loan losses as a percentage of: Nonaccrual loans 116% 111% Nonperforming assets 92 83 </TABLE> 19
22 The Company considers the reserve for loan losses of $686.2 million at September 30, 1998 adequate to cover losses inherent in the loan portfolio. Management bases its analysis of the adequacy of the reserve on a combination of factors, including, but not limited to, the composition of the loan portfolio, recent loss experience as reflected in net charge offs, fluctuations in its nonperforming assets, and general market conditions. The credit quality of the Company's loan portfolio as measured by its nonperforming loans has remained relatively unchanged during 1998 and, therefore, the absolute level of loss reserves has also remained at comparable levels. As a result of reduced charge offs during the third quarter of 1998, the Company has reduced its provision for loan losses in order to maintain its loan loss reserve at levels consistent with the inherent losses described above. However, no assurance can be given that the Company will not, in any particular period, sustain loan losses that are sizable in relation to the amount reserved, or that subsequent evaluation of the loan portfolio, in light of the factors then prevailing, including economic conditions and the Company's ongoing examination process and that of its regulators, will not require significant increases in the reserve for loan losses. YEAR 2000. This section contains forward-looking statements that have been prepared on the basis of the Company's best judgments and currently available information. These forward-looking statements are inherently subject to significant business, third-party and regulatory uncertainties and contingencies, many of which are beyond the control of the Company. In addition, these forward-looking statements are based on the Company's current assessments and remediation plans, which are based on certain representations of third-party servicers and are subject to change. Accordingly, there can be no assurance that the Company's results of operations will not be adversely affected by difficulties or delays in the Company's or third parties' Year 2000 readiness efforts. See "Risks" below for a discussion of factors that may cause such forward-looking statements to differ from actual results. Washington Mutual has implemented a company-wide program to renovate, test and document the readiness ("Year 2000 readiness") of its electronic systems, programs and processes ("Computer Systems") and facilities to properly recognize dates to and through the year 2000 (the "Year 2000 Project"). While the Company is in various stages of modification and testing of individual Year 2000 Project components, the Year 2000 Project is proceeding generally on schedule. The Company has assigned its Executive Vice President of Operations to oversee the Year 2000 Project, has set up a Year 2000 Project Office, and has charged a senior management team representing all significant operational areas of the Company to act as a Steering Committee. The Company has dedicated a substantial amount of management and staff time on the Year 2000 Project. In addition, the Company has engaged IBM Global Services to provide supplemental technical and management resources to assess and test the Year 2000 readiness of the Company's Computer Systems, Deloitte & Touche LLP to assist in documenting certain aspects of the Year 2000 Project, and CB Richard Ellis to provide technical and management resources in executing the Year 2000 Project with respect to facilities. Monthly progress reports are made to the Company's Board of Directors, and the Board's Audit Committee reviews Year 2000 Project progress on a quarterly basis. (a) Project. The Company has divided its Year 2000 Project into the following general phases, consistent with guidance issued by the Federal Financial Institutions Examinations Council (the "FFIEC"): (i) inventory and assessment; (ii) renovation, which includes repair or replacement; (iii) validation, which includes testing of Computer Systems and the Company's connections with other computer systems; (iv) due diligence on third-party servicers; and (v) development of contingency plans. The Year 2000 Project is divided into four categories: mainframe systems, non-mainframe systems, third-party servicers, and facilities. The inventory and assessment phases are substantially complete, and each component that has been identified has been assigned a priority rating corresponding to its significance. The rating has allowed the Company to direct its attention to those Computer Systems, third-party servicers, and facilities that it deems more critical to its ongoing business and the maintainance of good customer relationships. The Company is currently in the process of repairing or replacing and testing the most significant components of its Computer Systems and facilities, and it expects to be substantially complete with this phase by December 31, 1998. The Company has also adopted business contingency plans for the Computer Systems and facilities that it has determined to be most critical. These plans conform to recently issued guidance from the FFIEC on business contingency planning for Year 2000 readiness. Contingency plans include, among other actions, manual workarounds and identification of resource requirements and alternative solutions for resuming critical business processes in the event of a year 2000-related failure. 20
23 Prior to 1998, the Company undertook strategic business initiatives that shifted a significant portion of the cost for Year 2000 readiness to third-party servicers. Following the Company's merger with Ahmanson and after the data processing conversions associated with that merger, the Company will rely on third-party servicers for significant business processes such as item processing, loan servicing, and desktop and communications management. The Company has been communicating with its third-party servicers to assess and monitor their Year 2000 readiness, and it has undertaken a contingency planning process to be ready in case one of the servicers that it deems most critical fails in its own readiness efforts. The Company expects that its due diligence on third-party servicers for its most critical business processes, including the testing of the Company's connections with these servicers, will be substantially complete by March 31, 1999, although its monitoring of these servicers will continue after that date. The Company continues to assess its risk from other environmental factors over which it has little control, such as electrical power supply, and voice and data transmission. Because of the nature of the factors, however, the Company is not actively engaged in any repair, replacement or testing efforts for these services. (b) Costs. While the Company does not believe that the process of making its Computer Systems Year 2000 ready will result in material cost, it is expected that a substantial amount of management and staff time will be required on the Year 2000 Project. The Company has spent approximately $8.4 million during the first nine months of 1998 on its Year 2000 Project, and it currently expects to spend approximately $11.2 million more before it concludes its Year 2000 readiness efforts. In 1996 and 1997, the Company spent approximately $30.3 million on technology-related initiatives, which had the effect of reducing the Company's current cost of Year 2000 readiness. (c) Risks. Based on its current assessments and remediation plans, which are based in part on certain representations of third-party servicers, the Company does not expect that it will experience a significant disruption of its operations as a result of the change to the new millenium. Although the Company has no reason to conclude that a failure will occur, the most reasonably likely worst-case Year 2000 scenario would entail a disruption or failure of the Company's power supply or voice and data transmission suppliers, a Computer System, a third-party servicer, or a facility. If such a failure were to occur, the Company would implement its contingency plan. While it is impossible to quantify the impact of such a scenario, the most reasonably likely worst-case scenario would entail a diminishment of service levels, some customer inconvenience, and additional costs from the contingency plan implementation, which are not currently estimable. While the Company has contingency plans to address a temporary disruption in these services, there can be no assurance that any disruption or failure will be only temporary, that the Company's contingency plans will function as anticipated, or that the results of operations of the Company will not be adversely affected in the event of a prolonged disruption or failure. There can be no assurance that the FFIEC or other federal regulators will not issue new regulatory requirements that require additional work by the Company and, if issued, that new regulatory requirements will not increase the cost or delay the completion of Washington Mutual's Year 2000 Project. MARKET RISK AND ASSET/LIABILITY MANAGEMENT The long-run profitability of the Company depends not only on the success of the services it offers to its customers and the credit quality of its loans and securities, but also the extent to which its earnings are unaffected by changes in interest rates. The Company engages in a comprehensive asset and liability management program that attempts to reduce the risk of significant decreases in net interest income caused by interest-rate changes without unduly penalizing current earnings. A key component of this program is the origination and retention of short-term and adjustable-rate assets whose repricing characteristics more closely match the repricing characteristics of the Company's liabilities. At the same time, the Company's policy is to sell most fixed-rate loan originations. A conventional measure of interest-rate sensitivity for savings institutions is the one-year gap, which is calculated by dividing the difference between assets maturing or repricing within one year and total liabilities maturing or repricing within one year by total assets. The Company's assets and liabilities that mature or reprice within one year were as follows: 21
24 <TABLE> <CAPTION> September 30, December 31, 1998 1997 ------------- ------------- (dollars in thousands) <S> <C> <C> Interest-sensitive assets $ 79,321,675 $ 74,938,422 Derivative instruments designated against assets 300,000 500,000 Interest-sensitive liabilities (81,949,602) (70,204,799) Derivative instruments designated against liabilities 2,211,800 1,078,400 ------------ ------------ Net asset sensitivity $ (116,127) $ 6,312,023 ============ ============ One-year gap (0.11)% 6.51% </TABLE> The one-year gap declined to a negative 0.11% at September 30, 1998 from a positive 6.51% at December 31, 1997. The low interest-rate environment produced a high level of refinancings, which limited ARM originations as fixed-rate loans were more attractive to borrowers. The Company funded a large portion of its originations through short-term borrowings. While the one-year gap helps provide some information about a financial institution's interest-rate sensitivity, it does not predict the trend of future earnings. The Company uses financial modeling to forecast earnings under different interest-rate projections. Although this modeling is very helpful in managing interest-rate risk, it does require significant assumptions for the projection of loan prepayment rates, loan origination volumes and liability funding sources that may prove to be inaccurate. The Company monitors its interest-rate sensitivity and attempts to reduce the risk of a significant decrease in net interest income caused by a change in interest rates. LIQUIDITY Liquidity management focuses on the need to meet both short-term funding requirements and long-term growth objectives. The long-term growth objectives of the Company are to attract and retain stable consumer deposit relationships and to maintain stable sources of wholesale funds. Because the low interest-rate environment of recent years inhibited consumer deposits, Washington Mutual has supported its growth through business combinations with other financial institutions and by increasing its use of wholesale borrowings. Should the Company not be able to increase deposits either internally or through acquisitions, its ability to grow would be dependent upon, and to a certain extent limited by, its borrowing capacity. As presented in the Consolidated Statements of Cash Flows, the sources of liquidity vary between years. The statement of cash flows includes operating, investing and financing categories. Cash flows from operating activities included net income for the nine months ended September 30, 1998 of $792.0 million, $120.7 million for noncash items and $2.50 billion of other net cash flows provided by operating activities. For the nine months ended September 30, 1998, cash flows from investing activities included sales and principal payments on securities totaling $6.10 billion. Purchases of securities required $9.31 billion and loans originated and purchased for investment net of principal payments required $9.23 billion. Cash flows from financing activities consisted of the net change in the Company's deposit accounts and short-term borrowings, the proceeds and repayments from both long-term reverse repurchase agreements and FHLB advances, and also the issuance of long-term debt. For the nine months ended September 30, 1998, the above mentioned financing activities increased cash and cash equivalents by $9.10 billion on a net basis. Cash and cash equivalents were $1.35 billion at September 30, 1998. At September 30, 1998, the Company was in a position to obtain approximately $29.66 billion in additional borrowings primarily through the use of collateralized borrowings and deposits of public funds using unpledged MBS and other wholesale sources. Washington Mutual monitors its ability to meet short-term cash requirements using guidelines established by its Board of Directors. The operating liquidity ratio is used to ensure that normal short-term secured borrowing capacity is sufficient to satisfy unanticipated cash needs. The volatile dependency ratio measures the degree to which the Company depends on wholesale funds maturing within one year weighted by the dependability of the source. At September 30, 1998, the Company had substantial liquidity compared with its established guidelines. WMB monitors its liquidity position as measured by certain predetermined ratios established by the Federal Deposit Insurance Corporation ("FDIC") as benchmarks for liquidity management. At September 30, 1998, WMB's ratios were above the FDIC minimum ratios. Regulations promulgated by the Office of Thrift Supervision ("OTS") require that the Company's federal savings banks maintain, for each calendar quarter, certain liquidity ratios. At September 30, 1998, each of the Company's federal savings banks' liquidity ratios was in excess of the regulatory minimums. 22
25 CAPITAL ADEQUACY The Company's capital (stockholders' equity) was $5.80 billion at September 30, 1998 up from $5.31 billion at December 31, 1997. However, due to asset growth, the ratio of capital to total assets was 5.35% at the end of third quarter 1998 compared with 5.47% at December 31, 1997. The regulatory capital ratios of WMBFA, WMB and WMBfsb and minimum regulatory requirements to be categorized as well capitalized were as follows: <TABLE> <CAPTION> September 30, 1998 ----------------------------- Well-Capitalized WMBFA WMB WMBfsb Minimum ----- ----- ------ ---------------- <S> <C> <C> <C> <C> Capital ratios: Leverage 5.68% 5.71% 6.86% 5.00% Tier 1 risk-based 10.18 10.76 11.92 6.00 Total risk-based 11.59 11.48 13.18 10.00 </TABLE> The Company's federal savings banking subsidiaries are also required by OTS regulations to maintain core capital of at least 3.00% of assets. WMBFA and WMBfsb each satisfied this requirement at September 30, 1998. The Company's securities subsidiaries are also subject to capital requirements. At September 30, 1998, all of Washington Mutual's securities subsidiaries were in compliance with their applicable capital requirements. 23
26 PART II ITEM 1. LEGAL PROCEEDINGS Washington Mutual, Inc. has certain litigation and negotiations in progress resulting from activities arising from normal operations. In the opinion of management, none of these matters is likely to have a materially adverse effect on the Company's financial position or results of operation. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On August 28, 1998 at a special meeting of shareholders, holders of Washington Mutual common stock approved the issuance of shares of common stock pursuant to the Agreement and Plan of Merger dated as of March 16, 1998 between Washington Mutual and Ahmanson, with 302,062,514 common share votes cast for the issuance, 843,252 votes cast against the issuance, and 614,598 abstentions. Holders of Washington Mutual common stock and holders of Washington Mutual preferred stock also approved an amendment to Washington Mutual's Articles of Incorporation to increase the number of authorized shares of common stock from 800,000,000 shares to 1,600,000,000 shares. Common shareholders cast 301,340,571 votes for the amendment and 32,023,977 votes against the amendment, with 635,955 abstentions. An aggregate of 303,072,407 votes were cast for and 32,058,480 votes were cast against the amendment by the common and preferred shareholders, with 670,469 abstentions. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See Index of Exhibits on page 26. (b) Reports on Form 8-K During the third quarter of 1998, the Company filed a report on Form 8-K dated July 21, 1998. The report included under Item 7 of Form 8-K a press release announcing Washington Mutual's second quarter 1998 financial results and unaudited consolidated financial statements for the quarter ended June 30, 1998. 24
27 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 13, 1998. WASHINGTON MUTUAL, INC. By: /s/ FAY L. CHAPMAN ----------------------------------------- Fay L. Chapman Executive Vice President By: /s/ RICHARD M. LEVY ----------------------------------------- Richard M. Levy Senior Vice President and Controller (Principal Accounting Officer) 25
28 WASHINGTON MUTUAL, INC. INDEX OF EXHIBITS <TABLE> <CAPTION> Exhibit No. - ----------- <S> <C> 3.1 Restated Articles of Incorporation of the Registrant, as amended (filed herewith as amended). 3.2 By-laws of the Registrant (filed herewith as amended). 4.1 Rights Agreement dated October 16, 1990 (incorporated by reference to the Washington Mutual, Inc. Current Report on Form 8-K dated November 29, 1994. File No. 0-25188). 4.2 Amendment No. 1 to Rights Agreement dated October 16, 1990 (incorporated by reference to the Washington Mutual, Inc. Current Report on Form 8-K dated November 29, 1994. File No.0-25188). 4.3 The registrant agrees to furnish the Securities and Exchange Commission, upon request, with copies of all instruments defining the rights of holders of long-term debt of registrant and its consolidated subsidiaries. 27.1 Financial Data Schedule. 27.2 Amended Financial Data Schedule for the period ended June 30, 1998. 27.3 Amended Financial Data Schedule for the period ended March 31, 1998. </TABLE> 26