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, 1999. 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: 1-14667 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, 1999: Common Stock - 577,304,190
2 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1999 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, 1999 and 1998............. 2 Consolidated Statements of Comprehensive Income-- Three and Nine Months Ended September 30, 1999 and 1998............. 3 Consolidated Statements of Financial Condition-- September 30, 1999 and December 31, 1998............................ 4 Consolidated Statements of Stockholders' Equity-- Nine Months Ended September 30, 1999 and 1998....................... 5 Consolidated Statements of Cash Flows-- Nine Months Ended September 30, 1999 and 1998....................... 6 Notes to Consolidated Financial Statements............................ 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations: General...........................................................13 Results of Operations.............................................14 Review of Financial Condition.....................................21 Asset Quality.....................................................22 Asset and Liability Management Strategy...........................24 Liquidity.........................................................26 Capital Adequacy..................................................27 Year 2000 Project.................................................28 PART II Item 6. Exhibits and Reports on Form 8-K......................................31 </TABLE> i
3 PART I ITEM 1. FINANCIAL STATEMENTS In the opinion of management, the accompanying unaudited consolidated statements of financial condition and related interim consolidated statements of income, comprehensive income, stockholders' equity and cash flows reflect all adjustments (which consist only of 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. Certain reclassifications have been made to the 1998 financial statements to conform to the 1999 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, 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 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 1998 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, ----------------------------- ----------------------------- 1999 1998 1999 1998 ----------- ----------- ----------- ----------- (dollars in thousands, except per share amounts) <S> <C> <C> <C> <C> INTEREST INCOME Loans $ 2,126,725 $ 2,052,164 $ 6,168,599 $ 6,102,269 Available-for-sale securities 644,262 430,077 1,829,596 1,241,059 Held-to-maturity securities 239,199 288,197 744,992 910,162 Other interest income 49,330 43,840 130,069 130,607 ----------- ----------- ----------- ----------- Total interest income 3,059,516 2,814,278 8,873,256 8,384,097 INTEREST EXPENSE Deposits 775,800 890,311 2,382,121 2,721,536 Borrowings 1,164,050 860,598 3,095,566 2,449,193 ----------- ----------- ----------- ----------- Total interest expense 1,939,850 1,750,909 5,477,687 5,170,729 ----------- ----------- ----------- ----------- Net interest income 1,119,666 1,063,369 3,395,569 3,213,368 Provision for loan losses 40,799 34,376 125,356 128,745 ----------- ----------- ----------- ----------- Net interest income after provision for loan losses 1,078,867 1,028,993 3,270,213 3,084,623 OTHER INCOME Depositor and other retail banking fees 198,360 150,049 543,891 404,745 Loan servicing income 23,871 27,868 73,783 91,141 Loan related income 24,586 28,135 77,992 83,387 Securities fees and commissions 70,781 50,856 199,667 149,342 Insurance fees and commissions 10,571 14,075 31,510 40,452 Mortgage banking income 14,642 34,210 81,025 101,872 Gain on sale of other assets 6,547 8,677 22,872 23,464 Provision for recourse liability -- (15,917) (5,142) (41,436) Gain on sale of retail deposit branch systems -- 289,040 -- 289,040 Other operating income 20,161 22,073 60,183 60,824 ----------- ----------- ----------- ----------- Total other income 369,519 609,066 1,085,781 1,202,831 OTHER EXPENSE Salaries and employee benefits 294,323 299,785 898,052 896,423 Occupancy and equipment 139,237 120,820 411,301 367,403 Telecommunications and outsourced information services 70,862 64,211 208,106 190,501 Regulatory assessments 14,621 15,679 44,824 48,570 Transaction-related expense 12,673 20,465 73,044 76,747 Amortization of intangible assets 23,447 27,734 72,082 77,559 Foreclosed asset (income) expense (7,043) (1,786) (6,314) 17,442 Other operating expense 151,336 181,183 476,852 455,939 ----------- ----------- ----------- ----------- Total other expense 699,456 728,091 2,177,947 2,130,584 ----------- ----------- ----------- ----------- Income before income taxes 748,930 909,968 2,178,047 2,156,870 Income taxes 278,950 349,498 811,275 827,025 ----------- ----------- ----------- ----------- NET INCOME $ 469,980 $ 560,470 $ 1,366,772 $ 1,329,845 =========== =========== =========== =========== Net income attributable to common stock $ 469,980 $ 558,092 $ 1,366,772 $ 1,313,903 =========== =========== =========== =========== Net income per common share: Basic $ 0.83 $ 0.98 $ 2.37 $ 2.35 Diluted 0.83 0.96 2.37 2.29 </TABLE> See Notes to Consolidated Financial Statements. 2
5 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- 1999 1998 1999 1998 ----------- ----------- ----------- ----------- (dollars in thousands) <S> <C> <C> <C> <C> Net income $ 469,980 $ 560,470 $ 1,366,772 $ 1,329,845 Other comprehensive income, net of income taxes: Gross unrealized gain (loss) on securities: Unrealized holding gain (loss) during the period, net of deferred income tax (benefit) of $(126,019), $21,196, $(436,103), and $90,046 (192,855) 33,153 (667,396) 140,841 Gain (loss) included in net income, net of income tax (benefit) of $(4,099), $2,027, $(3,167) and $6,499 6,274 (3,170) 4,847 (10,165) Amortization of market adjustment for mortgage-backed securities ("MBS") transferred in 1997 from available for sale to held to maturity, net of deferred income tax of $1,573, $2,729, $5,960, and $7,706 (2,408) (4,269) (9,122) (12,053) ----------- ----------- ----------- ----------- (188,989) 25,714 (671,671) 118,623 Minimum pension liability adjustment (5,033) -- (6,793) -- ----------- ----------- ----------- ----------- Other comprehensive income (loss) (194,022) 25,714 (678,464) 118,623 ----------- ----------- ----------- ----------- Comprehensive income $ 275,958 $ 586,184 $ 688,308 $ 1,448,468 =========== =========== =========== =========== </TABLE> See Notes to Consolidated Financial Statements. 3
6 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited) <TABLE> <CAPTION> September 30, December 31, 1999 1998 ------------- ------------- (dollars in thousands) <S> <C> <C> ASSETS Cash $ 2,406,198 $ 2,695,454 Cash equivalents 60,911 61,520 Trading securities 30,740 39,068 Available-for-sale securities, amortized cost of $38,962,620 and $32,861,818: MBS 37,483,437 32,399,591 Investment securities 455,474 517,462 Held-to-maturity securities, fair value of $12,930,222 and $14,112,620: MBS 12,967,231 13,992,235 Investment securities 138,043 137,247 Loans: Loans held in portfolio 119,541,616 107,612,197 Loans held for sale 304,418 1,826,549 Reserve for loan losses (1,051,369) (1,067,840) ------------- ------------- Total loans 118,794,665 108,370,906 Investment in Federal Home Loan Banks ("FHLBs") 2,669,898 2,030,027 Foreclosed assets 222,689 274,767 Premises and equipment 1,544,342 1,421,162 Intangible assets 936,433 1,009,666 Mortgage servicing rights 489,037 461,295 Other assets 2,600,806 2,082,881 ------------- ------------- Total assets $ 180,799,904 $ 165,493,281 ============= ============= LIABILITIES Deposits: Interest-bearing checking accounts $ 6,150,686 $ 6,686,682 Noninterest-bearing checking accounts 7,391,511 6,774,049 Savings accounts and money market deposit accounts ("MMDAs") 31,127,144 28,285,868 Time deposit accounts 36,955,147 43,745,542 ------------- ------------- Total deposits 81,624,488 85,492,141 Federal funds purchased and commercial paper 1,574,706 2,482,830 Securities sold under agreements to repurchase 28,649,976 17,519,538 Advances from FHLBs 52,531,731 39,748,613 Other borrowings 5,850,417 5,449,508 Other liabilities 1,662,606 5,456,251 ------------- ------------- Total liabilities 171,893,924 156,148,881 STOCKHOLDERS' EQUITY Common stock, no par value: 1,600,000,000 shares authorized - 574,428,172 and 593,408,525 shares issued -- -- Capital surplus - common stock 2,288,097 2,994,653 Accumulated other comprehensive income (loss): Unrealized gain (loss) on available-for-sale securities (584,066) 87,605 Minimum pension liability adjustment (20,117) (13,324) Retained earnings 7,222,066 6,275,466 ------------- ------------- Total stockholders' equity 8,905,980 9,344,400 ------------- ------------- Total liabilities and stockholders' equity $ 180,799,904 $ 165,493,281 ============= ============= </TABLE> See Notes to Consolidated Financial Statements. 4
7 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Unaudited) <TABLE> <CAPTION> Capital Accumulated Common Surplus- Other Stock Preferred Common Comprehensive Retained in Total Stock Stock Income (Loss) Earnings Treasury ----------- ----------- ----------- ------------- ----------- ----------- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> BALANCE, December 31, 1998 $ 9,344,400 $ -- $ 2,994,653 $ 74,281 $ 6,275,466 $ -- Net income 1,366,772 -- -- -- 1,366,772 -- Cash dividends on common stock (420,172) -- -- -- (420,172) -- Repurchase of common stock, net (755,562) -- (755,562) -- -- -- Common stock issued through employee stock plans, including tax benefit 49,006 -- 49,006 -- -- -- Other comprehensive loss, net of related income tax benefit (678,464) -- -- (678,464) -- -- ----------- ----------- ----------- ----------- ----------- ----------- BALANCE, September 30, 1999 $ 8,905,980 $ -- $ 2,288,097 $ (604,183) $ 7,222,066 $ -- =========== =========== =========== =========== =========== =========== BALANCE, December 31, 1997 $ 7,601,085 $ 597,262 $ 2,629,377 $ 62,297 $ 5,244,509 $ (932,360) Net income 1,329,845 -- -- -- 1,329,845 -- Cash dividends on preferred stock (19,974) -- -- -- (19,974) -- Cash dividends on common stock (301,835) -- -- -- (301,835) -- Repurchase of common stock, net (24,082) -- -- -- -- (24,082) Redemption or conversion of preferred stock (313,063) (597,262) (112,085) -- -- 396,284 Common stock issued to acquire Coast Savings Financial, Inc. ("Coast") 925,143 -- 373,078 -- -- 552,065 Common stock issued through employee stock plans, including tax benefit 100,214 -- 108,551 -- -- (8,337) Treasury shares retired -- -- (10,896) -- -- 10,896 Other comprehensive income, net of related income taxes 118,623 -- -- 118,623 -- -- ----------- ----------- ----------- ----------- ----------- ----------- BALANCE, September 30, 1998 $ 9,415,956 $ -- $ 2,988,025 $ 180,920 $ 6,252,545 $ (5,534) =========== =========== =========== =========== =========== =========== </TABLE> See Notes to Consolidated Financial Statements. 5
8 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------- 1999 1998 ------------ ------------ (dollars in thousands) <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 1,366,772 $ 1,329,845 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 125,356 128,745 Mortgage banking income (81,025) (101,872) Gain on sale of other assets (22,872) (23,464) Depreciation and amortization 121,196 195,489 Stock dividends from FHLBs (97,598) (80,465) Provision for recourse liability 5,142 41,436 Decrease in trading securities 9,665 96,978 Origination of loans held for sale (3,496,969) (9,962,820) Sales of loans held for sale 7,414,583 12,908,315 Increase (decrease) in other assets (307,895) 257,875 Decrease in other liabilities (1,023,140) (145,097) Other, net 50 (27,727) ------------ ------------ Net cash provided by operating activities 4,013,265 4,617,238 CASH FLOWS FROM INVESTING ACTIVITIES Purchases of available-for-sale securities (17,861,797) (9,302,083) Purchases of held-to-maturity securities (86,510) (13,079) Sales of available-for-sale securities 2,146,690 1,373,423 Maturities of available-for-sale securities 117,142 321,661 Maturities of held-to-maturity securities 6,903 2,712 Principal payments on securities 10,372,697 6,447,887 Purchases of FHLB stock (552,153) (296,937) Purchases of loans (6,339,752) (1,729,182) Sales of loans 31,079 24,574 Origination of loans, net of principal payments (10,736,970) (5,111,487) Proceeds from sales of foreclosed assets 275,585 494,308 Cash from Coast acquisition -- 399,590 Purchases of premises and equipment (240,370) (197,585) Other, net -- 18,465 ------------ ------------ Net cash used in investing activities (22,867,456) (7,567,733) CASH FLOWS FROM FINANCING ACTIVITIES Decrease in deposits (3,867,653) (5,309,353) Increase in short-term borrowings 5,397,253 1,867,138 Proceeds from long-term borrowings 86,078,692 46,663,851 Repayments of long-term borrowings (67,916,349) (40,348,363) Cash dividends paid on preferred and common stock (420,172) (321,711) Redemption of preferred stock -- (313,161) Repurchase of common stock, net (755,562) (24,082) Other capital transactions 48,117 64,973 ------------ ------------ Net cash provided by financing activities 18,564,326 2,279,292 ------------ ------------ Decrease in cash and cash equivalents (289,865) (671,203) Cash and cash equivalents, beginning of period 2,756,974 2,719,997 ------------ ------------ Cash and cash equivalents, end of period $ 2,467,109 $ 2,048,794 ============ ============ </TABLE> See Notes to Consolidated Financial Statements. 6
9 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, -------------------------- 1999 1998 ---------- ---------- (dollars in thousands) <S> <C> <C> NONCASH INVESTING ACTIVITIES Loans exchanged for MBS $2,335,484 $ 647,020 Loans exchanged for trading securities -- 107,544 Real estate acquired through foreclosure 268,596 397,588 Loans originated to facilitate the sale of foreclosed assets 45,089 46,972 Loans held for sale originated to refinance existing loans 2,410,717 3,273,438 Loans held in portfolio originated to refinance existing loans 3,306,774 1,543,479 Trade date purchases not yet settled -- 2,178,226 Trade date sales not yet settled 217,814 272,589 Reserves related to internal securitizations 7,500 833 CASH PAID DURING THE PERIOD FOR Interest on deposits 2,333,109 2,665,920 Interest on borrowings 3,093,272 2,246,367 Income taxes 777,449 326,528 </TABLE> See Notes to Consolidated Financial Statements. 7
10 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 net income attributable to common stock by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if all 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 Nine Months Ended September 30, September 30, ------------------------------ ------------------------------ 1999 1998 1999 1998 ------------- ------------- ------------- ------------- (dollars in thousands, except per share amounts) <S> <C> <C> <C> <C> Net income: Net income $ 469,980 $ 560,470 $ 1,366,772 $ 1,329,845 Less: accumulated dividends on preferred stock -- (2,378) -- (15,942) ------------- ------------- ------------- ------------- Basic net income attributable to common stock 469,980 558,092 1,366,772 1,313,903 Add: accumulated dividends paid on convertible preferred stock -- 1,109 -- 9,269 ------------- ------------- ------------- ------------- Diluted net income attributable to common stock $ 469,980 $ 559,201 $ 1,366,772 $ 1,323,172 ============= ============= ============= ============= Weighted average shares: Basic weighted average number of common shares outstanding 565,360,141 571,589,704 575,777,473 558,830,010 Dilutive effect of outstanding common stock equivalents 1,333,556 11,759,104 1,997,716 19,588,600 ------------- ------------- ------------- ------------- Diluted weighted average number of common shares outstanding 566,693,697 583,348,808 577,775,189 578,418,610 ============= ============= ============= ============= Net income per common share: Basic $ 0.83 $ 0.98 $ 2.37 $ 2.35 Diluted 0.83 0.96 2.37 2.29 </TABLE> The decline in the dilutive effect of outstanding common stock equivalents from the prior year's periods was primarily attributable to the conversion to common stock of the Company's 6.00% Cumulative Convertible Preferred Stock, Series D in the third quarter of 1998, which caused a corresponding increase in the average number of common shares outstanding for the nine months ended September 30, 1999. In the third quarter of 1999, the increase in the average number of common shares outstanding resulting from the conversion of common stock was offset by the repurchase of 8.7 million and 21.0 million shares of the Company's common stock during the quarter and nine months ended September 30, 1999. As part of the business combination with Keystone Holdings, Inc., 12 million shares of common stock, with an assigned value of $27.7417 per share, were issued to an escrow for the benefit of the general and limited partners of Keystone Holdings, Inc. and the FSLIC Resolution Fund and their transferees. The conditions upon which these shares are contingently issuable are not based on earnings or market price. The contingencies had not occurred at September 30, 1999, and, therefore, the contingently issuable shares have not been included in the above computations. 8
11 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) NOTE 2: BORROWINGS Other borrowings included mandatorily redeemable Company-obligated capital securities of the Company's subsidiary trusts holding solely $950.0 million aggregate liquidation amount of subordinated deferrable interest debentures of the Company as of both September 30, 1999 and December 31, 1998. In August 1999, the Company issued senior debt securities totaling $750.0 million and bearing a fixed rate of 7.50%. The notes are due on August 15, 2006. Also in August 1999, Aristar, Inc. issued senior debt securities totaling $300.0 million and bearing a fixed rate of 7.375%. The notes are due on September 1, 2004. NOTE 3: LINES OF BUSINESS Washington Mutual is managed along five major lines of business: mortgage banking, consumer banking, commercial banking, financial services, and consumer finance. The treasury group, although not considered a line of business, is responsible for the management of investments and interest rate risk. The financial performance of these business lines is measured by the Company's profitability reporting processes, which utilize various management accounting techniques to ensure that each business line's financial results reflect the underlying performance of that business. Assets not originated through the Company's business operations are allocated to the treasury group. Prior to the Ahmanson merger and during the fourth quarter of 1998, Ahmanson was managed as a distinct business segment of Washington Mutual, and was therefore previously presented as a separate segment. Subsequent to year-end 1998, management began integrating the operations of Ahmanson into the Company's five major lines of business. The corresponding information for periods in 1998 has been restated to conform with the Company's current basis of segmentation. Financial highlights by lines of business: <TABLE> <CAPTION> Three Months Ended September 30, 1999 ---------------------------------------------------------------------------------------------- Mortgage Consumer Commercial Financial Consumer Treasury/ Banking Banking Banking Services Finance Other Total ---------- ---------- ---------- ---------- ---------- ---------- ---------- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> Condensed income statement: Net interest income after provision for loan losses $ 202,509 $ 610,254 $ 94,721 $ 498 $ 56,329 $ 114,556 $1,078,867 Other income 57,430 213,172 4,110 80,082 7,415 7,310 369,519 Transaction-related expense 137 11,664 137 (40) -- 775 12,673 Direct expense 52,474 249,091 21,844 52,469 32,945 (5,901) 402,922 ---------- ---------- ---------- ---------- ---------- ---------- ---------- Income before income taxes 207,328 562,671 76,850 28,151 30,799 126,992 1,032,791 Income taxes 76,937 208,802 28,619 10,811 12,011 47,127 384,307 ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net income (before centrally managed expense) 130,391 353,869 48,231 17,340 18,788 79,865 648,484 Centrally managed expense 74,112 201,664 4,787 20 643 2,635 283,861 Income taxes (27,502) (74,836) (1,783) (8) (251) (977) (105,357) ---------- ---------- ---------- ---------- ---------- ---------- ---------- Net income $ 83,781 $ 227,041 $ 45,227 $ 17,328 $ 18,396 $ 78,207 $ 469,980 ========== ========== ========== ========== ========== ========== ========== </TABLE> 9
12 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, 1999 ------------------------------------------------------------------------------------------------ Mortgage Consumer Commercial Financial Consumer Treasury/ Banking Banking Banking Services Finance Other Total ------------ ------------ ------------ ------------ ------------ ------------ ------------ (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> Condensed income statement: Net interest income after provision for loan losses $ 625,444 $ 1,809,614 $ 293,977 $ 1,591 $ 163,571 $ 376,016 $ 3,270,213 Other income 200,176 586,752 22,988 234,573 20,938 20,354 1,085,781 Transaction-related expense 13,868 54,207 558 2,156 -- 2,255 73,044 Direct expense 178,779 737,070 62,562 148,791 99,992 3,585 1,230,779 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Income before income taxes 632,973 1,605,089 253,845 85,217 84,517 390,530 3,052,171 Income taxes 234,989 595,870 94,514 32,444 32,959 145,055 1,135,831 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income (before centrally managed expense) 397,984 1,009,219 159,331 52,773 51,558 245,475 1,916,340 Centrally managed expense 223,314 616,731 16,038 238 1,279 16,524 874,124 Income taxes (82,904) (228,954) (5,971) (90) (499) (6,138) (324,556) ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income $ 257,574 $ 621,442 $ 149,264 $ 52,625 $ 50,778 $ 235,089 $ 1,366,772 ============ ============ ============ ============ ============ ============ ============ </TABLE> <TABLE> <CAPTION> September 30, 1999 ------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> <C> Total assets $ 40,388,799 $ 84,199,197 $ 19,437,360 $ 117,785 $ 3,061,725 $ 33,595,038 $180,799,904 ============ ============ ============ ============ ============ ============ ============ </TABLE> <TABLE> <CAPTION> Three Months Ended September 30, 1998 ------------------------------------------------------------------------------------------------ Mortgage Consumer Commercial Financial Consumer Treasury/ Banking Banking Banking Services Finance Other Total ------------ ------------ ------------ ------------ ------------ ------------ ------------ (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> Condensed income statement: Net interest income after provision for loan losses $ 206,191 $ 632,555 $ 99,434 $ 519 $ 49,991 $ 40,303 $ 1,028,993 Other income 85,417 149,927 6,570 58,253 7,844 301,055 609,066 Transaction-related expense 5,013 13,822 765 144 -- 721 20,465 Direct expense 71,152 244,573 18,964 40,347 32,932 15,239 423,207 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Income before income taxes 215,443 524,087 86,275 18,281 24,903 325,398 1,194,387 Income taxes 82,693 201,160 33,103 6,962 9,854 124,897 458,669 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income (before centrally managed expense) 132,750 322,927 53,172 11,319 15,049 200,501 735,718 Centrally managed expense 73,770 195,150 5,153 485 390 9,471 284,419 Income taxes (28,315) (74,904) (1,977) (185) (154) (3,636) (109,171) ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income $ 87,295 $ 202,681 $ 49,996 $ 11,019 $ 14,813 $ 194,666 $ 560,470 ============ ============ ============ ============ ============ ============ ============ </TABLE> 10
13 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, 1998 ------------------------------------------------------------------------------------------------------ Mortgage Consumer Commercial Financial Consumer Treasury/ Banking Banking Banking Services Finance Other Total ------------ ------------ ------------ ------------ ------------ ------------ ------------ (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> <C> Condensed income statement: Net interest income after provision for loan losses $ 573,078 $ 1,892,600 $ 287,137 $ 1,684 $ 148,555 $ 181,569 $ 3,084,623 Other income 265,266 432,958 17,784 173,794 20,110 292,919 1,202,831 Transaction-related expense 17,277 51,188 792 2,900 -- 4,590 76,747 Direct expense 193,066 703,790 59,107 123,645 99,349 48,329 1,227,286 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Income before income taxes 628,001 1,570,580 245,022 48,933 69,316 421,569 2,983,421 Income taxes 240,416 601,326 93,815 18,711 27,427 161,818 1,143,513 ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income (before centrally managed expense) 387,585 969,254 151,207 30,222 41,889 259,751 1,839,908 Centrally managed expense 214,145 568,058 13,356 2,422 825 27,745 826,551 Income taxes (81,981) (217,492) (5,114) (926) (327) (10,648) (316,488) ------------ ------------ ------------ ------------ ------------ ------------ ------------ Net income $ 255,421 $ 618,688 $ 142,965 $ 28,726 $ 41,391 $ 242,654 $ 1,329,845 ============ ============ ============ ============ ============ ============ ============ </TABLE> <TABLE> <CAPTION> September 30, 1998 ------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> <C> Total assets $ 33,114,883 $ 87,461,020 $ 19,598,268 $ 101,777 $ 2,583,769 $ 15,893,000 $158,752,717 ============ ============ ============ ============ ============ ============ ============ </TABLE> 11
14 WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) NOTE 4: IMPACT OF APPLICABLE RECENTLY ISSUED OR ADOPTED ACCOUNTING STANDARDS Statement of Financial Accounting Standards ("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 Financial Accounting Standards Board has issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities Deferral of the Effective Date of SFAS No. 133," which delays the implementation date of SFAS No. 133 for one year, to fiscal years beginning after June 15, 2000. The effect of the adoption of this statement on the results of operations or the financial condition 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 mortgage 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 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 adoption of this statement by the Company on January 1, 1999 did not affect the results of operations or financial condition of the Company. NOTE 5: LONG BEACH FINANCIAL CORPORATION ACQUISITION On October 1, 1999, Washington Mutual acquired Long Beach Financial Corporation ("Long Beach"), parent of Long Beach Mortgage Company ("Long Beach Mortgage") for $375.5 million in cash and stock. The acquisition was accounted for as a purchase. Under purchase accounting, the assets, liabilities and stockholders' equity of the acquired entity were recorded on the books of Washington Mutual at their respective fair values at the time of acquisition. This created goodwill of approximately $280.0 million, which is being amortized over 20 years. At September 30, 1999, Long Beach had $527.6 million in assets. Long Beach was merged with and into the Company. Long Beach Mortgage will retain its name and operate as a wholly-owned subsidiary of Washington Mutual. 12
15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report. This report contains forward-looking statements, which are not historical facts and pertain to future operating results of Washington Mutual, Inc. These forward-looking statements are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company's control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the results discussed in these forward-looking statements for the reasons, among others, discussed under the heading "Business-Risk Factors" in the Company's 1998 Annual Report on Form 10-K, which are incorporated herein by reference. GENERAL Washington Mutual, Inc. ("Washington Mutual" or the "Company") is a financial services company committed to serving consumers and small to 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 limited types of 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. As interest rates decreased during 1998, the Company experienced a substantial increase in the percentage of fixed-rate single-family residential ("SFR") mortgage originations. Since the Company's policy is to sell a substantial portion of its fixed-rate originations, the Company purchased investment grade mortgage-backed securities ("MBS") and whole loans in the secondary market during 1998 and the first half of 1999 in order to utilize its excess capital. These purchases, however, created assets with generally lower rates of return than loans originated by the Company and retained in its portfolio. After reviewing first quarter 1999 results, management re-evaluated its capital deployment strategy. In April 1999, the Company's Board of Directors approved a share repurchase program. Consequently, with the introduction of the share repurchase program, MBS purchases were curtailed. There were, however, significant purchases of whole loans during the third quarter of 1999. During the quarter and nine months ended September 30, 1999, the Company had an unrealized loss on available-for-sale securities of $189.0 million and $671.7 million, which resulted in an unrealized loss balance of $584.1 million at September 30, 1999. For the quarter and nine months ended September 30, 1998, the Company had an unrealized gain of $25.7 million and $118.6 million, which resulted in an unrealized gain balance of $180.9 million at September 30, 1998. The unrealized loss during the 1999 periods was due to a rise in interest rates. Commencing in 1998 and continuing through early 1999, mortgage interest rates generally decreased. During the second and third quarters of 1999, a rise in long-term interest rates prompted increased originations of adjustable-rate mortgage ("ARM") loans with a corresponding decrease in fixed-rate loan originations. ARMs comprised 86% of the Company's SFR originations in the third quarter of 1999, compared with 48% for the same period a year ago. ARMs comprised 68% of the Company's SFR originations in the nine months ended September 30, 1999, compared with 45% in the nine months ended September 30, 1998. The $11.93 billion growth in loans held in portfolio from year-end 1998 was primarily due to an increase in ARM loan originations and the purchase of whole loans during the nine months ended September 30, 1999. Loan growth during the third quarter of 1999 was enhanced by a decline in loan prepayment and refinancing 13
16 activity. Residential mortgage prepayment rates averaged 19% during the third quarter of 1999, down from 25% and 24% in the and first and second quarters of 1999. In April 1999, the Company's Board of Directors approved a share repurchase program to acquire up to 20 million shares of common stock. In May 1999, the Company's Board of Directors authorized the repurchase of common shares for reissuance to shareholders of Long Beach. In July 1999, the Board of Directors authorized the Company to repurchase up to 30 million additional shares. During the third quarter of 1999, the Company repurchased 8.7 million common shares at an average price of $34.16. Of the shares repurchased, 6.3 million shares were issued in conjunction with the completion of the Long Beach acquisition on October 1, 1999. During the first nine months of 1999, the Company repurchased 21.0 million common shares at an average price of $35.95. RESULTS OF OPERATIONS NET INTEREST INCOME. Net interest income for the third quarter of 1999 was $1.12 billion, a 5% increase from $1.06 billion in the third quarter of 1998. The increase was due to a 15% rise in average interest-earning assets to $171.92 billion from $149.47 billion in the third quarter of 1998, which more than offset the effect of the decline in the net interest spread to 2.50% in the third quarter of 1999 from 2.69% in the third quarter of 1998. The 6% increase in net interest income for the nine months ended September 30, 1999 to $3.40 billion was due to a 12% rise in average interest-earning assets from the nine months ended September 30, 1998. The net interest spread declined to 2.56% in the nine months ended September 30, 1999 from 2.72% for the same period in 1998. The Company's net interest margin declined to 2.64% in the third quarter of 1999 from 2.88% for the same period in 1998. Similarly, the net interest margin declined to 2.72% in the nine months ended September 30, 1999 from 2.89% for the same period in 1998. The yield on loans declined 37 basis points to 7.35% for the third quarter of 1999 from 7.72% for the same period in 1998. The yield on loans declined 40 basis points to 7.38% for the nine months ended September 30, 1999 from 7.78% for the same period in 1998. During 1998 and early 1999, there was a gradual decline in market interest rates, which reduced the yield on the Company's ARM portfolio and encouraged the prepayment of loans with higher rates. In addition, rates on new ARMs originated by the Company were generally lower than the rates on loans in the Company's portfolio. During the third quarter of 1999, the increase in long-term interest rates resulted in an increase in ARM originations. The impact of these higher rates on the existing portfolio was not immediately reflected in the yield on the loan portfolio due to a two- to three-month contractual lag before rates begin to adjust upward. In addition, the majority of ARM loans placed in the portfolio during the third quarter of 1999 contained a one- to three-month "teaser" rate that was significantly below the current portfolio yield. At September 30, 1999, 75% of total real estate loans and MBS were adjustable rate. The yield on MBS declined 45 basis points to 6.70% for the third quarter of 1999 from 7.15% for the same period in 1998. This decline was attributable to paydowns on higher yielding MBS, the lag in repricing of adjustable-rate MBS, and purchases of $8.50 billion of MBS to yield a weighted average rate of 6.33% during the fourth quarter of 1998 and $15.48 billion of MBS purchases to yield a weighted average rate of 6.25% during the nine months ended September 30, 1999. Adjustable-rate MBS comprised 55% of total MBS at September 30, 1999. The yield on MBS declined 49 basis points to 6.69% for the nine months ended September 30, 1999 from 7.18% for the same period a year ago. The 41 basis point decrease in the cost of deposits to 3.73% during third quarter 1999 from 4.14% for the same period in 1998 was primarily a result of a change in the composition of deposits. Higher-costing time deposits decreased from 54% of total deposits at September 30, 1998 to 45% at September 30, 1999, which reflected the Company's focus on growing retail transaction accounts rather than time deposits. Transaction accounts, consisting of savings accounts, money market deposit accounts ("MMDAs") and checking accounts, have the benefit of lower interest costs, compared with time deposits. 14
17 The Company's cost of borrowings declined 40 basis points to 5.47% for third quarter 1999 from 5.87% for third quarter 1998. Although there was a 50 basis point Fed tightening late in the second quarter and in the third quarter of 1999, short-term rates were generally lower compared with the same period a year ago. For example, the three-month London Interbank Offering Rate ("LIBOR") dropped from an average rate of 5.64% during third quarter 1998 to an average rate of 5.43% for third quarter 1999. At September 30, 1999, the majority of the Company's borrowings were tied to LIBOR. Also reflecting this decline in short-term rates, the cost of borrowings decreased 51 basis points to 5.39% for the nine months ended September 30, 1999, as compared with 5.90% for the same period a year ago. During the quarter and nine months ended September 30, 1999, there was a change in the mix of interest-bearing liabilities consisting of an increase in higher costing borrowings and a decline in lower costing deposits. In addition, the yield on interest-earning assets has declined at a faster rate than the cost of interest-bearing liabilities. These factors contributed to the compression of the interest spread and margin during the quarter and nine months ended September 30, 1999, compared with the same periods in 1998. 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, ------------------------------------ ------------------------------------ 1999 1998 1999 1998 --------------- --------------- --------------- --------------- (dollars in thousands) <S> <C> <C> <C> <C> Average Balances: Loans $ 115,584,502 $ 106,237,972 $ 111,504,519 $ 104,680,863 MBS 52,239,151 39,482,647 50,767,461 39,021,997 Investment securities 4,101,172 3,753,078 3,799,978 3,969,327 --------------- --------------- --------------- --------------- Total interest-earning assets 171,924,825 149,473,697 166,071,958 147,672,187 Deposits 82,511,343 85,426,522 83,566,677 86,896,450 Borrowings 84,500,292 58,235,865 76,795,776 55,458,676 --------------- --------------- --------------- --------------- Total interest-bearing liabilities 167,011,635 143,662,387 160,362,453 142,355,126 Total assets 177,663,218 155,456,034 171,129,534 153,699,694 Stockholders' equity 8,938,658 9,361,631 9,307,584 8,782,311 Weighted Average Yield On: Loans 7.35% 7.72% 7.38% 7.78% MBS 6.70 7.15 6.69 7.18 Investment securities 5.62 5.96 5.58 6.13 Interest-earning assets 7.11 7.53 7.13 7.57 Weighted Average Cost of: Deposits 3.73 4.14 3.81 4.19 Borrowings 5.47 5.87 5.39 5.90 Interest-bearing liabilities 4.61 4.84 4.57 4.85 Net interest spread 2.50 2.69 2.56 2.72 Net interest margin 2.64 2.88 2.72 2.89 </TABLE> The net interest spread is the difference between the Company's weighted average yield on its interest-earning assets and the weighted average cost of its interest-bearing liabilities. The net interest margin measures the Company's annualized net interest income as a percentage of average interest-earning assets. 15
18 The dollar amounts of interest income and interest expense fluctuate depending upon changes in interest rates and upon changes in amounts (volume) of the Company's interest-earning assets and interest-bearing liabilities. Changes attributable to (i) changes in volume (changes in average outstanding balances multiplied by the prior period's rate), (ii) changes in rate (changes in average interest rate multiplied by the prior period's volume), and (iii) changes in rate/volume (changes in rate times the change in volume that were allocated proportionately to the changes in volume and the changes in rate) were as follows: <TABLE> <CAPTION> Three Months Ended September 30, Nine Months Ended September 30, 1999 vs. 1998 1999 vs. 1998 --------------------------------------- --------------------------------------- Increase/(Decrease) Due to Increase/(Decrease) Due to --------------------------------------- --------------------------------------- Volume Rate Total Volume Rate Total --------- --------- --------- --------- --------- --------- (dollars in thousands) <S> <C> <C> <C> <C> <C> <C> Interest Income: Loans $ 175,150 $(100,589) $ 74,561 $ 386,719 $(320,389) $ 66,330 MBS 215,918 (47,051) 168,867 597,059 (150,801) 446,258 Investment securities 5,086 (3,276) 1,810 (7,555) (15,874) (23,429) --------- --------- --------- --------- --------- --------- Total interest income 396,154 (150,916) 245,238 976,223 (487,064) 489,159 Interest Expense: Deposits (29,603) (84,908) (114,511) (101,447) (237,968) (339,415) Borrowings 364,612 (61,160) 303,452 759,801 (113,428) 646,373 --------- --------- --------- --------- --------- --------- Total interest expense 335,009 (146,068) 188,941 658,354 (351,396) 306,958 --------- --------- --------- --------- --------- --------- Net interest income $ 61,145 $ (4,848) $ 56,297 $ 317,869 $(135,668) $ 182,201 ========= ========= ========= ========= ========= ========= </TABLE> OTHER INCOME. Other income was $369.5 million and $1.09 billion for the quarter and nine months ended September 30, 1999, compared with $609.1 million and $1.20 billion for the same periods in 1998. Other income consisted of the following: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ----------- ----------- ----------- ----------- 1999 1998 1999 1998 ----------- ----------- ----------- ----------- (dollars in thousands) <S> <C> <C> <C> <C> Depositor and other retail banking fees $ 198,360 $ 150,049 $ 543,891 $ 404,745 Loan servicing income 23,871 27,868 73,783 91,141 Loan related income 24,586 28,135 77,992 83,387 Securities fees and commissions 70,781 50,856 199,667 149,342 Insurance fees and commissions 10,571 14,075 31,510 40,452 Mortgage banking income 14,642 34,210 81,025 101,872 Gain on sale of other assets 6,547 8,677 22,872 23,464 Provision for recourse liability -- (15,917) (5,142) (41,436) Gain on sale of retail deposit branch systems -- 289,040 -- 289,040 Other operating income 20,161 22,073 60,183 60,824 ----------- ----------- ----------- ----------- Total other income $ 369,519 $ 609,066 $ 1,085,781 $ 1,202,831 =========== =========== =========== =========== </TABLE> Depositor and other retail banking fees of $198.4 million for the third quarter of 1999 increased from $150.0 million for the same period a year ago. Depositor and other retail banking fees of $543.9 million for the nine months ended September 30, 1999 increased from $404.7 million for the same period a year ago. The increase during the third quarter of 1999 was primarily due to increased nonsufficient funds and overdraft fees resulting from the growth in transaction deposits. The number of checking accounts increased 10% from September 30, 1998 to September 30, 1999. In addition, Visa interchange fees were higher due to increased volume of debit card usage. The increases on both a quarter and year-to-date basis also reflected the realization of the Company's consumer banking strategy in the former Great Western and American Savings Bank financial centers and implementation of this strategy in the former Home Savings financial centers. The strategy emphasizes the sale of value-added, fee-based services and an increased emphasis on the collection of fees. 16
19 The growth in depositor and other retail banking fees has been offset somewhat by an increase in the amount of deposit account-related losses (included in other operating expense) incurred by the Company resulting from the increased number of checking accounts. The number of net new retail checking accounts increased by 131,371 accounts or 3% during the third quarter of 1999 and 303,655 accounts or 8% during the nine months ended September 30, 1999. Securities fees and commissions increased to $70.8 million in the third quarter of 1999 from $50.9 million for the same period in 1998. These fees increased to $199.7 million in the nine months ended September 30, 1999 from $149.3 million for the comparable period in 1998. The increases were primarily attributable to higher sales of mutual funds and annuities during 1999. In addition, the former Ahmanson securities brokerage business began to offer Washington Mutual's products and services in early 1999, which resulted in increased fee income. Loan servicing income declined to $23.9 million for the third quarter of 1999 from $27.9 million for the comparable period in 1998. Loan servicing income declined to $73.8 million for the nine months ended September 30, 1999 from $91.1 million for the same period in 1998 due primarily to a 3.6 basis point drop in the average servicing fee. Loans serviced for others totaled $51.91 billion at September 30, 1999, up from $50.49 billion a year earlier. Increases in the portfolio from the sale of fixed-rate loans were offset by the high level of prepayments brought about by the refinance boom late in 1998 through mid-1999. The Company had mortgage banking income during the third quarter of 1999 of $14.6 million, compared with $34.2 million for the same period a year ago. It is the Company's strategy to sell the majority of its conforming fixed-rate loan production in the secondary market. However, due to the rise in interest rates and resulting customer shift to ARMs, the Company originated and therefore sold fewer fixed-rate mortgage loans during third quarter 1999. Fixed-rate SFR loan originations declined to $1.41 billion during third quarter 1999 from $3.77 billion in second quarter 1999 and $5.06 billion in third quarter 1998. The Company had mortgage banking income during the nine months ended September 30, 1999 of $81.0 million, compared with $101.9 million for the same period a year ago. Fixed-rate SFR loan originations decreased to $9.68 billion during the nine months ended September 30, 1999, compared with $15.94 billion for the same period a year ago. Gain on sale of other assets was $6.5 million for the third quarter of 1999, down from $8.7 million for the third quarter of 1998. Gain on sale of other assets declined slightly to $22.9 million for the nine months ended September 30, 1999 from $23.5 million for the same period in 1998. Third quarter 1999 included $15.8 million in gains attributable to the sale of financial centers, which were closed as a result of business combinations. These gains were offset by losses of $10.4 million on the sale of MBS during the third quarter of 1999. No gains on the sale of financial centers, closed as a result of business combinations, were included in the comparable periods for 1998. There was no provision for recourse liability in the third quarter of 1999, compared with $15.9 million for the same period in 1998. This provision declined to $5.1 million in the nine months ended September 30, 1999 from $41.4 million for the same period one year ago. The September 1999 quarterly analysis of the recourse liability on loans securitized and retained with recourse and loans sold with recourse confirmed the adequacy of the recourse liability when compared with the recourse obligation at September 30, 1999. The provision was higher in 1998 due to the establishment of the recourse liability in that year. OTHER EXPENSE. Other expense totaled $699.5 million and $2.18 billion for the quarter and nine months ended September 30, 1999, compared with $728.1 million and $2.13 billion for the same periods in 1998. 17
20 Other expense consisted of the following: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- 1999 1998 1999 1998 ----------- ----------- ----------- ----------- (dollars in thousands) <S> <C> <C> <C> <C> Salaries and employee benefits $ 294,323 $ 299,785 $ 898,052 $ 896,423 Occupancy and equipment: Premises and equipment 83,671 95,185 254,671 290,281 Data processing 55,566 25,635 156,630 77,122 ----------- ----------- ----------- ----------- Total occupancy and equipment 139,237 120,820 411,301 367,403 Telecommunications and outsourced information services 70,862 64,211 208,106 190,501 Regulatory assessments 14,621 15,679 44,824 48,570 Transaction-related expense 12,673 20,465 73,044 76,747 Amortization of intangible assets 23,447 27,734 72,082 77,559 Foreclosed asset (income) expense (7,043) (1,786) (6,314) 17,442 Other operating expense: Advertising and promotion 28,388 27,961 84,121 85,624 Operating losses and settlements 32,352 24,363 91,043 51,060 Postage 22,291 19,353 65,675 55,938 Professional fees 14,711 12,917 47,923 43,955 Travel and training 11,984 13,495 36,901 33,162 Office supplies 7,996 10,024 25,129 33,067 Other 33,614 73,070 126,060 153,133 ----------- ----------- ----------- ----------- Total other operating expense 151,336 181,183 476,852 455,939 ----------- ----------- ----------- ----------- Total other expense $ 699,456 $ 728,091 $ 2,177,947 $ 2,130,584 =========== =========== =========== =========== </TABLE> Salaries and employee benefits decreased to $294.3 million for the third quarter of 1999 from $299.8 million for the same period in 1998. Contributing to the decline was a reduction in average full-time equivalent employees ("FTE") from 27,887 for the quarter ended September 30, 1998 to 27,433 for the quarter ended September 30, 1999. Average FTE declined from 28,114 for the second quarter of 1999 to the third quarter of 1999 due to the completion of conversions related to the Ahmanson merger. The alignment of Ahmanson loan agent compensation with the Washington Mutual model also contributed to the decline. These declines were partially offset by lower loan origination costs resulting in a reduction in the deferral rate in salaries and benefits which in turn resulted in slightly higher current costs. Salaries and employee benefits increased slightly to $898.1 million for the nine months ended September 30, 1999 from $896.4 million for the same period in 1998. This increase was partially due to an increase in average FTE from 27,044 for the nine months ended September 30, 1998 to 27,822 for the comparable period in 1999. Average FTE declined from 28,017 for the six months ended June 30, 1999 to the nine months ended September 30, 1999 due to the completion of conversions related to the Ahmanson merger. Lower loan origination costs resulted in a reduction in the deferral rate in salaries and benefits which in turn resulted in slightly higher current costs. These increases were partially offset by the alignment of Ahmanson loan agent compensation with the Washington Mutual model. Occupancy and equipment expense was $139.2 million for the third quarter of 1999, up from $120.8 million for the same period a year ago. Occupancy and equipment expense was $411.3 million for the nine months ended September 30, 1999, compared with $367.4 million for the same period in 1998. The primary contributors to these increases were computer system upgrades and the conversion of systems at the former Ahmanson financial centers to Washington Mutual's platforms, which caused an increase in depreciation and related expenses recorded under data processing. Telecommunications and outsourced information services expense increased to $70.9 million for the third quarter of 1999 from $64.2 million for the same period in 1998. For the nine months ended September 30, 1999, this expense was $208.1 million, up from $190.5 million for the same period a year ago. These increases were primarily due to a new contract with IBM Global Services, effective January 1, 1999, which increased the cost for 1999. 18
21 As a result of merger activity, the Company recorded transaction-related expense of $12.7 million for the third quarter of 1999 and $20.5 million for the same period in 1998. For the nine months ended September 30, 1999 and 1998, this expense was $73.0 million and $76.7 million. The majority of the charges were for contract and temporary employment services, facilities and equipment impairment, and other costs, which are being expensed as incurred. Transaction-related expense in the first quarter of 1998 included $23.2 million related to the Coast acquisition. The Company continued to incur transaction-related expenses in connection with the Ahmanson merger in third quarter 1999, during which time several key computer systems were converted. During the third quarter of 1999, these transaction-related expenses were partially offset by reductions in the estimates of facilities holding costs of $11.9 million and severance costs of $2.5 million. During the nine months ended September 30, 1999, the reduction in the estimates of facilities holding costs was $19.8 million and severance costs was $3.6 million. There was also a reduction in contract cancellation costs of $8.9 million for the nine months ended September 30, 1999. The reduction in estimates of facilities holding costs and lease payments is attributable, in part, to the fact that certain office space was subleased sooner and at higher rates than expected. The reduction in estimates of contract cancellation fees was primarily due to contract negotiations resulting in lower than originally estimated fees. Gains of $15.8 million from the sale of financial centers closed as a result of business combinations were included in other income for the quarter and nine months ended September 30, 1999. The Company expected staff reductions related to the Ahmanson merger of approximately 3,400. As of September 30, 1999, 3,368 employee separations had occurred. The remaining employee separations are planned to be completed by the end of December 1999. At September 30, 1999, the carrying amount of all assets acquired through mergers and held for future disposal was $49.7 million. 19
22 Reconciliation of the transaction-related expense and accrual activity was as follows: <TABLE> <CAPTION> Three Months Three Months Ended Ended June 30, September 30, September 30, September 30, 1999 1999 1999 1999 Accrued Activity Charged Accrued Period Balance Against Accrual(1) Balance Costs(2) ------------ --------------------- -------------- --------------- (dollars in thousands) <S> <C> <C> <C> <C> Severance $ 19,860 $ (13,020) $ 6,840 $ (5,678) Premises and equipment 121,028 (11,070) 109,958 (1,194) Legal, underwriting and other direct transaction costs -- -- -- 1,122 Contract cancellation costs 5,927 (2,046) 3,881 4,494 Other -- -- -- 13,929 --------- --------- --------- --------- $ 146,815 $ (26,136) $ 120,679 $ 12,673 ========= ========= ========= ========= </TABLE> <TABLE> <CAPTION> Nine Months Nine Months Ended Ended December 31, September 30, September 30, September 30, 1998 1999 1999 1999 Accrued Activity Charged Accrued Period Balance Against Accrual(1) Balance Costs(2) ------------ --------------------- -------------- --------------- (dollars in thousands) <S> <C> <C> <C> <C> Severance $ 86,014 $ (79,174) $ 6,840 $ 4,211 Premises and equipment 158,932 (48,974) 109,958 1,578 Legal, underwriting and other direct transaction costs -- -- -- 5,163 Contract cancellation costs 15,678 (11,797) 3,881 (2,084) Other 1,406 (1,406) -- 64,176 --------- --------- --------- --------- $ 262,030 $(141,351) $ 120,679 $ 73,044 ========= ========= ========= ========= - ----------- (1) Amounts include activity charged against the accrual, additional accruals and reversals of excess accruals. (2) Amounts include additional accruals and reversals of excess accruals. </TABLE> Amortization of intangible assets was $23.4 million for the third quarter of 1999, down from $27.7 million for the same period in 1998. Similarly, amortization of intangible assets was $72.1 million for the nine months ended September 30, 1999, compared with $77.6 million for the same period in 1998. In February 1998, Ahmanson acquired Coast under the purchase accounting method, which created intangible assets of $516.5 million and amortization expense of $20.1 million in the nine months ended September 30, 1999, compared with $15.8 million in the same period of 1998. This increase was offset by goodwill and other intangible assets that had been fully amortized by March 31, 1999. Foreclosed assets generated net income of $7.0 million during third quarter 1999, compared with $1.8 million for the same period in 1998. Foreclosed assets generated net income of $6.3 million for the nine months ended September 30, 1999, compared with net expense of $17.4 million for the same period a year ago. The net income generated during the three and nine months ended September 30, 1999 primarily represented net gains on the sales of real estate owned, reflecting the improvement in California and Northwest real estate values. The majority of the net expense during the nine months ended September 30, 1998 represented foreclosed asset expense from the maintenance of a greater number of foreclosed assets in 1998, as compared with 1999. At September 30, 1999, the Company had 2,044 foreclosed properties, down from 3,014 a year ago. Other operating expense was $151.3 million in the third quarter of 1999, down from $181.2 million for the same period in 1998. Other operating expense increased to $476.9 million during the nine months ended September 30, 1999 from $455.9 million for the same period in 1998. During the third quarter of 1998, the other category of other operating expense included a $30.0 million expense for the donation of land for open space to support further development of property owned by Ahmanson as a real estate 20
23 investment. Excluding this expense, other operating expense was relatively unchanged from third quarter 1998 to third quarter 1999. The increase for the nine-month period was primarily due to a rise in operating losses and settlements to $91.0 million for the nine months ended September 30, 1999 from $51.1 million for the comparable period a year ago, resulting from the increased number of checking accounts. TAXATION. Income taxes include federal and applicable state income taxes and payments in lieu of taxes. Income taxes of $279.0 million and $811.3 million for the quarter and nine months ended September 30, 1999 represented an effective tax rate of 37.25%. Income taxes were $349.5 million and $827.0 million for the quarter and nine months ended September 30, 1998, which represented effective tax rates of 38.41% and 38.34%. The decline in the effective tax rate was due, in part, to benefits realized from certain tax strategies of the Company. REVIEW OF FINANCIAL CONDITION ASSETS. At September 30, 1999, the Company's total assets were $180.80 billion, an increase of 9% from $165.49 billion at December 31, 1998. The asset growth was the result of loan originations and asset purchases, partially offset by payments on loans and MBS. SECURITIES. The Company's securities portfolio increased by $3.99 billion to $51.07 billion during the nine months ended September 30, 1999 due to purchases of $15.48 billion in investment grade MBS in the secondary market. At September 30, 1999, 55% of MBS in the Company's securities portfolio were adjustable rate, down from 71% at December 31, 1998 due to purchases of the aforementioned MBS. These MBS purchases were primarily fixed rate and had an expected average remaining life from the time of purchase of 4.46 years. At September 30, 1999, of the $27.87 billion in MBS with an adjustable rate, 81% were indexed to the Cost of Funds Index of the Eleventh District Federal Home Loan Bank ("FHLB"), 15% were indexed to U.S. Treasury securities, and 4% were indexed to LIBOR. LOANS. Total loans (net of reserve for loan losses) at September 30, 1999 were $118.79 billion, a 10% increase from $108.37 billion at December 31, 1998. Loans held in portfolio increased by $11.93 billion during the nine months ended September 30, 1999 as a result of originations of $38.27 billion and purchases of $6.23 billion of whole loans, of which $2.81 billion were specialty mortgage finance loans at a weighted average yield of 8.65%. Specialty mortgage finance loans are loans to borrowers who generally would not qualify for a loan from the Company's banking subsidiaries due to the borrower's credit history, high debt-to-income ratio or other factors. A reduction in prepayment activity during third quarter 1999 also contributed to an increase in the loan portfolio. The $1.52 billion decrease in loans held for sale was primarily due to lower fixed-rate loan production. ARM production accounted for 86% and 68% of total SFR originations in the three and nine months ended September 30, 1999, up from 48% and 45% for the same periods a year ago. In particular, short-term ARM originations rose to 44% of total SFR originations in the third quarter of 1999 from 26% in the third quarter of 1998. Similarly, for the nine months ended September 30, 1999, these originations rose to 31% from 25% for the same period in 1998. The shift by borrowers from fixed-rate mortgages to ARMs was in response to a recent increase in rates for fixed-rate loans and a steepening of the yield curve. The difference between the yield on a three-month U.S Treasury bill and a ten-year U.S. government note averaged 110 basis points and 86 basis points in the three and nine months ended September 30, 1999, compared with 26 basis points and 38 basis points for the same periods in 1998. LIABILITIES. Due to increased market competition for customer deposits, the Company has increasingly relied upon wholesale borrowings to fund its asset growth. Deposits decreased from $85.49 billion at December 31, 1998 to $81.62 billion at September 30, 1999 with the majority of the decrease in time deposits. The Company's strategy has been to increase its ratio of transaction accounts to total deposits. As a result of this strategy, transaction accounts have increased as a percentage of total deposits to 55% at September 30, 1999, from 49% at year-end 1998. Transaction accounts generally carry lower interest costs to the Company, compared with time deposit accounts. Even though transaction accounts are more liquid, they are considered by the Company to be 21
24 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 than time deposits. The Company's asset growth during the nine months ended September 30, 1999 was funded by borrowings in the form of securities sold under agreements to repurchase ("reverse repurchase agreements") and advances from the FHLBs of Seattle and San Francisco. The exact mix of borrowings at any given time is dependent upon a variety of factors, primarily the market pricing of the individual borrowing sources. ASSET QUALITY PROVISION AND RESERVE FOR LOAN LOSSES. The Company analyzes several important elements in determining the level of the provision for loan losses in any given period, such as current and historical economic conditions, nonperforming asset trends, historical loan loss experience, and plans for problem loan administration and resolution. These elements are also captured in a migration analysis performed on the loan portfolio on a quarterly basis and used in determining the loan loss provision. During the third quarter of 1999, net charge offs increased to $43.0 million from $38.4 million for the same period in 1998. Net charge offs increased to $147.0 million for the nine months ended September 30, 1999 from $132.1 million for the same period a year ago. Included in the nine months ended September 30, 1999 were charge offs of $17.8 million in previously established specific reserves on four commercial real estate properties that were obtained through acquisitions. Excluding the charge off of these specific reserves, charge offs have continued to decline from 1998 levels, which reflects the improvement in credit quality and real estate values. The provision for loan losses was $40.8 million for third quarter 1999, compared with $34.4 million for the same period a year ago. The provision for the nine months ended September 30, 1999 was $125.4 million, down slightly from $128.7 million for the comparable period in 1998. Because of favorable credit trends, the provision for loan losses was $2.2 million and $21.7 million less than net charge offs for the quarter and nine months ended September 30, 1999. The Company's consistent application of its loan loss reserve methodology has resulted in a reduced loan loss reserve level at September 30, 1999, compared with June 30, 1999 and September 30, 1998. 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. 22
25 Changes in the reserve for loan losses were as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ----------------------------- ----------------------------- 1999 1998 1999 1998 ----------- ----------- ----------- ----------- (dollars in thousands) <S> <C> <C> <C> <C> Balance, beginning of period $ 1,053,589 $ 1,156,347 $ 1,067,840 $ 1,047,845 Provision for loan losses 40,799 34,376 125,356 128,745 Reserves added through business combinations -- -- -- 107,830 Reserves related to internal securitizations -- (833) (7,500) (833) Reserves transferred from other liabilities -- -- 12,714 -- Loans charged off: SFR and SFR construction (9,909) (13,505) (29,513) (52,547) Manufactured housing, second mortgage and other consumer (12,186) (7,367) (36,031) (25,662) Commercial business (689) (1,366) (4,405) (4,133) Commercial real estate (3,409) (5,795) (30,212) (24,765) Consumer finance (23,628) (21,917) (70,260) (65,610) ----------- ----------- ----------- ----------- (49,821) (49,950) (170,421) (172,717) Recoveries of loans previously charged off: SFR and SFR construction 505 5,918 2,752 14,617 Manufactured housing, second mortgage and other consumer 966 490 2,240 1,472 Commercial business 107 177 558 361 Commercial real estate 1,395 1,200 5,761 11,463 Consumer finance 3,829 3,761 12,069 12,703 ----------- ----------- ----------- ----------- 6,802 11,546 23,380 40,616 ----------- ----------- ----------- ----------- Net charge offs (43,019) (38,404) (147,041) (132,101) ----------- ----------- ----------- ----------- Balance, end of period $ 1,051,369 $ 1,151,486 $ 1,051,369 $ 1,151,486 =========== =========== =========== =========== Net charge offs as a percentage of average loans (annualized) 0.15% 0.14% 0.18% 0.17% </TABLE> An analysis of the reserve for loan losses was as follows: <TABLE> <CAPTION> September 30, December 31, 1999 1998 ------------- ------------ (dollars in thousands) <S> <C> <C> Specific and allocated reserves: Commercial real estate $ 74,574 $ 133,167 Commercial business 18,390 9,690 Builder construction 4,677 852 ---------- ---------- 97,641 143,709 Unallocated reserves 953,728 924,131 ---------- ---------- $1,051,369 $1,067,840 ========== ========== Total reserve for loan losses and recourse liability as a percentage of: Nonaccrual loans 140% 129% Nonperforming assets 110 100 Total reserve for loan losses as a percentage of total loans (exclusive of the reserve for loan losses) 0.88% 0.98% </TABLE> The Company follows the practice of securitizing (with and without recourse) certain loans and retaining them in its investment portfolio. At September 30, 1999, the Company had $20.51 billion of loans securitized and retained with recourse, and $4.83 billion of loans and MBS sold with recourse. At September 30, 1999, the total liability for this recourse was $117.0 million. 23
26 Changes in the recourse liability were as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ------------------------ ------------------------ 1999 1998 1999 1998 --------- --------- --------- --------- (dollars in thousands) <S> <C> <C> <C> <C> Balance, beginning of period $ 122,003 $ 74,047 $ 144,257 $ 80,157 Transfer of reserve on held-to-maturity REMIC securities -- -- (22,500) -- Transfer from reserve for loan losses -- 833 7,500 833 Charge offs, net of provision for losses (4,974) (2,304) (12,228) (8,414) --------- --------- --------- --------- Balance, end of period $ 117,029 $ 72,576 $ 117,029 $ 72,576 ========= ========= ========= ========= </TABLE> NONPERFORMING ASSETS. Assets considered to be nonperforming include nonaccrual loans and foreclosed assets. 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 securitized or sold with recourse that are four payments or more past due are included in nonaccrual loans. At foreclosure, such loans are repurchased by the Company and included in foreclosed assets. Nonperforming assets were $1.06 billion or 0.58% of total assets at September 30, 1999, compared with $1.21 billion or 0.73% of total assets at December 31, 1998. The reserve as a percentage of nonaccrual loans and nonperforming assets has increased due to the decline in nonaccrual loans and nonperforming assets. Nonperforming assets consisted of the following: <TABLE> <CAPTION> September 30, December 31, 1999 1998 ------------- ------------ (dollars in thousands) <S> <C> <C> Nonaccrual loans: SFR $ 641,928 $ 752,261 SFR construction 19,888 9,188 Manufactured housing 18,097 14,669 Second mortgage and other consumer 27,476 24,284 Commercial business 12,507 7,416 Apartment buildings 34,122 43,653 Other commercial real estate 23,748 33,077 Consumer finance 57,075 53,412 ---------- ---------- 834,841 937,960 Foreclosed assets 222,689 274,767 ---------- ---------- $1,057,530 $1,212,727 ========== ========== Nonperforming assets as a percentage of total assets 0.58% 0.73% </TABLE> SFR nonaccrual loans declined $110.3 million from December 31, 1998 to September 30, 1999. In addition, commercial real estate nonaccrual loans dropped $18.9 million during the same period. The decrease in these nonaccrual loans is primarily due to the improvement in the California economy. ASSET AND LIABILITY MANAGEMENT STRATEGY 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 not negatively affected 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. As part of this strategy, the Company actively manages the amounts and maturities of its assets and liabilities. One key component of the Company's program is the origination or purchase of adjustable-rate assets whose repricing characteristics more closely match the repricing characteristics of the Company's liabilities. At September 30, 1999, 75% of the 24
27 Company's total SFR loan and MBS portfolio had adjustable rates, compared with 80% at December 31, 1998. The decline resulted from $15.48 billion of primarily fixed-rate MBS purchases with an expected average remaining life from the time of purchase of 4.46 years during the nine months ended September 30, 1999. In addition, in order to better control its interest sensitivity, the Company attempts to manage its liability durations by utilizing a variety of deposit and borrowing types and sources. The Company also utilizes derivative instruments to adjust the interest-sensitivity characteristics of certain of its borrowings and deposits to better match the assets which the liabilities fund. The table below represents expected balances that are subject to maturity or a change in rate. It is conventionally referred to as an interest-rate-sensitivity gap report. The expected maturity and repricing categories take into consideration expected prepayment speeds as well as actual amortization of principal and do not take into consideration reinvestment of cash. Principal prepayments are the amounts of principal reduction over and above normal amortization. The Company has used prepayment assumptions based on market estimates and past experience with its current portfolio. Repricing mechanisms on the Company's assets are subject to limitations such as caps on the amount that interest rates and payments on its loans may adjust and, accordingly, such assets may not respond in the same manner or to the same extent to changes in interest rates as the Company's liabilities. Since the Company's non-maturity deposits are not contractually subject to repricing, they have been allocated based on expected decay rates. Non-rate sensitive items such as the reserve for loan losses and deferred loan fees/costs are not included in the table. The balance of fixed-rate loans held for sale is included in the first bucket. While interest-rate-sensitivity gap helps provide some information about a financial institution's interest sensitivity, it does not predict the trend of future earnings. This is due, in part, to lag risk whereby some indices respond in a lagging manner to market interest rates. For this reason, Washington Mutual uses financial modeling to forecast earnings under different interest rate projections. 25
28 The interest-rate-sensitivity gap report was as follows: <TABLE> <CAPTION> September 30, 1999 Projected Repricing - --------------------------------------------------------------------------------------------------------- 0-3 4-12 1-5 Months Months Years Thereafter - --------------------------------------------------------------------------------------------------------- (dollars in thousands) <S> <C> <C> <C> <C> Interest Sensitive Assets Adjustable-rate loans (1) $ 61,794,479 $ 10,664,978 $23,087,125 $ 671,580 Fixed-rate loans (1) 1,853,851 3,376,820 9,149,204 9,181,764 Adjustable-rate securities (1), (2) 26,989,385 3,597,509 292,381 127,218 Fixed-rate securities (1) 1,158,437 2,932,440 9,829,329 10,082,295 Cash and cash equivalents 2,467,109 - - - ------------------------------------------------------------ Total sensitive assets $ 94,263,261 $ 20,571,747 $42,358,039 $20,062,857 ============================================================ Interest Sensitive Liabilities Noninterest-bearing checking accounts (3) $ 408,386 $ 989,239 $ 2,763,403 $ 3,239,890 Interest-bearing checking accounts, savings accounts, and MMDAs (3) 4,714,810 7,822,006 14,964,656 9,766,400 Time deposit accounts 8,521,720 21,673,311 6,677,620 80,809 Short-term and adjustable-rate borrowings 64,581,474 10,204,009 - - Fixed-rate borrowings 3,561,747 4,170,519 3,838,437 2,276,991 Derivatives matched against liabilities (15,806,800) 4,393,000 12,163,800 (750,000) ------------------------------------------------------------ Total sensitive liabilities $ 65,981,337 $ 49,252,084 $40,407,916 $14,614,090 ------------------------------------------------------------ Repricing Gap $ 28,281,924 $(28,680,337) $ 1,950,123 $ 5,448,767 ============================================================ </TABLE> <TABLE> <CAPTION> - --------------------------------------------------------------------------------------------------------- 0-3 0-12 0-5 Months Months Years Thereafter - --------------------------------------------------------------------------------------------------------- (dollars in thousands) <S> <C> <C> <C> <C> Cumulative Gap $ 28,281,924 $ (398,413) $ 1,551,710 $ 7,000,477 ============================================================ Cumulative gap as a percentage of total assets 15.64% (0.22)% 0.86% 3.87% - ----------- (1) Based on scheduled maturity or scheduled repricing and estimated repayments of principal. (2) Includes FHLB stock. (3) Based on experienced and anticipated decay rates of checking, savings, and MMDAs. </TABLE> 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. At September 30, 1999, the one-year gap or cumulative gap as a percentage of total assets in the 0-12 month category was a negative 0.22%, compared with a positive 2.90% at December 31, 1998. The repricing of the Company's interest sensitive assets generally matches that of its interest sensitive liabilities. The market risk characteristics of the Company's assets and liabilities at September 30, 1999 were not materially different from year-end 1998. 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 growth of consumer deposits, Washington Mutual has supported its growth through business combinations with other financial institutions and by increasing its 26
29 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. Washington Mutual monitors its ability to meet short-term cash requirements using guidelines established by its Board of Directors. These guidelines ensure that short-term secured borrowing capacity is sufficient to satisfy unanticipated cash needs. As part of this process, the Company is developing plans for potential liquidity requirements for the Year 2000. Refer to separate discussion of "Year 2000 Project" below. Regulations promulgated by the Office of Thrift Supervision ("OTS") require that the Company's federal savings banks maintain for each calendar quarter an average daily balance of liquid assets at least equal to 4.00% of the prior quarter end's balance of withdrawable deposits plus borrowings due within one year. At September 30, 1999, both of the Company's federal savings banks had liquidity ratios in excess of 4.00%. As presented in the Consolidated Statements of Cash Flows, the sources of liquidity vary between the comparable periods. 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, 1999 of $1.37 billion, $73.1 million for noncash items and $2.57 billion of other net cash inflows from operating activities. Cash flows from investing activities consisted mainly of both proceeds from and purchases of securities, and loan principal repayments and loan originations. For the nine months ended September 30, 1999, cash flows from investing activities included sales, maturities and principal payments on securities totaling $12.64 billion. Loans originated and purchased for investment were in excess of repayments and sales by $17.05 billion, and $17.95 billion was used for the purchase of securities. 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, the issuance of long-term debt, and the repurchase of the Company's common stock. For the nine months ended September 30, 1999, the above mentioned financing activities increased cash and cash equivalents by $18.94 billion on a net basis. Cash and cash equivalents were $2.47 billion at September 30, 1999. See "Consolidated Financial Statements - Consolidated Statements of Cash Flows." At September 30, 1999, the Company was in a position to obtain approximately $27.39 billion in additional borrowings primarily through the use of collateralized borrowings and deposits of public funds using unpledged MBS and other wholesale borrowing sources. CAPITAL ADEQUACY The Company's capital (stockholders' equity) was $8.91 billion at September 30, 1999, down from $9.34 billion at December 31, 1998. During the first nine months of 1999, the Company repurchased 21.0 million common shares at an average price of $35.95. These stock repurchases, the unrealized loss on available-for-sale ("AFS") securities of $584.1 million, and the growth in assets contributed to a decline in the stockholders' equity ratio of 4.93% at the end of third quarter 1999 from 5.65% at December 31, 1998. Excluding the unrealized loss on AFS securities, the ratio of capital to total assets would have been 5.25% at September 30, 1999. At December 31, 1998, there was an unrealized gain on AFS securities of $87.6 million. The regulatory capital ratios of WMBFA, WMB and WMBfsb and the minimum regulatory requirements to be categorized as well-capitalized were as follows: <TABLE> <CAPTION> September 30, 1999 ---------------------- Well-Capitalized WMBFA WMB WMBfsb Minimum ------ ------ ------ ---------------- <S> <C> <C> <C> <C> Capital ratios: Leverage 5.59% 5.63% 8.17% 5.00% Tier 1 risk-based 10.07 10.37 13.87 6.00 Total risk-based 11.36 11.14 15.09 10.00 </TABLE> 27
30 In addition, Aristar, Inc.'s industrial bank, First Community Industrial Bank, met all Federal Deposit Insurance Corporation requirements to be categorized as well-capitalized at September 30, 1999. The Company's federal savings banking subsidiaries are also required by OTS regulations to maintain core capital of at least 3.00% of assets and tangible capital of at least 1.50% of assets. WMBFA and WMBfsb both satisfied these requirements at September 30, 1999. The Company's broker-dealer subsidiary is also subject to capital requirements. At September 30, 1999, it was in compliance with its applicable capital requirements. YEAR 2000 PROJECT This section contains forward-looking statements that have been prepared on the basis of management's best judgments and currently available information and constitutes a Year 2000 Readiness Disclosure within the meaning of the Year 2000 Readiness Disclosure Act of 1998. These forward-looking statements are inherently subject to significant business, third-party and regulatory uncertainties and contingencies, many of which are beyond the Company's control. In addition, these forward-looking statements are based on current assessments and remediation plans, which are based on certain representations of third-party service providers 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. The Company 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 of its significant operational areas 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, it has engaged IBM to provide supplemental technical and management resources to assess and test the Year 2000 readiness of its Computer Systems, Deloitte Consulting Group LLC 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 Board of Directors, and the Board's Audit Committee reviews Year 2000 Project progress on a quarterly basis. The 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 its connections with other computer systems; (iv) due diligence on third-party service providers; and (v) development of contingency plans. The Year 2000 Project is divided into four categories: mainframe systems, non-mainframe systems, third-party service providers, and facilities. The inventory and assessment phase is 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 service providers, and facilities that it deems more critical to its ongoing business and the maintenance of good customer relationships. The Company has also completed the process of repairing or replacing and testing the components of its Computer Systems it deems most critical and has tested these Computer 28
31 Systems in an integrated environment. It has also completed the process of repairing or replacing and testing the components of its facilities it deems most critical. It has also adopted business contingency plans for the Computer Systems and facilities that it has determined to be most critical. These plans conform to 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. Prior to 1998, the Company undertook strategic business initiatives that shifted a significant portion of the cost for Year 2000 readiness to third-party service providers. The Company relies on third-party service providers for significant business processes such as item processing, loan servicing, and desktop and communications management. It has been communicating with its third-party service providers to assess and monitor their Year 2000 readiness. The Company has completed its due diligence on third-party service providers for its most critical business processes, including the testing of connections with these service providers, where possible, although the monitoring of these service providers will continue. The Company has established contingency plans for the service providers it deems most critical and will continue monitoring to determine whether to implement specific contingency plans. The Company has completed testing the connections between its Computer Systems and third-party computer systems that it deems most critical. Additional testing of these Computer Systems and third-party computer systems will continue through 1999. 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. 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 spent approximately $21.5 million during 1998 and the nine months ended September 30, 1999 on its Year 2000 Project, and it currently expects to spend approximately $11.5 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 its current cost of Year 2000 readiness. Risks Based on its current assessments and remediation plans, which are based in part on certain representations of third-party service providers, the Company does not expect that it will experience a significant disruption of its operations as a result of the change to the new millennium. 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 its power supply or voice and data transmission suppliers, a Computer System, a third-party service provider, 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 contingency plans will function as anticipated, or that the Company's results of operations 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 the Year 2000 Project. 29
32 Liquidity Plan Washington Mutual has developed and implemented a Liquidity Plan to identify, monitor, and resolve potential funding impacts related to Year 2000. The plan includes early warning of funding trends and alternative sources of funds in the event of a disruption. The Company has also developed and implemented a Cash Contingency Plan to identify, monitor, and resolve potential impacts to cash sources and distribution systems related to Year 2000. The plan includes early warning of cash trends and alternative sources of cash in the event of a disruption. 30
33 PART II ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits See Index of Exhibits on page 33. (b) Reports on Form 8-K During the third quarter of 1999, the Company filed a report on Form 8-K dated July 20, 1999. The report included under Item 7 of Form 8-K a press release announcing Washington Mutual's second quarter 1999 financial results and unaudited consolidated financial statements for the quarter and six months ended June 30, 1999. The report also included under Item 7 of Form 8-K a press release announcing an additional share repurchase program. During the third quarter of 1999, the Company filed a report on Form 8-K dated June 29, 1999. The report included under Item 7 of Form 8-K a slide presentation to investors at a conference on June 29, 1999. During the third quarter of 1999, the Company filed a report on Form 8-K dated August 5, 1999. The report included under Item 7 of the Form 8-K an Underwriting Agreement dated August 5, 1999 between the Registrant and Chase Securities Inc., Lehman Brothers Inc., Salomon Smith Barney Inc. and Goldman, Sachs & Co. for the Company to issue senior debt securities totaling $750.0 million and bearing a fixed rate of 7.50%. The notes are due on August 15, 2006. During the third quarter of 1999, the Company filed a report on Form 8-K dated August 25, 1999. The report included under Item 7 of Form 8-K a slide presentation to investors and analysts. During the third quarter of 1999, the Company also filed a report on Form 8-K dated September 15, 1999. The report included under Item 7 of Form 8-K a press release reporting the shareholders of Long Beach Financial Corporation had approved the merger with Washington Mutual. 31
34 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 12, 1999. WASHINGTON MUTUAL, INC. By: /s/ FAY L. CHAPMAN ----------------------------------------- Fay L. Chapman Senior Executive Vice President and General Counsel By: /s/ RICHARD M. LEVY ----------------------------------------- Richard M. Levy Senior Vice President and Controller (Principal Accounting Officer) 32
35 WASHINGTON MUTUAL, INC. INDEX OF EXHIBITS <TABLE> <CAPTION> Exhibit No. - ----------- <S> <C> 3.1 Amended and restated Articles of Incorporation of the Registrant, as amended (filed herewith). 3.2 Restated By-laws of the Registrant, as amended (filed herewith). 4.1 Rights Agreement dated October 16, 1990 (filed as an exhibit to the Company's Current Report on Form 8-K dated November 29, 1994 and incorporated herein by reference. File No. 0-25188). 4.2 Amendment No. 1 to Rights Agreement, dated October 31, 1994 (filed as an exhibit to the Company's Current Report on Form 8-K dated November 29, 1994 and incorporated herein by reference. 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. 10.1 364-Day Credit Agreement by and among the Registrant and Aristar, Inc. and The Chase Manhattan Bank, as Administrative Agent (filed herewith). 10.2 Four-Year Credit Agreement by and among the Registrant and Aristar, Inc. and The Chase Manhattan Bank, as Administrative Agent (filed herewith). 27 Financial Data Schedule.* - ----------- * Filed electronically with the Securities and Exchange Commission. </TABLE> 33