UNITED STATESSECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
Commission File Number 1-14667
WASHINGTON MUTUAL, INC. (Exact name of registrant as specified in its charter)
(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 July 31, 2002:
Common Stock – 967,399,424(1)
(1)Includes 18,000,000 shares held in escrow.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIESFORM 10-QFOR THE QUARTER ENDED JUNE 30, 2002
TABLE OF CONTENTS
The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such periods. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with Washington Mutual, Inc.'s 2001 Annual Report on Form 10-K.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
See Notes to Consolidated Financial Statements.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited)
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (Unaudited)
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Note 1: Business Combinations
The business combinations consummated by Washington Mutual, Inc., and its consolidated subsidiaries (the "Company"), during 2001 and 2002 have been accounted for using the purchase method. Accordingly, the purchase price of each acquisition was first allocated to the tangible assets and liabilities and identifiable intangible assets based on their estimated fair values as of the closing date of the transaction, with the excess purchase price over the fair values recorded as goodwill. Results of operations for the business combinations are included from the date of acquisition.
On January 4, 2002, the Company acquired by merger Dime Bancorp, Inc. ("Dime") for a total purchase price of approximately $5.3 billion, which included approximately $1.5 billion in cash, approximately 96.4 million shares of common stock valued at $37.74 per share, the conversion of 109 million Dime Litigation Tracking Warrants™ ("LTW"), valued at $0.33 per warrant, into the contingent right to receive the Company's common stock, and the conversion of Dime stock options, valued at approximately $90 million, into options to purchase Company common stock. For purposes of this merger, Washington Mutual's common stock was valued based upon the average price of Washington Mutual common stock for the five-day trading period from June 21-27, 2001. This acquisition resulted in the recognition of goodwill of approximately $4 billion. This amount, as well as the estimated fair values assigned to the assets received and liabilities assumed, may change as certain estimates and contingencies are finalized.
The Company acquired Dime to create a broad-based platform for its retail banking operations in the greater New York metropolitan area. With the addition of the mortgage operations of Dime's subsidiary, North American Mortgage Company, the Company enhanced its position as one of the nation's largest mortgage lending franchises.
During the first quarter of 2002, the Company recorded a restructuring liability of $125 million related to the acquisition of Dime. The restructuring liability was recorded as an adjustment to goodwill. This liability included an initial reserve of approximately $100 million for severance and other costs related to the Company's announced plan to eliminate approximately 2,900 Dime positions. The majority of the staff reductions are the result of eliminating redundant headquarters and back office positions. The remaining $25 million of the original restructuring liability primarily consists of disposition costs related to exiting leasehold and other contractual obligations of Dime. During the six months ended June 30, 2002, the Company reduced the severance portion of the restructuring liability by approximately $20 million due to a reduction of 900 Dime positions that are expected to be eliminated. The Company also utilized approximately $50 million of the severance liability due to the termination of approximately 650 employees and utilized $3 million of the restructuring liability related to the exiting of leasehold and other contractual obligations.
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The fair value of the net assets acquired in the Dime acquisition was as follows:
Other intangible assets represent a core deposit intangible with an estimated useful life of 7 years. None of the goodwill balance is expected to be deductible for tax purposes.
Unaudited Pro Forma Combined Financial Data Reflecting the Dime Acquisition
The unaudited pro forma combined amounts presented below give effect to the merger with Dime as if it had been consummated on January 1, 2001. As the acquisition occurred on January 4, 2002, the pro forma combined information for the three and six months ended June 30, 2002, would not be materially different than the actual results for those periods and, therefore, is not presented. The unaudited pro forma information is not necessarily indicative of the results of operations that would have resulted had the merger been completed at the beginning of the applicable periods presented, nor is it necessarily indicative of the results of operations in future periods.
In addition to the acquisition of Dime, the Company acquired certain operating assets of HomeSide Lending, Inc. ("HomeSide") on March 1, 2002 for approximately $1.2 billion in cash. With this acquisition, the Company acquired approximately $1 billion in loans held for sale and a servicing technology platform valued at $52 million. The Company agreed to subservice HomeSide's mortgage servicing portfolio for a fee and acquired
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a right to make a first offer to purchase the associated mortgage servicing rights retained by HomeSide if it elects to seek proposals to sell such rights in the future.
Note 2: Earnings Per Share
Information used to calculate earnings per share ("EPS") was as follows:
Options to purchase an additional 269,689 and 42,546 shares of common stock were outstanding at June 30, 2002 and 2001, but were not included in the computation of diluted EPS because their inclusion would have had an antidilutive effect.
Additionally, as part of the 1996 business combination with Keystone Holdings, Inc. (parent of American Savings Bank, F.A.), 18 million shares of common stock, with an assigned value of $18.49 per share, are held in escrow for the benefit of the general and limited partners of Keystone Holdings, Inc., the Federal Savings and Loan Insurance Corporation Resolution Fund and their transferees. The conditions under which these shares can be released from escrow are related to the outcome of certain litigation and not based on future earnings or market prices. At June 30, 2002, the conditions were not met, and, therefore, the shares were not included in the above computations.
Note 3: Mortgage Banking Activities
Changes in the portfolio of loans serviced for others were as follows:
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Changes in the balance of MSR, net of the valuation allowance, were as follows:
Changes in the valuation allowance for MSR were as follows:
At June 30, 2002, the expected weighted average life of the Company's MSR was 4.4 years. Projected amortization expense for the gross carrying value of MSR at June 30, 2002 is estimated to be as follows (in millions):
The projected amortization expense of MSR is an estimate and should be used with caution. The amortization expense for future periods was calculated by applying the same quantitative factors, such as actual MSR prepayment experience, that were used to determine amortization expense for the second quarter of 2002. These factors are inherently subject to significant fluctuations, primarily due to the effect that changes in long-term interest rates have on loan prepayment experience. Accordingly, any projection of MSR amortization in future periods is limited by the conditions that existed at the time the calculations were performed, and may not be indicative of actual amortization expense that will be recorded in future periods.
Note 4: Goodwill and Other Intangible Assets
The results for the three and six months ended June 30, 2002, include the effect of adopting Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 provides that goodwill is no longer amortized and the value of an identifiable intangible asset must be amortized over its useful life, unless the asset is determined to have an indefinite useful life. Goodwill must be tested for
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impairment at the reporting unit level as of the beginning of the fiscal year in which SFAS No. 142 is adopted and at least annually thereafter. A reporting unit represents an operating segment or a component of an operating segment. The Company has identified four reporting units for purposes of impairment testing.
The Company has performed a transitional impairment test on the goodwill of each reporting unit using a discounted cash flow model and determined that the fair value of the Company's assets, net of liabilities, exceeded the recorded book value of the goodwill at January 1, 2002. On an ongoing basis (absent any impairment indicators), the Company expects to perform an impairment test during the third quarter of each year. Since there were no impairment indicators during the period, no impairment loss was recorded for the six months ending June 30, 2002.
Had the Company been accounting for its goodwill under SFAS No. 142 for all periods presented, the Company's net income and earnings per share would have been as follows:
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Changes in the carrying amount of goodwill for the six months ended June 30, 2002, by reporting unit were as follows:
During the first quarter of 2002, the Company acquired a $223 million core deposit intangible and $3 million of other intangible assets as a result of the acquisitions of Dime and HomeSide. During the second quarter of 2002, the Company increased goodwill associated with the Dime acquisition by $59 million due to various adjustments to the fair values assigned to the assets received and liabilities assumed and a $77 million adjustment of the total purchase price related to the valuation of Dime stock options.
Intangible asset balances (excluding MSR) as of June 30, 2002 were as follows:
The Company has no identifiable intangible assets with indefinite useful lives.
Amortization expense for the net carrying amount of intangible assets (excluding MSR) at June 30, 2002 is estimated to be as follows (in millions):
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Note 5: Operating Segments
The Company has identified three major operating segments for the purpose of management reporting: Banking and Financial Services; Home Loans and Insurance Services; and Specialty Finance. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The management reporting process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The Company's operating segments are defined by product type and customer segments.
The Company continues to enhance its segment reporting process methodologies. These methodologies assign certain balance sheet and income statement items to the responsible operating segment. Methodologies that are applied to the measurement of segment profitability include: (1) a funds transfer pricing system, which allocates net interest income between funds users and funds providers; (2) a calculation of the provision for loan and lease losses based on management's current assessment of the expected losses for loan products within each segment, which differs from the "losses inherent in the loan portfolio" methodology that is used to measure the allowance for loan and lease losses under generally accepted accounting principles; and (3) the utilization of an activity-based costing approach to measure allocations of certain operating expenses that were not directly charged to the segments. Changes to the operating segment structure and to certain of the foregoing performance measurement methodologies were made during the latter part of 2001 and the first quarter of 2002. Results for the prior periods have been revised to conform to these changes.
The Banking and Financial Services Group ("Banking & FS") offers a comprehensive line of consumer and business financial products and services to individuals and small and middle market businesses. In addition to traditional banking products, Banking & FS offers investment management and securities brokerage services, and distributes annuity products through the Company's subsidiaries and affiliates. The group's services are offered through multiple delivery channels, including financial centers, business banking centers, ATMs, the internet and 24-hour telephone banking centers.
The Home Loans and Insurance Services Group ("Home Loans Group") originates, purchases, sells, securitizes and services the Company's SFR mortgage loans. These mortgage assets may either be retained in the Company's portfolio, sold or securitized. The group's loan products are made available to consumers through various distribution channels, which include retail home loan centers, financial centers, correspondent financial institutions, prime and specialty wholesale home loan centers, consumer direct contact through call centers, and the internet. The Home Loans Group also includes the activities of Washington Mutual Insurance Services, Inc., an insurance agency that supports the mortgage lending process, as well as the insurance needs of consumers doing business with the Company. Additionally, the Home Loans Group manages the Company's captive private mortgage and hazard reinsurance activities.
The Specialty Finance Group conducts operations through the Company's banking subsidiaries and Washington Mutual Finance Corporation ("Washington Mutual Finance"). The Specialty Finance Group provides real estate secured financing primarily for multi-family properties. Commercial real estate lending, residential builder construction finance and mortgage banker financing are also part of the group's secured financing activities. This group also offers commercial banking services through Washington Mutual Bank and Washington Mutual Bank, FA and conducts a consumer finance business through Washington Mutual Finance.
The Corporate Support/Treasury & Other category includes management of the Company's interest rate risk, liquidity, capital, borrowings and purchased investment securities portfolios. To the extent not allocated to the business segments, this category also includes the costs of the Company's technology services, facilities, legal, accounting, human resources and community reinvestment functions. Also reported in this category are the net impact of transfer pricing for loan and deposit balances including the effects of changes in interest rates on the Company's net interest margin, the difference between the expected loss-based provision for loan and lease losses for the operating segments and the Company's provision, the effects of inter-segment allocations of financial hedge gains and losses, and the elimination of inter-segment noninterest income and noninterest expense.
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Financial highlights by operating segment were as follows:
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Note 6: Recently Adopted Accounting Standards
In April 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 145, Recission of FASB Statements No.4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections, that, among various topics, eliminated the requirement that all forms of gains or losses on debt extinguishments, such as the liquidation of repurchase agreements, be reported as extraordinary items. The early termination of repurchase agreements is a normal part of our asset and liability management strategy. As encouraged by this pronouncement, we applied the provisions of SFAS No. 145 related to the treatment of debt extinguishments as of January 1, 2002. Accordingly, the gain from the liquidation of repurchase agreements for the three and six months ended June 30, 2002 in the amount of $121 million and $195 million is now recorded as a component of noninterest income. Similar gains that were recorded as extraordinary items in the third and fourth quarter of 2001 will be reclassified as a component of noninterest income when comparative financial statements that include those prior periods are presented.
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Financial Review
Summary Financial Data
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Summary Financial Data (Continued)
Cautionary Statements
This section contains forward-looking statements, which are not historical facts and pertain to our future operating results. These forward-looking statements are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts. When used in this report, the words "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," or words of similar meaning, or future or conditional verbs, such as "will," "would," "should," "could," or "may" are generally intended to identify forward-looking statements. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our 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 due to the following factors, among others:
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Overview
Washington Mutual, Inc. is a financial services company committed to serving consumers and small to mid-sized businesses. When we refer to "we" or "Washington Mutual" or the "Company" in this Form 10-Q, we mean Washington Mutual, Inc., and its consolidated subsidiaries. We accept deposits from the general public, originate, purchase, service and sell residential loans, make consumer loans and commercial real estate loans (primarily loans secured by multi-family properties), and engage in certain commercial banking activities such as providing credit facilities and cash management and deposit services. We originate, sell and service specialty mortgage finance loans and provide direct installment loans and purchase retail installment contracts. We also market annuities and other insurance products, offer full service securities brokerage services, and act as the investment advisor to, and the distributor of, mutual funds.
During the first quarter of 2002, the Company completed two acquisitions. On January 4, 2002, we completed our acquisition of New York-based Dime Bancorp, Inc. ("Dime"). This acquisition added approximately $31 billion to our asset base and increased our deposit base by approximately $15 billion. On March 1, 2002, we acquired for cash, certain operating assets of HomeSide Lending, Inc. ("HomeSide"). HomeSide was the U.S. mortgage unit of the National Australia Bank Limited ("National"). National retained ownership of HomeSide's mortgage servicing rights, along with the related hedges and certain other assets and liabilities. We subservice HomeSide's mortgage servicing portfolio, which was approximately $160 billion as of June 30, 2002, pursuant to a subservicing agreement. Among other rights granted to us under the subservicing agreement, we acquired a right to make a first offer to purchase HomeSide's mortgage servicing rights if HomeSide elects to seek proposals to sell these rights in the future.
The acquisition of Dime contributed significantly to the growth in our mortgage lending business, and accordingly, resulted in significant increases in our MSR and our loans serviced for others portfolio. At the date of acquisition, Dime added $926 million to the MSR balance and also added $49,242 million to the loans serviced for others portfolio. Substantially all of the increase in the loan subservicing portfolio was a result of the HomeSide acquisition.
The Company's total assets decreased to $261,281 million at June 30, 2002 from $275,223 million at March 31, 2002. This decrease in total assets was primarily the result of the Company adjusting its holdings of MSR risk management instruments, which resulted in a decline in the available-for-sale securities portfolio of $8.5 billion. In a privately-placed securitization, the Company also sold 22 basis points of excess servicing on $91 billion of existing, conforming single-family loans that we service for others. Excess servicing is the difference between the normal servicing fee (typically 25 basis points in the case of conforming fixed-rate loans) and the total servicing fee we have a right to receive. This transaction reduced our net MSR balance by $711 million and had a nominal impact on the Consolidated Statements of Income.
Variances in the amounts reported on the Consolidated Statements of Income between the three months ended June 30, 2002 and the comparable period in 2001 are partially attributable to the results from the aforementioned acquisitions as well as the acquisition of Fleet Mortgage Corp. ("Fleet"). These acquisitions were accounted for as purchase transactions and thus the results of those operations are included within the consolidated results of the Company from the date of acquisition.
Critical Accounting Policies
Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified two policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our financial statements. These policies relate to the valuation of our MSR and rate lock commitments, and the methodology for the determination of our allowance for loan and lease losses.
There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards ("SFAS" or "Statement") No. 133, Accounting for Derivative Instruments and Hedging Activities, and the applicable hedge deferral criteria. These policies and the judgments, estimates and assumptions are described in greater detail in subsequent sections of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements included in the
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Company's 2001 Annual Report on Form 10-K. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of our Consolidated Financial Statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition.
Recently Issued Accounting Standards
In June 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement requires that a liability for costs associated with exit or disposition activities be recognized when the liability is incurred and be measured at fair value and adjusted for changes in estimated cash flows. Existing generally accepted accounting principles provide for the recognition of such costs at the date of management's commitment to an exit plan. Under SFAS No. 146, management's commitment to an exit plan would not be sufficient, by itself, to recognize a liability. The Statement is effective for exit or disposal activities initiated after December 31, 2002 and is not expected to have a material impact on the results of operations or financial condition of the Company.
Earnings Performance
Net Interest Income
Net interest income increased $427 million and $1,463 million, or 26% and 48% for the three and six months ended June 30, 2002 compared with the same periods in 2001. A majority of the increase in net interest income was due to improvement in the net interest margin. The net interest margin was 3.54% and 3.65% for the three and six months ended June 30, 2002 compared with 3.21% and 2.94% for the same periods in 2001. The increase in the margin was primarily due to significantly lower wholesale borrowing rates during the three and six months ended June 30, 2002, as compared with the same periods in 2001. Since our wholesale borrowing rates are closely correlated with interest rate policy changes made by the Federal Reserve and reprice more quickly to current market rates than our interest-earning assets, the margin benefited from the Federal Reserve's 200 basis point reduction in the Federal Funds rate, which declined from 3.75% in June 2001 to 1.75% in June 2002. An increase in average interest-earning assets, a majority of which resulted from the addition of the Dime loan portfolio and the mortgage banking operations of Dime and Fleet, also contributed to the growth in net interest income.
The net interest margin for the three months ended June 30, 2002 decreased 20 basis points from the net interest margin of 3.74% for the three months ended March 31, 2002 as a result of the lag effect of last year's Federal Reserve rate cuts on asset yields and an increase in borrowing rates that resulted from the Company's interest-rate risk management initiatives, which included extending the maturities of fixed-rate wholesale borrowings. We anticipate that the net interest margin will continue to decrease throughout the remainder of 2002 if interest rates remain at their current levels or trend upward.
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Certain average balances, together with the total dollar amounts of interest income and expense and the weighted average interest rates, were as follows:
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Noninterest Income
Noninterest income consisted of the following:
SFR Mortgage Banking (Expense) Income
The increase in SFR loan servicing fees for the three and six months ended June 30, 2002, was mostly the result of the addition of the loan servicing portfolios of Dime and Fleet. Our loans serviced for others portfolio increased from $365,699 million at June 30, 2001 to $477,309 million at June 30, 2002, largely the result of these acquired portfolios. Our strong levels of salable SFR loan volume, in which we retain the servicing relationship, also contributed to the growth in the loan servicing portfolio and the resulting loan servicing fees.
Total loans serviced for others portfolio by type was as follows:
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The decrease in the weighted average servicing fee from 47 basis points at March 31, 2002 to 41 basis points at June 30, 2002 was primarily due to the sale of excess servicing during the second quarter, which decreased the net MSR balance by $711 million but had no impact on the underlying loans serviced for others portfolio.
A decrease in long-term mortgage rates during the second quarter of 2002 led to higher anticipated prepayment rates, which resulted in MSR impairment of $1,107 million and $1,062 million for the three and six months ended June 30, 2002, leaving the MSR impairment reserve at $2,568 million as of June 30, 2002. Continued high volumes of actual prepayment activity during the second quarter of 2002, coupled with the growth of the MSR servicing portfolio, resulted in higher levels of MSR amortization, as compared with the second quarter of 2001.
The value of our MSR asset is subject to prepayment risk. Future expected net cash flows from servicing a loan in our servicing portfolio will not be realized if the loan pays off earlier than we anticipate. Moreover, since most loans within our servicing portfolio do not contain penalty provisions for early payoff, we will not receive a corresponding economic benefit if the loan pays off earlier than expected. MSR are the discounted present value of the future net cash flows we expect to receive from our servicing portfolio. Accordingly, prepayment risk subjects our MSR to impairment risk.
In measuring impairment of MSR, we stratify the loans in our servicing portfolio based on loan type, coupon rate and other predetermined characteristics. We measure MSR impairment by estimating the fair value of each stratum. An impairment allowance for a stratum is recorded when, and in the amount by which, its fair value is less than its carrying value. We estimate fair value using a discounted cash flow ("DCF") model, independent third-party appraisals and management's analysis of observable data to formulate conclusions about anticipated changes in future market conditions, including interest rates. The DCF model estimates the present value of the future net cash flows of the servicing portfolio based on various factors, such as servicing costs, expected prepayment speeds and discount rates, about which management must make assumptions based on future expectations. The reasonableness of management's assumptions about these factors is confirmed through independent broker surveys. Independent appraisals of the fair value of our servicing portfolio are obtained periodically, but not less frequently than annually, and are used by management to evaluate the reasonableness of the value conclusions. At June 30, 2002, key economic assumptions and the sensitivity of the current fair value for SFR MSR to immediate changes in those assumptions were as follows:
These sensitivities are hypothetical and should be used with caution. As the table above demonstrates, our methodology for estimating the fair value of MSR is highly sensitive to changes in assumptions. For example, our determination of fair value uses anticipated prepayment speeds. Actual prepayment experience may differ and any difference may have a material effect on our risk. Changes in fair value based on a variation in assumptions
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generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the MSR is calculated without changing any other assumption; in reality, changes in one factor may be associated with changes in another (for example, increases in market interest rates may result in lower prepayments, but credit losses may increase), which may magnify or counteract the sensitivities. Thus, any measurement of MSR fair value is limited by the conditions existing and assumptions made as of a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time. Refer to "Market Risk Management" for discussion of how MSR prepayment risk is managed and to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" in the Company's 2001 Annual Report on Form 10-K for further discussion of how MSR impairment is measured.
The continuing high volume of refinancing activity allowed us to generate strong levels of salable SFR loan volume in the second quarter. Additionally, the Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Therefore, they are recorded at fair value with changes in fair value recorded in gain from mortgage loans. Rate lock commitments totaled $44,292 million and $84,900 million for the three and six months ended June 30, 2002, compared with $26,428 million and $43,924 million for the same periods in 2001. This increase, coupled with high refinancing levels, resulted in gain from mortgage loans of $220 million and $471 million during the three and six months ended June 30, 2002.
For the three months ended June 30, 2002, we recorded a gain from other AFS securities of $137 million. The gain from AFS securities was primarily related to the sales of fixed-rate U.S. Government agency and treasury bonds. The Company has decreased its primary reliance on investment securities for MSR risk management to a blend of investment securities and interest rate contracts. Accordingly, the Company recognized $857 million of revaluation gain from derivative financial instruments, net settlement income from certain interest-rate swaps of $101 million and a gain from liquidation of repurchase agreements with embedded interest rate floors of $121 million, all of which are used by the Company for MSR risk management purposes.
Gain from sale of originated MBS during the six months ended June 30, 2001 included gains from the sale of adjustable-rate mortgage ("ARM") loans that were securitized in the fourth quarter of 2000 and other MBS that were securitized in earlier periods.
All Other Noninterest Income Analysis
The increase in depositor and other retail banking fees for the three and six months ended June 30, 2002 was primarily due to higher levels of nonsufficient funds and other fees that mostly resulted from an increased number of noninterest bearing checking accounts in comparison with the three and six months ended June 30, 2001. The number of these accounts at June 30, 2002 totaled 5,470,787, an increase of more than 853,000 from June 30, 2001. This increase included approximately 200,000 noninterest bearing checking accounts acquired from Dime during the first quarter of 2002.
Securities fees and commissions increased during the three and six months ended June 30, 2002, substantially due to an increase in sales of fixed annuities.
Insurance income increased during the three and six months ended June 30, 2002 substantially due to the continued growth in our captive reinsurance programs. The Dime acquisition also contributed to an increase in revenues in optional insurance and property and casualty insurance products.
A majority of the growth in portfolio loan related income for the three and six months ended June 30, 2002 was due to increased late charges on the loan portfolio, continued high loan prepayment fees as a result of refinancing activity, and the Dime acquisition.
Other income during the three months ended June 30, 2002 increased substantially due to a $28 million revaluation gain on collateralized mortgage obligations and a gain of $19 million from sale of early pool buy-outs.
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Noninterest Expense
Noninterest expense consisted of the following:
The increase in the employee base compensation and benefits expense for the three and six months ended June 30, 2002 over the same periods a year ago was primarily due to the acquisitions of Dime, HomeSide and Fleet and the hiring of additional staff to support our expanding operations. Full-time equivalent and leased employees ("FTE") were 50,001 at June 30, 2002 compared with 37,106 at June 30, 2001. The Dime, HomeSide and Fleet acquisitions added a total of approximately 11,000 FTE.
The increase in occupancy and equipment expense for the three and six months ended June 30, 2002 resulted primarily from recent acquisitions which increased rent, depreciation, and maintenance on newly leased and acquired properties and computer equipment.
The increase in telecommunications and outsourced information services expense during 2002 was mostly attributable to higher usage of voice and data network services, outsourced data processing services, and internet services. Additionally, the Company added 17 and 151 financial centers during the three and six months ended June 30, 2002 as a result of acquisitions and the opening of Occasio financial centers in new and existing markets, which also contributed to higher telecommunications expense. WorldCom, Inc. is a supplier of telecommunication services to the Company under the terms of a multi-year contract and has not taken action in its bankruptcy proceeding to either affirm or reject the contract.
The increase in depositor and other retail banking losses in the periods reported was substantially due to higher loss levels per account as a result of increases in forgeries and returned deposits.
A significant portion of the increase in amortization of other intangible assets expense during the periods reported was due to the core deposit intangible acquired in the Dime acquisition.
Advertising and promotion expense increased for the periods reported substantially due to seasonal marketing expenses incurred at the branch level and the Dime marketing campaign.
The increase in loan expense for the three and six months ended June 30, 2002 was primarily due to higher direct loan closing costs, which were attributable to an overall increase in loan originations and purchases, and higher mortgage pool payoffs.
The increase in travel and training for the periods reported was primarily due to increased travel related to the Dime and HomeSide acquisitions and the training of new and recently transferred employees.
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The increase in other expense during the periods reported was predominantly due to increases in outside services, business taxes, office supplies, increase in reinsurance management fees and security services. Partially offsetting this increase for the six months ended June 30, 2002, was a substantial decrease in contribution expense, as a result of the donation of Concord EFS, Inc. stock to the Washington Mutual Foundation during the second quarter of 2001.
Review of Financial Condition
Assets. At June 30, 2002, our assets were $261,281 million, an increase of 8% from $242,506 million at December 31, 2001. The increase was predominantly attributable to the Dime and HomeSide acquisitions.
Securities. Securities consisted of the following:
Our MBS portfolio declined $3,870 million to $24,698 million at June 30, 2002 from $28,568 million at December 31, 2001. This decrease was predominantly related to high prepayment activity and sales in the first and second quarters of 2002. Other investment securities increased $4,338 million to $34,119 million at June 30, 2002 from $29,781 million at December 31, 2001 due to the purchase of U.S. Government agency and treasury bonds.
In late June 2002, the Company recorded an impairment of $106 million on $3.9 billion of treasury bonds that were sold in early July.
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Loans. Loans held in portfolio consisted of the following:
Substantially all of the increase in loans held in portfolio was a result of the Dime acquisition along with high volumes of loan originations and purchases. This increase was partially offset by continuing high levels of prepayment activity within our SFR (excluding specialty mortgage finance) portfolio.
Loan volume was as follows:
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Loan volume by channel was as follows:
Refinancing activity(1) was as follows:
A majority of the increased volume of purchased/correspondent loans during the three and six months ended June 30, 2002 was due to the expansion of our correspondent lending activities which predominantly resulted from the acquisition of Dime, HomeSide and Fleet. Purchased/correspondent volume for specialty mortgage finance loans was $1,309 million and $2,823 million for the three and six months ended June 30, 2002, compared with $1,448 million and $2,497 million for the three and six months ended June 30, 2001.
Other Assets
Other assets consisted of the following:
GNMA early pool buy-outs represent advances made to GNMA mortgage pools that are guaranteed by the Federal Housing Administration or by the Department of Veterans Affairs (collectively, the "guarantors"). These advances are made to buy out government agency-guaranteed delinquent loans, pursuant to the Company's servicing agreements. The Company, on behalf of the guarantors, undertakes the collection and foreclosure process. After the foreclosure process is complete, the Company is reimbursed for most of the principal and interest advances to security holders and a majority of the administrative costs of the foreclosure. The Company has recorded a valuation allowance to provide for the unreimbursed portion of these advances and administrative costs of $60 million at June 30, 2002, compared with $42 million at December 31, 2001.
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Deposits consisted of the following:
Deposits increased to $129,069 million at June 30, 2002 from $107,182 million at December 31, 2001. As a result of the acquisition of Dime, we added $15.17 billion in deposits. At June 30, 2002, total deposits included $9.44 billion in custodial/escrow deposits related to loan servicing activities, compared with $10.11 billion at December 31, 2001. Time deposit accounts decreased by $849 million from year-end 2001, primarily as a result of decreases in liquid certificates of deposit and the Institutional Certificate of Deposit program, substantially offset by the addition of $6.10 billion of time deposit accounts included in the Dime acquisition.
Checking accounts, savings accounts and MMDAs ("transaction deposits") increased to 72% of total deposits at June 30, 2002, compared with 66% at year-end 2001. These products generally have the benefit of lower interest costs, compared with time deposit accounts. A majority of the increase in interest bearing checking accounts was due to the growth in Platinum Checking deposits, which increased from $9.40 billion at December 31, 2001 to $35.35 billion at June 30, 2002. During the quarter, over 137,434 Platinum Checking accounts were opened. This account combines a money market rate of interest with the convenience of a checking account. Even though transaction deposits are more liquid, we consider them to be the core relationship with our customers, as they provide a more stable source of long-term funding than time deposits. At June 30, 2002, deposits funded 49% of total assets, compared with 44% at year-end 2001.
Borrowings. Our borrowings primarily take the form of repurchase agreements and advances from the Federal Home Loan Banks of Seattle, San Francisco, Dallas and New York. The exact mix at any given time is dependent upon the market pricing of the individual borrowing sources.
Other borrowings increased by $1,441 million during the first half of 2002 primarily due to the issuance of senior and subordinated debt, and trust preferred income securities acquired from Dime. Refer to "Liquidity" for further discussion of funding sources.
Off-Balance Sheet Activities
In the ordinary course of business, we routinely securitize and sell residential mortgage loans, and from time to time, commercial mortgage loans into the secondary market. In general, these securitizations are structured without recourse to the Company. As part of non-agency securitizations, we use qualifying special purpose entities to facilitate the transfer of mortgage loans into the secondary market. These entities are generally not consolidated within our financial statements since they satisfy the criteria required by SFAS No. 140, Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
The Company has not used unconsolidated special purpose entities as a mechanism to remove nonaccrual loans and foreclosed assets ("nonperforming assets") from the balance sheet.
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Asset Quality
Nonaccrual Loans, Foreclosed Assets and Restructured Loans
Loans are generally placed on nonaccrual status when they are four payments or more past due or when the timely collection of the principal of the loan, in whole or in part, is not expected. Management's classification of a loan as nonaccrual or restructured does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.
Nonaccrual loans and foreclosed assets ("nonperforming assets") and restructured loans consisted of the following:
Nonaccrual loans decreased to $2,232 million at June 30, 2002 from $2,391 million at March 31, 2002 but remain above the $2,030 million at December 31, 2001. Of the increase in nonaccrual loans during the six months ended June 30, 2002, approximately $88 million was attributable to loans acquired in connection with the Dime acquisition. These Dime originated nonaccrual loans are concentrated in SFR as well as the commercial business and commercial real estate loan categories.
Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $114 million, $122 million, and $123 million at June 30, 2002, March 31, 2002 and December 31, 2001. Loans held for sale are accounted for at lower of aggregate cost or market value ("LOCOM"), with valuation changes included as adjustments to gain from mortgage loans.
SFR loans (excluding specialty mortgage finance) on nonaccrual status increased by $118 million from December 31, 2001, although for the quarter just ended, nonaccrual SFR showed improvement, declining $85 million or 7% from March 31, 2002. Management believes SFR nonaccrual loans declined during the quarter due to a stabilizing economy, a continuing strong housing market, and improved collection efforts internally.
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At June 30, 2002, commercial business nonaccrual loans were up $18 million from December 31, 2001 due primarily to the addition of $20 million from Dime and a $32 million increase in nonaccruals in franchise finance loans. These increases were offset by declines in the commercial syndication portfolios. The franchise finance loans portfolio balance of $815 million at June 30, 2002 includes term loans made to owners of franchise businesses such as restaurants (both fast food and family dining), convenience stores and auto lubrication businesses.
Commercial business nonaccrual loans decreased from the previous quarter primarily as a result of decreases in Small Business Administration ("SBA") nonaccrual loans. At June 30, 2002, the SBA portfolio totaled $375 million, of which loans on nonaccrual were $53 million compared with a portfolio of $367 million with nonaccrual loans of $65 million at March 31, 2002. This represents a slight decline from last quarter primarily due to transfers to real estate owned and principal write downs of $28 million. These charge offs reflect management's estimate of the anticipated recoveries after considering certain loan guarantees provided by the SBA.
Our multi-family loan portfolio comprises 72% of all commercial real estate loans at June 30, 2002. These loans continue to experience low nonaccrual levels as nonaccrual loans in this category represented only 0.37% of total multi-family loans at June 30, 2002, compared with 0.36% of the total multi-family loans at December 31, 2001.
Nonaccrual other commercial real estate loans decreased $27 million during the first half of the year primarily due to the foreclosure of nine properties totaling $31 million plus charge offs on nonaccrual loans of $12 million. Partially offsetting these declines was the addition of $10 million from Dime.
The increase of $46 million in foreclosed assets since December 31, 2001 includes $12 million of inventory from Dime as well as significant increases in properties secured by SFR and other commercial real estate.
Provision and Allowance for Loan and Lease Losses
When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the allowance for loan and lease losses. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not evidenced the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; or the fair value of the loan collateral is significantly below the current loan balance and there is little or no near-term prospect for improvement. Consumer loans secured by collateral other than real estate are charged off if and when they exceed a specified number of days contractually delinquent (120 days for substantially all loans). Single-family residential loans and consumer loans secured by real estate are written down to the fair value of the underlying collateral (less projected cost to sell) when they are contractually delinquent 180 days.
After considering the stabilizing economy, along with the growth in the commercial and specialty mortgage finance loan portfolios, and relatively high levels of nonaccrual loans, a $160 million provision for loan and lease losses was recorded in the second quarter of 2002. The provision was $44 million in excess of the $116 million in net charge offs during the quarter. As a percentage of average loans held in portfolio, annualized net charge offs were 0.31% and 0.29% for the three and six months ended June 30, 2002, compared with 0.23% and 0.20% for the same periods in 2001. Net charge offs were $116 million and $215 million for the three and six months ended June 30, 2002, compared with $75 million and $133 million for the same periods in 2001.
The allowance for loan and lease losses represents management's estimate of credit losses inherent in our loan and lease portfolios as of the balance sheet date. Management performs regular reviews in order to identify these inherent losses, and to assess the overall collection probability for these portfolios. This process provides an allowance that consists of two components: allocated and unallocated. To arrive at the allocated component, we combine estimates of the allowance needed for loans that are evaluated collectively, such as single family residential and specialty mortgage finance, and loans that are analyzed individually, such as commercial business and commercial real estate.
The determination of the allocated component for loans that are evaluated collectively involves the monitoring of delinquency, default, and loss rates (among other factors that determine portfolio risk) and an assessment of current economic conditions, particularly in geographic areas where we have significant
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concentrations. Loss factors are based on the analysis of the historical performance of each loan category and an assessment of portfolio trends and conditions, as well as specific risk factors impacting the loan and lease portfolios. These factors are then applied to the collective total of the loan balances and commitments.
Loans within the commercial business, commercial real estate and builder single-family residential construction categories are reviewed on an individual basis and loss factors are applied based on the risk rating assigned to the loan. A specific allowance, which is part of the allocated component, may be assigned on these loan types if they have been individually determined to be impaired. Loans are considered impaired when it is probable that we will be unable to collect all amounts contractually due as scheduled, including contractual interest payments. For loans that are determined to be impaired, the amount of impairment is measured by a discounted cash flow analysis, using the loan's effective interest rate, except when it is determined that the only source of repayment for the loan is the operation or liquidation of the underlying collateral. In such cases, the current fair value of the collateral, reduced by estimated disposal costs, will be used in place of discounted cash flows. In estimating the fair value of collateral, we evaluate various factors, such as occupancy and rental rates in our real estate markets and the level of obsolescence that may exist on assets acquired from commercial business loans.
In estimating the amount of credit losses inherent in our loan and lease portfolios, various judgments and assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding future market conditions and their impact on the loan and lease portfolios. In the event the national economy were to sustain a prolonged downturn, the loss factors applied to our portfolios may need to be revised, which may significantly impact the measurement of the allowance for loan and lease losses. For impaired loans that are collateral-dependent, the estimated fair value of the collateral may deviate significantly from the proceeds received when the collateral is sold. To mitigate the imprecision inherent in most estimates of expected credit losses, the allocated component of the allowance is supplemented by an unallocated component. The unallocated component reflects our judgmental assessment of the impact that various factors may have on the overall measurement of credit losses. These factors include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality and collateral value trends, loan concentrations, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, regulatory examination results and findings of the Company's internal credit review function.
Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" in our 2001 Annual Report on Form 10-K for further discussion of the Allowance for Loan and Lease Losses.
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Changes in the allowance for loan and lease losses were as follows:
Operating Segments
We manage our business along three major operating segments: Banking and Financial Services, Home Loans and Insurance Services, and Specialty Finance. Refer to Note 5 to the Consolidated Financial Statements – "Operating Segments" – for information regarding the key elements of our management reporting methodologies used to measure segment performance.
Banking and Financial Services
Net income was $399 million and $726 million for the three and six months ended June 30, 2002, up from $244 million and $452 million for the same periods a year ago. Net interest income was $899 million and $1,647 million for the three and six months ended June 30, 2002, up $329 million or 58% and $539 million or 49% from $570 million and $1,108 million for the three and six months ended June 30, 2001. These increases in net interest income are mostly due to the decrease in interest expense on deposit accounts and increase in interest income from consumer loans. Noninterest income increased to $540 million and $1,050 million during the three and six months ended June 30, 2002 from $443 million and $829 million for the same periods in 2001. The increases in noninterest income were largely due to the increase in depositor and other retail banking fees associated with higher collections of nonsufficient funds and other fees on existing noninterest bearing checking
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accounts and growth in new noninterest bearing checking accounts. The number of noninterest bearing checking accounts increased by 18% (including approximately 200,000 accounts acquired from Dime) since June 30, 2001.
Primarily reflecting increases in compensation and benefits expense, occupancy and equipment expense, and depositor and other retail banking losses, noninterest expense increased to $746 million and $1,432 million during the three and six months ended June 30, 2002, compared with $600 million and $1,169 million for the same periods in 2001. The acquisition of Dime also contributed to the increase during 2002.
Total assets increased by 35% from December 31, 2001, mostly due to the growth in loans held in portfolio as a result of the Dime acquisition along with high volumes of loan originations and correspondent purchases.
Home Loans and Insurance Services
Segment results for the Home Loans and Insurance Services Group were significantly impacted by the addition of the mortgage operations of Dime, HomeSide, and Fleet.
Net income was $487 million and $873 million for the three and six months ended June 30, 2002, up from $297 million and $603 million for the same periods a year ago. Net interest income was $856 million and $1,645 million during the three and six months ended June 30, 2002, up from $519 million and $960 million during the same periods in 2001 predominantly due to a decrease in funding costs that resulted from lower interest rates. Partially offsetting the decrease in funding costs was a reduction in interest income on AFS mortgage-backed securities and SFR mortgages.
Noninterest income increased to $599 million and $998 million during the three and six months ended June 30, 2002, compared with $300 million and $608 million for the same periods a year ago. The increases were primarily due to higher SFR loan related income, portfolio loan related income and insurance income. The increase in these income sources was primarily due to the acquisitions of Dime, HomeSide and Fleet and increases in late fees on loan payments.
Noninterest expense rose to $604 million and $1,102 million for the three and six months ended June 30, 2002 from $296 million and $517 million for the comparable periods in 2001. The increases were largely due to higher compensation and benefits expense and occupancy and equipment expense, resulting from the expanded loan servicing operations added by the Dime, HomeSide, and Fleet acquisitions. Additionally, the continued development of a new loan origination platform contributed to the increase in noninterest expense.
Total assets increased by 4% from December 31, 2001, substantially as a result of the growth of SFR mortgage loans, which grew primarily as a result of the Dime, HomeSide, and Fleet acquisitions. Partially offsetting this increase was a decrease in mortgage-backed securities resulting from higher prepayment activity and higher sales in the first and second quarter of 2002.
Specialty Finance
Net income for the three and six months ended June 30, 2002 was $105 million and $215 million, up from $86 million and $153 million for the same periods a year ago. Net interest income was $283 million and $582 million during the three and six months ended June 30, 2002, up from $251 million and $470 million during the same periods in 2001. The increases in net interest income predominantly reflected the lower interest expense on funding sources. Partially offsetting this decrease was lower interest income from multi-family and other commercial real estate loans.
Noninterest income for the three months ended June 30, 2002 and 2001 was $19 million. Noninterest income increased to $43 million for the six months ended June 30, 2002, from $33 million for the same period a year ago, largely due to higher portfolio loan related income recognized during the six months ended June 30, 2002 compared to the same period in 2001.
Noninterest expense increased to $73 million and $151 million for the three and six months ended June 30, 2002 from $64 million and $123 million for the same periods in 2001. These increases were largely attributable to higher compensation and benefits expense and other operating expenses in part due to the acquisition of Dime.
Total assets increased by 9% from December 31, 2001, primarily due to the acquisition of Dime.
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Liquidity
The objective of liquidity management is to ensure the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet obligations and other commitments on a timely and cost-effective basis.
The principal sources of liquidity for our consolidated enterprise are customer deposits, wholesale borrowings, the sale and securitization of mortgage loans into secondary market channels, the maturity and repayment of portfolio loans and MBS, and agency and treasury bonds held in our available-for-sale securities portfolio. Among these sources, transaction deposits and wholesale borrowings from Federal Home Loan Bank advances and repurchase agreements continue to provide the Company with a significant source of stable funding. During the six months ended June 30, 2002, those sources funded 70% of average total assets. Our continuing ability to retain our transaction deposit customer base and to attract new deposits is dependent on various factors, such as customer service satisfaction levels and the competitiveness of interest rates offered on our deposit products. We expect that Federal Home Loan Bank advances and repurchase agreements will continue to be our most significant sources of wholesale borrowings during 2002, and we expect to have the requisite assets available to pledge as collateral to obtain these funds.
To supplement these funding sources, our bank subsidiaries also raise funds in domestic and international capital markets. In April 2001, our two most significant bank subsidiaries, Washington Mutual Bank, FA ("WMBFA") and Washington Mutual Bank ("WMB"), established a $15 billion Global Bank Note Program (the "Program"). The Program facilitates issuance of both senior and subordinated debt in the United States and in international capital markets on both a syndicated and non-syndicated basis and in a variety of currencies and structures. Through June 30, 2002, our bank subsidiaries had issued $3.6 billion of senior notes and $1 billion of subordinated notes under the Program. At June 30, 2002, $10.4 billion remained available for issuance.
Liquidity for Washington Mutual, Inc. (the "Parent Company") is generated through its ability to raise funds in various capital markets, and through dividends from subsidiaries, lines of credit and commercial paper programs.
A significant portion of the Parent Company's funding was received from dividends paid by our bank subsidiaries. Although we expect the Parent Company to continue to receive bank subsidiary dividends during 2002, such dividends are limited by various regulatory requirements related to capital adequacy and retained earnings. For more information on dividend restrictions applicable to our banking subsidiaries, refer to "Business – Regulation and Supervision" and Note 17 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions" in the Company's 2001 Annual Report on Form 10-K.
In November 2001, the Parent Company filed a shelf registration with the Securities and Exchange Commission that allows for the issuance of $1.5 billion of senior and subordinated debt in the United States and in international capital markets and in a variety of currencies and structures. In January 2002, $1 billion of senior debt securities were issued under this shelf registration. In April 2002, the Parent Company filed a shelf registration with the Securities and Exchange Commission that allows for the issuance of an additional $1 billion of senior and subordinated debt in the United States and in international capital markets and in a variety of currencies and structures. The proceeds from the sale of debt securities will be used for general corporate purposes.
At June 30, 2002, the Parent Company shared two revolving credit facilities totaling $1.2 billion with Washington Mutual Finance. These facilities provided back-up for the commercial paper programs of the Parent Company and Washington Mutual Finance as well as funds for general corporate purposes. At June 30, 2002, the Parent Company had no commercial paper outstanding and the amount available under these shared facilities, net of the amount of commercial paper outstanding at Washington Mutual Finance, was $627 million. On August 12, 2002, the Parent Company and Washington Mutual Finance entered into a new three-year revolving credit facility totaling $800 million. This credit facility replaces the two revolving credit facilities totaling $1.2 billion that were in effect at June 30, 2002 and will be used for the same purposes as the previous credit facilities.
Effective July 31, 2002, Washington Mutual Finance, entered into an agreement with Westdeutsche Landesbank Girozentrale ("WestLP") to participate in a $300 million asset-backed commercial paper conduit program. This commercial paper program has a 364-day term with an option to extend for up to two additional
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364-day periods. The new revolving credit facility entered into on August 12, 2002 does not provide back-up for this commercial paper program.
Capital Adequacy
Reflecting the effects of the Dime acquisition and strong earnings during the six months ended June 30, 2002, the ratio of stockholders' equity to total assets increased to 7.50% at June 30, 2002 from 5.80% at year-end 2001.
The regulatory capital ratios of WMBFA, WMB and Washington Mutual Bank fsb ("WMBfsb") and the minimum regulatory requirements to be categorized as well capitalized were as follows:
Our federal savings bank subsidiaries are also required by Office of Thrift Supervision regulations to maintain tangible capital of at least 1.50% of assets. WMBFA and WMBfsb both satisfied this requirement at June 30, 2002.
Our broker-dealer subsidiaries are also subject to capital requirements. At June 30, 2002, both of our securities subsidiaries were in compliance with their applicable capital requirements.
In April 1999, the Board of Directors ("Board") approved a share repurchase program. From the second quarter of 1999 through June 30, 2000, we purchased a total of 100 million shares as part of our previously authorized total of 167 million shares. We did not repurchase any of our common stock from the second quarter of 2000 until the fourth quarter of 2001. Management instead focused on internal growth and acquisitions as a means of deploying capital during this time. On October 19, 2001, we announced the resumption of our share repurchase program and repurchased an additional seven million shares during the fourth quarter of 2001. An additional one million shares were repurchased during the second quarter of 2002. At June 30, 2002, our remaining repurchase authority was approximately 59 million shares.
On July 16, 2002, the Board approved an expansion to our share repurchase program. Under the expanded program, the Company is authorized to repurchase approximately 41 million additional shares of common stock, increasing our remaining purchase authority to approximately 100 million shares. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.
Market Risk Management
Certain of the statements contained within this section that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are intended to assist in the understanding of how our financial performance would be affected by the circumstances described in this section. However, such performance involves risks and uncertainties that may cause actual results to differ materially from those expressed in the forward-looking statements. See "Cautionary Statements."
Market risk is defined as the sensitivity of income, fair market values and capital to changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market rates or prices. The primary market risk to which we are exposed is interest rate risk. Substantially all of our interest rate risk arises from instruments, positions and transactions entered into for purposes other than trading. They include loans, MSR, securities, deposits, borrowings, long-term debt and derivative financial instruments.
We are exposed to different types of interest rate risks. These risks include lag, repricing, basis, prepayment, and lifetime cap risk. These risks are described in further detail within the "Market Risk Management" section of Management's Discussion and Analysis in our 2001 Annual Report on Form 10-K.
We manage interest rate risk within an overall asset/liability management framework. The principal objective of our asset/liability management is to manage the sensitivity of net income to changing interest rates.
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Asset/liability management is governed by a policy reviewed and approved annually by our Board. The Board has delegated the responsibility to oversee the administration of this policy to the Directors' Loan and Investment Committee.
Overview of Our Interest Rate Risk Profile
Increases or decreases in interest rates can cause changes in net income, fluctuations in the fair value of assets and liabilities, such as MSR, investment securities and derivatives, and changes in noninterest income and noninterest expense, particularly gain from mortgage loans and loan servicing fees. Our interest rate risk arises because as market interest rates change, assets and liabilities reprice, mature or prepay at different times or frequencies or in accordance with different indices.
Our sensitivity to changes in interest rates is affected, in part, by the slope of the yield curve. Changes in short-term rates generally have a more immediate effect on our borrowing and deposit rates than on our asset yields. Our deposits and borrowings typically reprice faster than our mortgage loans and securities. The slower repricing of assets results mainly from the lag effect inherent in loans and MBS indexed to the 12-month average of the annual yields on actively traded U.S. Treasury securities adjusted to a constant maturity of one year and to the 11th District FHLB monthly weighted average cost of funds index ("COFI"). The increase in the net interest margin tends to peak a few months after short-term rates stabilize and then trends downward until asset yields reprice to current market levels.
Prepayments, loan production, loan mix and gain from mortgage loans are normally all affected by changes in long-term rates and the slope of the yield curve. When long-term rates decline, prepayments tend to increase and refinancing activity also increases, leading to higher overall loan production. In a low rate environment, the percentage of new loans that are fixed-rate also increases. This in turn leads to higher gain from mortgage loans, due to our practice of selling the majority of our fixed-rate volume through secondary market channels. Although balance sheet shrinkage may occur during periods of declining or low long-term rates, net interest income may increase due to the expansion of the net interest margin.
Conversely, when long-term rates increase, prepayments slow and overall loan production is reduced. At the same time, the percentage of new loans that are adjustable-rate loans increases, and we generally retain these loans within our portfolio. Accordingly, balance sheet growth may occur in a rising long-term rate environment, although net interest income may decrease due to the contraction of the net interest margin.
Changes in long-term rates also impact the fair value and the amortization rate of MSR. The fair value of MSR decreases and the amortization rate increases in a declining long-term interest rate environment due to the higher prepayment activity, resulting in the potential for impairment and a reduction in net loan servicing income. During periods of rising long-term interest rates, the amortization rate of MSR decreases and the fair value of MSR increases, resulting in the potential recovery of the MSR valuation allowance and an increase in net loan servicing income.
Management of Interest Rate Risk
We manage our balance sheet to mitigate the impact of changes in market interest rates on net income. Key components of this strategy include the origination and retention of short-term and adjustable-rate assets and the origination and sale of most fixed-rate and certain hybrid ARM loans and the management of MSR.
We attempt to match our interest-earning assets with interest-bearing liabilities that have similar repricing characteristics. For example, the interest rate risk of holding fixed-rate loans is managed primarily with transaction deposits and long-term fixed-rate borrowings, while the risk of holding ARMs is managed primarily with short-term borrowings. Periodically, mismatches are identified and modified with interest rate contracts and embedded derivatives.
The interest rate contracts that are classified as asset/liability management instruments are intended to assist in the management of our net interest income. These contracts are used to effectively lengthen the repricing period of our interest-bearing funding sources in order to partially offset the temporary compression of the net interest margin that occurs during periods of rising short-term interest rates. The types of contracts used for this purpose consist of interest rate caps, collars, corridors, pay-fixed swaps and payer (pay-fixed) swaptions. The aggregate notional amount of these contracts totaled $46.08 billion at June 30, 2002. None of the interest
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rate caps had strike rates that were in effect at June 30, 2002. The payer swaptions are exercisable upon maturity, which ranges from February 2003 to February 2004. These swaptions provide protection in a rapidly rising interest rate environment, because these instruments offer a mechanism for fixing the rate on our deposits and borrowings to an interest rate that could be lower than eventual market levels. In addition to using interest rate contracts to help mitigate margin compression during periods of rising short-term interest rates, we may also directly extend the repricing frequency of our funding sources by supplanting short-term borrowings with longer term, fixed-rate instruments.
We also held $4.38 billion of receive-fixed interest rate swaps classified as asset/liability management instruments at June 30, 2002. These instruments are intended to reduce the interest expense on long-term, fixed-rate borrowings during stable or falling interest rate environments. Subordinated debt, which generally qualifies as a component of Tier 2 risk-based capital, provides an excellent source of long-term funds. However, the interest rates on long-term borrowings, such as subordinated debt, may be significantly higher than the interest rate on shorter-term instruments. Therefore, we have purchased receive-fixed interest rate swaps to obtain an attractive funding rate while maintaining the debt as a component of risk-based capital.
We analyze the change in fair value of our MSR portfolio under a variety of parallel shifts in the yield curve. As part of our overall approach to enterprise interest rate risk management, we manage potential impairment in the fair value of MSR and increased amortization levels of MSR by a comprehensive risk management program. This risk management program is comprised of three elements. The first element within this program uses the changes in the fair value of the risk management instruments, which include investment securities and interest rate contracts, to offset the changes in fair value and higher amortization levels of MSR. The intent is that decreases (increases) in the fair value of MSR are offset by increases (decreases) in the value of the investment securities and interest rate contracts. The investment securities generally consist of fixed-rate debt securities, such as agency and treasury bonds and mortgage-backed securities, including principal-only strips. The interest rate contracts typically consist of interest rate floors, receive-fixed interest rate swaps and receiver (receive-fixed) swaptions. Some of the interest rate floors are embedded in borrowings. We classify the interest rate contracts used in this strategy as MSR risk management instruments. The receive-fixed interest rate swaps, receiver swaptions and stand alone interest rate floors are accorded mark-to-market accounting treatment. Changes in the fair value of these instruments are recorded as revaluation gain (loss) from derivatives, while the interest income on the swaps is recorded as net settlement income from certain interest-rate swaps. Changes in interest expense on the embedded interest rate floors are recorded in net interest income, while a gain or loss on the termination of the instrument would be recorded as gain (loss) on extinguishment of securities sold under agreements to repurchase.
During the second quarter, we reduced our holdings of fixed-rate bonds and increased the holding of receive-fixed interest rate swaps, receiver swaptions, interest rate floors and mortgage-backed securities. The current mix of instruments is intended to enhance the efficiency of the risk management program and to deploy capital more effectively. It has also increased the notional amount of instruments receiving mark-to-market accounting treatment. This reduces the need to liquidate certain risk management instruments to generate gains or losses that offset changes in the fair value and amortization of MSR.
We adjust the mix of instruments used to manage MSR fair value changes as interest rate and market conditions warrant. The intent is to maintain an efficient and fairly liquid mix as well as a diverse portfolio of risk management instruments with broad maturity ranges. We may elect to increase or decrease our concentration of specific instruments during certain times based on the slope of the yield curve and other market conditions. We believe this approach will result in the most efficient strategy. However, our net income could be adversely affected if we are unable to execute or manage this strategy effectively.
The second element for managing changes in the fair value of MSR is the natural hedge that is inherent in our business. The current composition of the balance sheet and the increase in net income in a declining rate environment act, to some extent, as a hedge to MSR impairment and higher amortization. Lower interest rates also contribute to increased loan volume, particularly fixed-rate loan production. Since our strategy is to sell most of our fixed-rate loans, the higher volume would generally result in higher gain from mortgage loans. We may adjust our holdings of MSR risk management instruments based on the expected income, and the timing of such income, from the natural business hedge.
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The third and final element of this risk management program focuses on the management of the size of the MSR asset and its normal and excess servicing components. As a result of this element of the program, we sold excess servicing during the second quarter of 2002. The sale reduced the carrying value of MSR but did not affect the customer composition of our loan servicing portfolio, thus allowing us to retain all of our customer relationships. We are also striving to reduce the excess servicing we retain on future loan sales. Depending on market conditions and our desire to expand customer relationships, we may periodically sell or purchase additional servicing in the future. The current market conditions may present favorable opportunities to purchase additional servicing.
Overall, we believe our risk management program will minimize net income sensitivity under most interest rate environments. However, the success of this program is dependent on the judgments we make regarding the direction and timing of changes in long-term interest rates and the resulting decisions that are made regarding the amount and the mix of MSR risk management instruments that we believe are appropriate to manage MSR fair value risk. It is also dependent on the recognition of the estimates inherent in the projection of the natural business hedge. Our net income could be adversely affected if we are unable to effectively implement, execute or manage this strategy.
We also hedge the risks associated with our mortgage pipeline. The mortgage pipeline consists of fixed- and adjustable-rate SFR loans to be sold in the secondary market. The risk associated with the mortgage pipeline is the potential change in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold. This period is usually 60 to 90 days. To hedge this risk, we execute forward sales agreements and option contracts. A forward sales agreement protects us in a rising interest rate environment, since the sales price and delivery date are already established. A forward sales agreement is different, however, from an option contract in that we are obligated to deliver the loan to the third party on the agreed-upon future date. Consequently, if the loan does not fund, we may not have the necessary assets to meet the commitment; therefore, we may be required to purchase other assets, at current market prices, to satisfy the forward sales agreement. To mitigate this risk, we consider fallout factors, which represent the percentage of loans that are not expected to close, in calculating the amount of forward sales agreements to execute.
June 30, 2002 and December 31, 2001 Sensitivity Comparison
To analyze net income sensitivity, we project net income over a 12-month horizon based on parallel shifts in the yield curve. Management employs other analyses and interest rate scenarios to evaluate interest rate risk. We project net income and net interest income under a variety of interest rate scenarios, including non-parallel shifts in the yield curve and more extreme non-parallel rising and falling rate environments. These additional scenarios also address the risk exposure in time periods beyond the twelve months captured in the net income sensitivity analysis. Typically, net income sensitivity in a rising interest rate environment is not as pronounced in these longer time periods as lagging assets reprice to current market levels and balance sheet growth begins to offset a lower net interest margin. In addition, yields on new loan production gradually replace the comparatively lower yields of the more seasoned portion of the portfolio.
The table below indicates the sensitivity of net income and net interest income to interest rate movements. The comparative scenarios assume a parallel shift in the yield curve with interest rates rising or falling in even quarterly increments over the twelve month period ending June 30, 2003 and December 31, 2002. The analysis assumes increases in interest rates of 200 basis points ("bp") and decreases of 100 bp. The interest rate scenarios used below represent management's view of reasonably possible near-term interest rate movements.
Net income and net interest income sensitivity decreased since year-end 2001. The current profile is unusual as typically our net interest income increases in the -100 basis point environment and decreases in the +200
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basis point environment. The change is mainly due to faster prepayment expectations and increases in the notional amount of fixed-rate swaps and long-term fixed-rate borrowings. The changes in prepayment projections mainly result from the current interest rate and fast prepayment environment. Despite faster prepayment projections in all scenarios, the change in prepayments from a flat rate environment to the rate shocked scenarios was greater than in the year-end analysis. Therefore, the analysis projects greater balance sheet growth in the +200 basis point scenario and additional balance sheet shrinkage in the -100 basis point scenario. The increase in fixed-rate swaps and long-term borrowings reduced the sensitivity of the net interest margin. Overall, the increased balance sheet sensitivity and reduced net interest margin volatility reduced net interest income sensitivity.
Net income was projected to increase in the +200 basis point scenario despite the decline in net interest income mainly due to increases in loan servicing fees and a reduction in the amortization of MSR. The recovery of MSR valuation reserves was generally offset with losses on the sale of securities or mark-to-market adjustments on the financial hedges. Conversely, net income was projected to decrease in the -100 basis point scenario due to the decrease in net interest income, decreases in loan servicing fees and increased amortization of MSR. The impairment of MSR valuation reserves was generally offset with gains on the sale of securities or mark-to-market adjustments on the financial hedges.
The projection of the sensitivity of net income requires numerous behavioral assumptions. Prepayment, decay rate (the estimated runoff of deposit accounts that do not have a stated maturity) and new volume projections are the most significant assumptions. Prepayments affect the size of the balance sheet, which impacts net interest income, and they are also a major factor in the valuation of MSR. The decay rate assumptions also impact net interest income by altering the expected deposit mix and rates in the projected interest rate environments. The prepayment and decay rate assumptions reflect management's best estimate of future behavior. These assumptions are internally derived from internal and external analysis of customer behavior.
The sensitivity of new loan volume and mix to changes in market interest rate levels is also projected. Generally, we assume loan production increases in falling interest rate scenarios with an increased proportion of fixed-rate production. We generally assume a reduction in total loan production in rising interest rate scenarios with a shift towards a greater proportion of adjustable-rate production. The gain from mortgage loans as a percentage of total loan sales also varies under different interest rate scenarios. Normally, the gain from mortgage loans as a percentage of total loan sales increases in falling interest rate environments as higher consumer demand, generated primarily from high refinancing activity, allows loans to be priced more aggressively. Conversely, the gain from mortgage loans as a percentage of total loan sales tends to decline when interest rates increase as loan pricing becomes more competitive, since market participants strive to retain market share as consumer demand declines.
In addition to gain from mortgage loans, the sensitivity of noninterest income and expense are also estimated. The impairment and recovery of MSR is the most significant element of sensitivity in the projection of noninterest income. The fair value of MSR generally increases as interest rates rise and decreases as interest rates fall. The other components of noninterest income and expense, such as deposit and loan fees and expenses, generally increase or decrease in conjunction with deposit and loan volumes, although loan servicing fees are also dependent on prepayment expectations.
Maturity and Repricing Information
We use interest rate contracts as tools to manage interest rate risk. The following tables summarize the notional amounts, maturities, net fair values, credit risk and weighted average interest rates associated with these contracts. Derivatives that are embedded within certain adjustable-rate borrowings, while not accounted for as derivatives under SFAS No. 133, have been included in the tables since they also function as interest rate risk management tools.
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The following estimated net fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies:
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An additional risk that arises from our borrowing (including repurchase agreements) and derivative activities is counterparty risk. These activities generally involve an exchange of obligations with another financial institution, referred to in such transactions as a "counterparty." If a counterparty were to default, we could potentially be exposed to financial loss. In order to minimize this risk, we evaluate all counterparties for financial strength on at least an annual basis, then establish exposure limits for each counterparty. All of the counterparty credit risk is with counterparties rated A or better by Standard & Poor's at June 30, 2002, and we monitor our exposure and collateral requirements on a daily basis.
Gap Report
A conventional view of interest rate sensitivity for savings institutions is the gap report, which indicates the difference between assets maturing or repricing within a period and total liabilities maturing or repricing within the same period. In assigning assets to maturity and repricing categories, we take into consideration expected prepayment speeds rather than contractual maturities. The balances reflect 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. We have used prepayment assumptions based on market estimates and past experience with our current portfolio. The majority of our transaction deposits are not
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contractually subject to repricing. Therefore, these instruments have been allocated based on expected decay rates. Certain transaction accounts that reprice based on a market index and/or typically reprice more frequently were allocated based on the expected repricing period. Non-rate sensitive items such as the reserve for loan losses and deferred loan fees/costs are not included in the table. Loans held for sale are generally included in the 0-3 months category to the extent they are hedged with commitments to sell loans.
The gap information is limited by the fact that it is a point-in-time analysis. The date reflects conditions and assumptions as of June 30, 2002. These conditions and assumptions may not be appropriate at another point in time. The analysis is also subject to the accuracy of various assumptions used, particularly the prepayment and decay rate projections and the allocation of instruments with optionality to a specific maturity category. Consequently, the interpretation of the gap information is subjective.
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PART II – OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders.
Washington Mutual, Inc. held its annual meeting of shareholders on April 16, 2002. A brief description of each matter voted on and the results of the shareholder voting are set forth below:
Each of the following directors who were not up for reelection at the annual meeting of shareholders will continue to serve as directors: Douglas P. Beighle, J. Taylor Crandall, Anne V. Farrell, Stephen E. Frank, Enrique Hernandez, Jr., Kerry K. Killinger, Michael K. Murphy, Elizabeth A. Sanders, William D. Schulte and Willis B. Wood, Jr.
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Item 6. Exhibits and Reports on Form 8-K
See Index of Exhibits on page 45.
1. The Company filed a report on Form 8-K dated April 16, 2002. The report included under Item 7 of Form 8-K a press release announcing Washington Mutual's first quarter 2002 financial results and unaudited consolidated financial statements for the three months ended March 31, 2002.
2. The Company filed a report on Form 8-K dated April 25, 2002. The report included under Item 9 of Form 8-K a presentation by Kerry K. Killinger, Chairman, President and Chief Executive Officer at the UBS Warburg Global Financial Services Conference.
3. The Company filed a report on Form 8-K dated April 30, 2002. The report included under Item 5 of Form 8-K information regarding a suit filed by Anchor Savings Bank FSB ("Anchor FSB") against the U.S. Government in January 1995. Anchor FSB was acquired by Dime Savings Bank of New York, FSB ("Dime FSB") which was subsequently merged into Washington Mutual Bank, F.A. ("WMBFA") in January 2002.
4. The Company filed a report on Form 8-K dated June 6, 2002. The report included under Item 9 of Form 8-K a presentation by Kerry K. Killinger, Chairman, President and Chief Executive Officer at the Sanford Bernstein Strategic Decisions Conference.
5. The Company filed a report on Form 8-K dated June 25, 2002. The report included under Item 9 of Form 8-K a presentation by Kerry K. Killinger, Chairman, President and Chief Executive Officer at the Second Quarter 2002 Investor Day.
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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 August 14, 2002.
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WASHINGTON MUTUAL, INC.
INDEX OF EXHIBITS
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