UNITED STATESSECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
WASHINGTON MUTUAL, INC. (Exact name of registrant as specified in its charter)
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
The number of shares outstanding of the issuer's classes of common stock as of July 30, 2004:
Common Stock – 872,552,275(1)
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2004 TABLE OF CONTENTS
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PART I – FINANCIAL INFORMATION
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(This table is continued on the next page.)
See Notes to Consolidated Financial Statements
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Continued) (UNAUDITED)
(This table is continued from the previous page.)
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)
(The Consolidated Statements of Cash Flows are continued on the next page.)
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) (UNAUDITED)
(Continued from the previous page.)
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 1: Accounting Policies
Basis of Presentation
The accompanying Consolidated Financial Statements are unaudited and include the accounts of Washington Mutual, Inc. (together with its subsidiaries "Washington Mutual" or the "Company"). Washington Mutual's accounting and financial reporting policies are in accordance with accounting principles generally accepted in the United States of America. 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 2003 Annual Report on Form 10-K/A. Certain prior period amounts have been reclassified to conform to current period classifications.
Recently Adopted Accounting Standards
In December 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46R ("FIN 46R"), Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. FIN 46R is a revision to the original FIN 46 that addresses the consolidation of certain variable interest entities. The revision clarifies how variable interest entities should be identified and evaluated for consolidation purposes. FIN 46R must be applied no later than March 31, 2004. The Company applied FIN 46 as of July 1, 2003 and FIN 46R for the quarter ended March 31, 2004. The application of FIN 46R did not have a material effect on the results of operations or financial condition.
In March 2004, Securities and Exchange Commission ("SEC") Staff Accounting Bulletin No. 105, Loan Commitments Accounted for as Derivative Instruments ("SAB 105") was issued, which provides guidance regarding loan commitments that are accounted for as derivative instruments under Statement of Financial Accounting Standards ("Statement") No. 133 (as amended), Accounting for Derivative Instruments and Hedging Activities. In this Bulletin, the SEC stated that the amount of the expected servicing rights should not be included when determining the fair value of interest rate lock commitments that are considered to be derivatives. This guidance must be applied to rate locks issued after March 31, 2004. In anticipation of this Bulletin, the Company prospectively changed its accounting policy for such rate lock commitments on January 1, 2004. Under the new policy, gains resulting from the valuation of expected servicing rights that had previously been recorded at the issuance of the rate lock are recognized when the underlying loans are sold.
Recently Issued Accounting Standards
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") was enacted into law. On May 19, 2004, the FASB issued Staff Position ("FSP") No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, which supersedes FSP 106-1 which was issued on January 12, 2004. FSP 106-1 permitted employers that sponsor postretirement benefit plans that provide prescription drug benefits to retirees to make a one-time election to defer the accounting impact, if any, of the Act. The Company elected to defer recognition of the provisions of the Act as permitted by FSP 106-1. FSP 106-2 provides two transition options for companies that previously elected to defer the provisions of the Act, a retroactive application to the date of enactment or a prospective application from the date of adoption. The Company adopted FSP 106-2 as of July 1, 2004 and has elected to prospectively apply the provisions of the Act. The
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Company is in the process of measuring the effects of the Act on its accumulated postretirement benefit obligation as of June 30, 2004, and as such, the net periodic benefit cost disclosed in Note 6 – "Employee Benefits Programs" does not reflect any amount associated with the subsidy under the Act. The Company does not expect the effects of the Act to have a significant impact on its results of operations or financial condition.
In March of 2004, the Emerging Issues Task Force ("EITF") reached consensus on the guidance provided in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. Among other investments, this guidance is applicable to debt and equity securities that are within the scope of Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. A company's liquidity and capital requirements should be considered when assessing its intent and ability to hold an investment for a reasonable period of time that would allow the fair value of the investment to recover up to or beyond its cost. Although not presumptive, a pattern of selling investments prior to the forecasted fair value recovery may call into question a company's intent. In addition, the severity and duration of the impairment should also be considered when determining whether the impairment is other-than-temporary. This new guidance is effective for reporting periods beginning after June 15, 2004 and the Company is currently evaluating the impact this guidance will have on its process for determining whether other-than-temporary declines exist within its debt and equity investment securities portfolio. Adoption of this guidance may accelerate the recognition of losses from declines in value on debt securities due to interest rates; however, it is not anticipated to have a significant impact on stockholders' equity as changes in market value of available-for-sale securities are already included in Accumulated Other Comprehensive Income.
Mortgage Servicing Rights Hedging Activities
The Company began applying fair value hedge accounting treatment, as prescribed by Statement No. 133, as of April 1, 2004 to most of its mortgage servicing rights ("MSR"). Applying fair value hedge accounting to the MSR results in the changes in fair value of the hedging derivatives being netted against the changes in fair value of the hedged MSR, to the extent the hedge relationship is determined to be highly effective. We use standard statistical methods of correlation to determine if the results of the changes in value of the hedging derivative and the hedged item meet the Statement No. 133 criteria for a highly effective hedge accounting relationship. Unlike the lower of cost or market value accounting methodology, the recorded value of the hedged MSR may exceed its original cost basis. The portion of the MSR in which the hedging relationship is determined not to be highly effective will continue to be accounted for at the lower of aggregate cost or market value.
Hedge ineffectiveness from fair value hedges of MSR as well as any provision for impairment or reversal of such provision recognized on the MSR that are accounted for at the lower of aggregate cost or market value are reported as mortgage servicing rights valuation adjustments on the Consolidated Statements of Income.
The change in fair value of certain MSR risk management derivatives in which the Company either has not attempted to achieve, or has attempted but did not achieve, hedge accounting treatment under Statement No. 133 is included in revaluation gain (loss) from derivatives on the Consolidated Statements of Income.
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Stock-Based Compensation
In accordance with the transitional guidance of Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123, the Company elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. For such awards, fair value is estimated using a binomial option pricing model, with compensation expense recognized in earnings over the required service period. Stock-based awards granted prior to January 1, 2003, and not modified after December 31, 2002, will continue to be accounted for under Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees. The pro forma presentation of what the impact to the financial statements would be if these awards were accounted for on the fair value basis will continue to be disclosed in the Notes to Consolidated Financial Statements until the last of those awards vest in 2005.
Had compensation cost for the Company's stock-based compensation plans been determined using the fair value method consistent with Statement No. 123 for all periods presented, the Company's net income and net income per common share would have been reduced to the pro forma amounts indicated below:
Note 2: Discontinued Operations
During the first quarter of 2004 the Company sold its subsidiary, Washington Mutual Finance Corporation. Accordingly, Washington Mutual Finance has been accounted for as a discontinued operation and the results of operations and cash flows have been removed from the Company's results of continuing operations for all periods presented on the Consolidated Statements of Income, Cash Flows and Notes to the Consolidated Financial Statements, unless otherwise noted. Likewise, the assets and liabilities of Washington Mutual Finance are presented under separate captions on the Consolidated Statements of Financial Condition. The results from discontinued operations amounted to $399 million, net of tax, which includes a pretax gain of $676 million ($420 million, net of tax) that was recorded upon the sale of Washington Mutual Finance.
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Note 3: Earnings Per Share
Information used to calculate earnings per share was as follows:
For the three and six months ended June 30, 2004, options to purchase an additional 1,812,113 and 1,795,436 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because their inclusion would have had an antidilutive effect. Likewise, for the three and six months ended June 30, 2003, options to purchase an additional 41,700 and 1,907,973 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because their inclusion also would have had an antidilutive effect.
Additionally, as part of the 1996 business combination with Keystone Holdings, Inc. (the parent of American Savings Bank, F.A.), 6 million shares of common stock, with an assigned value of $18.4944 per share, are being held in escrow for the benefit of certain of the former investors in Keystone Holdings, and their transferees. During 2003, the number of escrow shares was reduced from 18 million to 6 million as a result of the return and cancellation of 12 million shares to the Company. The escrow will expire on December 20, 2008, subject to certain limited extensions. 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, 2004, the conditions for releasing the shares from escrow had not occurred, and therefore none of those shares were included in the above computations.
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Note 4: Mortgage Banking Activities
Changes in the portfolio of loans serviced for others were as follows:
Changes in the balance of MSR, net of the valuation allowance, were as follows:
Changes in the valuation allowance for MSR were as follows:
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At June 30, 2004, the expected weighted average life of the Company's MSR was 4.2 years. Projected amortization expense for the gross carrying value of MSR at June 30, 2004 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 and discount rates, as were used to determine amortization expense at the end of the second quarter of 2004. These factors are inherently subject to significant fluctuations, primarily due to the effect that changes in mortgage 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 5: Guarantees
The Company sells loans without recourse that may have to be subsequently repurchased if a defect that occurred during the loan's origination process results in a violation of a representation or warranty made in connection with the sale of the loan. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred and if such defects constitute a violation of a representation or warranty made to the investor in connection with the sale. If such a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, the Company has no commitment to repurchase the loan. As of June 30, 2004 and December 31, 2003, the amount of loans sold without recourse totaled $552.93 billion and $578.71 billion, which substantially represents the unpaid principal balance of the Company's loans serviced for others portfolio. The Company has reserved $118 million as of June 30, 2004 and $112 million as of December 31, 2003 to cover the estimated loss exposure related to the loan origination process defects that are inherent within this portfolio.
At June 30, 2004, the Company is the guarantor of five separate issues of trust preferred securities. The Company has issued subordinated debentures to wholly-owned special purpose trusts. Each trust has issued trust preferred securities. The sole assets of each trust are the subordinated debentures issued by the Company. The Company guarantees the accumulated and unpaid distributions of each trust, to the extent the Company provided funding to the trust per the Company's obligation under subordinated debentures, but the trust then failed to fulfill its distribution requirements to the security holders. The maximum potential amount of future payments the Company could be required to make under this guarantee is the expected principal and interest each trust is obligated to remit under the issuance of trust
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preferred securities, which totaled $2.23 billion as of June 30, 2004. No liability has been recorded as the Company does not expect it will be required to perform under this guarantee.
Note 6: Employee Benefits Programs
Pension Plan
Washington Mutual maintains a noncontributory cash balance defined benefit pension plan (the "Pension Plan") for eligible employees. Benefits earned for each year of service are based primarily on the level of compensation in that year plus a stipulated rate of return on the benefit balance. It is the Company's policy to contribute funds to the Pension Plan on a current basis to the extent its contributions are deductible under federal income tax regulations.
Nonqualified Defined Benefit Plans and Other Postretirement Benefit Plans
The Company, as successor to previously acquired companies, has assumed responsibility for a number of nonqualified, noncontributory, unfunded postretirement benefit plans, including retirement restoration plans for certain employees, a number of supplemental retirement plans for certain officers and multiple outside directors' retirement plans. Benefits under the retirement restoration plans are generally determined by the Company. Benefits under the supplemental retirement plans and outside directors retirement plans are generally based on years of service.
The Company, as successor to previously acquired companies, maintains unfunded defined benefit postretirement plans that make medical and life insurance coverage available to eligible retired employees and their beneficiaries and covered dependents. The expected cost of providing these benefits to retirees, their beneficiaries and covered dependents was accrued during the years each employee provided services.
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Components of net periodic benefit cost for the Pension Plan, Nonqualified Defined Benefit Plans and Other Postretirement Benefit Plans were as follows:
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Note 7: Operating Segments
The Company has grouped its products and services into two primary categories – those marketed to retail consumers and those marketed to commercial customers – and has established three operating segments for the purpose of management reporting: Retail Banking and Financial Services, Mortgage Banking and the Commercial Group. 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 the products and services they offer.
The Company uses various methodologies, and continues to enhance those methodologies, to assign certain balance sheet and income statement items to the responsible operating segment. When changes are made to the methodologies used to measure segment profitability, results for prior periods are restated for comparability. A significant change that occurred in the first quarter of 2004 that is reflected in the operating segment financial highlights tables is the modified calculation of the long-term, normalized net charge-off ratio that is used to measure each segment's provision for loan and lease losses. The revised methodology recalibrates this ratio more frequently to the latest available experience factors that are used to measure expected losses on the Company's loan products. In the second quarter of 2004, we applied this methodology change on prior years and reallocated the adjustments on a monthly basis from the original straight-line basis. This change did not have a material impact on 2003's results of operations, but did impact the quarterly results.
Methodologies that are applied to the measurement of segment profitability include: (1) a funds transfer pricing system, which allocates interest income funding credits and funding charges between the operating segments and the Treasury Division. A segment will receive a funding credit from the Treasury Division for its liabilities. Conversely, a segment is assigned a charge by the Treasury Division to fund its assets. The system is based on the interest rate sensitivities of assets and liabilities and is designed to extract net interest income volatility from the business units and concentrate it in the Treasury Division, where it is managed. Certain basis and other residual risk remains in the operating segments; (2) a calculation of the provision for loan and lease losses based on management's current assessment of the long-term, normalized net charge-off ratio for loan products within each segment, which is recalibrated periodically to the latest available loan loss experience data. This process differs from the "losses inherent in the loan portfolio" methodology that is used to measure the allowance for loan and lease losses at the Corporate level. This methodology is used to provide segment management with provision information for strategic decision making; (3) the utilization of an activity-based costing approach to measure allocations of certain operating expenses that were not directly charged to the segments; (4) the allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; (5) capital charges for goodwill as a component of an internal measurement of return on the goodwill allocated to the operating segment; (6) an economic capital model which is the framework for assessing business performance on a risk-adjusted basis. Changing economic conditions, further research and new data may lead to the update of the capital allocation assumptions; and (7) inter-segment activities which include a process for transferring originated mortgage loans held in portfolio from the Mortgage Banking segment to the Retail Banking and Financial Services segment and a broker fee arrangement between Mortgage Banking and Retail Banking and Financial Services. The process for transferring originated mortgage loans involves Mortgage Banking recognizing a gain on the sale of loans to Retail Banking and Financial Services based on an assumed profit factor. This assumed profit factor is included in Retail Banking and Financial Services loan premiums and amortization of loan premiums. The elimination of
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inter-segment gains on sale, loan premiums and amortization are included in the reconciliation adjustments column within these Note 7 tables and are described in the associated footnotes. The broker fee arrangement involves Retail Banking and Financial Services receiving revenue for the origination of home loans and Mortgage Banking receiving revenue for the origination of home equity loans and lines of credit. The net amount of the inter-segment broker fees is included in the inter-segment revenue (expense) line within these Note 7 tables.
The Consumer Group provides access to customers through a wide range of channels, which encompass a network of retail banking stores, retail and wholesale home loan centers, ATMs and online banking. The Consumer Group consists of two distinct operating segments for which separate financial reports are prepared: the Retail Banking and Financial Services segment, and the Mortgage Banking segment.
The Retail Banking and Financial Services segment offers a diversified set of deposits and consumer lending products and financial services to individual consumers. Loan products include home loans, home equity loans and lines of credit and consumer loans. This segment acquires home loans originated and serviced by the Mortgage Banking segment at a premium, which are amortized over the expected life of the loans. This segment's loan portfolio also includes purchased home loans made to higher risk borrowers. Financial services offered by this segment include the Company's mutual fund management business, WM Advisors, Inc., which provides investment advisory and mutual fund distribution services, and investment advisory and securities brokerage services that are offered by WM Financial Services, Inc., a licensed broker-dealer. Fixed annuities are also offered to the public through licensed bank employees.
The Mortgage Banking segment originates and services home loans that are sold to secondary market participants and loans that are held in portfolio by the Retail Banking and Financial Services segment. The Mortgage Banking segment charges a servicing fee to the Retail Banking and Financial Services segment for servicing the Company's home loan portfolio. This fee is based on a monthly charge determined by the types of loans serviced. Insurance products that complement the mortgage process, such as private mortgage insurance and property and casualty insurance policies, are also made available through insurance agencies that are part of this segment. This segment also manages the Company's captive reinsurance activities and makes available a variety of life insurance policies.
The Commercial Group's multiple business activities are managed as one operating segment. This group's products and services include loans made to developers of and investors in multi-family and real estate properties, commercial real estate loan servicing, selling commercial real estate loans to secondary market participants and mortgage banker financing. Through Long Beach Mortgage Company, a wholly-owned subsidiary of the Company and a component of the Company's specialty mortgage finance program, the Commercial Group originates and services home loans made to higher-risk borrowers that are sold to secondary market participants.
In July 2004 the Company announced that the Commercial Group is exiting certain activities that are no longer strategically aligned with the Group's business objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million.
The Corporate Support/Treasury and Other category includes management of the Company's interest rate risk, liquidity, capital, and borrowings and the investment securities and the mortgage-backed securities portfolios. This category also includes the costs of the Company's technology services, facilities, legal, accounting and finance, and human resources to the extent not allocated to the business segments. Also reported in this category is the net impact of funds transfer pricing for loan and deposit balances
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including the effects of changes in interest rates on the Company's net interest margin and the effects of inter-segment allocations of gains and losses related to interest rate risk management instruments.
Financial highlights by operating segment were as follows:
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Note 8: Restatement of Financial Statements
During the fourth quarter of 2003, the Company concluded that the inclusion of certain components (i.e. deferred acquisition costs and claims stabilization reserves) in the cash surrender value of its bank-owned life insurance policies was incorrect.
Deferred acquisition costs represent anticipated annual refunds of a lump-sum payment that the Company made to insurers at the inception of the policies to cover the insurers' related federal tax exposure. As the insurers realize the tax benefits of the acquisition costs over a 10-year period, the initial lump-sum payment is refunded to the Company. As the Company expects to receive a full refund of the initial lump-sum payment, the Company previously recorded the initial payment to the insurers as an asset. However, since the contractual agreement indicates the refunds will be made at the insurer's discretion, the immediate recognition of an asset was determined to not be appropriate. Under the revised accounting policy the Company records an expense for the initial lump-sum payments and records income as the payments are refunded.
Claims stabilization reserves represent funds that have been set aside by the insurer from income earned on investments to be used to fund the Company's self-insured portion of death benefit payments. Provided that the Company holds the policies until all benefit payments have been made, all funds will be remitted to the Company. Since the Company has the intent and ability to hold those policies until such time, the Company previously recorded increases to claims stabilization reserves as assets and recognized income. However, in the event that the Company does not hold the policies until all benefit payments have been made, such funds may not be remitted to the Company. Accordingly, the Company has changed its accounting policy, which now defers the recognition of this asset until benefit payments or refunds from that reserve are received.
The financial statement effect of the previous accounting treatment resulted in the overstatement of the cash surrender value component of the insurance policies and had the corresponding effect of overstating other noninterest income. Thus, the ensuing restatement decreased other assets and retained earnings by $83 million as of June 30, 2003. The Company has corrected its accounting for all affected prior reporting periods. The table below shows the impact of the restatements on net income and basic and diluted earnings per share for the three and six months ended June 30, 2003:
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Restatement of Financial Statements
During the fourth quarter of 2003, Washington Mutual, Inc. (together with its subsidiaries "Washington Mutual," or the "Company") concluded that the inclusion of certain components (i.e. deferred acquisition costs and claims stabilization reserves) in the cash surrender value of its bank-owned life insurance policies was incorrect. The accounting policy the Company previously used resulted in the overstatement of the cash surrender value of the policies and, accordingly, other noninterest income. This restatement also decreased other assets, and correspondingly, retained earnings by $83 million as of June 30, 2003. The restatement only affects periods commencing with the second quarter of 2000 when the policies were first acquired and had no tax effect. The Company has corrected its accounting for all affected prior reporting periods.
Discontinued Operations
On November 24, 2003 the Company announced a definitive agreement to sell its subsidiary, Washington Mutual Finance Corporation, for approximately $1.30 billion in cash. This sale was completed during the first quarter of 2004. Accordingly, Washington Mutual Finance is presented in this report as a discontinued operation with the results of operations and cash flows segregated from the Company's results of continuing operations for all periods presented on the Consolidated Statements of Income, Cash Flows and Notes to the Consolidated Financial Statements as well as the tables presented herein, unless otherwise noted. Likewise, the assets and liabilities of Washington Mutual Finance are presented as separate captions on the Consolidated Statements of Financial Condition.
Cautionary Statements
Our Form 10-Q and other documents that we file with the Securities and Exchange Commission ("SEC") contain forward-looking statements. In addition, our senior management may make forward-looking statements orally to analysts, investors, the media and others. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "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."
Forward-looking statements provide our expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. These statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made. There are a number of factors, many of which are beyond our control, that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. Some of these factors are:
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Overview
Net income for the second quarter of 2004 was $489 million, or $.55 per diluted share, a decrease from $995 million, or $1.07 per diluted share from continuing operations for the second quarter of 2003.
Home loan mortgage banking income declined from $531 million in the first quarter of 2004 to zero in the second quarter due to increases in mortgage interest rates during the quarter. At June 30, 2004, the 30-year conforming Freddie Mac fixed mortgage rate was 6.29%, an increase of 84 basis points from 5.45% at March 31, 2004. The performance of the Company's MSR asset, net of hedging and risk management activities was adversely impacted by the sharp increase in rates. As interest rates increased, basis spreads between mortgage rates and interest rate swap indices tightened, resulting in losses on MSR hedging and risk management derivatives that exceeded the increase in value of the MSR.
An important factor affecting the value of the MSR is the estimated prepayment speed of the underlying loan servicing portfolio. As interest rates increase the propensity for loans to be prepaid decreases as there is less incentive for customers to refinance. This lengthens the expected life of the loan and thus increases the value of the MSR. However, when interest rates increase beyond a point where the coupon rates in the loan servicing portfolio are lower than current market rates, the sensitivity of the MSR to further interest rate increases diminishes. At June 30, 2004, the weighted average coupon rate (annualized) of the loan servicing portfolio was 5.93%, 36 basis points below the 30-year conforming Freddie Mac fixed mortgage rate on that date. The corresponding MSR derivative instruments, in contrast, declined in value in a more linear fashion. Accordingly, these factors caused the decline in value of the derivatives to outpace the increase in value of the MSR.
The Company began applying fair value hedge accounting treatment to most of its MSR asset on April 1, 2004. To the extent that the hedging relationship is determined to be highly effective, this treatment requires changes in value of the hedging derivatives to be offset by changes in fair value of the hedged MSR. Unlike lower of cost or market value accounting, the recorded value of the hedged MSR may exceed its original cost basis. Had the Company not applied fair value hedge accounting treatment to the MSR asset in the second quarter, the Company estimates that the aggregate amount of MSR valuation changes would have decreased from $1.93 billion to $1.77 billion, which would have decreased noninterest income by approximately $165 million.
The following table presents the aggregate valuation adjustments for the MSR and the corresponding hedging and risk management derivative instruments during the first and second quarters of 2004 as well as the six months ended June 30, 2004:
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Gain from mortgage loans, net of risk management instruments increased to $255 million, compared with a net gain of $105 million in the first quarter of 2004. Rates experienced a brief decline during March of 2004, spurring a small refinancing surge and resulting in an increase in home loan volume to $63.15 billion in the second quarter of 2004, up from $50.50 billion in the preceding quarter. However, as mortgage rates subsequently increased, the U.S. mortgage refinance index (seasonally adjusted) declined by 71% between April 1 and June 30, 2004, resulting in much lower home loan application volume during the latter part of the second quarter. Recent forecasts of mortgage industry home loan volume for the second half of 2004 have also been revised downward in anticipation of a continuing slowdown in refinancing activity. As the Company expects the trend of a sustained higher interest rate environment to continue for the remainder of 2004, we expect gain from mortgage loans to decline as home loan volume diminishes.
A prominent management priority continues to be the cost containment initiative, originally announced in the fourth quarter of 2003. As of June 30, 2004, this initiative has resulted in cumulative headcount reductions of approximately 5,000, excluding temporary and contract workers, with approximately 1,300 additional employees who received termination notices as of that date. This initiative, which is not expected to be completed until the middle of 2005, is primarily directed at reducing the fixed cost structure of the mortgage banking business through employee headcount reductions and facilities closures. Until the cost structure approaches a level that is commensurate with the cost structures of other mortgage banking industry leaders, the profitability and the competitive position of our mortgage banking business will be adversely affected. The primary components of noninterest expense that are impacted by this initiative are compensation and benefits due to headcount reductions and severance charges associated with those reductions, and occupancy and equipment expenses due to facilities closures. A significant milestone within this initiative occurred in July 2004, when the Company completed its conversion of all home loan customer records onto a single servicing system.
In July 2004, the Company announced that approximately 2,500 additional mortgage banking positions are to be eliminated by the end of the year. The Company also announced in July 2004 that its mortgage banking business will concentrate its activities in markets in which the Company believes it can optimize its retail banking cross-selling opportunities. Customers outside of these markets will continue to be served through existing wholesale and correspondent lending relationships. This initiative resulted in the sale of 94 retail mortgage lending offices in August 2004, with six additional offices expected to be closed or sold by September 30, 2004.
In July 2004, the Company announced that the Commercial Group is exiting certain activities that are no longer strategically aligned with the Group's business objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million. This initiative will result in the closure, over time, of approximately 50 commercial banking locations and the elimination of approximately 850 positions.
Ultimately, the reduced expenses to be realized in 2004 from the cost containment initiative are expected to offset this year's incremental costs from the continuing expansion of the retail banking franchise, thus producing a noninterest expense run rate in 2004 that is essentially flat when compared to the total noninterest expense incurred in 2003.
The net interest margin was 2.86% for the second quarter of 2004, a decline of 36 basis points from the second quarter of 2003 as yields on interest-earning assets continued to decline, primarily from the sales and runoff of higher yielding debt securities and loans during the second half of 2003 and the first part of 2004. On a sequential quarter basis, the margin declined by only three basis points, as it was sustained by the first quarter 2004 termination of approximately $5 billion in higher costing floating-rate Federal Home Loan Bank ("FHLB") advances, along with certain interest rate swaps that had been used to synthetically convert these borrowings to fixed-rate instruments. The sequential quarter performance of the margin also benefited from a significant increase in average noninterest-bearing custodial and escrow
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deposits, which resulted from the brief increase in refinancing activity during the earlier part of the second quarter. Although the Company expects the margin for the full year of 2004 to fall toward the lower end of our long-term target range of 2.80% to 3.10%, the margin for the subsequent quarters in 2004 is expected to dip below this low point as a result of the Federal Reserve's recent 25 basis point increase in the targeted federal funds rate and due to the significant decline in custodial and escrow deposits at the end of the second quarter, which occurred due to the diminishing levels of refinancing activity. At June 30, 2004, custodial and escrow deposits were $4.18 billion lower than the quarterly average. The margin may face further pressure if the future performance of the domestic economy prompts the Federal Reserve to initiate further rate increases.
The Company continued to make progress in deepening its retail banking market penetration, as more than 200 net new retail banking stores were opened during the past twelve months and the number of retail checking accounts grew by nearly 800,000 during that period, which contributed to a $53 million increase in depositor and other retail banking fees in the second quarter of 2004 as compared with the same quarter in 2003. During the quarter the Company opened 61 net new retail banking stores, including 20 in the Company's newest market, Tampa-St. Petersburg, Florida and 20 in Chicago, Illinois.
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
The Company's management, under the direction of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or furnishes under the Securities Exchange Act of 1934.
We review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and improve our controls and procedures over time and correct any deficiencies that we may discover. While we believe the present design of our disclosure controls and procedures is effective, future events affecting our business may cause us to modify our disclosure controls and procedures.
Internal Control Over Financial Reporting
There have not been any changes in the Company's internal control environment over financial reporting during the second quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
Critical Accounting Policies
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our Consolidated Financial Statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances as of June 30, 2004.
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 three accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, and the sensitivity of our Consolidated Financial Statements to those judgments, estimates and assumptions, are critical to an understanding of our Consolidated Financial Statements. These policies relate to the
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valuation of our MSR, the methodology that determines our allowance for loan and lease losses and the assumptions used in the calculation of our net periodic benefit cost. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors. The Company no longer considers its accounting policy for interest rate lock commitments on loans to be held for sale to be critical as the valuation of the expected servicing rights that the Company retains when the underlying loans are sold is no longer recognized at the issuance of the rate lock as a result of the guidance issued in SEC Staff Accounting Bulletin No. 105.
These policies and the judgments, estimates and assumptions are described in greater detail in the Company's 2003 Annual Report on Form 10-K/A in the "Critical Accounting Policies" section of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."
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Summary Financial Data
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Summary Financial Data (Continued)
Earnings Performance from Continuing Operations
Net Interest Income
Net interest income decreased predominantly from contraction of the net interest margin, which declined by 36 and 37 basis points to 2.86% and 2.88% for the three and six months ended June 30, 2004 from 3.22% and 3.25% for the same periods in 2003, as yields on interest-earning assets continue to decline, primarily as a result of the sales and runoff of higher yielding loans and debt securities during the second half of 2003 and the first part of 2004. The decline in the net interest margin was partially offset by decreases in the cost of deposits. In particular, the average rate paid on interest-bearing checking (Platinum) accounts decreased to 1.39% from 1.89% on an average balance of $61.77 billion and $54.94 billion for the three months ended June 30, 2004 and 2003, and decreased to 1.38% from 1.99% on an average balance of $62.07 billion and $53.68 billion for the six months ended June 30, 2004 and 2003. Further offsetting the decline in the net interest margin was the termination of higher cost FHLB advances along with the termination of swaps hedging those advances. This contributed to the decrease in FHLB funding costs of 68 basis points, from 2.56% at the end of the second quarter 2003 to 1.88% at the end of the second quarter 2004.
Interest rate contracts, including embedded derivatives, held for asset/liability interest rate risk management purposes decreased net interest income by $74 million and $201 million for the three and six months ended June 30, 2004, compared with $156 million and $304 million for the same periods in 2003.
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Detailed average balances of interest and noninterest-earning assets as well as interest income and expense and the weighted average interest rates, were as follows:
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Noninterest Income
Noninterest income from continuing operations consisted of the following:
Home Loan Mortgage Banking Income
The decrease in home loan servicing fees for the three and six months ended June 30, 2004 was the result of the decrease in our loans serviced for others portfolio and a decline in the weighted average servicing fee. Our loans serviced for others portfolio decreased as the Company's loan volume mix began to shift from salable production to balance sheet portfolio lending during the second half of 2003 due to the end of the refinancing boom. This caused the volume of new, salable loan production to be lower than the paydown rate of the servicing portfolio.
The weighted average servicing fee decreased from 36 basis points at June 30, 2003 to 34 basis points at June 30, 2004 largely due to transactions entered into, from time to time, in which a portion of the future contractual servicing cash flows are securitized and sold to third parties. These transactions decreased the net MSR balance by $248 million during the twelve months ending June 30, 2004, but had no impact on the unpaid principal balance of the loans serviced for others portfolio. Additionally, the Company has entered into loan sales and securitizations with certain government-sponsored and private enterprises in which it has retained a smaller servicing fee than is common in the industry. The smaller servicing fee leads to a lower value for the resulting MSR and greater cash proceeds when the loans or securities are sold.
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The following table presents the aggregate valuation adjustments for the MSR and the corresponding hedging and risk management derivative instruments during the three and six months ended June 30, 2004 and 2003:
The following tables separately present the risk management results associated with the economic hedges of MSR, loans held for sale and other risk management activities included within noninterest income for the three and six months ended June 30, 2004 and June 30, 2003:
Revaluation gain (loss) from derivatives is the earnings impact of the changes in fair value from certain derivatives where the Company either has not attempted to achieve, or has attempted but did not achieve, hedge accounting treatment under Statement of Financial Accounting Standards ("Statement") No. 133.
The Company began applying fair value hedge accounting treatment, as prescribed by Statement No. 133, as of April 1, 2004 to most of its MSR. Applying fair value hedge accounting to the MSR results in the changes in fair value of the hedging derivatives to be netted against the changes in fair value of the hedged MSR, to the extent the hedge relationship is determined to be highly effective. We use standard
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statistical methods of correlation to determine if the results of the changes in value of the hedging derivative and the hedged item meet the Statement No. 133 criteria for a highly effective hedge accounting relationship. Unlike the lower of cost or market value accounting methodology, the recorded value of the hedged MSR may exceed its original cost basis. The portion of the MSR in which the hedging relationship is determined not to be highly effective will continue to be accounted for at the lower of aggregate cost or market value.
The total change in MSR valuation, net of hedging and risk management instruments was a loss of $178 million in the second quarter of 2004, compared with a gain of $520 million in the second quarter of 2003. The hedging performance of the MSR asset was affected by the significant increase in mortgage interest rates during the quarter. At June 30, 2004, the 30-year conforming Freddie Mac fixed mortgage rate was 6.29%, an increase of 84 basis points from 5.45% at March 31, 2004. As interest rates increased, basis spreads between mortgage rates and interest rate swap indices tightened, resulting in losses on MSR hedging and risk management derivatives that exceeded the increase in value of the MSR.
MSR amortization expense was lower in the first half of 2004, compared with the same period in 2003, due to a decline in the high prepayment rates experienced in the first half of 2003 and the large other than temporary MSR impairment recorded in that year.
During the second quarter of 2004, we recorded other than temporary MSR impairment of $388 million on the MSR asset. This amount was determined by applying an appropriate interest rate shock to the MSR in order to estimate the amount of the valuation allowance we may expect to recover in the foreseeable future. To the extent that the gross carrying value of the MSR, including the Statement No. 133 valuation adjustments, exceeded the estimated recoverable amount, that portion of the gross carrying value was written off as other than temporary impairment. The initial application of fair value hedge accounting treatment to most of the Company's MSR during the second quarter of 2004 effectively resulted in the Company recording much of the recovery in the value as a Statement No. 133 valuation adjustment. Absent the application of Statement 133 to the Company's MSR asset, most of the MSR recovery recognized during the second quarter would have been recorded as a reversal of the valuation allowance.
The decrease in other home loan servicing expense for the three and six months ended June 30, 2004 resulted from lower loan pool expenses due to the reduction in refinancing activity. Loan pool expenses represent the amount of interest expense that the Company incurs for the elapsed time between the borrower payoff date and the next monthly investor pool cutoff date.
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In measuring the fair value of MSR, we stratify the loans in our servicing portfolio based on loan type and coupon rate. For the portion of the MSR that is accounted for under the lower of aggregate cost or market value methodology, an impairment valuation allowance for a stratum is recorded when, and in the amount by which, its fair value is less than its gross carrying value. A reversal of the impairment allowance for a stratum is recorded when its fair value exceeds its net carrying value. However, a reversal in any particular stratum cannot exceed its valuation allowance. At June 30, 2004, we stratified the loans in our servicing portfolio as follows:
At June 30, 2004, key economic assumptions and the sensitivity of the current fair value of home loan MSR to immediate changes in those assumptions were as follows:
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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 MSR fair value. Changes in fair value based on a variation in assumptions 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 2003 Annual Report on Form 10-K/A for further discussion of how MSR impairment is measured.
The Company recorded a gain from mortgage loans, net of revaluation gain from derivatives used as loans held for sale risk management instruments, of $255 million and $360 million for the three and six months ended June 30, 2004, compared with a net gain of $600 million and $1.05 billion for the same periods in 2003. Historically low mortgage interest rates during the first part of 2003 generated extremely high levels of salable fixed-rate home loan volume, most of which was the result of refinancing activity. When the industry-wide refinancing boom ended later that year, customer preferences began to shift away from fixed-rate loans to adjustable-rate products. Accordingly, the Company's fixed-rate home loan volume declined from $155.07 billion in the first half of 2003 to $52.09 billion in the same period of 2004. Conversely, short-term adjustable-rate loan volume, which the Company generally retains in its loan portfolio, increased from $10.94 billion in the first half of 2003 to $31.21 billion in the same period of 2004.
As part of its mortgage banking activities, the Company enters into commitments to originate or purchase loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Changes in fair value that occur subsequent to the issuance of these rate lock commitments are recorded in gain from mortgage loans on the Consolidated Statements of Income. For all reporting periods prior to the first quarter of 2004, the amount of the expected servicing rights to be retained upon the sale of the loans was included in the initial valuation. In March 2004, SEC Staff Accounting Bulletin No. 105 ("SAB 105") was issued, which provided guidance regarding loan commitments that are intended to be sold. In this Bulletin, the SEC stated that the amount of the expected servicing rights should not be included when determining the fair value of interest rate lock commitments on mortgage loans that are intended to be sold. The guidance in SAB 105 must be applied to such interest rate locks issued after March 31, 2004. In anticipation of this Bulletin, the Company prospectively changed its accounting policy for rate lock commitments on January 1, 2004. Under the new policy, gains resulting from the valuation of expected servicing rights that had previously been recorded at the issuance of the rate lock are not recognized until the underlying loans are sold or securitized. Generally, loans held for sale are sold within 60 to 120 days after the issuance of the rate lock commitment.
As part of its normal servicing activities, the Company repurchases delinquent mortgages contained within Government National Mortgage Association ("GNMA") loan servicing pools and, in general, resells them to secondary market participants. Accordingly, gains from the resale of these mortgages are reported as gain from mortgage loans. In one part of the Company's program, certain loans that have been 30 days past due for three consecutive months (referred to as "rolling 30 loans") are repurchased from GNMA and then resold in the secondary market. In the other, certain loans that have missed three consecutive payments are likewise purchased and resold. Gain from the sale of these loans was $45 million and $100 million for the three and six months ended June 30, 2004 and $152 million and $228 million for the
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same periods in 2003. The Company does not have the option of repurchasing "rolling 30 loans" from pools created after January 1, 2003, but continues to make such purchases from previously created pools. Over time, we expect gains from the repurchase of "rolling 30 loans" to diminish as the pools that are eligible for repurchase are depleted.
The fair value changes in loans held for sale and the offsetting changes in the derivative instruments used as fair value hedges are recorded within gain from mortgage loans when hedge accounting treatment is achieved. Loans held for sale where hedge accounting treatment is not achieved ("nonqualifying" loans held for sale) are not recorded at fair value and are instead recorded at the lower of aggregate cost or market value. Due to changes in the fair value of derivatives acquired to mitigate the risk of fair value changes to these nonqualifying loans, net gains of $142 million and $76 million were recognized as revaluation gains from derivatives during the three and six months ended June 30, 2004, compared with revaluation losses of $147 million and $342 million for the same periods in 2003. A gain may be recognized when the loans are subsequently sold if the fair value of those loans is higher than the carrying amount. As of June 30, 2004, the fair value of loans held for sale was $26.53 billion with a carrying amount of $26.41 billion, and as of December 31, 2003, the fair value and carrying amount were $20.34 billion.
Net settlement income from certain interest-rate swaps consisted of receive-fixed swaps, which were used predominantly as MSR risk management derivatives. At June 30, 2004, the total notional amount of these receive-fixed swaps was $34.13 billion, compared with $8.15 billion at June 30, 2003.
All Other Noninterest Income Analysis
The increase in depositor and other retail banking fees for the three and six months ended June 30, 2004, compared with the same periods in 2003, was largely due to higher levels of checking fees that resulted from an increase in the number of noninterest-bearing checking accounts and an increase in ATM and debit card related income. The number of noninterest-bearing checking accounts at June 30, 2004 totaled approximately 6.8 million, compared with approximately 6.1 million at June 30, 2003.
Insurance income increased during the three and six months ended June 30, 2004 substantially due to the continued growth in our captive reinsurance programs.
Gain from other available-for-sale securities decreased to $41 million for the second quarter of 2004 from $137 million for the same period in 2003. During the second quarter of 2003, sales of approximately $1.69 billion in mortgage-backed securities and investment securities resulted in gains of $140 million, all of which were designated as MSR risk management instruments. There was no comparable activity for the same period in 2004. During the second quarter of 2004, the Company sold mortgage-backed securities retained from a fourth quarter 2003 multi-family securitization and recognized a gain of $25 million.
During the first half of 2004, the Company terminated certain pay-fixed swaps hedging variable rate FHLB advances, resulting in a loss on extinguishment of borrowings of approximately $90 million. Several securities sold under agreements to repurchase ("repurchase agreements") that contained embedded pay-fixed swaps were restructured during the first half of 2003, resulting in losses on extinguishment of borrowings of $49 million and $136 million for the three and six months ended June 30, 2003. The restructured repurchase agreements contain embedded pay-fixed swaps with the same terms except with a lower pay rate.
The decrease in other income for the three and six months ended June 30, 2004 was largely due to a decline in the income recorded on residual interests in collateralized mortgage obligations and an increase in losses on sales of mortgage-backed securities classified as trading securities.
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Noninterest Expense
Noninterest expense from continuing operations consisted of the following:
A significant portion of the increase in employee compensation and benefits for the six months ended June 30, 2004 over the same period in 2003 was due to lower levels of compensation expense that are deferrable as direct loan origination costs. Also contributing to the increase was the continued expansion of the retail banking network. Partially offsetting the increase was a decrease in incentive and commission compensation, resulting from lower loan volumes, and a reduction in temporary help expense. The number of employees was 57,274 at June 30, 2004, compared with 61,374 at December 31, 2003 and 57,769 at June 30, 2003. A $43 million charge was also recorded for severance expense related to staffing reductions that occurred as part of the Company's ongoing cost containment initiative.
The increase in occupancy and equipment expense for the three and six months ended June 30, 2004 resulted primarily from higher equipment depreciation expense and building rent expense. Depreciation expense increased due to the completion of technology projects that were placed in service during the second quarter of 2003. The increase in rent expense was due to the continued expansion of new retail banking stores throughout 2003 and the first half of 2004. In addition, a $37 million charge was recognized for the discontinued use of facilities, including lease terminations and the write-off of surplus property during the first half of 2004.
Substantially all of the decrease in professional fees for the three and six months ended June 30, 2004 compared to the same periods in 2003 resulted from decreases in fees associated with technology-related projects.
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Review of Financial Condition
Assets
At June 30, 2004, our assets increased from year-end predominantly due to an increase in loans held for sale and loans held in portfolio, largely offset by a decrease in investment securities and the sale of Washington Mutual Finance.
Securities
Securities consisted of the following:
The realized gross gains and losses of securities for the periods indicated were as follows:
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Our investment securities decreased predominantly due to the sale of U.S. Government and agency bonds. The proceeds from the sales of these securities were used, in part, to allow for the growth in the loan portfolio.
Loans
Loans held in portfolio consisted of the following:
Our loans held in portfolio increased predominantly due to an increase in home loans and home equity loans and lines of credit. Substantially all of the growth in the home loan and home equity loans and lines of credit portfolios resulted from the origination of short-term adjustable-rate products.
Other Assets
Other assets consisted of the following:
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Deposits
Deposits consisted of the following:
The overall increase in deposits was substantially the result of the $6.30 billion increase in wholesale deposits from year-end 2003, which was predominantly due to an upgrade in our credit rating from a major agency, making the Company more attractive to institutional investors and increased marketing levels for brokered certificates of deposit. Retail deposits increased primarily due to the new Platinum Savings account, substantially offset by a decline in Platinum Checking accounts.
Checking, savings and money market deposits composed 81% of retail deposits at June 30, 2004, unchanged from year-end 2003. These products generally have the benefit of lower interest costs, compared with time deposits. Even though checking, savings and money market deposits are more liquid, we consider them to be the core relationship with our customers. At June 30, 2004, deposits funded 58% of total assets, compared with 56% at December 31, 2003.
Borrowings
At June 30, 2004, our borrowings were largely in the form of advances from the Federal Home Loan Banks ("FHLBs") of Seattle, San Francisco, Dallas and New York and repurchase agreements. Although the Company acquired advances from the FHLBs of Dallas and New York during its acquisitions of Bank United in 2001 and Dime Bancorp, Inc. in 2002, the Company does not have continuing borrowing privileges at these FHLBs. The mix of our borrowing sources at any given time is dependent on market conditions.
Operating Segments
We manage and report information concerning the Company's activities, operations, products and services around two primary categories: consumers and commercial customers and have established three operating segments for the purpose of management reporting: Retail Banking and Financial Services, Mortgage Banking and the Commercial Group. Results for Corporate Support/Treasury and Other are also presented. Refer to Note 7 to the Consolidated Financial Statements – "Operating Segments" for information regarding the key elements of our management reporting methodologies used to measure segment performance.
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Consumer Group
Retail Banking and Financial Services
The increases in net interest income were largely due to increases in interest income from higher levels of mortgage loans and home equity loans and lines of credit balances and decreased interest expense on deposits resulting from lower interest rates.
The increases in noninterest income were mostly due to increases in depositor and other retail banking fees resulting from higher numbers of checking accounts. Securities fees and commissions also increased due to an increase in advisory fee income earned from managing the Company's proprietary mutual fund family.
Inter-segment revenue decreased due to lower origination broker fees received from the Mortgage Banking Group for the origination of mortgage loans resulting from the overall decline of refinancing activity, compared with the first half of 2003.
Increases in noninterest expense were primarily driven by employee base compensation and benefits, occupancy and equipment and advertising expense resulting from expansion of the Company's distribution network, which included the opening of more than 60 stores in the second quarter of 2004.
The increases in average assets were predominantly driven by higher home loan mortgages and home equity loans and lines of credit. Home loan mortgages have increased $25.75 billion and $22.51 billion, or 32% and 27%, for the three and six months ended June 30, 2004, compared with the same periods in 2003, resulting from increased growth in adjustable-rate mortgages held in portfolio. Home equity loans and lines of credit increased $14.50 billion and $13.26 billion or 75% and 73%, for the three and six months ended June 30, 2004, compared with the same periods in 2003.
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Mortgage Banking
The decreases in net interest income were mostly due to declining average loans held for sale balances, resulting from a shift in volume mix from fixed-rate loans to adjustable-rate loans, which are held in portfolio.
The decreases in noninterest income were primarily due to the difference in the performance of the MSR asset and the corresponding hedging and risk management derivatives, which reflected both tightening basis spreads (the difference between the mortgage and interest rate swap indices) during the quarter and rising interest rates. This caused the loss in hedge value to exceed the increase in MSR value, thus reducing Mortgage Banking income. The second quarter of 2004 includes a $143 million gain from mortgage loans from the intersegment sale of loans originated for the home loan portfolio to the Retail Banking and Financial Services segment, compared with a $174 million gain in the second quarter of 2003.
The decrease in noninterest expense for the three months ended June 30, 2004 was primarily due to lower employee base compensation and benefits expense and technology expense resulting from the Company's ongoing cost containment initiative. The decrease for the six months ended June 30, 2004, resulted primarily from lower technology expense and advertising and promotion expense.
Inter-segment expense has decreased due to lower origination broker fees paid to the Retail Banking and Financial Services Group for the origination of mortgage loans resulting from the overall decline of refinancing activity, compared with the first half of 2003.
The decreases in average assets were largely due to lower average loans held for sale and investment securities acquired to economically hedge the MSR asset.
The decreases in average deposits were predominantly due to lower custodial and escrow balances resulting from a decline in refinancing activity.
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Commercial Group
The increases in net interest income were predominantly due to lower funding costs resulting from reduced interest rates and increased interest income from higher average loans held for sale balances. These increases were partially offset by lower interest income from investment securities and loans held in portfolio and lower interest rates.
The decreases in provision for loan and lease losses were driven by stronger credit performance resulting in lower expected loss rates, compared with the first half of 2003.
The decreases in noninterest income were substantially due to a reduction in income from residual interests in collateralized mortgage obligations and lower gains from the sale of specialty mortgage finance loans. These decreases were partially offset by increased gains from the sale of originated mortgage-backed securities and the securitization and sale of multi-family and commercial real estate loans.
The increases in noninterest expense were predominantly due to increased employee base compensation and benefits, technology and occupancy and equipment expense due to growth in the Commercial group network.
In July 2004, the Company announced that the Commercial Group is exiting certain activities that are no longer strategically aligned with the Group's business objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million. This initiative will result in the closure, over time, of approximately 50 commercial banking locations and the elimination of approximately 850 positions during the remainder of 2004.
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Corporate Support/Treasury and Other
The increases in net interest expense were substantially due to lower interest income from available-for-sale securities, the balances of which declined due to sales of mortgage-backed securities and prepayment of these securities that occurred from refinancing activity. The increases were also attributable to the impact of the funds transfer pricing process. This increase was partially offset by a reduction in interest expense from borrowed funds, as a result of lower interest rates and higher levels of lower-costing average deposit balances.
The decrease in noninterest expense for the three months ended June 30, 2004 was primarily due to lower employee base compensation and benefits and professional fees, resulting from the Company's ongoing cost containment initiative.
The decreases in average assets were mostly due to the sale of mortgage-backed available-for-sale securities during the preceding twelve months.
Income from discontinued operations resulted from the sale of the Company's subsidiary, Washington Mutual Finance, in the first quarter of 2004.
Off-Balance Sheet Activities
Asset Securitization
We transform loans into securities, which are sold to investors – a process known as securitization. Securitization involves the sale of loans to a qualifying special-purpose entity ("QSPE"), typically a trust. The QSPE, in turn, issues interest-bearing securities, commonly called asset-backed securities, which are secured by future collections on the sold loans. The QSPE sells securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These QSPEs are not consolidated within our financial statements since they satisfy the criteria established by Statement No. 140, Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. In general, these criteria require the QSPE to be legally isolated from the transferor (the Company), be
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limited to permitted activities, and have defined limits on the assets it can hold and the permitted sales, exchanges or distributions of its assets.
When we sell or securitize loans, we generally retain the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the sold or securitized assets. Retained interests may provide credit enhancement to the investors and, absent the violation of representations and warranties, generally represent the Company's maximum risk exposure associated with these transactions. Retained interests in securitizations were $1.77 billion at June 30, 2004, of which $1.74 billion have either a AAA credit rating or are agency insured. Additional information concerning securitization transactions is included in Note 7 to the Consolidated Financial Statements – "Mortgage Banking Activities" of the Company's 2003 Annual Report on Form 10-K/A.
Guarantees
The Company may incur liabilities under certain contractual agreements contingent upon the occurrence of certain events. A discussion of these contractual arrangements under which the Company may be held liable is included in Note 5 to the Consolidated Financial Statements – "Guarantees."
Asset Quality
Nonaccrual Loans, Foreclosed Assets and Restructured Loans
Loans are generally placed on nonaccrual status when they are 90 days or more past due. Additionally, loans in non-homogeneous portfolios are placed on nonaccrual status prior to becoming 90 days past due when payment in full of principal and interest is not expected. Management's classification of a loan as nonaccrual or restructured does not necessarily indicate that the principal or interest of the loan is uncollectible in whole or in part.
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Nonaccrual loans and foreclosed assets ("nonperforming assets") and restructured loans from continuing operations consisted of the following:
The reduction in nonaccrual loans during the first six months of 2004 was predominantly driven by declines in nonaccrual home loans. The Company continued its program of selling packages of nonperforming loans that it holds in portfolio, including $66 million of such nonperforming loans sold during the second quarter. Year-to-date, $246 million of nonperforming loans held in portfolio were sold which resulted in $15 million in related charge-offs. We will continue to periodically evaluate nonperforming loan sales as part of our ongoing portfolio management strategy.
Nonaccrual home equity loans and lines of credit remained flat in dollars during the first six months of 2004, but as a percentage to total loans in this portfolio declined to 0.13% at June 30, 2004 from 0.17% at December 31, 2003. Other real estate nonaccrual loans declined $20 million during the quarter and first half of 2004, primarily resulting from the payoff of a $23 million healthcare-related loan.
Foreclosed assets totaled $286 million at June 30, 2004, compared with $307 million at March 31, 2004 and $311 million at December 31, 2003. The Company's foreclosed assets include residential and commercial real estate as well as a small amount of personal property. Driving the decline during the six months ended were the sales of several commercial foreclosed assets.
Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $99 million, $135 million and $66 million at June 30, 2004, March 31, 2004 and December 31, 2003.
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90 or More Days Past Due
The amount of loans held in portfolio which were 90 or more days contractually past due and still accruing interest was $53 million at June 30, 2004, compared with $76 million at March 31, 2004 and $46 million at December 31, 2003. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest.
Provision and Allowance for Loan and Lease Losses
Changes in the allowance for loan and lease losses from continuing operations were as follows:
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Net charge-offs for the three and six months ended June 30, 2004 decreased $57 million and $69 million, compared with the same periods during 2003. As an annualized percentage of average loans held in portfolio, net charge-offs were 0.05% and 0.08% for the three and six months ended June 30, 2004, compared with 0.22% and 0.19% for the same periods in 2003.
With economic statistics in the fourth quarter of 2003 affirming the trend of a strengthening national economy accompanied by a significant reduction in the Company's nonperforming loan balances and the disposition of a higher risk loan portfolio, management determined that a reduction in the overall size of the allowance was appropriate. Accordingly, a $202 million reversal of the allowance for loan and lease losses was recorded during the fourth quarter, which had the effect of reducing the allowance as a percentage of total loans held in portfolio to 0.71% at year-end 2003.
During the first six months of 2004, the Company recorded a provision of $116 million which exceeded net charge-offs by $46 million in support of the loan portfolio growth. The resulting allowance as a percentage of total loans held in portfolio at June 30, 2004 was 0.66% compared with 0.67% at March 31, 2004 and 0.71% at December 31, 2003. While current coverage to total loans declined from 1.02% one year earlier, the allowance coverage to annualized year-to-date net charge-offs at 11% was significantly less than 18%, the level recorded in the same period of 2003.
The allowance for loan and lease losses represents management's estimate of credit losses inherent in the Company's loan and lease portfolios as of the balance sheet date. The estimation of the allowance is based on a variety of factors, including past loan loss experience, adverse situations that have occurred but are not yet known that may affect the borrower's ability to repay, the estimated value of underlying collateral and general economic conditions. The Company's methodology for assessing the adequacy of the allowance includes the evaluation of three distinct elements: the formula allowance, the specific allowance (which includes the allowance for loans deemed to be impaired by Statement No. 114, Accounting by Creditors for Impairment of a Loan) and the unallocated allowance. The formula allowance and the specific allowance collectively represent the portion of the allowance for loan and lease losses that are allocated to the various loan portfolios.
Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" in our 2003 Annual Report on Form 10-K/A for further discussion of the Allowance for Loan and Lease Losses.
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 Company establishes liquidity guidelines for the parent holding company, Washington Mutual, Inc., as well as for its principal operating subsidiaries.
Washington Mutual, Inc.
Liquidity for Washington Mutual, Inc. is generated through its ability to raise funds through dividends from subsidiaries and in various capital markets such as unsecured debt, commercial paper and lines of credit.
Washington Mutual, Inc.'s primary funding source during 2003 was from dividends paid by our banking subsidiaries. Although no dividends were paid by our banking subsidiaries during the first half of 2004, we expect Washington Mutual, Inc. to continue to receive banking subsidiary dividends during the second half of 2004. Banking subsidiaries dividends may be reduced from time to time to ensure that internal capital targets are met. Various regulatory requirements related to capital adequacy and retained earnings also limit the amount of dividends that can be paid by our banking subsidiaries. For more information on dividend restrictions applicable to our banking subsidiaries, refer to the Company's 2003
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Annual Report on Form 10-K/A, "Business – Regulation and Supervision" and Note 19 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."
During 2003, Washington Mutual, Inc. filed two shelf registration statements with the Securities and Exchange Commission, registering a total of $7 billion of debt securities, preferred stock and depositary shares in the United States and in international capital markets. In 2003, the Company issued $1.65 billion of fixed- and adjustable-rate senior debt securities. In March 2004, the Company issued $750 million of fixed-rate subordinated debt securities. At June 30, 2004, the Company had $4.60 billion available for issuance.
Washington Mutual, Inc. also has a revolving credit facility and a commercial paper program that are sources of liquidity. The revolving credit facility totaling $800 million provides credit support for Washington Mutual, Inc.'s commercial paper program as well as funds for general corporate purposes. At June 30, 2004, Washington Mutual, Inc. had no commercial paper outstanding and the entire amount of $800 million was available under this facility.
Banking Subsidiaries
The principal sources of liquidity for our banking subsidiaries are customer deposits, wholesale borrowings, the maturity and repayment of portfolio loans, securities held in our available-for-sale portfolio and mortgage loans designated as held for sale. Among these sources, transaction deposits and wholesale borrowings from FHLB advances and repurchase agreements continue to provide the Company with a significant source of stable funding. During the six months ended June 30, 2004, those sources funded 72% of average total assets. Our continuing ability to retain our transaction deposit base and to attract new deposits depends on various factors, such as customer service satisfaction levels and the competitiveness of interest rates offered on our deposit products. We expect to continue to have the necessary assets available to pledge as collateral to obtain FHLB advances and repurchase agreements to offset any potential declines in deposit balances.
In the six months ended June 30, 2004, the Company's proceeds from the sales of loans held for sale were approximately $71 billion. These proceeds were, in turn, used as the primary funding source for the origination and purchases, net of principal payments, of approximately $79 billion of loans held for sale during the same period. Typically, a cyclical pattern of sales and originations/purchases repeats itself during the course of a period and the amount of funding necessary to sustain our mortgage banking operations does not significantly affect the Company's overall level of liquidity resources. In the six months ended June 30, 2004, originations/purchases of loans held for sale, net of principal payments, exceeded the proceeds from the sale of loans held for sale by approximately $8 billion.
To supplement our funding sources, our banking subsidiaries also raise funds in domestic and international capital markets. In August 2003, the Company established a $20 billion Global Bank Note Program for Washington Mutual Bank, FA ("WMBFA") and Washington Mutual Bank ("WMB") to issue senior and subordinated notes in the United States and in international capital markets in a variety of currencies and structures. Under this program, WMBFA is allowed to issue up to $15 billion in notes, of which $5 billion can be issued as subordinated notes subject to regulatory approval. WMB is allowed to issue up to $5 billion in senior notes. The maximum aggregate principal amount of notes with maturities greater than 270 days from the date of issue offered by WMBFA may not exceed $7.5 billion. As part of this program, WMBFA issued $750 million of 10 year fixed-rate subordinated notes in August of 2004. After this issuance, these two banking subsidiaries had a combined total of $19.25 billion available under this program.
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Non-banking Subsidiaries
Long Beach Mortgage has revolving credit facilities with non-affiliated lenders totaling $2.5 billion that are used to fund loans held for sale. At June 30, 2004, Long Beach Mortgage had borrowings outstanding of $248 million under these credit facilities.
Capital Adequacy
The regulatory capital ratios of WMBFA, WMB and Washington Mutual Bank fsb ("WMBfsb") and the minimum regulatory ratios to be categorized as well-capitalized were as follows:
Our federal savings bank subsidiaries, WMBFA and WMBfsb, 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, 2004.
Our broker-dealer subsidiaries are also subject to capital requirements. At June 30, 2004, both of our broker-dealer subsidiaries were in compliance with their applicable capital requirements.
On February 1, 2004, WMBfsb became a subsidiary of WMBFA. This reorganization was followed by the contribution of $23.27 billion of mortgage-backed and investment securities by WMBFA to WMBfsb on March 1, 2004. Due to the low risk weights assigned to these securities under the federal banking agency regulatory capital guidelines, their contribution to WMBfsb's capital base substantially increased that entity's risk-based capital ratios.
Market Risk Management
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. These include loans, MSR, securities, deposits, borrowings, long-term debt and derivative financial instruments.
We manage interest rate risk within a consolidated enterprise risk management framework that includes the measurement and management of specific portfolios (MSR and Other Mortgage Banking) discussed below. The principal objective of asset/liability management is to manage the sensitivity of net income to changing interest rates. Asset/liability management is governed by a policy reviewed and approved annually by our Board. The Board has delegated the oversight of the administration of this policy to the Finance Committee of the Board.
MSR Risk Management
We manage potential impairment in the fair value of MSR and increased amortization levels of MSR through a comprehensive risk management program. Our intent is to offset the changes in fair value and amortization levels of MSR with changes in the fair value of risk management instruments. The risk management instruments include interest rate contracts, forward purchase commitments and available-for-sale securities.
The available-for-sale securities generally consist of fixed-rate debt securities, such as U.S. Government and agency obligations and mortgage-backed securities, including principal-only strips. The
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interest rate contracts typically consist of interest rate swaps, interest rate swaptions and interest rate floors. We also enter into forward commitments to purchase mortgage-backed securities which generally are agreements to purchase 15- and 30-year fixed-rate mortgage-backed securities. From time to time, we may choose to embed interest rate contracts into our borrowing instruments, such as repurchase agreements.
We measure on a daily basis the fair value and risk profile of the MSR and, when appropriate, adjust on a daily basis the instruments we use to manage MSR fair value changes. The fair value of MSR is primarily affected by changes in prepayments that result from shifts in mortgage rates. Changes in the value of MSR risk management instruments due to changes in interest rates vary based on the specific instrument. For example, changes in the fair value of interest rate swaps are driven by shifts in interest rate swap rates and the fair value of U.S. Treasury securities is based on changes in U.S. Treasury rates. Mortgage rates may move more or less than the rates on Treasury bonds or interest rate swaps. This could result in a change in the fair value of the MSR that differs from the change in fair value of the MSR risk management instruments. This difference in market indices between the MSR and the risk management instruments results in what is referred to as basis risk.
The fair value of MSR decreases and the amortization rate increases in a declining interest rate environment due to the higher prepayment activity, resulting in the potential for loss of value and a reduction in net loan servicing income. During periods of rising interest rates, the amortization rate of MSR decreases and the fair value of MSR increases. The timing and amount of any potential MSR valuation adjustment cannot be predicted with precision because of its dependency on the timing and magnitude of future interest rate changes.
We manage the MSR daily and adjust the mix of instruments used to manage MSR fair value changes as interest rates and market conditions warrant. The objective is to maintain an efficient and fairly liquid mix as well as a diverse portfolio of risk management instruments with maturity ranges that correspond well to the anticipated behavior of the MSR. For that portion of the MSR which qualifies for hedge accounting treatment, all changes in fair value of the MSR, even when the fair value is higher than amortized cost, will be recorded through earnings. MSR which do not qualify for hedge accounting treatment must be accounted for at the lower of aggregate cost or market value. We also manage the size of the MSR asset. Depending on market conditions and our desire to expand customer relationships, we may periodically sell or purchase additional servicing. We also may structure loan sales to control the size of the MSR asset created by any particular transaction.
We believe this overall risk management strategy is the most efficient approach to managing MSR fair value risk. The success of this strategy, however, is dependent on management's judgments regarding the amount, type and mix of MSR risk management instruments that we select to manage the changes in fair value of our mortgage servicing asset. If this strategy is not successful, our net income could be adversely affected.
Other Mortgage Banking Risk Management
We also manage the risks associated with our home loan mortgage warehouse and pipeline. The mortgage warehouse consists of funded loans, which are primarily fixed-rate home mortgages intended for sale in the secondary market. The pipeline consists of commitments to originate or purchase fixed-rate and, to a lesser degree, adjustable-rate home loans to be sold in the secondary market. The risk associated with the mortgage pipeline and warehouse is the potential for change in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold.
We measure the risk profile of the mortgage warehouse and pipeline daily. As needed, to manage the warehouse and pipeline risk, we execute forward sales commitments, interest rate contracts, mortgage option contracts and interest rate futures. A forward sales commitment protects us in a rising interest rate environment, since the sales price and delivery date are already established. A forward sales commitment
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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. We also estimate the fallout factor, which represents the percentage of loans that are not expected to be funded, when determining the appropriate amount of our pipeline and warehouse risk management instruments.
Asset/Liability Risk Management
The asset/liability risk management process oversees the aggregate risk profile of the consolidated Company. Asset/liability risk analysis combines the MSR and Other Mortgage Banking activities with substantially all the other remaining interest rate risk positions inherent in the Company's operations.
To analyze net income sensitivity, management projects net income under a variety of interest rate scenarios, including parallel and non-parallel shifts in the yield curve and more extreme non-parallel rising and falling rate environments. These scenarios also capture the net interest income sensitivity due to changes in the slope of the yield curve and changes in the spread between Treasury and LIBOR rates. Additionally, management measures the sensitivity of asset and liability fair value changes to changes in interest rates to analyze risk exposure over longer periods of time.
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 loan and deposit volume and mix projections are the most significant assumptions. Prepayments affect the size of the balance sheet, which impacts net interest income, and is 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 various interest rate environments. The prepayment and decay rate assumptions reflect management's best estimate of future behavior. These assumptions are derived from internal and external analysis of customer behavior.
The slope of the yield curve, current interest rate conditions and the speed of changes in interest rates all affect our sensitivity to changes in interest rates. Our interest-bearing deposits and borrowings typically reprice faster than our mortgage loans and securities. In addition, a lag effect is inherent in our adjustable-rate loans and mortgage-backed securities 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 those indexed to the 11th District FHLB monthly weighted average cost of funds index.
The sensitivity of new loan volume and mix to changes in market interest rate levels is also projected. 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, which we generally hold in our loan portfolio. The gain from mortgage loans also varies under different interest rate scenarios. Normally, the gain from mortgage loans increases in falling interest rate environments primarily from high fixed-rate mortgage refinancing activity. Conversely, the gain from mortgage loans tends to decline when interest rates increase as salable loan volume declines.
In periods of rising interest rates, the net interest margin normally contracts since the repricing period of liabilities is shorter than the repricing period of assets. The net interest margin generally expands in periods of falling interest rates as borrowing costs reprice downward faster than asset yields.
To manage interest rate sensitivity, management first utilizes the interest rate risk characteristics of our balance sheet assets and liabilities to offset each other as much as possible. Balance sheet products have a variety of risk profiles and sensitivities. Some of the components of our interest rate risk are countercyclical. We may adjust the amount or mix of risk management instruments based on the countercyclical behavior of our balance sheet products.
When the countercyclical behavior inherent in portions of our balance sheet does not result in an acceptable risk profile, management utilizes investment securities and interest rate contracts to mitigate this situation. The interest rate contracts used for this purpose are classified as asset/liability risk
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management instruments. These contracts are often used to modify the repricing period of our interest-bearing funding sources with the intention of reducing the volatility of net interest income. The types of contracts used for this purpose consist of interest rate swaps, interest rate corridors, interest rate swaptions and certain derivatives that are embedded in borrowings. We also use receive-fixed swaps as part of our asset/liability risk management strategy to help us modify the repricing characteristics of certain long-term liabilities to match those of our assets. Typically, these are swaps of long-term fixed-rate debt to a short-term adjustable rate which more closely resembles our asset repricing characteristics.
July 1, 2004 and January 1, 2004 Sensitivity Comparison
The table below indicates the sensitivity of net interest income and net income to interest rate movements in market risk sensitive instruments. The base case used for this sensitivity analysis is our most likely earnings plan for the respective twelve month periods as of the date the analysis was performed. The comparative results also assume a parallel shift in the yield curve with interest rates rising 200 basis points in even quarterly increments over the twelve-month periods ending June 30, 2005 and December 31, 2004 and interest rates decreasing by 50 basis points in even quarterly increments over the first six months of the twelve-month periods. The projected interest rate sensitivities of net interest income and net income shown below may differ significantly from actual results, particularly with respect to non-parallel shifts in the yield curve or changes in the spreads between mortgage, Treasury and LIBOR rates.
The change in net income sensitivity was primarily due to the increased sensitivity in projected home loan mortgage banking income partially offset by a reduction in the volatility of net interest income. The reduced volatility of net interest income was due to the sale of fixed-rate bonds during the first six months of the year combined with an increase in adjustable-rate loans held in portfolio. The change in the volatility of home loan mortgage banking income was primarily the result of the changes in interest rates since year end and an increase in the weighted average coupon rate of the MSR portfolio. As a result the potential for further increases to the MSR value in the rising interest rate scenario was significantly reduced. This changed profile of the MSR portfolio also resulted in a projected reduction in the notional amount of the instruments used to hedge MSR in the rising rate scenario.
These sensitivity analyses are limited in that they were performed at a particular point in time; are subject to the accuracy of various assumptions used, including prepayment forecasts and discount rates; and do not incorporate other factors that would impact the Company's overall financial performance in such scenarios, most significantly the impact of changes in salable loan volume that result from changes in interest rates. Before the second quarter of 2004, an assumed level of salable loan volume had been included as a component within the sensitivity model. Accordingly, the results of the January 1, 2004 net income simulation have been restated to conform to this change in methodology. In addition, not all of the changes in fair value may impact current period earnings. For example, the portion of the MSR that does not qualify for fair value hedge accounting treatment may increase in value, but the amount of the increase that is recorded in current period earnings may be limited to the recovery of the impairment reserve within each stratum. These analyses also assume that the composition of MSR hedging and risk management instruments remain fairly constant, and that mortgage and interest rate swap spreads remain constant in all interest rate environments. These assumptions may not be realized. For example, changes in spreads
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between interest rate indices could result in significant changes in projected net income sensitivity. Given our current mix of MSR hedging and risk management instruments, projected net income would increase if market rates on interest rate swaps decreased by more than the decrease in mortgage rates, while the projected net income could decline if the rates on swaps increased by more than mortgage rates. For all of these reasons, the preceding sensitivity estimates should not be viewed as an earnings forecast.
Maturity and Repricing Information
We use interest rate risk management contracts and available-for-sale securities as tools to manage our interest rate risk profile. The following tables summarize the key contractual terms associated with these contracts and available-for-sale securities. Interest rate risk management contracts that are embedded within certain adjustable- and fixed-rate borrowings, while not accounted for as derivatives under Statement No. 133, have been included in the tables since they also function as interest rate risk management tools. Substantially all of the interest rate swaps, interest rate swaptions and embedded derivatives at June 30, 2004 are indexed to three-month LIBOR.
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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(This table is continued on the next page)
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Derivative Counterparty Credit Risk
Derivative financial instruments expose the Company to credit risk in the event of nonperformance by counterparties to such agreements. This risk consists primarily of the termination value of agreements where the Company is in a favorable position. Credit risk related to derivative financial instruments is considered and provided for separately from the allowance for loan and lease losses. The Company manages the credit risk associated with its various derivative agreements through counterparty credit review, counterparty exposure limits and monitoring procedures. With the exception of forward purchase and sales commitments, the Company obtains collateral from the counterparties for amounts in excess of the exposure limits and monitors its exposure and collateral requirements on a daily basis. The fair value of collateral received from a counterparty is continually monitored and the Company may request additional
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collateral from counterparties or return collateral pledged as deemed appropriate. The Company's agreements generally include master netting agreements whereby the counterparties are entitled to settle their positions "net." At June 30, 2004 and December 31, 2003, the gross positive fair value of the Company's derivative financial instruments was $1.05 billion and $1.34 billion. The Company's master netting agreements at June 30, 2004 and December 31, 2003 reduced the Company's derivative counterparty credit risk by $622 million and $646 million. The Company's collateral against derivative financial instruments was $190 million and $323 million at June 30, 2004 and December 31, 2003.
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PART II – OTHER INFORMATION
Item 1. Legal Proceedings
The following lawsuits alleging violations of Section 19(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), Rule 10b-5 thereunder and Section 20(a) of the Exchange Act have been filed in the United States District Court for the Western District of Washington:
The plaintiff in each case purports to represent a class of purchasers of Washington Mutual, Inc. securities from April 15, 2003 through June 28, 2004. The complaints allege that in various public statements the defendants made misrepresentations, and failed to disclose material facts, concerning the Company's business, business model and future revenue potential. Each complaint seeks compensatory damages, fees, costs, expenses and other equitable and/or injunctive relief permitted by law.
Item 2. Changes in Securities and Use of Proceeds
The table below represents share repurchases made by the Company for the quarter ended June 30, 2004. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.
For a discussion regarding working capital requirements and dividend restrictions applicable to our banking subsidiaries, refer to the Company's 2003 Annual Report on Form 10-K/A, "Business – Regulation and Supervision" and Note 19 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."
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Item 4. Submission of Matters to a Vote of Security Holders
Washington Mutual, Inc. held its annual meeting of shareholders on April 20, 2004. 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 re-election at the annual meeting of shareholders will continue to serve as directors: Douglas P. Beighle, Kerry K. Killinger, Phillip D. Matthews, Michael K. Murphy, Mary E. Pugh, William G. Reed, Jr., Elizabeth A. Sanders, James H. Stever and Willis B. Wood, Jr.
Item 6. Exhibits and Reports on Form 8-K
See Index of Exhibits on page 65.
1. The Company filed a report on Form 8-K dated April 19, 2004, under Item 7. Exhibits, and Item 12. Results of Operations and Financial Condition. The report included a press release announcing Washington Mutual's first quarter 2004 financial results and unaudited Consolidated Financial Statements for the three months ended March 31, 2004.
2. The Company filed a report on Form 8-K dated June 28, 2004, under Item 7. Exhibits, and Item 9. Regulation FD Disclosure. The report included a press release giving revised earnings guidance for 2004.
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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 9, 2004.
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WASHINGTON MUTUAL, INC. INDEX OF EXHIBITS
Exhibit No.
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