UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
Commission File Number 1-14667
WASHINGTON MUTUAL, INC.
(Exact name of registrant as specified in its charter)
Washington
91-1653725
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification Number)
1301 Second Avenue, Seattle, Washington
98101
(Address of principal executive offices)
(Zip Code)
(206) 461-2000
(Registrant’s telephone number, including area code)
1201 Third Avenue, Seattle, Washington
(Registrant’s former address)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer o Non-accelerated filer o.
Indicate by check mark whether the registrant is a shell company (as defined in 12b-2 of the Exchange Act.) Yes o No x.
The number of shares outstanding of the issuer’s classes of common stock as of October 31, 2006:
Common Stock – 945,221,245(1)
(1) Includes 6,000,000 shares held in escrow.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIESFORM 10-QFOR THE QUARTER ENDED SEPTEMBER 30, 2006TABLE OF CONTENTS
Page
PART I – Financial Information
1
Item 1. Financial Statements
Consolidated Statements of Income – Three and Nine Months Ended September 30, 2006 and 2005
Consolidated Statements of Financial Condition – September 30, 2006 and December 31, 2005
2
Consolidated Statements of Stockholders’ Equity and Comprehensive Income – Nine Months Ended September 30, 2006 and 2005
3
Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2006 and 2005
4
Notes to Consolidated Financial Statements
6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
33
Cautionary Statements
Controls and Procedures
34
Overview
Critical Accounting Estimates
36
Recently Issued Accounting Standards Not Yet Adopted
Summary Financial Data
37
Earnings Performance from Continuing Operations
38
Review of Financial Condition
49
Operating Segments
52
Off-Balance Sheet Activities
57
Capital Adequacy
58
Risk Management
Credit Risk Management
59
Liquidity Risk Management
63
Market Risk Management
65
Operational Risk Management
68
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II – Other Information
69
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
70
Item 4. Submission of Matters to a Vote of Security Holders
71
Item 6. Exhibits
i
Part I – FINANCIAL INFORMATION
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)
Three Months EndedSeptember 30,
Nine Months EndedSeptember 30,
2006
2005
2005__
(in millions, except per share amounts)
Interest Income
Loans held for sale
$
439
665
1,304
1,719
Loans held in portfolio
4,008
2,947
11,468
8,395
Available-for-sale securities
379
238
1,068
695
Trading assets
140
114
503
284
Other interest and dividend income
139
354
159
Total interest income
5,105
4,029
14,697
11,252
Interest Expense
Deposits
1,739
996
4,420
2,544
Borrowings
1,419
1,028
4,154
2,731
Total interest expense
3,158
2,024
8,574
5,275
Net interest income
1,947
2,005
6,123
5,977
Provision for loan and lease losses
166
472
99
Net interest income after provision for loan and lease losses
1,781
1,953
5,651
5,878
Noninterest Income
Revenue from sales and servicing of home mortgage loans
118
710
603
1,600
Revenue from sales and servicing of consumer loans
355
1,155
Depositor and other retail banking fees
655
578
1,875
1,608
Credit card fees
165
–
456
Securities fees and commissions
48
161
142
Insurance income
31
42
97
135
Trading assets income (loss)
(171
)
(74
15
Loss from sales of other available-for-sale securities
(1
(32
(8
(129
Other income
127
521
197
Total noninterest income
1,570
1,208
4,786
3,572
Noninterest Expense
Compensation and benefits
939
930
2,992
2,673
Occupancy and equipment
408
372
1,235
1,122
Telecommunications and outsourced information services
107
421
310
Depositor and other retail banking losses
61
Advertising and promotion
124
78
335
206
Professional fees
47
138
119
Other expense
457
265
1,265
812
Total noninterest expense
2,184
1,860
6,551
5,407
Minority interest expense
Income from continuing operations before income taxes
1,133
1,301
3,815
4,043
Income taxes
394
488
1,341
1,507
Income from continuing operations, net of taxes
739
813
2,474
2,536
Discontinued Operations
Income from discontinued operations before income taxes
14
12
5
16
Income from discontinued operations, net of taxes
9
8
27
Net Income
748
821
2,501
2,567
Basic Earnings Per Common Share:
Income from continuing operations
0.78
0.94
2.59
2.93
Income from discontinued operations
0.01
0.03
0.04
Net income
0.79
0.95
2.62
2.97
Diluted Earnings Per Common Share:
0.76
0.91
2.51
2.86
0.77
0.92
2.54
2.89
Dividends declared per common share
0.52
0.48
1.53
1.41
Basic weighted average number of common shares outstanding (in thousands)
941,898
866,541
954,062
865,571
Diluted weighted average number of common shares outstanding (in thousands)
967,376
888,495
981,997
888,184
See Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION(UNAUDITED)
September 30,2006
December 31,2005
(dollars in millions)
Assets
Cash and cash equivalents
6,649
6,214
Federal funds sold and securities purchased under agreements to resell
5,102
2,137
Trading assets (including securities pledged of $198 and $3,281)
5,391
10,999
Available-for-sale securities, total amortized cost of $29,136 and $24,810:
Mortgage-backed securities (including securities pledged of $2,837 and $3,950)
22,353
20,648
Investment securities (including securities pledged of $2,042 and $2,773)
6,664
4,011
Total available-for-sale securities
29,017
24,659
23,720
33,582
241,765
229,632
Allowance for loan and lease losses
(1,550
(1,695
Total loans held in portfolio, net of allowance for loan and lease losses
240,215
227,937
Investment in Federal Home Loan Banks
3,013
4,257
Mortgage servicing rights
6,288
8,041
Goodwill
8,368
8,298
Other assets
21,114
17,449
Total assets
348,877
343,573
Liabilities
Deposits:
Noninterest-bearing deposits
34,667
34,014
Interest-bearing deposits
176,215
159,153
Total deposits
210,882
193,167
Federal funds purchased and commercial paper
5,282
7,081
Securities sold under agreements to repurchase
13,665
15,532
Advances from Federal Home Loan Banks
47,247
68,771
Other borrowings
33,883
23,777
Other liabilities
9,501
7,951
Minority interests
1,959
Total liabilities
322,419
316,294
Stockholders’ Equity
Preferred stock, no par value: 600 and zero shares authorized, 500 and zero shares issued and outstanding ($1,000,000 per share liquidation preference)
492
Common stock, no par value: 1,600,000,000 shares authorized, 945,098,276 and 993,913,800 shares issued and outstanding
Capital surplus – common stock
5,761
8,176
Accumulated other comprehensive loss
(180
(235
Retained earnings
20,385
19,338
Total stockholders’ equity
26,458
27,279
Total liabilities and stockholders’ equity
p
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYAND COMPREHENSIVE INCOME(UNAUDITED)
NumberofCommonShares
PreferredStock
CapitalSurplus –CommonStock
AccumulatedOtherComprehensiveIncome (Loss)
RetainedEarnings
Total
(in millions)
BALANCE, December 31, 2004
874.3
3,350
(76
17,615
20,889
Comprehensive income:
Other comprehensive income (loss), net of tax:
Net unrealized loss from securities arising during the period, net of reclassification adjustments
(105
Net unrealized gain from cash flow hedging instruments
Total comprehensive income
2,499
Cash dividends declared on common stock
(1,230
Common stock repurchased and retired
(4.9
(198
Common stock issued
8.3
299
BALANCE, September 30, 2005
877.7
3,451
(144
18,952
22,259
BALANCE, December 31, 2005
993.9
Cumulative effect from the adoption of Statement No. 156, net of income taxes
29
35
Adjusted balance
(229
19,367
27,314
Net unrealized gain from securities arising during the period, net of reclassification adjustments
Minimum pension liability adjustments
2,550
(1,483
(65.8
(3,039
17
624
Preferred stock issued
BALANCE, September 30, 2006
945.1
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Cash Flows from Operating Activities
Adjustments to reconcile net income to net cash provided (used) by operating activities:
Gain from mortgage loans
(552
(632
Loss from sales of available-for-sale securities
Depreciation and amortization
639
2,040
Provision for mortgage servicing rights reversal
(590
Stock dividends from Federal Home Loan Banks
(89
(102
Capitalized interest income from option adjustable-rate mortgages
(706
(159
Origination and purchases of loans held for sale, net of principalpayments
(93,662
(128,520
Proceeds from sales of loans held for sale
100,412
118,007
Excess tax benefits from stock-based payment arrangement
(16
Net decrease (increase) in trading assets
6,875
(1,416
Increase in other assets
(1,706
(1,877
Increase in other liabilities
1,153
1,694
Net cash provided (used) by operating activities
15,323
(8,765
Cash Flows from Investing Activities
Purchases of available-for-sale securities
(12,375
(14,033
Proceeds from sales and maturities of mortgage-backed securities
5,556
4,834
Proceeds from sales and maturities of other available-for-sale securities
1,140
4,615
Principal payments on available-for-sale securities
2,208
2,570
Purchases of Federal Home Loan Bank stock
(38
(163
Redemption of Federal Home Loan Bank stock
1,368
96
Proceeds from sale of mortgage servicing rights
2,527
Restricted cash pursuant to Commercial Capital Bancorp acquisition
(960
Origination and purchases of loans held in portfolio
(67,787
(72,589
Principal payments on loans held in portfolio
52,247
64,456
Proceeds from sales of loans held in portfolio
2,750
173
Proceeds from sales of foreclosed assets
321
Net increase in federal funds sold and securities purchased under agreements to resell
(2,965
(3,112
Purchases of premises and equipment, net
(314
(398
Net cash used by investing activities
(16,289
(13,230
(The Consolidated Statements of Cash Flows are continued on the next page.)
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (UNAUDITED)
(Continued from the previous page.)
Nine Months Ended
September 30,
Cash Flows from Financing Activities
Increase in deposits
17,715
16,754
(Decrease) increase in short-term borrowings
(1,394
887
Proceeds from long-term borrowings
25,054
12,416
Repayments of long-term borrowings
(16,742
(5,737
Proceeds from advances from Federal Home Loan Banks
30,660
57,738
Repayments of advances from Federal Home Loan Banks
(52,185
(58,404
Preferred securities issued by subsidiary
Proceeds from issuance of preferred stock
Cash dividends paid on common stock
Repurchase of common stock
Other
348
Net cash provided by financing activities
1,401
22,464
Increase in cash and cash equivalents
435
469
Cash and cash equivalents, beginning of period
4,455
Cash and cash equivalents, end of period
4,924
Noncash Activities
Loans exchanged for mortgage-backed securities
1,952
802
Real estate acquired through foreclosure
485
317
Loans transferred (to) from held for sale (from) to held in portfolio, net
(388
3,457
Mortgage-backed securities transferred from available-for-sale to trading
858
Cash Paid During the Period For
Interest on deposits
4,050
2,425
Interest on borrowings
4,062
2,569
736
1,535
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1: Summary of Significant Accounting Policies
Basis of Presentation
The accompanying Consolidated Financial Statements are unaudited and include the accounts of Washington Mutual, Inc. and its subsidiaries (“Washington Mutual” or the “Company”). The Company’s financial reporting and accounting policies conform toaccounting principles generally accepted in the United States of America (“GAAP”). All intercompany transactions and balances have been eliminated. Certain amounts in prior periods have been reclassified to conform to the current period’s presentation. In particular, prepayment fees were reclassified from noninterest income to interest income and losses related to low income housing partnerships were reclassified from noninterest expense to other income.
The reclassification of prepayment fees was made in conjunction with changes made to regulatory financial reporting standards by the Office of Thrift Supervision. The amount reclassified to interest income totaled $89 million and $245 million for the three and nine months ended September 30, 2005. Prepayment fees totaled $57 million and $188 million for the three and nine months ended September 30, 2006.
In the second quarter of 2006, the Company reclassified losses related to its investments in low income housing partnerships. The amount reclassified to other income totaled $13 million and $39 million for the three and nine months ended September 30, 2005 and $20 million for the three months ended March 31, 2006. Such losses totaled $68 million for the nine months ended September 30, 2006.
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 2005 Annual Report on Form 10-K/A.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“Statement”) No. 155, Accounting for Certain Hybrid Financial Instruments. This Statement amends Statements No. 133, Accounting for Derivative Instruments and Hedging Activities and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities to simplify and achieve more consistency in the accounting for certain financial instruments. This Statement permits fair value remeasurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided the entire instrument is accounted for on a fair value basis and establishes a requirement to evaluate interests in securitized financial assets to separately identify interests that are freestanding derivatives from those that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. Statement No. 155 is effective for all of the Company’s financial instruments acquired or issued after December 31, 2006. The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.
In June 2006, the FASB issued Interpretation 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes. This Interpretation requires that a tax benefit be recognized only if it is “more likely than not” of being realized, based solely on its technical merits, as of the reporting date. A tax position that meets the more-likely-than-not criterion shall be measured at the largest amount of benefit that is more than 50 percent likely of being realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. Statement No. 157 prescribes a definition of the term “fair value”, establishes a framework for measuring fair value and expands disclosure about fair value measurements. Statement No. 157 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted as of January 1, 2007. The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.
In September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of Statements No. 87, 88, 106 and 132(R). Statement No. 158 requires that the funded status of a defined benefit plan (generally measured as the difference between plan assets at fair value and the benefit obligation) be recognized in the Company’s Consolidated Statements of Financial Condition at December 31, 2006. Statement No. 158 also requires an employer to disclose additional information about certain effects on net periodic benefit cost expected to be recognized over the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits and transition amounts. The Company is currently evaluating the impact this guidance will have on its financial statements.
In September 2006, Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”) was issued. SAB 108 prescribes two methods that must be used for quantifying the effects of financial statement misstatements. The first method quantifies a misstatement based on the amount of the error applicable to the current year income statement and the second method quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current period, irrespective of the misstatement’s year(s) of origination. If a misstatement amount is deemed material to the financial statements under either method, SAB 108 provides guidance for recognizing that adjustment and correcting any misstatements in the current or prior period financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006 and is not expected to have a material effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.
In September 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force in Issue No. 06-5, Accounting for Purchases of Life Insurance– Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance (“EITF 06-5”). EITF 06-5 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.
Note 2: Discontinued Operations
In July 2006 the Company announced its exit from the retail mutual fund management business and subsequently entered into a definitive agreement to sell its subsidiary, WM Advisors, Inc. WM Advisors provides investment management, distribution and shareholder services to the WM Group of Funds. Accordingly, the results of its operations have been removed from the Company’s results of continuing operations for all periods presented on the Consolidated Statements of Income and in Notes 7 and 8 to the Consolidated Financial Statements – “Operating Segments” and “Condensed Consolidating Financial Statements”, and are presented in the aggregate as discontinued operations. Assets and liabilities of WM Advisors have been reclassified to other assets and other liabilities on the Consolidated Statements of
7
Financial Condition. The sale is expected to close late in the fourth quarter of 2006. Estimated charges of $37 million, which represent substantially all of the costs associated with the sale, are expected to be incurred during the fourth quarter of 2006 and will be reported as discontinued operations in the Company’s Consolidated Statements of Income.
Results of operations for WM Advisors were as follows:
Noninterest income
204
192
Noninterest expense
55
164
146
Note 3: Earnings Per Common Share
Information used to calculate earnings per common share was as follows:
(in thousands)
Weighted average common shares:
Basic weighted average number of common shares outstanding
Dilutive effect of potential common shares from:
Awards granted under equity incentive programs
13,145
12,165
15,054
13,034
Common stock warrants
10,698
9,789
10,736
9,579
Convertible debt
1,178
1,674
Accelerated share repurchase program
471
Diluted weighted average number of common shares outstanding
For the three months and nine months ended September 30, 2006, options to purchase approximately 14.1 million and 14.9 million 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 nine months ended September 30, 2005, options to purchase approximately 8.5 million and 8.6 million 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.
Additionally, as part of the 1996 business combination with Keystone Holdings, Inc., 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 to certain of the former investors in Keystone Holdings and their transferees are related to the outcome of certain litigation and not based on future earnings or market prices. At September 30, 2006, the conditions for releasing the shares from escrow did not exist, and therefore, none of the shares in escrow were included in the above computations.
Accelerated Share Repurchases
On March 16, 2006, the Company repurchased 34 million shares of its common stock at an initial cost of $1.48 billion. The shares were purchased from a broker-dealer counterparty under an accelerated share repurchase transaction at an initial settlement price of $43.61 per share. The Company simultaneously entered into a forward contract indexed to the price of the Company’s common stock. Upon completion of this forward contract on July 31, 2006, a net settlement amount, referred to as the purchase price adjustment, was calculated based upon the difference between the counterparty’s average actual purchase price of the Company’s shares during the repurchase period and the initial purchase price of $43.61 per share. As the counterparty’s average actual purchase price of the Company’s shares exceeded the initial purchase price, the Company was required to pay the counterparty the purchase price adjustment and had the option to settle the forward contract in shares or cash. At the election of the Company, a final cash settlement payment of $60 million was made to the counterparty and was recorded as a reduction of capital surplus.
On August 21, 2006, the Company repurchased 16 million shares of its common stock under an accelerated share repurchase transaction. The Company simultaneously entered into a forward contract indexed to the price of the Company’s common stock, which subjects the accelerated share repurchase program to future price adjustments during the contractually-specified time period between the initiation and the final settlement date. The initial price of the repurchased shares, before the effects of any such adjustments, was $753 million, or $47.06 per share. Under the terms of the contract, the Company will not be required to make any additional payments to the counterparty. However, depending on fluctuations in the weighted average price of the Company’s common stock between the initiation and the final settlement date, the Company may receive up to 9 million additional shares of its common stock from the counterparty in settlement of the contract. While the scheduled termination date of the forward contract is December 5, 2006, the counterparty may, at any time, exercise its right to accelerate the termination date. For example, if this contract had actually been settled at September 30, 2006, the Company would have received approximately 1.82 million additional common shares from the counterparty, thereby reducing the price of the shares repurchased to $42.26 per share. As the purchase price adjustment cannot result in the issuance of additional common shares, there was no impact on diluted earnings per share for the three and nine months ended September 30, 2006.
Note 4: Mortgage Banking Activities
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets, which amends Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. For each class of separately recognized servicing asset, this Statement permits an entity to choose either to amortize such assets in proportion to and over the period of estimated net servicing income and perform an impairment assessment at each reporting date, or to report servicing assets at fair value at each reporting date and record changes in fair value in earnings in the period in which the changes occur. At its initial adoption, the Statement permits a one-time reclassification of available-for-sale securities to trading securities, provided that the securities are identified as offsetting the entity’s exposure to changes in fair value of servicing assets that are reported at fair value.
As permitted by the early adoption provisions of this accounting standard, the Company applied Statement No. 156 to its financial statements on January 1, 2006 and elected to measure all classes of mortgage servicing assets at fair value. The Company also elected to transfer its January 1, 2006 portfolio of available-for-sale mortgage servicing rights (“MSR”) risk management securities to trading. As the retrospective application of the Statement to prior periods is not permitted, these changes were recorded
as a cumulative effect of a change in accounting principle to retained earnings as of January 1, 2006 and were comprised of a $35 million adjustment, net of taxes, from the MSR fair value election and a $(6) million adjustment, net of taxes, from the transfer of available-for-sale securities, designated as MSR risk management instruments, to the trading portfolio. Upon electing the fair value method of accounting for its mortgage servicing assets, the Company discontinued the application of fair value hedge accounting. Accordingly, beginning in 2006, all derivatives held for MSR risk management are treated as economic hedges, with valuation changes recorded as revaluation gain (loss) from derivatives economically hedging MSR. Additionally, upon the change from the lower of cost or fair value accounting method to fair value accounting under Statement No. 156, the calculation of amortization and the assessment of impairment were discontinued and the MSR valuation allowance was written off against the recorded value of the MSR. Those measurements have been replaced by fair value adjustments that encompass market-driven valuation changes and the runoff in value that occurs from the passage of time, which are each separately reported.
Revenue from sales and servicing of home mortgage loans, including the effects of derivative risk management instruments, consisted of the following:
Revenue from sales and servicing of home mortgage loans:
Sales activity:
Gain from home mortgage loans and originated mortgage-backed securities
217
558
637
Revaluation gain (loss) from derivatives economically hedging loans held for sale
(98
73
22
74
Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments
279
580
711
Servicing activity:
Home mortgage loan servicing revenue(1)
525
534
1,683
1,567
Change in MSR fair value due to payments on loans and other
(410
(1,279
Change in MSR fair value due to valuation inputs or assumptions
(469
MSR valuation adjustments(2)
412
874
Amortization of MSR
(555
(1,689
Revaluation gain (loss) from derivatives economically hedging MSR
353
40
(603
137
Adjustment to MSR fair value for MSR sale
(157
Home mortgage loan servicing revenue (expense), net of MSR valuation changes and derivative risk management instruments
431
23
889
Total revenue from sales and servicing of home mortgage loans
(1) Includes late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors compared to what is collected from the borrowers upon payoff).
(2) Net of fair value hedge ineffectiveness as well as any impairment/reversal recognized on MSR that results from the application of the lower of cost or fair value accounting methodology in 2005.
10
Changes in the portfolio of mortgage loans serviced for others were as follows:
Balance, beginning of period
570,352
543,324
563,208
540,392
Home loans:
Additions
29,899
43,418
95,873
114,124
Sale of servicing
(141,842
(141,851
Loan payments and other
(19,288
(39,005
(78,719
(107,555
Net change in commercial real estate loans
87
697
617
Balance, end of period
439,208
547,578
Changes in the balance of MSR were as follows:
Balance, beginning of period(1)
9,162
5,730
5,906
533
605
1,773
1,651
Fair value basis adjustment(2)
Amortization
Impairment reversal
413
590
Statement No. 133 MSR accounting valuation adjustments
849
Sale of MSR
(2,527
Net change in commercial real estate MSR
Balance, end of period(1)
7,042
(3)
(1) Net of valuation allowance for all periods in 2005.
(2) Pursuant to the adoption of Statement No. 156 on January 1, 2006, the $57 million difference between the net carrying value and fair value was recorded as an increase to the basis of the Company’s MSR.
(3) At September 30, 2005, aggregate MSR fair value was $7.06 billion.
11
Changes in the valuation allowance for MSR were as follows:
1,746
914
1,981
(413
Other-than-temporary impairment
(18
(63
(3
(914
)(1)
1,312
(1) Pursuant to the adoption of Statement No. 156, the valuation allowance was written off against the recorded value of the MSR.
In July 2006, the Company sold $2.53 billion of mortgage servicing rights, representing substantially all of the Company’s government loan servicing and a portion of its conforming, fixed-rate servicing which is predominantly comprised of customers whose only relationship with the Company consisted of a serviced home mortgage loan. During the third quarter of 2006 the Company incurred transaction-related costs of $58 million, substantially all of which are reported as part of “other expense” on the Consolidated Statements of Income. The principal activities associated with these costs included preparing and recording mortgage servicing assignment documentation, and securing and transferring actual loan files to the purchaser. For management reporting purposes, all such transaction-related costs are recorded in Corporate Support/Treasury and Other. Approximately $10 million in additional costs are expected to be incurred over the next two quarters, at which time the transfer of loans to the purchaser is expected to be complete. Substantially all of the transaction costs recognized in the third quarter were included in other liabilities on the Consolidated Statements of Financial Condition at September 30, 2006.
Note 5: Guarantees
In the ordinary course of business, the Company sells loans to third parties and in certain circumstances, such as in the event of early or first payment default, retains credit risk exposure on those loans. Whether or not the Company retains credit risk exposure on sold loans, it may be required to repurchase sold loans in the event of a violation of a representation or warranty made in connection with the sale of the loan if the violation has a material adverse effect on the value of the loan. When a loan sold to an investor fails to perform according to its contractual terms the investor will typically review the loan file to search for errors that may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a violation of a representation or warranty made to the investor in connection with the loan’s sale, then the Company will be required to either repurchase the loan or indemnify the investor for losses sustained if the violation had a material adverse effect on the value of the loan. The Company has recorded loss contingency reserves of $131 million as of September 30, 2006 and $173 million as of December 31, 2005 to cover the estimated loss exposure related to potential loan repurchases.
Note 6: Stock-Based Compensation
Effective January 1, 2003 and in accordance with the transitional guidance of Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, the Company elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. Effective January 1, 2006, the Company adopted Statement No. 123R, Share-Based Payment, using the modified prospective application transition method. As the Company had already adopted Statement No. 148 and substantially all stock-based awards granted prior to its adoption are fully
vested at December 31, 2005, Statement No. 123R did not have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition. Prior to the Company’s adoption of Statement No. 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows in the Consolidated Statements of Cash Flows. Statement No. 123R requires excess tax benefits to be reported as a financing cash inflow rather than as a reduction of taxes paid.
Statement No. 123R requires an entity that previously had a policy of recognizing the effect of forfeitures as they occurred to estimate the number of outstanding instruments for which the requisite service is not expected to be rendered. The effect of this change in accounting principle amounted to $25 million and has been reflected as a decrease to compensation and benefits expense in the three months ended March 31, 2006.
Net income for the three and nine months ended September 30, 2006 included $53 million and $167 million of compensation costs and $20 million and $63 million of income tax benefits related to the Company’s stock-based compensation arrangements. Net income for the three and nine months ended September 30, 2005 included $45 million and $112 million of compensation costs and $17 million and $43 million of income tax benefits related to the Company’s stock-based compensation arrangements. As the Company elected to use the modified prospective application method, results for the three and nine months ended September 30, 2005 do not reflect any restated amounts.
Washington Mutual maintains an equity incentive plan and an employee stock purchase plan. For further discussion of the Company’s equity incentive plan and employee stock purchase plan, refer to Note 20 to the Consolidated Financial Statements – “Stock-Based Compensation Plan and Shareholder Rights Plan” of Washington Mutual, Inc.’s 2005 Annual Report on Form 10-K/A.
13
The following table presents the status of all stock option plans at September 30, 2006 during the nine months then ended:
Number
WeightedAverageExercisePrice
Weighted AverageRemainingContractualTerm(in years)
AggregateIntrinsic Value(in millions)
1994 Stock Option Plan:
Outstanding at December 31, 2005
19,590,567
31.40
5.15
237
Granted
Exercised
(4,794,456
30.72
Forfeited
(3,841
34.40
Outstanding at September 30, 2006
14,792,270
31.62
4.56
175
Outstanding options exercisable as of September 30, 2006
WAMU Shares Stock Option Plan:
4,869,410
36.59
4.22
(1,717,717
36.07
(207,954
35.51
2,943,739
36.97
4.11
19
Acquired Plans:
8,217,386
51.98
4.74
104
(2,101,593
20.21
(393,332
97.39
5,722,461
60.52
3.91
2003 Equity Incentive Plan:
17,271,539
40.91
8.38
45
7,086,091
43.39
(1,356,206
40.45
(1,786,167
42.15
21,215,257
41.65
7.93
39
7,968,121
40.59
6.72
The fair value of the options granted under the Company’s stock options plans is estimated on the date of the grant using a binomial model that used the assumptions noted in the following table. Expected volatilities are based on implied volatilities from traded options on the Company’s stock, the historical volatility of the Company’s stock and other factors. Employees that have similar historical exercise behavior are grouped together for valuation purposes. The expected term of options granted is derived from historical exercise behavior combined with possible option lives based on remaining contractual terms of unexercised and outstanding options. The range given below results from certain groups of employees exhibiting different behavior. The risk-free rate for periods within the contractual life of the option is based on the rate available on zero-coupon government issues in effect at the time of the grant.
Nine Months Ended September 30,
Weighted average grant-date fair value:
2003 Equity Incentive Plan
8.06
8.39
Dividend yield
4.70
%
4.17 – 4.28
Expected volatility
21.90 – 25.50
25.45 – 30.74
Risk free interest rate
4.22 – 5.02
3.55 – 4.21
Expected life (in years)
5.1 – 6.2 years
4.5 – 7.0 years
The total intrinsic value of options exercised under the plans during the three and nine months ended September 30, 2006 was $20 million and $137 million. The total intrinsic value of options exercised under the plans during the three and nine months ended September 30, 2005 was $20 million and $65 million. As of September 30, 2006, there was $74 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 1.8 years.
Cash received from stock options exercised for the three and nine months ended September 30, 2006 was $38 million and $307 million. The income tax benefits from stock options exercised total $9 million and $50 million for the same periods.
Equity Incentive Plan
The 2003 Equity Incentive Plan (“2003 EIP”) and two of its predecessor plans (the Equity Incentive Plan and the Restricted Stock Plan) permit grants of restricted stock, with or without performance-based vesting restrictions, for the benefit of all employees, officers, directors, consultants and advisors of the Company. The Company measures the fair value of the 2003 EIP restricted stock awards based upon the market price of the underlying common stock as of the date of grant. The 2003 EIP restricted stock awards are amortized over their applicable vesting period (generally three years) using the straight-line method.
The following table presents the status and changes in restricted stock awards issued under all plans:
Shares
Weighted AverageGrant-DateFair Value
Restricted stock awards:
Nonvested balance at December 31, 2005
6,388,821
40.80
3,879,168
43.35
Vested
(1,660,839
41.52
(1,128,713
41.53
Nonvested balance at September 30, 2006
7,478,437
41.85
As of September 30, 2006, there was $202 million of total unrecognized compensation cost related to unvested restricted stock awards. The cost is expected to be recognized over a weighted average period of 2.0 years.
During the three and nine months ended September 30, 2006, 2003 EIP restricted stock and awards of 27,000 and 3.9 million were granted with a weighted average grant-date per share fair value of $42.95 and $43.35. During the three and nine months ended September 30, 2005, 2003 EIP restricted stock and awards of 75,000 and 3.6 million were granted with a weighted average grant-date per share fair value of $41.57 and $40.45. The total fair value of EIP restricted stock and awards vested during the three and nine months ended September 30, 2006 was $1 million and $71 million. The total fair value of EIP restricted stock and awards vested during the three and nine months ended September 30, 2005 was $4 million and $47 million.
The 2003 Equity Incentive Plan also allows for awards denominated in units of stock (“performance units”). These awards are paid out at the Company’s discretion in cash or shares of Washington Mutual common stock at the end of a three-year period only if the Company achieves specified performance goals compared to the performance of a peer group in the S&P Financial Index. The fair value of performance awards is estimated at grant date utilizing a Monte Carlo valuation methodology to determine the value of the market condition, which is combined with the estimated value of the performance conditions. The total value of the award will be determined at the end of the three-year performance period based on the actual results of the performance conditions and the value of the market condition determined at the grant date.
The following table presents the status and changes in performance unit awards:
Performance Unit awards:
1,086,348
$ 40.65
545,809
46.21
(201,674
42.04
1,430,483
42.58
As of September 30, 2006, there was $9 million of total unrecognized compensation cost related to unvested performance unit awards. The cost is expected to be recognized over a weighted average period of 2.0 years.
The Long-Term Cash Incentive program (“LTCIP”) provides eligible employees the opportunity to earn cash awards aligned with the Company’s common stock performance over a three-year period. Participants are awarded a number of units and on each of the three award anniversaries, participants receive a cash payment equal to the value of one-third of the participant’s units multiplied by the average closing price of Washington Mutual’s common stock over a period preceding the award anniversary date. These awards are classified as liabilities and are valued at each reporting period, based on the closing price of the Company’s common stock.
The following table presents the status and changes in LTCIP awards:
LTCIP awards:
1,429,180
$ 40.91
1,255,535
43.09
(490,865
40.93
(148,589
42.07
2,045,261
42.16
As of September 30, 2006, there was $56 million of total unrecognized compensation cost related to unvested LTCIP awards. The cost is expected to be recognized over a weighted average period of 1.5 years. Cash used to settle vested LTCIP awards was $226,000 and $21 million for the three and nine months ended September 30, 2006.
Employee Stock Purchase Plan
The Employee Stock Purchase Plan (“ESPP”) was amended effective January 1, 2004, and the Plan Administrator exercised its discretion under the Plan to change certain terms. The ESPP no longer permits lump sum contributions, excludes employees who work for less than 5 months per year, has twelve monthly offering periods, and provides for purchase of stock at a 5% discount from the price at the end of the offering period. The Company pays for the program’s administrative expenses. The plan is open to all employees who are at least 18 years old, work at least 20 hours per week and have completed three months of service with the Company. Participation is through payroll deductions with a maximum annual contribution of 10% of each employee’s eligible cash compensation. Under the ESPP, dividends may be automatically reinvested at the discretion of the participant. The Company sold 117,306 and 409,167 shares to employees during the three and nine months ended September 30, 2006 and 114,314 and 372,063 shares to employees during the three and nine months ended September 30, 2005. At September 30, 2006, 2 million shares were reserved for future issuance under this plan.
Note 7: Operating Segments
The Company has four operating segments for the purpose of management reporting: the Retail Banking Group, the Card Services Group, the Commercial Group and the Home Loans Group. The results of these operating segments are based on the Company’s management accounting process. Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting that is equivalent to generally accepted accounting principles. The management accounting 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 principal activities of the Retail Banking Group include: (1) offering a comprehensive line of deposit and other retail banking products and services to consumers and small businesses; (2) originating, managing and servicing home equity loans and lines of credit; (3) providing investment advisory and brokerage services, sales of annuities and other financial services; and (4) holding the Company’s portfolio of home loans held for investment, including certain subprime home loans. The Company has entered into an agreement to sell the retail mutual fund management business, WM Advisors, Inc., whose activities are reported within this segment’s results as discontinued operations. The gain on disposition of these discontinued operations will be reported as part of the Corporate Support/Treasury and Other category.
Deposit products offered to consumers and small businesses include the Company’s signature free checking and interest-bearing Platinum checking accounts, as well as other personal checking, savings, money market deposit and time deposit accounts. Such products are offered online and in retail banking stores. Financial consultants provide investment advisory and securities brokerage services to the public while appropriately licensed bank employees offer fixed annuities and mutual funds.
This segment’s home loan portfolio consists of home loans purchased from both the Home Loans Group and secondary market participants. Loans to subprime borrowers purchased prior to 2006 are also held in the segment’s home loan portfolio. Loans held in portfolio generate interest income, including prepayment fees, and loan-related noninterest income, such as late fees.
The Card Services Groupmanages the Company’s credit card operations. The segment’s principal activities include (1) originating credit card loans; (2) either holding such loans in portfolio or securitizing and selling them; (3) servicing credit card loans; and (4) providing other cardholder services. Credit card loans that are held in the Company’s loan portfolio generate interest income from finance charges on outstanding card balances, and noninterest income from the collection of fees associated with the credit card portfolio, such as performance fees (late, overlimit, and returned check charges), annual membership fees, and cash advance and balance transfer fees. Losses from credit risk that are inherent in the credit card loan portfolio are charged to the provision for loan and lease losses on the income statement and the allowance for loan and lease losses on the balance sheet.
When credit card loans are securitized, the loans are sold to a qualifying special-purpose entity (“QSPE”), typically a securitization trust. The QSPE issues asset-backed securities that are secured by the future expected cash flows on the sold loans, and cash proceeds from the sale of those securities to third parties are received by the Company. When such loans are transferred to held for sale, any reduction in the loan’s value that is attributable to a decline in credit quality is reflected as an adjustment to the loan’s cost basis and a corresponding reduction in the allowance for loan and lease losses. Any remaining loan loss allowance that was associated with those loans prior to the transfer is reversed through the provision for loan and lease losses. The resulting gain from the securitization and sale, along with the ensuing fee income associated with the Company’s retention of servicing responsibilities on the securitized loans, are reported as revenue from sales and servicing of consumer loans in noninterest income. Certain interests in the securitized loans are retained by the Company and are classified as trading assets on the balance sheet, with changes in the fair value of those retained interests recognized in current period earnings. The mix at any point in time between the amount of credit card loans held in the loan portfolio and those that have been securitized and sold is influenced by market conditions, the Company’s evaluation of capital deployment alternatives, and liquidity factors.
The Card Services Group acquires new customers primarily by leveraging the Company’s retail banking distribution network and through direct mail solicitations, augmented by online and telemarketing activities and other marketing programs including affinity programs. In addition to credit cards, this segment markets a variety of other products to its customer base.
18
The principal activities of the Commercial Group include: (1) providing financing to developers and investors for multi-family dwellings and, to a lesser extent, other commercial properties; (2) servicing multi-family and other commercial real estate loans and either holding such loans in portfolio as part of its commercial asset management business or selling them in the secondary market; and (3) providing limited deposit services to commercial customers.
The principal activities of the Home Loans Group include: (1) originating and servicing home loans; (2) buying and selling home loans in the secondary market; (3) providing financing and other banking services to mortgage bankers for the origination of mortgage loans; (4) holding both subprime loans purchased after 2005 and Long Beach Mortgage’s portfolio of home loans held for investment; and (5) making available insurance-related products and participating in reinsurance activities with other insurance companies.
The segment offers a wide variety of home loans, including fixed-rate home loans, adjustable-rate home loans or “ARMs”, hybrid home loans, Option ARM loans and home loans to subprime borrowers. Such loans are either held in portfolio by the Home Loans Group, sold to secondary market participants or transferred through inter-segment sales to the Retail Banking Group. The decision to retain or sell home loans, and the related decision to retain or not retain servicing when loans are sold, involve the analysis and comparison of expected interest income and the interest rate and credit risks inherent with holding loans in portfolio, with the expected servicing fees, the size of the gain or loss that would be realized if the loans were sold and the expected expense of managing the risk related to any retained mortgage servicing rights.
In addition to selling loans to secondary market participants, the Home Loans Group generates both interest income and noninterest income by acquiring home loans from a variety of sources, pooling and securitizing those loans, selling the resulting mortgage-backed securities to secondary market participants and providing ongoing servicing and bond administration for all securities issued.
The Corporate Support/Treasury and Other category includes enterprise-wide management of the Company’s interest rate risk, liquidity, capital, borrowings, and a majority of the Company’s investment securities. As part of the Company’s asset and liability management process, the Treasury function provides oversight and direction across the enterprise over matters that impact the profile of the Company’s balance sheet, such as product composition of loans that the Company holds in the portfolio, the appropriate mix of wholesale and capital markets borrowings at any given point in time, and the allocation of capital resources to the business segments. This category also includes the costs of the Company’s technology services, facilities, legal, human resources, and accounting and finance functions to the extent not allocated to the business segments, and community lending and investment operations. Community lending and investment programs help fund the development of affordable housing units in traditionally underserved communities. Other costs which are included in this category include those charges associated with the Company’s ongoing productivity and efficiency initiatives and costs related to the sale of the Company’s MSR during the third quarter of 2006. As the Company’s chief operating decision maker does not consider the financial impact of these costs when evaluating the performance of the Company’s four operating segments, such costs were not charged to the operating segments. Also reported in this category is the net impact of funds transfer pricing for loan and deposit balances and items associated with transfers of loans from the Retail Banking Group to the Home Loans Group when home loans previously designated as held for investment are transferred to held for sale, such as lower of cost or fair value adjustments and the write-off of inter-segment premiums.
The Company uses various management accounting methodologies, which are enhanced from time to time, to assign certain balance sheet and income statement items to the responsible operating segment. Methodologies that are applied to the measurement of segment profitability include:
· 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 and its share of risk-adjusted economic capital. Conversely, a segment is assigned a charge by the Treasury Division to fund its assets. The system takes into account the interest rate risk profile of the Company’s assets and liabilities and concentrates their sensitivities within the Treasury Division, where it is centrally managed. Certain basis and other residual risk remains in the operating segments;
· 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 calculation differs, in some respects, from the Company’s financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio under generally accepted accounting principles;
· the allocation of certain operating expenses that are not directly charged to the segments (i.e., corporate overhead), which generally are based on each segment’s consumption patterns;
· the allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; and
· inter-segment activities which include the transfer of certain originated home loans that are to be held in portfolio from the Home Loans Group to the Retail Banking Group and a broker fee arrangement between Home Loans and Retail Banking. When originated home loans are transferred, the Home Loans Group records a gain on the sale of the loans based on an assumed profit factor. This profit factor is included as a premium to the value of the transferred loans, which is amortized as an adjustment to the net interest income recorded by the Retail Banking Group while the loan is held for investment. If a loan that was designated as held for investment is subsequently transferred to held for sale, the inter-segment premium is written off through Corporate Support/Treasury and Other. Inter-segment broker fees are recorded by the Retail Banking Group when home loans are initiated through retail banking stores. The results of all inter-segment activities are eliminated as reconciling adjustments that are necessary to conform the presentation of management accounting policies to the accounting principles used in the Company’s consolidated financial statements.
During the fourth quarter of 2005, the Company began integrating the Card Services Group into its management accounting process. During this period and through the third quarter of 2006, only the funds transfer pricing management accounting methodology and charges for legal services were applied to this segment. As charges related to the administrative support functions of the former Providian Financial Corporation continue to be incurred by the Card Services Group, corporate overhead charges have not been allocated to this segment . The Company evaluates the performance of the Card Services Group on a managed asset basis. Managed financial information is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest and fee income and credit losses.
20
Financial highlights by operating segment were as follows:
Three Months Ended September 30, 2006
Corporate
Support/
Retail
Card
Home
Treasury
Banking
Services
Commercial
Loans
and
Reconciling Adjustments
Group
Group(1)
Group(2)
Securitization(3)
Condensed income statement:
Net interest income (expense)
1,444
627
198
(244
(411
(4)
345
(220
(21
)(5)
756
343
25
263
79
191
(87
)(6)
Inter-segment revenue (expense)
(15
1,105
504
232
Income (loss) from continuing operations before income taxes
1,053
340
163
(53
(431
Income taxes (benefit)
402
130
62
(20
(172
Income (loss) from continuing operations, net of taxes
651
210
101
(33
(259
Net income (loss)
660
Performance and other data:
Average loans
192,445
21,706
32,414
33,718
1,245
(12,169
(1,527
)(7)
267,832
Average assets
205,063
24,236
34,794
59,110
38,245
(10,330
(1,576
)(7)(8)
349,542
Average deposits
139,954
n/a
2,323
20,659
45,976
208,912
(1) Operating results for the Card Services Group are presented on a managed basis as the Company treats securitized and sold credit card receivables as if they were still on the balance sheet in evaluating the overall performance of this operating segment.
(2) Effective January 1, 2006, the Company reorganized its single family residential mortgage lending operations. This reorganization combined the Company’s subprime mortgage origination business, Long Beach Mortgage, as well as its Mortgage Banker Finance lending operations with the Home Loans Group. Previously these operations were reported within the Commercial Group. This change in organization was retrospectively applied to prior periods.
(3) The managed basis presentation of the Card Services Group is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest and fee income and provision for credit losses. Such adjustments to arrive at the reported GAAP results are eliminated within Securitization Adjustments.
(4) Represents the difference between home loan premium amortization recorded by the Retail Banking Group and the amount recognized in the Company’s Consolidated Statements of Income. For management reporting purposes, loans that are held in portfolio by the Retail Banking Group are treated as if they are purchased from the Home Loans Group. Since the cost basis of these loans includes an assumed profit factor paid to the Home Loans Group, the amortization of loan premiums recorded by the Retail Banking Group reflects this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(5) Represents the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio.
(6) Represents the difference between gain from mortgage loans primarily recorded by the Home Loans Group and the gain from mortgage loans recognized in the Company’s Consolidated Statements of Income. A substantial amount of loans originated or purchased by this segment are considered to be salable for management reporting purposes.
(7) Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking Group recognized from the transfer of portfolio loans from the Home Loans Group.
(8) Includes the impact to the allowance for loan and lease losses of $49 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio.
21
Three Months Ended September 30, 2005
RetailBankingGroup
CommercialGroup(1)
HomeLoansGroup(1)
CorporateSupport/TreasuryandOther
ReconcilingAdjustments
1,417
222
480
115
(2)
Noninterest income (expense)
653
659
(62
(50
)(4)
(12
1,080
641
76
Income (loss) from continuingoperations before income taxes
955
(367
363
183
(150
30
592
302
(217
32
600
179,361
30,433
53,424
1,095
262,763
191,865
34,001
75,138
27,678
(1,727
)(5)(6)
326,955
138,741
2,485
21,563
25,531
188,320
(1) Effective January 1, 2006, the Company reorganized its single family residential mortgage lending operations. This reorganization combined the Company’s subprime mortgage origination business, Long Beach Mortgage, as well as its Mortgage Banker Finance lending operations with the Home Loans Group. Previously these operations were reported within the Commercial Group. This change in organization has been retrospectively applied to prior periods.
(2) Represents the difference between home loan premium amortization recorded by the Retail Banking Group and the amount recognized in the Company’s Consolidated Statements of Income. For management reporting purposes, loans that are held in portfolio by the Retail Banking Group are treated as if they are purchased from the Home Loans Group. Since the cost basis of these loans includes an assumed profit factor paid to the Home Loans Group, the amortization of loan premiums recorded by the Retail Banking Group reflects this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(3) Represents the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio.
(4) Represents the difference between gain from mortgage loans primarily recorded by the Home Loans Group and the gain from mortgage loans recognized in the Company’s Consolidated Statements of Income. A substantial amount of loans originated or purchased by this segment are considered to be salable for management reporting purposes.
(5) Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking Group recognized from the transfer of portfolio loans from the Home Loans Group.
(6) Includes the impact to the allowance for loan and lease losses of $177 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio.
Nine Months Ended September 30, 2006
4,475
1,850
682
(602
(1,249
367
1,092
(662
(112
2,162
1,076
54
1,123
152
587
(368
50
(47
3,360
855
184
1,692
460
3,181
976
467
(981
111
1,215
373
178
24
(397
(52
1,966
289
(584
1,993
192,539
20,762
31,648
33,012
1,188
(11,947
(1,506
265,696
205,396
23,354
34,361
60,555
35,354
(10,101
(1,609
347,310
139,276
2,276
19,120
39,459
200,131
(8) Includes the impact to the allowance for loan and lease losses of $103 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio.
Nine Months Ended September 30, 2005
Reconciling
Adjustments
4,275
668
1,330
(639
123
(30
)(3)
1,845
86
2,074
(185
(248
(34
3,136
174
1,888
209
2,895
577
1,479
(1,033
125
1,097
218
(420
1,798
359
921
(613
1,829
179,447
29,894
46,842
1,066
(1,549
255,700
192,190
33,374
68,419
26,284
(1,764
318,503
135,775
2,646
19,379
24,590
182,390
(6) Includes the impact to the allowance for loan and lease losses of $215 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the financial accounting methodology that is used to estimate incurred credit losses inherent in the Company’s loan portfolio.
Note 8: Condensed Consolidating Financial Statements
The following are the condensed consolidating financial statements of the parent companies of Washington Mutual, Inc. and New American Capital, Inc.
CONDENSED CONSOLIDATING STATEMENTS OF INCOME
WashingtonMutual, Inc.(Parent Only)
NewAmericanCapital, Inc.(Parent Only)
All OtherWashingtonMutual, Inc.ConsolidatingSubsidiaries
Eliminations
WashingtonMutual, Inc.Consolidated
Notes receivable from subsidiaries
(19
Other interest income
5,104
5,111
160
1,271
Other interest expense
3,010
2,101
Net interest income (expense) after provision for loan and lease losses
1,935
1,565
(9
2,218
Net income (loss) from continuing operations before income taxes, dividends from subsidiaries and equity in undistributed income of subsidiaries
(2
1,316
Income tax expense (benefit)
(44
453
Dividends from subsidiaries
2,300
823
(3,123
Equity in undistributed income (loss) of subsidiaries
43
1,373
879
863
(1,751
Discontinued Operations, net of taxes
872
41
4,067
(39
4,071
(92
987
(93
1028
1,983
(118
2,088
2,036
1,211
(4
1,826
(152
1,421
(42
508
Equity in undistributed income of subsidiaries
873
892
(1,765
932
913
(1,853
26
All Other
New
American
Mutual, Inc.
Capital, Inc.
Consolidating
(Parent Only)
Subsidiaries
Consolidated
51
(78
14,693
14,711
(82
461
3,748
4,421
8,169
(79
(448
6,542
6,070
4,785
(27
93
6,520
(22
6,622
(525
4,335
(177
1,533
5,900
4,956
(10,856
Equity in undistributed loss of subsidiaries
(3,051
(2,151
5,202
2,833
2,802
(5,662
2,829
(119
11,356
(108
11,361
(227
339
2,617
(245
5,161
(318
77
6,200
6,101
3,587
(43
88
5,349
(379
75
4,339
(99
1,574
1,005
943
(1,948
1,842
1,807
(3,649
2,793
2,765
(5,589
2,796
28
CONDENSED CONSOLIDATING STATEMENTS OF FINANCIAL CONDITION
September 30, 2006
3,835
337
7,125
(4,648
53
28,964
Loans, net of allowance for loan and lease losses
263,928
263,935
950
494
(1,475
Investment in subsidiaries
31,712
29,056
(60,768
1,263
1,275
47,088
(350
49,276
36,894
31,625
347,599
(67,241
Notes payable to subsidiaries
273
(1,476
9,683
462
89,932
100,077
226,882
(5,034
222,342
10,436
501
317,992
(6,510
31,124
29,607
(60,731
December 31, 2005
New AmericanCapital, Inc.(Parent Only)
781
108
6,653
(1,328
24,604
261,510
261,519
1,354
3,550
473
(5,377
34,707
31,116
(65,823
1,396
51,668
(2,488
51,181
38,294
35,387
344,908
(75,016
266
549
6,918
(7,733
10,194
705
104,262
115,161
555
202,040
(1,496
201,133
11,015
1,288
313,220
(9,229
34,099
31,688
(65,787
CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
All OtherWashingtonMutual, Inc.ConsolidatingSubsidiaries(1)
(2,833
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in undistributed (income) loss of subsidiaries
3,051
2,152
(5,203
Decrease (increase) in other assets
205
(669
5,633
5,169
(Decrease) increase in other liabilities
(123
1,296
(6
(5
6,511
6,500
Net cash provided by operating activities
5,628
4,291
5,404
Purchases of securities
Proceeds from sales and maturities of securities
8,904
Origination of loans, net of principal payments
(15,541
(15,540
Decrease (increase) in notes receivable from subsidiaries
1,323
2,600
(3,923
234
(234
2,722
Net cash provided (used) by investingactivities
1,558
(20,447
Repayments on borrowings, net
(470
(762
(13,375
(14,607
Cash dividends paid on preferred and common stock
(1,482
(5,900
5,899
859
19,671
20,530
Net cash (used) provided by financingactivities
(4,132
(6,662
12,195
Increase (decrease) in cash and cash equivalents
3,054
229
(2,848
Cash and cash equivalents, beginningof period
5,325
2,477
(1) Includes intercompany eliminations.
(2,793
(1,842
(1,807
3,649
(Increase) decrease in other assets
(576
64
(2,781
(3,293
(23
(7
1,724
(9,710
(9,733
103
1,043
(9,911
Purchase of securities
Proceeds from sales and maturities ofsecurities
12,017
12,019
(8,135
(8,133
(Increase) decrease in notes receivable from subsidiaries
(2,249
(1,050
3,299
(3,083
(2,391
(1,023
(9,816
Proceeds from borrowings, net
2,685
1,840
2,375
6,900
(1,229
(925
924
16,992
1,496
915
20,053
(Decrease) increase in cash and cash equivalents
(792
935
326
1,517
2,867
725
1,006
3,193
Note 9: Subsequent Event
On October 1, 2006 the Company completed its acquisition of Commercial Capital Bancorp, Inc. (“CCB”), a multi-family and small commercial real estate lending institution located in Southern California, in a cash transaction with an estimated purchase price of approximately $989 million. CCB stockholders received $16.00 in cash for each share of CCB common stock. Most of the business activities of CCB will be conducted through the Company’s Commercial Group operating segment.
To facilitate the closure of the acquisition, the Company transferred $960 million of cash to an escrow agent on September 29, 2006. At September 30, 2006, this restricted cash was reported within other assets on the Consolidated Statements of Financial Condition. On October 2, 2006, the funds were disbursed to the stockholders of CCB to complete the acquisition.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS
In July 2006 Washington Mutual, Inc. (“Washington Mutual” or the “Company”) decided to exit the retail mutual fund management business and entered into a definitive agreement to sell its subsidiary, WM Advisors, Inc. WM Advisors provides investment management, distribution and shareholder services to the WM Group of Funds. Accordingly, the results of its operations have been removed from the Company’s results of continuing operations for all periods presented on the Consolidated Statements of Income and in Notes 7 and 8 to the Consolidated Financial Statements – “Operating Segments” and “Condensed Consolidating Financial Statements”, and are presented in aggregate as discontinued operations. Assets and liabilities of WM Advisors have been reclassified to other assets and other liabilities on the Consolidated Statements of Financial Condition. The sale is expected to close late in the fourth quarter of 2006.
The Company’s Form 10-Q and other documents that it files with the Securities and Exchange Commission (“SEC”) contain forward-looking statements. In addition, the Company’s 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 management’s current expectations or predictions of future conditions, events or results. They may include projections of the Company’s revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items, descriptions of management’s plans or objectives for future operations, products or services, or descriptions of assumptions underlying or relating to the foregoing. 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. Management does 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 management’s control or its ability to accurately forecast or predict their significance, which could cause actual conditions, events or results to differ materially from those described in the forward-looking statements. Significant among these factors are:
· General business and economic conditions, including movements in interest rates, the slope of the yield curve and the overextension of housing prices in certain geographic markets;
· Rising interest rates, unemployment and decreases in housing prices;
· Risks related to the option adjustable-rate mortgage product;
· Risks related to subprime lending;
· Risks related to credit card operations;
· Changes in the regulation of financial services companies, housing government-sponsored enterprises and credit card lenders;
· Competition from banking and nonbanking companies; and
· Negative public opinion which may impact the Company’s reputation.
Each of these factors can significantly impact the Company’s businesses, operations, activities, condition and results in significant ways that are not described in the foregoing discussion and which are beyond the Company’s ability to anticipate or control, and could cause actual results to differ materially from the outcomes described in the forward-looking statements. These factors are described in greater detail in “Business – Factors That May Affect Future Results” in the Company’s 2005 Annual Report on Form 10-K/A.
Disclosure Controls and Procedures
The Company’s management, with the participation 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 submits under the Securities Exchange Act of 1934.
Management reviews and evaluates the design and effectiveness of the Company’s disclosure controls and procedures on an ongoing basis, which may result in the discovery of deficiencies, and improves its controls and procedures over time, correcting any deficiencies that may have been discovered.
Changes in Internal Control Over Financial Reporting
Management reviews and evaluates the design and effectiveness of the Company’s internal control over financial reporting on an ongoing basis, which may result in the discovery of deficiencies, some of which may be significant, and changes its internal control over financial reporting as needed to maintain their effectiveness, correcting any deficiencies, as needed, in order to ensure the continued effectiveness of the Company’s internal controls. There have not been any changes in the Company’s internal control over financial reporting during the third quarter of 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. For management’s assessment of the Company’s internal control over financial reporting, refer to the Company’s 2005 Annual Report on Form 10-K/A, “Management’s Report on Internal Control Over Financial Reporting.”
Net income for the third quarter of 2006 was $748 million, or $0.77 per diluted share, compared with $821 million, or $0.92 per diluted share, in the third quarter of 2005.
Net interest income was $1.95 billion in the third quarter of 2006, compared with $2.00 billion for the same quarter in 2005. The decrease was predominantly due to contraction in the net interest margin, partially offset by an increase in average interest-earning assets. The net interest margin in the third quarter of 2006 was 2.53%, a 20 basis point decline from the third quarter of 2005. The decrease was due to an increase in the cost of the Company’s interest-bearing liabilities, which was driven by a continual increase in short-term interest rates and the ensuing higher competitive pricing environment for deposits that has recently accompanied the increase in rates.
As economic activity has decelerated in recent months, the Federal Reserve decided to hold the targeted federal funds rate at 5.25% in the third quarter of 2006, ending its methodical program of continuous increases after 17 consecutive adjustments. Although the Federal Reserve has expressed concerns regarding elevated readings on core inflation, they also acknowledged that the general softening of economic indicators, coupled with the cumulative effect of past interest rate increases that have not yet been fully absorbed by the economy and the recent decline in energy prices, should facilitate the reduction
of inflation pressures over time. Accordingly, additional increases in the federal funds rate, if any, will not be foreordained. If this rate does not increase during the remainder of 2006, the Company’s net interest margin should expand in the fourth quarter. This expansion, however, may be tempered by a continuing competitive deposit pricing environment.
Noninterest income totaled $1.57 billion in the third quarter of 2006, compared with $1.21 billion in the third quarter of 2005. The increase is primarily due to consumer loan sales and servicing revenue of $355 million and credit card fee income of $165 million, both of which are attributable to the Providian acquisition in the fourth quarter of 2005. Depositor and other retail banking fees also grew significantly, increasing from $578 million in the third quarter of 2005 to $655 million in the third quarter of 2006, reflecting higher levels of transaction fees and a 13% increase in the number of checking accounts. Partially offsetting these increases was a decline in revenue from the Company’s home mortgage loan operations. Revenue from sales and servicing of home mortgage loans, including the effects of all MSR risk management instruments, was $156 million in the third quarter of 2006, compared with $493 million in the third quarter of 2005, primarily reflecting a more favorable MSR hedging environment in the earlier period. Additionally, the slowdown in the housing market contributed to lower gain on sale performance.
Total home loan volume in the current quarter was down 34% from the same quarter of the prior year, reflecting a widespread decline in national home sales activity. Also contributing to the decline was the Company’s decision in the second quarter of 2006 to discontinue the origination of mortgages through the less-profitable correspondent channel.
The Company recorded a provision for loan and lease losses of $166 million in the third quarter of 2006, compared with $224 million in the second quarter of 2006 and $52 million in the third quarter of 2005, which preceded the acquisition of Providian on October 1, 2005. The decrease in the provision from the second quarter is the result of ongoing refinements made to the Company’s methodology that measures credit losses inherent in the loan portfolio, the planned sale of higher-risk credit card accounts and a slight decline in the loan portfolio, all of which mitigated the effects of a more challenging credit environment. Reflecting the softening of the housing market, nonperforming assets, as a percentage of total assets, increased from 0.62% at June 30, 2006 to 0.69% at September 30, 2006, while net home loan charge-offs increased from $29 million to $53 million between the same periods. Near the end of the third quarter, the Company transferred $403 million of higher risk credit card accounts to loans held for sale, in anticipation of a transaction that is expected to occur during the fourth quarter. As the accounts in the credit card portfolio at the end of the third quarter generally had more favorable credit risk scores than the loans to be sold, the provision for loan and lease losses benefited from the improved risk profile of that portfolio.
Noninterest expense totaled $2.18 billion in the third quarter of 2006, up from $1.86 billion in the same quarter of the prior year but down from $2.23 billion in the second quarter of 2006. The increase from the third quarter of 2005 is primarily due to the inclusion of credit card operating expenses that resulted from the Providian acquisition in the fourth quarter of 2005, and costs associated with the continuing expansion of the retail banking franchise. The Company opened 89 new retail banking stores and closed 4 stores during the first nine months of 2006.
The $45 million decline in noninterest expense from the second quarter of 2006 is largely due to a 9 percent reduction in the number of employees in the most recent period, reflecting the positive effects of the Company’s ongoing productivity and efficiency initiatives during 2006. Charges associated with these initiatives totaled $52 million in the third quarter, compared with $81 million in the prior quarter and are primarily comprised of severance and facilities closure costs that were incurred as part of the Company’s efforts to redeploy certain back-office support operations to more cost-effective labor markets and the consolidation of other administrative support facilities. The Company expects to incur additional charges in the fourth quarter that will result from the continuing execution of productivity and efficiency initiatives.
During the most recent quarter, the Company sold $2.53 billion of mortgage servicing rights. The servicing portfolio associated with this sale included substantially all of the Company’s government loan servicing and a portion of its conforming, fixed-rate servicing which is predominantly comprised of customers whose only relationship with the Company consisted of a serviced home mortgage loan. The Company incurred $58 million of transaction-related noninterest expense charges in the third quarter associated with this sale, and expects to incur approximately $10 million in additional charges over the next two quarters, at which time the transfer of loans to the purchaser is expected to be complete. The Company also expects to incur estimated charges of $37 million in the fourth quarter from the announced sale of the retail mutual fund management business, which is expected to occur near the end of that quarter. Such charges will be reported as discontinued operations in the Company’s Consolidated Statements of Income.
On October 1, 2006 the Company completed its acquisition of Commercial Capital Bancorp, Inc. (“CCB”), a multi-family and small commercial real estate lending institution located in Southern California, in a cash transaction with an estimated purchase price of $989 million. CCB stockholders received $16.00 in cash for each share of CCB common stock. Most of the business activities of CCB will be conducted through the Company’s Commercial Group operating segment.
The preparation of financial statements in accordance with the accounting principles generally accepted in the United States of America (“GAAP”) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the Consolidated Financial Statements. Various elements of the Company’s accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain inherent uncertainties. In some instances, different estimates and assumptions could have been reasonably used to supplant those that were applied. Had those alternative estimates and assumptions been applied, the differences that may result from those alternative applications could have a material effect on the financial statements.
The Company has identified three accounting estimates that, due to the judgments and assumptions inherent in those estimates, and the potential sensitivity of its Consolidated Financial Statements to those judgments and assumptions, are critical to an understanding of its Consolidated Financial Statements. These estimates are: the fair value of certain financial instruments and other assets; derivatives and hedging activities; and the allowance for loan and lease losses and contingent credit risk liabilities.
Management has discussed the development and selection of these critical accounting estimates with the Company’s Audit Committee. The Company believes that the judgments, estimates and assumptions used in the preparation of its Consolidated Financial Statements are appropriate given the facts and circumstances as of September 30, 2006. These judgments, estimates and assumptions are described in greater detail in the Company’s 2005 Annual Report on Form 10-K/A in the “Critical Accounting Estimates” section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies.”
Refer to Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies.”
(dollars in millions, except per share amounts)
Profitability
Net interest margin
2.53
2.73
2.64
2.77
Basic earnings per common share:
Diluted earnings per common share:
Diluted weighted average number of common shares outstanding(in thousands)
Return on average assets(1)
0.86
1.00
0.96
1.07
Return on average common equity(1)
11.47
14.88
12.68
15.77
Efficiency ratio(2)(3)
62.09
57.88
60.05
56.62
Asset Quality (period end)
Nonaccrual loans(4)
1,987
1,465
Foreclosed assets
405
256
Total nonperforming assets(4)
2,392
1,721
Nonperforming assets(4) to total assets
0.69
Restructured loans
Total nonperforming assets and restructured loans(4)
2,411
1,550
1,264
Allowance as a percentage of total loans held in portfolio
0.64
0.58
Credit Performance
Net charge-offs
154
375
Capital Adequacy (period end)
Stockholders’ equity to total assets
7.58
6.68
Tangible equity to total tangible assets(5)
5.86
4.99
Estimated total risk-based capital to total risk-weighted assets(6)
11.10
10.56
Per Common Share Data
Book value per common share (period end)(7)
28.17
25.54
Market prices:
High
46.42
43.60
46.48
Low
41.47
39.22
37.78
Period end
43.47
Supplemental Data
Total home loan volume(8)
37,169
56,142
124,210
157,293
Total loan volume
49,368
70,732
159,309
197,865
(1) Includes income from continuing and discontinued operations.
(2) Based on continuing operations.
(3) The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(4) Excludes nonaccrual loans held for sale.
(5) Excludes unrealized net gain/loss on available-for-sale securities and derivatives, goodwill and intangible assets (except MSR). Minority interests of $1.96 billion at September 30, 2006 are included in the numerator.
(6) The total risk-based capital ratio is estimated as if Washington Mutual, Inc. were a bank holding company subject to Federal Reserve Board capital requirements.
(7) Excludes six million shares held in escrow at September 30, 2006 and 2005.
(8) Includes specialty mortgage finance loans, which are comprised of purchased subprime home loans and subprime home loans originated by Long Beach Mortgage. Specialty mortgage finance loan volumes were $7.79 billion and $8.41 billion for the three months ended September 30, 2006 and 2005 and $21.49 billion and $24.82 billion for the nine months ended September 30, 2006 and 2005.
Net Interest Income
Net interest income decreased $58 million, or 3%, for the three months ended September 30, 2006, compared with the same period in 2005. The decrease was due to a 20 basis point decline in the net interest margin as an increase in the cost of interest-bearing liabilities, driven by higher short-term interest rates and a more competitive deposit pricing environment, outpaced the increase in yield on interest-earning assets. Partially offsetting the decline in the net interest margin was a 5% increase in average interest-earning assets, driven primarily by an increase in home loans held in portfolio and the addition of the credit card portfolio in the fourth quarter of 2005.
Net interest income increased $146 million, or 2%, for the nine months ended September 30, 2006, compared with the same period in 2005. The increase was due to an 8% increase in average interest-earning assets and reflects an 11% increase in the average balance of the home loan portfolio and the addition of the credit card portfolio in the fourth quarter of 2005. Substantially offsetting the impact of the increase in average interest-earning assets was contraction in the net interest margin, which declined 13 basis points from the nine months ended September 30, 2005.
Average balances, together with the total dollar amounts of interest income and expense related to such balances and the weighted average interest rates, were as follows:
Three Months Ended September 30,
AverageBalance
Rate
InterestIncome
Interest-earning assets:
5,085
5.38
2,891
3.52
6,264
8.92
6,532
6.97
Available-for-sale securities(1):
Mortgage-backed securities
21,488
5.41
291
15,666
4.72
185
Investment securities
6,910
5.06
4,321
4.94
Loans held for sale(2)
25,667
6.82
49,747
5.33
Loans held in portfolio(2)(3):
Loans secured by real estate:
Home(4)
123,355
5.92
108,783
5.05
1,374
Specialty mortgage finance(5)
19,600
6.14
301
20,298
5.89
Total home loans
142,955
5.95
2,127
129,081
5.18
1,673
Home equity loans and lines of credit
53,253
7.59
1,017
49,237
6.17
765
Home construction(6)
2,059
6.41
2,001
6.31
Multi-family
27,100
6.42
24,550
5.49
Other real estate
5,696
6.76
98
4,904
7.32
91
Total loans secured by real estate
231,063
3,710
209,773
5.51
2,898
Consumer:
Credit card
9,058
11.39
260
12.57
686
10.67
1,760
2,557
4.78
Total loans held in portfolio
242,165
6.60
213,016
5.52
Other(7)
5,248
5.21
4,356
Total interest-earning assets
312,827
6.51
296,529
5.42
Noninterest-earning assets:
7,201
6,408
8,339
6,196
Other assets(8)
21,175
17,822
(This table is continued on the next page.)
(1) The average balance and yield are based on average amortized cost balances.
(2) Nonaccrual loans and related income, if any, are included in their respective loan categories.
(3) Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $119 million and $115 million for the three months ended September 30, 2006 and 2005.
(4) Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $278 million and $86 million for the three months ended September 30, 2006 and 2005.
(5) Represents purchased subprime home loan portfolios and subprime home loans originated by Long Beach Mortgage held in portfolio.
(6) Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(7) Interest-earning assets in nonaccrual status (other than loans) and related income, if any, are included within this category.
(8) Includes assets of discontinued operations.
InterestExpense
Interest-bearing liabilities:
Interest-bearing checking deposits
34,866
2.90
255
45,305
2.12
242
Savings and money market deposits
49,144
3.19
396
42,944
1.92
208
Time deposits
90,001
4.77
1,088
63,338
3.41
546
Total interest-bearing deposits
174,011
3.95
151,587
2.60
Federal funds purchased and commercialpaper
7,382
5.31
6,719
3.60
Securities sold under agreements torepurchase
15,676
5.39
216
13,159
3.65
52,886
5.28
68,597
3.54
620
27,815
5.59
393
21,734
4.12
224
Total interest-bearing liabilities
277,770
4.48
261,796
3.05
Noninterest-bearing sources:
34,901
36,733
Other liabilities(9)
8,765
6,337
Stockholders’ equity
26,147
22,075
Net interest spread and net interest income
2.03
2.37
Impact of noninterest-bearing sources
0.50
0.36
(9) Includes liabilities of discontinued operations.
4,422
5.04
169
2,078
3.13
8,831
7.60
6,169
6.15
21,163
5.35
848
15,407
4.61
5,997
4.88
220
4,569
162
26,659
44,354
5.16
122,232
5.76
5,278
110,057
4.86
4,013
19,718
6.09
900
19,928
5.84
141,950
5.80
6,178
129,985
5.01
4,886
Home equity loans and linesof credit
52,289
7.29
2,852
47,056
5.81
2,048
2,062
2,096
6.16
26,388
6.19
1,226
23,651
937
5,482
6.85
5,138
6.94
269
228,171
6.22
10,639
207,926
8,237
8,442
11.16
704
499
10.84
726
10.64
1,925
5.87
85
2,694
4.93
100
239,037
6.40
211,346
5.30
5,191
4,280
3.42
109
311,300
6.30
288,203
5.20
8,151
6,232
8,313
19,546
17,872
(3) Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $334 million and $291 million for the nine months ended September 30, 2006 and 2005.
(4) Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $706 million and $159 million for the nine months ended September 30, 2006 and 2005.
37,615
728
47,609
1.86
663
47,367
2.81
997
42,125
1.65
520
80,970
4.42
2,695
58,089
3.12
1,361
165,952
3.55
147,823
2.29
7,537
4.92
4,330
16,294
4.95
612
15,377
3.11
60,197
4.84
2,203
68,241
3.20
1,652
26,901
5.23
1,060
20,554
3.98
276,881
256,325
34,179
34,567
8,445
5,897
1,497
26,308
21,701
2.19
2.47
0.45
0.30
Noninterest income from continuing operations consisted of the following:
Percentage
Change
(83
)%
(29
(94
294
Revenues from sales and servicing of home mortgage loans
Three MonthsEndedSeptember 30,
Nine MonthsEndedSeptember 30,
Revaluation gain (loss) from derivatives economically hedging loans heldfor sale
(69
Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and riskmanagement instruments
(57
775
Adjustment to MSR fair value forMSR sale
(97
(2) Net of fair value hedge ineffectiveness as well as any impairment/reversal recognized on MSR that resulted from the application of the lower of cost or fair value accounting methodology in 2005.
In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets,which amends Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.For each class of separately recognized servicing asset, this Statement permits an entity to choose either to amortize such assets in proportion to and over the period of estimated net servicing income and perform an impairment assessment at each reporting date, or to report servicing assets at fair value at each reporting date and record changes in fair value in earnings in the period in which the changes occur. At its initial adoption, the Statement permits a one-time reclassification of available-for-sale
44
securities to trading securities, provided that the securities are identified as offsetting the entity’s exposure to changes in fair value of servicing assets that are reported at fair value. As permitted by the early adoption provisions of this accounting standard, the Company applied Statement No. 156 to its financial statements on January 1, 2006 and elected to measure all classes of mortgage servicing assets at fair value. The Company also elected to transfer its January 1, 2006 portfolio of available-for-sale MSR risk management securities to trading. Upon electing the fair value method of accounting for its mortgage servicing assets, the Company discontinued the application of fair value hedge accounting. Accordingly, beginning in 2006, all derivatives held for MSR risk management are treated as economic hedges, with valuation changes recorded as revaluation gain (loss) from derivatives economically hedging MSR. Additionally, upon the change from the lower of cost or fair value accounting method to fair value accounting under Statement No. 156, the calculation of amortization and the assessment of impairment were discontinued and the MSR valuation allowance was written off against the recorded value of the MSR. Those measurements have been replaced by fair value adjustments that encompass market-driven valuation changes and the runoff in value that occurs from the passage of time, which are each separately reported.
The retrospective application of this Statement to prior periods is not permitted. However, the Company believes that, due to the significant differences between the fair value measurement method and the lower of cost or fair value method of accounting for MSR, comparative, pro forma information prepared on a fair value basis of accounting that is consistent with the standards of Statement No. 156 is valuable to users of this financial information. Accordingly, the information for the three and nine months ended September 30, 2005 presented in the MSR valuation and risk management table below conforms to the presentation of the three and nine months ended September 30, 2006, and incorporates the assumption that the fair value measurement method of accounting for MSR was in effect during 2005. As such, all of the derivatives designated as MSR risk management instruments during that period are presented in the revaluation gain (loss) from derivatives line item, even if they previously qualified for hedge accounting treatment.
(Pro Forma)2005
MSR Valuation and Risk Management(1):
1,193
733
Gain (loss) on MSR risk management instruments:
Revaluation gain (loss) from derivatives
(810
Revaluation gain (loss) from certain trading securities
(219
(68
Loss from sales of certain available-for-sale securities
Total gain (loss) on MSR risk management instruments
391
(1,029
(654
Total changes in MSR valuation and risk management
(275
(1) Excludes $157 million loss on MSR sale.
The following tables reconcile the gains (losses) on investment securities that are designated as MSR risk management instruments to trading assets income (loss) and the loss on other available-for-sale securities that are reported within noninterest income during the three and nine months ended September 30, 2006 and 2005:
Three Months EndedSeptember 30, 2006
Nine Months EndedSeptember 30, 2006
MSR
(24
Three Months EndedSeptember 30, 2005
Nine Months EndedSeptember 30, 2005
46
(66
81
(111
MSR valuation and risk management results were $(78) million for the three months ended September 30, 2006, compared with $164 million for the same period in 2005. Mortgage interest rates decreased during the third quarter of 2006, which led to higher loan prepayment speeds and a decline in MSR value. That decline was not entirely offset by the Company’s MSR risk management instruments, as their performance was adversely affected by the inverted slope of the yield curve in the most recent quarter, which had the effect of increasing hedging costs. Mortgage rates increased in the third quarter of 2005, resulting in lower loan prepayment speeds and an increase in MSR value. Although that increase was partially offset by declines in risk management instruments, those declines were mitigated by a more favorable hedging environment during that quarter, which was fostered, in part, by the positive slope of the yield curve.
The value of the MSR asset is subject to prepayment risk. Future expected net cash flows from servicing a loan in the servicing portfolio will not be realized if the loan pays off earlier than anticipated. Moreover, since most loans within the servicing portfolio do not contain penalty provisions for early payoff, a corresponding economic benefit will not be received if the loan pays off earlier than expected. MSR represent the discounted present value of the future net cash flows the Company expects to receive from the servicing portfolio. Accordingly, prepayment risk subjects the MSR to potential declines in fair value.
The Company estimates MSR fair value using a discounted cash flow model. The discounted cash flow model calculates the present value of the estimated future net cash flows of the servicing portfolio based on various factors, such as servicing costs, expected prepayment speeds and discount rates, about which management must make assumptions based on future expectations. While the Company’s model estimates a value, the specific value used is based on a variety of market-based factors, such as documented observable data and anticipated changes in prepayment speeds. The reasonableness of management’s assumptions about these factors is evaluated through quarterly independent broker surveys. Independent appraisals of the fair value of the servicing portfolio are obtained periodically, but not less frequently than quarterly, and are used by management to evaluate the reasonableness of the fair value conclusions.
Gain from home loans and originated mortgage-backed securities, net of hedging and risk management instruments, was $119 million in the third quarter of 2006, compared with $279 million in the same quarter of the prior year. With the slowdown in the housing market, home loan sales volume declined from $44.98 billion to $30.24 billion between those periods.
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 are recorded at the lower of cost or fair value. This accounting method requires declines in the fair value of these loans, to the extent such value is below their cost basis, to be immediately recognized in earnings, but any increases in the value of these loans that exceed their original cost basis may not be recorded until the loans are sold. However, all changes in the value of derivative instruments that are used to manage the interest rate risk of these loans must be recognized in earnings as those changes occur. At September 30, 2006, the amount by which the aggregate fair value of loans held for sale exceeded their aggregate cost basis was approximately $83 million.
All Other Noninterest Income Analysis
Revenue from sales and servicing of consumer loans of $355 million and $1.16 billion and credit card fees of $165 million and $456 million for the three and nine months ended September 30, 2006 is attributable to the addition of the Company’s credit card operations in the fourth quarter of 2005.
Depositor and other retail banking fees increased by $77 million and $267 million for the three and nine months ended September 30, 2006, compared with the same periods in 2005, due to higher levels of transaction fees and growth in the number of retail checking accounts. The number of retail checking accounts at September 30, 2006 totaled approximately 10.9 million, compared with approximately 9.7 million at September 30, 2005.
Insurance income decreased $11 million and $38 million for the three and nine months ended September 30, 2006, compared with the same periods in 2005, predominantly due to a decline in mortgage-related insurance income, as payoffs of loans with mortgage insurance more than offset insurance income generated from loan volume during the three and nine months ended September 30, 2006.
The decrease in trading assets income, excluding the revaluation gain or loss from trading securities used to economically hedge the MSR, for the three months and nine months ended September 30, 2006, compared to the same periods in 2005, was predominantly due to a change in the value of retained, residual interests held by Long Beach Mortgage. Also contributing to the decrease for the nine months ended September 30, 2006 was a $70 million decline in the fair value of basis floater interest-only securities.
Loss from sales of other available-for-sale securities during the nine months ended September 30, 2005 was primarily due to the partial restructuring of this portfolio in the first quarter of 2005 by selling approximately $3 billion of lower-yielding debt securities and replacing those assets by the purchase of debt securities with comparatively higher yields.
A significant portion of the increase in other income for the nine months ended September 30, 2006 compared to the same period in 2005 is due to a $134 million litigation award recorded by the Company in the first quarter of 2006 from the partial settlement of the Company’s claim against the U.S. Government with regard to the Home Savings supervisory goodwill lawsuit.
Noninterest expense from continuing operations consisted of the following:
Postage
110
60
84
356
92
Loan expense
67
330
188
842
565
Employee compensation and benefits expense remained relatively flat for the three months ended September 30, 2006 compared with the same period in 2005, as reductions in the total number of employees more than offset salaries and benefits expense related to the addition of the Company’s credit card operations and severance costs associated with the Company’s ongoing productivity and efficiency initiatives in 2006. Employee compensation and benefits expense increased for the nine months ended September 30, 2006 compared with the same period in 2005 mostly due to the increase in salaries and benefits expense related to the addition of the Company’s credit card operations and the addition of 174 retail banking stores in the last twelve months. The number of employees decreased from 56,214 at September 30, 2005 to 51,056 at September 30, 2006. Severance charges were approximately $22 million and $71 million for the three and nine months ended September 30, 2006.
The increases in occupancy and equipment expense for the three and nine months ended September 30, 2006 compared with the same periods in 2005 were primarily due to charges of approximately $28 million and $85 million related to the Company’s ongoing productivity and efficiency initiatives in 2006.
The increases in telecommunications and outsourced information services for the three and nine months ended September 30, 2006 compared with the same periods in 2005 were primarily due to the addition of the Company’s credit card operations.
The increases in advertising and promotion expense for the three and nine months ended September 30, 2006 were mostly due to marketing and other professional services expenses incurred due to the addition of the Company’s credit card operations.
Postage expense increased for the three and nine months ended September 30, 2006 compared with the same periods in 2005 primarily due to increased direct mail solicitation volume related to the Company’s credit card operations.
A significant portion of the increase in other expense from the third quarter of 2005 was due to transaction costs associated with the partial sale of the Company’s MSR asset and an increase in amortization of other intangibles expense related to the Company’s purchase of Providian in the fourth quarter of 2005.
Securities
Securities consisted of the following:
AmortizedCost
UnrealizedGains
UnrealizedLosses
FairValue
Mortgage-backed securities:
U.S. Government
Agency
13,666
13,627
Private issue
8,779
8,699
Total mortgage-backed securities
22,473
Investment securities:
404
400
3,491
3,462
Other debt securities
2,680
2,710
Equity securities
Total investment securities
6,663
29,136
145
(264
14,138
14,081
6,633
(84
6,567
20,771
(196
407
(36
2,514
988
94
4,039
24,810
(238
The realized gross gains and losses of securities for the periods indicated were as follows:
Realized gross gains
120
Realized gross losses
(77
(122
(308
Realized net loss
(31
(124
Loans held in portfolio consisted of the following:
Home:
Short-term adjustable-rate loans(1):
Option ARMs(2)
64,822
70,191
Other ARMs
18,695
14,666
Total short-term adjustable-rate loans
83,517
84,857
Medium-term adjustable-rate loans(3)
47,740
41,511
Fixed-rate loans
9,928
8,922
Total home loans(4)
141,185
135,290
54,364
50,851
Home construction(5)
2,077
2,037
27,407
25,601
5,869
5,035
230,902
218,814
8,807
8,043
281
638
1,775
Total loans held in portfolio(6)
(1) Short-term is defined as adjustable-rate loans that reprice within one year or less.
(2) The total amount by which the unpaid principal balance of Option ARM loans exceeded their original principal amount was $654 million at September 30, 2006 and $157 million at December 31, 2005.
(3) Medium-term is defined as adjustable-rate loans that reprice after one year.
(4) Includes specialty mortgage finance loans, which are comprised of purchased subprime home loans and subprime home loans originated by Long Beach Mortgage held in portfolio. Specialty mortgage finance loans were $20.08 billion and $21.15 billion at September 30, 2006 and December 31, 2005.
(5) Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(6) Includes net unamortized deferred loan origination costs of $1.61 billion and $1.53 billion at September 30, 2006 and December 31, 2005.
Other Assets
Other assets consisted of the following:
Accounts receivable
6,951
4,570
Investment in bank-owned life insurance
3,773
3,056
Premises and equipment
3,097
3,262
Accrued interest receivable
1,790
1,914
Restricted cash
960
Derivatives
606
Identifiable intangible assets
677
276
2,977
2,873
Total other assets
The increase in accounts receivable is primarily due to the sale of $2.53 billion of MSR in the third quarter of 2006.
The restricted cash balance at September 30, 2006 was the result of the transfer of cash to an escrow agent in conjunction with the purchase of Commercial Capital Bancorp, Inc. Those funds were disbursed shortly after the acquisition was completed on October 1, 2006.
Deposits consisted of the following:
Retail deposits:
Checking deposits:
Noninterest bearing
22,466
20,752
Interest bearing
33,761
42,253
Total checking deposits
56,227
63,005
39,481
36,664
47,361
40,359
Total retail deposits
143,069
140,028
Commercial business deposits
15,831
11,459
Wholesale deposits
40,666
29,917
Custodial and escrow deposits(1)
11,316
11,763
(1) Substantially all custodial and escrow deposits reside in noninterest-bearing checking accounts.
The increase in noninterest-bearing retail checking deposits was primarily driven by the Company’s new free checking product that was launched during the first quarter of 2006. Interest-bearing checking deposits decreased as customers shifted from Platinum checking accounts to time deposits and savings accounts as a result of higher rates offered for these products. Substantially all of the $4.37 billion increase from December 31, 2005 in commercial business deposits was due to increases in Mortgage Banker Finance money market accounts. Wholesale deposits increased 36% from year-end 2005, predominantly due to an increase in brokered certificates of deposits.
Transaction accounts (checking, savings and money market deposits) comprised 67% of retail deposits at September 30, 2006, compared with 71% at year-end 2005. These products generally have the benefit of lower interest costs, compared with time deposits, and represent the core customer relationship that is maintained within the retail banking franchise. At September 30, 2006, deposits funded 60% of total assets, compared with 56% at December 31, 2005.
Borrowings consisted of the following:
Total borrowings
During the quarter, the Company continued to diversify its mix of funding sources. FHLB advances of $47.25 billion at September 30, 2006 decreased $21.52 billion, or 31%, from December 31, 2005 as the Company replaced maturing advances with a higher proportion of wholesale deposits and debt instruments that were issued in domestic and international capital markets in a variety of structures. These instruments are reported in other borrowings. Advances from the San Francisco FHLB represented 80% of total FHLB advances at September 30, 2006.
The Company has four operating segments for the purpose of management reporting: the Retail Banking Group, the Card Services Group, the Commercial Group and the Home Loans Group. Refer to Note 7 to the Consolidated Financial Statements – “Operating Segments” for information regarding the key elements of management reporting methodologies used to measure segment performance.
During the fourth quarter of 2005, the Company announced its plans to reorganize its single family residential mortgage lending operations. This reorganization combined the Company’s subprime mortgage origination business, Long Beach Mortgage, as well as its Mortgage Banker Finance lending operations within the Home Loans Group. This change in structure was effective as of January 1, 2006 and was retrospectively applied to the prior period operating segment financial results for comparability.
The Company serves the needs of 19 million consumer households through its 2,225 retail banking stores, 465 lending stores and centers, 3,924 ATMs, telephone call centers and online banking.
Retail Banking Group
Inter-segment revenue
(14
Efficiency ratio
49.89
51.90
50.24
50.95
Loan volume
9,006
11,191
26,749
35,388
Employees at end of period
29,624
33,754
The increase in net interest income was predominantly due to an increase in deposit transfer pricing credits, which increased due to rising short-term interest rates. Generally, the Company’s transfer pricing methodology is closely aligned with current market interest rate conditions. The credits more than offset the increase in interest expense on such deposits.
The increase in noninterest incomeduring the three months ended September 30, 2006, compared with the same period in 2005, was largely due to a 14% growth in depositor and other retail banking fees reflecting higher levels of transaction fees and continued growth in the number of checking accounts. The number of retail checking accounts at September 30, 2006 totaled approximately 10.9 million, compared to approximately 9.7 million at September 30, 2005, an increase of over one million accounts.
The increase in noninterest expense was primarily due to increases in occupancy and equipment expense and advertising and promotion expense. The increase in occupancy and equipment expense is attributable to the continued expansion of the retail banking distribution network, which included the opening of 25 new retail banking stores in the third quarter of 2006 and 174 net new retail banking stores since September 30, 2005. Advertising and promotion expense increased due to the Company’s new free checking campaign.
The activities of WM Advisors, Inc. are reported within this segment as discontinued operations.
Card Services Group (Managed basis)
Three Months Ended
June 30, 2006
610
417
(17
387
Inter-segment expense
283
Income before income taxes
296
113
29.30
28.33
29.25
20,474
23,044
2,755
2,620
The Company evaluates the performance of the Card Services Group on a managed basis. Managed financial information is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and credit losses.
Following the acquisition of Providian Financial Corporation on October 1, 2005, the Company began integrating the Card Services Group into its management accounting process. During this period and through the third quarter of 2006, only the funds transfer pricing management accounting methodology and charges for legal services were applied to this segment. As the Card Services Group continues to incur charges related to the administrative support functions of the former Providian Financial Corporation, corporate overhead charges have not been allocated to this segment.
Net interest income increased $17 million in the third quarter of 2006 from the immediately preceding quarter due to a 6% increase in average loan balances, which more than offset higher funds transfer pricing charges.
The increase in average loan balances is largely the result of cross-selling credit card products to the retail banking customer base.
The Card Services Group’s credit performance continues to benefit from a lower level of bankruptcy-related charge-offs than occurred prior to the fourth quarter 2005 change in consumer bankruptcy law. The transfer of $403 million of higher risk credit card accounts to loans held for sale at the end of the third quarter, in anticipation of a transaction that is expected to occur during the fourth quarter, resulted in the remaining accounts in the credit card portfolio having more favorable credit risk scores than the loans transferred to held for sale. Accordingly, the provision for loan and lease losses benefited from the improved risk profile of that portfolio.
Noninterest income decreased $44 million in the third quarter of 2006, compared with the immediately preceding quarter, as higher credit card fees were offset by decreased revenue from sales and servicing of consumer loans.
Commercial Group
(11
(10
230
(37
26.57
27.45
28.20
23.12
3,104
3,003
8,835
8,300
1,246
1,259
The decrease in net interest income was substantially due to higher transfer pricing charges, which more than offset the growth in interest income generated from multi-family and other commercial loans held by this group. The increase in transfer pricing charges was due to higher short-term interest rates. Generally, the Company’s transfer pricing methodology is closely aligned with current market interest rate conditions.
A significant portion of the increase in noninterest income during the three months ended September 30, 2006, compared with the same period in 2005, was due to increased gain on loan sales. The decline in noninterest income for the nine months ended September 30, 2006 was predominantly due to a $59 million pretax gain on the sale of a real estate investment property during the first quarter of 2005.
Most of the business activities of Commercial Capital Bancorp, Inc., acquired on October 1, 2006, will be conducted through the Commercial Group operating segment.
Home Loans Group
(58
(49
293
132
(60
(46
Income (loss) before income taxes
(96
110.99
56.68
96.22
56.04
72
37,200
56,471
123,562
153,996
12,598
15,685
The decrease in net interest income was predominantly due to higher transfer pricing charges driven by increasing short-term interest rates and lower average balances of loans held for sale as a result of lower loan volumes. The average balance of loans held for sale during the third quarter of 2006 totaled $24.66 billion, compared with $48.59 billion for the third quarter of 2005. Total loan volume was $37.20 billion in the third quarter of 2006 compared with $56.47 billion for the same period last year.
The decrease in noninterest income was largely due to a less favorable MSR hedging environment in the third quarter of 2006 compared to the third quarter of 2005. Additionally, the gain from loan sales was lower due to the slowdown in the housing market.
The decrease in noninterest expense was primarily due to lower compensation and benefits expense resulting from a reduction in the number of employees.
56
Corporate Support/Treasury and Other
Net interest expense
203
Loss before income taxes
Income tax benefit
Net loss
80
(13
181
4,833
5,516
The increase in noninterest expense is predominantly due to transaction costs related to the sale of MSR and charges related to the Company’s ongoing productivity and efficiency initiatives.
Minority interest expense represents payment of dividends on preferred securities that were issued by a subsidiary during the first quarter of 2006.
Asset Securitization
The Company transforms loans into securities through a process known as securitization. When the Company securitizes loans, the loans are sold to a qualifying special-purpose entity (“QSPE”), typically a trust. The QSPE, in turn, issues securities, commonly referred to as asset-backed securities, which are secured by future cash flows on the sold loans. The QSPE sells the securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses the proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These QSPEs are not consolidated within the 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 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 the Company sells or securitizes loans, it generally retains 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 mortgage loan securitizations, excluding the rights to service such loans, were $1.98 billion at September 30, 2006, of which $1.43 billion have either a AAA credit rating or are agency insured. Retained interests in credit card securitizations were $1.72 billion at September 30, 2006. Additional information concerning securitization transactions is included in Notes 6 and 7 to the Consolidated Financial Statements – “Securitizations” and “Mortgage Banking Activities” in the Company’s 2005 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.”
The regulatory capital ratios of Washington Mutual Bank and Washington Mutual Bank fsb (“WMBfsb”) and minimum regulatory capital ratios to be categorized as well-capitalized were as follows:
Well-Capitalized
WMB
WMBfsb
Minimum
Tier 1 capital to adjusted total assets (leverage)
6.47
82.50
5.00
Adjusted Tier 1 capital to total risk-weighted assets
8.12
277.06
6.00
Total risk-based capital to total risk-weighted assets
11.30
277.94
10.00
The Company’s federal savings bank subsidiaries are also required by Office of Thrift Supervision regulations to maintain tangible capital of at least 1.50% of assets. WMB and WMBfsb satisfied this requirement at September 30, 2006.
The Company’s broker-dealer subsidiaries are also subject to capital requirements. At September 30, 2006, all of its broker-dealer subsidiaries were in compliance with their applicable capital requirements.
In 2005, the Company adopted a share repurchase program approved by the Board of Directors (the “2005 Program”). Under the 2005 Program, the Company was authorized to repurchase up to 100 million shares of its common stock, as conditions warranted. On July 18, 2006, the Company discontinued the 2005 Program and adopted a new share repurchase program approved by the Board of Directors (the “2006 Program”). Under the 2006 Program, the Company is authorized to repurchase up to 150 million shares of its common stock, as conditions warrant. There is no fixed termination date for the 2006 Program, and purchases may be made in the open market, through block trades, accelerated share repurchase transactions, private transactions, or otherwise. The Company repurchased 18.8 million and 65.8 million common shares in the three and nine months ended September 30, 2006, which includes the effects of two accelerated share repurchase transactions initiated in March 2006 and August 2006. Additional information regarding these transactions is included in Note 3 to the Consolidated Financial Statements – “Earnings Per Common Share.” Refer to Item 2 – “Unregistered Sales of Equity Securities and Use of Proceeds” for additional information regarding share repurchase activities conducted under the 2006 Program.
The Company is exposed to four major categories of risk: credit, liquidity, market and operational.
The Company’s Chief Enterprise Risk Officer is responsible for enterprise-wide risk management. The Company’s Enterprise Risk Management function oversees the identification, measurement, monitoring, control and reporting of credit, market and operational risk. The Company’s Treasury function is responsible for the measurement, management and control of liquidity risk. The Internal Audit function, which reports to the Audit Committee of the Board of Directors, independently assesses the Company’s compliance with risk management controls, policies and procedures.
The Board of Directors, assisted by the Audit and Finance Committees on certain delegated matters, oversees the Company’s monitoring and controlling of significant risk exposures, including the Company’s policies governing risk management. The Corporate Relations Committee of the Board of Directors oversees the Company’s reputation and those elements of operational risk that impact the Company’s reputation. Governance and oversight of credit, liquidity and market risks are provided by the Finance Committee of the Board of Directors. Governance and oversight of operational risks are provided by the
Audit Committee of the Board of Directors. Risk oversight is also provided by management committees whose membership includes representation from the Company’s lines of business and the Enterprise Risk Management function. These committees include the Enterprise Risk Management Committee, the Credit Risk Management Committee, the Market Risk Committee and the Asset and Liability Committee.
Enterprise Risk Management works with the lines of business to establish appropriate policies, standards and limits designed to maintain risk exposures within the Company’s risk tolerance. Significant risk management policies approved by the relevant management committees are also reviewed and approved by the Board, Audit, and Finance Committees. Enterprise Risk Management also provides objective oversight of risk elements inherent in the Company’s business activities and practices, oversees compliance with laws and regulations, and reports periodically to the Board of Directors.
Management is responsible for balancing risk and reward in determining and executing business strategies. Business lines, Enterprise Risk Management and Treasury divide the responsibilities of conducting measurement and monitoring of the Company’s risk exposures. Risk exceptions, depending on their type and significance, are elevated to management or Board committees responsible for oversight.
Credit risk is the risk of loss arising from adverse changes in a borrower’s or counterparty’s ability to meet its financial obligations under agreed-upon terms and exists primarily in lending and derivative portfolios. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the borrower, the contractual terms of the agreement and the availability and quality of collateral. Credit risk management is based on analyzing the creditworthiness of the borrower, the adequacy of underlying collateral given current events and conditions and the existence and strength of any guarantor support.
Nonaccrual Loans, Foreclosed Assets and Restructured Loans
Loans, excluding credit card loans, are generally placed on nonaccrual status upon reaching 90 days 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 or 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. Nonaccrual loans and foreclosed assets (“nonperforming assets”) and restructured loans consisted of the following:
June 30,2006
Nonperforming assets and restructured loans:
Nonaccrual loans(1)(2):
568
512
Specialty mortgage finance(3)
1,114
1,085
Total home nonaccrual loans
1,682
1,597
1,437
Home construction(4)
Total nonaccrual loans secured by real estate
1,970
1,813
1,630
Consumer
Total nonaccrual loans held in portfolio
1,830
1,686
Foreclosed assets(5)
Total nonperforming assets
2,160
1,962
As a percentage of total assets
0.62
0.57
Total nonperforming assets and restructured loans
2,180
1,984
(1) Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $129 million, $122 million and $245 million at September 30, 2006, June 30, 2006 and December 31, 2005. Loans held for sale are accounted for at lower of aggregate cost or fair value, with valuation changes included as adjustments to noninterest income.
(2) Credit card loans are exempt under regulatory rules from being classified as nonaccrual because they are charged off when they are determined to be uncollectible, or by the end of the month in which the account becomes 180 days past due.
(3) Represents purchased subprime home loan portfolios and subprime home loans originated by Long Beach Mortgage and held in its investment portfolio.
(4) Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(5) Foreclosed real estate securing Government National Mortgage Association (“GNMA”) loans of $129 million, $142 million and $79 million at September 30, 2006, June 30, 2006 and December 31, 2005 have been excluded. These assets are fully collectible as the corresponding GNMA loans are insured by the Federal Housing Administration (“FHA”) or guaranteed by the Department of Veteran’s Affairs (“VA”).
Allowance for Loan and Lease Losses
The allowance for loan and lease losses represents management’s estimate of incurred 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, the credit profile of borrowers, adverse situations that have occurred that may affect the borrowers’ ability to repay, the existence and estimated value of underlying collateral, the interest rate climate as it affects adjustable-rate loans and general economic conditions.
The dynamics involved in determining inherent credit losses can vary considerably based on the existence, type and quality of the security underpinning the loan and the credit characteristics of the borrower. Hence, real estate secured loans are generally accorded a proportionately lower allowance for loan and lease losses than unsecured credit card loans held in portfolio. Similarly, loans to higher risk borrowers, in the absence of mitigating factors, are generally accorded a proportionately higher allowance for loan and lease losses. Certain real estate secured loans that have features which may result in increased credit risk when compared to real estate secured loans without those features are discussed in the Company’s 2005 Annual Report on Form 10-K/A, “Credit Risk Management – Features of Residential Loans” and Note 5 to the Consolidated Financial Statements – “Loans and Allowance for Loan and Lease Losses – Features of Residential Loans.”
In determining the allowance for loan and lease losses, the Company allocates a portion of the allowance to its various loan product categories based on an analysis of individual loans and pools of loans. The tools utilized for this determination include statistical forecasting models that estimate the default and loss outcomes based on an evaluation of past performance of loans in the Company’s portfolio and other factors as well as industry historical loss data (primarily for homogeneous loan portfolios). Non-homogeneous loans are individually reviewed and assigned loss factors commensurate with the applicable level of estimated risk.
Refer to Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies” in the Company’s 2005 Annual Report on Form 10-K/A for further discussion of the Allowance for Loan and Lease Losses.
Changes in the allowance for loan and lease losses were as follows:
1,663
1,243
1,695
Allowance transferred to loans held for sale
(125
-
(242
1,704
1,295
1,371
Loans charged off:
Specialty mortgage finance(1)
(41
(81
Total home loans charged off
(115
(67
(26
Home construction(2)
(72
(148
(254
Total loans charged off
(179
(437
(147
Recoveries of loans previously charged off:
Total home loan recoveries
Total recoveries of loans previously charged off
(154
(375
(107
Net charge-offs (annualized) as a percentage of average loans held in portfolio
0.26
0.06
0.21
0.07
(1) Represents purchased subprime loan portfolios and subprime loans originated by Long Beach Mortgage that are designated as held for investment.
(2) Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
90 Days or More Past Due and Still Accruing
The total amount of loans held in portfolio, excluding credit card loans, that were 90 days or more contractually past due and still accruing interest were $79 million at September 30, 2006, $88 million at June 30, 2006 and $107 million at December 31, 2005. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest. Managed credit card loans that were 90 days or more contractually past due and still accruing interest were $631 million, $504 million and $465 million at September 30, 2006, June 30, 2006 and December 31, 2005, including $73 million, $119 million and $87 million related to loans held in portfolio. The delinquency rate on managed credit card loans that were 30 days or more delinquent at September 30, 2006, June 30, 2006 and December 31, 2005 was 5.99%, 5.23% and 5.07%. Excluding managed credit card loans held for sale that were 30 days or more delinquent at September 30, 2006, the delinquency rate would be 5.53%.
As a result of regulatory guidelines issued in 2003, delinquent mortgages contained within GNMA servicing pools that are repurchased or are eligible to be repurchased by the Company must be reported as loans on the Consolidated Statements of Financial Condition. As the Company sells most of these repurchased loans to secondary market participants, they are classified as loans held for sale on the Consolidated Statements of Financial Condition. The Company’s held for sale portfolio contained $313 million, $796 million and $1.06 billion of such loans that were 90 days or more contractually past due and still accruing interest at September 30, 2006, June 30, 2006 and December 31, 2005.
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. The Company generally manages its derivative counterparty credit risk through the active use of collateralized trading agreements. Further, the Company monitors all exposure and collateral requirements daily. The fair value of collateral received from a counterparty is continually monitored and the Company may request additional 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 September 30, 2006 and December 31, 2005, the gross positive fair value of the Company’s derivative financial instruments was $505 million and $792 million. The Company’s master netting agreements at September 30, 2006 and December 31, 2005 reduced the exposure to this gross positive fair value by $338 million and $561 million. The Company’s collateral against derivative financial instruments was $17 million and $82 million at September 30, 2006 and December 31, 2005. Accordingly, the Company’s net exposure to derivative counterparty credit risk at September 30, 2006 and December 31, 2005 was $150 million and $149 million.
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 its other obligations 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. The Company also maintains contingency liquidity plans that outline alternative actions and enable appropriate and timely responses under stress scenarios.
Washington Mutual, Inc.
Liquidity for Washington Mutual, Inc. (“the Parent Company”) is generated through its ability to raise funds through dividends from subsidiaries and in various capital markets through the issuance of unsecured debt, commercial paper and other securities.
One of Washington Mutual, Inc.’s key funding sources is from dividends paid by its banking subsidiaries. Banking subsidiaries dividends may fluctuate 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 the Parent Company’s banking subsidiaries. For more information on such dividend limitations applicable to the Company’s banking subsidiaries, refer to the Company’s 2005 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.”
In January 2006, the Company filed an automatically effective registration statement under the Securities Offering Reform rules recently adopted by the SEC. The Company registered an unlimited amount of debt securities, preferred stock and depositary shares on this registration statement.
Liquidity sources for Washington Mutual, Inc. include a commercial paper program and a revolving credit facility. At September 30, 2006, the commercial paper program provided for up to $1 billion in funds. In addition, the Company’s revolving credit facility of $800 million provides credit support for Washington Mutual, Inc.’s commercial paper program as well as funds for general corporate purposes. At September 30, 2006, Washington Mutual, Inc. had no commercial paper outstanding and the entire amount of the revolving credit facility was available.
The Parent Company’s senior debt and commercial paper was rated A and F1 by Fitch, A3 and P2 by Moody’s and A- and A2 by Standard and Poor’s.
Washington Mutual, Inc. maintains sufficient liquidity to cover all debt obligations maturing over the next twelve months.
Banking Subsidiaries
The principal sources of liquidity for the Company’s banking subsidiaries are customer deposits, wholesale borrowings, the maturity and repayment of portfolio loans, securities held in the available-for-sale portfolio and mortgage loans designated as held for sale. Among these sources, retail deposits, wholesale deposits, borrowings from FHLB advances, repurchase agreements and federal funds purchased continue to provide the Company with a significant source of stable funding. During the first nine months of 2006, those sources funded 68% of average total assets. The Company’s continuing ability to retain its transaction account 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 deposit products. The Company continues to have the necessary assets available to pledge as collateral to obtain additional FHLB advances and repurchase agreements to offset potential declines in deposit balances.
For the nine months ended September 30, 2006, the Company’s proceeds from the sales of loans were approximately $100 billion. These proceeds were, in turn, used as the primary funding source for the origination and purchase, net of principal payments, of approximately $94 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 mortgage banking operations does not significantly affect the Company’s overall level of liquidity resources.
The Company’s banking subsidiaries also raise funds in domestic and international capital markets to supplement their primary funding sources. In August 2003, the Company established a Global Bank Note Program that allows Washington Mutual Bank to issue senior and subordinated notes in the United States
and in international capital markets in a variety of currencies and structures. The program was renewed in December 2005. Washington Mutual Bank had $15.83 billion available under this program at September 30, 2006.
In September 2006, Washington Mutual Bank launched a EUR 20 billion (approximately $25 billion) covered bond program that will diversify its investor base, lengthen the maturity profile of its liabilities and provide an additional significant source of stable funding. Under the program, the Company will, from time to time, issue floating rate USD-denominated mortgage bonds secured on its portfolio of residential mortgage loans. At September 30, 2006 approximately $5 billion of covered bonds were outstanding.
Senior unsecured long-term obligations of Washington Mutual Bank were rated A by Fitch, A2 by Moody’s and A by Standard and Poor’s. Short-term obligations were rated F1 by Fitch, P1 by Moody’s and A1 by Standard and Poor’s.
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 the Company is exposed is interest rate risk. Substantially all of its 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.
The Company’s trading assets are primarily comprised of financial instruments that are retained from securitization transactions, or are purchased for MSR risk management purposes. The Company does not take significant short-term trading positions for the purpose of benefiting from price differences between financial instruments and markets.
Interest rate risk is managed within a consolidated enterprise risk management framework that includes asset/liability management and the 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 the Board. The Board has delegated the oversight of the administration of this policy to the Finance Committee of the Board.
MSR Risk Management
The Company manages potential changes in the fair value of MSR through a comprehensive risk management program. The intent is to mitigate the effects of changes in MSR fair value through the use of risk management instruments. The risk management instruments include interest rate contracts, forward rate agreements, forward purchase commitments and available-for-sale and trading securities. The 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 interest rate contracts typically consist of interest rate swaps, interest rate swaptions, interest rate futures and interest rate caps and floors. The Company may purchase or sell option contracts, depending on the portfolio risks it seeks to manage. The Company also enters into forward commitments to purchase and sell mortgage-backed securities, which generally are comprised of fixed-rate mortgage-backed securities with 15 or 30 year maturities.
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 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 Company manages the MSR daily and adjusts the mix of instruments used to offset 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. The Company also manages the size of the MSR asset, such as through the structuring of servicing agreements when loans are sold, and by periodically selling or purchasing servicing assets.
The Company believes 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 decisions regarding the amount, type and mix of MSR risk management instruments that are selected to manage the changes in fair value of the mortgage servicing asset. If this strategy is not successful, net income could be adversely affected.
Other Mortgage Banking Risk Management
The Company also manages the risks associated with its home loan mortgage warehouse and pipeline. The mortgage warehouse consists of funded loans intended for sale in the secondary market. The pipeline consists of commitments to originate or purchase mortgages to be sold in the secondary market. The risk associated with the mortgage pipeline and warehouse is the potential for changes in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold.
The Company measures the risk profile of the mortgage warehouse and pipeline daily. To manage the warehouse and pipeline risk, management executes forward sales commitments, interest rate contracts and mortgage option contracts. A forward sales commitment protects against a rising interest rate environment, since the sales price and delivery date are already established. A forward sales commitment is different, however, from an option contract in that the Company is obligated to deliver the loan to the third party on the agreed-upon future date. Management also estimates the fallout factor, which represents the percentage of loans that are not expected to be funded, when determining the appropriate amount of pipeline risk management instruments.
Asset/Liability Risk Management
The purpose of asset/liability risk management is to assess the aggregate interest rate risk profile of the Company. Asset/liability risk analysis combines the MSR and Other Mortgage Banking activities with substantially all of the other remaining interest rate risk positions inherent in the Company’s operations.
To analyze net income sensitivity, management projects net income in a variety of interest rate scenarios, assuming both parallel and non-parallel shifts in the yield curve. These scenarios illustrate net interest income sensitivity that results from changes in the slope of the yield curve and changes in the spread between Treasury and LIBOR rates. The net income simulations also demonstrate projected changes in MSR and MSR hedging activity under a variety of scenarios. Additionally, management projects the fair market values of assets and liabilities under different interest rate scenarios to assess their risk exposure over longer periods of time.
The projection of the sensitivity of net interest income and net income requires numerous assumptions. Prepayment speeds, decay rates (the estimated runoff of deposit accounts that do not have a stated maturity), future deposit and loan rates and loan and deposit volume and mix projections are among the most significant assumptions. Prepayments affect the size of the loan and mortgage-backed securities portfolios, which impacts net interest income. All deposit and loan portfolio assumptions, including loan prepayment speeds and deposit decay rates, require management’s judgments of anticipated customer behavior in various interest rate environments. These assumptions are derived from internal and external
66
analyses. The rates on new investment securities are estimated based on secondary market rates while the rates on loans are estimated based on the rates offered by the Company to retail customers.
The slope of the yield curve, current interest rate conditions and the speed of changes in interest rates all affect sensitivity to changes in interest rates. Short-term borrowings and, to a lesser extent, interest-bearing deposits typically reprice faster than the Company’s adjustable-rate assets. This lag effect is inherent in 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. Management generally assumes a reduction in total loan production in rising long-term interest rate scenarios accompanied by a shift towards a greater proportion of adjustable-rate production. Conversely, the Company generally assumes an increase in total loan production in falling long-term interest rate scenarios accompanied by a shift towards a greater proportion of fixed-rate loans. The gain from mortgage loans also varies under different interest rate scenarios. Normally, the gain from mortgage loans increases in falling long-term interest rate environments primarily from high fixed-rate mortgage refinancing activity. Conversely, the gain from mortgage loans may decline when long-term interest rates increase if management chooses to retain more loans in the portfolio.
In periods of rising interest rates, the net interest margin normally contracts since the repricing period of the Company’s liabilities is shorter than the repricing period of its 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 utilizes the interest rate risk characteristics of the 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 interest rate risk are countercyclical. Management may adjust the amount or mix of risk management instruments based on the countercyclical behavior of the balance sheet products.
When the countercyclical behavior inherent in portions of the Company’s 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 management instruments. These contracts are often used to modify the repricing period of interest-bearing funding sources with the intention of reducing the volatility of net interest income. The types of contracts used for this purpose may consist of interest rate swaps, interest rate corridors, interest rate swaptions and certain derivatives that are embedded in borrowings. Management also uses receive-fixed swaps as part of the asset/liability risk management strategy to help modify the repricing characteristics of certain long-term liabilities to match those of the assets. Typically, these are swaps of long-term fixed-rate debt to a short-term adjustable-rate, which more closely resembles asset repricing characteristics.
October 1, 2006 and January 1, 2006 Sensitivity Comparison
The table below indicates the sensitivity of net interest income and net income as a result of hypothetical interest rate movements on market risk sensitive instruments. The base case used for this sensitivity analysis is similar to the Company’s most recent earnings projection for the respective twelve-month periods as of the date the analysis was performed. The comparative results assume parallel shifts in the yield curve with interest rates rising 100 basis points and decreasing 100 basis points in even quarterly increments over the twelve-month periods ending September 30, 2007 and December 31, 2006.
These analyses also incorporate assumptions about balance sheet dynamics such as loan and deposit growth and pricing, changes in funding mix and asset and liability repricing and maturity characteristics. 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 October 1, 2006 analysis reflects the sale of $2.53 billion of mortgage servicing rights in July 2006.
Comparative Net Interest Income and Net Income Sensitivity
Gradual Change in Rates
-100 basis points
+100 basis points
Net interest income change for the one-year period beginning:
October 1, 2006
4.36
(3.05
January 1, 2006
(2.45
Net income change for the one-year period beginning:
1.15
(1.92
(3.27
Net interest income was adversely impacted by rising short-term rates and the continued flattening of the yield curve. Short-term interest rates have increased approximately 80 basis points since December 31, 2005 while long-term rates have increased approximately 25 basis points. These yield curve movements have resulted in flat to slightly inverted Treasury and LIBOR curves at September 30, 2006.
Net interest income was projected to increase in the -100 basis point scenario primarily due to the projected expansion of the net interest margin. Net income was projected to increase although the favorable impact of net interest income was partially offset by adverse changes in other income in this scenario.
Net interest income was projected to decrease in the +100 basis point scenario mainly due to projected contraction of the net interest margin. Net income was also projected to decline in this scenario mainly due to the adverse impact of net interest income.
These sensitivity analyses are limited in that they were performed at a particular point in time. The analyses assume management does not initiate strategic actions, such as increasing or decreasing term funding or selling assets, to offset the impact of projected changes in net interest income or net income in these scenarios. The analyses are also dependent on the reliability 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 gain from mortgage loans that result from changes in interest rates. These analyses also assume that the projected MSR risk management strategy is effectively implemented and that mortgage and interest rate swap spreads are constant in all interest rate environments. These assumptions may not be realized. For example, changes in spreads between interest rate indices could result in significant changes in projected net income sensitivity. Projected net income may increase if market rates on interest rate swaps decrease by more than the decrease in mortgage rates, while the projected net income may decline if the rates on swaps increase by more than mortgage rates. Accordingly, the preceding sensitivity estimates should not be viewed as an earnings forecast.
Operational risk is the risk of loss resulting from human fallibility, inadequate or failed internal processes and systems, or from external events, including loss related to legal risk. Operational risk can occur in any activity, function, or unit of the Company.
Primary responsibility for managing operational risk rests with the lines of business. Each line of business is responsible for identifying its operational risks and establishing and maintaining appropriate business-specific policies, internal control procedures and tools to monitor these risks. To help identify, assess and manage corporate-wide risks, the Company uses corporate support groups such as Legal, Compliance, Information Security, Continuity Assurance, Strategic Sourcing and Finance. These groups assist the lines of business in the development and implementation of risk management practices specific to the needs of each business.
The Operational Risk Management Policy, approved by the Audit Committee of the Board of Directors, establishes the Company’s operational risk framework and defines the roles and responsibilities for the management of operational risk. The operational risk framework consists of a methodology for identifying, measuring, monitoring and controlling operational risk combined with a governance process that complements the Company’s organizational structure and risk management philosophy. The Enterprise Risk Management Committee is responsible for operational risk measurement, ensures consistent communication and oversight of significant operational risk issues across the Company and ensures sufficient resources are allocated to maintain business-specific operational risk controls, policies and practices consistent with and in support of the operational risk framework and corporate standards. The Operational Risk Management function, part of Enterprise Risk Management, is responsible for maintaining the operational risk framework and works with the lines of business and corporate support functions to ensure consistent and effective policies, practices, controls and monitoring tools for assessing and managing operational risk across the Company. The objective of the framework is to provide an integrated risk management approach that emphasizes proactive management of operational risk using measures, tools and techniques that are risk-focused and consistently applied company-wide.
The Company has a process for identifying and monitoring operational loss event data, thereby permitting root cause analysis and monitoring of trends by line of business, process, product and risk-type. This analysis is essential to sound risk management and supports the Company’s process management and improvement efforts.
PART II – OTHER INFORMATION
In the ordinary course of business, the Company and its subsidiaries are routinely defendants in or parties to a number of pending and threatened legal actions and proceedings, including actions brought on behalf of various classes of claimants. In certain of these actions and proceedings, claims for substantial monetary damages are asserted against the Company and its subsidiaries. Certain of these actions and proceedings are based on alleged violations of consumer protection, banking and other laws.
In July 2004, the Company and a number of its officers were named as defendants in a series of cases alleging violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 thereunder and Section 20(a) of the Exchange Act. By stipulation, those cases were consolidated into a single case currently pending in the U.S. District Court for the Western Division of Washington. South Ferry L.P. #2 v. Killinger et al., No. CV04-1599C (W.D. Wa., Filed Jul. 19, 2004) (the “Securities Action”). In brief, the plaintiffs in the Securities Action allege, on behalf of a putative class of purchasers of Washington Mutual, Inc. securities from April 15, 2003, through June 28, 2004, that in various public statements the defendants purportedly made misrepresentations and failed to disclose material facts concerning, among other things, alleged internal systems problems and hedging issues.
The defendants moved to dismiss the Securities Action on May 17, 2005. After briefing, but without oral argument, the Court on November 17, 2005, denied the motion in principal part; however, the Court dismissed the claims against certain of the individual defendants, dismissed claims pleaded on behalf of sellers of put options on Washington Mutual stock, and concluded that the plaintiffs could not rely on supposed violations of accounting standards to support their claims. The remaining defendants subsequently moved for reconsideration or, in the alternative, certification of the opinion for interlocutory appeal to the United States Court of Appeals for the Ninth Circuit. The District Court denied the motion for reconsideration, but on March 6, 2006, granted the motion for certification. At the same time, the District Court stayed further proceedings before it pending the outcome of any proceedings before the Ninth Circuit.
The defendants thereafter moved the Ninth Circuit to have the Appellate Court accept the case for interlocutory review of the District Court’s original order denying the motion to dismiss. On June 9, 2006, the Ninth Circuit granted the defendants’ motion, indicating that the Court will hear the merits of the defendants’ appeal. The Appellate Court subsequently set a briefing schedule pursuant to which the defendants filed their initial brief on September 25, 2006. Subsequently, the parties stipulated that the plaintiffs’ response brief will be filed no later than December 11, 2006, and the defendants’ reply will be due no later than February 8, 2007.
On November 29, 2005, 12 days after the District Court denied the motion to dismiss the Securities Action, a separate plaintiff filed in Washington State Superior Court a derivative shareholder lawsuit purportedly asserting claims for the benefit of the Company. The case was removed to federal court, where it is now pending. Lee Family Investments, by and through its Trustee W.B. Lee, Derivatively and on behalf of Nominal Defendant Washington Mutual, Inc. v. Killinger et al., No. CV05-2121C (W.D. Wa., Filed Nov. 29, 2005) (the “Derivative Action”). The defendants in the Derivative Action include those individuals remaining as defendants in the Securities Action, as well as those of the Company’s current independent directors who were directors at any time from April 15, 2003, through June 2004. The allegations in the Derivative Action mirror those in the Securities Action, but seek relief based on claims that the independent director defendants failed properly to respond to the misrepresentations alleged in the Securities Action and that the filing of that action has caused the Company to expend sums to defend itself and the individual defendants and to conduct internal investigations related to the underlying claims. At the end of February 2006, the parties submitted a stipulation to the Court that the matter be stayed pending the outcome of the Securities Action. On March 2, 2006, the Court entered an Order pursuant to that stipulation, staying the Derivative Action in its entirety.
Refer to Note 15 to the Consolidated Financial Statements – “Commitments, Guarantees and Contingencies” in the Company’s 2005 Annual Report on Form 10-K/A for a further discussion of pending and threatened litigation action and proceedings against the Company.
The table below represents share repurchases made by the Company for the quarter ended September 30, 2006. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.
Issuer Purchases of Equity Securities
(a) TotalNumberof Shares(or Units)Purchased(1)
(b) AveragePrice Paidper Share(or Unit)
(c) TotalNumber ofShares (or Units)Purchased asPart of PubliclyAnnouncedPlans orPrograms(2)
(d) MaximumNumber (orApproximateDollar Value)of Shares(or Units) thatMay Yet BePurchasedUnder the Plansor Programs
July 3, 2006 to July 31, 2006
133,326
45.48
150,000,000
August 1, 2006 to August 31, 2006
16,000,779
47.06
16,000,000
134,000,000
September 1, 2006 to September 29, 2006
2,806,331
41.98
2,800,000
131,200,000
18,940,436
46.30
18,800,000
(1) In addition to shares repurchased pursuant to the Company’s publicly announced repurchase program, this column includes shares acquired under equity compensation arrangements with the Company’s employees and directors.
(2) Effective July 18, 2006, the Company adopted a share repurchase program approved by the Board of Directors (the “2006 Program”). Under the 2006 Program, the Company is authorized to repurchase up to 150 million shares of its common stock as conditions warrant and had repurchased 18,800,000 shares under this program as of September 30, 2006.
For a discussion regarding working capital requirements and dividend restrictions applicable to the Company’s banking subsidiaries, refer to the Company’s 2005 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.”
None.
(a) Exhibits
See Index of Exhibits on page 73.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on November 9, 2006.
By:
/s/ THOMAS W. CASEY
Thomas W. Casey
Executive Vice President and Chief Financial Officer
/s/ JOHN F. WOODS
John F. Woods
Senior Vice President and Controller (Principal Accounting Officer)
WASHINGTON MUTUAL, INC.INDEX OF EXHIBITS
Exhibit No.
3.1
Amended and Restated Articles of Incorporation of the Company, as amended (Filed herewith).
3.2
Restated Bylaws of the Company as amended (Incorporated by reference to the Company’s Current Report on Form 8-K filed June 28, 2006. File No. 001-14667).
4.1
The Company will furnish upon request copies of all instruments defining the rights of holders of long-term debt instruments of the Company and its consolidated subsidiaries.
31.1
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Filed herewith).
31.2
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Filed herewith).
32.1
Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished herewith).
32.2
Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Furnished herewith).
99.1
Computation of Ratios of Earnings to Fixed Charges (Filed herewith).