UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
or
Commission File Number 1-14667
WASHINGTON MUTUAL, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
(206) 461-2000
(Registrant’s telephone number, including area code)
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 ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
The number of shares outstanding of the issuer’s classes of common stock as of July 31, 2003:
Common Stock – 923,252,415(1)
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
FOR THE QUARTER ENDED JUNE 30, 2003
TABLE OF CONTENTS
PART I Financial Information
Item 1. Financial Statements
Consolidated Statements of Income—Three and Six Months Ended June 30, 2003 and 2002
Consolidated Statements of Financial Condition—June 30, 2003 and December 31, 2002
Consolidated Statements of Stockholders’ Equity and Comprehensive Income—Six Months Ended June 30, 2003 and 2002
Consolidated Statements of Cash Flows—Six Months Ended June 30, 2003 and 2002
Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statements
Controls and Procedures
Critical Accounting Policies
Recently Issued Accounting Standards
Summary Financial Data
Earnings Performance
Review of Financial Condition
Operating Segments
Off-Balance Sheet Activities
Asset Quality
Liquidity
Capital Adequacy
Market Risk Management
Maturity and Repricing Information
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II Other Information
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K
PART I—FINANCIAL INFORMATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Interest Income
Loans held for sale
Loans held in portfolio
Available-for-sale securities
Other interest and dividend income
Total interest income
Interest Expense
Deposits
Borrowings
Total interest expense
Net interest income
Provision for loan and lease losses
Net interest income after provision for loan and lease losses
Noninterest Income
Home loan mortgage banking income (expense):
Loan servicing fees
Amortization of mortgage servicing rights
Mortgage servicing rights impairment
Revaluation gain from derivatives
Net settlement income from certain interest-rate swaps
Gain from mortgage loans
Other home loan mortgage banking income, net
Total home loan mortgage banking income
Depositor and other retail banking fees
Securities fees and commissions
Insurance income
Portfolio loan related income
Gain (loss) from other available-for-sale securities
(Loss) gain on extinguishment of securities sold under agreements to repurchase
Other income
Total noninterest income
Noninterest Expense
Compensation and benefits
Occupancy and equipment
Telecommunications and outsourced information services
Depositor and other retail banking losses
Amortization of other intangible assets
Advertising and promotion
Professional fees
Other expense
Total noninterest expense
Income before income taxes
Income taxes
Net Income
Net Income Attributable to Common Stock
Net income per common share:
Basic
Diluted
Dividends declared per common share
Basic weighted average number of common shares outstanding (in thousands)
Diluted weighted average number of common shares outstanding (in thousands)
See Notes to Consolidated Financial Statements.
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CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
Assets
Cash and cash equivalents
Federal funds sold and securities purchased under resale agreements
Available-for-sale securities, total amortized cost of $43,306 and $42,592:
Mortgage-backed securities (including assets pledged of $7,433 and $6,570)
Investment securities (including assets pledged of $15,686 and $10,679)
Allowance for loan and lease losses
Total loans held in portfolio, net of allowance for loan and lease losses
Investment in Federal Home Loan Banks
Mortgage servicing rights
Goodwill
Other assets
Total assets
Liabilities
Deposits:
Noninterest-bearing deposits
Interest-bearing deposits
Total deposits
Federal funds purchased and commercial paper
Securities sold under agreements to repurchase
Advances from Federal Home Loan Banks
Other borrowings
Other liabilities
Total liabilities
Stockholders’ Equity
Common stock, no par value: 1,600,000,000 shares authorized, 924,237,997 and 944,046,787 shares issued and outstanding
Capital surplus—common stock
Accumulated other comprehensive income
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME
BALANCE, December 31, 2001
Comprehensive income:
Net income
Other comprehensive income (loss), net of tax:
Net unrealized gain from securities arising during the period, net of reclassification adjustments
Net unrealized loss on cash flow hedging instruments
Minimum pension liability adjustment
Total comprehensive income
Cash dividends declared on common stock
Cash dividends declared on redeemable preferred stock
Common stock repurchased and retired
Common stock issued for acquisitions
Fair value of Dime stock options
Common stock issued
BALANCE, June 30, 2002
BALANCE, December 31, 2002
BALANCE, June 30, 2003
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended
June 30,
Cash Flows from Operating Activities
Adjustments to reconcile net income to net cash (used) provided by operating activities:
(Gain) loss from securities
Loss (gain) on extinguishment of securities sold under agreements to repurchase
Depreciation and amortization
Stock dividends from Federal Home Loan Banks
Origination and purchases of loans held for sale, net of principal payments
Proceeds from sales of loans held for sale
Decrease (increase) in other assets
Decrease in other liabilities
Net cash (used) provided by operating activities
Cash Flows from Investing Activities
Purchases of securities
Proceeds from sales and maturities of mortgage-backed securities
Proceeds from sales and maturities of other available-for-sale securities
Principal payments on securities
Purchases of Federal Home Loan Bank stock
Redemption of Federal Home Loan Bank stock
Proceeds from sales of mortgage servicing rights
Origination and purchases of loans held in portfolio
Principal payments on loans held in portfolio
Proceeds from sales of foreclosed assets
Net (increase) decrease in federal funds sold and securities purchased under resale agreements
Net cash used for acquisitions
Purchases of premises and equipment, net
Net cash (used) provided by investing activities
(The Consolidated Statements of Cash Flows are continued on the next page.)
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(Continued from the previous page.)
Cash Flows from Financing Activities
Increase in deposits
Increase (decrease) in short-term borrowings
Proceeds from long-term borrowings
Repayments of long-term borrowings
Proceeds from advances from Federal Home Loan Banks
Repayments of advances from Federal Home Loan Banks
Cash dividends paid on preferred and common stock
Repurchase of common stock
Other
Net cash provided (used) by financing activities
Increase in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
Noncash Activities
Loans exchanged for mortgage-backed securities
Real estate acquired through foreclosure
Cash Paid During the Period for
Interest on deposits
Interest on borrowings
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1: Accounting Policies
Basis of Presentation
The accompanying Consolidated Financial Statements are unaudited and include the accounts of Washington Mutual, Inc. (together with its subsidiaries “Washington Mutual” or the “Company”). Washington Mutual’s accounting and financial reporting policies are in accordance with accounting principles generally accepted in the United States of America. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such periods. Such adjustments are of a normal recurring nature unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with Washington Mutual, Inc.’s 2002 Annual Report on Form 10-K. Certain prior period amounts have been reclassified to conform to current period classifications.
Recently Adopted Accounting Standards
In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. This Interpretation provides guidance on how to identify a variable interest entity and determine when the assets, liabilities, noncontrolling interests and results of operations of a variable interest entity should be consolidated by the primary beneficiary. The primary beneficiary is the enterprise that will absorb a majority of the variable interest entity’s expected losses or receive a majority of the expected residual returns as a result of holding variable interests. The recognition and measurement provisions of this Interpretation apply at inception to any variable interest entity formed after January 31, 2003, and become effective for existing variable interest entities on the first interim or annual reporting period beginning after June 15, 2003. The Company adopted the provisions of FIN 46 for variable interest entities formed on or after February 1, 2003, which did not have a material effect on the Company’s Consolidated Financial Statements. The Company adopted the provisions of FIN 46 for existing variable interest entities on July 1, 2003. As of June 30, 2003, the Company had variable interests in securitization trusts, which are discussed in the 2002 Annual Report on Form 10-K in Note 5 to the Consolidated Financial Statements— “Mortgage Banking Activities.” These trusts are qualifying special-purpose entities, which are exempt from the consolidation requirements of FIN 46. The Company reports its rights and obligations related to these qualifying special-purpose entities according to the requirements of Statement of Financial Accounting Standards (“Statement” or “SFAS”) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. The Company has not identified any unconsolidated investments in variable interest entities that are not qualifying special-purpose entities as of June 30, 2003.
In December 2002, the FASB issued Statement No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, which amends Statement No. 123, Accounting for Stock-Based Compensation. This Statement provides alternative methods of transitioning, on a voluntary basis, from the intrinsic value method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, to the fair value method of accounting for stock-based employee compensation. Effective January 1, 2003 and in accordance with the transitional guidance of Statement No. 148, the Company elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. Stock-based awards granted prior to January 1, 2003, and not modified after December 31, 2002, will continue to be accounted for under APB Opinion No. 25.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value method consistent with Statement No. 123 for all periods presented, the Company’s net income attributable to common stock and net income per common share would have been reduced to the pro forma amounts indicated below:
Net income attributable to common stock
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects
Pro forma net income attributable to common stock
Basic:
As reported
Pro forma
Diluted:
In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which expands on the accounting guidance of Statements No. 5, 57, and 107 and incorporates without change the provisions of FASB Interpretation No. 34, which is being superseded. This Interpretation requires a guarantor to recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The recognition requirements of FIN 45 apply prospectively to guarantees issued or modified after December 31, 2002. Refer to Note 4 to the Consolidated Financial Statements—“Guarantees” for discussion on significant guarantees that have been entered into by the Company.
In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Statement No. 149 provides clarification on the definition of derivative instruments within the scope of FASB Statement No. 133. Generally, this Statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003, and is not expected to have a material impact on the Consolidated Financial Statements.
In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Statement No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This Statement, which was effective for financial instruments entered into or modified after May 31, 2003 and for all financial instruments on July 1, 2003, did not have a material impact on the Consolidated Financial Statements.
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Note 2: Earnings Per Share
Information used to calculate earnings per share (“EPS”) was as follows:
Accumulated dividends on preferred stock
Weighted average shares (in thousands)
Basic weighted average number of common shares outstanding
Dilutive effect of potential common shares from:
Stock options
Premium Income Equity SecuritiesSM
Trust Preferred Income Equity Redeemable SecuritiesSM
Diluted weighted average number of common shares outstanding
Net income per common share
For the three and six months ended June 30, 2003, options to purchase an additional 41,700 and 1,907,973 shares of common stock were outstanding, but were not included in the computation of diluted EPS because their inclusion would have had an antidilutive effect. For the three and six months ended June 30, 2002, options to purchase an additional 269,689 and 318,187 shares of common stock were outstanding, but were not included in the computation of diluted EPS because their inclusion would have had an antidilutive effect.
Additionally, as part of the 1996 business combination with Keystone Holdings, Inc. (the parent of American Savings Bank, F.A.), 18 million shares of common stock, with an assigned value of $18.4944 per share, were, as of January 1, 2003, held in escrow for the benefit of the investors in Keystone Holdings, the Federal Deposit Insurance Corporation (“FDIC”) as manager of the Federal Savings and Loan Insurance Corporation Resolution Fund and their transferees. The conditions under which these shares can be released from escrow to the Keystone Holdings’ investors and the FDIC are related to the outcome of certain litigation and not based on future earnings or market prices. The escrow would have by its terms automatically expired on December 20, 2002, absent the occurrence of certain circumstances that would extend it. The Company contends that these circumstances have not occurred, while the Keystone Holdings’ investors and the FDIC contend that they have occurred.
Pursuant to an amended tolling agreement, the parties agreed to return to the Company 225,000 shares per month through June 30, 2003. During the six months ended June 30, 2003, 900,000 of these shares were returned to the Company and the return of an additional 450,000 shares was in process. These 450,000 shares have since been returned to the Company subsequent to June 30, 2003. At June 30, 2003, the Company continues to assert the conditions for releasing the remaining shares to the Keystone Holdings’ investors and the FDIC had not occurred, and thus the remaining shares were still in the escrow. Therefore, none of the shares in the escrow during the periods indicated above were included in the above computations.
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While the Company and Keystone Holdings have been willing to extend the tolling agreement beyond June 30, 2003, the FDIC has refused to do so. Accordingly, since the Company contends that it is entitled to the shares in the escrow, the Company expects to take all appropriate actions to seek the return of these shares, including if necessary the commencement of litigation against Keystone Holdings and the FDIC.
Note 3: Mortgage Banking Activities
Changes in the portfolio of loans serviced for others were as follows:
Balance, beginning of period
Home loans:
Additions through acquisitions
Other additions
Sales
Loan payments and other
Net change in commercial real estate loans serviced for others
Balance, end of period
Changes in the balance of mortgage servicing rights (“MSR”), net of the valuation allowance, were as follows:
Amortization
Impairment provision
Net change in commercial real estate MSR
Balance, end of period(1)
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Changes in the valuation allowance for MSR were as follows:
Other than temporary impairment
At June 30, 2003, the expected weighted average life of the Company’s MSR was 3 years. Projected amortization expense for the gross carrying value of MSR at June 30, 2003 is estimated to be as follows (in millions):
Remainder of 2003
2004
2005
2006
2007
2008
After 2008
Gross carrying value of MSR
Less: valuation allowance
Net carrying value of MSR
The projected amortization expense of MSR is an estimate and should be used with caution. The amortization expense for future periods was calculated by applying the same quantitative factors, such as estimated MSR prepayment assumptions, that were used to determine amortization expense for the second quarter of 2003. These factors are inherently subject to significant fluctuations, primarily due to the effect that changes in mortgage rates have on loan prepayment experience. Accordingly, any projection of MSR amortization in future periods is limited by the conditions that existed at the time the calculations were performed, and may not be indicative of actual amortization expense that will be recorded in future periods.
Note 4: Guarantees
In the ordinary course of business, the Company sells loans with recourse. For loans that have been sold with recourse, the recourse component is considered a guarantee. When the Company sells a loan with recourse, it commits to stand ready to perform, if the loan defaults, and to make payments to remedy the default. As of June 30, 2003 and December 31, 2002, loans sold with recourse totaled $3.61 billion and $4.26 billion. The Company’s recourse reserve related to these loans totaled $10 million and $11 million at June 30, 2003 and December 31, 2002.
The Company sells loans without recourse that may have to be subsequently repurchased due to defects that occurred during the loan’s origination process. The defects are categorized as documentation errors, underwriting errors and fraud. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process
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occurred. If a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no defects, the Company has no commitment to repurchase the loan. As of June 30, 2003 and December 31, 2002, the amount of loans sold without recourse totaled $583.17 billion and $600.25 billion, which substantially represents the unpaid principal balance of the Company’s loans serviced for others portfolio. The Company has reserved $115 million as of June 30, 2003 and $74 million as of December 31, 2002 to cover the estimated loss exposure related to the loan origination process defects that are inherent within this portfolio.
Note 5: Operating Segments
The Company has identified three major operating segments for the purpose of management reporting: Banking and Financial Services; Home Loans and Insurance Services; and Specialty Finance. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The management reporting process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The Company’s operating segments are defined by the products and services they offer.
The Company uses various methodologies 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: (1) a funds transfer pricing system, which matches assets and liabilities with the market benchmark (approximation) of the Company’s cost of funds based on interest rate sensitivity and maturity characteristics and determines how much each interest margin source contributes to the Company’s total net interest income; (2) a calculation of the provision for loan and lease losses based on management’s current assessment of the long-term, normalized net charge-off ratio for loan products within each segment, which differs from the “losses inherent in the loan portfolio” methodology that is used to measure the allowance for loan and lease losses under accounting principles generally accepted in the United States of America. This methodology is used to provide segment management with provision information for strategic decision making; (3) the utilization of an activity-based costing approach to measure allocations of certain operating expenses that were not directly charged to the segments; (4) the allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; (5) capital charges for goodwill as a component of an internal measurement of return on the goodwill allocated to the operating segment; and (6) an economic capital model which is the framework for assessing business performance on a risk-adjusted basis. Changing economic conditions, further research and new data may lead to the update of the capital allocation assumptions.
The Company continues to enhance its segment reporting process methodologies. Changes to the operating segment structure and the funds transfer pricing methodology were made during the first quarter of 2003. Additionally, effective January 1, 2003, the primary management responsibilities for the Company’s originated home loan mortgage-backed securities portfolio were transferred from the Home Loans and Insurance Services Group to the Company’s corporate treasury operations. Accordingly, the earnings performance and financial condition of this portfolio are now included within the Corporate Support/Treasury and Other category. Results for the prior periods have been restated to conform to all of these changes.
The Banking and Financial Services Group offers a comprehensive line of financial products and services to a broad spectrum of consumers and small- to mid-sized businesses. The Group offers various deposit products including the Group’s signature Free Checking accounts as well as other personal and business checking accounts, savings accounts, money market deposit accounts and time deposit accounts. It also offers consumer loans as well as small business and commercial loans to small- and mid-sized businesses. The Group’s services are offered through multiple delivery channels, including financial center stores, business banking centers, ATMs, the internet and 24-hour telephone banking centers.
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The principal activities of the Home Loans and Insurance Services Group include: originating and servicing the Company’s home loans, buying and selling home loans in the secondary market and managing the home loan portfolio. Home loans are either originated or purchased, and are either held in portfolio or held for sale and subsequently sold into the secondary market. The Group offers home loans through multiple distribution channels, which include retail home loan centers, financial center stores, correspondent channels, wholesale home loan centers and directly to consumers through call centers and the internet. The Home Loans Group also includes the Company’s community reinvestment functions and the activities of Washington Mutual Insurance Services, Inc., WaMu Capital Corp. and Washington Mutual Mortgage Securities Corp.
The Specialty Finance Group provides financing to developers, investors, mortgage bankers and homebuilders for the acquisition, construction and development of apartment buildings (“multi-family” lending), other commercial real estate and homes. The Group also services commercial real estate mortgages as part of its commercial asset management business and conducts a consumer finance business through Washington Mutual Finance Corporation.
The Corporate Support/Treasury and Other category includes management of the Company’s interest rate risk, liquidity, capital, borrowings, and investment securities and home loan mortgage-backed securities portfolios. To the extent not allocated to the business segments, this category also includes the costs of the Company’s technology services, facilities, legal, accounting and human resources. Also reported in this category is the net impact of funds transfer pricing for loan and deposit balances including the effects of changes in interest rates on the Company’s net interest margin and the effects of inter-segment allocations of gains and losses related to interest rate risk management instruments. The funds transfer pricing methodology isolates the majority of interest rate risk and concentrates it in our Treasury operations. It captures historical interest rate sensitivity of the balance sheet, risk management decisions within approved limits and the temporary divergence of funds transfer pricing assumptions from the actual duration of assets and liabilities. Certain basis and other residual risk remains in the operating segments.
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Financial highlights by operating segment were as follows:
Condensed income statement:
Net interest income (expense)
Noninterest income (expense)
Noninterest expense
Income taxes (benefit)
Net income (loss)
Performance and other data:
Efficiency ratio
Average loans
Average assets
Average deposits
Noninterest income
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MANAGEMENT’S DISCUSSION AND ANALYSIS
Our Form 10-Q and other documents that we file with the Securities and Exchange Commission contain forward-looking statements. In addition, our senior management may make forward-looking statements orally to analysts, investors, the media and others. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could” or “may.”
Forward-looking statements provide our expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. These statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made. There are a number of factors, many of which are beyond our control, that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. Some of these factors are:
An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of June 30, 2003. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective.
We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our Consolidated Financial Statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances as of June 30, 2003.
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Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified four accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, and the sensitivity of our Consolidated Financial Statements to those judgments, estimates and assumptions, are critical to an understanding of our Consolidated Financial Statements. These policies relate to the valuation of our mortgage servicing rights (“MSR”) and rate lock commitments, the methodology that determines our allowance for loan and lease losses, and the assumptions used in the calculation of our net periodic pension expense.
Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors. In addition, there are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards (“Statement”) No. 133, Accounting for Derivative Instruments and Hedging Activities, and the applicable hedge deferral criteria. These policies and the judgments, estimates and assumptions are described in greater detail in the Company’s 2002 Annual Report on Form 10-K in the “Critical Accounting Policies” section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements—“Summary of Significant Accounting Policies.”
Refer to Note 1 to the Consolidated Financial Statements—“Accounting Policies” for discussion of the recently issued accounting standards.
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Profitability
Net interest margin
Return on average assets
Return on average common equity
Efficiency ratio(1)
Nonaccrual loans(2)
Foreclosed assets
Total nonperforming assets
Nonperforming assets/total assets
Restructured loans
Total nonperforming assets and restructured loans
Allowance as a percentage of total loans held in portfolio
Net charge-offs
Stockholders’ equity/total assets
Tangible common equity(3)/total tangible assets(3)
Estimated total risk-based capital/risk-weighted assets(4)
Per Common Share Data
Book value per common share(5)
Market prices:
High
Low
Period end
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Summary Financial Data (Continued)
Supplemental Data
Average balance sheet:
Average loans held for sale
Average loans held in portfolio
Average interest-earning assets
Average total assets
Average interest-bearing deposits
Average noninterest-bearing deposits
Average stockholders’ equity
Period-end balance sheet:
Total interest-earning assets
Total interest-bearing deposits
Total noninterest-bearing deposits
Loan volume:
Adjustable rate
Fixed rate
Specialty mortgage finance
Total home loan volume
Total loan volume
Home loan refinancing
Total refinancing
Net Interest Income
For the three and six months ended June 30, 2003, net interest income decreased $75 million or 4% and $454 million or 10% compared with the same periods in 2002. These decreases resulted from contraction of the margin, which declined to 3.30% and 3.31% for the three and six months ended June 30, 2003 from 3.54% and 3.65% for the same periods in 2002, as yields on loans and debt securities continued to reprice downward from the higher interest rate environment of 2002. The decline in the margin was partially offset by decreases in the rates paid on interest-bearing deposits. In particular, the average rate paid on interest-bearing checking (Platinum) accounts decreased to 1.89% from 3.12% on an average balance of $54.94 billion and $30.49 billion for the three months ended June 30, 2003 and 2002, and decreased to 1.99% from 3.31% on an average balance of $53.68 billion and $23.83 billion for the six months ended June 30, 2003 and 2002. The free funding impact of noninterest-bearing sources that resulted from higher average custodial and escrow balances also offset the contraction in the margin for the three and six months ended June 30, 2003, by 16 and 15 basis points when compared with the same periods in 2002. Higher average balances of loans held for sale and home equity loans and lines of credit during the second quarter and first half of 2003, as compared with the same periods in the prior year, further reduced the decline in net interest income.
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Interest rate contracts, including embedded derivatives, held for asset/liability interest rate risk management purposes decreased net interest income by $151 million and $294 million for the three and six months ended June 30, 2003, compared with $92 million and $129 million for the same periods in 2002.
Certain average balances, together with the total dollar amounts of interest income and expense and the weighted average interest rates, were as follows:
Interest-earning assets:
Available-for-sale securities(1):
Mortgage-backed securities
Investment securities
Loans held for sale(2)
Loans held in portfolio(2)(3):
Loans secured by real estate:
Home loans
Purchased specialty mortgage finance
Total home loans
Home construction loans:
Builder(4)
Custom(5)
Home equity loans and lines of credit:
Banking subsidiaries
Washington Mutual Finance
Multi-family
Other real estate
Total loans secured by real estate
Consumer:
Commercial business
Total loans held in portfolio
Noninterest-earning assets:
(This table is continued on the next page.)
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Interest-bearing liabilities:
Interest-bearing checking
Savings accounts and money market deposit accounts
Time deposit accounts
Total interest-bearing liabilities
Noninterest-bearing sources:
Stockholders’ equity
Net interest spread and net interest income
Impact of noninterest-bearing sources
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Noninterest income consisted of the following:
Loan servicing income:
Loan subservicing fees
Other, net
Net home loan servicing expense
GNMA pool buy-out income
Loan related income
Gain from sale of originated mortgage- backed securities
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Home Loan Mortgage Banking Income (Expense)
The increase in home loan servicing fees for the three and six months ended June 30, 2003 was the result of the increase in our loans serviced for others portfolio, partially offset by a decline in the aggregate weighted average servicing fee. Our loans serviced for others portfolio increased from $477.31 billion at June 30, 2002 to $583.82 billion at June 30, 2003 primarily as a result of the acquisition of HomeSide Lending, Inc., including its servicing portfolio, in the fourth quarter of 2002.
Total loans serviced for others portfolio by type was as follows:
Government
Agency
Private
Specialty home loans
Total loans serviced for others portfolio(1)
The weighted average servicing fee decreased from 41 basis points at June 30, 2002 to 36 basis points at June 30, 2003 largely due to the Company’s continuing process of selling a portion of the future contractual servicing cash flows to third parties. This process decreased the net MSR balance by $664 million but had no impact on the unpaid principal balance of the loans serviced for others portfolio.
Historically low long-term mortgage rates led to higher anticipated prepayment rates, which resulted in MSR impairment of $309 million during the second quarter of 2003. Higher levels of prepayment activity during the three and six months ended June 30, 2003 resulted in higher MSR amortization, as compared with the same periods in 2002.
For the three and six months ended June 30, 2003, we recorded an other than temporary MSR impairment of $579 million and $1,115 million, which reduced both the gross carrying value of the MSR and the MSR valuation allowance. The amounts of the other than temporary impairment were determined by selecting an appropriate interest rate shock to estimate the amount of MSR fair value that might be expected to recover in the foreseeable future. To the extent that the gross carrying value of the MSR exceeded the estimated recoverable amount, that portion of the gross carrying value was written off as an other than temporary impairment. Although the writedowns had no impact on our results of operations or financial condition, they did reduce the gross carrying value of the MSR, which is used as the basis for MSR amortization.
The increase in other home loan mortgage banking expense for the three and six months ended June 30, 2003 resulted from higher loan pool expenses due to significant refinancing activity. Loan pool expenses represent the amount of interest expense that the Company incurs for the elapsed time between the borrower payoff date and the next monthly loan servicing investor pool cutoff date.
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In measuring the fair value of MSR, we stratify the loans in our servicing portfolio based on loan type and coupon rate. We measure MSR impairment by estimating the fair value of each stratum. An impairment allowance for a stratum is recorded when, and in the amount by which, its fair value is less than its gross carrying value. A recovery of the impairment allowance for a stratum is recorded when its fair value exceeds its net carrying value. At June 30, 2003, we stratified the loans in our servicing portfolio as follows:
Rate Band
Adjustable
Conventional
Primary Servicing
Master servicing
Total
Since loans with coupon rates at or below 6.00% reached a significant level, the Company adjusted the strata of the loan servicing portfolio during the second quarter of 2003 to the rate bands illustrated in the table above. This change did not have a significant impact on the MSR valuation allowance as of June 30, 2003.
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At June 30, 2003, key economic assumptions and the sensitivity of the current fair value for home loans MSR to immediate changes in those assumptions were as follows:
Fixed-Rate
Mortgage Loans
SpecialtyHomeLoans
Fair value of home loans MSR
Expected-weighted-average life (in years)
Constant prepayment rate(1)
Impact on fair value of 25% decrease
Impact on fair value of 50% decrease
Impact on fair value of 25% increase
Impact on fair value of 50% increase
Future cash flows discounted at
Impact on fair value of 10% decrease
These sensitivities are hypothetical and should be used with caution. As the table above demonstrates, our methodology for estimating the fair value of MSR is highly sensitive to changes in assumptions. For example, our determination of fair value uses anticipated prepayment speeds. Actual prepayment experience may differ and any difference may have a material effect on MSR fair value. Changes in fair value based on a variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the MSR is calculated without changing any other assumption; in reality, changes in one factor may be associated with changes in another (for example, increases in market interest rates may result in lower prepayments, but credit losses may increase), which may magnify or counteract the sensitivities. Thus, any measurement of MSR fair value is limited by the conditions existing and assumptions made as of a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time. Refer to “Market Risk Management” for discussion of how MSR prepayment risk is managed and to Note 1 to the Consolidated Financial Statements—“Summary of Significant Accounting Policies” in the Company’s 2002 Annual Report on Form 10-K for further discussion of how MSR impairment is measured.
As part of its mortgage banking activities, the Company enters into commitments to originate or purchase loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Therefore, they are recorded at fair value on the Consolidated Statements of Financial Condition with changes in fair value recorded in gain from mortgage loans on the Consolidated Statements of Income. In measuring the fair value of rate lock commitments, the amount of the expected servicing rights is included in the valuation. This value is calculated using the same methodologies as are used to value the Company’s MSR, adjusted using an anticipated fallout factor for loan commitments that will never be funded. The fair value of rate lock commitments on the Consolidated Statements of Financial Condition at June 30, 2003 and 2002 for which the underlying loans had not been funded was $210 million and $107 million.
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This policy of recognizing the value of the derivative has the effect of recognizing the gain from mortgage loans before the loans are sold. The Financial Accounting Standards Board (“FASB”) staff or the Emerging Issues Task Force may issue additional guidance on this matter. Depending on what, if any, additional guidance is issued, the timing of the gain recognition inherent within our rate lock commitments could be delayed, possibly until the date that the anticipated loans are sold. Generally, loans held for sale are sold within 60 to 120 days after the initial recognition of the rate lock commitment.
Rate lock commitment volume, adjusted for actual and anticipated fallout factors, totaled $101.08 billion and $194.74 billion for the three and six months ended June 30, 2003, compared with $44.29 billion and $84.90 billion for the same periods in 2002.
The fair value changes in loans held for sale and the offsetting changes in the derivative instruments used as fair value hedges are also recorded within gain from mortgage loans when hedge accounting treatment is achieved. Loans held for sale where hedge accounting treatment is not achieved (“nonqualifying” loans held for sale) are not recorded at fair value and are instead recorded at the lower of aggregate cost or market value. Due to decreases in the fair value of derivatives acquired to mitigate the risk of fair value changes to these nonqualifying loans, losses of $147 million and $342 million were recognized in revaluation gain (loss) from derivatives during the three and six months ended June 30, 2003. A gain may be recognized when the loans are subsequently sold if the fair value of those loans is higher than the carrying amount. As of June 30, 2003, the fair value of loans held for sale and the carrying amount were $40.63 billion, and as of December 31, 2002, the fair value was $34.06 billion with a carrying amount of $34.00 billion.
The high levels of rate lock commitment volume and the sale of nonqualifying loans held for sale resulted in a gain from mortgage loans of $622 million and $1,210 million during the three and six months ended June 30, 2003, compared with $220 million and $471 million during the same periods in 2002.
The following tables separately present the MSR, loans held for sale and the asset/liability risk management activities included within noninterest income for the three and six months ended June 30, 2003.
Revaluation gain (loss) from derivatives
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Revaluation gain from derivatives is the earnings impact of the changes in fair value from certain derivatives where the Company either has not attempted to achieve, or has attempted but did not achieve, hedge accounting treatment under Statement No. 133. The revaluation gain from derivatives during the three and six months ended June 30, 2003 resulted from the Company’s continued usage of derivative instruments for interest rate risk management purposes. Derivatives that were used for MSR risk management purposes produced a revaluation gain of $745 million and $1,157 million during the three and six months ended June 30, 2003, compared with gains of $857 million and $842 million for the same periods in 2002. The total notional amount of these MSR risk management derivatives at June 30, 2003 was $32.07 billion with a combined net fair value of $554 million.
Net settlement income from certain interest-rate swaps consisted of receive-fixed interest rate swaps, which were used as MSR risk management derivatives. At June 30, 2003, the total notional amount of these receive-fixed interest-rate swaps was $8.15 billion, compared with $11.58 billion at June 30, 2002.
Gain from other available-for-sale securities of $140 million for the three and six months ended June 30, 2003 resulted from sales of approximately $1.69 billion in mortgage-backed securities and investment securities, all of which were designated as MSR risk management instruments.
Government National Mortgage Association (“GNMA”) pool buy-out income was $219 million and $373 million for the three and six months ended June 30, 2003 and $78 million and $91 million for the same periods in 2002. Beginning in September of 2002, the Company began to regularly exercise its buy-back rights under the terms of its contract with GNMA. The Company has the right to repurchase certain loans that are part of GNMA securitization pools before they have reached nonperforming status. In one part of the Company’s program, loans that have been 30 days past due for three consecutive months (referred to as “rolling 30 loans”) are repurchased from GNMA and then resold in the secondary market. In the other, loans that have missed three consecutive payments are likewise purchased and resold. These loans are collectively referred to as Early Buy-Out Loans.
Gain from the sale of these loans was $152 million and $228 million for the three and six months ended June 30, 2003 and $19 million and $22 million for the three and six months ended June 30, 2002. The Company does not have the option of repurchasing “rolling 30 loans” from pools created after January 1, 2003, but continues to make such purchases from previously created pools. The Company does not expect this change to have a significant impact on its results of operations throughout the remainder of 2003.
Additionally, as part of its normal Federal Housing Administration and Department of Veterans Affairs lending program, the Company repurchases defaulted loans from GNMA and undertakes collection and, if necessary, foreclosure proceedings with respect to those loans. Upon completion of the foreclosure, the Company can also submit a claim to either the Federal Housing Administration or the Department of Veterans Affairs for payment on the insurance or guarantee, as the case may be, issued by that agency. The portion of the recovery which is attributed to interest income owed to the Company is also recorded in this category. That interest income, together with interest income on the Early Buy-Out Loans was $67 million and $145 million for the three and six months ended June 30, 2003 and $59 million and $69 million for the three and six months ended June 30, 2002.
Loan related income increased during the three and six months ended June 30, 2003, primarily due to increased fees charged to our correspondent lenders and late charges on the loans serviced for others portfolio.
All Other Noninterest Income Analysis
The increase in depositor and other retail banking fees for the three and six months ended June 30, 2003 was primarily due to higher levels of checking fees that resulted from an increased number of noninterest-bearing checking accounts in comparison with the three and six months ended June 30, 2002 and an increase in debit card and ATM related income. The number of noninterest-bearing checking accounts at June 30, 2003 totaled approximately 6.1 million, an increase of more than 600,000 from June 30, 2002.
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Insurance income increased during the three and six months ended June 30, 2003 primarily due to the continued growth in our captive reinsurance programs.
The growth in portfolio loan related income for the three and six months ended June 30, 2003 was primarily due to increased late charges on the loan portfolio and continued high loan prepayment fees as a result of refinancing activity.
Several securities sold under agreements to repurchase (“repurchase agreements”) that contained embedded pay-fixed swaps were restructured during the first half of 2003, resulting in losses on extinguishment of repurchase agreements of $49 million and $136 million for the three and six months ended June 30, 2003. The restructured repurchase agreements contain embedded pay-fixed swaps with the same terms except with a lower pay rate.
Other noninterest income for the three and six months ended June 30, 2003 increased largely due to a revaluation gain recognized on residual interests in collateralized mortgage obligations.
Noninterest expense consisted of the following:
Postage
Loan expense
Travel and training
Reinsurance expense
The increase in employee base compensation and benefits expense for the three and six months ended June 30, 2003 over the same periods in 2002 was substantially due to the hiring of additional staff to support our expanding operations. Full-time equivalent employees were 57,516 at June 30, 2003, compared with 50,001 at June 30, 2002. Overtime and second shifts have grown in response to the increased loan production and loan payoff processing. The Company’s variable compensation and benefits expense related to loan servicing activities, which include loan payoff processing, and loan production for the three and six months ended June 30, 2003 was $243 million and $433 million compared with $197 million and $363 million for the same periods in 2002.
The increase in occupancy and equipment expense for the three months ended June 30, 2003 resulted partially from higher equipment depreciation expense of $21 million related to various technology related projects that were placed in service during the second quarter of 2003. Occupancy expense increased for the period by $17 million due to continued branch expansions into new markets. Additionally, during the second quarter of 2003, the Company recorded an expense of $20 million, which represented a vendor payment to obtain the rights necessary to ensure the sustained functionality of certain mortgage loan origination system software. The Company also wrote-off approximately $16 million of capitalized software that was no longer considered to have future value.
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Professional fees increased for the three and six months ended June 30, 2003, primarily as a result of increased technology related projects and legal fees.
The increase in loan expense for the three and six months ended June 30, 2003 was substantially due to higher non-deferred loan closing costs and mortgage payoff expenses, resulting from an overall increase in refinancing activity.
Other expense increased during the periods reported mostly due to higher foreclosed asset expenses, outside services and charitable contributions.
At June 30, 2003, our assets were $283.20 billion, an increase of 6% from $268.30 billion at December 31, 2002. The increase was predominantly due to an increase in investment securities, loans held for sale and loans held in portfolio.
Securities
Securities consisted of the following:
Mortgage-backed securities:
U.S. Government and agency
Private issue
Total mortgage-backed securities
Investment securities:
Other debt securities
Equity securities
Total investment securities
Total available-for-sale securities
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Three Months Ended
Realized gross gains
Realized gross losses
Realized net gain (loss)
Our mortgage-backed securities portfolio declined $3.50 billion to $24.88 billion at June 30, 2003 from $28.38 billion at December 31, 2002. Substantially all of this decrease resulted from pay-downs that occurred from refinancing activity. Our investment securities portfolio increased $4.69 billion to $20.29 billion at June 30, 2003 from $15.60 billion at December 31, 2002. This increase resulted from the purchase of U.S. Government and agency investment securities. The Company’s available-for-sale securities portfolio includes both mortgage-backed securities and investment securities that are used for MSR risk management purposes. At June 30, 2003, these MSR risk management securities had a total amortized cost of $10.63 billion and a fair value of $11.03 billion. At December 31, 2002, these MSR risk management securities had a total amortized cost of $7.85 billion and a fair value of $8.08 billion.
Loans
Loans held in portfolio consisted of the following:
Builder(1)
Custom(2)
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Other Assets
Other assets consisted of the following:
Premises and equipment
Investment in bank-owned life insurance
Accrued interest receivable
GNMA pool buy-outs
Other intangible assets
Derivatives
Trading securities
Total other assets
The decrease in the derivatives balance from December 31, 2002 to June 30, 2003 was largely due to a decrease in the net fair value of receive-fixed swaps held for MSR risk management purposes. The decrease in the net fair value of the receive-fixed swaps was primarily attributable to the sales of certain of those swaps with higher receive-fixed rates and thus a higher net fair value. The net fair value of the receive-fixed swaps used for MSR risk management purposes was $274 million at June 30, 2003, compared with $2.18 billion at December 31, 2002.
The increase in trading securities is a result of growth in mortgage-backed securities held by WaMu Capital Corp., the Company’s institutional broker-dealer.
A majority of the increase in other assets—other was due to the sale in June 2003 of repurchase agreements where we had not yet settled with the counterparty as of June 30, 2003.
Deposits consisted of the following:
Checking accounts:
Interest bearing
Noninterest bearing
Savings accounts
Money market deposit accounts
Deposits increased to $166,457 million at June 30, 2003 from $155,516 million at December 31, 2002. Substantially all of the increase in interest-bearing checking accounts was due to the growth in Platinum Accounts, which increased from $50.20 billion at December 31, 2002 to $55.90 billion at June 30, 2003. Approximately $4.10 billion of this $5.70 billion increase in Platinum Account deposits occurred during the first quarter of 2003. During the six months ended June 30, 2003, the number of Platinum Accounts increased by
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153,847 from 683,245 to 837,092 total accounts. At June 30, 2003, total deposits included $32.95 billion in custodial/escrow deposits related to loan servicing activities, compared with $25.90 billion at December 31, 2002. Time deposit accounts decreased by $3.10 billion from year-end 2002 primarily as a result of decreases in certificates of deposit accounts.
Checking accounts, savings accounts and money market deposit accounts increased to 82% of total deposits at June 30, 2003, compared with 78% at year-end 2002. These products generally have the benefit of lower interest costs, compared with time deposit accounts. At June 30, 2003 deposits funded 59% of total assets compared with 58% at December 31, 2002.
Our borrowings largely take the form of repurchase agreements and advances from the Federal Home Loan Banks (“FHLB”) of Seattle, San Francisco, Dallas and New York. The exact mix of these two types of wholesale borrowings at any given time is dependent upon the market pricing of the individual borrowing sources.
Our wholesale borrowings increased by $3,441 million at June 30, 2003, compared with year-end 2002 predominantly due to an increase in federal funds purchased and repurchase agreements, which was partially offset by a decrease in advances from FHLBs. Other borrowings decreased by $564 million during the six months ended June 30, 2003 primarily as a result of a reduction in our senior debt. Refer to “Liquidity” for further discussion of funding sources at June 30, 2003, compared with year-end 2002.
We manage our business along three major operating segments: Banking and Financial Services; Home Loans and Insurance Services; and Specialty Finance. Results for Corporate Support/Treasury and Other are also presented. Refer to Note 5 to the Consolidated Financial Statements—“Operating Segments” for information regarding the key elements of our management reporting methodologies used to measure segment performance.
Banking and Financial Services
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Net income was $327 million and $633 million for the three and six months ended June 30, 2003, compared with $237 million and $444 million for the same periods in 2002. Net interest income increased to $891 million and $1,757 million for the three and six months ended June 30, 2003, compared with $762 million and $1,425 million for the same periods in 2002. The primary sources of net interest income are a funds transfer credit for deposits and interest income on home equity loans and lines of credit, commercial and consumer loans. These increases in net interest income for the three and six months ended June 30, 2003 were primarily due to a decrease in interest expense on money market deposit accounts and time deposit accounts resulting from declining interest rates and balances.
Noninterest income was $624 million and $1,208 million for the three and six months ended June 30, 2003, compared with $541 million and $1,054 million for the same periods in 2002. These increases were primarily due to higher depositor and other retail banking fees and an increase in home loan origination broker fees received from the Home Loans and Insurance Services Group, which totaled $47 million and $97 million for the three and six months ended June 30, 2003, compared with $17 million and $40 million for the same periods in 2002.
Noninterest expense increased to $949 million and $1,868 million for the three and six months ended June 30, 2003, compared with $880 million and $1,689 million for the same periods in 2002. These increases were predominantly due to increased allocated technology expense, compensation and benefits expense, and occupancy and equipment expense.
Total average assets increased to $33,998 million and $33,205 million for the three and six months ended June 30, 2003, compared with $28,850 million and $28,021 million for the same periods in 2002. The increase in average assets for the six months ended June 30, 2003 was substantially a result of a 48% increase in home equity loans and lines of credit average balances to $18,227 million from $12,334 million, partly offset by a decrease in consumer loans.
Total average deposits increased to $125,025 million and $124,716 million for the three and six months ended June 30, 2003, compared with $111,425 million and $107,820 million for the same periods in 2002. These increases in average deposits were predominantly due to higher levels of Platinum balances, partly offset by decreasing balances for money market deposit accounts and time deposit accounts. Average Platinum balances increased approximately 80% to $54.94 billion for the three months ended June 30, 2003 from $30.49 billion for the same period in 2002.
Home Loans and Insurance Services
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Net income was $758 million and $1,483 million for the three and six months ended June 30, 2003, compared with $395 million and $786 million for the same periods in 2002. Net interest income increased to $1,155 million and $2,245 million for the three and six months ended June 30, 2003, compared with $750 million and $1,597 million for the same periods in 2002. These increases in net interest income were largely due to increases in interest income resulting from higher loans held for sale average balances and decreases in funding costs due to lower interest rates. Partially offsetting these increases were decreases in interest income on loans held in portfolio, primarily adjustable-rate loans, which continue to reprice downward from higher interest rate levels in 2002.
Noninterest income increased to $1,002 million and $1,880 million during the three and six months ended June 30, 2003, compared with $600 million and $993 million for the same periods in 2002. These increases were primarily due to higher gain from mortgage loans and GNMA pool buy-out income, partly offset by MSR impairment and higher amortization for the three and six months ended June 30, 2003.
Noninterest expense increased to $903 million and $1,676 million for the three and six months ended June 30, 2003 from $668 million and $1,225 million for the same periods in 2002. These increases were primarily due to higher allocated technology expense resulting from various ongoing projects, compensation and benefits expense, and foreclosed assets expense.
Total average assets increased to $176,709 million and $174,496 million for the three and six months ended June 30, 2003, compared with $138,427 million and $141,451 million for the same periods in 2002. These increases were primarily due to growth in average loans held for sale balances resulting from higher home loan volume of $108.16 billion for the quarter compared with $50.17 billion for the same period in 2002.
Total average deposits increased to $30,257 million and $27,757 million for the three and six months ended June 30, 2003, compared with $11,073 million and $10,854 million for the same periods in 2002. These increases were predominantly due to the growth of custodial and escrow balances resulting from higher loan prepayments.
Specialty Finance
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Net income for the three and six months ended June 30, 2003 was $124 million and $243 million, compared with $99 million and $208 million for the same periods in 2002. Net interest income was $344 million and $683 million for the three and six months ended June 30, 2003, compared with $297 million and $614 million for the same periods in 2002. These increases in net interest income were substantially due to increased interest income on available-for-sale mortgage-backed securities resulting from higher levels of securitized multi-family loans and lower funding costs resulting from reduced interest rates. These increases were partially offset by reduced interest income from multi-family loans held in portfolio as a result of the lower interest rate environment.
Noninterest income was $20 million and $28 million for the three and six months ended June 30, 2003, compared with $19 million and $43 million for the same periods in 2002. The decrease for the six months ended June 30, 2003 was substantially due to a write-down in the valuation of an equity investment and a revaluation loss from derivatives during the first quarter of 2003.
Noninterest expense was $114 million and $219 million for the three and six months ended June 30, 2003, compared with $96 million and $195 million for the same periods in 2002. These increases were primarily due to increased compensation and benefits expense as a result of higher multi-family loan volumes and an increase in foreclosed assets expense.
Total average assets increased to $34,814 million and $34,437 million for the three and six months ended June 30, 2003, compared with $31,784 million and $32,200 million for the same periods in 2002. A significant portion of these increases were driven by higher multi-family loans and an increase in the available-for-sale mortgage-backed securities portfolio.
Corporate Support/Treasury and Other
Corporate Support/Treasury and Other had a net loss of $339 million and $624 million for the three and six months ended June 30, 2003, compared with net income of $130 million and $277 million for the same periods in 2002. Net interest expense was $365 million and $643 million for the three and six months ended June 30, 2003, compared with net interest income of $291 million and $860 million for the same periods in 2002. These decreases in net interest income were predominantly due to a decrease in average investment securities balances resulting from a change in our MSR hedging strategy toward an increase in the use of derivatives and the negative impact of the funds transfer pricing process due to higher average deposit balances within the operating segments. These decreases were partially offset by a reduction in interest expense from borrowed funds, as a result of lower rates and higher average deposit balances, which reduced the need for these borrowings.
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Noninterest expense was $164 million and $285 million for the three and six months ended June 30, 2003, compared with $150 million and $391 million for the same periods in 2002. The decrease for the six months ended June 30, 2003 was predominantly due to an increase in the technology expenses allocated to the operating segments.
Asset Securitization
We transform loans into securities, which are sold to investors—a process known as securitization. Securitization involves the sale of loans to a qualifying special-purpose entity (“QSPE”), typically a trust. The QSPEs, in turn, issue interest-bearing securities, commonly called asset-backed securities, that are secured by future collections on the sold loans. The QSPE sells securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These entities are not consolidated within our financial statements since they satisfy the criteria established by Statement No. 140, Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. In general, these criteria require the QSPE to be legally isolated from the transferor (the Company), be limited to permitted activities, and have defined limits on the assets it can hold and the permitted sales, exchanges or distributions of its assets.
When we sell or securitize loans, we generally retain the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the securitized assets. Retained interests may provide credit enhancement to the investors and generally represent the Company’s maximum risk exposure associated with these transactions. Retained interests in the form of mortgage-backed securities were $9.20 billion at June 30, 2003, of which $9.01 billion have either a AAA credit rating or are agency insured. Additional information concerning securitization transactions is included in Note 5 to the Consolidated Financial Statements—“Mortgage Banking Activities” of the Company’s 2002 Annual Report on Form 10-K.
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 4—“Guarantees” to the Consolidated Financial Statements.
Nonaccrual Loans, Foreclosed Assets and Restructured Loans
Loans are generally placed on nonaccrual status when they are 90 days or more past due or when the timely collection of the principal of the loan, in whole or in part, is not expected. Management’s classification of a loan as nonaccrual or restructured does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.
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Nonaccrual loans and foreclosed assets (“nonperforming assets”) and restructured loans consisted of the following:
Nonperforming assets and restructured loans:
Nonaccrual loans:
Total home loan nonaccrual loans
Total nonaccrual loans secured by real estate
Total nonaccrual loans held in portfolio
As a percentage of total assets
Nonaccrual loans totaled $1,996 million at June 30, 2003, compared with $2,166 million at March 31, 2003 and $2,257 million at December 31, 2002. During the first six months of 2003, declines in home loans and other real estate nonaccruals were partially offset by increases in purchased specialty mortgage finance and home equity loans and lines of credit nonaccruals.
Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $73 million, $72 million and $119 million at June 30, 2003, March 31, 2003 and December 31, 2002. Valuation changes on loans held for sale are reflected as gains or losses within gain from mortgage loans in noninterest income.
Home loan nonaccruals were $804 million at June 30, 2003, down $264 million from December 31, 2002. The decline in nonaccrual home loans was achieved through sales of nonperforming home loans.
During the first quarter of 2003, the Company sold a package of loans held in portfolio that totaled $131 million. Of this amount, $104 million were nonperforming loans and resulted in the Company incurring
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$8 million in charge-offs. In the second quarter of 2003, the Company completed a sale of loans held in portfolio totaling $195 million, of which $161 million were nonperforming loans that resulted in a charge-off of $4 million. The Company will periodically evaluate nonperforming loan sales as part of its ongoing portfolio management strategy.
Purchased specialty mortgage finance nonaccrual loans totaled $483 million at June 30, 2003 relatively unchanged during the second quarter, but up $45 million from December 31, 2002 primarily reflecting growth and seasoning of this loan portfolio.
Nonaccrual home equity loans and lines of credit totaled $90 million at quarter end, an increase of $5 million during the quarter and $17 million from December 31, 2002. However, the percentage of nonaccruals to total loans in this portfolio totaled 0.40% at June 30, 2003, unchanged from December 31, 2002.
At quarter end, other real estate loans on nonaccrual totaled $369 million, down from $402 million last quarter and $413 million at December 31, 2002. Much of the year-to-date improvement was due to principal charge-offs totaling $13 million and reinstatements to performing status and principal paydowns within the Company’s franchise-oriented finance business.
The multi-family portfolio continues to exhibit strong performance, with nonaccrual loans in this category representing 0.28% of total multi-family loans at June 30, 2003, unchanged from year-end 2002.
At June 30, 2003, foreclosed assets were $317 million, compared with $334 million at March 31, 2003 and $336 million at December 31, 2002. The Company’s foreclosed assets include home and commercial real estate as well as a small amount of personal property.
90 or More Days Past Due
The amount of loans held in portfolio which were 90 or more days contractually past due and still accruing interest was $47 million at June 30, 2003, compared with $93 million at March 31, 2003 and $60 million at December 31, 2002. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest.
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Provision and Allowance for Loan and Lease Losses
Changes in the allowance for loan and lease losses were as follows:
Allowance acquired through business combinations
Allowance for transfer to loans held for sale
Loans charged off:
Total home loan charge-offs
Total loans charged off
Recoveries of loans previously charged off:
Total recoveries of loans previously charged off
Net charge-offs (annualized) as a percentage of average loans held in portfolio
From the fourth quarter of 2001 through the third quarter of 2002, the Company provided for amounts significantly in excess of charge-offs reflecting risks associated with growth in nonaccrual loans and economic uncertainty. As the economy stabilizes and nonperforming loan levels continue to decrease, the Company is adjusting the provision to amounts approaching actual charge-offs. The Company believes its portfolio is adequately reserved, and accordingly, decreased its second quarter 2003 provision to $118 million compared
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with $160 million during the same period in 2002. As a percentage of average loans, net charge offs were 0.31% and 0.28% for the three and six months ended June 30, 2003, compared with 0.32% and 0.29% for the same periods in 2002.
Net charge-offs for the three and six months ended June 30, 2003 were $118 million and $213 million compared with $116 million and $215 million for the same periods in 2002. While representing less than 2% of the Company’s assets, Washington Mutual Finance accounted for 35% of total net charge-offs during the first half of 2003. This higher level of charge-offs in a consumer finance operation such as Washington Mutual Finance is expected due to the higher risk profile of the customer base as reflected in the interest rates charged for these loans.
The allowance for loan and lease losses represents management’s estimate of credit losses inherent in the Company’s loan and lease portfolios as of the balance sheet date. The estimation of the allowance is based on a variety of factors, including past loan loss experience, adverse situations that have occurred but are not yet known that may affect the borrower’s ability to repay, the estimated value of underlying collateral and general economic conditions. The Company’s methodology for assessing the adequacy of the allowance includes the evaluation of three distinct elements: the formula allowance, the specific allowance (which includes the allowance for loans deemed to be impaired by Statement No. 114, Accounting by Creditors for Impairment of a Loan) and the unallocated allowance. The formula allowance and the specific allowance collectively represent the portion of the allowance for loan and lease losses that are allocated to the various loan portfolios.
Refer to Note 1 to the Consolidated Financial Statements—“Summary of Significant Accounting Policies” in our 2002 Annual Report on Form 10-K for further discussion of the Allowance for Loan and Lease Losses.
The objective of liquidity management is to ensure the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet obligations and other commitments on a timely and cost-effective basis. The Company establishes liquidity guidelines for its principal operating subsidiaries as well as for the parent holding company, Washington Mutual, Inc. The principal sources of liquidity for our banking subsidiaries are customer deposits, wholesale borrowings, the maturity and repayment of portfolio loans, securities held in our available-for-sale portfolio and mortgage loans designated as held for sale. Among these sources, transaction deposits and wholesale borrowings from FHLB advances and repurchase agreements continue to provide the Company with a significant source of stable funding. During the six months ended June 30, 2003, those sources funded 72% of average total assets. Our continuing ability to retain our transaction-deposit customer base and to attract new deposits depends on various factors, such as customer service satisfaction levels and the competitiveness of interest rates offered on our deposit products. The Company would primarily use wholesale borrowings to offset any potential declines in deposit balances. We expect that FHLB advances and repurchase agreements will continue to be our most significant sources of wholesale borrowings during 2003, and we expect to have the necessary assets available to pledge as collateral to obtain these funds.
In the six months ended June 30, 2003, the Company’s proceeds from the sales of loans held for sale were approximately $168.93 billion. These proceeds were, in turn, used as the primary funding source for the origination and purchases of approximately $177.30 billion of loans held for sale during the same period. As this cyclical pattern of sales and originations/purchases repeats itself during the course of a period, the amount of funding necessary to sustain our mortgage banking operations does not significantly affect the Company’s overall level of liquidity resources.
To supplement our funding sources, our banking subsidiaries also raise funds in domestic and international capital markets. Effective August 7, 2003, the Company established a new $20 billion Global Bank Note Program for Washington Mutual Bank, FA (“WMBFA”) and Washington Mutual Bank (“WMB”) to issue senior and subordinated notes in the United States and in international capital markets in a variety of currencies and
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structures. This program replaced the $15 billion program established in April, 2001. Under this program, WMBFA will be allowed to issue up to $15 billion in notes of which $5 billion can be issued as subordinated notes. WMB will be allowed to issue up to $5 billion in senior notes. The maximum aggregate principal amount of notes with maturities greater than 270 days from the date of issue offered by WMBFA may not exceed $7.5 billion.
Liquidity for Washington Mutual, Inc. is generated through its ability to raise funds in various capital markets and through dividends from subsidiaries, commercial paper programs and lines of credit.
Washington Mutual, Inc.’s primary funding source during the first six months of 2003 was from dividends paid by our banking subsidiaries. Although we expect Washington Mutual, Inc. to continue to receive banking subsidiary dividends during 2003, including the amount necessary to support the ten cent per share dividend increase approved by the Company’s Board of Directors in July 2003, various regulatory requirements related to capital adequacy and retained earnings limit the amount of dividends that can be paid by our banking subsidiaries. For more information on dividend restrictions applicable to our banking subsidiaries, refer to the Company’s 2002 Annual Report on Form 10-K, “Business—Regulation and Supervision” and Note 18 to the Consolidated Financial Statements—“Regulatory Capital Requirements and Dividend Restrictions.”
In February 2003, Washington Mutual, Inc. filed a shelf registration statement with the Securities and Exchange Commission to register $2 billion of debt securities, preferred stock and depository shares in the United States and in international capital markets and in a variety of currencies and structures. The shelf registration statement was declared effective on April 15, 2003. At June 30, 2003, Washington Mutual, Inc. had $2 billion available under this shelf registration.
Washington Mutual, Inc. and its subsidiaries also have various other credit facilities and agreements that are sources of liquidity. Washington Mutual, Inc. and Washington Mutual Finance have a revolving credit facility totaling $800 million which provides back-up for the commercial paper programs of Washington Mutual, Inc. and Washington Mutual Finance as well as funds for general corporate purposes. At June 30, 2003, there was $348 million borrowed under this credit facility. Washington Mutual Finance has agreements to participate in a $600 million asset-backed commercial paper conduit program. At June 30, 2003, Washington Mutual Finance had asset-backed commercial paper of $600 million outstanding. Long Beach Mortgage has revolving credit facilities totaling $2.0 billion that are used to fund loans held for sale. At June 30, 2003, Long Beach Mortgage had borrowed $1.40 billion under these credit facilities.
Reflecting the increases in loans held for sale and loans held in portfolio during the six months ended June 30, 2003, the ratio of stockholders’ equity to total assets decreased to 7.44% at June 30, 2003 from 7.50% at December 31, 2002.
The regulatory capital ratios of WMBFA, WMB and Washington Mutual Bank fsb (“WMBfsb”) and the minimum regulatory ratios to be categorized as well-capitalized were as follows:
Well-Capitalized
Minimum
Tier 1 capital to adjusted total assets (leverage)
Adjusted tier 1 capital to total risk-weighted assets
Total risk-based capital to total risk-weighted assets
Our federal savings bank subsidiaries, WMBFA and WMBfsb, are also required by Office of Thrift Supervision regulations to maintain tangible capital of at least 1.50% of assets. WMBFA and WMBfsb both satisfied this requirement at June 30, 2003.
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Our broker-dealer subsidiaries are also subject to capital requirements. At June 30, 2003, both of our broker-dealer subsidiaries were in compliance with their applicable capital requirements.
During the three and six months ended June 30, 2003, the Company repurchased 15.3 million and 25.5 million shares of our common stock at an average price of $40.52 and $38.08 per share as part of our share repurchase program. Effective July 15, 2003, the Company adopted a new share purchase program approved by the Board of Directors. Under the new program, the Company is authorized to repurchase up to 100 million shares of its common stock, as conditions warrant. This Program replaces the Company’s previous share repurchase program. From July 1, 2003 through July 31, 2003, the Company repurchased an additional 2.2 million shares. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.
Market risk is defined as the sensitivity of income, fair market values and capital to changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market rates or prices. The primary market risk to which we are exposed is interest rate risk. Substantially all of our interest rate risk arises from instruments, positions and transactions entered into for purposes other than trading. They include loans, MSR, securities, deposits, borrowings, long-term debt and derivative financial instruments.
We are exposed to different types of interest rate risks, including lag, repricing, basis, prepayment and lifetime cap risk. These risks are described in further detail within the “Market Risk Management” section of Management’s Discussion and Analysis in our 2002 Annual Report on Form 10-K. We manage interest rate risk within an overall asset/liability management framework. The principal objective of our asset/liability management is to manage the sensitivity of net income to changing interest rates. Asset/liability management is governed by a policy reviewed and approved annually by our Board. The Board has delegated the oversight of the administration of this policy to the Finance Committee of the Board of Directors.
Management of Interest Rate Risk
We manage our balance sheet to mitigate the impact of changes in market interest rates on net income and changes in the fair value of MSR. Key components of our balance sheet strategy include the origination and retention of short-term and adjustable-rate assets, the origination and sale of most fixed-rate and certain hybrid adjustable-rate mortgage loans, the management of MSR and the management of our deposit and borrowing portfolios. We may also modify our interest rate risk profile with interest rate contracts, including embedded derivatives and forward commitments.
Overall, we believe our risk management program will minimize net income sensitivity under most interest rate environments. However, the success of this program is dependent on the judgments we make regarding the direction and timing of changes in interest rates and the amount and mix of risk management instruments that we believe are appropriate to manage our interest rate risk. Our net income could be adversely affected if we are unable to effectively implement, execute or manage this strategy.
Asset/Liability Risk Management
The interest rate contracts that are classified as asset/liability risk management instruments are intended to assist in the management of our net interest income. These contracts are often used to modify the repricing period of our interest-bearing funding with the intention of reducing the volatility of changes in net interest income. The types of contracts used for this purpose consist of interest rate swaps, interest rate corridors and certain derivatives that are embedded in borrowings. The aggregate notional amount of these contracts totaled $38.01 billion at June 30, 2003.
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The pay-fixed swaps, interest rate corridors and embedded payor swaptions are intended to assist in reducing the sensitivity of the net interest margin to changes in interest rates. The embedded payor swaptions are exercisable upon maturity, which ranges from July 2003 to February 2004. None of the interest rate corridors had strike rates that were in the money at June 30, 2003. We also use receive-fixed swaps as part of our asset/liability risk management strategy to help us modify the repricing characteristics of certain long-term liabilities to match those of our assets. Typically, these are swaps of long-term fixed-rate debt to a short-term adjustable-rate which more closely resembles our asset repricing characteristics.
MSR Risk Management
As part of our overall approach to interest rate risk management, we manage potential impairment in the fair value of MSR and increased amortization levels of MSR by a comprehensive risk management program. Our intent is to offset the changes in fair value and higher amortization levels of MSR with changes in the fair value of risk management instruments. The risk management instruments include forward purchase commitments, interest rate contracts and available-for-sale securities. The goal is to offset decreases (increases) in the fair value of MSR with increases (decreases) in the fair value of the forward purchase commitments, interest rate contracts and available-for-sale securities.
The available-for-sale securities generally consist of fixed-rate debt securities, such as U.S. Government and agency bonds and mortgage-backed securities, including principal-only strips. The interest rate contracts typically consist of interest rate floors and interest rate swaps and swaptions. From time to time, we may choose to embed interest rate contracts into our borrowing instruments, such as repurchase agreements. The forward purchase commitments generally consist of agreements to purchase 15- and 30-year fixed-rate mortgage-backed securities.
As derivatives, the interest rate swaps, swaptions, stand alone interest rate floors and forward commitments receive mark-to-market accounting treatment. Changes in the fair value of instruments that manage MSR fair value changes are recorded as components of noninterest income.
We adjust the mix of instruments used to manage MSR fair value changes as interest rates and market conditions warrant. The intent is to maintain an efficient and fairly liquid mix as well as a diverse portfolio of risk management instruments with broad maturity ranges. We may elect to increase or decrease our concentration of specific instruments during certain times based on market conditions. We believe this approach will result in the most efficient strategy. However, our net income could be adversely affected if we are unable to effectively implement, execute or manage this strategy.
The mix of instruments is predicated, in part, on the requirement of lower of cost or market accounting treatment for MSR; i.e. each MSR stratum is recorded at its fair value unless the fair value exceeds the amortized cost. This could result in increases in the fair value of MSR that are not marked-to-market through earnings. Therefore, management may elect to decrease the emphasis on risk management instruments accorded mark-to-market accounting treatment in periods in which the fair value of MSR significantly exceeds its amortized cost.
We also manage the size and risk profile of the MSR asset. Depending on market conditions and our desire to expand customer relationships, we may periodically sell or purchase servicing rights. We also may structure loan sales to reduce the size of the MSR asset.
Other Mortgage Banking Risk Management
We also manage the risks associated with our mortgage warehouse and pipeline. The mortgage warehouse consists of fixed-rate and, to a lesser degree, adjustable-rate home loans to be sold in the secondary market. The pipeline consists of commitments to originate or purchase fixed-rate and, to a lesser degree, adjustable-rate home
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loans to be sold in the secondary market. The risk associated with the mortgage pipeline and warehouse is the potential change in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold. This period is usually 60 to 120 days.
To manage the warehouse and pipeline risks, we execute forward sales commitments, mortgage option contracts and interest rate futures. A forward sales commitment protects us in a rising interest rate environment, since the sales price and delivery date are already established. A forward sales commitment is different, however, from an option contract in that we are obligated to deliver the loan to the third party on the agreed-upon future date. We also consider the fallout factor, which represents the percentage of loans that are not expected to close, when determining the appropriate amount of forward sales commitments.
June 30, 2003 and December 31, 2002 Sensitivity Comparison
To analyze net income sensitivity, we project net income over a twelve month horizon based on parallel shifts in the yield curve. Management employs other analyses and interest rate scenarios to evaluate interest rate risk. For example, we project net income and net interest income under a variety of interest rate scenarios, including immediate parallel shifts in the yield curve, non-parallel shifts in the yield curve and more extreme non-parallel rising and falling interest rate environments. These additional scenarios also address the risk exposure over longer periods of time. They also capture the net income and net interest income sensitivity due to changes in the slope of the yield curve and changes in the spread between Treasury and LIBOR rates. The Company’s net income and net interest income sensitivity analysis methodologies are described in further detail within the “Market Risk Management” section of Management’s Discussion and Analysis in our 2002 Annual Report on Form 10-K.
The table below indicates the sensitivity of net income and net interest income to interest rate movements. The comparative scenarios assume a parallel shift in the yield curve with interest rates rising 200 basis points in even quarterly increments over the twelve month periods ending June 30, 2004 and December 31, 2003 and interest rates decreasing by 50 basis points in even quarterly increments over the first six months of the twelve month period.
Net income change for the one-year period beginning:
July 1, 2003
January 1, 2003
Net interest income change for the one-year period beginning:
The projected increase in net income in the -50 basis point scenario in the July 1st analysis was less than in the January 1st analysis due to a reduction in the anticipated increase in net interest income as well as a slightly less favorable change in the fair value of the MSR and the MSR risk management instruments. The change in net interest income was due to modest decreases in the expansion of the net interest margin and increased balance sheet shrinkage. The slight increase in net income in the +200 basis point environment was due to the reduced sensitivity of net interest income which was partially offset by further decreases in gain from mortgage loans. Net interest income improved from the levels in the January 1, 2003 analysis in the +200 basis point scenario mainly due to an increase in interest-earning assets in this environment. The projected growth in interest-earning assets was mainly due to the anticipated purchase of investment securities used to manage the fair value changes of the MSR after the fair value of the MSR begins to exceed its amortized cost and thus cannot be marked-to-market through earnings. The balance sheet was projected to decrease without these purchases of investment securities due to the expected decline in the extremely high levels of loans held for sale that are not expected to be entirely offset by increases in the loans held in portfolio balance.
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We use interest rate risk management contracts and available-for-sale securities as tools to manage our interest rate risk profile. The following tables summarize the key contractual terms associated with these contracts and available-for-sale securities. Interest rate risk management contracts that are embedded within certain adjustable- and fixed-rate borrowings, while not accounted for as derivatives under Statement No. 133, have been included in the tables since they also function as interest rate risk management tools. Substantially all of the pay-fixed swaps, receive-fixed swaps, payor swaptions, floors and embedded derivatives at June 30, 2003 are indexed to three-month LIBOR.
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The following estimated net fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies:
Interest Rate Risk Management Contracts:
Pay-fixed swaps:
Contractual maturity
Weighted average pay rate
Weighted average receive rate
Receive-fixed swaps:
Interest rate corridors:
Weighted average strike rate—long cap
Weighted average strike rate—short cap
Embedded pay-fixed swaps:
Embedded caps:
Weighted average strike rate
Embedded payor swaptions(1):
Contractual maturity (option)
Contractual maturity (swap)
Total asset/liability risk management
Forward purchase commitments:
Weighted average price
Forward sales commitments:
Interest rate futures:
Mortgage put options:
Weighted average strike price
Total other mortgage banking risk management
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Constant maturity mortgage swaps:
Floors(2):
Payor swaptions:
Total interest rate contracts
Total MSR risk management
Total interest rate risk management contracts
Available-For-Sale Securities:
Mortgage-backed securities(1):
Investment securities(1):
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Interest rate caps:
Payor swaptions(1):
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Receiver swaptions:
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Derivative Counterparty Credit Risk
Derivative financial instruments expose the Company to credit risk in the event of nonperformance by counterparties to such agreements. This risk consists primarily of the termination value of agreements where the company is in a favorable position. Credit risk related to derivative financial instruments is considered and provided for separately from the allowance for loan and lease losses. The Company manages the credit risk associated with its various derivative agreements through counterparty credit review, counterparty exposure limits and monitoring procedures. Substantially all of the counterparty credit risk associated with derivative financial instruments is with counterparties rated A or better by Standard & Poor’s at June 30, 2003. The Company obtains collateral from the counterparties for amounts in excess of the exposure limits and monitors its exposure and collateral requirements on a daily basis. The fair value of collateral either received from or provided to 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 June 30, 2003 and December 31, 2002, the Company’s credit risk related to derivative financial instruments, net of the effects of collateral and master netting agreements, was $422 million and $780 million.
Gap Report
A historical view of interest rate sensitivity for savings institutions is the gap report, which indicates the difference between assets maturing or repricing within a period and total liabilities maturing or repricing within the same period. In assigning assets to maturity and repricing categories, we consider expected prepayment speeds and amortization of principal in addition to the contractual maturities. The analysis excludes reinvestment of cash. Prepayment assumptions are based on internal projections based on an analysis of market prepayment estimates and past experience with our current loan and mortgage-backed securities portfolios. The majority of our transaction deposits are not contractually subject to repricing. Therefore, these instruments have been allocated based on expected decay rates and/or repricing intervals. Certain transaction deposits that reprice based on a market index or which typically have frequent repricing intervals are allocated to the repricing or maturity buckets based on the expected repricing period. Non-rate sensitive items such as the reserve for loan losses, mark-to-market adjustments, premiums and discounts and deferred loan fees/costs are not included in the table. Loans held for sale are included in the 0-3 months category, provided that these instruments are offset with forward commitments to sell loans. In addition, MSR risk management contracts are excluded from the analysis except for the pay-fixed swaps that were fair value hedges of specified fixed-rate investment securities.
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The gap information is limited by the fact that it is a point-in-time analysis. The data reflects conditions and assumptions as of June 30, 2003. These conditions and assumptions may not be appropriate at another point in time. The analysis is also subject to the accuracy of various assumptions used, particularly the prepayment and decay rate projections, the expected repricing period of certain deposits and the allocation of instruments with optionality to a specific maturity category, especially interest rate contracts. Consequently, the interpretation of the gap information is subjective.
Interest-Sensitive Assets
Adjustable-rate loans(1)
Fixed-rate loans(1)
Adjustable-rate securities(1)(2)
Fixed-rate securities(1)
Cash and cash equivalents, federal funds sold and securities purchased under resale agreements
Derivatives matched against assets
Interest-Sensitive Liabilities
Noninterest-bearing deposits(3)
Interest-bearing checking accounts, savings accounts and money market deposit accounts(3)
Interest-bearing time deposit accounts
Short-term and adjustable-rate borrowings
Long-term fixed-rate borrowings
Derivatives matched against liabilities
Repricing gap
Cumulative gap
Cumulative gap as a percentage of total assets
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PART II—OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders.
Washington Mutual, Inc. held its annual meeting of shareholders on April 15, 2003. A brief description of each matter voted on and the results of the shareholder voting are set forth below:
1.
2.
3.
4.
Each of the following directors who were not up for re-election at the annual meeting of shareholders will continue to serve as directors: Anne V. Farrell, Stephen E. Frank, Phillip D. Matthews, Margaret Osmer McQuade, Mary E. Pugh, William G. Reed, Jr., William D. Schulte and James H. Stever.
(a) Exhibits
See Index of Exhibits on page 57.
(b) Reports on Form 8-K
1. The Company filed a report on Form 8-K dated April 15, 2003, under Item 9. The report included a press release reporting Washington Mutual’s results of operations for the first quarter ended March 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on August 14, 2003.
/s/ THOMAS W. CASEY
Thomas W. Casey
Executive Vice President and Chief Financial Officer
/s/ ROBERT H. MILES
Robert H. Miles
Senior Vice President and Controller (Principal Accounting Officer)
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INDEX OF EXHIBITS
57