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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K


(Mark One)


[X]

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR FISCAL YEAR ENDED DECEMBER 31, 2001

OR

[  ]

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM              TO              :

Commission File Number 1-14667

WASHINGTON MUTUAL, INC.
(Exact name of registrant as specified in its charter)


Washington   91-1653725
(State or Other Jurisdiction of Incorporation
or Organization)
  (I.R.S. Employer
Identification Number)

1201 Third Avenue, Seattle, Washington

 

98101
(Address of Principal Executive Offices)   (Zip Code)

Registrant's telephone number, including area code: (206) 461-2000


Securities registered pursuant to Section 12(b) of the Act:

Title of each class
  Name of each exchange
on which registered

Common Stock   New York Stock Exchange
8% Corporate Premium Income Equity Securities   New York Stock Exchange
Litigation Tracking Warrants TM   NASDAQ

Securities registered pursuant to Section 12(g) of the Act: none

        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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [    ]

        The aggregate market value of voting stock held by nonaffiliates of the registrant as of March 1, 2002:

Common Stock — $31,328,958,175 (1)

(1)   Does not include any value attributable to 18,000,000 shares that are held in escrow and not traded.

        The number of shares outstanding of the issuer's classes of common stock as of March 1, 2002:

Common Stock — 971,374,311 (2)

(2)   Includes the 18,000,000 shares held in escrow.

Documents Incorporated by Reference

        Portions of the definitive proxy statement for the Annual Meeting of Shareholders to be held April 16, 2002, are incorporated by reference into Part III.





WASHINGTON MUTUAL, INC.

2001 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 
  Page
PART I   1
  Item 1. Business   1
    Overview   1
    Banking and Financial Services Group   1
    Home Loans and Insurance Services Group   2
    Specialty Finance Group   4
    Employees   5
    Factors That May Affect Future Results   5
    Business Combinations   8
    Taxation   8
    Environmental Regulation   9
    Regulation and Supervision   10
    Principal Officers   21
  Item 2. Properties   23
  Item 3. Legal Proceedings   23
  Item 4. Submission of Matters to a Vote of Security Holders   23
PART II   24
  Item 5. Market for our Common Stock and Related Security Holder Matters   24
  Item 6. Selected Financial Data   25
  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations   25
    Cautionary Statements   25
    Overview   26
    Recently Issued Accounting Standards   26
    Critical Accounting Policies   27
    Earnings Performance   27
    Review of Financial Condition   34
    Asset Quality   38
    Operating Segments   44
    Liquidity   45
    Capital Adequacy   46
    Market Risk Management   47
    Maturity and Repricing Information   54
    Tax Contingency   55
    Goodwill Litigation   56
  Item 7A. Quantitative and Qualitative Disclosures about Market Risk   47
  Item 8. Financial Statements and Supplementary Data   58
  Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   58
PART III   59
PART IV   59
  Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K   59

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PART I

Business

    Overview

        With a history dating back to 1889, Washington Mutual, Inc. is a financial services company committed to serving consumers and small- to mid-sized businesses. Based on our consolidated assets at December 31, 2001, we were the largest savings institution and the seventh largest banking company in the United States.

        Our assets have grown over the last six years primarily through acquisitions. In 1996, we acquired Keystone Holdings, Inc., the parent of American Savings Bank, F.A. This acquisition, referred to as the "Keystone Transaction," gave us our first depository institution in California. In 1997, we acquired Great Western Financial Corporation and in October 1998, we acquired H.F. Ahmanson & Co. ("Ahmanson"). In February 1998, Ahmanson had acquired Coast Savings Financial, Inc.

        During 2001, we completed three acquisitions. On January 31, we acquired the mortgage operations of The PNC Financial Services Group, Inc. ("PNC"). On February 9, we acquired Texas-based Bank United Corp. ("Bank United"), and on June 1, we acquired Fleet Mortgage Corp., a unit of FleetBoston Financial Corp., and certain other mortgage lending operations of Fleet National Bank ("Fleet"). Substantially due to these acquisitions, our loan servicing portfolio (excluding loans retained in our portfolio) grew from $79.34 billion at January 1, 2001 to $378.38 billion at December 31, 2001. Correspondingly, the mortgage servicing rights ("MSR") associated with our servicing portfolio increased from $1.02 billion at January 1, 2001 to $6.24 billion at December 31, 2001. The acquisition of Bank United also increased our deposit base by $8.09 billion and added approximately $12 billion to our loans held in portfolio.

        On January 4, 2002, we completed our acquisition of New York-based Dime Bancorp, Inc. ("Dime"). This acquisition added approximately $28 billion to our asset base, and increased our deposit base by approximately $15 billion.

        On March 1, 2002, we acquired for cash certain operating assets of HomeSide Lending, Inc. ("HomeSide"). HomeSide is the U.S. mortgage unit of the National Australia Bank Limited ("National"). We will subservice HomeSide's $187 billion mortgage servicing portfolio. National retained ownership of HomeSide's mortgage servicing rights, along with the related hedges and certain other assets and liabilities.

        We manage our operations by grouping our products and services within business segments. These business segments are:

    Banking and Financial Services Group

    Home Loans and Insurance Services Group

    Specialty Finance Group

        In addition, the management of our interest rate risk, liquidity, capital, borrowings and purchased investment securities portfolios are performed by our Treasury Division.

Banking and Financial Services Group

        The Banking and Financial Services Group ("Banking & FS") offers a comprehensive line of consumer and business financial products and services to individuals and small and middle market businesses. Banking & FS provides services to approximately seven million consumer and business households through over 1,400 financial centers (both free-standing and in-store), 51 business banking centers, and over 2,150 automated teller machines located in twelve states. With the acquisitions of Bank United and Dime, the group now serves more than 415,000 households in Texas through over 200 financial

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centers, and approximately one million households in the greater New York metropolitan area through 123 financial centers and approximately 250 automated teller machines.

        Banking & FS offers various consumer deposit products as well as a variety of fee-based banking services. Deposit products offered include the group's signature Free Checking accounts as well as savings accounts, money market deposit accounts and time deposit accounts. In 2001 the group introduced a new checking account product, the Platinum Account, which combines a money market rate of interest with a checking account. In addition to traditional banking products, fixed annuities, home mortgage loans and insurance products are made available through the financial centers. The group also offers investment advisory and securities brokerage services. Banking & FS offers customers the convenience of 24-hour telephone and internet banking and investment services through wamu.com, wmfinancial.com, wmgroupoffunds.com and invest1to1.com.

        In 2000, Banking & FS began opening financial centers in Las Vegas with project Occasio TM (Latin for "favorable opportunity"), which features a new retail approach to banking. Occasio financial centers serve customers in an open, free-flowing retail environment where they can interact with roaming customer service representatives. Occasio provides Banking & FS a vehicle for expanding into new market areas where acquisition opportunities may be limited. By the end of 2001, the group had opened 20 Occasio financial centers in Las Vegas and 16 Occasio financial centers in Phoenix and established a retail banking presence in Atlanta with the opening of 20 Occasio financial centers. The group will continue to expand its presence in Phoenix and Atlanta and expects eventually to have a total of approximately 40 and 80 Occasio financial centers in those markets, respectively. Future plans for project Occasio also include the enhancement of the group's financial center network in existing markets, including the greater New York metropolitan area. Additional market areas are also under evaluation for the future expansion of project Occasio.

        Banking & FS offers a full array of consumer and business loan products. Consumer lending products include home equity lines of credit and loans, transportation financing (cars, recreational vehicles and boats), student loans, lines of credit and installment loans, and manufactured housing loans. Credit products and financial services offered to small- and mid-sized businesses include lines of credit, receivables and inventory financing, equipment loans, real estate financing, Small Business Administration ("SBA") loans, international trade financing, cash management and merchant bankcard services. One of Banking & FS's primary business objectives is to expand consumer and business lending activities, as they generally offer higher yields than prime mortgage lending activities. The size of the consumer and business loan portfolios has grown in recent years, partly due to the introduction of the consumer lending product line in California, Florida and Texas and the expansion of business banking in California. The merger with Bank United also strengthened the group's market position for business lending in Texas and nationally through SBA lending offices.

        The group's investment services are offered to the public by over 500 financial consultants of WM Financial Services, a licensed broker-dealer. Fixed annuities are offered to the public by over 900 bank employees licensed to offer such products. Investment advisory and distribution services for WM Group of Funds are provided respectively by WM Advisors, Inc. and WM Funds Distributor, Inc. At December 31, 2001, WM Advisors had $11.58 billion of assets under management.

Home Loans and Insurance Services Group

        The principal activities of the Home Loans & Insurance Services Group ("Home Loans Group") are originating and servicing single-family residential ("SFR") loans. Loans are originated and held in the loan portfolio or sold into the secondary market. The Home Loans Group also offers insurance products that complement the mortgage lending process. The group's products are offered to customers through multiple distribution channels, including retail home loan centers, financial centers, correspondent channels, wholesale home loan centers, and consumer direct through call centers and the internet.

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        The acquisitions of Bank United and the mortgage operations of PNC and Fleet in 2001, and Dime, including its North American Mortgage Company subsidiary, in early 2002 have significantly strengthened the group's mortgage banking capability, further diversified its mortgage operations geographically, increased its servicing portfolio, and enhanced its market position in the home lending business. These acquisitions strengthened our ability to originate loans in all 50 states, including originating FHA-insured and VA-guaranteed loans on a national scale. The correspondent lending channel, in particular, grew significantly during 2001, as the result of the acquisition of the mortgage operations of PNC and Fleet. These acquisitions, along with the recently completed acquisition of certain operating assets of HomeSide, have made the Home Loans Group the nation's largest residential mortgage servicer.

        The Home Loans Group has developed an automated mortgage origination platform, Optis TM . The first release of Optis was completed in 2001 and is designed to enhance productivity with automated pricing and approval, while providing consistent evaluations of credit quality. The second release is expected to improve functionality of the mortgage origination process, reduce costs and improve operating efficiencies.

        The Home Loans Group's strength as a portfolio lender provides customers with a range of choices designed to meet their financial needs. The group offers a broad product line that includes adjustable-rate mortgages ("ARMs") offering borrowers multiple payment options, traditional ARMs, and fixed-rate mortgages, both conforming and nonconforming. The Home Loans Group also offers FHA-insured and VA-guaranteed fixed-rate mortgages and, through Long Beach Mortgage Company ("Long Beach Mortgage"), its subprime wholesale channel, originates specialty home loans, a component of specialty mortgage finance ("SMF") lending.

        To manage risk, all loans originated are subjected to the same nondiscriminatory underwriting standards and to certain restrictions on terms and origination practices. The determination of the risk and the amount of review necessary is based on the credit profile of the borrower and the size and characteristics of the loan. Additionally, the group performs re-underwriting and appraisal review on some of the loans acquired from its correspondents, or delegates the underwriting of these loans to specific correspondents. All loans secured by first liens on real property require title insurance and casualty insurance for the lesser of the outstanding balance of the loan plus all prior liens on the property or the replacement cost of the property.

        The Home Loans Group generally retains the servicing of loans that are originated for sale into the secondary market, thereby maintaining the customer relationship. Mortgage servicing is the administration and collection of mortgage payments and fees. The SFR servicing portfolio (including loans retained in the portfolio) grew from approximately 1.4 million customers at December 31, 2000 to approximately 4.3 million at December 31, 2001 with an average loan size of $115,000. At year-end, Washington Mutual had a $496.7 billion loan servicing portfolio which represented an 8.62% market share, based upon a 2001 mortgage servicer ranking by Inside Mortgage Finance . As part of the integration steps taken on the recent acquisitions, the group consolidated eight servicing facilities into four to reduce overhead. The remaining four locations are in California, South Carolina, Wisconsin and Illinois. With the recent acquisition of certain operating assets of HomeSide, the group acquired two additional servicing sites in Texas and Florida and a loan servicing platform that, together with the Optis origination platform, is expected to enable end-to-end control of the mortgage process.

        The capital markets function of the Home Loans Group manages loan pricing and loan sales, and loans purchased from correspondents. Capital markets also hedges the interest rate risk of loans originated for sale by entering into forward sales agreements and by purchasing interest rate option contracts. Capital markets sells most of the fixed-rate SFR loan volume, with most fixed-rate conforming mortgage loans sold to government sponsored enterprises ("GSEs") such as Fannie Mae ("FNMA"). Loans that do not conform to GSE standards, such as jumbo loans, are generally held in portfolio or sold by capital markets in the secondary market either directly or through securitizations. Capital markets also periodically sells

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originated SMF loans in whole loan or securitization transactions. ARM loans are also sold periodically in the secondary market in order to manage asset growth more efficiently. In addition, the group is developing an institutional broker-dealer business to help facilitate its loan securitizations. When licensing is completed later this year, the broker-dealer business will provide a link between the Home Loans Group and the capital markets, allowing the group to sell, trade, and underwrite mortgage-related products directly to institutional investors.

        The Home Loans Group manages a portfolio of originated ARM and fixed-rate loans and mortgage-backed securities ("MBS"). The group also purchases and manages SMF loans with risk characteristics similar to those originated by Long Beach Mortgage. While the group reviews and re-underwrites SMF loans for unacceptable credit risk, charge offs on these loans are expected to be higher over time than on the group's prime mortgage loans. SMF loans have higher credit risk and, thus, generally provide higher risk-adjusted yields than prime mortgage loans or agency MBS.

        The Home Loans Group provides insurance services that support the mortgage lending process by offering homeowners, flood, earthquake and other property and casualty insurance products to mortgage borrowers. In addition, the group offers mortgage life insurance, accidental death and dismemberment, term and whole life insurance, and other insurance products to existing mortgage and deposit customers. The group also manages the Company's captive private mortgage reinsurance activities. The group's insurance services website, wamuins.com, provides information, quotes, and buying capabilities over the internet.

Specialty Finance Group

        The Specialty Finance Group provides real estate secured financing primarily for multi-family properties. Additionally, the group provides commercial real estate lending and residential builder construction financing as a part of its secured financing activities. The group also offers mortgage banker financing and conducts a consumer finance business through Washington Mutual Finance Corporation ("Washington Mutual Finance"). Washington Mutual Finance currently operates 459 branches in 25 states, primarily in the southeastern United States, Texas and California.

        The group's multi-family lending base includes products for permanent financing, construction lending and rehab financing. Multi-family loans are offered to property owners and developers throughout the United States. While the national market for multi-family lending is quite large, market share is highly fragmented, as the top 25 lenders account for only 32% of the total number of loans originated annually. As part of its business strategy, the Specialty Finance Group intends to seek additional market share by pursuing multi-family industry consolidation opportunities.

        The Specialty Finance Group's multi-family lending program revolves around three key elements: originating loans, servicing loans and providing ancillary banking services to enhance customer retention. Combining these three elements under one umbrella has allowed the group to attain a leading market position in this field.

        The Company was recently ranked as a leading national originator of multi-family loans, measured both in terms of number of loans and total origination dollar volume. This has been achieved through both internal growth and acquisitions. The recent acquisitions of Bank United and Dime have expanded our origination activities into the Midwest and East and broadened our multi-family product line.

        The Company also leads the nation in the number of multi-family loans serviced. Around this servicing base, the Specialty Finance Group is developing uniform loan servicing standards across a national servicing platform. Periodic economic analysis, such as debt service coverage on each property and ongoing credit review will also be part of this platform's capabilities. Additionally, the group is developing a scalable business template that is designed to enable it to maintain high levels of service with low operating costs in all types of multi-family markets.

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        Combining the origination and servicing of multi-family loans with full-service banking allows the Specialty Finance Group to focus on the customers' total needs. As part of this relationship banking, the group provides operating accounts for daily cash needs, investment accounts for security and escrow deposits, and other business-related accounts to ensure that customers are offered a full array of banking services.

        The Specialty Finance Group also provides loans for residential builders, real estate developers, and mortgage bankers. These areas represent approximately 30% of the total non multi-family commercial lending activities of the group. As an extension of its multi-family lending activities, these products will provide additional services to the group's traditional customer base. The group anticipates further growth in these product categories, as the Company expands its multi-family lending.

        In addition to the commercial lending and servicing activities mentioned above, the Specialty Finance Group, through Washington Mutual Finance, originates and services consumer installment loans and consumer real estate secured loans. These loans are generally held in the loan portfolio. Loans originated by Washington Mutual Finance generally earn higher yields than loans made by the Company's banking subsidiaries because they tend to have higher credit risk. The majority of the growth in the loan portfolio originated in 2001 was related to loans secured by real estate. The consumer installment loans are primarily for personal, family or household purposes. Such loans are unsecured or secured by luxury goods, automobiles or other personal property. Additionally, Washington Mutual Finance acquires installment contracts from local retail establishments, usually without recourse to the originating merchant.

Employees

        Our number of full-time equivalent employees ("FTE") at December 31, 2001 was 39,465, compared with 28,798 at December 31, 2000 and 28,509 at December 31, 1999. During 2001, the number of FTE increased primarily as a result of the acquisitions of Bank United and the mortgage operations of PNC and Fleet. In addition, the acquisition of Dime added approximately 6,900 FTE during the first quarter of 2002. We believe that we have been successful in attracting quality employees and that our employee relations are good.

Factors That May Affect Future Results

        From time to time, we have made and will make forward-looking statements. Our Form 10-K and other documents that we file with the Securities and Exchange Commission have 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.

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        Some of these factors are described below.

    General business and economic conditions may significantly affect our earnings.

        Our business and earnings are sensitive to general business and economic conditions. These conditions include short-term and long-term interest rates, inflation, money supply, fluctuations in both debt and equity capital markets, the strength of the U.S. economy, and the local economies in which we conduct business. If any of these conditions worsen, our business and earnings could be adversely affected. For example, if short-term interest rates rise faster than mortgage rates, our net interest income, which is our largest component of net income, would be adversely affected. A prolonged economic downturn could increase the number of customers who become delinquent or default on their loans, or a rising interest rate environment could decrease the demand for loans. An increase in delinquencies or defaults could result in a higher level of charge offs and provision for loan and lease losses, which could adversely affect our earnings.

        In addition, our business and earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. The Federal Reserve Board's policies directly and indirectly influence the yield on our interest-earning assets and the cost of our interest-bearing liabilities. Changes in those policies are beyond our control and difficult to predict.

    If we are unable to effectively manage the volatility of our mortgage banking business, our earnings could be adversely affected.

        During 2001, through a series of acquisitions, we became one of the largest originators and servicers of SFR loans in the nation. Changes in interest rates significantly affect the mortgage banking business. One of the principal risks to the mortgage banking business is prepayments and their effect on MSR. One of the ways we mitigate this risk is by purchasing financial instruments, such as fixed-rate investment securities, which tend to increase in value when long-term interest rates decline. The success of this strategy, however, is dependent on management's judgments regarding the direction and timing of changes in long-term interest rates, and the resulting decisions that are made regarding the purchases and subsequent sales of these financial instruments. If this strategy is not successful, our net income could be adversely affected. For further discussion of how MSR prepayment risk is managed, see "Market Risk Management."

    A failure to effectively integrate the operations and personnel of companies we have acquired could adversely affect our earnings and financial condition.

        During 2001 and early 2002, we consummated five large acquisitions. As a result of these acquisitions, we significantly expanded our mortgage banking and loan servicing business, greatly expanded our consumer banking and lending presence in Texas and began consumer banking operations in the State of New York. If we experience difficulties in integrating the acquired operations into our company, including the integration of technology platforms, this could result in higher than anticipated administrative costs, employee turnover and the loss of customers, among other things. These events could cause our earnings to be lower than anticipated and could adversely affect our operations and financial condition.

    Due to the concentration of our operations in California, a decline in the California economy could adversely affect our earnings and financial condition.

        At December 31, 2001, 51% of our SFR and multi-family loan portfolio and 63% of our deposits were concentrated in California. Consequently, our results of operations and financial condition are particularly subject to the conditions in the single-family and multi-family residential markets in California. If economic conditions generally, or in California in particular, worsen or if the market for residential real

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estate declines, we may experience greater delinquencies, which may result in a higher provision for loan and lease losses and decreased collateral values on our existing portfolio. We also may not be able to originate the volume or type of loans or achieve the level of deposits that we currently anticipate.

    The financial services industry is highly competitive.

        We operate in a highly competitive environment. The activities of our three major lines of business (Banking and Financial Services, Home Loans and Insurance Services, and Specialty Finance) are subject to significant competition in attracting and retaining deposits and making loans as well as in providing other financial services in all of our market areas. We face competition in customer service, interest rates on loans and deposits, lending limits and customer convenience, such as product lines offered and the accessibility of services.

        Our most direct competition for deposits comes from savings institutions, credit unions and commercial banks doing business in our market areas. Enacted in 1999, the Gramm-Leach-Bliley Act ("GLB Act") does not increase our authority to affiliate, but it does benefit our competitors, as discussed below. As with all banking organizations, we have also experienced competition from nonbanking sources, including mutual funds, corporate and governmental debt securities and other investment alternatives offered within and outside of our primary market areas.

        Our most direct competition for loans comes from other savings institutions, national mortgage companies, insurance companies, commercial banks and GSEs. In addition to the provisions of the GLB Act, technological advances and heightened e-commerce activities have also increased accessibility to services without physical presence, which has intensified competition among banking as well as nonbanking companies in offering financial products and services. Although our competitors' activities may make it a bigger challenge for us to achieve our financial goals, we are continuously reassessing our overall competitive edge to attract more customers for our products and services.

    Changes in the regulation of financial services companies could adversely affect our business.

        Proposals for further regulation of the financial services industry are continually being introduced in Congress. The agencies regulating the financial services industry periodically adopt changes to their regulations. It is possible that one or more legislative proposals may be adopted or regulatory changes may be made that would have an adverse effect on our business. For further discussion of the regulations of financial services, see "Regulation and Supervision — Recent and Proposed Legislation and Regulation."

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Business Combinations

        Most of our growth since 1988 has occurred as a result of business combinations. The following table summarizes our business combinations since 1988:

Acquisition Name

  Date Acquired
  Loans
  Deposits
  Assets
 
   
  (in millions)

Columbia Federal Savings Bank and Shoreline Savings Bank   April 29, 1988   $ 551   $ 555   $ 753
Old Stone Bank (1)   June 1, 1990     230     293     294
Frontier Federal Savings Association (2)   June 30, 1990     -     96     -
Williamsburg Federal Savings Bank (2)   Sept. 14, 1990     -     4     -
Vancouver Federal Savings Bank   July 31, 1991     200     253     261
CrossLand Savings, FSB (2)   Nov. 8, 1991     -     185     -
Sound Savings and Loan Association   Jan. 1, 1992     17     21     24
World Savings and Loan Association (2)   March 6, 1992     -     38     -
Great Northwest Bank   April 1, 1992     603     586     710
Pioneer Savings Bank   March 1, 1993     625     660     927
Pacific First Bank, a Federal Savings Bank   April 9, 1993     3,771     3,832     5,861
Far West Federal Savings Bank (2)   April 15, 1994     -     42     -
Summit Savings Bank   Nov. 14, 1994     128     169     188
Olympus Bank, a Federal Savings Bank   April 28, 1995     238     279     391
Enterprise Bank   Aug. 31, 1995     93     139     154
Western Bank   Jan. 31, 1996     501     696     776
Utah Federal Savings Bank   Nov. 30, 1996     89     107     122
Keystone Holdings, Inc.   Dec. 20, 1996     14,563     12,815     21,894
United Western Financial Group   Jan. 15, 1997     273     300     404
Great Western Financial Corporation   July 1, 1997     32,448     27,785     43,770
H.F. Ahmanson & Company (3)   Oct. 1, 1998     33,939     33,975     50,355
Industrial Bank   Dec. 31, 1998     11     26     27
Long Beach Financial Corporation   Oct. 1, 1999     415     -     821
Alta Residential Mortgage Trust   Feb. 1, 2000     156     -     158
Mortgage operations of The PNC Financial Services Group, Inc. (1)   Jan. 31, 2001     3,352     -     7,307
Bank United Corp.    Feb. 9, 2001     14,983     8,093     19,034
Fleet Mortgage Corp. (1)   Jun 1, 2001     4,378     -     7,813
Dime Bancorp, Inc.   Jan. 4, 2002     16,271     15,117     27,934
HomeSide Lending, Inc. (1)   Mar. 1, 2002     1,071     -     1,178

(1)
This was an acquisition of selected assets and/or liabilities.
(2)
The acquisition was of financial centers and deposits only. The only assets acquired were branch facilities or loans collateralized by acquired savings deposits.
(3)
Includes loans, deposits and assets acquired by Ahmanson from Coast Savings Financial, Inc.

Taxation

    General

        For federal income tax purposes, we report income and expenses using the accrual method of accounting on a calendar year basis. We are subject to federal income tax under existing provisions of the Internal Revenue Code of 1986, as amended (the "Code"), in generally the same manner as other corporations.

    State Income Taxation

        Many of the states in which we do business, impose corporate income taxes on companies doing business in those states. The state of Washington does not currently have a corporate income tax. Washington imposes on businesses a business and occupation tax based on a percentage of gross receipts.

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Currently, the tax does not apply to interest received on loans secured by first mortgages or deeds of trust on residential properties. However, it is possible that legislation might be introduced in the future that would repeal or limit this exemption.

    Assistance Agreement

        In connection with the Keystone Transaction, we acquired American Savings Bank, F.A. ("ASB"). ASB was formed to effect the December 1988 acquisition (the "1988 Acquisition") of certain assets and liabilities of the failed savings and loan association subsidiary of Financial Corporation of America. In connection with the 1988 Acquisition, Keystone Holdings and certain of its affiliates entered into a number of continuing agreements with the predecessor to the Federal Deposit Insurance Corporation ("FDIC"), including an Assistance Agreement. The Assistance Agreement provides, in part, for the payment to the Federal Savings & Loan Insurance Corporation ("FSLIC") Resolution Fund over time of 75% of most of the federal tax savings and 19.5% of most of the California tax savings (in each case computed in accordance with specific provisions contained in the Assistance Agreement) attributable to the utilization of certain tax loss carryforwards. The provision for such payments is reflected in the financial statements as "Income Taxes."

        In connection with the acquisition of Bank United in 2001, we acquired Bank United Holdings. Bank United Holdings entered into a Tax Benefits Agreement with the Federal Home Loan Bank Board. The Tax Benefits Agreement requires the Bank to pay to the FSLIC Resolution Fund an amount equal to one-third of the sum of the federal and state net tax benefits as defined in the original acquisition agreements ("Net Tax Benefits"). Net Tax Benefits are equal to the excess of any of the federal income tax liability which would have incurred if the tax benefit item had not been deducted or excluded from income over the federal income tax liability actually incurred. Net Tax Benefits items are tax savings resulting mainly from the utilization of net operating losses. The obligation to share tax benefit utilization continues through 2003.

        See Note 12 to the Consolidated Financial Statements – "Income Taxes."

Environmental Regulation

        Our business and properties are subject to federal and state laws and regulations governing environmental matters, including the regulation of hazardous substances and wastes. For example, under the federal Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") and similar state laws, owners and operators of contaminated properties may be liable for the costs of cleaning up hazardous substances without regard to whether such persons actually caused the contamination. Such laws may affect us both as an owner of properties used in or held for our business, and as a secured lender of property that is found to contain hazardous substances or wastes.

        Further, although CERCLA exempts holders of security interests, the exemption may not be available if a secured party engages in the management of its borrower or the collateral property in a manner deemed beyond the protection of the secured party's interest. Federal and state legislation, as well as guidance issued by the United States Environmental Protection Agency and a number of court decisions, have provided assurance to lenders regarding the activities they may undertake and remain within CERCLA's secured party exemption. However, these assurances are not absolute and generally will not protect a lender or fiduciary that participates or otherwise involves itself in the management of its borrower, particularly in foreclosure proceedings. As a result, CERCLA and similar state statutes may influence our decision whether to foreclose on property that is found to be contaminated. Our general policy is to obtain an environmental assessment prior to foreclosing on commercial property. The existence of hazardous substances or wastes on such property may cause us to elect not to foreclose on the property, thereby limiting, and in some instances precluding, our realization on such loans.

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Regulation and Supervision

        References in this section to applicable statutes and regulations are brief summaries only. One should consult the statutes and regulations for a full understanding of the details of their operation.

    General

        As a savings and loan holding company, Washington Mutual, Inc. ("WMI" or "the Parent Company") is subject to regulation by the Office of Thrift Supervision (the "OTS"). Washington Mutual Bank, FA ("WMBFA") and Washington Mutual Bank fsb ("WMBfsb") are federal savings associations and are subject to extensive regulation and examination by the OTS, which is their primary federal regulator. Their deposit accounts are insured by the FDIC, through the Savings Association Insurance Fund (the "SAIF") and, to a lesser extent, in the case of WMBFA, the Bank Insurance Fund (the "BIF"). The FDIC also has some authority to regulate WMBFA and WMBfsb. Washington Mutual Bank ("WMB") is subject to regulation and supervision by the Director of Financial Institutions of the State of Washington (the "State Director"). The FDIC insures the deposit accounts of WMB through both the BIF and the SAIF. The FDIC examines and regulates WMB and other state-chartered banks that are not members of the Federal Reserve System ("FDIC-regulated banks"). Federal and state laws and regulations govern, among other things, investment powers, deposit activities, borrowings, maintenance of guaranty funds and retained earnings.

Entity

  Charter
  Primary Federal
Regulator

  State Regulator
  Insurance Fund(s)
WMI   State (WA)   OTS   None   n.a.
WMBFA   Federal   OTS   None   SAIF, BIF
WMB   State (WA)   FDIC   State Director   BIF, SAIF
WMBfsb   Federal   OTS   None   SAIF

        State and federal laws govern our consumer finance subsidiaries. Federal laws apply to various aspects of their lending practices. State laws establish applicable licensing requirements, provide for periodic examinations and establish maximum finance charges on credit extensions.

    Holding Company Regulation

        WMI is a multiple savings and loan holding company, as defined by federal law, because it owns three savings associations: WMB, WMBFA and WMBfsb. WMB is a state-chartered savings bank that has elected to be treated as a savings association for purposes of the federal savings and loan holding company law. WMI is regulated as a unitary savings and loan holding company because WMBFA and WMBfsb are deemed to have been acquired in supervisory transactions. Therefore, certain restrictions under federal law on the activities and investments of multiple savings and loan holding companies do not apply to WMI. These restrictions will apply to WMI if WMB, WMBFA or WMBfsb fails to be a qualified thrift lender ("QTL"). By this we mean generally that:

    at least 65% of a specified asset base must consist of: loans to small businesses, credit card loans, educational loans, or certain assets related to domestic residential real estate, including residential mortgage loans and mortgage securities; or

    at least 60% of total assets must consist of cash, United States government or government agency debt or equity securities, fixed assets, or loans secured by: deposits, real property used for residential, educational, church, welfare or health purposes, or real property in certain urban renewal areas.

        WMB, WMBFA and WMBfsb are currently in compliance with QTL standards. Failure to remain a QTL also would restrict the ability of WMBFA, WMBfsb or WMB to obtain advances from a Federal

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Home Loan Bank ("FHLB"). In addition, failure to remain a QTL would restrict the ability of WMBFA or WMBfsb to establish new financial centers and pay dividends.

        Acquisitions by Savings and Loan Holding Companies.     Neither WMI nor any other person may acquire control of a savings institution or a savings and loan holding company without the prior approval of the OTS, or, if the acquirer is an individual, the OTS' lack of disapproval. In either case, the public must have an opportunity to comment on the proposed acquisition, and the OTS must complete an application review. Without prior approval from the OTS, WMI may not acquire more than 5% of the voting stock of any savings institution that is not one of its subsidiaries.

        The GLB Act generally restricts any nonfinancial entity from acquiring us unless such nonfinancial entity was, or had submitted an application to become, a savings and loan holding company as of May 4, 1999. Since we were treated as a unitary savings and loan holding company prior to that date, we may engage in nonfinancial activities and acquire nonfinancial subsidiaries.

        Annual Reporting; Examinations.     Under the Home Owners' Loan Act ("HOLA") and OTS regulations, WMI, as a savings and loan holding company, must file periodic reports with the OTS. In addition, WMI must comply with OTS record-keeping requirements.

        WMI is subject to holding company examination by the OTS. The OTS may take enforcement action if the activities of a savings and loan holding company constitute a serious risk to the financial safety, soundness or stability of a subsidiary savings association.

        Commonly Controlled Depository Institutions.     Depository institutions are "commonly controlled" if they are controlled by the same holding company or if one depository institution controls another depository institution. WMI controls WMB, WMBFA and WMBfsb. The FDIC has authority to require FDIC-insured banks and savings associations to reimburse the FDIC for losses it incurs in connection either with the default of a "commonly controlled" depository institution or with the FDIC's provision of assistance to such an institution.

        Capital Adequacy.     WMI is not currently subject to any regulatory capital requirements, but each of its subsidiary depository institutions is subject to various capital requirements. See "Regulation and Supervision- Capital Requirements."

    Subsidiary Savings Institution Regulation

        As federally-chartered savings associations, WMBFA and WMBfsb are subject to regulation and supervision by the OTS. As a state-chartered savings bank, WMB is subject to regulation and supervision by the State Director and the FDIC.

        Federal Regulation and Supervision of WMBFA and WMBfsb.     Federal statutes empower federal savings institutions, such as WMBFA and WMBfsb, to conduct, subject to various conditions and limitations, business activities that include:

    accepting deposits and paying interest on them;

    making and buying loans on residential and other real estate;

    making and buying a limited amount of consumer loans;

    making and buying a limited amount of commercial loans;

    investing in corporate obligations, government debt securities, and other securities;

    offering various banking services to their customers; and

    owning subsidiaries that invest in real estate and carry on certain other activities, including securities and insurance agency activities.

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        OTS regulations further delineate such institutions' investment and lending powers. Federal savings institutions generally may not invest in noninvestment-grade debt securities, nor may they generally make equity investments, other than investments in service corporations.

        State Regulation and Supervision.     Washington State statutes empower savings banks, such as WMB, to conduct, subject to various conditions and limitations, business activities that include:

    accepting deposits and paying interest on them;

    making or buying loans on or investing in residential and other real estate;

    making consumer loans;

    making commercial loans;

    investing in corporate obligations, government debt securities, and other securities;

    offering various banking services to their customers; and

    owning subsidiaries that engage in a wide variety of activities.

        Under state law, savings banks in Washington also generally have all of the powers that federal mutual savings banks have under federal laws and regulations.

        Federal Prohibitions on Exercise of State Bank Powers.     Federal law prohibits banks, such as WMB, and their subsidiaries from exercising certain powers that were granted by state law to make investments or carry on activities as principal (i.e., for their own account) unless either (i) national banks have power under federal law to make such investments or carry on such activities, or (ii) the bank and such investments or activities meet certain requirements established by federal law and the FDIC.

        Federal Restrictions on Transactions with Affiliates.     WMB, WMBFA and WMBfsb, as holding company subsidiaries that are depository institutions, are subject to both qualitative and quantitative limitations on their transactions with WMI and its other subsidiaries. They are subject to the same affiliate and insider transaction rules applicable to member banks of the Federal Reserve System, as set forth in Sections 23A, 23B, 22(g) and 22(h) of the Federal Reserve Act, as well as such additional limitations as the institution's primary federal regulator may adopt. These provisions prohibit or limit a savings institution from extending credit to, or entering into certain transactions with, affiliates, principal stockholders, directors and executive officers of the savings institution and its affiliates. For these purposes, the term "affiliate" generally includes a holding company such as WMI and any company under common control with the savings institution. In addition, the federal law governing unitary savings and loan holding companies flatly prohibits WMB, WMBFA or WMBfsb from making any loan to any affiliate whose activity is not permitted for a subsidiary of a bank holding company. This law also prohibits WMB, WMBFA or WMBfsb from making any equity investment in any affiliate that is not its subsidiary. We currently are in material compliance with all these provisions.

        Restrictions on Subsidiary Savings Institution Capital Distributions.     WMI's principal sources of funds are cash dividends paid to it by its banking and other subsidiaries, investment income, and borrowings. Federal and state law limits the ability of a depository institution, such as WMB, WMBFA or WMBfsb, to pay dividends or make other capital distributions.

        Washington state law prohibits WMB from declaring or paying a dividend greater than its retained earnings if doing so would cause its net worth to be reduced below (i) the amount required for the protection of preconversion depositors or (ii) the net worth requirements, if any, imposed by the State Director.

        OTS regulations limit the ability of savings associations such as WMBFA and WMBfsb to pay dividends and make other capital distributions. Certain savings associations, including WMBFA and WMBfsb, must file an application for approval by the OTS before the proposed declaration of a dividend

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or approval of the proposed capital distribution by its board of directors. In addition, a savings association must obtain prior approval from the OTS if it fails to meet certain regulatory conditions, or if, after giving effect to the proposed distribution, the association's capital distributions in a calendar year would exceed its year-to-date net income plus retained net income for the preceding two years or the association would not be at least adequately capitalized or if the distribution would violate a statute, regulation, regulatory agreement or a regulatory condition to which the association is subject.

    FDIC Insurance

        The FDIC insures the deposits of each of our banking subsidiaries to the applicable maximum in each institution. The FDIC administers two separate deposit insurance funds, the BIF and the SAIF. The BIF is a deposit insurance fund for commercial banks and some state-chartered savings banks. The SAIF is a deposit insurance fund for most savings associations. WMB is a member of the BIF, but a substantial portion of its deposits is insured through the SAIF. WMBFA and WMBfsb are members of the SAIF, but a small portion of WMBFA's deposits is insured through the BIF. WMB and WMBFA are subject to payment of assessments ratably to both funds.

        The FDIC has established a risk-based system for setting deposit insurance assessments. Under the risk-based assessment system, an institution's insurance assessments vary according to the level of capital the institution holds and the degree to which it is the subject of supervisory concern. In addition, regardless of the potential risk to the insurance fund, federal law requires the FDIC to establish assessment rates that will maintain each insurance fund's ratio of reserves to insured deposits at $1.25 per $100. Both funds currently meet this reserve ratio. During 2001, the assessment rate for both SAIF and BIF deposits ranged from zero to 0.27% of covered deposits. WMB and WMBFA qualified for the lowest rate on their BIF deposits in 2001, and WMB, WMBFA and WMBfsb qualified for the lowest rate on their SAIF deposits in 2001. Accordingly, none of these institutions paid any deposit insurance assessments in 2001. If, in the future, the reserve ratio of either insurance fund falls below required levels, that fund may reinstitute deposit insurance assessments for all institutions, including those not currently subject to deposit insurance assessments.

        In addition to deposit insurance assessments, the FDIC is authorized to collect assessments against insured deposits to be paid to the Financing Corporation ("FICO") to service FICO debt incurred in the 1980s. The FICO assessment rate is adjusted quarterly. Since 2000, SAIF- and BIF-insured deposits have been assessed at the same rate by FICO. For the years 2000 and 2001, the average annual rate was 2.07 cents and 1.90 cents per $100 of insured deposits.

    Capital Requirements

        Each of our subsidiary depository institutions is subject to various capital requirements. WMB is subject to FDIC capital requirements, while WMBFA and WMBfsb are subject to OTS capital requirements.

        WMB.     FDIC regulations recognize two types or tiers of capital: core ("Tier 1") capital and supplementary ("Tier 2") capital. Tier 1 capital generally includes common stockholders' equity and noncumulative perpetual preferred stock less most intangible assets. Tier 2 capital, which is limited to 100% of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock that may be included in Tier 2 capital is limited to 50% of Tier 1 capital.

        The FDIC uses a combination of risk-based guidelines and leverage ratios to evaluate capital adequacy. Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. For example, U.S. Treasury Bills and Government National Mortgage Association ("GNMA") securities are placed in the 0% risk category,

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FNMA and Federal Home Loan Mortgage Corporation ("FHLMC") MBS are placed in the 20% risk category, loans secured by SFR properties are generally placed in the 50% risk category, and commercial real estate and consumer loans are generally placed in the 100% risk category. These risk weights are multiplied by corresponding asset balances to determine a risk-weighted asset base. Certain off-balance sheet items are added to the risk-weighted asset base by converting them to a balance sheet equivalent and assigning them the appropriate risk weight in one of four categories.

        Under FDIC guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8.00%, and the ratio of Tier 1 capital to risk-weighted assets must be at least 4.00%.

        In addition to the risk-based capital guidelines, the FDIC uses a leverage ratio to evaluate a bank's capital adequacy. Most banks are required to maintain a minimum leverage ratio or Tier 1 capital to average assets of 4.00%. The FDIC retains the right to require a particular institution to maintain a higher capital level based on the institution's particular risk profile.

        The FDIC may consider other factors that may affect a bank's financial condition. These factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks.

        The following table sets forth the current regulatory requirement for capital ratios for FDIC regulated banks as compared with our capital ratios at December 31, 2001:

 
  Tier 1 Capital to
Average Assets
(FDIC Leverage Ratio)

  Tier 1 Capital to
Risk-Weighted Assets

  Total Capital to
Risk-Weighted Assets

 
Regulatory Minimum   4.00 % (1) 4.00 % 8.00 %
WMB's Actual   6.45   10.86   12.08  

(1)
The minimum leverage ratio guideline is 3% for financial institutions that do not anticipate significant growth and that have well-diversified risk, excellent asset quality, high liquidity, good earnings, effective management and monitoring of market risk and, in general, are considered top-rate, strong banking organizations.

        WMBFA and WMBfsb.     The OTS requires savings associations, such as WMBFA and WMBfsb, to meet each of three separate regulatory capital standards:

    a core capital leverage requirement,

    a tangible capital requirement, and

    a risk-based capital requirement.

        For a limited time, core capital may include certain amounts of qualifying supervisory goodwill.

        OTS regulations incorporate a risk-based capital requirement that is designed to be no less stringent than the capital standard applicable to national banks. It is modeled in many respects on, but not identical to, the risk-based capital requirements adopted by the FDIC. The OTS may establish, on a case-by-case basis, individual minimum capital requirements for a savings association that vary from the requirements that otherwise would apply under the OTS capital regulations. The OTS has not established such individual minimum capital requirements for WMBFA or WMBfsb.

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        The following table sets forth the current regulatory requirement for capital ratios for savings associations as compared with our capital ratios at December 31, 2001:

 
  Tier 1 Capital to
Adjusted Total Assets
(OTS Leverage Ratio)

  Tangible Capital to
Tangible Assets

  Tier 1 Capital to
Risk-Weighted
Assets

  Total Capital to
Risk-Weighted
Assets

 
Regulatory Minimum   4.00 % (1) 1.50 % 4.00 % 8.00 %
WMBFA's Actual   5.18   5.18   9.00   10.93  
WMBfsb's Actual   7.30   7.30   11.53   12.78  

(1)
The minimum leverage ratio guideline is 3% for financial institutions that do not anticipate significant growth and that have well-diversified risk, excellent asset quality, high liquidity, good earnings, effective management and monitoring of market risk and, in general, are considered top-rate, strong banking organizations.

    Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") Requirements

        FDICIA created a statutory framework that increased the importance of meeting applicable capital requirements. FDICIA established five capital categories:

    well-capitalized,

    adequately capitalized,

    undercapitalized,

    significantly undercapitalized, and

    critically undercapitalized.

        An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure, a tangible equity ratio measure, and certain other factors. The federal banking agencies (including the FDIC and the OTS) have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well-capitalized if its ratio of total capital to risk-weighted assets is 10.00% or more, its ratio of core capital to risk-weighted assets is 6.00% or more, its leverage ratio is 5.00% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capital ratio of not less than 4.00%, and a leverage ratio of not less than 4.00%. Any institution that is neither well capitalized nor adequately capitalized will be considered undercapitalized. Any institution with a tangible equity ratio of 2.00% or less will be considered critically undercapitalized.

        Federal law requires that the federal banking agencies' risk-based capital guidelines take into account various factors including interest rate risk, concentration of credit risk, risks associated with nontraditional activities, and the actual performance and expected risk of loss of multi-family mortgages. The federal banking agencies' capital standards specify that concentration of credit and nontraditional activities are among the factors that the agencies will consider in evaluating capital adequacy. The OTS and FDIC risk-based capital standards include provisions for the risk weighting of loans made to finance the purchase or construction of multi-family residences. The OTS's risk-based capital requirements for savings associations (such as WMBFA and WMBfsb) include an interest rate risk component. Implementation of this requirement has been delayed, and the OTS has proposed eliminating this interest rate risk component. Management believes that the effect of including such an interest rate risk component in the calculation of risk-adjusted capital will not cause WMBFA or WMBfsb to cease to be well capitalized. A joint policy statement of the FDIC and certain other federal banking agencies (not including the OTS) provides guidance on prudent interest rate risk management principles, and states that these agencies will evaluate the banks' interest rate risk on a case-by-case basis rather than adopting a standardized measure or establish an explicit minimum capital charge for interest rate risk.

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    Other FDIC and OTS Regulations and Examination Authority

        The FDIC has adopted regulations to protect the deposit insurance funds and depositors, including regulations governing the deposit insurance of various forms of accounts. The FDIC also has adopted numerous regulations to protect the safety and soundness of FDIC-regulated banks. These regulations cover a wide range of subjects including financial reporting, change in bank control, affiliations with securities firms and capital requirements. In certain instances, these regulations restrict the exercise of powers granted by state law.

        An FDIC regulation and a joint FDIC/OTS policy statement place a number of restrictions on the activities of WMB's and WMBFA's securities affiliates and on such affiliates' transactions with WMB, WMBFA and WMBfsb. These restrictions include requirements that such affiliates follow practices and procedures to distinguish them from WMB, WMBFA and WMBfsb and that such affiliates give customers notice from time to time of their separate corporate status and of the distinction between insured deposits and uninsured nondeposit products.

        As required by applicable Federal laws, FDIC regulations and OTS regulations impose requirements and restrictions on the operations of WMB, WMBFA and WMBfsb. These regulations include requirements to protect the privacy of consumers' nonpublic financial information and to provide 90 days advance notice of the closure of certain facilities.

        FDICIA imposes supervisory standards requiring periodic OTS or FDIC examinations, independent audits, uniform accounting and management standards, and prompt corrective action for problem institutions. As a result of FDICIA, depository institutions and their affiliates are subject to federal standards governing asset growth, interest rate exposure, executive compensation, and many other areas of depository institution operations. FDICIA contains numerous other provisions, including reporting requirements and revised regulatory standards for, among other things, real estate lending.

        The FDIC may sanction any FDIC-regulated bank that does not operate in accordance with FDIC regulations, policies and directives. Proceedings may be instituted against any FDIC-regulated bank, or any institution-affiliated party, such as a trustee, director, officer, employee, agent, or controlling person of the bank, who engages in unsafe and unsound practices, including violations of applicable laws and regulations. The FDIC may revalue assets of an institution, based upon appraisals, and may require the establishment of specific reserves in amounts equal to the difference between such revaluation and the book value of the assets. The State Director has similar authority under Washington State law, and the OTS has similar authority under HOLA. The FDIC has additional authority to terminate insurance of accounts, after notice and hearing, upon a finding that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, is operating in an unsafe or unsound condition, or has violated any applicable law, regulation, rule, or order of or condition imposed by the FDIC.

        Federal regulation of depository institutions is intended for the protection of depositors (and the BIF and the SAIF), and not for the protection of stockholders or other creditors. In addition, a provision in the Omnibus Budget Reconciliation Act of 1993 requires that in any liquidation or other resolution of any FDIC-insured depository institution, claims for administrative expenses of the receiver and for deposits in U.S. financial centers (including claims of the FDIC as subrogee of the insured institution) shall have priority over the claims of general unsecured creditors.

    Federal Reserve and Consumer Regulation

        Under Federal Reserve Board regulations, WMB, WMBFA and WMBfsb are each required to maintain a reserve against their transaction accounts (primarily interest-bearing and noninterest-bearing checking accounts). Because reserves must generally be maintained in cash or in noninterest-bearing accounts, the effect of the reserve requirements is to increase an institution's cost of funds. These regulations generally require that WMB, WMBFA and WMBfsb each maintain reserves against net

16



transaction accounts in the amount of 3% on amounts of $41.3 million or less, plus 10% on amounts in excess of $41.3 million. Institutions may designate and exempt $5.7 million of certain reservable liabilities from these reserve requirements. These amounts and percentages are subject to adjustment by the Federal Reserve Board. A savings bank, like other depository institutions maintaining reservable accounts, may borrow from the Federal Reserve Bank discount window, but the Federal Reserve Board's regulations require the savings bank to exhaust other reasonable alternative sources before borrowing from the Federal Reserve Bank.

        Numerous other regulations promulgated by the Federal Reserve Board affect the business operations of our banking subsidiaries. These include regulations relating to equal credit opportunity, electronic fund transfers, collection of checks, truth in lending, truth in savings and availability of funds.

        The GLB Act included provisions which give consumers new protections regarding the transfer and use of their nonpublic personal information by financial institutions. The four banking agencies have issued regulations implementing these provisions of the GLB Act. In addition, states are permitted under the GLB Act to have their own privacy laws which offer greater protection to consumers than the GLB Act. Numerous states in which the Company does business have enacted such laws.

    Federal Home Loan Bank System

        The FHLB System was created in 1932 and consists of twelve regional FHLBs. The FHLBs are federally chartered but privately owned institutions created by Congress. The Federal Housing Finance Board ("Finance Board") is an agency of the federal government and is generally responsible for regulating the FHLB System. Each FHLB is owned by its member institutions. The primary purpose of the FHLBs is to provide funding to their members for making housing loans as well as for affordable housing and community development lending. FHLBs are generally able to make advances to their member institutions at interest rates that are lower than could otherwise be obtained by such institutions.

        Under current rules, an FHLB member is generally required to purchase FHLB stock in an amount equal to at least 5% of the aggregate outstanding advances made by the FHLB to the member. The GLB Act and new regulations adopted by the Finance Board in December 2000 require a new capital structure for the FHLBs. The new capital structure contains risk-based and leverage capital requirements similar to those currently in place for depository institutions. Each FHLB has submitted a capital structure plan to the Finance Board, which is in the process of reviewing each of the plans.

        Other changes in the GLB Act to the FHLB system included a broadening of purposes for which FHLB advances may be used, and a change in the manner of calculating the obligations payable by the FHLBs for the Resolution Funding Corporation ("REFCORP"). Previously, the aggregate amount of the annual REFCORP obligation paid by all FHLBs was $300 million. The GLB Act imposes an annual obligation equal to 20% of the net earnings of the FHLBs. This change will result in a greater obligation in years when FHLBs have high income levels, thereby reducing the return on members' investments. With the broadening in the purpose for which FHLB advances can be used, our borrowing costs may rise as demand for advances increases.

        Generally, an institution eligible to be a member must initially apply for membership in the FHLB for the district where the member's principal place of business is located. WMBFA currently is a member only of the San Francisco FHLB, because WMBFA's home office is in Stockton, California. WMB, whose head office is in Seattle, is a member of the Seattle FHLB, as is WMBfsb, whose home office is in Salt Lake City. The Dallas FHLB (of which Bank United was a member prior to merging into WMBFA) and the New York FHLB (of which Dime's depository institution subsidiary, The Dime Savings Bank of New York, FSB, was a member prior to merging into WMBFA), have requested that the Finance Board allow WMBFA to be a member of those FHLBs without terminating WMBFA's membership in the San Francisco FHLB. WMBFA has supported these requests. On January 22, 2002, the Finance Board

17



announced that it will not consider any applications by institutions to be members of more than one FHLB until the Finance Board has developed a comprehensive policy solution.

    Community Reinvestment Act

        The Community Reinvestment Act ("CRA") requires financial institutions regulated by the federal financial supervisory agencies to ascertain and help meet the credit needs of the communities we serve, including low- to moderate-income ("LMI") neighborhoods, while maintaining safe and sound banking practices. The regulatory agency assigns one of four possible ratings to an institution's CRA performance and is required to make public an institution's rating and written evaluation. The four possible ratings of meeting community credit needs are outstanding, satisfactory, needs to improve, and substantial noncompliance. In 1998, WMBFA and WMBfsb each received an "outstanding" CRA rating from the OTS, and WMB received an "outstanding" CRA rating from the FDIC in 1999. These ratings reflect our commitment to meeting the credit needs of the communities we serve.

        Under regulations that apply to all CRA performance evaluations after July 1, 1997, many factors play a role in assessing a financial institution's CRA performance. The institution's regulator must consider its financial capacity and size, legal impediments, local economic conditions and demographics, including the competitive environment in which it operates. The evaluation does not rely on absolute standards, and the institutions are not required to perform specific activities or to provide specific amounts or types of credit. We maintain a CRA file available for public viewing, as well as an annual CRA highlights document. These documents describe our credit programs and services, community outreach activities, public comments and other efforts to meet community credit needs.

        In May 1998, we announced a ten-year $120 billion community commitment to all areas in which we conduct business. As of December 31, 2001, we had exceeded our targets for lending in LMI neighborhoods and under-served market areas, reaching almost 30% of our ten-year goal in only two years. In September 2001, we announced a new ten-year $375 billion community commitment, effective January 2002. This commitment replaced prior ones made by us and the companies we acquired.

        The $375 billion commitment targets single-family, small business and consumer, and multi-family lending, and community investment at the following levels:

    Single-family lending — $300 billion in affordable housing loans to minority borrowers, borrowers in LMI census tracts, and borrowers earning less than 80% of median income. Of this amount, $100 billion is specifically targeted to LMI borrowers.

    Consumer and small business and lending — $48 billion in loans to LMI consumers and small businesses, including:

    Consumer loans, home equity loans and lines of credit to borrowers with low-to moderate-incomes and in LMI census tracts, and

    Small business lending, with an emphasis on loans and lines of credit of $50,000 or less and loans to people of color, women and disabled persons.

    Multi-family lending — $25 billion for multi-family structures, including (among others) apartment and manufactured home park developments, in LMI census tracts or serving families earning less than 80% of median income.

    Community investment — $2 billion in investments and loans for community development. This commitment area includes low-income housing initiatives, tax-exempt housing revenue bonds, and community banks and financial institutions targeting multi-cultural communities or other community needs.

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        In addition to these goals and objectives, we made a commitment (along with pledges in other areas, like diversity) to philanthropically support the communities in which we conduct our business. Towards that end we will strive to return to our neighborhoods 2% of our pre-tax earnings. This corporate support is returned through grants, sponsorships, loans at below market rates, in-kind donations, paid employee volunteer time, and other financial support of our efforts to develop our communities.

    Recent and Proposed Legislation and Regulation

        In January 2001, the four federal banking agencies jointly issued expanded examination and supervision guidance relating to subprime lending activities. In the guidance, "subprime" lending generally refers to programs that target borrowers with weakened credit histories or lower repayment capacity. The guidance principally applies to institutions with subprime lending programs with an aggregate credit exposure equal to or greater than 25 percent of an institution's Tier 1 capital. Such institutions would be subject to more stringent risk management standards and, in many cases, additional capital requirements. As a starting point, the guidance generally expects that such an institution would hold capital against subprime portfolios in an amount that is one and one half to three times greater than the amount appropriate for similar types of non-subprime assets.

        The guidance is primarily directed at insured depository institutions. WMBFA currently holds specialty mortgage finance loans in excess of 25 percent of its Tier 1 capital and could be adversely affected by the application of the guidance. A significant portion of these loans and the consumer finance loans originated by Washington Mutual Finance may be considered subprime loans under the guidance. While WMI, Long Beach Mortgage and Washington Mutual Finance are not currently subject to any specific capital requirements imposed by the federal banking agencies, the OTS does have certain examination authority over WMI in its capacity as a savings and loan holding company and, accordingly, WMI and its nonbanking subsidiaries could also be adversely affected by the guidance. Management is currently analyzing the impact of the guidance on the conduct of its business.

        In December 2001, the Federal Reserve Board published final regulations implementing the Home Ownership and Equity Protection Act ("HOEPA"). Compliance with the regulations is mandatory as of October 1, 2002. HOEPA, which was enacted in 1994, imposes additional disclosure requirements and certain substantive limitations on certain mortgage loans with rates or fees above specified levels. The regulations lower the rate levels that trigger the application of HOEPA and include additional fees in the calculation of the fee amount that triggers HOEPA. The loans Washington Mutual currently makes are generally below the rate and fee levels that trigger HOEPA. However, as a result of the new regulations, more of the loans we currently offer will be subject to HOEPA.

        The OTS adopted as final on July 18, 2001 an interim rule that removed the regulation that required a savings association to maintain an average daily balance of liquid assets of at least four percent of its liquidity base, and retained a provision requiring a savings association to maintain sufficient liquidity to ensure its safe and sound operation.

        The OTS is soliciting comments on a number of proposed changes to the capital regulations. These changes are designed to eliminate unnecessary capital burdens and to align OTS capital regulations more closely to those of other banking regulators. Under the proposed rule, a one-to-four family residential first mortgage loan may qualify for a 50 percent risk weight if it meets certain criteria, including a loan-to-value ("LTV") ratio below 90 percent. Currently these loans must have an LTV ratio of 80 percent or less to qualify for the 50 percent risk weight. The OTS also proposes to eliminate the requirement that a thrift institution must deduct from total capital that portion of a land loan or a nonresidential construction loan in excess of an 80 percent LTV ratio and eliminate the interest rate risk component of the risk-based capital regulations.

        On November 29, 2001 the banking agencies issued a final rule that changed regulatory capital standards to address the treatment of recourse obligations, residual interests and direct credit substitutes

19



that expose banking organizations to credit risk. The final rule treats recourse obligations and direct credit substitutes more consistently than the agencies' prior risk-based capital standards and adds new standards for the treatment of residual interests, including a concentration limit for credit-enhancing interest-only strips. In addition, the agencies allow the use of credit ratings and certain alternative approaches to match the risk-based capital requirement more closely to a banking organization's relative risk of loss for certain positions in asset securitizations. The final rule was effective on January 1, 2002. Any transactions settled on or after January 1, 2002, are subject to this final rule. Banking organizations that entered into transactions before January 1, 2002 were permitted to elect early adoption, as of November 29, 2001, of any provision of the final rule if such adoption resulted in reduced capital requirements. Conversely, banking organizations that entered into transactions before January 1, 2002 that resulted in increased capital requirements under the final rule may delay the application of this rule to those transactions until December 31, 2002. Washington Mutual elected early adoption of the final rule as of December 31, 2001. The overall impact was favorable to our capital position.

        On October 26, 2001, President Bush signed into law the USA PATRIOT Act. The Act includes numerous provisions designed to fight international money laundering and to block terrorist access to the U.S. financial system. The provisions generally affecting banking organizations relate to the relationships of such organizations with foreign banks and with individuals and entities who reside or are located outside the United States.

    Regulation of Nonbanking Affiliates

        As broker-dealers registered with the Securities and Exchange Commission and as members of the National Association of Securities Dealers, Inc. ("NASD"), WM Financial Services and our mutual fund distributor subsidiary are subject to various regulations and restrictions imposed by those entities, as well as by various state authorities. As our registered investment advisor, WM Advisors is subject to various federal and state securities regulations and restrictions. A new subsidiary, WaMu Capital Corp., has applied to the Securities and Exchange Commission and the NASD for registration as a broker-dealer. WaMu Capital Corp. will be subject to the various regulations and restrictions imposed by those entities, as well as by various state authorities.

        The NASD has adopted rules concerning NASD member operations conducted in financial centers of depository institutions. The NASD requirements are substantially similar to the policy statements governing the activities of our securities affiliates previously issued by the various banking regulators.

        Our consumer finance subsidiaries are subject to various federal and state laws and regulations, including those relating to truth-in-lending, equal credit opportunity, fair credit reporting, real estate settlement procedures, debt collection practices and usury. The subsidiaries are subject to various state licensing and examination requirements.

20



Principal Officers

        The following table sets forth certain information regarding the principal officers of Washington Mutual:

Principal Officers

  Age
  Capacity in Which Served
  Employee of
Company Since

Kerry K. Killinger   52   Chairman of the Board of Directors, President and Chief Executive Officer   1983
Craig J. Chapman   45   President, Specialty Finance Group   1998
Fay L. Chapman   55   Senior Executive Vice President and General Counsel   1997
Jack A. Cornick   55   Executive Vice President and Interim President, Banking and Financial Services Group   1968
Daryl D. David   47   Executive Vice President, Human Resources   2000
Craig S. Davis   50   President, Home Loans and Insurance Services Group   1996
William W. Ehrlich   35   Executive Vice President, Corporate Relations   1993
Steven P. Freimuth   45   Senior Executive Vice President, Corporate Services   1988
Jeremy V. Gross   43   Executive Vice President and Chief Information Officer   2001
William A. Longbrake   58   Vice Chair, Enterprise Risk Management and Chief Financial Officer   1996
Robert H. Miles   45   Senior Vice President and Controller   1999
Deanna W. Oppenheimer   43   President, Banking and Financial Services Group   1985
Craig E. Tall   56   Vice Chair, Corporate Development and Specialty Finance Group   1985
James G. Vanasek   57   Executive Vice President and Chief Credit Risk Officer   1999

        Mr. Killinger is Chairman, President and Chief Executive Officer of Washington Mutual. He was named President and director in 1988, Chief Executive Officer in 1990 and Chairman in 1991. Mr. Killinger joined Washington Mutual as an Executive Vice President of WMB in 1983.

        Mr. Chapman is President of Washington Mutual's Specialty Finance Group. He is responsible for overseeing the Commercial Real Estate and Specialty Lending units and Washington Mutual Finance Corporation. After joining Washington Mutual in 1998 as President and Chief Executive Officer of Washington Mutual Finance Corporation, he became a member of the Executive Committee in 2001. Previously, Mr. Chapman served as President of AMRESCO Residential Mortgage Corporation and spent seventeen years in various positions with Household Finance Corporation.

        Ms. Chapman has been Senior Executive Vice President and General Counsel since 1999. She became Executive Vice President, General Counsel and a member of the Executive Committee in 1997. Prior to joining Washington Mutual, Ms. Chapman was a partner with Foster Pepper & Shefelman PLLC, a Seattle, Washington law firm.

        Mr. Cornick is an Executive Vice President of Washington Mutual and is serving as interim President of the Banking and Financial Services Group. He is responsible for consumer banking, financial services and business banking. Mr. Cornick, who has served 35 years with Washington Mutual, was named Senior Vice President in 1988 and Executive Vice President in 1997. He is also serving as an interim member of the Executive Committee from August 2001 to August 2002.

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        Mr. David joined Washington Mutual in 2000 as Executive Vice President, Human Resources. He is responsible for talent acquisition, organizational capabilities, leadership development and rewards and benefits. Mr. David became a member of the Executive Committee in 2001. He has more than 25 years of human resources management experience, most recently, at Amazon.com as Vice President of Strategic Growth and Human Resources.

        Mr. Davis is President, Home Loans and Insurance Services Group. He is responsible for single family lending and insurance services. Mr. Davis became Executive Vice President and a member of the Executive Committee in January 1997. Prior to joining Washington Mutual, he was Director of Mortgage Originations of American Savings Bank, F.A. from 1993 through 1996 and served as President of ASB Financial Services, Inc. from 1989 to 1993.

        Mr. Ehrlich has been Executive Vice President, Corporate Relations and a member of the Executive Committee since 1999. He is responsible for overseeing the Company's corporate public relations, employee communications, government relations and investor relations. Mr. Ehrlich became Assistant Vice President of Corporate Communications in 1994 and Senior Vice President in 1998. He joined Washington Mutual as a public relations consultant in 1990.

        Mr. Freimuth has been Senior Executive Vice President, Corporate Services since 1999. He is responsible for a variety of central corporate support areas, including human resources and credit oversight. Mr. Freimuth became Senior Vice President in 1991 and Executive Vice President and a member of the Executive Committee in 1997. Mr. Freimuth joined WMB as a Vice President in 1988.

        Mr. Gross joined Washington Mutual in 2001 as Executive Vice President and Chief Information Officer and became a member of the Executive Committee at that time. He is responsible for directing the Company's corporate technology strategy. Mr. Gross joined Washington Mutual from Sydney, Australia-based Westpac Banking Corp. where he was Group Executive of Technology, Operations and eCommerce.

        Mr. Longbrake has been Vice Chair and Chief Financial Officer since 1999. He is responsible for corporate finance and enterprise risk management. Mr. Longbrake rejoined Washington Mutual as Executive Vice President and Chief Financial Officer and a member of the Executive Committee in October 1996. From March of 1995 through September of 1996, he served as Deputy to the Chairman for Finance and Chief Financial Officer of the FDIC. Mr. Longbrake became Vice Chair, Enterprise Risk Management and Chief Financial Officer in 2002.

        Mr. Miles has been Senior Vice President and Controller since January 2001. He serves as Washington Mutual's principal accounting officer. Mr. Miles joined the Company as Senior Vice President, Corporate Tax in June 1999. Prior to joining the Company, Mr. Miles was Director, Domestic Taxes of BankBoston, N.A.

        Ms. Oppenheimer is President of the Banking and Financial Services Group. She is responsible for consumer banking, financial services and business banking. Ms. Oppenheimer became Executive Vice President in 1993 and has been a member of the Executive Committee since its formation in 1990. She has been an officer of the Company since 1985. From August 2001 through August 2002, Ms. Oppenheimer is on part-time status, but she continues to play a strategic role in the Company.

        Mr. Tall is Vice Chair, Corporate Development and Specialty Finance Group. He is responsible for mergers and acquisitions, commercial real estate, specialty commercial lending, and the consumer finance subsidiaries. Mr. Tall became an Executive Vice President in 1987 and Vice Chair in 1999. He has been a member of the Executive Committee since its formation in 1990.

        Mr. Vanasek is Executive Vice President and Chief Credit Risk Officer. He is responsible for overseeing all facets of the Company's credit risk management policies, strategies and performance. Mr. Vanasek became a member of the Executive Committee in 2001. Prior to joining Washington Mutual

22



in 1999, he spent eight years at the former Norwest Bank, in a variety of lending risk management positions including Chief Credit Officer.


Properties

        The Company's headquarters are located at 1201 Third Avenue, Seattle, Washington 98101. As of December 31, 2001, we conducted business in 41 states through approximately 2,200 physical distribution centers.

        Additionally, significant administration offices that we owned or leased were as follows:

Location

  Leased/Owned
  Approximate
Square Footage

  Termination or
Renewal Date (1)

1201 3rd Ave., Seattle, WA   Leased   310,000   2007
1191 2nd Ave., Seattle, WA   Leased   193,000   2006
1111 3rd Ave., Seattle, WA   Leased   177,000   2006
2520 & 2530 223 rd St. SE, Bothell, WA   Leased   106,000   2008
999 3rd Ave., Seattle, WA   Leased   84,000   2005
1401 2nd Ave., Seattle, WA   Leased   83,000   2009
1101 2nd Ave., Seattle, WA   Leased   77,000   2006
1501 4th Ave., Seattle, WA   Leased   60,000   2010
1301 5th Ave., Seattle, WA   Leased   58,000   2008
Northridge, CA (2)   Leased   441,000   2005-2006
Stockton, CA (2)   Owned   334,000   n.a.
Chatsworth, CA (2)   Owned   323,000   n.a.
17875 & 17877 Von Karman, Irvine, CA   Owned   290,000   n.a.
Chatsworth, CA (2)   Leased   286,000   2002-2015
4150 N. Palm Dr., Fullerton, CA   Owned   86,000   n.a.
7600 Dublin Blvd., Dublin, CA   Owned   76,000   n.a.
1100 Town & Country Rd., Orange, CA   Leased   72,000   2002
3351 Michaelson Dr., Irvine, CA   Leased   53,000   2004
2601 10th Ave. N., Lake Worth, FL   Owned   112,000   n.a.
333 E. Butterfield Rd., Lombard, IL   Leased   105,000   2003
Vernon Hills, IL (2)   Leased   81,000   2002-2006
2000 Oxford Dr., Bethel Park, PA   Leased   71,000   2006
2210 Enterprise Dr., Florence, SC   Leased   179,000   2008
3200 SW Freeway, Houston, TX   Leased   384,000   2008
11200 W. Parkland Ave., Milwaukee, WI   Owned   242,000   n.a.

(1)
The Company has options to renew leases at most locations.
(2)
Multiple locations.


Legal Proceedings

        We have certain litigation and negotiations in progress resulting from activities arising from normal operations. These include actions which are or purport to be class actions, some of which seek large damage awards. Nevertheless, in the opinion of management, none of the pending litigation matters is likely to have a materially adverse effect on our results of operations or financial condition.


Submission of Matters to a Vote of Security Holders

        No matters were submitted to shareholders during the fourth quarter of 2001.

23



PART II

Market for our Common Stock and Related Security Holder Matters

        Our common stock trades on The New York Stock Exchange under the symbol WM. As of March 1, 2002, there were 971,374,311 shares issued and outstanding held by 42,399 shareholders of record. The closing price of our common stock on March 1, 2002 was $33.24 per share. The information regarding high and low quarterly sales prices of the Company's common stock, and the quarterly cash dividends declared thereon, is set forth in this Form 10-K in the "Quarterly Results of Operations" table included under Supplementary Data and is expressly incorporated herein by reference.

24


Financial Review

Cautionary Statements

         This section contains forward-looking statements, which are not historical facts and pertain to our future operating results. These forward-looking statements are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts. When used in this report, the words "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," or words of similar meaning, or future or conditional verbs, such as "will," "would," "should," "could," or "may" are generally intended to identify forward-looking statements. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the results discussed in these forward-looking statements due to the following factors, among others: changes in business and economic conditions that negatively affect credit quality; concentration of operations in California; competition; changes in interest rates that could negatively affect the net interest margin and the expected duration of assets; and the effects of mergers and acquisitions.


Five-Year Summary of Selected Financial Data

 
  Year Ended December 31,
 
 
  2001
  2000
  1999
  1998
  1997
 
 
  (dollars in millions, except per share amounts)

 
Income Statement Data                                
Net interest income   $ 6,876   $ 4,311   $ 4,452   $ 4,292   $ 3,916  
Provision for loan and lease losses     575     185     167     162     247  
Noninterest income     2,627     1,984     1,509     1,507     980  
Noninterest expense     4,617     3,126     2,910     3,268     3,111  
Income before income taxes and extraordinary item     4,311     2,984     2,884     2,369     1,538  
Extraordinary item – gain on extinguishment of repurchase agreements, net of taxes of $239 million in 2001     382     -     -     -     -  
Net income     3,114     1,899     1,817     1,487     885  
Net income attributable to common stock     3,107     1,899     1,817     1,471     830  
Net income per common share (1) :                                
  Basic     3.65     2.37     2.12     1.74     1.04  
  Diluted     3.59     2.36     2.11     1.71     1.01  
Average diluted common shares used to calculate earnings per share (in thousands) (1)     864,658     804,695     861,830     867,843     835,139  
Cash dividends declared per common share (1)     0.90     0.76     0.65     0.49     0.44  
Common stock dividend payout ratio (2)     24.66 %   32.07 %   30.82 %   27.97 %   42.31 %
Return on average assets     1.38     1.01     1.04     0.96     0.63  
Return on average common stockholders' equity     23.53     21.15     19.66     16.67     11.95  
Net interest margin     3.32     2.38     2.63     2.88     2.91  

(1)
Restated for all stock splits.
(2)
Based on net income per basic common share and post-business combination dividends declared per common share.

 


 

December 31,


 
 
  2001
  2000
  1999
  1998
  1997
 
 
  (dollars in millions, except per share amounts)

 
Balance Sheet Data                                
Assets   $ 242,506   $ 194,716   $ 186,514   $ 165,493   $ 143,522  
Securities     58,349     58,724     60,786     47,046     37,025  
Loans held for sale     23,842     3,404     794     1,827     1,141  
Loans held in portfolio     132,991     119,626     113,746     107,612     97,550  
Mortgage servicing rights     6,241     1,017     643     461     311  
Deposits     107,182     79,574     81,130     85,492     83,429  
Other borrowings     12,576     9,930     6,203     4,630     7,175  
Redeemable preferred stock     102     -     -     -     -  
Stockholders' equity     14,063     10,166     9,053     9,344     7,601  
Ratio of stockholders' equity to total assets     5.80 %   5.22 %   4.85 %   5.65 %   5.30 %
Ratio of average stockholders' equity to average total assets     5.85 %   4.79 %   5.29 %   5.77 %   5.41 %
Book value per common share (1)(2)   $ 16.45   $ 12.84   $ 10.78   $ 10.71   $ 9.20  
Number of common shares outstanding at end of period (in thousands) (1)(2)     855,089     791,784     839,384     872,113     826,035  

(1)
Restated for all stock splits.
(2)
18,000,000 shares of common stock issued to an escrow for the benefit of the general and limited partners of Keystone Holdings and the FSLIC Resolution Fund and their transferees were not included.

25


Overview

        The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto presented elsewhere in this report.

        The acquisitions of Bank United and the mortgage operations of PNC added approximately $26 billion in assets during the first quarter of 2001. The acquisition of Fleet Mortgage Corp., a unit of FleetBoston Financial Corp., and certain other mortgage lending operations of Fleet National Bank (collectively, "Fleet") added approximately $8 billion in assets during the second quarter of 2001. These acquisitions contributed significantly to the growth in our mortgage banking business, and accordingly, resulted in significant increases in our MSR and loan servicing portfolios. Largely due to these acquisitions, the balance of MSR increased from $1.02 billion at December 31, 2000 to $6.24 billion at December 31, 2001 and the loan servicing portfolio with MSR increased from $79.34 billion at December 31, 2000 to $378.38 billion at December 31, 2001.

        Variances in the amounts reported on the Statements of Income between 2001 and prior years are partially attributable to the results from the aforementioned acquisitions, which are referred to hereafter as the "Acquired Companies." These acquisitions were accounted for as purchase transactions. Consequently, the results of those operations are included prospectively from the date of acquisition.

Recently Issued Accounting Standards

        In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, Business Combinations , and SFAS No. 142, Goodwill and Other Intangible Assets . SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. SFAS No. 142 became effective January 1, 2002 and eliminates the amortization of goodwill relating to past and future acquisitions (except that goodwill related to business combinations initiated after June 30, 2001 and consummated before January 1, 2002 was not required to be amortized). Instead, goodwill is subject to an impairment assessment that must be performed upon adoption of SFAS No. 142 and at least annually thereafter.

        The impairment assessment in connection with the initial adoption of SFAS No. 142 did not have a material impact on the results of operations or financial condition of the Company. For acquisitions initiated prior to July 1, 2001, pretax goodwill amortization of approximately $110 million will no longer be expensed. Certain other identifiable intangible assets will continue to be amortized.

        In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations . SFAS No. 143 addresses the accounting and reporting for obligations associated with the retirement of tangible, long-lived assets. The Statement is effective January 1, 2003 and is not expected to have a material impact on the results of operations or financial condition of the Company.

        In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets . The Statement supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of , but retains the requirements relating to recognition and measurement of an impairment loss and resolves certain implementation issues resulting from SFAS No. 121. The Statement became effective January 1, 2002 and is not expected to have a material impact on the results of operations or financial condition of the Company.

26


Critical Accounting Policies

        Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified three policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our financial statements. These policies relate to the valuation of our MSR, the methodology for the determination of our allowance for loan and lease losses and the valuation of derivatives under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities . These policies and the judgments, estimates and assumptions are described in greater detail in subsequent sections of Management's Discussion and Analysis and in the notes to the financial statements included herein. In particular, Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" describes generally our accounting policies and Note 5 to the Consolidated Financial Statements – "Mortgage Banking Activities" provides details of the assumptions used in valuing our MSR and the effect of changes to certain of those assumptions. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of our Consolidated Financial Statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition.

Earnings Performance

    Net Interest Income

        Net interest income increased $2.57 billion, or 59% in 2001 from 2000. The increase in net interest income was primarily due to a significant improvement in the net interest margin. The net interest margin was 3.32% for 2001, compared with 2.38% for 2000. The increase in the margin was primarily due to significantly lower wholesale borrowing rates during 2001, as compared with 2000. Since our wholesale borrowing rates are closely correlated with interest rate policy changes made by the Federal Reserve and reprice more quickly to current market rates than our interest-earning assets, the margin benefited from the Federal Reserve's 475 basis point reduction in the Federal Funds rate, which declined from 6.50% in December 2000 to 1.75% in December 2001. The increase in deposits (a cost-effective funding source for asset growth), coupled with lower rates, also benefited the margin in 2001. An increase in average interest-earning assets, primarily resulting from the addition of the Bank United loan portfolio and the mortgage banking operations of the Acquired Companies, also contributed to the growth in net interest income.

        Net interest income decreased $141 million, or 3% in 2000 compared with 1999. The decline in net interest income for 2000 was primarily due to the decrease in the net interest margin, partially offset by an increase in average interest-earning assets. The net interest margin was 2.38% for 2000, compared with 2.63% for 1999. The decrease in the margin occurred due to the rising interest rate environment that existed during the first half of 2000. From November 1999 to May 2000, the Federal Funds rate increased 100 basis points to 6.50%, which caused our wholesale borrowing costs to increase accordingly.

        Interest income included hedging-related expense from stand alone derivatives of $7 million in 2001. Interest expense in 2001 included net hedging-related income from derivatives embedded in repurchase agreements of $69 million, largely offset by hedging-related expense of $54 million from stand alone derivatives.

27



        Certain average balances, together with the total dollar amounts of interest income and expense and the weighted average interest rates, were as follows:

 
  Year Ended December 31,
 
  2001
  2000
  1999
 
  Average
Balance

  Rate
  Interest
Income or
Expense

  Average
Balance

  Rate
  Interest
Income or
Expense

  Average
Balance

  Rate
  Interest
Income or
Expense

 
  (dollars in millions)

Assets                                                
Interest-earning assets:                                                
  Loans (1) (2) :                                                
    SFR   $ 98,494   7.01 % $ 6,908   $ 81,471   7.40 % $ 6,028   $ 82,568   6.96 % $ 5,743
    Specialty mortgage finance (3)     9,054   9.96     902     5,352   10.42     557     2,390   10.72     256
   
     
 
     
 
     
        Total SFR     107,548   7.26     7,810     86,823   7.59     6,585     84,958   7.06     5,999
    SFR construction (4)     2,731   8.09     221     1,331   9.51     127     1,077   8.64     93
    Second mortgage and other consumer:                                                
      Home equity loans and lines     8,201   8.37     686     5,613   8.99     505     3,630   8.63     313
      Other     3,957   13.64     540     3,777   14.39     543     4,106   13.43     551
    Commercial business     4,856   7.13     349     1,794   9.42     169     1,242   8.65     108
    Commercial real estate:                                                
      Multi-family     16,487   7.73     1,274     15,507   7.85     1,218     14,554   7.05     1,026
      Other commercial real estate     4,534   7.75     353     2,897   8.32     241     3,292   7.84     258
   
     
 
     
 
     
        Total loans     148,314   7.57     11,233     117,742   7.97     9,388     112,859   7.40     8,348
  MBS (5)     41,430   6.95     2,875     58,469   6.97     4,078     52,293   6.68     3,493
  Investment securities and other (5)     17,625   5.43     957     4,598   6.90     317     3,884   5.68     221
   
     
 
     
 
     
        Total interest-earning assets     207,369   7.26     15,065     180,809   7.62     13,783     169,036   7.14     12,062
Noninterest-earning assets     18,204               6,763               5,750          
   
           
           
         
        Total assets   $ 225,573             $ 187,572             $ 174,786          
   
           
           
         
Liabilities                                                
Interest-bearing liabilities:                                                
  Deposits:                                                
    Checking accounts   $ 23,502   0.51     119   $ 14,120   0.46     65   $ 13,645   0.60     82
    Savings accounts and money market deposit accounts ("MMDAs")     34,168   3.00     1,017     29,816   4.05     1,207     30,267   4.82     1,460
    Time deposit accounts     38,852   5.04     1,958     36,340   5.55     2,018     39,183   4.16     1,628
   
     
 
     
 
     
      Total deposits     96,522   3.21     3,094     80,276   4.10     3,290     83,095   3.82     3,170
  Borrowings:                                                
    Securities sold under agreements to repurchase ("repurchase agreements")     29,582   4.04     1,196     28,491   6.33     1,804     26,082   5.36     1,397
    Advances from FHLBs     63,859   4.58     2,924     56,979   6.33     3,608     47,008   5.37     2,522
    Federal funds purchased and commercial paper     4,806   4.11     198     3,442   6.52     224     2,421   5.19     126
    Other     13,289   5.85     777     7,198   7.59     546     4,958   7.97     395
   
     
 
     
 
     
      Total borrowings     111,536   4.57     5,095     96,110   6.43     6,182     80,469   5.52     4,440
   
     
 
     
 
     
        Total interest-bearing liabilities     208,058   3.93     8,189     176,386   5.37     9,472     163,564   4.66     7,610
             
           
           
Noninterest-bearing liabilities     4,308               2,207               1,978          
   
           
           
         
        Total liabilities     212,366               178,593               165,542          
Stockholders' equity     13,207               8,979               9,244          
   
           
           
         
        Total liabilities and stockholders' equity   $ 225,573             $ 187,572             $ 174,786          
   
           
           
         
Net interest spread and net interest income         3.33   $ 6,876         2.25   $ 4,311         2.48   $ 4,452
             
           
           
Net interest margin         3.32               2.38               2.63      

(1)
Nonaccrual loans were included in the average loan amounts outstanding.
(2)
Interest income for loans includes amortization of net deferred loan origination costs of $172 million, $65 million, and $48 million for the years ended December 31, 2001, 2000, and 1999.
(3)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(4)
Includes custom construction loans to the intended occupant of a house to finance the house's construction and residential builder construction loans to borrowers who are in the business of acquiring land and building homes for resale.
(5)
Yield on MBS and investment securities are based on average amortized cost balances.

28


        The dollar amounts of interest income and interest expense fluctuate depending upon changes in interest rates and upon changes in the volume of our interest-earning assets and interest-bearing liabilities. Changes attributable to (i) changes in volume (changes in average outstanding balances multiplied by the prior period's rate), (ii) changes in rate (changes in average interest rate multiplied by the prior period's volume), and (iii) changes in rate/volume (changes in rate times the change in volume) which were allocated proportionately to the changes in volume and the changes in rate and included in the relevant column below were as follows:

 
  2001 vs. 2000
  2000 vs. 1999
 
 
  Increase/(Decrease)
Due to

   
  Increase/(Decrease)
Due to

   
 
 
  Total Change
  Total Change
 
 
  Volume
  Rate
  Volume
  Rate
 
 
  (dollars in millions)

 
Interest Income                                      
Loans                                      
  SFR   $ 1,207   $ (327 ) $ 880   $ (77 ) $ 362   $ 285  
  Specialty mortgage finance (1)     370     (25 )   345     309     (8 )   301  
   
 
 
 
 
 
 
        Total SFR     1,577     (352 )   1,225     232     354     586  
  SFR construction (2)     115     (21 )   94     24     10     34  
  Second mortgage and other consumer:                                      
    Home equity loans and lines     218     (37 )   181     178     14     192  
    Other     26     (29 )   (3 )   (46 )   38     (8 )
  Commercial business     229     (49 )   180     51     10     61  
  Commercial real estate:                                      
    Multi-family     76     (20 )   56     70     122     192  
    Other commercial real estate     129     (17 )   112     (32 )   15     (17 )
   
 
 
 
 
 
 
        Total loans     2,370     (525 )   1,845     477     563     1,040  
MBS     (1,182 )   (21 )   (1,203 )   426     159     585  
Investment securities and other     720     (80 )   640     49     47     96  
   
 
 
 
 
 
 
        Total interest income     1,908     (626 )   1,282     952     769     1,721  
Interest Expense                                      
Deposits:                                      
  Checking accounts     47     7     54     3     (20 )   (17 )
  Savings accounts and MMDAs     159     (349 )   (190 )   (21 )   (232 )   (253 )
  Time deposit accounts     134     (194 )   (60 )   (125 )   515     390  
   
 
 
 
 
 
 
        Total deposit expense     340     (536 )   (196 )   (143 )   263     120  
Borrowings:                                      
  Repurchase agreements     66     (674 )   (608 )   137     270     407  
  Advances from FHLBs     399     (1,083 )   (684 )   587     499     1,086  
  Federal funds purchased and commercial paper     73     (99 )   (26 )   61     37     98  
  Other     379     (148 )   231     171     (20 )   151  
   
 
 
 
 
 
 
        Total borrowing expense     917     (2,004 )   (1,087 )   956     786     1,742  
   
 
 
 
 
 
 
        Total interest expense     1,257     (2,540 )   (1,283 )   813     1,049     1,862  
   
 
 
 
 
 
 
Net interest income   $ 651   $ 1,914   $ 2,565   $ 139   $ (280 ) $ (141 )
   
 
 
 
 
 
 

(1)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(2)
Includes custom construction loans to the intended occupant of a house to finance the house's construction and residential builder construction loans to borrowers who are in the business of acquiring land and building homes for resale.

29


    Noninterest Income

        Noninterest income consisted of the following:

 
   
   
   
  Percentage Change
 
 
  Year Ended December 31,
 
 
  2001/
2000

  2000/
1999

 
 
  2001
  2000
  1999
 
 
  (in millions)

   
   
 
Depositor and other retail banking fees   $ 1,290   $ 976   $ 764   32 % 28 %
Securities fees and commissions     303     318     271   (5 ) 17  
Insurance income     100     49     43   104   14  
SFR mortgage banking (expense) income:                            
  Loan servicing fees     1,375     295     291   366   1  
  Amortization of MSR     (1,006 )   (133 )   (88 ) 656   51  
  Impairment of MSR     (1,749 )   (9 )   4   -   -  
  Other, net     (141 )   (19 )   (109 ) 642   (83 )
   
 
 
         
    Net SFR loan servicing (expense) income     (1,521 )   134     98   -   37  
  Loan related income     156     35     30   346   17  
  Gain from mortgage loans     963     262     109   268   140  
  Gain from sale of originated MBS     117     2     -   -   -  
   
 
 
         
    Total SFR mortgage banking (expense) income     (285 )   433     237   -   83  
Portfolio loan related income     193     82     73   135   12  
Gain (loss) from other securities     744     (3 )   (12 ) -   75  
Other income     282     129     133   119   (3 )
   
 
 
         
    Total noninterest income   $ 2,627   $ 1,984   $ 1,509   32   31  
   
 
 
         

    SFR Mortgage Banking Income

        The increase in SFR loan servicing fees for 2001, as compared with 2000, was substantially the result of the addition of the loan servicing portfolios of the Acquired Companies. The acquisitions also resulted in a substantial increase in MSR, which grew from $1.02 billion at December 31, 2000 to $6.24 billion at December 31, 2001. The Acquired Companies added $4.82 billion to our MSR portfolio at the time of the acquisitions. Our loan servicing portfolio with MSR increased by $299.04 billion to $378.38 billion at December 31, 2001. Of this increase, $255.43 billion was attributable to the Acquired Companies.

        Total servicing portfolio by type, excluding retained MBS without MSR and owned loans, was as follows:

 
  December 31, 2001
 
  Unpaid Principal
Balance

  Weighted Average
Servicing Fee

 
  (in millions)

  (in basis points, annualized)

Government   $ 61,541   52
Agency     242,075   45
Private     69,996   51
Specialty home loans     8,888   50
   
   
  Total servicing portfolio, excluding retained MBS without MSR and owned loans   $ 382,500 * 47
   
   

*
Includes $4.12 billion of loans serviced without MSR.

30


        MSR impairment was $1.75 billion in 2001 and MSR amortization was $1.01 billion in 2001, representing increases of $1.74 billion and $873 million, respectively, from 2000 primarily as a result of the growth in MSR and higher actual prepayment volumes and anticipated prepayment rates during 2001. Long-term mortgage interest rates declined and remained low during much of the year resulting in high levels of refinancing activity that in turn led to higher actual prepayment volumes and anticipated prepayment rates within our mortgage servicing portfolio.

        The value of our MSR asset is subject to prepayment risk. Future expected net cash flows from servicing a loan in our servicing portfolio will not be realized if the loan pays off earlier than we anticipate. Moreover, since most loans within our servicing portfolio do not contain penalty provisions for early payoff, we will not receive a corresponding economic benefit if the loan pays off earlier than expected. MSR are the discounted present value of the future net cash flows we expect to receive from our servicing portfolio. Accordingly, prepayment risk subjects our MSR to impairment.

        In measuring impairment of MSR, we stratify the loans in our servicing portfolio based on loan type, coupon rate and other predetermined characteristics. We measure MSR impairment by estimating the fair value of each stratum. An impairment allowance for a stratum is recorded when, and in the amount by which, its fair value is less than its carrying value. We estimate fair value using a discounted cash flow (DCF) model, independent third-party appraisals and management's analysis of observable data to formulate conclusions about anticipated changes in future market conditions, including interest rates. The DCF model estimates the present value of the future net cash flows of the servicing portfolio based on various factors, such as servicing costs, expected prepayment speeds and discount rates, about which management must make assumptions based on future expectations. The reasonableness of management's assumptions about these factors is confirmed through independent broker surveys. Independent appraisals of the fair value of our servicing portfolio are obtained periodically, but not less frequently than annually, and are used by management to evaluate the reasonableness of the value conclusions.

        Our methodology for estimating the fair value of MSR is highly sensitive to changes in assumptions. For example, our determination of fair value uses anticipated prepayment speeds. Actual prepayment experience may differ and any difference may have a material effect on our risk. 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" for further discussion of how MSR impairment is measured. For a quantitative analysis of key economic assumptions used in measuring the fair value of MSR, and a sensitivity analysis based on changes to those assumptions, see Note 5 to the Consolidated Financial Statements – "Mortgage Banking Activities."

        Although low mortgage interest rates caused prepayment levels to rise, they also allowed us to generate strong levels of salable fixed-rate loan volume. This resulted in a gain from mortgage loans of $963 million during 2001. The adoption of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, on January 1, 2001 had the effect of accelerating gains from mortgage loans by $217 million during the year. The increase in gain from mortgage loans in 2000, as compared with 1999, was largely the result of the sale of $12.90 billion of loans previously held in portfolio.

        We recorded a gain from other securities of $744 million in 2001. Of this gain, $643 million represented sales of fixed-rate U.S. Government agency and treasury bonds. Since these fixed-rate securities generally benefit from declining interest rates, they were sold to partially offset MSR impairment. To further offset the impairment, we liquidated certain repurchase agreements with embedded interest rate floors, which resulted in a pretax gain, accounted for on a net-of-tax basis as an extraordinary item under current accounting rules, of $621 million.

        The FASB is nearing the completion of a statement that would eliminate the requirement that all forms of gains or losses on debt extinguishments, such as the liquidation of repurchase agreements, be

31



reported as extraordinary items. The early termination of repurchase agreements constitutes a normal part of our asset and liability management strategy. Upon adoption of that statement, gains or losses on debt extinguishments that are considered to be part of our normal business operations would be allowed to be reported as a component of noninterest income or noninterest expense for all financial statement periods presented.

    All Other Noninterest Income Analysis

        The increase in depositor and other retail banking fees during 2001 and 2000 was predominantly due to higher collections of nonsufficient funds and other fees that resulted from an increased number of checking accounts. The number of checking accounts increased by more than one million during 2001 to approximately 6 million accounts and over 500,000 during 2000 to approximately 5 million accounts.

        The decrease in securities fees and commissions from 2001 compared with 2000 was due to lower sales of investment products, including variable annuities, largely the result of continued investor uncertainty regarding the stock market. Offsetting this decline was a significant increase in fees from the sale of fixed annuities. In addition, this decline was also offset by an $11 million increase in asset management fees. Funds under management totaled $11.58 billion at December 31, 2001, up from $9.70 billion at December 31, 2000 and $8.32 billion at December 31, 1999. We earned more investment management fees in 2000, as compared with 1999, due to the growth in assets under management in the WM Group of Funds, and recognized higher commission income from increased volume of securities transactions.

        Insurance income increased during 2001 primarily due to growth in our captive reinsurance programs. Acquisitions also contributed to an increase in revenues in optional insurance and property and casualty insurance products.

        A large portion of the growth in portfolio loan related income during 2001 was due to increased late charges on the loan portfolio and higher loan prepayment fees as a result of the higher level of refinancing activity within our loan portfolio. The increase from 1999 to 2000 resulted from higher levels of late charges and higher prepayment fees, primarily due to the growth of the purchased specialty mortgage finance portfolio.

        The increase in other income during 2001 included an increase of $37 million from our bank-owned life insurance program, which was initially funded in the second quarter of 2000. In addition, the increase includes a $34 million net gain from the sale of 13 financial centers and a gain of $32 million on Concord EFS, Inc. ("Concord") stock. We donated the Concord stock to the Washington Mutual Foundation; therefore, there is a similar increase in "other expense."

32



    Noninterest Expense

        Noninterest expense consisted of the following:

 
   
   
   
  Percentage Change
 
 
  Year Ended December 31,
 
 
  2001/
2000

  2000/
1999

 
 
  2001
  2000
  1999
 
 
  (in millions)

   
   
 
Compensation and benefits   $ 1,924   $ 1,348   $ 1,223   43 % 10 %
Occupancy and equipment     804     604     575   33   5  
Telecommunications and outsourced
information services
    441     323     276   37   17  
Professional fees     201     101     76   99   33  
Advertising and promotion     185     132     111   40   19  
Amortization of goodwill and other
intangible assets
    172     106     98   62   8  
Depositor and other retail banking losses     144     105     107   37   (2 )
Postage     136     98     89   39   10  
Loan expense     126     50     33   152   52  
Travel and training     112     63     55   78   15  
Other expense     372     196     267   90   (27 )
   
 
 
         
  Total noninterest expense   $ 4,617   $ 3,126   $ 2,910   48   7  
   
 
 
         

        Employee base compensation and benefits expense increased during 2001 due primarily to the addition of the Acquired Companies and the hiring of additional staff to support our expanding operations. Full-time equivalent employees ("FTE") were 39,465 at December 31, 2001, compared with 28,798 at December 31, 2000 and 28,509 at December 31, 1999. During the first quarter of 2002, the acquisition of Dime added approximately 6,900 FTE. We therefore expect employee base compensation and benefits expense to increase in 2002.

        The increase in occupancy and equipment expense in 2001 resulted primarily from rent, maintenance, and depreciation expense on newly leased or acquired properties, including those of the Acquired Companies. The increase during 2000 was mostly due to computer equipment upgrades.

        A significant portion of the increase in telecommunications and outsourced information services expense during 2001 was attributable to higher rates, effective at the beginning of the year, with a third party service provider. Additionally, the Company added 194 financial centers as a result of acquisitions and the opening of Occasio financial centers in new markets, which also contributed to higher telecommunications expense. In 2000, the majority of the increase reflected higher use of outsourced data processing. During 2002, the Company plans to open approximately 120 additional financial centers. We anticipate that this will result in higher telecommunication and outsourced information services expense in 2002.

        The increase in professional fees in 2001 was predominantly the result of higher consulting and other professional service fees from various technology projects as well as the development of our website, a new loan origination platform and new products. In 2000, the increase was attributable to various consulting projects designed to streamline our processes and procedures as well as to develop and deliver new products.

        The increase in advertising and promotion expense during 2001 and 2000 was primarily due to additional costs associated with campaigns for various loan and deposit products and our expansion into new markets.

33



        Amortization of goodwill and intangible assets increased in 2001 primarily due to the Acquired Companies. Upon adopting SFAS No. 142 at January 1, 2002, goodwill amortization was eliminated.

        The increase in depositor and other retail banking losses in 2001 was primarily the result of growth in new checking accounts and an increase in the number of ATMs.

        The increase in loan expense in 2001 and 2000 was mostly due to higher closing costs associated with increased loan originations, as a result of increased refinancing activity and the acquisition of the Acquired Companies.

        The increase in other expense in 2001 was primarily due to increases in contributions to the Washington Mutual Foundation, provision for losses on delinquent FHA and VA loans repurchased from GNMA, and other outside services expense. The major portion of the decrease from 1999 to 2000 was due to the elimination of FDIC insurance premiums on customer deposits.

Review of Financial Condition

        Assets.     At December 31, 2001, our assets were $242.51 billion, an increase of $47.79 billion or 25% from $194.72 billion at December 31, 2000. This increase was primarily attributable to the Acquired Companies.

        Securities.     Securities consisted of the following:

 
  December 31,
 
  2001
  2000
 
  (in millions)

Available-for-sale securities, total amortized cost of $58,783 and $42,288:            
  MBS   $ 28,568   $ 40,349
  Other investment securities     29,781     1,810
   
 
    Total available-for-sale securities   $ 58,349   $ 42,159
   
 
Held-to-maturity securities, total fair value of zero and $16,486:            
  MBS   $ -   $ 16,428
  Other investment securities     -     137
   
 
    Total held-to-maturity securities   $ -   $ 16,565
   
 

        Upon adopting SFAS No. 133 at January 1, 2001, we reclassified our held-to-maturity securities to available-for-sale. Our combined MBS portfolio declined $28.21 billion to $28.57 billion at December 31, 2001 from $56.78 billion at December 31, 2000. This decrease was principally related to high prepayment activity and sales in 2001. Other investment securities increased $27.83 billion to $29.78 billion at December 31, 2001 from $1.95 billion at December 31, 2000 due to the purchase of U.S. Government agency and treasury bonds. Refer to Note 3 to the Consolidated Financial Statements – "Securities" for additional information on securities, classified by security type.

34



        Loans.     Total loans consisted of the following:

 
  December 31,
 
  2001
  2000
  1999
  1998
  1997
 
  (in millions)

Loans held for sale   $ 23,842   $ 3,404   $ 794   $ 1,827   $ 1,141
Loans held in portfolio:                              
  SFR     82,021     80,181     79,834     79,275     71,020
  Specialty mortgage finance (1)     9,821     6,783     4,452     722     529
   
 
 
 
 
      Total SFR loans     91,842     86,964     84,286     79,997     71,549
  SFR construction:                              
    Builder (2)     2,127     1,040     729     505     401
    Custom (3)     475     391     514     515     476
  Second mortgage and other consumer:                              
    Home equity loans and lines     9,320     6,521     4,822     3,845     3,468
    Other     3,728     3,957     3,705     3,486     3,245
  Commercial business     5,390     2,274     1,452     1,129     838
  Commercial real estate (4) :                              
    Multi-family     15,608     15,657     15,261     14,559     14,022
    Other commercial real estate     4,501     2,822     2,977     3,576     3,551
   
 
 
 
 
      Total loans held in portfolio   $ 132,991   $ 119,626   $ 113,746   $ 107,612   $ 97,550
   
 
 
 
 

(1)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance.
(2)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(3)
Represents construction loans made directly to the intended occupant of a single-family residence.
(4)
Includes commercial real estate construction balances of $993 million in 2001, $267 million in 2000, $237 million in 1999, $221 million in 1998, and $65 million in 1997.

        SFR construction, commercial real estate construction and commercial business loans by maturity date were as follows:

 
  December 31, 2001
 
  Due
Within One Year

  After One But
Within Five Years

  After
Five Years

  Total
 
  (in millions)

SFR construction:                        
  ARMs   $ 549   $ 1,233   $ 41   $ 1,823
  Fixed-rate     131     102     546     779
Commercial real estate construction:                        
  ARMs     22     722     130     874
  Fixed-rate     5     50     64     119
Commercial business:                        
  ARMs     650     2,437     1,124     4,211
  Fixed-rate     126     203     850     1,179
   
 
 
 
    Total   $ 1,483   $ 4,747   $ 2,755   $ 8,985
   
 
 
 

        The increase in loans held for sale was substantially the result of higher fixed-rate loan production, which occurred due to lower mortgage rates and the addition of the mortgage operations of the Acquired Companies. The reduction in mortgage rates also led to substantially higher volumes of refinancing activity. Loan applications increased beginning in the second half of the first quarter of 2001 and remained high throughout the year.

35



        The increase in loans held in portfolio was substantially due to the acquisition of Bank United. This increase was partially offset by higher levels of prepayment activity within our SFR (excluding specialty mortgage finance) portfolio.

        Loan volume was as follows:

 
  Year Ended December 31,
 
  2001
  2000
 
  (in millions)

SFR:            
  ARMs   $ 37,224   $ 37,286
  Fixed rate     107,538     6,631
  Specialty mortgage finance (1)     11,059     8,501
   
 
    Total SFR loan volume     155,821     52,418
SFR construction:            
  Builder (2)     2,244     1,210
  Custom (3)     630     639
Second mortgage and other consumer:            
  Home equity loans and lines     7,747     4,449
  Other     2,321     2,897
Commercial business     2,650     2,695
Commercial real estate:            
  Multi-family     2,053     1,601
  Other commercial real estate     570     358
   
 
    Total loan volume   $ 174,036   $ 66,267
   
 

(1)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(2)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(3)
Represents construction loans made directly to the intended occupant of a single-family residence.

        Loan volume by channel was as follows:

 
  Year Ended December 31,
 
  2001
  2000
 
  (in millions)

Originated   $ 111,128   $ 59,263
Purchased/Correspondent     62,908     7,004
   
 
  Total loan volume by channel   $ 174,036   $ 66,267
   
 

36


        Refinancing activity (1) was as follows:

 
  Year Ended December 31,
 
  2001
  2000
 
  (in millions)

SFR:            
  ARMs   $ 27,300   $ 13,299
  Fixed rate     70,255     1,554
SFR construction     31     22
Commercial real estate     1,580     1,020
   
 
  Total refinances   $ 99,166   $ 15,895
   
 

(1)
Includes loan refinancings entered into by both new and pre-existing loan customers.

        The increased volume of purchased/correspondent loans during 2001 was predominantly due to the mortgage operations of PNC and Fleet, which added $28.58 billion and $26.55 billion, respectively, during the year ended December 31, 2001. Purchases of specialty mortgage finance loans were $5.05 billion in 2001 compared with $4.01 billion in 2000.

        Deposits.     Deposits consisted of the following:

 
  December 31,
 
  2001
  2000
 
  (in millions)

Checking accounts:            
  Interest bearing   $ 15,350   $ 5,925
  Noninterest bearing     22,386     8,575
   
 
      37,736     14,500
Savings accounts     6,970     5,436
MMDAs     25,514     25,220
Time deposit accounts     36,962     34,418
   
 
    Total deposits   $ 107,182   $ 79,574
   
 

        Deposits increased to $107.18 billion at December 31, 2001 from $79.57 billion at December 31, 2000. As a result of the acquisition of Bank United, we added $7.70 billion in retail deposits for the year. At December 31, 2001, total deposits included $12.79 billion in custodial/escrow deposits related to loan servicing activities, compared with $1.32 billion at December 31, 2000. Escrow deposits increased in 2001 due to our expanded mortgage banking operations. Time deposit accounts increased by $2.54 billion from year-end 2000 substantially due to the commencement in July 2001 of our Institutional Certificate of Deposit program, which totaled $2.38 billion at December 31, 2001. This program, with an authorized size of $15 billion, offers fixed or floating rate certificates of deposit to institutional investors. Terms range from seven days to five years, and the minimum denomination offered is $100,000.

        Checking accounts, savings accounts and MMDAs ("transaction deposits") increased to 66% of total deposits at December 31, 2001, compared with 57% at year-end 2000. These three products generally have the benefit of lower interest costs, compared with time deposit accounts. The increase in deposits and the continuing migration towards transaction deposits have benefited our cost of funds and net interest margin. Even though these deposits are more liquid, we consider them to be the core relationship with our customers, as they provide a more stable source of long-term funding than time deposits. At December 31, 2001, deposits funded 44% of total assets, compared with 41% at year-end 2000.

37



        Time deposit accounts in amounts of $100,000 or more totaled $6.92 billion and $8.75 billion at December 31, 2001 and 2000. At December 31, 2001, $2.33 billion of these deposits mature within three months, $1.45 billion mature in over three to six months, $1.37 billion mature in over six months to one year, and $1.77 billion mature after one year.

        Borrowings.     Our borrowings mostly take the form of repurchase agreements and advances from the Federal Home Loan Banks of Seattle, San Francisco and Dallas. The exact mix at any given time is dependent upon the market pricing of the individual borrowing sources.

        Our wholesale borrowings increased by $13.59 billion at December 31, 2001, compared with year-end 2000. Other borrowings also increased by $2.65 billion during 2001 predominantly due to the issuance of senior and subordinated debt, and Trust Preferred Income Equity Redeemable Securities SM ("PIERS SM "). Refer to "Liquidity" for further discussion of these funding sources.

Asset Quality

    Nonaccrual Loans, Foreclosed Assets and Restructured Loans.

        Loans are generally placed on nonaccrual status when they are four payments or more past due or when the timely collection of the principal or interest, in whole or in part, is not expected. Management's classification of a loan as nonaccrual or restructured does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.

        Nonaccrual loans and foreclosed assets ("nonperforming assets") and restructured loans consisted of the following:

 
  December 31,
 
 
  2001
  2000
  1999
  1998
  1997
 
 
  (dollars in millions)

 
Nonaccrual loans:                                
  SFR   $ 1,041   $ 509   $ 572   $ 689   $ 744  
  Specialty mortgage finance (1)     415     179     57     2     2  
   
 
 
 
 
 
    Total SFR nonaccrual loans     1,456     688     629     691     746  
SFR construction:                                
  Builder (2)     26     16     15     7     10  
  Custom (3)     10     2     3     2     -  
Second mortgage and other consumer:                                
  Home equity loans and lines     44     32     27     21     11  
  Other     104     85     72     69     67  
Commercial business     159     12     10     7     3  
Commercial real estate:                                
  Multi-family     56     10     21     44     38  
  Other commercial real estate     298     21     20     33     58  
   
 
 
 
 
 
    Total nonaccrual loans     2,153     866     797     874     933  
Foreclosed assets     228     153     199     275     341  
   
 
 
 
 
 
    Total nonperforming assets   $ 2,381   $ 1,019   $ 996   $ 1,149   $ 1,274  
    As a percentage of total assets     0.98 %   0.52 %   0.53 %   0.69 %   0.89 %

Restructured loans

 

$

118

 

$

120

 

$

117

 

$

179

 

$

183

 
   
 
 
 
 
 
    Total nonperforming assets and restructured loans   $ 2,499   $ 1,139   $ 1,113   $ 1,328   $ 1,457  
   
 
 
 
 
 

(1)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(2)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(3)
Represents construction loans made directly to the intended occupant of a single-family residence.

38


        Nonaccrual loans increased to $2.15 billion at December 31, 2001 from $866 million at December 31, 2000. Of the increase in nonaccrual loans during the year ended December 31, 2001, approximately $634 million was attributable to loans originated by the Acquired Companies. These loans are concentrated in the SFR, commercial business and commercial real estate loan categories.

        SFR loans (excluding specialty mortgage finance) on nonaccrual status increased by $532 million during the year ended December 31, 2001. This increase is attributable to loans originated by the Acquired Companies' lending channels, loans repurchased from investors in conjunction with our expanded mortgage banking operations (which includes loans originated through correspondent channels) and internal portfolio activity.

        The SFR portfolio consists of loans within all regions of the country and has been impacted by the national economic decline. During the year, general economic conditions have deteriorated as evidenced by the increase in the national unemployment rate from 4.0% at December 31, 2000 to 5.8% at December 31, 2001.

        Management anticipates that SFR nonaccrual loans will continue to increase in light of softening economic conditions and has taken steps to minimize our exposure through enhanced default management processes. Additionally, we have taken steps to reduce risk through the implementation of more stringent credit standards for new transactions, including the adoption of lower limits on loan-to-value ratios, particularly in markets that have recently experienced significant price appreciation or reflect a high probability of price depreciation. Revised policy limits relating to refinancing transactions have also been adopted. As of December 31, 2001, approximately 6% of the nonaccrual portfolio has a current loan-to-value ratio above 80% for which no private mortgage insurance coverage exists.

        The increase in specialty mortgage finance loans on nonaccrual status is attributable to the continued growth and seasoning of loans within this category. Increased nonaccrual amounts are likely as portfolio growth continues and existing loans season.

        In the commercial real estate portfolio, approximately $236 million of the Company's healthcare loans have been placed on nonaccrual status. While the majority of these loans continues to meet contractual payment performance requirements, concerns over the future timely collection of principal and interest supported their transfer to nonaccrual status. These loans are secured by healthcare properties located throughout the United States. We have taken steps to reduce our exposure in this lending activity and have assigned the responsibility for these relationships to our Asset Management Group, which specializes in the management of complex and/or troubled credits.

        In the commercial business portfolio, we continue to closely monitor small business loans originated by Bank United. These consist primarily of Small Business Administration loans and have experienced significant increases in nonaccrual loans. As of December 31, 2001, this portfolio totaled $493 million, of which nonaccrual loans were $61 million. We continue to closely monitor loans in the nationally syndicated loan portfolio, including shared national credits. We have placed our $53 million interest in seven of these loans on nonaccrual status as of the year end, and additional nonaccrual loans in this category are likely.

        Our portfolio of multi-family loans, which comprise 78% of our commercial real estate loan portfolio at December 31, 2001, continues to perform well. At December 31, 2001, nonaccrual loans in this category represented 0.36% of total multi-family loans. Two loans totaling $34 million that were originated by Bank United comprise approximately 60% of the December 31, 2001 nonaccrual total.

        Commercial and commercial real estate loans originated by Bank United that are eligible for credit renewals are subjected to our standards for commercial lending activities, which are typically more restrictive than those previously used by Bank United. In addition, we are limiting the volume of new loan originations and reducing portfolio expenses made to borrowers in higher risk categories, whenever possible.

        The increase in foreclosed assets since December 31, 2000 includes $38 million of inventory from the Acquired Companies.

39


        As a result of the increase in nonaccrual loans during the year ended December 31, 2001, the ratio of the allowance for loan and lease losses to nonaccrual loans declined to 65% at December 31, 2001 from 117% at December 31, 2000. This ratio is subject to significant fluctuations from year to year due to such factors as the mix of loan types in the portfolio, the economic prospects of our borrowers and, in the case of secured loans, the value and marketability of collateral. The methodologies we use to determine the allowance for loan and lease losses are discussed below.

        If interest on nonaccrual loans under the original terms had been recognized, such income would have been $187 million in 2001, $83 million in 2000 and $67 million in 1999.

        Loans (exclusive of the allowance for loan and lease losses) and nonaccrual loans by geographic concentration at December 31, 2001 were as follows:

 
  California
  Washington
Oregon

  Florida
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
SFR   $ 50,609   $ 368   $ 12,283   $ 136   $ 5,110   $ 82  
Specialty mortgage finance (1)     2,442     66     352     22     593     21  
   
 
 
 
 
 
 
  Total SFR     53,051     434     12,635     158     5,703     103  
SFR construction:                                      
  Builder (2)     666     3     314     4     284     8  
  Custom (3)     53     1     319     6     6     -  
Second mortgage and other consumer:                                      
  Home equity loans and lines     4,794     15     1,921     11     373     2  
  Other     805     7     1,103     20     197     5  
Commercial business     830     3     1,014     7     165     11  
Commercial real estate:                                      
  Multi-family     13,344     10     1,151     1     131     34  
  Other commercial real estate     1,479     5     1,191     7     131     10  
   
 
 
 
 
 
 
    Total loans (exclusive of the allowance for loan and lease losses)   $ 75,022   $ 478   $ 19,648   $ 214   $ 6,990   $ 173  
   
 
 
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     48 %   22 %   13 %   10 %   4 %   8 %

 


 

Texas


 

Other (4) (5)


 

Total


 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
SFR   $ 2,463   $ 38   $ 35,316   $ 417   $ 105,781   $ 1,041  
Specialty mortgage finance (1)     580     19     5,854     287     9,821     415  
   
 
 
 
 
 
 
  Total SFR     3,043     57     41,170     704     115,602     1,456  
SFR construction:                                      
  Builder (2)     347     -     516     11     2,127     26  
  Custom (3)     8     -     89     3     475     10  
Second mortgage and other consumer:                                      
  Home equity loans and lines     1,115     4     1,124     12     9,327     44  
  Other     227     8     1,459     64     3,791     104  
Commercial business     954     68     2,428     70     5,391     159  
Commercial real estate:                                      
  Multi-family     386     1     606     10     15,618     56  
  Other commercial real estate     347     6     1,354     270     4,502     298  
   
 
 
 
 
 
 
    Total loans (exclusive of the allowance for loan and lease losses)   $ 6,427   $ 144   $ 48,746   $ 1,144   $ 156,833   $ 2,153  
   
 
 
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     4 %   7 %   31 %   53 %   100 %   100 %

(1)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(2)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(3)
Represents construction loans made directly to the intended occupant of a single-family residence.
(4)
Of this category, Illinois had the largest portfolio balance of approximately $5.68 billion with nonaccrual loans of $92 million.
(5)
Of this category, New York had the largest nonaccrual amount of approximately $150 million with a portfolio balance of $5.45 billion.

40


        At December 31, 2001, nonaccrual loans in California accounted for 22% of total nonaccrual loans, down from 35% in 2000. Due to the concentration of our loans in California, the California real estate market requires continual review. In general, California real estate values increased during 1999, 2000 and 2001. However, economic performance within California may vary significantly among property types or by region.

    Provision and Allowance for Loan and Lease Losses

        Due to economic trends, growth in the commercial and specialty mortgage finance loan portfolios and nonaccrual loans, we increased the provision for loan and lease losses to $575 million during 2001, while incurring $305 million in net charge offs for the year. As a result of the slowing economy and resulting portfolio weaknesses, we anticipate that the provision may continue to exceed net charge offs in coming quarters. As a percentage of average loans, net charge offs were 0.21% for the year ended December 31, 2001, compared with 0.15% for the year ended December 31, 2000.

        The allowance for loan and lease losses represents management's estimate of credit losses inherent in our loan and lease portfolios as of the balance sheet date. Management performs regular reviews in order to identify these inherent losses, and to assess the overall collection probability for these portfolios. This process provides an allowance that consists of two components: allocated and unallocated. To arrive at the allocated component, we combine estimates of the allowance needed for loans that are evaluated collectively, such as single family residential and specialty mortgage finance, and loans that are analyzed individually, such as commercial business and commercial real estate.

        The determination of the allocated component for loans that are evaluated collectively involves the monitoring of delinquency, default, and loss rates (among other factors that determine portfolio risk) and an assessment of current economic conditions, particularly in geographic areas where we have significant concentrations. Loss factors are based on the analysis of the historical performance of each loan category and an assessment of portfolio trends and conditions, as well as specific risk factors impacting the loan and lease portfolios. These factors are then applied to the collective total of the loan balances and commitments.

        Loans within the commercial business, commercial real estate and builder single family residential construction categories are reviewed on an individual basis and loss factors are applied based on the risk rating assigned to the loan. A specific allowance, which is part of the allocated component, may be assigned on these loan types if they have been individually determined to be impaired. Loans are considered impaired when it is probable that we will be unable to collect all amounts contractually due as scheduled, including contractual interest payments. For loans that are determined to be impaired, the amount of impairment is measured by a discounted cash flow analysis, using the loan's effective interest rate, except when it is determined that the only source of repayment for the loan is the operation or liquidation of the underlying collateral. In such cases, the current fair value of the collateral, reduced by estimated disposal costs, will be used in place of discounted cash flows. In estimating the fair value of collateral, we evaluate various factors, such as occupancy and rental rates in our real estate markets and the level of obsolescence that may exist on assets acquired from commercial business loans.

        In estimating the amount of credit losses inherent in our loan and lease portfolios, various judgments and assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding future market conditions and their impact on the loan and lease portfolio. In the event the national economy were to sustain a prolonged downturn, the loss factors applied to our portfolios may need to be revised, which may significantly impact the measurement of the allowance for loan and lease losses. For impaired loans that are collateral-dependent, the estimated fair value of the collateral may deviate significantly from the proceeds received when the collateral is sold. To mitigate the imprecision inherent in most estimates of expected credit losses, the allocated component of the allowance is supplemented by an unallocated component. The unallocated component reflects our judgmental assessment of the impact that various factors have on the overall measurement of credit losses.

41



These factors include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality and collateral value trends, loan concentrations, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, regulatory examination results and findings of the Company's internal credit review function. As of December 31, 2001, 74% of the allowance for loan and lease losses was allocated to individual loans or loan categories, although the entire allowance was available to absorb charge offs across the entire loan and lease portfolio.

        Although we consider the allowance for loan and lease losses of $1.40 billion adequate to cover losses inherent in our loan portfolio at December 31, 2001, in light of the foregoing, no assurance can be given that we will not in any particular period sustain loan losses that are significantly different from the amount reserved, or that subsequent evaluations of the loan portfolio, in light of factors then prevailing, would not result in a significant change in the allowance for loan and lease losses.

        Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" for further discussion of the Allowance for Loan and Lease Losses.

        Changes in the allowance for loan and lease losses were as follows:

 
  Year Ended December 31,
 
 
  2001
  2000
  1999
  1998
  1997
 
 
  (dollars in millions)

 
Balance, beginning of year   $ 1,014   $ 1,042   $ 1,068   $ 1,048   $ 1,066  
Allowance acquired through business combinations/other     120     (36 )   (1 )   34     (14 )
Provision for loan and lease losses     575     185     167     162     247  
   
 
 
 
 
 
      1,709     1,191     1,234     1,244     1,299  
Loans charged off:                                
  SFR     (29 )   (19 )   (38 )   (65 )   (141 )
  Specialty mortgage finance (1)     (26 )   (5 )   -     -     -  
   
 
 
 
 
 
      Total SFR charge offs     (55 )   (24 )   (38 )   (65 )   (141 )
  SFR construction (2)     -     (1 )   -     (1 )   -  
  Second mortgage and other consumer     (200 )   (163 )   (143 )   (124 )   (103 )
  Commercial business     (74 )   (11 )   (5 )   (5 )   (3 )
  Commercial real estate:                                
    Multi-family     -     (2 )   (15 )   (22 )   (41 )
    Other commercial real estate     (10 )   (2 )   (22 )   (10 )   (17 )
   
 
 
 
 
 
      Total charge offs     (339 )   (203 )   (223 )   (227 )   (305 )
Recoveries of loans previously charged off:                                
  SFR     2     1     4     18     22  
  Specialty mortgage finance (1)     -     1     -     -     -  
   
 
 
 
 
 
      Total SFR recoveries     2     2     4     18     22  
  Second mortgage and other consumer     23     21     19     18     21  
  Commercial business     6     1     1     1     -  
  Commercial real estate:                                
    Multi-family     -     1     3     6     7  
    Other commercial real estate     3     1     4     8     4  
   
 
 
 
 
 
      Total recoveries     34     26     31     51     54  
   
 
 
 
 
 
  Net charge offs     (305 )   (177 )   (192 )   (176 )   (251 )
   
 
 
 
 
 
Balance, end of year   $ 1,404   $ 1,014   $ 1,042   $ 1,068   $ 1,048  
   
 
 
 
 
 
Net charge offs as a percentage of average loans     0.21 %   0.15 %   0.17 %   0.17 %   0.26 %
Allowance as a percentage of total loans held in portfolio     1.06 %   0.85 %   0.92 %   0.99 %   1.07 %

(1)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(2)
Includes custom construction loans to the intended occupant of a house to finance the house's construction and residential builder construction loans to borrowers who are in the business of acquiring land and building homes for resale.

42


        An analysis of the allowance for loan and lease losses was as follows:

 
  December 31,
 
 
  2001
  2000
  1999
 
 
  Allowance
for Loan
and Lease
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans (1)

  Allowance
for Loan
and Lease
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans (1)

  Allowance
for Loan
and Lease
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans (1)

 
 
  (dollars in millions)

 
Specific and allocated allowances:                                            
SFR   $ 290   0.35 % 61.67 % $ 250   0.31 % 67.03 % $ -   - % 70.19 %
Specialty mortgage finance (2)     97   0.99   7.39     52   0.77   5.67     -   -   3.91  
   
     
 
     
 
     
 
  Total SFR     387   0.42   69.06     302   0.35   72.70     -   -   74.10  
SFR construction (3)     32   1.23   1.96     7   0.49   1.20     5   0.40   1.09  
Second mortgage and other consumer     247   1.89   9.81     220   2.10   8.76     -   -   7.50  
Commercial business     116   2.15   4.05     44   1.94   1.90     18   1.24   1.28  
Commercial real estate:                                            
  Multi-family     138   0.88   11.74     138   0.88   13.09     59   0.39   13.42  
  Other commercial real estate     114   2.53   3.38     64   2.27   2.35     -   -   2.61  
   
     
 
     
 
     
 
    Total allocated allowance     1,034   0.78 % 100.00 %   775   0.65 % 100.00 %   82   0.07 % 100.00 %
Unallocated allowance     370   0.28   -     239   0.20   -     960   0.85   -  
   
 
 
 
 
 
 
 
 
 
    Total allowance for loan and lease losses   $ 1,404   1.06 % 100.00 % $ 1,014   0.85 % 100.00 % $ 1,042   0.92 % 100.00 %
   
 
 
 
 
 
 
 
 
 

 


 

December 31,


 
 
  1998
  1997
 
 
  Allowance
for Loan
and Lease
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans (1)

  Allowance
for Loan
and Lease
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans (1)

 
 
  (dollars in millions)

 
Specific and allocated allowances:                              
SFR   $ -   - % 73.67 % $ -   - % 72.81 %
Specialty mortgage finance (2)     -   -   0.67     -   -   0.54  
   
     
 
     
 
    Total SFR     -   -   74.34     -   -   73.35  
SFR construction (3)     1   0.10   0.95     2   0.23   0.90  
Second mortgage and other consumer     -   -   6.81     -   -   6.87  
Commercial business     17   1.51   1.05     3   0.36   0.86  
Commercial real estate:                              
  Multi-family     126   0.87   13.53     123   0.88   14.38  
  Other commercial real estate     -   -   3.32     -   -   3.64  
   
     
 
     
 
    Total allocated allowance     144   0.13 % 100.00 %   128   0.13 % 100.00 %
Unallocated allowance     924   0.86   -     920   0.94   -  
   
 
 
 
 
 
 
    Total allowance for loan and lease losses   $ 1,068   0.99 % 100.00 % $ 1,048   1.07 % 100.00 %
   
 
 
 
 
 
 

(1)
Excludes loans held for sale.
(2)
Includes purchased subprime loans as well as first mortgages originated by Washington Mutual Finance and Long Beach Mortgage.
(3)
Includes custom construction loans to the intended occupant of a house to finance the house's construction and residential builder construction loans to borrowers who are in the business of acquiring land and building homes for resale.

43


        During 2000, in conjunction with our continued expansion of our lending activity beyond traditional SFR loans, management enhanced its methodology for determining the allocated components of the allowance. This enhancement resulted in an allocation of previously unallocated allowance amounts to individual loan categories.

Operating Segments

        Effective January 1, 2001, we realigned our operating segments and enhanced our segment reporting process methodologies. Historical periods have been restated to be consistent with the new alignment and methodologies. We are now managed along three major operating segments: Banking and Financial Services, Home Loans and Insurance Services, and Specialty Finance. Refer to Note 23 to the Consolidated Financial Statements – "Operating Segments" – for information regarding the key elements of our management reporting methodologies used to measure segment performance.

    Banking and Financial Services

        Net income was $955 million in 2001, compared with $787 million in 2000 and $490 million in 1999. Due to the growth in deposits and consumer loans, net interest income was $2.27 billion, up from $1.90 billion in 2000 and $1.71 billion in 1999. Noninterest income increased to $1.78 billion in 2001 from $1.40 billion and $1.14 billion in 2000 and 1999, respectively. The increase in noninterest income was predominantly due to the increase in depositor and other retail banking fees associated with higher collections of nonsufficient funds, other fees on existing checking accounts and growth in new checking accounts. The number of checking accounts increased by 21% in 2001 (including 271,183 accounts acquired from Bank United) and 12% in 2000.

        Primarily reflecting increases in compensation and benefits expense, occupancy and equipment expense, and depositor and other retail banking losses, noninterest expense increased to $2.41 billion in 2001, compared with $1.97 billion in 2000 and $2.04 billion in 1999. The acquisition of Bank United also contributed to the increase during the 2001 periods.

        Total average assets increased by approximately 37% during 2001. The increase in 2001 was due to the growth in consumer loans. Average consumer loans increased 35% during 2001.

    Home Loans and Insurance Services

        Segment results for the Home Loans and Insurance Services Group were significantly impacted by the addition of the mortgage operations of the Acquired Companies.

        Net income was $1.35 billion, $910 million, and $684 million in 2001, 2000 and 1999, respectively. Net interest income was $2.14 billion in 2001, up from $1.63 billion in 2000 and $1.41 billion in 1999. The increase in 2001 was primarily due to the growth of loans held for sale, resulting from the substantial increase in SFR loan volume.

        Noninterest income increased to $1,481 million in 2001, compared with $548 million in 2000 and $302 million in 1999. The increase was predominantly due to higher gains from mortgage loans, SFR mortgage banking loan related income, and portfolio loan related income. The increase in gain from mortgage loans during 2001 reflected the addition of the loan origination operations of the Acquired Companies, a substantial increase in salable fixed-rate SFR loan volume due to refinancing activity, and the impact of the adoption of SFAS No. 133. The increase in SFR mortgage banking loan related income was primarily due to higher levels of late fees on loan payments. A significant portion of the growth in portfolio loan related income in 2001 was due to higher loan prepayment fees resulting from a higher level of refinancing activity. Due to high levels of amortization and the recognition of MSR impairment, net SFR loan servicing expense totaled $1.52 billion in 2001, compared with net SFR loan servicing income of $134 million in 2000 and $98 million in 1999. To offset most of the MSR impairment in 2001, the group received an inter-segment allocation of pretax financial hedge gains of $1.49 billion.

44



        Noninterest expense rose to $1.34 billion in 2001 from $607 million in 2000 and $582 million in 1999. The increase was mostly due to higher compensation and benefits expense, primarily the result of the expanded loan servicing operations added by the Acquired Companies.

        Total average assets increased by approximately 19% during 2001, compared with the same period a year ago, primarily as a result of the Acquired Companies.

    Specialty Finance

        Net income was $378 million in 2001, up from $274 million and $290 million in 2000 and 1999, respectively. Net interest income was $984 million in 2001, $734 million in 2000, and $703 million in 1999. The increase in net interest income reflected growth in other commercial real estate loans from the acquisition of Bank United, and the continuing growth of the group's loan portfolio. Total average assets increased by approximately 29% in 2001 due primarily to the acquisition of Bank United.

        Noninterest income increased to $77 million in 2001 from $43 million in 2000 and 1999, primarily due to increases in loan related income. The acquisition of Bank United contributed to the increase in loan related income.

        Noninterest expense increased to $256 million in 2001 from $190 million and $164 million in 2000 and 1999, respectively. The increase during 2001 was primarily attributable to higher compensation and benefits expense and occupancy and equipment expense from the acquisition of Bank United.

Liquidity

        The objective of liquidity management is to ensure the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet obligations and other commitments on a timely and cost-effective basis.

        The principal sources of liquidity for our consolidated enterprise are customer deposits, wholesale borrowings, the sale and securitization of mortgage loans into secondary market channels, the maturity and repayment of portfolio loans and MBS, and agency and treasury bonds held in our available-for-sale securities portfolio. Among these sources, transaction deposits and wholesale borrowings from Federal Home Loan Bank advances and repurchase agreements continue to provide the Company with a significant source of stable funding. During 2001, those sources funded 67% of average total assets. Our continuing ability to retain our transaction deposit customer base and to attract new deposits is dependent on various factors, such as customer service satisfaction levels and the competitiveness of interest rates offered on our deposit products. We expect that Federal Home Loan Bank advances and repurchase agreements will continue to be our most significant sources of wholesale borrowings during 2002, and we expect to have the requisite assets available to pledge as collateral to obtain these funds.

        To supplement these funding sources, our bank subsidiaries also raise funds in domestic and international capital markets. In April 2001, our two most significant bank subsidiaries, WMBFA and WMB, established a $15 billion Global Bank Note Program (the "Program"). The Program facilitates issuance of both senior and subordinated debt in the United States and in international capital markets on both a syndicated and non-syndicated basis and in a variety of currencies and structures. During 2001, our bank subsidiaries issued $3.75 billion of senior notes and $1 billion of subordinated notes under the Program. At December 31, 2001, $10.25 billion remained unissued.

        The Company, through Long Beach Mortgage, had credit facilities in the aggregate amount of $1 billion available at December 31, 2001, of which $500 million expires in April 2002 and $500 million expires in September 2002.

        Liquidity for the Parent Company is generated through its ability to raise funds in various capital markets, and through dividends from subsidiaries, lines of credit and commercial paper programs.

45



        A significant portion of the Parent Company's funding during 2001 was received from dividends paid by our bank subsidiaries. Although we expect the Parent Company to continue to receive bank subsidiary dividends during 2002, such dividends are limited by various regulatory requirements related to capital adequacy and retained earnings. For more information on dividend restrictions applicable to our banking subsidiaries, refer to "Business – Regulation and Supervision" and Note 17 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."

        During 2001, the Parent Company consummated a private placement offering of $1.15 billion of Trust Preferred Income Equity Redeemable Securities SM ("PIERS SM "). The offering consisted of 23 million units, with each unit comprised of a preferred security issued by a special purpose subsidiary trust, and a warrant to purchase approximately 1.2 shares of Washington Mutual common stock. The trust preferred securities would qualify as Tier 1 capital for the Parent Company if it were subject to the same regulatory capital adequacy standards applicable to commercial bank holding companies. The proceeds from the PIERS SM were used for general corporate purposes, including the funding of acquisitions.

        In November 2001, the Parent Company filed a shelf registration with the Securities and Exchange Commission that allows for the issuance of $1.5 billion of senior and subordinated debt in the United States and in international capital markets and in a variety of currencies and structures. The proceeds from the sale of the debt securities will be used for general corporate purposes. In January 2002, $1 billion of senior debt securities were issued under this shelf registration.

        At December 31, 2001, the Parent Company had no commercial paper outstanding. The Parent Company shares two revolving credit facilities totaling $1.2 billion with Washington Mutual Finance. These facilities provide back-up for the commercial paper programs of the Parent Company and Washington Mutual Finance. The amount available under these shared facilities, net of the amount of commercial paper outstanding at Washington Mutual Finance, was $849 million at December 31, 2001.

Capital Adequacy

        Reflecting strong earnings and the issuance of $1.15 billion of PIERS SM , $398 million of which was attributable to the attached warrants (recorded as capital surplus), the ratio of stockholders' equity to total assets increased to 5.80% at December 31, 2001 from 5.22% at year-end 2000. These sources of capital were more than adequate to accommodate the recent acquisitions as well as support growth.

        In April 1999, the Board of Directors ("Board") approved a share repurchase program. From the second quarter of 1999 through June 30, 2000, we purchased a total of 100 million shares as part of our previously authorized total of 167 million shares. We did not repurchase any of our common stock from the second quarter of 2000 until the fourth quarter of 2001. Management instead focused on internal growth and acquisitions as a means of deploying capital during this time. On October 19, 2001, we announced the resumption of our share repurchase program and repurchased an additional 7 million shares during the fourth quarter of 2001. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.

        The regulatory capital ratios of WMBFA, WMB and WMBfsb and minimum regulatory requirements to be categorized as well capitalized were as follows:

 
  December 31, 2001
   
 
 
  Well-
Capitalized
Minimum

 
 
  WMBFA
  WMB
  WMBfsb
 
Tier 1 capital to adjusted total assets (leverage)   5.18 % 6.45 % 7.30 % 5.00 %
Adjusted tier 1 capital to total risk-weighted assets   9.00   10.86   11.53   6.00  
Total risk-based capital to total risk-weighted assets   10.93   12.08   12.78   10.00  

46


        Our federal savings bank subsidiaries are also required by OTS regulations to maintain tangible capital of at least 1.50% of assets. WMBFA and WMBfsb both satisfied this requirement at December 31, 2001.

        Our broker-dealer subsidiaries are also subject to capital requirements. At December 31, 2001, both of our securities subsidiaries were in compliance with their applicable capital requirements.

Market Risk Management

        Certain of the statements contained within this section that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are intended to assist in the understanding of how our financial performance would be affected by the circumstances described in this section. However, such performance involves risks and uncertainties that may cause actual results to differ materially from those expressed in the forward-looking statements. See "Cautionary Statements."

        Market risk is defined as the sensitivity of income 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.

        Interest rate risk is managed within an overall asset/liability management framework. The principal objective of asset/liability management is to manage the sensitivity of net income to changing interest rates. Asset/liability management is governed by policies reviewed and approved annually by our Board. The Board has delegated the responsibility to oversee the administration of these policies to the Directors' Loan and Investment Committee.

    Overview of Our Interest Rate Risk Profile

        Increases or decreases in interest rates can cause changes in net income, fluctuations in the fair value of assets and liabilities, such as MSR and investment securities, and changes in noninterest income and noninterest expense, particularly gain from mortgage loans. Our interest rate risk arises because assets and liabilities reprice, mature or prepay at different times or frequencies as market interest rates change. Our loan volume and mix also vary as interest rates change. Our net interest income generally increases in a falling interest rate environment and decreases in a rising interest rate environment. In addition, gain from mortgage loans tends to increase in a falling interest rate environment and decrease as interest rates rise. The changes in net interest income and gain from mortgage loans are inversely related to the changes in the value of MSR, which decrease as interest rates fall and increase as interest rates rise.

        The increase in the net interest margin in a falling interest rate environment is because our deposits and borrowings typically reprice faster than our mortgage loans and securities, contributing to an expansion in the net interest margin. The slower repricing of assets results mainly from the lag effect inherent in loans and MBS indexed to the 12-month average of the annual yields on actively traded U.S. Treasury securities adjusted to a constant maturity of one year and to the 11th District FHLB monthly weighted average cost of funds index ("COFI").

        In a falling interest rate environment, we also experience faster prepayments and increased loan volume with a shift to fixed-rate loan production. As most of the fixed-rate production is sold in the secondary market, we potentially face balance sheet shrinkage. In spite of this shrinkage, net income tends to increase in a falling interest rate environment as a result of the expansion in the net interest margin. The increased loan production combined with a higher percentage of fixed-rate loans results in an increase in gain from mortgage loans. The fair value of MSR decreases in falling interest rate environments due to the higher prepayment activity, resulting in the potential for impairment. This impairment is normally offset by

47



the increased net interest margin and gain from mortgage loans as well as gains from the sale of bonds and the extinguishment of borrowings with embedded interest rate floors.

        Conversely, in a rising interest rate environment, we normally experience slower prepayments, decreased loan volume and a shift to adjustable-rate production. Balance sheet growth typically occurs, despite the decrease in loan production, due to the increased volume of adjustable-rate loans, which we typically hold in our portfolio. In spite of balance sheet growth, net interest income tends to decrease in a rising interest rate environment as a result of the compressed net interest margin. Gain from mortgage loans normally decreases as rates rise due to the decrease in loan production and the lower percentage of fixed-rate loans. However, the fair value of MSR increases in this environment, resulting in the potential recovery of any MSR reserves. We may offset the recovery of the MSR reserves by selling securities, interest rate floors or other derivatives at a loss. The intent would be to reset these instruments to current market rates to enhance their ability to hedge against MSR impairment in falling interest rate environments.

    Types of Interest Rate Risk

        We are exposed to different types of interest rate risks. These risks include: lag, repricing, basis, prepayment, and lifetime cap risk. These risks are described in further detail in the following paragraphs.

        Lag risk.     Lag risk results from the inherent timing difference between the repricing of our adjustable-rate assets and our liabilities. The effect of this timing difference, or "lag," will be favorable during a period of declining interest rates and unfavorable during a period of rising interest rates. This lag risk can produce short-term volatility in our net interest income during periods of interest rate movements even though the effect of this lag generally balances out over time. One example of lag risk is the repricing of assets indexed to the monthly treasury average ("MTA"). The MTA index is based on a moving average of rates outstanding during the previous twelve months. A sharp movement in interest rates in a month will not be fully reflected in the index for twelve months resulting in a lag in the repricing of loans and securities based on this index. This contrasts with borrowings which generally reprice based on current market interest rates.

        Repricing risk.     Repricing risk is caused by the mismatch in the maturities and/or repricing periods between interest-earning assets and interest-bearing liabilities. In periods of rising interest rates, the net interest margin normally contracts since the repricing period of liabilities is shorter than the repricing period of assets. This results in funding costs rising faster than asset yields. The net interest margin expands in periods of falling interest rates as borrowing costs reprice downward faster than asset yields. Repricing risk is managed by changing the repricing characteristics of interest-bearing liabilities with derivatives and by selling fixed-rate and adjustable-rate loans and securities.

        Basis risk.     Basis risk results from our assets and liabilities reacting differently to interest rate movements due to their dependency on different indices. For example, most adjustable-rate loans are indexed to COFI, MTA, Prime or Treasury based indexes. The rates on the majority of our borrowings are derived from the London Interbank Offered Rates ("LIBOR") or interest rate swap curves. This results in basis risk as the loan indices may move at a different rate or in a different direction than the rate on our borrowings or deposits.

        Prepayment risk.     Prepayment risk results from the ability of customers to pay off their loans prior to maturity. Generally, prepayments increase in falling interest rate environments and decrease in rising interest rate environments. In falling interest rate environments, this normally results in the prepayment and refinancing of existing fixed- and adjustable-rate loans to lower coupon, fixed-rate mortgage loans. This preference, when combined with our policy of selling most of our fixed-rate loan production, may make it difficult to increase or even maintain the size of our loan and MBS portfolio during these periods. During such periods, it is likely that we would decrease the percentage of adjustable-rate loans that are

48



sold. This could result in an increase in our held for sale portfolio, offsetting some of the potential balance sheet shrinkage resulting from the faster prepayments of existing loans and securities.

        In rising interest rate environments, the decline in prepayments would normally result in an increase in the size of our loan and MBS portfolios. During these periods, we may increase the percentage of adjustable-rate loans that are sold. This could result in a decrease in our held for sale portfolio. These additional sales may generate gain on sale offsetting some of the reduction in the net interest margin.

        Prepayment risk also has a significant impact on the fair value of MSR. Faster prepayments of loans within our servicing portfolio can be expected to result in a reduction in the fair value of MSR, while slower prepayments of loans within our servicing portfolio can be expected to result in an increase in the fair value. In addition, the amortization of premiums and discounts related to loans and MBS are affected by increases or decreases in prepayments.

        Lifetime cap risk.     The lifetime interest rate caps on adjustable-rate loans held in portfolio introduce another element of interest rate risk to our earnings. In periods of rising interest rates, it is possible for the fully indexed interest rate (index rate plus the margin) to exceed the lifetime interest rate cap. This feature prevents the loan from repricing to a level that exceeds the cap's specified interest rate, thus adversely impacting net interest income in periods of relatively high interest rates. Typically, the lifetime cap is 300 to 500 basis points above the fully indexed initial rate. The lifetime caps on our existing loan and MBS portfolios would not have a material adverse effect on net interest income unless interest rates increased substantially from current levels.

    Management of Interest Rate Risk

        To mitigate the impact of changes in market interest rates on our interest-earning assets and interest-bearing liabilities, we actively manage the amounts and maturities of these assets and liabilities. A key component of this strategy is the origination and retention of short-term and adjustable-rate assets and the origination and sale of fixed-rate loans. We retain short-term and adjustable-rate assets because they have repricing characteristics that more closely match the repricing characteristics of our liabilities. In addition to selling fixed-rate loans, we also sell a portion of our ARMs with three- to five-year initial fixed interest rates. We have also established additional balance sheet flexibility and diversity by designating some monthly option ARMs as held for sale.

        To further mitigate the risk of timing differences in the repricing of assets and liabilities, our interest-earning assets are matched with interest-bearing liabilities that have similar repricing characteristics. For example, the interest rate risk of holding fixed-rate loans is managed with long-term deposits and borrowings, and the risk of holding ARMs is managed with short-term deposits and borrowings. Periodically, mismatches are identified and managed by adjusting the repricing characteristics of our interest-bearing liabilities with derivatives, such as interest rate caps, collars, corridors, interest rate swaps and swaptions.

        Through the use of these derivative instruments, management attempts to reduce or offset increases in interest expense related to deposits and borrowings. We use interest rate caps, collars, corridors, pay-fixed interest rate swaps and swaptions to protect against rising interest rates. We use receive-fixed interest rate swaps to reduce the interest expense on long-term, fixed-rate borrowings during stable or falling interest rate environments.

        The interest rate caps, collars, corridors, pay-fixed interest rate swaps and swaptions are designed to provide an additional layer of protection should interest rates on deposits and borrowings rise, by effectively lengthening the repricing period. At December 31, 2001, we held an aggregate notional value of $25.84 billion of caps, collars, corridors, pay-fixed interest rate swaps and swaptions. This included $5.90 billion of swaptions and $696 million of interest rate caps embedded in adjustable-rate borrowings. None of the interest rate caps had strike rates that were in effect at December 31, 2001, as current LIBOR

49



rates were below the strike rates. The swaptions are exercisable upon maturity, which range from February 2002 to September 2003. Thus, we have a degree of interest rate protection when interest rates rise, because these instruments provide a mechanism for fixing the rate on our deposits and borrowings to an interest rate that could be lower than market levels.

        Using receive-fixed interest rate swaps, we can effectively reduce the interest expense on long-term, fixed-rate borrowings during periods when the receive-fixed rate is greater than the short-term floating rate on the interest rate swap. Long-term borrowings, such as subordinated debt, also provide an excellent source of long-term funds. The issuance of subordinated debt, which generally qualifies as a component of Tier 2 risk-based capital, combined with a receive-fixed rate swap provides capital at an attractive funding rate. At December 31, 2001, we held $3.63 billion of receive-fixed interest rate swaps. We are also striving to increase the proportion of transaction deposits to total deposits to mitigate our exposure to adverse changes in interest rates. In particular, noninterest-bearing checking accounts and custodial accounts are not sensitive to interest rate fluctuations. Additionally, checking accounts provide a growing source of noninterest income through depositor and other retail banking fees.

        We analyze the change in fair value of our MSR portfolio under a variety of parallel shifts in yield curves. Since most loans within our servicing portfolio do not contain penalty provisions for early payoff, the value of our underlying MSR is subject to impairment from prepayment risk. This risk generally increases in a declining interest rate environment, as prepayments on loans in our servicing portfolio tend to move inversely with mortgage rates. Increases in prepayments shorten the expected life of MSR, thereby decreasing their fair value and creating impairment.

        Within our overall approach to enterprise interest rate risk management, we currently have two main strategies designed for handling potential impairments in the fair value of MSR. The first is the "natural business hedge" that is inherent in our mortgage banking business. The current composition of the balance sheet and the response of net income to declining interest rates act, to some extent, as a hedge to MSR impairment. Net interest income generally increases in a declining interest rate environment, providing an offset for impairment. Lower interest rates also contribute to increased loan volume, particularly fixed-rate loan production. Since our strategy is to sell most of our fixed-rate loans, we are able to recognize additional gain from mortgage loans and gains from securitized loans. The effectiveness of the natural business hedge increases to the extent that our loan servicing portfolio is replenished more quickly than the loans prepay.

        The second risk management strategy involves the use of investment securities and embedded derivatives. We use fixed-rate investment securities, such as agency and treasury bonds, and interest rate floors embedded in certain adjustable-rate borrowings to supplement the "natural business hedge" of our MSR. The fixed-rate securities can be sold at a gain in falling interest rate environments assisting in offsetting the MSR impairment. The embedded interest rate floors provide a benefit when the specified interest rate index drops below certain levels (strike rate). Similar to the fixed-rate securities, the borrowings with embedded interest rate floors can be terminated at a gain in falling interest environments to assist in offsetting MSR impairment. We may elect to retain some of the fixed-rate securities or the borrowings with embedded interest rate floors in declining interest rate markets. The retained instruments would increase net interest income, providing some protection against MSR impairment.

        We purchased additional bonds in early 2002. We expect to purchase derivatives such as pay-fixed swaptions (options to enter into pay-fixed interest rate swaps) or swaps to hedge the risk of holding the fixed-income bonds, as market conditions warrant. Gain from the sale of bonds in a declining interest rate environment may be used to offset MSR impairment. Loss from the sale of bonds in a rising interest rate environment may generally be offset by gain on the termination of the derivatives and the recovery of the MSR impairment reserve. We expect to maintain the market position of the bond portfolio so that the gain from the sale of bonds in a falling interest rate environment combined with the increased income from the natural business hedge is sufficient to offset most of the MSR impairment. Overall, we believe this strategy

50



will minimize net income sensitivity under most interest rate environments. Our net income could be adversely affected if we are unable to effectively implement or manage our hedging strategy.

        We also hedge the risks associated with our mortgage pipeline. The mortgage pipeline consists of fixed-and adjustable-rate SFR loans to be sold in the secondary market. The risk associated with the mortgage pipeline is the potential rise in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold. This period is usually 60 to 90 days. To hedge this risk, we execute forward sales agreements and option contracts. A forward sales agreement protects us in a rising interest rate environment, since the sales price and delivery date are already established. A forward sales agreement is different, however, from an option contract in that we are obligated to deliver the loan to the third party on the agreed-upon future date. Consequently, if the loan does not fund, we may not have the necessary assets to meet the commitment; therefore, we may be required to purchase other assets, at current market prices, to satisfy the forward sales agreement. To mitigate this risk, we consider fallout factors, which represent the percentage of loans that are not expected to close, in calculating the amount of forward sales agreements to execute.

    2001 and 2000 Sensitivity Comparison

        To analyze net income sensitivity, we project net income over a 12-month horizon based on parallel shifts in the yield curve. Management employs numerous other analyses and interest rate scenarios to evaluate interest rate risk. We project net interest income under a variety of interest rate scenarios, including non-parallel shifts in the yield curve and more extreme non-parallel rising and falling rate environments. These additional scenarios also address the risk exposure in time periods beyond the twelve months captured in the net income sensitivity analysis. Typically, net interest income sensitivity in a rising interest rate environment is not as pronounced in these longer time periods as lagging assets reprice to current market levels and balance sheet growth begins to offset a lower net interest margin. In addition, yields on new loan production gradually replace the comparatively lower yields of the more seasoned portion of the portfolio.

        The table below indicates the sensitivity of net income and net interest income to interest rate movements. The comparative scenarios assume a parallel shift in the yield curve with interest rates rising or falling in even quarterly increments over the twelve month period ending December 31, 2002 and December 31, 2001. The analysis assumes increases in interest rates of 200 basis points ("bp") and decreases of 100 bp. The interest rate scenarios used below represent management's view of reasonably possible near-term interest rate movements.

 
  Gradual Change in Rates
 
 
  -100bp
  +200bp
 
Net income change for the one-year period beginning:          
  January 1, 2002   2.19 % (2.76 )%
  January 1, 2001   6.85 % (8.68 )%
Net interest income change for the one-year period beginning:          
  January 1, 2002   1.47 % (5.18 )%
  January 1, 2001   5.85 % (12.45 )%

        Net income and net interest income sensitivity declined since the prior year mainly due to the purchase of pay-fixed derivatives and additional fixed-rate funding. The funding mix changed as the interest rate environment in 2001 was relatively attractive for obtaining fixed-rate borrowings and derivatives. We expect to continue to add fixed-rate borrowings and derivatives in 2002 based on the relatively low interest rate environment.

        The acquisitions of Bank United, the mortgage operations of PNC and Fleet changed our interest rate risk profile. These acquisitions increased the balances of noninterest bearing escrow accounts, our loan

51



production, and MSR. The increase in noninterest bearing accounts reduced our net interest income sensitivity since these types of accounts are relatively insensitive to interest rate movements. Most of the loan production from the mortgage entities consists of fixed-rate loans that are sold into the secondary market. The sales also reduce the sensitivity of net interest income and, in falling interest rate environments, result in higher gain from mortgage loans, which serves to offset MSR impairment. Since the loan portfolio acquired from Bank United generally reprices to market rates more quickly than our historical loan portfolio, this has reduced our sensitivity to net interest margin compression, which occurs during periods of rising interest rates.

        The projection of the sensitivity of net income requires numerous behavioral assumptions. Prepayment, decay rate (the estimated runoff of deposit accounts that do not have a stated maturity) and new volume projections are the most significant assumptions. Prepayments affect the size of the balance sheet, which impacts net interest income, and they are also a major factor in the valuation of MSR. The decay rate assumptions also impact net interest income by altering the expected deposit mix and rates in the projected interest rate environments. The prepayment and decay rate assumptions reflect management's best estimate of future behavior. These assumptions are internally derived from internal and external analysis of customer behavior.

        The sensitivity of new loan volume and mix to changes in market interest rate levels is also projected. Generally, we assume loan production increases in falling interest rate scenarios with an increased proportion of fixed-rate production. We generally assume a reduction in total loan production in rising interest rate scenarios with a shift towards a greater proportion of adjustable-rate production. The gain from mortgage loans as a percentage of total loan sales also varies under different interest rate scenarios. Normally, the gain from mortgage loans as a percentage of total loan sales increases in falling interest rate environments as higher consumer demand, generated primarily from high refinancing activity, allows loans to be priced more aggressively. Conversely, the gain from mortgage loans as a percentage of total loan sales tends to decline when interest rates increase as loan pricing becomes more competitive, since market participants strive to retain market share as consumer demand declines.

        In addition to gain from mortgage loans, the sensitivity of noninterest income and expense are also estimated. The impairment and recovery of MSR is the most significant element of sensitivity in the projection of noninterest income and expense. The fair value of MSR generally increases as interest rates rise and decreases as interest rates fall. The other components of noninterest income and expense, such as deposit and loan fees and expenses, generally increase or decrease in conjunction with deposit and loan volumes, although loan servicing fees are also dependent on prepayment expectations.

        The analysis is predicated on the effectiveness of our strategy for hedging the fair value of MSR and in managing the instruments used to hedge the fair value of MSR. We have used embedded interest rate floors and fixed-rate bonds as the primary instruments in hedging MSR. However, purchasing bonds increases our exposure to rising interest rates so this risk must also be managed. Our strategy includes purchasing derivatives such as pay-fixed swaptions or swaps to hedge the risk of holding the fixed-rate bonds.

        In a falling interest rate environment, we project MSR impairment as well as gains on the termination or liquidation of MSR hedges. These gains, combined with the increase in net interest income and gain from mortgage loans, generally offset the impairment of MSR. We assume the hedges of MSR will be reset every quarter subsequent to the termination or liquidation, as the need to hedge against further impairment is still present. In a rising interest rate environment, we assume the swaptions and/or swaps hedging the fixed-rate bonds will be terminated and the bonds will be liquidated. We assume the hedges are reset every quarter to the extent gains on the swaptions and/or swaps exist.

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    Counterparty Risk

        An additional risk that arises from our borrowing (including repurchase agreements) and derivative activities is counterparty risk. These activities generally involve an exchange of obligations with another financial institution, referred to in such transactions as a "counterparty." If a counterparty were to default, we could potentially be exposed to financial loss. In order to minimize this risk, we evaluate all counterparties for financial strength on at least an annual basis, then establish exposure limits for each counterparty. We obtain collateral from the counterparties for amounts in excess of the exposure limits, and we monitor our exposure and collateral requirements on a daily basis. We strive to deal with well-established, reputable and financially strong firms.

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Maturity and Repricing Information

        We use interest rate derivative financial instruments as an asset/liability management tool to hedge mismatches in interest rate maturities in order to reduce our sensitivity to interest rate fluctuations. The following table summarizes the notional amounts, expected maturities and weighted average interest rates associated with amounts to be received or paid on interest rate swaps, and the notional amounts, expected maturities and weighted average strike rates for interest rate caps and corridors. Derivatives that are embedded within certain adjustable-rate borrowings, while not accounted for as derivatives under SFAS No. 133, have been included in the table since they also function as asset/liability management tools.

 
  December 31, 2001
 
 
  Expected Maturity
 
 
  Total
  2002
  2003
  2004
  2005
  2006
  After 2006
 
 
  (notional dollars in millions)

 
Stand Alone Derivatives:                                            
Pay-fixed interest rate swaps:                                            
  Contractual maturity   $ 12,905   $ 2,914   $ 2,036   $ 2,534   $ 30   $ 4,448   $ 943  
  Weighted average pay rate     4.82 %   6.09 %   3.78 %   4.63 %   7.15 %   4.39 %   5.58 %
  Weighted average receive rate     2.18 %   2.21 %   2.23 %   2.21 %   2.11 %   2.20 %   1.75 %
Receive-fixed interest rate swaps:                                            
  Contractual maturity   $ 3,627   $ 40   $ 120     -   $ 560   $ 1,005   $ 1,902  
  Weighted average pay rate     2.05 %   2.11 %   1.95 %   -     1.89 %   2.01 %   2.13 %
  Weighted average receive rate     6.63 %   7.17 %   5.55 %   -     5.48 %   6.81 %   6.94 %
Interest rate caps/collars/corridors:                                            
  Contractual maturity   $ 835   $ 380   $ 214   $ 191     -   $ 50     -  
  Weighted average strike rate     7.59 %   7.47 %   7.86 %   8.14 %   -     5.25 %   -  
Swaptions:                                            
  Contractual maturity (option)   $ 5,500   $ 500   $ 5,000     -     -     -     -  
  Weighted average strike rate     6.11 %   6.04 %   6.12 %   -     -     -     -  
  Contractual maturity (swap)   $ 5,500     -     -     -     -   $ 1,000   $ 4,500  
  Weighted average strike rate     6.11 %   -     -     -     -     6.05 %   6.12 %
Embedded Derivatives:                                            
Embedded caps:                                            
  Contractual maturity   $ 696     -   $ 196   $ 500     -     -     -  
  Weighted average strike rate     7.60 %   -     7.25 %   7.75 %   -     -     -  
Embedded floors:                                            
  Contractual maturity   $ 2,300     -     -     -   $ 2,300     -     -  
  Weighted average strike rate     5.12 %   -     -     -     5.12 %   -     -  
Embedded swaptions:                                            
  Contractual maturity (option)   $ 5,900     -   $ 5,900     -     -     -     -  
  Weighted average strike rate     6.13 %   -     6.13 %   -     -     -     -  
  Contractual maturity (swap)   $ 5,900     -     -     -     -   $ 3,750   $ 2,150  
  Weighted average pay rate     6.13 %   -     -     -     -     5.99 %   6.37 %

        A conventional view of interest rate sensitivity for savings institutions is the gap report, which indicates the difference between assets maturing or repricing within a period and total liabilities maturing or repricing within the same period. In assigning assets to maturity and repricing categories, we take into consideration expected prepayment speeds rather than contractual maturities. The balances reflect actual amortization of principal and do not take into consideration reinvestment of cash. Principal prepayments are the amounts of principal reduction over and above normal amortization. We have used prepayment assumptions based on market estimates and past experience with our current portfolio. The majority of our transaction deposits are not contractually subject to repricing. Therefore, these instruments have been allocated based on expected decay rates. Certain transaction accounts that reprice based on a market index and/or typically reprice more frequently were allocated based on the expected repricing period. Non-rate sensitive items such as the allowance for loan and lease losses and deferred loan fees/costs are not included

54



in the table. Loans held for sale are generally included in the 0-3 months category to the extent they are hedged with commitments to sell loans.

        The gap information is limited by the fact that it is a point-in-time analysis. The date reflects conditions and assumptions as of December 31, 2001. These conditions and assumptions may not be appropriate at another point in time. The analysis is also subject to the accuracy of various assumptions used, particularly the prepayment and decay rate projections and the allocation of instruments with optionality to a specific maturity category. Consequently, the interpretation of the gap information is subjective.

 
  December 31, 2001
 
 
  Projected Repricing
 
 
  0-3 months
  4-12 months
  1-5 years
  Thereafter
  Total
 
 
  (dollars in millions)

 
Interest-Sensitive Assets                                
Adjustable-rate loans (1)   $ 70,579   $ 20,258   $ 19,836   $ 235   $ 110,908  
Fixed-rate loans (1)     14,461     5,539     14,520     6,191     40,711  
Adjustable-rate securities (1),(2)     24,263     752     713     16     25,744  
Fixed-rate securities (1)     455     991     5,205     28,815     35,466  
Cash and cash equivalents     6,044     -     -     -     6,044  
Derivatives matched against assets     1,040     -     (100 )   (940 )   -  
   
 
 
 
 
 
    $ 116,842   $ 27,540   $ 40,174   $ 34,317   $ 218,873  
   
 
 
 
 
 
Interest-Sensitive Liabilities                                
Noninterest-bearing checking accounts (3)   $ 1,464   $ 3,885   $ 11,986   $ 6,372   $ 23,707  
Interest-bearing checking accounts, savings accounts and MMDAs (3)     10,703     9,919     14,226     11,666     46,514  
Time deposit accounts     12,854     17,007     6,453     578     36,892  
Short-term and adjustable-rate borrowings     89,173     4,553     -     -     93,726  
Long-term fixed-rate borrowings     1,033     6,592     12,196     4,858     24,679  
Derivatives matched against liabilities     (4,680 )   1,312     (1,382 )   4,750     -  
   
 
 
 
 
 
    $ 110,547   $ 43,268   $ 43,479   $ 28,224   $ 225,518  
   
 
 
 
 
 
Repricing gap   $ 6,295   $ (15,728 ) $ (3,305 ) $ 6,093   $ (6,645 )
   
 
 
 
 
 
Cumulative gap   $ 6,295   $ (9,433 ) $ (12,738 ) $ (6,645 ) $ (6,645 )
   
 
 
 
 
 
Cumulative gap as a percentage of total assets     2.60 %   (3.89 )%   (5.25 )%   (2.74 )%   (2.74 )%
  Total assets                           $ 242,506  
                           
 

(1)
Based on scheduled maturity or scheduled repricing and estimated prepayments of principal.
(2)
Includes investment in FHLBs.
(3)
Based on projected decay rates and/or repricing periods for checking, savings, and money market deposit accounts.

Tax Contingency

        From 1981 through 1985, Ahmanson acquired thrift institutions in six states through Federal Savings and Loan Insurance Corporation ("FSLIC")-assisted transactions. The position was that assistance received from the FSLIC included out-of-state branching rights valued at approximately $740 million. Prior to December 31, 1998, Ahmanson had sold its deposit-taking businesses and abandoned such branching rights in five states, the first of which was Missouri in 1993. Our financial statements do not contain any benefit related to our determination that we are entitled to a deduction for the amount of our tax bases in certain state branching rights when we sold our deposit-taking businesses in those states, thereby abandoning such branching rights. Our position is that the tax bases result from the tax treatment of property received as assistance from the FSLIC in conjunction with FSLIC-assisted transactions. The potential tax benefit related to these abandonments as of December 31, 2001 could approach $238 million.

55



        The Internal Revenue Service (the "Service") has completed its examination of the Ahmanson federal income tax returns for the years 1990 through 1993. The return for 1993 included the proposed adjustment related to the abandonment of the Missouri branching rights. A tentative settlement was reached with the Appeals Branch level of the Service and it is currently under review by the Joint Committee on Taxation. In accordance with accounting principles generally accepted in the United States of America, we do not believe it is appropriate at this time to reflect any tax benefits in our financial statements.

Goodwill Litigation

        On August 9, 1989, the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA") was enacted. Among other things, FIRREA raised the minimum capital requirements for savings institutions and required a phase-out of the amount of supervisory goodwill that could be included in satisfying certain regulatory capital requirements. The exclusion of supervisory goodwill from regulatory capital led many savings institutions to either replace the lost capital by issuing new qualifying debt or equity securities or to reduce assets.

        To date, trials have been concluded and opinions have been issued in a number of actions in the United States Court of Federal Claims (the "Court") in which savings institutions and investors in savings institutions sought damages from the U.S. Government based on breach of contract and other theories. Generally, in cases in which these opinions on the merits have been issued by the Court, either the plaintiff(s), the defendant (U.S. Government), or both the plaintiff(s) and the defendant, have opted to appeal the Court's decision. Of those appeals, some are now pending before the United States Court of Appeals for the Federal Circuit and others have been decided. Generally, the appeals have resulted in the cases being remanded to the Court for further trial proceedings. In one case, California Federal Bank v. United States , the plaintiff petitioned and the defendant cross petitioned the United States Supreme Court for a writ of certiorari, both of which were denied.

    Home Savings

        WMBFA, as successor to Home Savings, has continued to pursue a favorable outcome in the lawsuit filed by Home Savings in September 1992 ("Home Savings Goodwill Litigation") against the U.S. Government for damages from the exclusion from regulatory capital of supervisory goodwill resulting from Home Savings' acquisitions of savings institutions in Florida, Missouri, Texas, Illinois, and Ohio, and of Century Federal Savings of New York, over the period from 1981 to 1985. As of August 31, 1989, Home Savings possessed approximately $460 million in unamortized supervisory goodwill from these acquisitions.

        In the Home Savings Goodwill Litigation, Home Savings and Ahmanson (the parent of Home Savings prior to its acquisition by WMBFA) alleged breaches of contract as well as certain other claims arising from facts substantially identical to those giving rise to the breaches of contract.

        On May 18, 2001, the Court issued an opinion holding the U.S. Government liable for breaches of the contracts which permitted Home Savings to count supervisory goodwill toward regulatory capital requirements in regard to all of the supervisory acquisitions of savings institutions in the states of Florida, Missouri, Texas, and Illinois, and in regard to the acquisition of Century Federal Savings of New York. The Court's opinion further holds the U.S. Government liable for breach of the contract which permitted Home Savings to count supervisory goodwill toward regulatory capital in regard to one of the five savings institutions that Home Savings acquired in the state of Ohio. The Court held that the U.S. Government was not liable for any breach of contract in regard to the other four savings institutions in Ohio which Home Savings had acquired. Approximately $34 million of the $460 million of unamortized goodwill Home Savings had as of August 31, 1989, was attributable to Home Savings' acquisition of the five savings institutions in Ohio. WMBFA is currently assessing how much of the supervisory goodwill attributable to Home Savings' acquisitions in Ohio remains the subject of the Home Savings Goodwill Litigation as a result of the Court's May 18 opinion.

56



        On January 16, 2002, the Court issued an opinion dismissing the remaining claims of Home Savings other than those for breach of contract. In the same opinion, the Court denied a motion by the United States for summary judgment with respect to damages resulting from the U.S. Government's breaches of contract. Thus, as yet, there has been no determination as to the amount of any damages, if any, that Home Savings may be entitled to recover in compensation for the U.S. Government's breaches.

        On February 6, 2002, at the direction of the Court, the parties submitted status reports proposing dates for a trial to determine the amount of any damages that WMBFA might recover in the Home Savings Goodwill Litigation. Pursuant to an order entered on February 25, 2002, trial is now set to commence in October 2002.

    American Savings Bank, F.A.

        In December 1992, ASB, Keystone Holdings and certain related parties brought a lawsuit against the U.S. Government, alleging, among other things, that in connection with the acquisition of ASB they entered into a contract with agencies of the United States and that the U.S. Government breached that contract. As a result of the Keystone Transaction, we succeeded to all of the rights of ASB, Keystone Holdings and such related parties in such litigation and will receive any recovery from the litigation. ASB is now WMBFA.

        In connection with the Keystone Transaction, we delivered a specified number of shares of our common stock into an escrow. There are currently 18 million shares in the escrow (the "Escrow Shares"). Upon our receipt of net cash proceeds from a judgment in or settlement of the litigation, all or part of the Escrow Shares will be released, 64.9% to investors in Keystone Holdings or their assigns, and 35.1% to the FSLIC Resolution Fund or its assigns. The number of Escrow Shares to be released will be equal to the case proceeds, reduced by certain tax and litigation-related costs and expenses, divided by $27.7417. The escrow will expire on December 20, 2002, subject to extensions in certain circumstances. If not all Escrow Shares are released prior to such expiration, any remaining Escrow Shares will be returned to us for cancellation.

        The allegations made in the ASB case are similar to those asserted in other cases where the United States Supreme Court affirmed decisions holding the U.S. Government liable for breach of contract. However, no record has been established in these other cases which would indicate what, if any, damages we are entitled to receive in this case. Accordingly, the ultimate outcome of the ASB case is uncertain, and there can be no assurance that we will benefit financially from it. Generally, we expect to receive financial benefit only if the cash proceeds, after reduction for certain tax and litigation-related costs and expenses, exceed $333 million.

    Coast Savings Financial, Inc. and Bank United Corp.

        Prior to their acquisitions, Coast Savings Financial, Inc. and Bank United Corp. ("Bank United") had similar lawsuits against the U.S. Government. Generally, securities representing interests in these lawsuits were issued to Coast Savings Financial, Inc. and Bank United shareholders. These securities, called contingent payment rights certificates, are currently traded on the NASDAQ Stock Market under the symbols CCPRZ and BNKUZ, respectively. We do not own a significant number of these securities.

    Dime Bancorp, Inc.

        In January 1995, Anchor Savings Bank FSB ("Anchor FSB"), filed suit against the U.S. Government for unspecified damages involving supervisory goodwill related to its acquisition of eight troubled savings institutions from 1982-1985. The Dime Savings Bank of New York, FSB ("Dime FSB") acquired Anchor FSB shortly after the case was brought and Dime FSB was subsequently merged into WMBFA in January 2002.

57



        In 1997, Dime FSB moved for partial summary judgment as to the existence of a contract and the U.S. Government's breach of that contract in each of the related transactions. The U.S. Government disputed the existence of a contract in each case, cross-moved for summary judgment and submitted a filing acknowledging that it was not aware of any affirmative defenses. In August 1997, the Court held a hearing on summary judgment motions in four other related cases and ruled in favor of the plaintiffs on all "common" issues. From April 1998 through July 1999, Dime FSB conducted discovery. In September 1999, the U.S. Government filed supplemental papers in support of its pending summary judgment motion. Dime FSB responded to such filings in early November 1999, at which time it again requested entry of summary judgment on liability in its favor.

        In October 1999, Dime FSB filed expert reports claiming damages under three alternative theories. Dime FSB sought lost profits in the amount of $980 million, restitution damages in the amount of $681 million, and reliance damages in the amount of $446 million. In March 2000, the U.S. Government filed expert reports denying the existence of damages under any of these theories.

        In March 2001, the Court heard oral argument on the pending summary judgment motions with respect to three of the eight institutions acquired by Dime FSB. It is not possible to predict whether the Court will grant any of Dime FSB's motions for partial summary judgment or, if so, when it will schedule a trial on damages and any remaining liability issues.

        In December 2000, Dime Bancorp, Inc., Dime FSB's parent, distributed Litigation Tracking Warrants™ to its shareholders, which represent the right to purchase Common Stock equal in value to 85% of the net after-tax proceeds, if any, from this lawsuit.


Financial Statements and Supplementary Data

        For financial statements, see Index to Consolidated Financial Statements on page 61.


Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

        None.

58



PART III

        Part III is incorporated by reference from our definitive proxy statement issued in conjunction with our Annual Meeting of Shareholders to be held April 16, 2002. Certain information regarding our principal officers is set forth in "Business – Principal Officers."


PART IV

Exhibits, Financial Statement Schedules and Reports on Form 8-K

(a)
(1)       Financial Statements

        See Index to Consolidated Financial Statements on page 61.

    (2)
    Financial Statement Schedules

        All financial statement schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or the Notes thereto.

(b)     Reports on Form 8-K:

        Washington Mutual filed the following reports on Form 8-K during the fourth quarter of 2001:

        1.    Report filed October 16, 2001. Items included: Item 5. Other Events, and Item 7. Financial Statements and Exhibits. The report included a press release announcing the Company's third quarter financial results.

        2.    Report filed on October 17, 2001. Items included: Item 5. Other Events, and Item 7. Financial Statements and Exhibits. The report included a transcript of remarks of Company management from the conference call held to discuss the Company's results of operations for the third quarter of 2001.

        3.    Report filed December 21, 2001. Items included: Item 9. Regulation FD Disclosure. The report included an announcement by the Company that it received from the Office of Thrift Supervision (OTS) approval of the Company's acquisition of Dime Bancorp, Inc.

(c)     Exhibits:

        The Index of Exhibits is included in the version of this Form 10-K filed with the Securities and Exchange Commission.

59



Signatures

        Pursuant to the requirements of Section 13 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 February 25, 2002.

    WASHINGTON MUTUAL, INC.

 

 

/s/  
KERRY K. KILLINGER           
Kerry K. Killinger
Chairman, President and Chief Executive Officer

        Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated on February 25, 2002.


 

 

 
/s/   KERRY K. KILLINGER           
Kerry K. Killinger
Chairman, President and Chief Executive Officer; Director (Principal Executive Officer)
  /s/   WILLIAM A. LONGBRAKE           
William A. Longbrake
Vice Chair, Enterprise Risk Management and Chief Financial Officer

/s/  
DOUGLAS P. BEIGHLE           
Douglas P. Beighle
Director

 

/s/  
ROBERT H. MILES           
Robert H. Miles
Senior Vice President and Controller

/s/  
DAVID BONDERMAN           
David Bonderman
Director

 

/s/  
MARGARET OSMER-MCQUADE           
Margaret Osmer-McQuade
Director

/s/  
J. TAYLOR CRANDALL           
J. Taylor Crandall
Director

 

/s/  
MARY E. PUGH           
Mary E. Pugh
Director

/s/  
ANNE V. FARRELL           
Anne V. Farrell
Director

 

/s/  
WILLIAM G. REED, JR.           
William G. Reed, Jr.
Director

/s/  
STEPHEN E. FRANK           
Stephen E. Frank
Director

 

/s/  
ELIZABETH A. SANDERS           
Elizabeth A. Sanders
Director

/s/  
WILLIAM P. GERBERDING           
William P. Gerberding
Director

 

/s/  
WILLIAM D. SCHULTE           
William D. Schulte
Director

/s/  
ENRIQUE HERNANDEZ, JR.           
Enrique Hernandez, Jr.
Director

 

/s/  
JAMES H. STEVER           
James H. Stever
Director

/s/  
PHILLIP D. MATTHEWS           
Phillip D. Matthews
Director

 

/s/  
WILLIS B. WOOD, JR.           
Willis B. Wood, Jr.
Director

/s/  
MICHAEL K. MURPHY           
Michael K. Murphy
Director

 

 

60


Financial Statements and Supplementary Data


INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 
  Page
Independent Auditors' Report   62

Consolidated Statements of Income for the years ended December 31, 2001, 2000 and 1999

 

63

Consolidated Statements of Financial Condition at December 31, 2001 and 2000

 

64

Consolidated Statements of Stockholders' Equity and Comprehensive Income for the years ended December 31, 2001, 2000 and 1999

 

65

Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999

 

66

Notes to Consolidated Financial Statements

 

68

Supplementary Data (unaudited)

 

120

61



INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Shareholders
of Washington Mutual, Inc.:

        We have audited the accompanying consolidated statements of financial condition of Washington Mutual, Inc. and subsidiaries ("the Company") as of December 31, 2001 and 2000, and the related consolidated statements of income, stockholders' equity and comprehensive income, and of cash flows for each of the three years in the period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial condition of Washington Mutual, Inc. and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America.

        As discussed in Note 1 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 133 , Accounting for Derivative Instruments and Hedging Activities , as amended, on January 1, 2001.

/s/   DELOITTE & TOUCHE LLP       

Seattle, Washington
February 19, 2002
(March 1, 2002 as to Note 2)

62


WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 
  Year Ended December 31,
 
 
  2001
  2000
  1999
 
 
  (in millions,
except per share amounts)

 
Interest Income                    
Loans   $ 11,233   $ 9,388   $ 8,348  
Available-for-sale securities     3,573     2,811     2,481  
Held-to-maturity securities     -     1,319     1,050  
Other interest and dividend income     259     265     183  
   
 
 
 
  Total interest income     15,065     13,783     12,062  
Interest Expense                    
Deposits     3,094     3,290     3,170  
Borrowings     5,095     6,182     4,440  
   
 
 
 
  Total interest expense     8,189     9,472     7,610  
   
 
 
 
  Net interest income     6,876     4,311     4,452  
Provision for loan and lease losses     575     185     167  
   
 
 
 
  Net interest income after provision for loan and lease losses     6,301     4,126     4,285  
Noninterest Income                    
Depositor and other retail banking fees     1,290     976     764  
Securities fees and commissions     303     318     271  
Insurance income     100     49     43  
Single-family residential ("SFR") mortgage banking (expense) income     (285 )   433     237  
Portfolio loan related income     193     82     73  
Gain (loss) from other securities     744     (3 )   (12 )
Other income     282     129     133  
   
 
 
 
  Total noninterest income     2,627     1,984     1,509  
Noninterest Expense                    
Compensation and benefits     1,924     1,348     1,223  
Occupancy and equipment     804     604     575  
Telecommunications and outsourced information services     441     323     276  
Professional fees     201     101     76  
Advertising and promotion     185     132     111  
Depositor and other retail banking losses     144     105     107  
Amortization of goodwill and other intangible assets     172     106     98  
Other expense     746     407     444  
   
 
 
 
  Total noninterest expense     4,617     3,126     2,910  
   
 
 
 
  Income before income taxes and extraordinary item     4,311     2,984     2,884  
Income taxes     1,579     1,085     1,067  
   
 
 
 
Income before extraordinary item     2,732     1,899     1,817  
Extraordinary item – gain on extinguishment of securities sold under agreements to repurchase ("repurchase agreements"), net of taxes of $239 million     382     -     -  
   
 
 
 
Net Income   $ 3,114   $ 1,899   $ 1,817  
   
 
 
 
Net Income Attributable to Common Stock   $ 3,107   $ 1,899   $ 1,817  
   
 
 
 
  Basic earnings per common share:                    
    Income before extraordinary item   $ 3.20   $ 2.37   $ 2.12  
    Extraordinary item     0.45     -     -  
   
 
 
 
    Net income   $ 3.65   $ 2.37   $ 2.12  
   
 
 
 
  Diluted earnings per common share:                    
    Income before extraordinary item   $ 3.15   $ 2.36   $ 2.11  
    Extraordinary item     0.44     -     -  
   
 
 
 
    Net income   $ 3.59   $ 2.36   $ 2.11  
   
 
 
 
Dividends declared per common share   $ 0.90   $ 0.76   $ 0.65  
Basic weighted average common shares outstanding     850.2     801.3     859.0  
Diluted weighted average common shares outstanding     864.7     804.7     861.8  

See Notes to Consolidated Financial Statements.

63


WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

 
  December 31,
 
 
  2001
  2000
 
 
  (dollars in millions)

 
Assets              
Cash and cash equivalents   $ 6,044   $ 2,622  
Available-for-sale securities, total amortized cost of $58,783 and $42,288:              
  Encumbered     38,649     23,576  
  Unencumbered     19,700     18,583  
   
 
 
      58,349     42,159  
Held-to-maturity securities, total fair value of zero and $16,486:              
  Encumbered     -     9,566  
  Unencumbered     -     6,999  
   
 
 
      -     16,565  
Loans held for sale     23,842     3,404  
Loans held in portfolio     132,991     119,626  
Allowance for loan and lease losses     (1,404 )   (1,014 )
   
 
 
    Total loans held in portfolio, net of allowance for loan and lease losses     131,587     118,612  
Mortgage servicing rights ("MSR")     6,241     1,017  
Investment in Federal Home Loan Banks ("FHLBs")     3,873     3,260  
Goodwill and other intangible assets     2,330     1,084  
Other assets     10,240     5,993  
   
 
 
    Total assets   $ 242,506   $ 194,716  
   
 
 

Liabilities

 

 

 

 

 

 

 
Deposits:              
  Noninterest-bearing deposits   $ 22,441   $ 8,755  
  Interest-bearing deposits     84,741     70,819  
   
 
 
    Total deposits     107,182     79,574  
Federal funds purchased and commercial paper     4,690     4,115  
Securities sold under agreements to repurchase     39,447     29,756  
Advances from FHLBs     61,182     57,855  
Other borrowings     12,576     9,930  
Other liabilities     3,264     3,320  
   
 
 
    Total liabilities     228,341     184,550  
Redeemable preferred stock     102     -  
Stockholders' Equity              
Common stock, no par value: 1,600,000,000 shares authorized, 873,089,120 and
809,783,580 shares issued and outstanding
    -     -  
Capital surplus - common stock     3,178     1,425  
Accumulated other comprehensive loss     (243 )   (54 )
Retained earnings     11,128     8,795  
   
 
 
    Total stockholders' equity     14,063     10,166  
   
 
 
    Total liabilities, redeemable preferred stock, and stockholders' equity   $ 242,506   $ 194,716  
   
 
 

See Notes to Consolidated Financial Statements.

64


WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME

 
  Number of
Shares

  Total
  Capital Surplus —
Common Stock

  Accumulated
Other
Comprehensive
Income (Loss)

  Retained
Earnings

 
 
  (in millions)

 
BALANCE, December 31, 1998   890.1   $ 9,344   $ 2,995   $ 74   $ 6,275  
Comprehensive income:                              
  Net income – 1999   -     1,817     -     -     1,817  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized losses on securities arising during the year, net of reclassification adjustments   -     (754 )   -     (754 )   -  
    Minimum pension liability adjustment   -     6     -     6     -  
       
                   
Total comprehensive income   -     1,069     -     -     -  
Cash dividends declared on common stock   -     (570 )   -     -     (570 )
Common stock repurchased and retired   (47.3 )   (1,082 )   (1,082 )   -     -  
Common stock issued to acquire Long Beach Financial Corp   9.5     207     207     -     -  
Common stock issued   5.1     85     85     -     -  
   
 
 
 
 
 
BALANCE, December 31, 1999   857.4     9,053     2,205     (674 )   7,522  
   
 
 
 
 
 
Comprehensive income:                              
  Net income – 2000   -     1,899     -     -     1,899  
  Other comprehensive income, net of tax:                              
    Net unrealized gains on securities arising during the year, net of reclassification adjustments   -     616     -     616     -  
    Minimum pension liability adjustment   -     4     -     4     -  
       
                   
Total comprehensive income   -     2,519     -     -     -  
Cash dividends declared on common stock   -     (626 )   -     -     (626 )
Common stock repurchased and retired   (52.2 )   (869 )   (869 )   -     -  
Common stock issued   4.6     89     89     -     -  
   
 
 
 
 
 
BALANCE, December 31, 2000   809.8     10,166     1,425     (54 )   8,795  
   
 
 
 
 
 
Comprehensive income:                              
  Net income – 2001   -     3,114     -     -     3,114  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized losses on securities arising during the year, net of reclassification adjustments   -     (191 )   -     (191 )   -  
    Minimum pension liability adjustment   -     (1 )   -     (1 )   -  
    Net unrealized gain on cash flow hedging instruments   -     3     -     3     -  
       
                   
Total comprehensive income   -     2,925     -     -     -  
Cash dividends declared on common stock   -     (774 )   -     -     (774 )
Cash dividends declared on redeemable preferred stock   -     (7 )   -     -     (7 )
Common stock repurchased and retired   (7.3 )   (231 )   (231 )   -     -  
Common stock warrants issued,
net of issuance costs
  -     398     398     -     -  
Common stock issued to acquire Bank United Corp.   63.9     1,389     1,389     -     -  
Common stock issued   6.7     197     197     -     -  
   
 
 
 
 
 
BALANCE, December 31, 2001   873.1   $ 14,063   $ 3,178   $ (243 ) $ 11,128  
   
 
 
 
 
 

See Notes to Consolidated Financial Statements.

65



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 
  Year Ended December 31,
 
 
  2001
  2000
  1999
 
 
  (in millions)

 
Cash Flows from Operating Activities                    
Net income   $ 3,114   $ 1,899   $ 1,817  
Adjustments to reconcile net income to net cash provided by operating activities:                    
  Provision for loan and lease losses     575     185     167  
  Gain from mortgage loans     (967 )   (262 )   (109 )
  (Gain) loss from securities     (861 )   1     12  
  Extraordinary item – gain on extinguishment of repurchase agreements, net of taxes     (382 )   -     -  
  Depreciation and amortization     1,590     539     400  
  MSR impairment (recovery)     1,749     9     (4 )
  Stock dividends from FHLBs     (216 )   (221 )   (139 )
  Origination and purchases of loans held for sale, net of principal payments     (133,534 )   (13,123 )   (4,996 )
  Proceeds from sales of loans held for sale     118,131     12,610     8,960  
  Decrease (increase) in other assets     1,418     793     (502 )
  (Decrease) increase in other liabilities     (1,394 )   592     (336 )
   
 
 
 
    Net cash (used) provided by operating activities     (10,777 )   3,022     5,270  

Cash Flows from Investing Activities

 

 

 

 

 

 

 

 

 

 
Purchases of securities     (60,077 )   (2,843 )   (17,091 )
Proceeds from sales of mortgage-backed securities ("MBS")     20,202     2,366     1,409  
Proceeds from sales and maturities of other available-for-sale securities     31,691     1,476     271  
Principal payments on securities     11,830     8,373     12,411  
Purchases of investment in FHLBs     -     (136 )   (787 )
Proceeds from sales of loans     -     13,164     55  
Origination and purchases of loans, net of principal payments     (1,677 )   (29,023 )   (23,928 )
Proceeds from sales of foreclosed assets     257     265     354  
Net cash used for acquisitions     (13,818 )   (23 )   (144 )
Purchases of premises and equipment, net     (753 )   (272 )   (319 )
Purchases of bank-owned life insurance     -     (1,000 )   -  
   
 
 
 
    Net cash used by investing activities, carried forward     (12,345 )   (7,653 )   (27,769 )

See Notes to Consolidated Financial Statements.

66



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

 
  Year Ended December 31,
 
 
  2001
  2000
  1999
 
 
  (in millions)

 
  Net cash used by investing activities, brought forward     (12,345 )   (7,653 )   (27,769 )

Cash Flows from Financing Activities

 

 

 

 

 

 

 

 

 

 
Increase (decrease) in deposits     19,932     (1,553 )   (4,289 )
Deposits sold     (423 )   (3 )   (73 )
Increase (decrease) in short-term borrowings     24,220     (6,373 )   5,413  
Proceeds from long-term borrowings     12,799     32,615     15,881  
Repayments of long-term borrowings     (25,252 )   (19,817 )   (9,911 )
Proceeds from advances from FHLBs     135,015     88,749     87,174  
Repayments of advances from FHLBs     (139,302 )   (87,990 )   (69,828 )
Cash dividends paid on preferred and common stock     (781 )   (626 )   (570 )
Repurchase of common stock     (231 )   (869 )   (1,082 )
Common stock warrants issued     398     -     -  
Other     169     80     67  
   
 
 
 
    Net cash provided by financing activities     26,544     4,213     22,782  
   
 
 
 
    Increase (decrease) in cash and cash equivalents     3,422     (418 )   283  
    Cash and cash equivalents, beginning of year     2,622     3,040     2,757  
   
 
 
 
    Cash and cash equivalents, end of year   $ 6,044   $ 2,622   $ 3,040  
   
 
 
 

Noncash Activities

 

 

 

 

 

 

 

 

 

 
Loans exchanged for MBS   $ 2,399   $ 7,414   $ 14,764  
Real estate acquired through foreclosure     345     255     338  
Loans originated to facilitate the sale of foreclosed assets     13     36     65  
Loans held in portfolio transferred to loans held for sale     -     1,314     -  
Fair value of Bank United Corp. assets acquired     19,034     -     -  
Fair value of Bank United Corp. liabilities acquired     17,374     -     -  

Cash Paid During the Year For

 

 

 

 

 

 

 

 

 

 
Interest on deposits     3,070     3,287     3,151  
Interest on borrowings     5,388     6,257     4,251  
Income taxes     1,477     444     855  

See Notes to Consolidated Financial Statements.

67


WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Summary of Significant Accounting Policies

        Washington Mutual, Inc. ("WMI" and together with its subsidiaries, "Washington Mutual" or the "Company") is a financial services company committed to serving consumers and small to mid-sized businesses. The Company accepts deposits from the general public, makes, buys and sells residential loans, consumer loans, and commercial loans, and engages in certain commercial banking activities. The Company originates, purchases, sells and services specialty mortgage finance loans.

        The Company has a concentration of operations in California. At December 31, 2001, 51% of the Company's loan portfolio and 63% of the Company's deposits were concentrated in California.

        Certain reclassifications have been made to the 2000 and 1999 financial statements to conform to the 2001 presentation. All intercompany transactions and balances have been eliminated.

        On October 1, 1999, Washington Mutual acquired Long Beach Financial Corporation, parent of Long Beach Mortgage Company ("Long Beach Mortgage"). In 2001, Washington Mutual acquired Bank United Corp., Fleet Mortgage Corp., and the mortgage operations of The PNC Financial Services Group, Inc. These acquisitions were accounted for as purchases.

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

        For the purpose of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, U.S. Treasury bills, overnight investments, commercial paper and repurchase agreements with an initial maturity of three months or less.

        Investments classified as held to maturity are accounted for at amortized cost because the Company has both the positive intent and the ability to hold those securities to maturity. Other than temporary declines in fair value are recognized in the income statement as loss from securities. With the adoption of Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, the Company reclassified its held-to-maturity MBS and investment portfolios to available-for-sale.

        Securities not classified as held to maturity are considered to be available for sale. Gains and losses realized on the sale of these securities are based on the specific identification method. Unrealized gains and losses from available-for-sale securities are excluded from earnings and reported (net of tax) in accumulated other comprehensive income until realized. Other than temporary declines in fair value are recognized in the income statement as loss from securities.

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        Loans held for sale include originated and purchased/correspondent mortgage loans intended for sale in the secondary market. The Company enters into forward sales agreements to manage interest rate risk associated with loans held for sale. Loans held for sale with designated fair value hedges are recorded at fair value. Loans held for sale without designated fair value hedges are recorded at the lower of aggregate cost or fair value.

        Loans held in portfolio are recorded at the principal amount outstanding, net of deferred loan costs or fees and any discounts or premiums on purchased loans. Deferred costs or fees, discounts and premiums are amortized using the interest method over the contractual term of the loan adjusted for actual prepayments.

        Management generally ceases to accrue interest income on all loans that become four payments delinquent and reverses all interest accrued up to that time. Thereafter, interest income is accrued only if and when, in management's opinion, projected cash proceeds are deemed sufficient to repay both principal and interest. All loans for which interest is not being accrued are referred to as loans on nonaccrual status.

        Commercial real estate loans over $1 million and all commercial business and builder construction loans are individually evaluated for impairment. Management generally identifies loans to be evaluated for impairment when such loans are on nonaccrual status or have been restructured. However, not all nonaccrual loans are impaired. Loans are considered impaired when it is probable that the Company will be unable to collect all amounts contractually due, including scheduled interest payments. Restructured loans are evaluated for impairment based on the contractual terms specified by the original loan agreement, rather than the contractual terms specified by the restructuring agreement. Loans performing under restructured terms beyond a specified performance period are classified as accruing, but may still be deemed impaired. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, the value of the underlying collateral, and current economic conditions. All other loans are reviewed on a collective basis.

        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. Management performs regular, ongoing reviews of its portfolios to identify these inherent losses, and to assess the overall probability of collection of these portfolios. The Company monitors delinquency, default, and loss rates, among other factors impacting portfolio risk. The Company's methodology for assessing the appropriate level of the allowance consists of several key elements, which include the allocated allowance, specific allowances for identified loans and the unallocated allowance.

        The allocated allowance is assessed on both homogeneous and non-homogeneous loan portfolios. The amount is calculated by applying loss factors to the outstanding loan balances and commitments of these portfolios. Loss factors are based on analysis of the historical performance of each loan category and an assessment of portfolio trends and conditions, as well as specific risk factors impacting the loan and lease portfolios. Each homogeneous portfolio, such as single family residential or specialty mortgage finance, is evaluated collectively.

        Non-homogeneous type loans, such as commercial business, commercial real estate and builder SFR construction loans, are analyzed and segregated by risk according to the Company's internal risk rating

69



scale. These loans are reviewed on an individual loan basis and loss factors are applied based on the risk rating assigned to the loan. A specific allowance may be assigned to non-homogeneous type loans that have been individually determined to be impaired. Any specific allowance considers all available evidence including, as appropriate, the present value of payments expected to be received, or for loans that are solely dependent on collateral for repayment, the estimated fair value of the collateral.

        The unallocated allowance is based upon management's evaluation and judgment of various conditions that are not directly measured in the determination of the allocated and specific allowances. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, bank regulatory examination results and findings of the Company's internal credit examiners.

        When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the allowance for loan and lease losses. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not evidenced the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; or the fair value of the loan collateral is significantly below the current loan balance and there is little or no near-term prospect for improvement.

        Consumer loans secured by collateral other than real estate are charged off if and when they exceed a specified number of days contractually delinquent (180 days for substantially all loans). Single-family residential loans and consumer loans secured by real estate are written down to the fair value of the underlying collateral (less projected cost to sell) when they are contractually delinquent 120 days.