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

FORM 10-K


(Mark One)  

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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

OR

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

1201 Third Avenue, Seattle, Washington
(Address of Principal Executive Offices)

 

98101
(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

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

Title of each class
  Name of each exchange on which registered
Ligitation Tracking Warrants™   NASDAQ

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  ý     No  o .

        Indicate by check mark 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.  o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes  ý     No  o .

        The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2002:

Common Stock – $35,086,844,423 (1)

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

        The number of shares outstanding of the issuer's classes of common stock as of February 28, 2003:

Common Stock – 939,456,466 (2)

(2)
Includes 17,775,000 shares held in escrow pending resolution of the Company's asserted right to the return of such shares.

Documents Incorporated by Reference

        Portions of the definitive proxy statement for the Annual Meeting of Shareholders to be held April 15, 2003, are incorporated by reference into Part II and Part III.




WASHINGTON MUTUAL, INC.
2002 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

 
  Page
PART I   1
  Item 1. Business   1
      Business Segments   2
      Available Information   5
      Employees   5
      Factors That May Affect Future Results   5
      Taxation   7
      Environmental Regulation   7
      Regulation and Supervision   8
      Principal Officers   13
  Item 2. Properties   15
  Item 3. Legal Proceedings   16
  Item 4. Submission of Matters to a Vote of Security Holders   16
PART II   16
  Item 5. Market for our Common Stock and Related Stockholder Matters   16
  Item 6. Selected Financial Data   20
  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations   17
      Controls and Procedures   17
      Critical Accounting Policies   17
      Five-Year Summary of Selected Financial Data   20
      Significant Transactions   20
      Ratios and Other Supplemental Data   22
      Earnings Performance   26
      Review of Financial Condition   33
      Off-Balance Sheet Arrangements   38
      Asset Quality   40
      Operating Segments   47
      Liquidity   51
      Capital Adequacy   54
      Market Risk Management   54
      Maturity and Repricing Information   61
      Recently Issued Accounting Standards   66
      Tax Contingency   67
      Goodwill Litigation   68
  Item 7A. Quantitative and Qualitative Disclosures about Market Risk   54
  Item 8. Financial Statements and Supplementary Data   70
  Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   70
PART III   70
  Item 10. Directors and Executive Officers of the Registrant   70
  Item 11. Executive Compensation   70
  Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   70
  Item 13. Certain Relationships and Related Transactions   70
  Item 14. Controls and Procedures   17
PART IV   71
  Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K   71

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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, 2002, we were the largest thrift holding company in the United States and the seventh largest among all U.S. bank and thrift holding companies.

    Company Growth

        Our assets have grown over the last seven years primarily through the following acquisitions:

Acquisition Name

  Date Acquired
  Loans
  Deposits
  Assets
 
  (in millions)

Keystone Holdings, Inc.   Dec. 20, 1996   $ 14,563   $ 12,815   $ 21,894
Great Western Financial Corporation   July 1, 1997     32,448     27,785     43,770
H.F. Ahmanson & Company (1)   Oct. 1, 1998     33,939     33,975     50,355
Long Beach Financial Corporation   Oct. 1, 1999     415     -     821
Mortgage operations of The PNC Financial Services Group, Inc. (2)   Jan. 31, 2001     3,352     -     7,307
Bank United Corp.   Feb. 9, 2001     14,983     8,093     19,034
Fleet Mortgage Corp. (2)   June 1, 2001     4,378     -     7,813
Dime Bancorp, Inc.   Jan. 4, 2002     21,660     15,171     31,288
HomeSide Lending (2)   Mar. 1, 2002     1,094     -     1,232
HomeSide Lending, Inc. (3)   Oct. 1, 2002     42     -     2,775

(1)
Includes loans, deposits and assets acquired by Ahmanson from Coast Savings Financial, Inc.
(2)
This was an acquisition of selected assets and/or liabilities.
(3)
With the acquisition of SR Investment, Inc., the Company purchased the ownership of HomeSide Lending, Inc.

        During 2002, the Company completed three acquisitions. On January 4, 2002, we completed our acquisition of New York-based Dime Bancorp, Inc. The acquisition of Dime added approximately $31 billion to our asset base, including approximately $22 billion in loans, and increased our deposit base by approximately $15 billion. The acquisition of Dime also significantly contributed to the growth in our mortgage banking business, resulting in a $926 million increase to our mortgage servicing rights ("MSR") balance and a $49.24 billion increase in our portfolio of loans serviced for others.

        In two transactions during 2002, we purchased for cash HomeSide Lending, Inc., the U.S. mortgage unit of National Australia Bank Limited. The aggregate purchase price of HomeSide was $2.45 billion. The acquisition of HomeSide added approximately $1 billion in loans held for sale, approximately $960 million in net MSR and approximately $130 billion to our portfolio of loans serviced for others. We also acquired a proprietary loan servicing platform, which we intend to make our primary loan servicing platform. In addition we assumed $760 million in long-term debt and $750 million in other liabilities.

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Business Segments

        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; and

    Specialty Finance Group

        The management of our interest rate risk, liquidity, capital, borrowings and purchased investment securities portfolios is performed by our Treasury Division.

        Our mission is to become the nation's leading retailer of consumer financial services. Our strategy is to focus primarily on middle-market consumers in the largest metropolitan areas. Our entry into new markets is led by the Home Loans and Insurance Services Group. Through advertising, branding and positioning we build customer awareness and encourage households to conduct business with Washington Mutual. In our selected market areas, we then overlay our retail banking operations and cross-sell key products, including checking accounts, deposit accounts and home equity loans. Store expansion was a priority in 2002 and will continue to be a priority in 2003. We plan to achieve our mission principally through organic growth and ongoing operational improvements.

    Banking and Financial Services Group

        The Banking and Financial Services Group offers a comprehensive line of financial products and services to a broad spectrum of consumers and small- to mid-sized businesses. The Group serves approximately seven million consumer households and businesses through 1,526 financial center stores, 59 business banking centers and 2,490 ATMs. The Group offers various deposit products including the Group's signature Free Checking accounts as well as other personal and business checking accounts, savings accounts, money market deposit accounts and time deposit accounts.

        The Group's goal is to increase the number of the Company's products and services used by customers, thus increasing profitability. To achieve this goal, the Group's strategy is to cross-sell products and services to existing home loan customers and to new customers in selected market areas. During 2002, we opened 143 new financial center stores primarily in the Atlanta, Phoenix, Denver and New York metropolitan areas. The configuration of our new stores is based on an innovative retail banking platform that was launched in Las Vegas in 2000, and serves customers in an open, free-flowing retail environment. We also acquired 123 financial center stores in the New York/New Jersey area as part of the Dime acquisition. In 2003 we plan to add approximately 250 new stores primarily in Chicago and the New York metropolitan area.

        In addition to deposit products and home loans and insurance products, the Group offers a full range of other consumer products and services through its financial center stores, including:

    Home equity loans and lines of credit;

    Investment advisory and securities brokerage services;

    Annuities and mutual funds; and

    Student loans, unsecured lines of credit and other consumer loans.

        Home equity loans and lines of credit account for 11% of loans held in portfolio, up from 6% at the end of 2001. Currently, less than 3% of households that have a home loan serviced by Washington Mutual have a home equity loan or line of credit with us. Home equity loans and lines of credit generally provide higher margins than home loans and represent an opportunity to expand the non-home loan portfolio.

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        Investment advisory and securities brokerage services are provided by approximately 650 financial consultants of WM Financial Services, a licensed broker-dealer. In addition, fixed annuities are offered to the public by approximately 1,500 licensed bank employees. Our mutual fund management business, WM Advisors, Inc., offers investment advisory and mutual fund distribution services. Assets under management at December 31, 2002 totaled $13.09 billion.

        The Banking and Financial Services Group also offers a full array of commercial banking products and services primarily to small- and mid-sized businesses. These products include lines of credit, receivables and inventory financing, equipment loans, real estate financing, government-guaranteed loans, international trade financing, cash management and merchant bankcard services.

        See "Operating Segments" within Management's Discussion and Analysis for financial information regarding the Banking and Financial Services Group.

    Home Loans and Insurance Services Group

        The principal activities of the Home Loans & Insurance Services Group include:

    Originating and servicing home loans;

    Buying and selling home loans in the secondary market; and

    Managing the home loan portfolio.

        In 2002, Washington Mutual was the largest servicer and the second largest originator of mortgage loans in the nation. The Group's strategy is to remain a leading originator and servicer of home loans and to increase its market share in both loan origination and loan servicing.

        The Group offers home loans through multiple distribution channels, including 386 retail home loan centers, 36 wholesale home loan centers, correspondent channels, and directly to consumers through call centers and the internet. The Group also offers home loans through the Banking and Financial Services Group's 1,526 financial center stores.

        Through these lending channels the Group offers a diversified set of home loan products including:

    Fixed-rate home loans;

    Adjustable-rate home loans (where the interest rate may be adjusted as frequently as every month);

    Hybrid home loans (loans with a rate of interest that is fixed for a predetermined time period, typically 3 or 5 years, and then becomes adjustable); and

    Government insured or guaranteed home loans.

        Insurance services complement the mortgage lending process, and products offered include homeowners', flood, earthquake and other property and casualty insurance. Other types of insurance products offered include mortgage life insurance, accidental death and dismemberment, and term and whole life insurance. The Group also manages the Company's captive reinsurance activities.

        Home loans are either originated or purchased, and are either held in portfolio or held for sale and subsequently sold into the secondary market. We generally sell newly originated fixed-rate home loans and hybrid home loans to the Federal National Mortgage Association ("Fannie Mae"), a government-sponsored enterprise.

        All loans, whether originated or purchased, are subject to the same nondiscriminatory underwriting standards. When determining whether to make a loan, the Group follows established lending policies and procedures that require consideration of an applicant's credit profile and the size and characteristics of the loan. When the Group purchases home loans, it normally delegates the underwriting responsibility to the correspondent lenders that originate the loans. Correspondent lenders are required to comply with the

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Group's underwriting and appraisal standards, and quality control procedures are performed to ensure that compliance occurs.

        The Group is migrating to single platforms for originating and servicing home loans. The process of reducing the number of origination systems from seven to a single platform will occur in stages throughout 2003 and should be completed in 2004. In the fourth quarter of 2003, we expect to begin the multi-year process of converting from an outsourced loan servicing system to a proprietary system acquired as part of the HomeSide Lending transaction. During 2003, we will also be consolidating our nationwide loan fulfillment operations from approximately 500 locations to approximately 60 locations. We anticipate that these initiatives will improve operational efficiencies and productivity.

        Mortgage servicing involves the administration and collection of home loan payments and fees. When loans are sold into the secondary market, the Group generally retains the right to service those loans and hence retains the customer relationship. We intend to use these customer relationships to cross-sell additional products and services. The mortgage servicing portfolio (including owned loans) grew from approximately 4.3 million loans at December 31, 2001 to approximately 6.3 million at December 31, 2002. Growth in the mortgage servicing portfolio in 2002 was largely due to the acquisitions of Dime and HomeSide.

        The Group also originates, and purchases from correspondents, loans to higher-risk borrowers as part of its specialty mortgage finance program. Originated specialty mortgage finance loans, also called specialty home loans, are made through Long Beach Mortgage Company and are usually held for sale. Purchased specialty mortgage finance loans are generally held in portfolio. The risk characteristics of specialty mortgage finance loans are similar whether originated or purchased. The Group reviews and re-underwrites purchased specialty mortgage finance loans prior to purchasing them from correspondents. Charge-offs on specialty mortgage finance loans are expected to be higher over time than the Group's other home loans.

        See "Operating Segments" within Management's Discussion and Analysis for financial information regarding the Home Loans and Insurance Services Group.

    Specialty Finance Group

        The Specialty Finance Group provides financing to developers, investors, mortgage bankers and homebuilders for the acquisition, construction and development of apartment buildings ("multi-family" lending), other commercial real estate and homes. The multi-family lending business accounts for a majority of the Group's revenues. The Group also services commercial real estate mortgages as part of its commercial asset management business and conducts a consumer finance business through Washington Mutual Finance Corporation's 432 branches.

        A key element of the Group's strategy is to reduce its dependence on interest-earning assets and to increase its fee-based service offerings. The Group will achieve this goal by:

    Developing a program to pool commercial real estate loans into mortgage-backed securities for sale into the secondary market. This program will provide a distribution channel to originate, securitize and sell commercial real estate assets while retaining the servicing rights and customer relationships;

    Increasing its service offerings to include products sold to government agencies; and

    Increasing market share in the highly fragmented multi-family market through acquisition, when, and if, suitable opportunities are identified.

        The Group's multi-family lending program entails 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 become a leading originator and servicer of multi-

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family loans. The Group's multi-family lending program has a dominant market share – more than 20% in certain key cities along the West Coast and is building its market share in the Northeast and the Midwest. In early 2003, the Group completed the consolidation of its four multi-family servicing locations into one location in Texas. The consolidation is expected to result in increased operating efficiencies while improving already high levels of customer service.

        In addition to commercial lending and servicing activities, the Specialty Finance Group, through Washington Mutual Finance's 432 branches, 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 Washington Mutual's banking subsidiaries because they tend to have higher credit risk. 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.

        See "Operating Segments" within Management's Discussion and Analysis for financial information regarding the Specialty Finance Group.


Available Information

        We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to such reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act, available as soon as reasonably practicable free of charge on or through our website located at www.wamu.com/ir after filing with the United States Securities and Exchange Commission.


Employees

        Our number of full-time equivalent employees at December 31, 2002 was 52,459, compared with 39,465 at December 31, 2001 and 28,798 at December 31, 2000. During 2002, the number of full-time equivalent employees increased primarily as a result of the acquisitions of Dime and HomeSide. 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.

        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

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debt and equity capital markets, the strength of the U.S. economy, and of 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 home 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, interest rate contracts and forward commitments to purchase home loans, 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 amount, type and mix of MSR risk management instruments that we believe are appropriate to manage the changes in fair value of our MSR asset. If this strategy is not successful, our net income could be adversely affected. For further discussion of how interest rate basis risk and MSR prepayment risk is managed, see "Market Risk Management."

         A failure to effectively implement our business operations technology solutions could adversely affect our earnings and financial condition.

        During 2001 and early 2002, we consummated five 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. On the mortgage banking side, we are currently integrating the technology platforms of the acquired companies into our business. We are developing single operating platforms for the origination and servicing of home loans and are migrating from a decentralized mortgage operations model to a regional processing configuration. We anticipate that these initiatives will result in economies of scale and operating efficiencies. On the consumer banking side, we are currently upgrading the technology used in our ATMs and financial center stores.

        If we experience difficulties in the integration of the technology platforms or the upgrading of software or any prolonged interruption of our service, we could experience higher than anticipated administrative costs 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.

    The financial services industry is highly competitive.

        We 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 pricing competition for loan and deposit products. In addition, customer convenience and service capabilities, such as product lines offered and the accessibility of services are significant competitive factors.

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        Our most direct competition for loans comes from other savings institutions, national mortgage companies, insurance companies, commercial banks and government-sponsored enterprises. Our most direct competition for deposits comes from savings institutions, credit unions and commercial banks doing business in our market areas. 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.

    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. Proposals that are now receiving a great deal of attention include consumer protection initiatives on predatory lending, credit reporting and privacy. The agencies regulating the financial services industry also 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."


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, 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, but has a business and occupation tax on gross receipts. Currently, the tax does not apply to interest received on loans secured by first mortgages or deeds of trust on residential properties.

    Assistance Agreement

        In connection with the Keystone acquisition, we acquired American Savings Bank, F.A. American Savings Bank was formed to effect the December 1988 acquisition of certain assets and liabilities of the failed savings and loan association subsidiary of Financial Corporation of America. In connection with the acquisition of American Savings Bank, 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 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 Consolidated Financial Statements as "Income Taxes."

        See Note 13 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 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 on property that is found to contain hazardous substances or wastes.

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        Further, although the environmental regulations exempt 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 the environmental regulations' 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, the federal environmental regulations 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.


Regulation and Supervision

        The following discussion describes elements of the extensive regulatory framework applicable to savings and loan holding companies, federal savings associations and state savings banks and provides some specific information relevant to us. This regulatory framework is primarily intended for the protection of depositors, federal deposit insurance funds and the banking system as a whole rather than for the protection of shareholders and creditors.

        To the extent that this section describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Those statues and regulations, as well as related policies, are subject to change by Congress, state legislatures and federal and state regulators. Changes in statutes, regulations or regulatory policies applicable to the Company, including interpretation or implementation thereof, could have a material effect on the Company's business.

    General

        Washington Mutual, Inc. is a Washington state corporation. It owns two federal savings associations and one Washington state-chartered savings bank, as well as numerous nonbank subsidiaries. Because our state bank has elected to be treated as a savings association for purposes of federal holding company law, Washington Mutual, Inc. is a savings and loan holding company. As a savings and loan holding company, Washington Mutual, Inc. is subject to regulation by the Office of Thrift Supervision (the "OTS").

        Our federal savings associations are subject to extensive regulation and examination by the OTS, their primary federal regulator, as well as by the FDIC. Our state bank is subject to regulation and supervision by the Director of Financial Institutions of the State of Washington (the "State Director") and by the FDIC. Our nonbank financial subsidiaries are also subject to various federal and state laws and regulations.

        All of our banking subsidiaries are under the common control of Washington Mutual, Inc. and are insured by the FDIC. If an insured institution fails, claims for administrative expenses of the receiver and for deposits in U.S. branches (including claims of the FDIC as subrogee of the failed institution) have priority over the claims of general unsecured creditors. In addition, the FDIC has authority to require any of our banking subsidiaries to reimburse it for losses it incurs in connection either with the failure of another of our banking subsidiaries or with the FDIC's provision of assistance to one of our banking subsidiaries that is in danger of failure.

    Payment of Dividends

        Washington Mutual, Inc. is a legal entity separate and distinct from its banking and other subsidiaries. Its principal sources of funds are cash dividends paid by those subsidiaries, investment income, and borrowings. Federal and state law limits the amount of dividends or other capital distributions that a

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banking institution, such as our federal associations and our state bank, can pay. Each of our banking subsidiaries has a policy to remain well-capitalized and, accordingly, would not pay dividends to the extent payment of the dividend would result in it not being well-capitalized. In addition, our federal associations must file an application with the OTS at least 30 days before they can pay dividends to Washington Mutual, Inc. The ability of Washington Mutual, Inc. to borrow funds, for the purpose of paying dividends to its shareholders or otherwise, from its banking subsidiaries is limited by affiliate transaction restrictions discussed below. See Note 18 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions" for a more detailed description of the limits on the dividends our subsidiary banks can pay.

    Capital Adequacy

        Washington Mutual, Inc. is not currently subject to any regulatory capital requirements, but each of its subsidiary banking institutions is subject to various capital requirements. Our state bank is subject to FDIC capital requirements, while our federal associations are subject to OTS capital requirements. An institution's capital 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.

        Federal law and regulations establish minimum capital standards, and under the OTS and FDIC regulations, an institution is required to have a leverage ratio of at least 4.00%, a Tier 1 risk-based ratio of 4.00% and a total risk-based ratio of 8.00%. In addition, our federal associations are required to have a tangible capital ratio of 1.50%. Federal law and regulations also establish five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. 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.

        As of December 31, 2002, each of our banking subsidiaries met all capital requirements to which they were subject and satisfied the requirements to be treated as well-capitalized. See Note 18 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions" for an analysis of our regulatory capital.

    Holding Company Status and Acquisitions

        Washington Mutual, Inc. is a multiple savings and loan holding company, as defined by federal law, because it owns more than one savings association. Washington Mutual, Inc. is regulated as a unitary savings and loan holding company, however, because the OTS deems our federal associations to have been acquired in supervisory transactions. Therefore, we are exempt from certain restrictions that would otherwise apply under federal law to the activities and investments of a multiple savings and loan holding company. These restrictions will apply to Washington Mutual, Inc. if any of our three banking institutions fails to meet a qualified thrift lender test established by federal law. The Company's three banking subsidiaries are currently in compliance with qualified thrift lender standards.

        Washington Mutual, Inc. may not acquire control of another savings association unless the OTS approves. Washington Mutual, Inc. may not be acquired by a company, other than a bank holding company, unless the OTS approves, or by an individual unless the OTS does not object after receiving notice. Washington Mutual, Inc. may not be acquired by a bank holding company unless the Board of Governors of the Federal Reserve System (the "Federal Reserve") approves. In any case, the public must

9



have an opportunity to comment on the proposed acquisition, and the OTS or Federal Reserve must complete an application review. Without prior approval from the OTS, Washington Mutual, Inc. may not acquire more than 5% of the voting stock of any savings institution that is not one of its subsidiaries.

        The Gramm-Leach-Bliley Act generally restricts any non-financial entity from acquiring us unless such non-financial entity was, or had submitted an application to become, a savings and loan holding company as of May 4, 1999. Since Washington Mutual, Inc. was treated as a unitary savings and loan holding company prior to that date, Washington Mutual, Inc. may engage in non-financial activities and acquire non-financial subsidiaries.

    Federal Home Loan Bank System

        The primary purpose of the Federal Home Loan Banks (the "FHLBs") is to provide funding to their members for making housing loans as well as for affordable housing and community development lending. The 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. The FHLB System consists of twelve regional FHLBs; each is federally chartered but privately owned by its member institutions. The Federal Housing Finance Board ("Finance Board"), a government agency, is generally responsible for regulating the FHLB System.

        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. One of our savings associations, Washington Mutual Bank, FA ("WMBFA"), currently is a member only of the San Francisco FHLB, because WMBFA's home office is in Stockton, California. Our state bank, whose head office is in Seattle, is a member of the Seattle FHLB, as is our other federal association, 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. The Finance Board is currently considering whether institutions may be members of more than one FHLB.

    Deposit Insurance

        The FDIC insures the deposits of each of our banking subsidiaries to the applicable maximum in each institution, and such insurance is backed by the full faith and credit of the United States government. The FDIC administers two separate deposit insurance funds, the Bank Insurance Fund (the "BIF") and the Savings Association Investment Fund (the "SAIF"). The BIF is a deposit insurance fund for commercial banks and some federal and state-chartered savings banks. The SAIF is a deposit insurance fund for most savings associations. Our state bank is a member of the BIF, but a substantial portion of its deposits is insured through the SAIF. Our federal associations are members of the SAIF, but a small portion of WMBFA's deposits is insured through the BIF.

        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 2002, the assessment rate for both SAIF and BIF deposits ranged from zero to 0.27% of assessable deposits. Our banking subsidiaries qualified for the lowest rate on their deposits in 2002. Accordingly, none of these institutions paid any deposit insurance assessments in 2002. 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.

10


        In addition to deposit insurance assessments, the FDIC is authorized to collect assessments against 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-assessable deposits have been assessed at the same rate by FICO. For the years 2001 and 2002, the average annual rate was 1.90 cents and 1.75 cents per $100 of assessable deposits.

    Affiliate Transaction Restrictions

        Our three banking subsidiaries are subject to the same affiliate and insider transaction rules applicable to member banks of the Federal Reserve System as well as additional limitations imposed by the OTS. These provisions prohibit or limit a banking institution from extending credit to, or entering into certain transactions with, affiliates, principal stockholders, directors and executive officers of the banking institution and its affiliates. For these purposes, the term "affiliate" generally includes a holding company such as Washington Mutual, Inc. and any company under common control with the banking institution. In addition, the federal law governing unitary savings and loan holding companies prohibits our banking subsidiaries from making any loan to any affiliate whose activity is not permitted for a subsidiary of a bank holding company. This law also prohibits each of our banking institutions from making any equity investment in any affiliate that is not its subsidiary. Each of our banking subsidiaries currently is in material compliance with all these provisions.

    Federal Reserve, Consumer and Other Regulation

        Numerous 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.

        Under Federal Reserve regulations, our banking subsidiaries 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 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.

        The Gramm-Leach-Bliley Act included provisions that give consumers new protections regarding the transfer and use of their nonpublic personal information by financial institutions. In addition, states are permitted under the Gramm-Leach-Bliley Act to have their own privacy laws, which may offer greater protection to consumers than the Gramm-Leach-Bliley Act. Numerous states in which the Company does business have enacted such laws.

        The four federal banking agencies, including our regulators, have jointly issued expanded examination and supervision guidance relating to two areas affecting our activities – subprime lending and, most recently, mortgage banking and MSR. The guidance on subprime lending principally applies to institutions with subprime lending programs with an aggregate credit exposure equal to or greater than 25% of an institution's Tier 1 capital and advises that examiners will evaluate the capital of each subprime lender on a case-by-case basis. WMBFA currently holds purchased specialty mortgage finance loans significantly in excess of 25% of its Tier 1 capital and could be adversely affected by the application of the guidance since a significant portion of these loans may be considered subprime loans under the guidance.

        The guidance on mortgage banking activities and mortgage servicing rights highlights the banking agencies' concerns about and provides guidance relating to mortgage banking activities, primarily in the valuation and hedging of mortgage servicing rights. The guidance states that institutions with significant exposure to mortgage related assets, especially mortgage servicing rights, should expect greater scrutiny of

11



those assets during examinations, and additional capital may be required for institutions that fail to follow the practices set forth in the guidelines.

        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 affect banking institutions, broker-dealers and certain other financial institutions. The Act requires some of our subsidiaries to adopt new policies and procedures to combat money laundering and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on subsidiary operations. We do not expect the impact of the Act on our operations to be material, and we have established policies and procedures to ensure compliance with the Act's provisions.

    Community Reinvestment Act

        The Community Reinvestment Act ("CRA") requires that our banking subsidiaries ascertain and help meet the credit needs of the communities we serve, including low- to moderate-income 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 2000, each of our federal associations received an "outstanding" CRA rating from the OTS. In 2002, our state bank received a "satisfactory" CRA rating from the FDIC. We maintain a CRA public file that is available for viewing. The file includes copies of our most recent CRA Public Evaluations, descriptions of our products and services, delivery outlet information, and public comments.

        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. As of December 31, 2002, we had exceeded our yearly targets for lending in low- to moderate-income neighborhoods and underserved market areas.

    Regulatory Sanctions

        The OTS, FDIC and the State Director may sanction any of their regulated institutions that do not operate in accordance with applicable regulations, policies and directives. Proceedings may be instituted against any banking institution, or any institution-affiliated party, such as a trustee, director, officer, employee, agent, or controlling person, who engages in unsafe and unsound practices, including violations of applicable laws and regulations. The OTS, FDIC and the State Director 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 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.

    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"), our broker-dealer subsidiaries are subject to various regulations and restrictions imposed by those entities, as well as by various state authorities. As a registered investment advisor, WM Advisors is subject to various federal and state securities regulations and restrictions. 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. Our insurance subsidiaries are subject to regulation by various state insurance regulators. Some of our subsidiaries are subject to various state licensing and examination requirements.

12



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   53   Chairman of the Board of Directors, President and Chief Executive Officer   1983
Thomas W. Casey   40   Executive Vice President and Chief Financial Officer   2002
Craig J. Chapman   46   Group President, Specialty Finance Group and Chief Administrative Officer   1998
Fay L. Chapman   56   Senior Executive Vice President and General Counsel   1997
Daryl D. David   48   Executive Vice President, Human Resources   2000
Craig S. Davis   51   Group President, Home Loans and Insurance Services   1996
Jeremy V. Gross   44   Executive Vice President and Chief Information Officer   2001
William A. Longbrake   59   Vice Chair, Enterprise Risk Management and Chief Risk Officer   1996
Robert H. Miles   46   Senior Vice President and Controller   1999
Deanna W. Oppenheimer   44   Group President, Banking and Financial Services   1985
Craig E. Tall   57   Vice Chair, Corporate Development and Strategic Planning   1985
James G. Vanasek   58   Executive Vice President and Chief Credit Officer   1999

        Mr. Killinger has established two committees within the management of the Company, the Executive Committee and the President's Council. He established the Executive Committee in 1990 to facilitate and coordinate decision making by and communication among the most senior executive officers of the Company who, as a committee, determine the Company's strategic direction. The President's Council, established by Mr. Killinger in December 2002 and comprised of the Chief Financial Officer, the Chief Administrative Officer and the Group Presidents, is focused on operational efficiency, operational decision-making and strategic execution, with particular emphasis on operations and execution across business segments. The executive officers serving on these committees at December 31, 2002 are indicated below.

        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 Washington Mutual Bank in 1983. He has been a member of the Executive Committee since its formation in 1990.

        Mr. Casey is Executive Vice President and Chief Financial Officer of Washington Mutual. As a member of the Executive Committee and the President's Council, he oversees all aspects of Washington Mutual's corporate finance and investor relations functions. Prior to joining Washington Mutual, Mr. Casey was with GE Capital Corp. from 1992 through 2002 where he held advising, controllership and analyst positions prior to becoming Vice President of GE Capital and Vice President and CFO of GE Financial Assurance.

        Mr. Chapman is Group President of Specialty Finance and Chief Administrative Officer. He is responsible for overseeing the Commercial Real Estate and Specialty Lending units and Washington Mutual Finance Corporation. As Chief Administrative Officer, Mr. Chapman oversees operational

13



excellence, acquisition integration, corporate property services and strategic sourcing. 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 and a member of the President's Council in 2002. Previously, Mr. Chapman served as President of AMRESCO Residential Mortgage Corporation from 1996 to 1997.

        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.

        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 Group President of Home Loans and Insurance Services. He is responsible for home loan lending and insurance services and overseeing the Community and External Affairs division. Mr. Davis became Executive Vice President and a member of the Executive Committee in January 1997 and a member of the President's Council in 2002. 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. 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 from 1999 to 2001. Previously, he spent seven years at Countrywide Credit Industries where he was Managing Director and Chief Technology Officer.

        Mr. Longbrake has been Vice Chair, Enterprise Risk Management and Chief Risk Officer since 2002. He has been a member of the Executive Committee since 1996. He is responsible for managing the Company's market risk, operational risk, compliance, internal audit, security, information security, business continuity planning, insurance risk and regulatory relations. From 1996 to 1999, Mr. Longbrake was Executive Vice President and Chief Financial Officer. He became Vice Chair in 1999.

        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. from 1996 to 1999.

        Ms. Oppenheimer is Group President of Banking and Financial Services. She is responsible for consumer banking, financial services and business banking. Additionally, Ms. Oppenheimer oversees corporate marketing and corporate communications. Ms. Oppenheimer became Executive Vice President in 1993, has been a member of the Executive Committee since its formation in 1990, and became a member of the President's Council in 2002. She has been an officer of the Company since 1985.

        Mr. Tall is Vice Chair, Corporate Development and Strategic Planning. He is responsible for overseeing the Company's corporate development, including acquisitions, strategic planning, real estate investments, and Washington Mutual's Strategic Capital Fund. 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 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 in 1999, he spent eight

14



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, 2002, we conducted business in 44 states through approximately 2,773 physical distribution centers.

        Additionally, significant facilities 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   308,000   2007
1191 2nd Ave., Seattle, WA   Leased   189,000   2006
1111 3rd Ave., Seattle, WA   Leased   231,000   2006
999 3rd Ave., Seattle, WA   Leased   142,000   2006
1501 4th Ave., Seattle, WA   Leased   104,000   2010
1301 5th Ave., Seattle, WA   Leased   133,000   2008
2500 & 2530 223rd St. SE, Bothell, WA   Leased   106,000   2008
18525 36 th Ave. S, SeaTac, WA   Owned   104,000   n/a
Northridge, CA (2)   Leased   351,000   2005-2006
Stockton, CA (2)   Owned   326,000   n/a
Chatsworth, CA (2)   Leased   404,000   2003-2015
Chatsworth, CA (2)   Owned   331,000   n/a
Irvine, CA (2)   Leased   183,000   2004-2010
Irvine, CA (2)   Owned   345,000   n/a
3883 Airway Drive, Santa Rosa, CA   Owned   110,000   n/a
3200 SW Freeway, Houston, TX   Leased   358,000   2008
9601 McAllister Fwy, San Antonio, TX   Leased   159,000   2005
Jacksonville, FL (2)   Leased   409,000   2003-2009
7301 Baymeadows Way, Jacksonville, FL   Owned   147,000   n/a
2601 10th Ave. N., Lake Worth, FL   Owned   112,000   n/a
2210 Enterprise Dr., Florence, SC   Leased   179,000   2008
231 E. Ave., Albion, NY   Leased   132,000   2011
EAB Plaza, Uniondale, NY   Leased   126,000   2007
3050 Highland Pkwy, Downers Grove, IL   Leased   181,000   2013
Vernon Hills, IL (2)   Leased   408,000   2003-2006
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.

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Legal Proceedings

        In the ordinary course of business, the Company and its subsidiaries are routinely defendants in or parties to a number of pending and threatened legal actions and proceedings, including actions brought on behalf of various classes of claimants. In certain of these actions and proceedings, claims for substantial monetary damages are asserted against the Company and its subsidiaries. Certain of these actions and proceedings are based on alleged violations of consumer protection, banking and other laws.

        In view of the inherent difficulty of predicting the outcome of such matters, the Company cannot state what the eventual outcome of pending matters will be. Based on current knowledge, management does not believe that liabilities, if any, arising from any single pending proceeding will have a material adverse effect on the consolidated financial position, operations or liquidity of the Company. However, if an unfavorable outcome were to occur in more than one proceeding during the same reporting period, there exists the possibility of a material adverse impact on the Company's operating results for that particular period, depending upon, among other things, the level of the Company's income for such period.


Submission of Matters to a Vote of Security Holders

        No matters were submitted to shareholders during the fourth quarter of 2002.


PART II


Market for our Common Stock and Related Stockholder Matters

        Our common stock trades on The New York Stock Exchange under the symbol WM. As of February 28, 2003, there were 939,456,466 shares issued and outstanding (including 17.775 million shares held in escrow) held by 45,385 shareholders of record. 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 on page 142 and is expressly incorporated herein by reference.

        The "Securities Authorized for Issuance Under Equity Compensation Plans" are incorporated by reference from our definitive proxy statement in conjunction with our Annual Meeting of Shareholders to be held April 15, 2003.

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Management's Discussion and Analysis of Financial Condition and Results of Operations


Controls and Procedures

        An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), of the effectiveness of the design and operation of the Company's disclosure controls and procedures within 90 days before the filing date of this annual report. Based on that evaluation, the Company's management, including the CEO and CFO, concluded that the Company's disclosure controls and procedures were effective. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation.

        We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and to improve our controls and procedures over time and to correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.


Critical Accounting Policies

        The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our Consolidated Financial Statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances as of December 31, 2002. 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.

        Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified four policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an

17



understanding of our Consolidated Financial Statements. The table below represents information about the nature of and rationale for the Company's critical accounting policies:



Critical
Accounting
Policy

  Consolidated
Statements
of Financial
Position Caption

  Consolidated
Statements of
Income Caption

  Nature of Estimates Required

  Reference



Fair value of mortgage servicing rights   Mortgage servicing rights   Home loan mortgage banking income (expense): Impairment adjustment   Determining the fair value of our MSR requires us to formulate conclusions about anticipated changes in future market conditions, including interest rates. Our loan servicing portfolio is subject to prepayment risk, which subjects our MSR to impairment risk.
The fair value of our MSR is estimated using a discounted cash flow model. The discounted cash flow 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. While the Company's model estimates a value, the specific value used is based on a variety of factors, such as documented observable data and anticipated changes in market conditions. All of the assumptions are based on standards used by market participants in valuing MSR. The reasonableness of management's assumptions about these factors is confirmed through quarterly 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 fair value conclusions.
  Limitations to the measurement of MSR fair value are described in the subsequent section of Management's Discussion and Analysis – "Earnings Performance" on page 29. See the key economic assumptions and the sensitivity of the current fair value for home loans' MSR to immediate changes in those assumptions in Note 5 to the Consolidated Financial Statements – "Mortgage Banking Activities."

Rate lock commitments   Other assets   Home loan mortgage banking income (expense): Gain from mortgage loans   The Company enters into commitments to make loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives, and therefore, they are recorded at fair value. In measuring the fair value of rate lock commitments, the amount of the expected servicing rights is included in the valuation. This value is calculated using the same methodologies as are used to value the Company's MSR, adjusted using an anticipated fallout factor for loan commitments that will never be funded. This policy of recognizing the value of the derivative has the effect of recognizing the gain from mortgage loans before the loans are sold.   See further discussion in the subsequent section of Management's Discussion and Analysis – "Earnings Performance" on page 29.

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Critical
Accounting
Policy

  Consolidated
Statements
of Financial
Position Caption

  Consolidated
Statements of
Income Caption

  Nature of Estimates Required

  Reference



Allowance for loan and lease losses   Allowance for loan and lease losses   Provision for loan and lease losses   The allowance for loan and lease losses represents management's estimate of credit losses inherent in the Company's loan and lease portfolios as of the balance sheet date. The estimation of the allowance is based on a variety of factors, including past loan loss experience, adverse situations that have occurred but are not yet known that may affect the borrower's ability to repay, the estimated value of the underlying collateral and general economic conditions. The Company's methodology for assessing the adequacy of the allowance includes the evaluation of three distinct elements: the formula allowance, the specific allowance and the unallocated allowance. The ultimate recovery of all loans is susceptible to future market factors beyond the Company's control.   The estimates and judgments are described in further detail in the subsequent sections of Management's Discussion and Analysis – "Asset Quality" on page 43 and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

Net periodic pension expense   Other assets   Compensation and benefits   The net periodic pension expense is actuarially determined using assumed discount rates, assumed rates of compensation increase and expected return on assets. These assumptions are ultimately determined by management.
The discount rate is determined using Moody's Aa spot rate as of year end. The compensation rate is determined by reviewing the Company's salary increases each year along with reviewing industry averages. The expected return on assets represents management's expectation of the average rate of earnings on the funds invested to provide for the benefits included in the projected benefit obligation.
  The impact to compensation and benefits expense if certain assumptions are changed is discussed in the subsequent section of Management's Discussion and Analysis – "Liquidity" on page 53.

        Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors. In addition, there are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement No. 133, Accounting for Derivative Instruments and Hedging Activities , and the applicable hedge deferral criteria. These policies and the judgments, estimates and assumptions are described in greater detail in subsequent sections of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

19




Five-Year Summary of Selected Financial Data

 
  December 31,
 
  2002
  2001
  2000
  1999
  1998
 
  (in millions, except per share amounts)

Income Statement Data (for the year ended)                              
  Net interest income   $ 8,341   $ 6,876   $ 4,311   $ 4,452   $ 4,292
  Provision for loan and lease losses     595     575     185     167     162
  Noninterest income     4,790     3,248     1,984     1,509     1,507
  Noninterest expense     6,382     4,617     3,126     2,910     3,268
  Net income     3,896     3,114     1,899     1,817     1,487
  Net income per common share (1) :                              
    Basic   $ 4.12   $ 3.65   $ 2.37   $ 2.12   $ 1.74
    Diluted     4.05     3.59     2.36     2.11     1.71
  Dividends declared per common share     1.06     0.90     0.76     0.65     0.49

Balance Sheet Data (at year end)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Securities   $ 43,972   $ 58,349   $ 58,724   $ 60,786   $ 47,046
  Loans held for sale     33,996     26,582     3,404     794     1,827
  Loans held in portfolio     147,528     130,251     119,626     113,746     107,612
  Mortgage servicing rights     5,341     6,241     1,017     643     461
  Goodwill     6,270     2,175     937     1,077     862
  Assets     268,298     242,506     194,716     186,514     165,493
  Deposits     155,516     107,182     79,574     81,130     85,492
  Securities sold under agreements to repurchase     16,717     39,447     29,756     30,163     18,340
  Advances from Federal Home Loan Banks     51,265     61,182     57,855     57,094     39,749
  Other borrowings     15,264     12,576     9,930     6,203     4,630
  Redeemable preferred stock     -     102     -     -     -
  Stockholders' equity     20,134     14,063     10,166     9,053     9,344

(1)
Restated for all stock splits.


Significant Transactions

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

        During 2002, the Company completed three acquisitions. On January 4, 2002, we completed our acquisition of New York-based Dime Bancorp, Inc. The aggregate purchase price of Dime was approximately $5.3 billion. The acquisition of Dime added approximately $31 billion to our asset base, including approximately $22 billion in loans, and increased our deposit base by approximately $15 billion. The acquisition of Dime also significantly contributed to the growth in our mortgage banking business, resulting in a $926 million increase to our MSR balance and a $49.24 billion increase in our portfolio of loans serviced for others.

        In two transactions during 2002, we purchased for cash HomeSide Lending, Inc., the U.S. mortgage unit of National Australia Bank Limited. The aggregate purchase price of HomeSide was $2.45 billion. The acquisition of HomeSide added approximately $1 billion in loans held for sale, approximately $960 million in net MSR and approximately $130 billion to our portfolio of loans serviced for others. We also acquired a proprietary loan servicing platform, which we intend to make our primary loan servicing platform. In addition we assumed $760 million in long-term debt and $750 million in other liabilities.

        The Company also sold servicing rights during 2002, which, together with high amortization levels and impairment that were attributable to low interest rates during the year, resulted in a $900 million decrease in our net MSR balance. These sales were part of the Company's strategy to actively manage the size of our MSR while still retaining the customer relationships.

20



        Also during 2002, the Company significantly increased its level of deposits primarily due to the growth in Platinum Account balances, which increased from $9.40 billion at December 31, 2001 to $50.20 billion at December 31, 2002. The increase in deposits resulted in a reduction in our wholesale borrowings, which declined from $105.32 billion at December 31, 2001 to $69.23 billion at December 31, 2002.

        During 2001, we completed three acquisitions. On January 31, we acquired the mortgage operations of The PNC Financial Services Group, Inc. for approximately $7.0 billion. On February 9, we acquired Texas-based Bank United Corp. for approximately $1.4 billion, 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 for approximately $7.5 billion. Substantially due to these acquisitions, our loan serviced for others portfolio grew from $85.88 billion at January 1, 2001 to $382.50 billion at December 31, 2001 and our loans held for sale increased from $3.40 billion to $26.58 billion. Correspondingly, the 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.

        Variances in the amounts reported on the Consolidated Statements of Income between 2002, 2001 and prior years and on the Consolidated Statements of Financial Condition between 2002 and 2001 are partially attributable to the results from the aforementioned acquisitions as the results from those operations are included prospectively from the date of acquisition.

21



    Ratios and Other Supplemental Data

 
  Year Ended December 31,
 
 
  2002
  2001
  2000
 
 
  (dollars in millions, except per share amounts)

 
Profitability                    
  Return on average assets     1.44 %   1.38 %   1.01 %
  Return on average common stockholders' equity     19.48     23.53     21.15  
  Net interest margin     3.48     3.32     2.38  
  Efficiency ratio (1)     48.60     44.23     48.34  

Asset Quality

 

 

 

 

 

 

 

 

 

 
  Nonaccrual loans   $ 2,257   $ 2,030   $ 834  
  Foreclosed assets     336     228     153  
   
 
 
 
    Total nonperforming assets     2,593     2,258     987  
  Nonperforming assets/total assets     0.97 %   0.93 %   0.51 %
  Restructured loans   $ 98   $ 118   $ 120  
   
 
 
 
    Total nonperforming assets and restructured loans     2,691     2,376     1,107  
  Allowance for loan and lease losses     1,653     1,404     1,014  
  Allowance as a percentage of total loans held in portfolio     1.12 %   1.08 %   0.85 %
  Net charge-offs   $ 411   $ 305   $ 177  

Capital Adequacy

 

 

 

 

 

 

 

 

 

 
  Stockholders' equity/total assets     7.50 %   5.80 %   5.22 %
  Tangible common equity (2) /total tangible assets (2)     5.29     5.14     4.79  
  Estimated total risk-based capital/risk-weighted assets (3)     11.57     12.87     11.07  

Per Common Share Data

 

 

 

 

 

 

 

 

 

 
  Number of common shares outstanding at end of period (in thousands)     944,047     873,089     809,784  
  Common stock dividend payout ratio     25.73 %   24.66 %   32.07 %
  Book value per common share (4)     $21.74     $16.45     $12.84  
  Market prices:                    
    High     39.45     42.69     37.25  
    Low     28.41     28.56     14.54  
    Year end     34.53     32.70     35.38  

(1)
The efficiency ratio is defined as noninterest expense, excluding amortization of goodwill, divided by total revenue (net interest income and noninterest income).
(2)
Excludes unrealized net gain/loss on available-for-sale securities and derivatives, goodwill and intangible assets, but includes MSR.
(3)
Estimate of what the total risk-based capital ratio would be if Washington Mutual, Inc. was a bank holding company that complies with Federal Reserve Board capital requirements.
(4)
Excludes 18 million shares held in escrow pending resolution of the Company's asserted right to the return of such shares.

22


        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,
 
  2002
  2001
  2000
 
  Average
Balance

  Rate
  Interest
Income

  Average
Balance

  Rate
  Interest
Income

  Average
Balance

  Rate
  Interest
Income

 
  (dollars in millions)

Assets                                                
Interest-earning assets:                                                
  Federal funds sold and securities purchased under resale agreements   $ 2,352   1.70 % $ 40   $ 335   4.46 % $ 15   $ 132   5.95 % $ 8
  Available-for-sale securities (1) :                                                
    Mortgage-backed securities     24,656   5.46     1,345     41,430   6.94     2,875     40,699   6.80     2,767
    Investment securities     32,508   4.96     1,614     13,187   5.29     698     681   6.44     44
  Held-to-maturity securities (1) :                                                
    Mortgage-backed securities     -   -     -     -   -     -     17,770   7.38     1,311
    Investment securities     -   -     -     -   -     -     137   5.82     8
  Loans held for sale  (2)     28,128   6.13     1,724     17,719   6.79     1,203     2,338   8.58     201
  Loans held in portfolio (2)(3) :                                                
    Loans secured by real estate:                                                
      Home loans     86,042   5.90     5,077     81,686   7.23     5,908     78,980   7.47     5,898
      Purchased specialty mortgage finance     9,028   6.27     566     6,936   7.63     529     4,387   7.83     344
   
     
 
     
 
     
          Total home loans     95,070   5.94     5,643     88,622   7.26     6,437     83,367   7.49     6,242
      Home construction loans:                                                
        Builder (4)     1,316   5.93     78     1,826   7.72     141     424   10.60     45
        Custom (5)     906   8.19     74     905   8.96     81     908   9.01     82
      Home equity loans and lines of credit:                                                
        Banking subsidiaries     13,382   5.91     790     7,248   7.72     560     5,005   8.47     424
        Washington Mutual Finance     2,100   12.06     253     2,056   12.74     262     1,782   12.61     225
      Multi-family     17,973   6.01     1,081     16,480   7.72     1,273     15,507   7.85     1,218
      Other real estate     8,368   6.83     572     5,913   7.98     472     3,700   8.59     317
   
     
 
     
 
     
          Total loans secured by real estate     139,115   6.10     8,491     123,050   7.50     9,226     110,693   7.73     8,553
    Consumer:                                                
      Banking subsidiaries     2,349   9.37     220     1,804   10.96     198     1,476   10.90     161
      Washington Mutual Finance     1,714   18.87     324     1,731   18.63     322     1,673   19.38     324
    Commercial business     4,227   5.13     217     4,010   7.08     284     1,562   9.56     149
   
     
 
     
 
     
          Total loans held in portfolio     147,405   6.28     9,252     130,595   7.68     10,030     115,404   7.96     9,187
  Other     4,597   5.93     272     4,103   5.95     244     3,648   7.06     257
   
     
 
     
 
     
          Total interest-earning assets     239,646   5.94     14,247     207,369   7.26     15,065     180,809   7.62     13,783
Noninterest-earning assets:                                                
  Mortgage servicing rights     6,650               5,276               808          
  Goodwill     6,054               1,901               1,024          
  Other     19,117               11,027               4,931          
   
           
           
         
          Total assets   $ 271,467             $ 225,573             $ 187,572          
   
           
           
         
(This table is continued on next page)                                                

(1)
The average balance and yield on available-for-sale and held-to-maturity securities are based on average amortized cost balances.
(2)
Nonaccrual loans are included in the average loan amounts outstanding.
(3)
Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $259 million, $173 million, and $65 million for the years ended December 31, 2002, 2001, and 2000.
(4)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(5)
Represents construction loans made directly to the intended occupant of a single-family residence.

23


 
  Year Ended December 31,
 
  2002
  2001
  2000
 
  Average
Balance

  Rate
  Interest
Expense

  Average
Balance

  Rate
  Interest
Expense

  Average
Balance

  Rate
  Interest
Expense

 
  (dollars in millions)

Liabilities                                                
Interest-bearing liabilities:                                                
  Deposits:                                                
    Interest-bearing checking   $ 40,338   2.55 % $ 1,028   $ 7,540   1.58 % $ 119   $ 5,967   1.08 % $ 65
    Savings accounts and money market deposit accounts     31,545   1.48     466     35,873   3.17     1,136     29,553   4.08     1,207
    Time deposit accounts     37,422   3.14     1,174     36,496   5.04     1,839     36,340   5.55     2,018
   
     
 
     
 
     
      Total interest-bearing deposits     109,305   2.44     2,668     79,909   3.87     3,094     71,860   4.58     3,290
  Federal funds purchased and commercial paper     3,478   1.92     67     4,806   4.11     198     3,442   6.34     218
  Securities sold under agreements to repurchase     34,830   2.31     804     29,582   4.05     1,197     28,491   6.62     1,885
  Advances from Federal Home Loan Banks     59,449   2.83     1,680     63,859   4.58     2,924     56,979   6.39     3,643
  Other     14,014   4.90     687     13,289   5.84     776     7,198   6.05     436
   
     
 
     
 
     
      Total interest-bearing liabilities     221,076   2.67     5,906     191,445   4.28     8,189     167,970   5.64     9,472
   
     
 
     
 
     
Noninterest-bearing sources:                                                
  Noninterest-bearing deposits     25,396               16,613               8,416          
  Other liabilities     5,015               4,308               2,207          
  Stockholders' equity     19,980               13,207               8,979          
   
           
           
         
      Total liabilities and stockholders' equity   $ 271,467             $ 225,573             $ 187,572          
   
           
           
         
Net interest spread and net interest income         3.27   $ 8,341         2.98   $ 6,876         1.98   $ 4,311
             
           
           
Impact of noninterest-bearing sources         0.21               0.34               0.40      
Net interest margin         3.48               3.32               2.38      

24


        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:

 
  2002 vs. 2001
  2001 vs. 2000
 
 
  Increase/(Decrease) Due to
   
  Increase/(Decrease) Due to
   
 
 
  Total
Change

  Total
Change

 
 
  Volume
  Rate
  Volume
  Rate
 
 
  (in millions)

 
Interest Income                                      
Federal funds sold and securities purchased
under resale agreements
  $ 39   $ (14 ) $ 25   $ 9   $ (2 ) $ 7  
Available-for-sale securities:                                      
  Mortgage-backed securities     (1,001 )   (529 )   (1,530 )   50     58     108  
  Investment securities     962     (46 )   916     663     (9 )   654  
Held-to-maturity securities:                                      
  Mortgage-backed securities     -     -     -     (2,525 )   1,214     (1,311 )
  Investment securities     -     -     -     (15 )   7     (8 )
Loans held for sale     647     (126 )   521     1,052     (50 )   1,002  
Loans held in portfolio:                                      
  Loans secured by real estate:                                      
    Home loans     302     (1,133 )   (831 )   199     (190 )   9  
    Purchased specialty mortgage finance     142     (106 )   36     195     (9 )   186  
   
 
 
 
 
 
 
      Total home loans     444     (1,239 )   (795 )   394     (199 )   195  
    Home construction loans:                                      
      Builder (1)     (34 )   (28 )   (62 )   111     (15 )   96  
      Custom (2)     -     (7 )   (7 )   -     (1 )   (1 )
    Home equity loans and lines of credit:                                      
      Banking subsidiaries     386     (156 )   230     176     (40 )   136  
      Washington Mutual Finance     5     (14 )   (9 )   35     2     37  
    Multi-family     108     (300 )   (192 )   76     (20 )   56  
    Other real estate     175     (75 )   100     178     (24 )   154  
   
 
 
 
 
 
 
      Total loans secured by real estate     1,084     (1,819 )   (735 )   970     (297 )   673  
  Consumer:                                      
    Banking subsidiaries     54     (31 )   23     36     1     37  
    Washington Mutual Finance     (3 )   4     1     11     (12 )   (1 )
  Commercial business     15     (82 )   (67 )   182     (48 )   134  
   
 
 
 
 
 
 
      Total loans held in portfolio     1,150     (1,928 )   (778 )   1,199     (356 )   843  
Other     29     (1 )   28     30     (43 )   (13 )
   
 
 
 
 
 
 
      Total interest income     1,826     (2,644 )   (818 )   463     819     1,282  
Interest Expense                                      
Deposits:                                      
  Interest-bearing checking     797     113     910     20     35     55  
  Savings accounts and money market deposit
accounts
    (124 )   (546 )   (670 )   230     (301 )   (71 )
  Time deposit accounts     46     (712 )   (666 )   8     (188 )   (180 )
   
 
 
 
 
 
 
      Total deposit expense     719     (1,145 )   (426 )   258     (454 )   (196 )
Borrowings:                                      
  Federal funds purchased and commercial paper     (45 )   (86 )   (131 )   70     (91 )   (21 )
  Securities sold under agreements to repurchase     186     (579 )   (393 )   70     (758 )   (688 )
  Advances from Federal Home Loan Banks     (190 )   (1,054 )   (1,244 )   402     (1,121 )   (719 )
  Other     41     (130 )   (89 )   357     (16 )   341  
   
 
 
 
 
 
 
      Total borrowing expense     (8 )   (1,849 )   (1,857 )   899     (1,986 )   (1,087 )
   
 
 
 
 
 
 
      Total interest expense     711     (2,994 )   (2,283 )   1,157     (2,440 )   (1,283 )
   
 
 
 
 
 
 
Net interest income   $ 1,115   $ 350   $ 1,465   $ (694 ) $ 3,259   $ 2,565  
   
 
 
 
 
 
 

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(2)
Represents construction loans made directly to the intended occupant of a single-family residence.

25



Earnings Performance

    Net Interest Income

        For the year ended December 31, 2002, net interest income increased $1.47 billion, or 21% compared with the same period in 2001. Most of this increase was attributable to the growth in average interest-earning assets, which increased primarily as a result of the Dime acquisition, and the expansion of the net interest margin, which increased 16 basis points during the year. The margin benefited from the full effect that the 475 basis point reduction in the Federal Funds rate in 2001 had on our wholesale borrowings, which reprice to market interest levels more quickly than our interest-earning assets. After peaking in the first quarter of 2002, the net interest margin declined throughout the remainder of 2002, largely due to the downward repricing of loans and debt securities.

        The interest expense on interest-bearing checking accounts experienced a significant increase in 2002 due to the growth of, and the rates offered on, Platinum Accounts. During the year ended December 31, 2002, the average balance of Platinum Accounts was $34,018 million, compared with $1,384 million during the year ended December 31, 2001. The rates offered on Platinum Accounts increased the average rate paid on interest-bearing checking accounts from 1.58% in 2001 to 2.55% in 2002. At December 31, 2002, the balance in Platinum Accounts totaled $50.20 billion.

        For the year ended December 31, 2001, net interest income increased $2.57 billion, or 59%, compared with the same period in 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. As a result of the Federal Funds rate cuts that occurred during 2001, the cost of our wholesale borrowings during 2001 was significantly lower than 2000. The increase in deposits, 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 PNC and Fleet, also contributed to the growth in net interest income.

        Interest rate contracts, including embedded derivatives, held for asset/liability interest rate risk management purposes decreased net interest income by $407 million for the year ended December 31, 2002. Interest rate contracts, including embedded derivatives, increased net interest income by $22 million for the year ended December 31, 2001 and by $67 million for the year ended December 31, 2000.

26



    Noninterest Income

        Noninterest income consisted of the following:

 
   
   
   
  Percentage Change
 
 
  Year Ended December 31,
 
 
  2002/
2001

  2001/
2000

 
 
  2002
  2001
  2000
 
 
  (in millions)

   
   
 
Home loan mortgage banking income (expense):                            
  Loan servicing income:                            
    Loan servicing fees   $ 2,237   $ 1,375   $ 295   63 % 366 %
    Loan subservicing fees     100     24     -   317   -  
    Amortization of mortgage servicing rights     (2,616 )   (1,054 )   (133 ) 148   692  
    Impairment adjustment     (3,219 )   (1,701 )   (9 ) 89   -  
    Other, net     (371 )   (165 )   (19 ) 125   768  
   
 
 
         
      Net home loan servicing (expense) income     (3,869 )   (1,521 )   134   154   -  
  Revaluation gain from derivatives     2,517     -     -   -   -  
  Net settlement income from certain interest-rate swaps     382     -     -   -   -  
  Gain from mortgage loans     1,280     963     262   33   268  
  GNMA pool buy-out income     319     2     -   -   -  
  Loan related income     268     156     35   72   346  
  Gain on sale of originated mortgage-backed securities     34     117     2   (71 ) -  
   
 
 
         
      Total home loan mortgage banking income (expense)     931     (283 )   433   -   -  
Depositor and other retail banking fees     1,634     1,290     976   27   32  
Securities fees and commissions     362     303     318   19   (5 )
Insurance income     177     100     49   77   104  
Portfolio loan related income     349     193     82   81   135  
Gain (loss) from other available-for-sale securities     768     600     (4 ) 28   -  
Gain on extinguishment of securities sold under agreements to repurchase     282     621     -   (55 ) -  
Other income     287     424     130   (32 ) 226  
   
 
 
         
      Total noninterest income   $ 4,790   $ 3,248   $ 1,984   47   64  
   
 
 
         

    Home Loan Mortgage Banking Income

        The increase in home loan servicing fees for the year ended December 31, 2002 was the result of the increase in our loans serviced for others portfolio, partially offset by a decline in the aggregate weighted average servicing fee. Our loans serviced for others portfolio increased from $382,500 million at year ended December 31, 2001 to $604,504 million at year ended December 31, 2002 primarily as a result of the acquisition of Dime and HomeSide along with strong levels of salable home loan volume, in which we retain the servicing relationship. The strong home loan volume during 2002 was primarily due to high refinancing volume, which was caused by very low mortgage rates and the expansion of our correspondent lending activities, which resulted from the acquisition of Dime and HomeSide in 2002, and Fleet Mortgage in 2001. The increase in home loan servicing fees for 2001, as compared with 2000, was substantially the result of the addition of the loan servicing portfolios of Bank United, PNC Mortgage and Fleet Mortgage.

27


        Total loans serviced for others portfolio by type was as follows:

 
  December 31, 2002
  December 31, 2001
 
  Unpaid Principal
Balance

  Weighted Average
Servicing Fee

  Unpaid Principal
Balance

  Weighted Average
Servicing Fee

 
  (in millions)

  (in basis points, annualized)

  (in millions)

  (in basis points, annualized)

Government   $ 89,762   54   $ 61,541   52
Agency     391,833   35     242,075   45
Private     110,808   46     69,996   51
Specialty home loans     12,101   50     8,888   50
   
     
   
  Total loans serviced for others portfolio   $ 604,504   40   $ 382,500   47
   
     
   

        The decrease in the weighted average servicing fee from 47 basis points at December 31, 2001 to 40 basis points at December 31, 2002 was primarily due to sales of servicing rights, which decreased the net MSR balance by $997 million, but had no impact on the unpaid principal balance of the loans serviced for others portfolio.

        A continued decrease in long-term mortgage rates during the years ended December 31, 2002 and 2001 led to higher anticipated prepayment rates, which resulted in MSR impairment of $3,219 million and $1,701 million for 2002 and 2001, thereby increasing the MSR impairment allowance to $4,521 million at December 31, 2002 and $1,714 million at December 31, 2001. Continued high volumes of actual prepayment activity during the years ended December 31, 2002 and 2001, coupled with the growth in the MSR servicing portfolio, resulted in higher MSR amortization, as compared with the years ended December 31, 2001 and 2000.

        In measuring the impairment of MSR, we stratify the loans in our servicing portfolio primarily based on loan type and coupon rate. We measure MSR impairment by estimating the fair value of each stratum. An impairment allowance for a stratum is recorded when, and in the amount by which, its fair value is less than its carrying value. At December 31, 2002, we stratified the loans in our servicing portfolio as follows:

 
  December 31, 2002
 
  Rate Band

  Gross
Book Value

  Valuation
Allowance

  Net
Book Value

  Fair Value
 
   
  (in millions)

   
   
Adjustable   All loans   $ 1,643   $ 382   $ 1,261   $ 1,261
Conventional   7.49% and below     4,148     2,040     2,108     2,108
Conventional   7.50% to 8.99%     915     527     388     388
Conventional   9.00% and above     34     -     34     40
Government   7.49% and below     1,079     522     557     557
Government   7.50% to 8.99%     728     373     355     355
Government   9.00% and above     46     19     27     27
Private   7.49% and below     744     422     322     322
Private   7.50% to 8.99%     298     178     120     120
Private   9.00% and above     27     -     27     27
       
 
 
 
  Primary servicing         9,662     4,463     5,199     5,205
Master servicing   All loans     127     58     69     69
Specialty home loans   All loans     53     -     53     84
Multi-family   All loans     20     -     20     22
       
 
 
 
  Total       $ 9,862   $ 4,521   $ 5,341   $ 5,380
       
 
 
 

28


        Interest rate bands are generally sorted into 150 basis point intervals. The Company will consider adding additional strata to our servicing portfolio if loans with coupon rates below 6.00% reach significant levels.

        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 anticipated. 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 represent the discounted present value of the future net cash flows we expect to receive from our servicing portfolio. Accordingly, prepayment risk subjects our MSR to impairment risk.

        We estimate fair value of each MSR stratum using a discounted cash flow model. The discounted cash flow 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. While the Company's model estimates a value, the specific value used is based on a variety of factors, such as documented observable data and anticipated changes in market conditions. All the assumptions are based on standards used by market participants in valuing MSR. The reasonableness of management's assumptions about these factors is confirmed through quarterly 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 fair 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 the MSR fair value. Changes in fair value based on a variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. 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."

        The continuing high volume of refinancing activity allowed us to generate strong levels of salable home loan volume during the year ended December 31, 2002. Additionally, the Company enters into commitments to make loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Therefore, they are recorded, at fair value, in other assets on the Consolidated Statements of Financial Condition with changes in fair value recorded in gain from mortgage loans on the Consolidated Statements of Income. In measuring the fair value of rate lock commitments, the amount of the expected servicing rights is included in the valuation. This value is calculated using the same methodologies as are used to value the Company's MSR, adjusted using an anticipated fallout factor for loan commitments that will never be funded.

        This policy of recognizing the value of the derivative has the effect of recognizing the gain from mortgage loans before the loans are sold. The fair value of rate lock commitments on the Consolidated Statements of Financial Condition at December 31, 2002 and 2001 for which the underlying loans had not been funded was $473 million and $3 million.

        The FASB staff or the Emerging Issues Task Force may issue additional guidance on this matter. Depending on what, if any, additional guidance is issued, the timing of the gain recognition inherent within our rate lock commitments could be delayed, possibly until the date that the anticipated loans are sold.

29



Generally, loans held for sale are sold within 60 to 120 days after the initial recognition of the rate lock commitment.

        Rate lock commitment volume totaled $236.05 billion for the year ended December 31, 2002, compared with $134.16 billion for the same period in 2001. The total notional amounts of rate lock commitments outstanding, including an anticipated fallout factor, at December 31, 2002 and December 31, 2001 were $26.97 billion and $12.59 billion. The high levels of rate lock commitment volume resulted in gain from mortgage loans of $1,280 million during the year ended December 31, 2002 compared with $963 million during the same period in 2001. Gain from mortgage loans for the year ended December 31, 2001 increased compared with 2000 as a result of higher levels of loan volume caused by low mortgage interest rates.

        Government National Mortgage Association ("GNMA") pool buy-out income was $319 million for 2002. Beginning in 2002, the Company began to regularly exercise its buy-back rights under the terms of its contracts with GNMA. The Company has the right to repurchase certain loans that are part of GNMA securitization pools before they have reached nonperforming status. In one part of the Company's program, loans that have been 30 days past due for three consecutive months (referred to as "rolling 30 loans") are repurchased from GNMA and then resold in the secondary market. In the other, loans that have missed three consecutive payments are likewise purchased and resold. These loans are collectively referred to as Early Buy-Out Loans.

        Gain from the sale of these loans was $126 million for the year ended December 31, 2002. In the future, the Company will not have the option of repurchasing "rolling 30 loans" from pools created after January 1, 2003, but will continue to make such purchases from previously created pools. The Company does not expect this change to have a significant impact on its results of operations in 2003.

        Additionally, as part of its normal Federal Housing Administration and Department of Veterans Affairs lending program, the Company repurchases defaulted loans from GNMA and undertakes collection and, if necessary, foreclosure proceedings with respect to those loans. Upon completion of the foreclosure, the Company can also submit a claim to either the Federal Housing Administration or the Department of Veterans Affairs for payment on the insurance or guarantee, as the case may be, issued by that agency. The portion of the recovery which is attributed to interest income owed to the Company is also recorded in this category. That interest income, together with interest income on the Early Buy-Out Loans was $193 million for 2002.

        Loan related income increased during the years ended December 31, 2002 and 2001. A significant portion of this increase was due to increased late charges on the loans serviced for others and loan prepayment fees on certain adjustable-rate mortgages with prepayment penalty provisions.

        Gain from sale of originated mortgage-backed securities during the first quarter of 2001 included gains from the sale of adjustable-rate mortgage loans that were securitized in the fourth quarter of 2000 and other mortgage-backed securities that were securitized in earlier periods.

30



        The following table separately presents the MSR and the asset/liability risk management activities included within noninterest income for the year ended December 31, 2002.

 
  MSR Risk
Management

  Asset/Liability
Risk Management

  Total
 
  (in millions)

Gain (loss) from other available-for-sale securities   $ 795   $ (27 ) $ 768
Revaluation gain (loss) from derivatives     2,645     (128 )   2,517
Gain on extinguishment of securities sold under agreements to repurchase     257     25     282
Net settlement income from certain interest-rate swaps     382     -     382
   
 
 
  Total   $ 4,079   $ (130 ) $ 3,949
   
 
 

        The total amount of income from MSR risk management instruments offset MSR impairment and higher levels of MSR amortization that resulted from high loan prepayment activity.

        Revaluation gain from derivatives is the earnings impact of the changes in fair value from certain derivatives where the Company has not attempted to achieve hedge accounting treatment under Statement No. 133. The significant increase in the revaluation gain from derivatives was due to the Company decreasing its reliance on investment securities during 2002 by shifting to a blend of investment securities and derivatives. These derivatives were mostly used for MSR risk management purposes. The total notional amount of these MSR risk management derivatives at December 31, 2002 was $41.97 billion with a combined fair value of $3.03 billion, compared with zero at December 31, 2001.

        Net settlement income from certain interest-rate swaps represents the income from interest rate swaps where the Company has not attempted to achieve hedge accounting treatment under Statement No. 133. These swaps predominantly consisted of receive-fixed interest rate swaps, which were used as MSR risk management derivatives. At December 31, 2002, the total notional amount of these receive-fixed interest-rate swaps was $17.92 billion, compared with zero at December 31, 2001.

    All Other Noninterest Income Analysis

        The increase in depositor and other retail banking fees for the year ended December 31, 2002 was primarily due to higher levels of checking fees that resulted from an increased number of noninterest-bearing checking accounts in comparison with the year ended December 31, 2001 and an increase in fees from debit card services. The number of these accounts at December 31, 2002 totaled over 5.8 million, an increase of more than 846,000 from December 31, 2001. This increase included approximately 200,000 noninterest-bearing checking accounts acquired from Dime during the first quarter of 2002. The increase in depositor and other retail banking fees for the year ended December 31, 2001 was primarily due to higher levels of checking fees that resulted from an increased number of noninterest-bearing checking accounts.

        Securities fees and commissions increased during the year ended December 31, 2002 primarily due to a continued increase in sales of fixed annuities. 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 investor uncertainty regarding the stock market. Offsetting this decline was a significant increase in fees from the sale of fixed annuities.

        Insurance income increased during the year ended December 31, 2002 and year ended December 31, 2001 primarily due to the continued growth in our captive reinsurance programs. The Dime acquisition also contributed to an increase in revenues in optional insurance and property and casualty insurance products.

        The growth in portfolio loan related income for the year ended December 31, 2002 was mostly due to increased late charges on the loan portfolio, continued high loan prepayment fees as a result of refinancing activity and the Dime acquisition. The growth in portfolio related income for the year ended December 31, 2001 was also largely due to increased late charges and higher loan prepayment fees.

31


        Gain from other available-for-sale securities increased during the year ended December 31, 2002, mostly as a result of increased sales of U.S. Government securities used as MSR risk management instruments. Gain on extinguishment of securities sold under agreements to repurchase ("repurchase agreements") decreased during the year ended December 31, 2002 compared with 2001 largely due to a reduction in terminations of certain repurchase agreements with embedded interest rate floors.

        The decrease in other noninterest income during the year ended December 31, 2002 was primarily due to the Company's removal of the cash flow hedge designation on certain payor swaptions which resulted in the Company reclassifying a loss of $112 million from accumulated other comprehensive income to other noninterest income, and a reduction in some of the specific gains realized during 2001 as described below. This overall decrease during 2002 was partially offset by a $125 million revaluation gain on residual interests in collateralized mortgage obligations. The increase in other income during the year ended December 31, 2001 was primarily due to a $55 million revaluation gain on residual interests in collateralized mortgage obligations, $37 million from our bank-owned life insurance program, a $34 million net gain from the sale of financial center stores and a gain of $32 million on Concord EFS, Inc. stock prior to its donation to the Washington Mutual Foundation.

    Noninterest Expense

        Noninterest expense consisted of the following:

 
   
   
   
  Percentage Change
 
 
  Year Ended December 31,
 
 
  2002/
2001

  2001/
2000

 
 
  2002
  2001
  2000
 
 
  (in millions)

   
   
 
Compensation and benefits   $ 2,899   $ 1,924   $ 1,348   51 % 43 %
Occupancy and equipment     1,153     804     604   43   33  
Telecommunications and outsourced information services     524     441     323   19   37  
Depositor and other retail banking losses     204     144     105   42   37  
Amortization of goodwill     - (1)     139     83   (100 ) 67  
Amortization of other intangible assets     67     33     23   103   43  
Advertising and promotion     246     185     132   33   40  
Postage     192     136     98   41   39  
Professional fees     208     201     101   3   99  
Loan expense     211     126     50   67   152  
Travel and training     141     112     63   26   78  
Reinsurance expense     51     13     -   292   -  
Other expense     486     359     196   35   83  
   
 
 
         
  Total noninterest expense   $ 6,382   $ 4,617   $ 3,126   38   48  
   
 
 
         

(1)
The Company adopted Statement No. 142 on January 1, 2002, and no longer amortizes goodwill.

        The increase in employee base compensation and benefits expense for the year ended December 31, 2002 over the same period a year ago was primarily due to the acquisitions of Dime and HomeSide, the hiring of additional staff to support our expanding operations and an increase in incentive compensation. The increase for the year ended December 31, 2001 over the same period in December 31, 2000 was primarily due to the acquisition of PNC Mortgage, Bank United and Fleet Mortgage. Full-time equivalent employees were 52,459 at December 31, 2002 compared with 39,465 at December 31, 2001 and 28,798 at December 31, 2000. The Dime and HomeSide acquisitions added a total of approximately 9,000 full-time equivalent employees.

32



        The increase in occupancy and equipment expense for the year ended December 31, 2002 resulted primarily from rent, maintenance and depreciation expense related to the recent acquisitions. A majority of the increase in occupancy and equipment expense for the year ended December 31, 2001 resulted from properties and equipment acquired from the PNC Mortgage, Bank United and Fleet Mortgage acquisitions.

        The increase in telecommunications and outsourced information services expense for the year ended December 31, 2002 was primarily attributable to higher usage of voice and data network services, outsourced data processing services and internet services. A significant portion of the increase in telecommunications and outsourced information services expense during the year ended December 31, 2001 was attributable to higher rates, effective at the beginning of the year, with a third party service provider. Additionally, the Company added 266 and 194 financial center stores during the years ended December 31, 2002 and 2001 as a result of organic growth and acquisitions.

        A majority of the increase in depositor and other retail banking losses in the periods reported was due to higher loss levels per account as a result of increases in forgeries and returned deposited items. Also contributing to this increase was the growth in new checking accounts and the number of ATMs.

        The increase in amortization of other intangible assets expense during the year ended December 31, 2002 was substantially due to the core deposit intangible acquired in the Dime acquisition. Amortization of goodwill and intangible assets increased in 2001 primarily due to the PNC Mortgage, Bank United and Fleet Mortgage acquisitions. Upon adopting Statement No. 142 at January 1, 2002, goodwill amortization was eliminated.

        Advertising and promotion expense increased for the year ended December 31, 2002 primarily due to the marketing campaign in the greater New York metropolitan area, and to a lesser extent, due to our expansion into the metropolitan areas of Denver, Atlanta and Phoenix. The increase in advertising and promotion expense during the year ended December 31, 2001 was primarily due to additional costs associated with marketing campaigns for various loan and deposit products and our expansion into new markets.

        The increase in loan expense for the year ended December 31, 2002 and for the year ended December 31, 2001 was primarily due to higher non-deferred loan closing costs, which were attributable to an overall increase in loan originations and purchases, and higher mortgage payoff expenses.

        Travel and training increased for the year ended December 31, 2002 and for the year ended December 31, 2001 primarily due to increased travel related to the 2002 acquisitions of Dime and HomeSide and the 2001 acquisitions of PNC Mortgage, Bank United and Fleet Mortgage, and the training of new employees and recently transferred employees from the aforementioned acquisitions.

        A significant portion of the increase in other expense during the year ended December 31, 2002 was due to increases in foreclosed assets expense, regulatory assessments, outside printing services, business taxes and office supplies. The increase in other expense during the year ended December 31, 2001 was primarily due to increases in contributions to the Washington Mutual Foundation, provision for losses on delinquent GNMA pool buy-outs and other outside services expense.


Review of Financial Condition

    Assets

        At December 31, 2002, our assets were $268.30 billion, an increase of $25.79 billion or 11% from $242.51 billion at December 31, 2001. This increase was primarily attributable to the Dime and HomeSide acquisitions.

33


    Securities

        Securities consisted of the following:

 
  December 31,
 
  2002
  2001
 
  (in millions)

Available-for-sale securities, total amortized cost of $42,592 and $58,783:            
  Mortgage-backed securities   $ 28,375   $ 28,568
  Other investment securities     15,597     29,781
   
 
    Total available-for-sale securities   $ 43,972   $ 58,349
   
 

        Upon adopting Statement No. 133 at January 1, 2001, we reclassified our held-to-maturity securities to available-for-sale. Other investment securities decreased $14,184 million to $15,597 million at December 31, 2002 from $29,781 million at December 31, 2001, largely due to the sales of U.S. Government and agency bonds. Refer to Note 3 to the Consolidated Financial Statements – "Securities" for additional information on securities, classified by security type.

    Loans

        Total loans consisted of the following:

 
  December 31,
 
  2002
  2001
  2000
  1999
  1998
 
  (in millions)

Loans held for sale   $ 33,996   $ 26,582   $ 3,404   $ 794   $ 1,827
Loans held in portfolio:                              
  Loans secured by real estate:                              
    Home loans     82,842     79,624     80,181     80,234     79,275
    Purchased specialty mortgage finance     10,128     8,209     5,541     3,124     -
   
 
 
 
 
        Total home loans     92,970     87,833     85,722     83,358     79,275
    Home construction loans:                              
      Builder (1)     1,017     1,623     440     338     280
      Custom (2)     932     979     991     905     740
    Home equity loans and lines of credit:                              
      Banking subsidiaries     16,168     7,970     5,772     4,404     3,444
      Washington Mutual Finance     1,930     2,100     1,991     1,433     1,123
    Multi-family (3)     18,000     15,608     15,657     15,261     14,559
    Other real estate (4)     7,986     6,089     3,920     3,585     4,195
   
 
 
 
 
        Total loans secured by real estate     139,003     122,202     114,493     109,284     103,616
  Consumer:                              
    Banking subsidiaries     1,663     2,009     1,669     1,438     1,460
    Washington Mutual Finance     1,729     1,755     1,737     1,629     1,451
  Commercial business     5,133     4,285     1,727     1,395     1,085
   
 
 
 
 
        Total loans held in portfolio   $ 147,528   $ 130,251   $ 119,626   $ 113,746   $ 107,612
   
 
 
 
 

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(2)
Represents construction loans made directly to the intended occupant of a single-family residence.
(3)
Includes multi-family construction balances of $491 million in 2002, $385 million in 2001, $90 million in 2000, $52 million in 1999 and $16 million in 1998.
(4)
Includes other commercial real estate construction balances of $469 million in 2002, $608 million in 2001, $177 million in 2000, $185 million in 1999 and $205 million in 1998.

34


        The increase in loans held for sale in 2002 was primarily the result of higher fixed-rate loan production, which occurred due to high refinancing activity from lower mortgage rates and the addition of the mortgage operations through the acquisitions of Dime and HomeSide in 2002. Substantially all of the increase in loans held for sale in 2001 was due to higher fixed-rate loan production, which occurred due to lower mortgage rates and the acquisitions of Bank United, PNC Mortgage and Fleet Mortgage.

        The increase in loans held in portfolio resulted predominantly from increases in total home loans, home equity loans and lines of credit, and multi-family loans. The increase in these categories of loans resulted from high volumes of loan originations and purchases coupled with loans added through the Dime and HomeSide acquisitions. The increase in loans held in portfolio in 2001 was mostly due to the acquisition of Bank United. The increase in loans held in portfolio for both 2002 and 2001 was partially offset by higher levels of prepayment activity within our home loans (excluding purchased specialty mortgage finance) portfolio.

        Home, multi-family and other commercial real estate construction loans and commercial business loans by maturity date were as follows:

 
  December 31, 2002
 
  Due
Within One Year

  After One But
Within Five Years

  After
Five Years

  Total
 
  (in millions)

Home construction loans:                        
  Adjustable rate   $ 434   $ 742   $ 14   $ 1,190
  Fixed rate     121     59     579     759
Multi-family construction loans:                        
  Adjustable rate     18     369     43     430
  Fixed rate     -     35     26     61
Other commercial real estate construction loans:                        
  Adjustable rate     19     306     118     443
  Fixed rate     -     17     9     26
Commercial business:                        
  Adjustable rate     1,450     2,521     794     4,765
  Fixed rate     13     151     204     368
   
 
 
 
    Total   $ 2,055   $ 4,200   $ 1,787   $ 8,042
   
 
 
 

35


        Loan volume was as follows:

 
  Year Ended December 31,
 
  2002
  2001
 
  (in millions)

Loans secured by real estate:            
  Home loans:            
    Adjustable rate   $ 84,627   $ 37,224
    Fixed rate     176,040     107,538
    Specialty mortgage finance     14,077     10,333
   
 
      Total home loan volume     274,744     155,095
  Home construction loans:            
    Builder (1)     1,842     1,957
    Custom (2)     761     917
  Home equity loans and lines of credit:            
    Banking subsidiaries     15,254     7,537
    Washington Mutual Finance     1,051     937
  Multi-family     5,839     2,697
  Other real estate     1,818     1,422
   
 
      Total loans secured by real estate     301,309     170,562
Consumer:            
  Banking subsidiaries     760     540
  Washington Mutual Finance     1,791     1,760
Commercial business     2,193     2,219
   
 
      Total loan volume   $ 306,053   $ 175,081
   
 

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(2)
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,
 
  2002
  2001
 
  (in millions)

Originated   $ 200,107   $ 112,173
Purchased/Correspondent     105,946     62,908
   
 
  Total loan volume by channel   $ 306,053   $ 175,081
   
 

36


        Refinancing activity (1) was as follows:

 
  Year Ended December 31,
 
  2002
  2001
 
  (in millions)

Home loans:            
  Adjustable rate   $ 60,170   $ 25,099
  Fixed rate     118,224     70,023
  Specialty mortgage finance     5,394     2,433
   
 
    Total home loan refinances     183,788     97,555
Home construction loans     50     31
Home equity loans and lines of credit and consumer     2,814     364
Multi-family and other real estate     2,155     1,257
   
 
    Total refinances   $ 188,807   $ 99,207
   
 

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

        Loan volume increased during 2002 due primarily to higher refinancing activity caused by historically low mortgage rates. Purchased/correspondent loans increased during 2002 due to the expansion of our correspondent lending activities, which was primarily due to the acquisition of Fleet Mortgage. The acquisitions of Dime and HomeSide also partly contributed to the increase. Purchased/correspondent volume for specialty mortgage finance loans was $5.87 billion in 2002, compared with $4.95 billion in 2001.

    Deposits

        Deposits consisted of the following:

 
  December 31,
 
  2002
  2001
 
  (in millions)

Checking accounts:            
  Interest bearing   $ 56,132   $ 15,350
  Noninterest bearing     35,730     22,386
   
 
      91,862     37,736
Savings accounts     10,313     6,970
Money market deposit accounts     19,573     25,514
Time deposit accounts     33,768     36,962
   
 
    Total deposits   $ 155,516   $ 107,182
   
 

        Deposits increased to $155,516 million at December 31, 2002 from $107,182 million at December 31, 2001. Substantially all of the increase in interest-bearing checking accounts was due to the growth in Platinum Accounts, which increased from $9.40 billion at December 31, 2001 to $50.20 billion at December 31, 2002. During the year ended December 31, 2002, the number of Platinum Accounts increased by 549,688 from 133,557 to 683,245. As a result of the Dime acquisition, we added $15.17 billion in deposits for the year. At December 31, 2002, total deposits included $25.90 billion in custodial/escrow deposits related to loan servicing activities, compared with $10.11 billion at December 31, 2001. Time deposit accounts decreased by $9.29 billion from year-end 2001 offset by the addition of $6.10 billion of time deposit accounts included in the Dime acquisition. The net decrease was primarily a result of decreases in liquid certificates of deposit accounts and other certificates of deposits maturing in less than one year.

37



        Checking accounts, savings accounts and money market deposit accounts increased to 78% of total deposits at December 31, 2002, compared with 66% at year-end 2001. These products generally have the benefit of lower interest costs, compared with time deposit accounts. Even though checking, savings and money market deposits are more liquid, we consider them to be the core relationship with our customers. At December 31, 2002, deposits funded 58% of total assets, compared with 44% at year-end 2001.

    Borrowings

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

        Our wholesale borrowings decreased by $36,090 million at December 31, 2002 compared with year-end 2001 due to a significant increase in deposits as a result of Platinum Accounts. Other borrowings, however, increased by $2,688 million during 2002 predominantly due to the issuance of senior and subordinated debt, and trust preferred income securities acquired from Dime. Refer to "Liquidity" for further discussion of funding sources at December 31, 2002, compared with year-end 2001.


Off-Balance Sheet Arrangements

    Asset Securitization

        We transform loans into securities, which are sold to investors – a process known as securitization. Securitization involves the sale of loans to a qualifying special-purpose entity ("QSPE"), typically a trust. Generally, in a securitization, we transfer financial assets to QSPEs, which are legally isolated from the Company. The QSPEs, in turn, issue interest-bearing securities, commonly called asset-backed securities, that are secured by future collections on the sold loans. The QSPE sells securities to investors, which entitle them to receive specified cash flows during the term of the security. The QSPE uses proceeds from the sale of these securities to pay the purchase price for the sold loans. The proceeds from the issuance of the securities are then distributed to the Company as consideration for the loans transferred. The Company has not used unconsolidated special-purpose entities as a mechanism to remove nonaccrual loans and foreclosed assets from the balance sheet.

        Securitization is used to provide a source of liquidity and less expensive funding and also reduces our credit exposure to borrowers. As part of non-agency securitizations, we use QSPEs to facilitate the transfer of mortgage loans into the secondary market. These entities are not consolidated within our financial statements since they satisfy the criteria established by Statement No. 140 , Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities . In general, these criteria require the QSPE to be demonstrably distinct from the transferor (the Company), be limited to permitted activities, and have defined limits on the assets it can hold and the permitted sales, exchanges or distributions of its assets.

        We routinely securitize home, specialty home loans and commercial real estate loans into the secondary market. The allocated carrying value of loans securitized and sold during the year ended December 31, 2002 was $163.60 billion compared with $102.05 billion in 2001. Investors and securitization trusts do not have any recourse to the Company for loans securitized and sold during the years ended December 31, 2002 and 2001. When we sell or securitize loans, we generally retain the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the securitized assets. Retained interests may provide credit enhancement to the investors and represent the Company's maximum risk exposure associated with these transactions. Investors in the securities issued by the QSPEs have no further recourse against the Company if cash flows generated by the securitized assets are inadequate to service the obligations of the QSPEs. Additional information concerning securitization transactions is included in Note 5 to the Consolidated Financial Statements – "Mortgage Banking Activities."

38



        Retained interests are recorded on the balance sheet and represent mortgage-backed securities and MSR. Retained interests in mortgage-backed securities in which the securitization has been accounted for as a sale, were $10.78 billion at December 31, 2002. Retained interests in MSR were $5.34 billion at December 31, 2002.

    Contractual Obligations

        The following table presents, as of December 31, 2002, the Company's significant fixed and determinable contractual obligations, within the categories described below, by payment date. These contractual obligations, except for the operating lease obligations, are included in the Consolidated Statements of Financial Condition. The payment amounts represent those amounts contractually due to the recipient.

 
  Payments Due by Period (in millions)
Contractual Obligations

  Total
  Less than
1 year

  1-3 years
  3-5 years
  After
5 years

Debt obligations   $ 83,246   $ 32,437   $ 25,017   $ 19,689   $ 6,103
Capital lease obligations     90     9     17     13     51
Operating lease obligations     1,702     365     574     316     447
Purchase obligations:                              
  Forward purchase commitments     23,443     23,443     -     -     -
  Loan rate lock commitments (1)     26,970     26,970     -     -     -
   
 
 
 
 
Total contractual obligations   $ 135,451   $ 83,224   $ 25,608   $ 20,018   $ 6,601
   
 
 
 
 

(1)
Loan rate lock commitments are adjusted for rate locks which are expected to terminate prior to the time the loan is funded.

        The Company enters into derivative contracts under which the Company is required to either receive cash or pay cash to counterparties depending on changes in interest rates. Derivative contracts are carried at fair value on the Consolidated Statements of Financial Condition with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of the contracts changes daily as market interest rates change. Further discussion of derivative instruments is included in Note 1 – "Summary of Significant Accounting Policies" and Note 21 – "Derivative Financial Instruments" to the Consolidated Financial Statements.

    Commitments, Guarantees and Contingencies

        The Company may also have liabilities under certain contractual agreements contingent upon occurrence of certain events. A discussion of significant contractual arrangements under which the Company may be held contingently liable, including guarantee arrangements, is included in Note 14 – "Commitments, Guarantees and Contingencies" to the Consolidated Financial Statements. In addition, the Company has commitments and obligations under pension and other postretirement benefit plans as described in Note 20 – "Employee Benefits Programs and Other Expense" to the Consolidated Financial Statements.

39



Asset Quality

    Nonaccrual Loans, Foreclosed Assets and Restructured Loans.

        Loans are generally placed on nonaccrual status when they are 90 days or more past due or when the timely collection of the principal of the loan, in whole or in part, is not expected. Management's classification of a loan as nonaccrual or restructured does not necessarily indicate that the principal of the loan is uncollectible in whole or in part.

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

 
  December 31,
 
 
  2002
  2001
  2000
  1999
  1998
 
 
  (dollars in millions)

 
Nonaccrual loans:                                
  Nonaccrual loans secured by real estate:                                
    Home loans   $ 1,017   $ 974   $ 509   $ 572   $ 689  
    Purchased specialty mortgage finance     488     328     127     23     -  
   
 
 
 
 
 
        Total home loan nonaccrual loans     1,505     1,302     636     595     689  
    Home construction loans:                                
      Builder (1)     42     26     16     15     7  
      Custom (2)     7     10     2     3     2  
    Home equity loans and lines of credit:                                
      Banking subsidiaries     36     34     27     22     19  
      Washington Mutual Finance     37     40     25     10     4  
    Multi-family     50     56     10     21     44  
    Other real estate     414     376     35     33     44  
   
 
 
 
 
 
        Total nonaccrual loans secured by real estate     2,091     1,844     751     699     809  
  Consumer:                                
    Banking subsidiaries     18     12     10     8     9  
    Washington Mutual Finance     69     74     61     50     49  
  Commercial business     79     100     12     10     7  
   
 
 
 
 
 
        Total nonaccrual loans held in portfolio     2,257     2,030     834     767     874  
Foreclosed assets     336     228     153     199     275  
   
 
 
 
 
 
        Total nonperforming assets   $ 2,593   $ 2,258   $ 987   $ 966   $ 1,149  
        As a percentage of total assets     0.97 %   0.93 %   0.51 %   0.52 %   0.69 %
Restructured loans   $ 98   $ 118   $ 120   $ 117   $ 179  
   
 
 
 
 
 
        Total nonperforming assets and restructured loans   $ 2,691   $ 2,376   $ 1,107   $ 1,083   $ 1,328  
   
 
 
 
 
 

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(2)
Represents construction loans made directly to the intended occupant of a single-family residence.

        Nonaccrual loans increased to $2,257 million at December 31, 2002 from $2,030 million at December 31, 2001. Of the increase in nonaccrual loans during the year ended December 31, 2002, approximately $106 million was attributable to loans originated by Dime and HomeSide. These loans are concentrated in home loans as well as the commercial business and commercial real estate loan categories.

        Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $119 million, $123 million, $32 million, $30 million and zero at December 31, 2002, 2001, 2000, 1999

40



and 1998. Loans held for sale are accounted for at the lower of aggregate cost or market value, with valuation changes included as adjustments to gain from mortgage loans.

        Home loan nonaccrual loans (excluding purchased specialty mortgage finance) of $1,017 million increased by $43 million during the year ended December 31, 2002. Nonperforming loan sales, as well as continued strength in the housing market, moderated the overall increase in home loan nonaccruals. During the year, nonperforming loans sale activity reduced nonaccrual loans by $135 million.

        Purchased specialty mortgage finance nonaccrual loans totaled $488 million, an increase of $160 million for the year ended December 31, 2002. The increase was primarily due to higher rates of unemployment, which resulted from the sluggish economy.

        At December 31, 2002, other real estate on nonaccrual totaled $414 million, compared with $376 million at December 31, 2001. Nonaccrual loans to finance franchise-oriented businesses increased $128 million during the year offsetting improvements in the nonresidential commercial real estate portfolio. The Company elected to discontinue its franchise finance lending activities due to the weak performance of the convenience store segment of the business and the change in ownership of Franchise Finance Corporation of America, the source of this portfolio. This portfolio, which includes both the fast food and convenience store segments, totaled $633 million at December 31, 2002. The nonaccrual loans in this portfolio have been specifically reserved.

        Multi-family loans on nonaccrual totaled $50 million at year end, of which $5 million was attributable to Dime and HomeSide. This portfolio continues to exhibit strong and stable performance with nonaccrual loans in this category representing 0.28% of total multi-family loans at December 31, 2002 compared with 0.36% at December 31, 2001. Commercial business nonaccrual loans decreased $21 million during the year ended December 31, 2002 to $79 million.

        At December 31, 2002, foreclosed assets were $336 million, compared with $228 million at December 31, 2001. The Company's foreclosed assets include both home and commercial real estate as well as a small amount of personal property. Of the $108 million increase in 2002, $65 million was comprised of home loan properties and $43 million was comprised of commercial real estate.

        If interest on nonaccrual loans under the original terms had been recognized, such income is estimated to have been $134 million in 2002, $106 million in 2001 and $66 million in 2000.

41



        Loans held in portfolio (exclusive of the allowance for loan and lease losses) and nonaccrual loans by geographic concentration at December 31, 2002 were as follows:

 
  California
  Washington/Oregon
  New York/New Jersey
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
Loans secured by real estate:                                      
  Home loans   $ 40,897   $ 280   $ 7,344   $ 129   $ 7,496   $ 124  
  Purchased specialty mortgage finance     2,562     53     347     27     1,136     55  
   
 
 
 
 
 
 
    Total home loans     43,459     333     7,691     156     8,632     179  
  Home construction loans:                                      
    Builder (1)     315     2     87     1     48     -  
    Custom (2)     377     1     356     3     20     1  
  Home equity loans and lines of credit:                                      
    Banking subsidiaries     8,272     12     2,668     12     1,211     1  
    Washington Mutual Finance     447     4     54     2     21     -  
  Multi-family     13,628     2     1,090     1     1,766     5  
  Other real estate     1,746     18     1,649     17     1,851     17  
   
 
 
 
 
 
 
      Total loans secured by real estate     68,244     372     13,595     192     13,549     203  
Consumer:                                      
  Banking subsidiaries     461     2     519     7     101     -  
  Washington Mutual Finance     154     7     25     1     2     -  
Commercial business     1,003     4     920     6     761     17  
   
 
 
 
 
 
 
    Total loans held in portfolio (exclusive of the allowance for loan and lease losses)   $ 69,862   $ 385   $ 15,059   $ 206   $ 14,413   $ 220  
   
 
 
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     47 %   17 %   10 %   9 %   10 %   10 %
 
  Florida
  Texas
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
Loans secured by real estate:                          
  Home loans   $ 4,887   $ 74   $ 1,657   $ 35  
  Purchased specialty mortgage finance     671     30     630     30  
   
 
 
 
 
    Total home loans     5,558     104     2,287     65  
  Home construction loans:                          
    Builder (1)     104     18     231     16  
    Custom (2)     24     -     8     -  
  Home equity loans and lines of credit:                          
    Banking subsidiaries     639     2     1,691     3  
    Washington Mutual Finance     138     3     225     3  
  Multi-family     164     20     260     15  
  Other real estate     192     38     531     39  
   
 
 
 
 
      Total loans secured by real estate     6,819     185     5,233     141  
Consumer:                          
  Banking subsidiaries     70     1     288     3  
  Washington Mutual Finance     111     5     267     9  
Commercial business     294     6     576     27  
   
 
 
 
 
    Total loans held in portfolio (exclusive of the allowance for loan and lease losses)   $ 7,294   $ 197   $ 6,364   $ 180  
   
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     5 %   9 %   4 %   8 %
(Continued on next table)                          

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(2)
Represents construction loans made directly to the intended occupant of a single-family residence.

42


 
  Other (3)
  Total
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
Loans secured by real estate:                          
  Home loans   $ 20,561   $ 375   $ 82,842   $ 1,017  
  Purchased specialty mortgage finance     4,782     293     10,128     488  
   
 
 
 
 
    Total home loans     25,343     668     92,970     1,505  
  Home construction loans:                          
    Builder (1)     232     5     1,017     42  
    Custom (2)     147     2     932     7  
  Home equity loans and lines of credit:                          
    Banking subsidiaries     1,687     6     16,168     36  
    Washington Mutual Finance     1,045     25     1,930     37  
  Multi-family     1,092     7     18,000     50  
  Other real estate     2,017     285     7,986     414  
   
 
 
 
 
      Total loans secured by real estate     31,563     998     139,003     2,091  
Consumer:                          
  Banking subsidiaries     224     5     1,663     18  
  Washington Mutual Finance     1,170     47     1,729     69  
Commercial business     1,579     19     5,133     79  
   
 
 
 
 
    Total loans held in portfolio (exclusive of the allowance for loan and lease losses)   $ 34,536   $ 1,069   $ 147,528   $ 2,257  
   
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     24 %   47 %   100 %   100 %

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale.
(2)
Represents construction loans made directly to the intended occupant of a single-family residence.
(3)
Of this category, Illinois had the largest portfolio balance of approximately $3.92 billion and the largest nonaccrual amount of $132 million.

    Provision and Allowance for Loan and Lease Losses

        Due to economic trends, and the growth in nonaccrual loans, the provision for loan and lease losses increased to $595 million during 2002 from $575 million in 2001. As a percentage of average loans, net charge-offs were 0.28% for the year ended December 31, 2002 compared with 0.23% for the year ended December 31, 2001.

        Net charge-offs for 2002 totaled $411 million, an increase of $106 million over the prior year. While representing less than 2% of the Company's assets, Washington Mutual Finance represented 40% of total net charge-offs for the year. This higher level of charge-offs in a consumer finance operation such as Washington Mutual Finance is expected due to the higher risk nature of the customer base as reflected in the interest rates charged for these loans.

        During 2002, growth in purchased specialty mortgage finance and Small Business Administration charge-offs exceeded the growth of the corresponding portfolios. Small Business Administration losses centered on convenience store lending and declined substantially in the latter months of 2002. The primary reason for increased consumer finance and home loan losses was the higher unemployment rate throughout the year stemming from a slower national economy.

        The allowance for loan and lease losses represents management's estimate of credit losses inherent in the Company's loan and lease portfolios as of the balance sheet date. The estimation of the allowance is based on a variety of factors, including past loan loss experience, adverse situations that have occurred but

43



are not yet known that may affect the borrower's ability to repay, the estimated value of underlying collateral and general economic conditions. The Company's methodology for assessing the adequacy of the allowance includes the evaluation of three distinct elements: the formula allowance, the specific allowance (which includes the allowance for loans deemed to be impaired by Statement No. 114, "Accounting by Creditors for Impairment of a Loan ") and the unallocated allowance. The formula allowance and the specific allowance collectively represent the portion of the allowance for loan and lease losses that are allocated to the various loan portfolios.

        The formula allowance considers losses that are embedded within loan portfolios, but have not yet been realized. Losses are recognized when (a) available information indicates that it is probable that a loss has been incurred and (b) the amount of the loss can be reasonably estimated. Generally, the Company believes that borrowers are impacted by events that result in loan default and eventual loss well in advance of a lender's knowledge of those events. The time frame between the occurrence of such events and the resulting default and loss realization is referred to as the "loss emergence period." Examples of such loss-causing events for home loans are borrower job loss, divorce and medical crisis. An example for commercial real estate loans would be the loss of a major tenant.

        The formula allowance is determined by applying loss factors against all loans that are not determined to be impaired. Such loans include those within homogeneous portfolios, such as home loans and home equity loans and lines of credit, purchased specialty mortgage finance loans and pools of smaller commercial business loans. Loss factors are based on the analysis of the historical loss experience 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 may be adjusted for external factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Such external factors include, but are not limited to, the interest rate environment and housing price trends.

        For non-homogeneous loans such as commercial real estate, larger commercial business loans and builder home construction loans, loss factors are assigned based on risk ratings that are ascribed to the individual loans. A specific allowance may be assigned to 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 past 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. Loans that are determined to be impaired are excluded from the formula allowance analysis so as not to double-count the loss exposure.

        In estimating the amount of credit losses inherent in the Company's loan and lease portfolios, various assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding current economic trends 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. 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,

44



duration of the current business cycle, the impact of new product initiatives and other such variables for which recent historical data do not provide a high level of precision for risk evaluation, the results of regulatory examinations and findings from the Company's internal credit review function.

        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,
 
 
  2002
  2001
  2000
  1999
  1998
 
 
  (dollars in millions)

 
Balance, beginning of year   $ 1,404   $ 1,014   $ 1,042   $ 1,068   $ 1,048  
Allowance acquired through business combinations     148     120     -     -     108  
Allowance for transfer to loans held for sale     (31 )   -     (36 )   (1 )   (74 )
Allowance for certain loan commitments     (52 )   -     -     -     -  
Provision for loan and lease losses     595     575     185     167     162  
   
 
 
 
 
 
      2,064     1,709     1,191     1,234     1,244  
Loans charged off:                                
  Loans secured by real estate:                                
    Home loans     (52 )   (29 )   (19 )   (38 )   (65 )
    Purchased specialty mortgage finance     (33 )   (25 )   (4 )   -     -  
   
 
 
 
 
 
        Total home loan charge-offs     (85 )   (54 )   (23 )   (38 )   (65 )
    Home construction loans (1)     (1 )   -     (1 )   -     (1 )
    Home equity loans and lines of credit:                                
      Banking subsidiaries     (14 )   (4 )   (3 )   -     -  
      Washington Mutual Finance     (12 )   (8 )   (3 )   (2 )   (2 )
    Multi-family     (1 )   -     (2 )   (15 )   (22 )
    Other real estate     (60 )   (35 )   (4 )   (24 )   (12 )
   
 
 
 
 
 
        Total loans secured by real estate     (173 )   (101 )   (36 )   (79 )   (102 )
  Consumer:                                
    Banking subsidiaries     (70 )   (51 )   (41 )   (46 )   (34 )
    Washington Mutual Finance     (170 )   (138 )   (117 )   (95 )   (88 )
  Commercial business     (73 )   (49 )   (9 )   (3 )   (3 )
   
 
 
 
 
 
      Total loans charged off     (486 )   (339 )   (203 )   (223 )   (227 )
Recoveries of loans previously charged off:                                
  Loans secured by real estate:                                
    Home loans     2     2     1     4     18  
    Purchased specialty mortgage finance     -     -     1     -     -  
    Home equity loans and lines of credit:                                
      Banking subsidiaries     1     1     -     -     -  
      Washington Mutual Finance     -     -     -     -     -  
    Multi-family     1     -     1     3     6  
    Other real estate     12     3     1     4     8  
   
 
 
 
 
 
        Total loans secured by real estate     16     6     4     11     32  
  Consumer:                                
    Banking subsidiaries     13     4     4     3     2  
    Washington Mutual Finance     19     18     17     16     16  
  Commercial business     27     6     1     1     1  
   
 
 
 
 
 
      Total recoveries of loans previously charged off     75     34     26     31     51  
   
 
 
 
 
 
      Net charge-offs     (411 )   (305 )   (177 )   (192 )   (176 )
   
 
 
 
 
 
Balance, end of year   $ 1,653   $ 1,404   $ 1,014   $ 1,042   $ 1,068  
   
 
 
 
 
 
Net charge-offs as a percentage of average loans held in portfolio     0.28 %   0.23 %   0.15 %   0.17 %   0.17 %
Allowance as a percentage of total loans held in portfolio     1.12 %   1.08 %   0.85 %   0.92 %   0.99 %

(1)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

45


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

 
  December 31,
 
 
  2002
  2001
  2000
 
 
  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:                                            
  Loans secured by real estate:                                            
    Home loans   $ 251   0.30 % 56.15 % $ 290   0.37 % 60.87 % $ 250   0.31 % 67.03 %
    Purchased specialty mortgage finance     169   1.67   6.87     97   1.13   6.56     52   0.94   4.63  
   
     
 
     
 
     
 
        Total home loans     420   0.45   63.02     387   0.44   67.43     302   0.35   71.66  
    Home construction loans:                                            
      Builder (2)     15   1.48   0.69     28   1.73   1.25     4   0.91   0.37  
      Custom (3)     7   0.75   0.63     4   0.41   0.75     3   0.30   0.83  
    Home equity loans and lines of credit:                                            
      Banking subsidiaries     46   0.29   10.96     27   0.34   6.12     20   0.35   4.82  
      Washington Mutual Finance     79   4.09   1.31     69   3.29   1.61     57   2.86   1.66  
    Multi-family     146   0.81   12.20     138   0.88   11.98     138   0.88   13.09  
    Other real estate     296   3.71   5.41     161   2.64   4.68     100   2.91   2.88  
   
     
 
     
 
     
 
        Total allocated allowance secured by real estate     1,009   0.73   94.22     814   0.67   93.82     624   0.55   95.31  
  Consumer:                                            
    Banking subsidiaries     70   4.21   1.13     71   3.53   1.54     70   4.19   1.40  
    Washington Mutual
Finance
    71   4.11   1.17     57   3.25   1.35     48   2.76   1.45  
  Commercial business     116   2.26   3.48     92   2.15   3.29     33   1.50   1.84  
   
     
 
     
 
     
 
        Total allocated allowance held in portfolio     1,266   0.86   100.00     1,034   0.79   100.00     775   0.65   100.00  
Unallocated allowance     387   0.26   -     370   0.29   -     239   0.20   -  
   
 
 
 
 
 
 
 
 
 
        Total allowance for loan and lease losses   $ 1,653   1.12 % 100.00 % $ 1,404   1.08 % 100.00 % $ 1,014   0.85 % 100.00 %
   
 
 
 
 
 
 
 
 
 
(Continued on next table)                                            

(1)
Excludes loans held for sale.
(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.

46


 
  December 31,
 
 
  1999
  1998
 
 
  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:                              
  Loans secured by real estate:                              
    Home loans   $ -   - % 70.54 % $ -   - % 73.67 %
    Purchased specialty mortgage finance     -   -   2.74     -   -   -  
   
     
 
     
 
        Total home loans     -   -   73.28     -   -   73.67  
    Home construction loans:                              
      Builder (2)     5   1.48   0.30     1   0.36   0.26  
      Custom (3)     -   -   0.80     -   -   0.69  
    Home equity loans and lines of credit:                              
      Banking subsidiaries     -   -   3.87     -   -   3.20  
      Washington Mutual Finance     -   -   1.26     -   -   1.04  
    Multi-family     59   0.39   13.42     126   0.87   13.53  
    Other real estate     -   -   3.15     -   -   3.90  
   
     
 
     
 
        Total allocated allowance secured by real estate     64   0.06   96.08     127   0.12   96.29  
  Consumer:                              
    Banking subsidiaries     -   -   1.26     -   -   1.35  
    Washington Mutual Finance     -   -   1.43     -   -   1.35  
  Commercial business     18   1.29   1.23     17   1.57   1.01  
   
     
 
     
 
        Total allocated allowance held in portfolio     82   0.07   100.00     144   0.13   100.00  
Unallocated allowance     960   0.85   -     924   0.86   -  
   
 
 
 
 
 
 
        Total allowance for loan and lease losses   $ 1,042   0.92 % 100.00 % $ 1,068   0.99 % 100.00 %
   
 
 
 
 
 
 

(1)
Excludes loans held for sale.
(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.

        During 2000, in conjunction with our continued expansion of our lending activity beyond traditional home 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.

        The amount of loans which were 90 or more days contractually past due and still accruing interest were $60 million, $86 million, $45 million, $60 million and $95 million at December 31, 2002, 2001, 2000, 1999 and 1998.


Operating Segments

        The Company continues to enhance its operating segment reporting process methodologies. These methodologies assign certain balance sheet and income statement items to the responsible operating segment. Methodologies that are applied to the measurement of segment profitability include: (1) a funds transfer pricing system, which matches assets and liabilities with the market benchmark (approximation) of the Company's cost of funds based on the interest rate sensitivity and maturity characteristics and determines how much each interest margin source contributes to the Company's total net interest income; (2) a calculation of the provision for loan and lease losses based on management's current assessment of the expected losses for loan products within each segment, which differs from the "losses inherent in the loan portfolio" methodology that is used to measure the allowance for loan and lease losses under generally accepted accounting principles; (3) the utilization of an activity-based costing approach to measure allocations of certain operating expenses that were not directly charged to the segments; (4) the

47



allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; (5) capital charges for goodwill as a component of an internal measurement of return on the goodwill allocated to the operating segment, which accounts for the additional income the operating segment received via acquisition; and (6) an economic capital model which is the framework for assessing business performance on a risk-adjusted basis. Changing economic conditions, further research and new data may result in revisions to the capital allocation assumptions. Changes to the operating segment structure and to certain of the foregoing performance measurement methodologies were made during the fourth quarter of 2002. Results for the prior periods have been revised to conform to these changes.

        We manage our business along three major operating segments: Banking and Financial Services, Home Loans and Insurance Services and Specialty Finance. Results for Corporate Support/Treasury and Other are also presented.

    Banking and Financial Services

 
  Year Ended December 31,
  Percentage Change
 
 
  2002
  2001
  2000
  2002/2001
  2001/2000
 
 
  (in millions)

   
   
 
Condensed income statement:                            
  Net interest income   $ 3,314   $ 2,321   $ 2,061   43 % 13 %
  Provision for loan and lease losses     160     146     65   10   125  
  Noninterest income     2,222     1,793     1,403   24   28  
  Noninterest expense     3,514     2,512     2,010   40   25  
  Income taxes     713     551     528   29   4  
   
 
 
         
    Net income   $ 1,149   $ 905   $ 861   27   5  
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Operating efficiency (1)     55.22 %   59.18 %   58.21 % (7 ) 2  
  Average loans   $ 20,915   $ 13,123   $ 9,315   59   41  
  Average assets     29,126     17,931     12,441   62   44  
  Average deposits     113,250     82,384     78,074   37   6  

(1)
The efficiency ratio is defined as noninterest expense, excluding goodwill cost of capital, divided by total revenue (net interest income and noninterest income).

        Net income was $1,149 million in 2002, compared with $905 million in 2001 and $861 million in 2000. Net interest income increased to $3,314 million in 2002 from $2,321 million in 2001 and $2,061 million in 2000. A significant portion of the increase in net interest income for 2002 and 2001 was due to increased interest income from higher home equity loans and lines of credit balances and a funding credit from growth in average deposits, mostly Platinum Accounts. A decrease in interest expense, as a result of the lower interest rate environment, also contributed to the increased net interest income.

        Noninterest income was $2,222 million in 2002, up from $1,793 million in 2001 and $1,403 million in 2000. The increase in noninterest income was predominantly due to an increase in depositor and other retail banking fees associated with higher levels of checking fees that resulted from an increased number of noninterest-bearing checking accounts and an increase in securities fees and commissions.

        Higher loan and deposit volumes drove increases in compensation and benefits expense, occupancy and equipment expense, and other direct expenses, which primarily increased noninterest expense to $3,514 million in 2002 from $2,512 million in 2001 and $2,010 million in 2000. The acquisition of Dime and HomeSide also contributed to the increase during 2002.

48



        Total average assets increased by approximately 62% during 2002. This increase was primarily due to the growth in consumer loans, which increased 69% from 2001, as well as an increase in goodwill resulting from the Dime acquisition.

        Total average deposits increased by 37% or $30,866 million during 2002. This increase was largely driven by the growth in Platinum Accounts, partially offset by decreases in money market and time deposit accounts. Total average deposits increased 6%, or $4,310 million, in 2001.

    Home Loans and Insurance Services

 
  Year Ended December 31,
  Percentage Change
 
 
  2002
  2001
  2000
  2002/2001
  2001/2000
 
 
  (in millions)

   
   
 
Condensed income statement:                            
  Net interest income   $ 4,455   $ 2,457   $ 1,864   81 % 32 %
  Provision for loan and lease losses     219     219     101   -   117  
  Noninterest income     2,522     1,469     548   72   168  
  Noninterest expense     2,695     1,433     679   88   111  
  Income taxes     1,525     880     620   73   42  
   
 
 
         
    Net income   $ 2,538   $ 1,394   $ 1,012   82   38  
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Operating efficiency (1)     34.73 %   33.01 %   26.95 % 5   22  
  Average loans   $ 123,954   $ 107,110   $ 86,044   16   24  
  Average assets     173,221     148,614     124,704   17   19  
  Average deposits     13,714     7,860     1,213   74   548  

(1)
The efficiency ratio is defined as noninterest expense, excluding goodwill cost of capital, divided by total revenue (net interest income and noninterest income).

        Segment results for the Home Loans and Insurance Services Group for 2002 were primarily impacted by the addition of the mortgage operations of Dime and HomeSide, as well as the low interest rate environment. Segment results for 2001 were primarily impacted by the addition of the mortgage operations of Fleet Mortgage and PNC Mortgage.

        Net income was $2,538 million in 2002, compared with $1,394 million in 2001 and $1,012 million in 2000. Net interest income increased to $4,455 million in 2002 from $2,457 million in 2001 and $1,864 million in 2000. Substantially all of the increase in 2002 was due to a decrease in funding costs that resulted from the lower interest rate environment and an increase in interest income on loans held for sale resulting from high origination volumes. Predominantly offsetting the decrease in funding costs was a reduction in interest income on available-for-sale mortgage-backed securities and home loans, also due to lower interest rates. The increase in 2001 was primarily due to the growth of loans held for sale, resulting from the substantial increase in home loan volume.

        Noninterest income increased to $2,522 million in 2002, compared with $1,469 million in 2001 and $548 million in 2000. The increases were largely due to increases in revaluation gain from derivatives, investor loan servicing fees, gain from mortgage loans and mortgage banking loan related income. These increases were mostly offset by increases in the impairment and amortization expenses associated with MSR. The increase in noninterest income in 2001 was predominantly due to higher gains from mortgage loans, mortgage banking loan related income and portfolio loan related income.

        Noninterest expense increased to $2,695 million in 2002 from $1,433 million in 2001 and $679 million in 2000. A significant portion of the increase was due to higher compensation and benefits expense,

49



primarily the result of the expanded loan servicing operations added by the Dime and HomeSide acquisitions.

        Total average assets increased by approximately 17% during 2002, primarily as a result of the Dime and HomeSide acquisitions, and by approximately 19% in 2001, primarily as a result of the Fleet Mortgage and PNC Mortgage acquisitions.

    Specialty Finance

 
  Year Ended December 31,
  Percentage Change
 
 
  2002
  2001
  2000
  2002/2001
  2001/2000
 
 
  (in millions)

   
   
 
Condensed income statement:                            
  Net interest income   $ 1,337   $ 1,073   $ 822   25 % 31 %
  Provision for loan and lease losses     271     298     148   (9 ) 101  
  Noninterest income     114     74     42   54   76  
  Noninterest expense     400     294     215   36   37  
  Income taxes     293     208     190   41   9  
   
 
 
         
    Net income   $ 487   $ 347   $ 311   40   12  
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Operating efficiency (1)     21.39 %   21.76 %   23.67 % (2 ) (8 )
  Average loans   $ 30,488   $ 27,684   $ 22,383   10   24  
  Average assets     32,647     29,261     22,839   12   28  
  Average deposits     2,836     2,613     191   9   -  

(1)
The efficiency ratio is defined as noninterest expense, excluding goodwill cost of capital, divided by total revenue (net interest income and noninterest income).

        Net income was $487 million in 2002, up from $347 million in 2001 and $311 million in 2000. Net interest income was $1,337 million in 2002, $1,073 million in 2001 and $822 million in 2000. The increase in net interest income was predominantly due to lower interest expense on funding sources and an increase in interest income on other commercial real estate loans resulting from a 62% increase in the portfolio during 2002, primarily from the Dime acquisition. The increase in net interest income was mostly offset by lower interest income from multi-family and home loans resulting from lower interest rates.

        Noninterest income increased to $114 million in 2002 from $74 million in 2001 and $42 million in 2000, which was predominantly due to increases in loan related income, specifically loan prepayment fees, and other income from the sale of First Community Industrial Bank, a subsidiary of Washington Mutual Finance Corporation, in 2002.

        Noninterest expense increased to $400 million in 2002 from $294 million in 2001 and $215 million in 2000. A major portion of the increase was attributable to higher compensation and benefits expense, telecommunications and outsourced information services expense and other operating expenses, primarily related to the Dime acquisition. This acquisition also contributed to a significant portion of the increase in the cost of capital charged against the resulting goodwill.

        Total average assets increased by approximately 12% during 2002, primarily due to the Dime acquisition. Total average assets increased by approximately 28% in 2001, primarily due to the acquisition of Bank United.

50



    Corporate Support/Treasury and Other

 
  Year Ended December 31,
  Percentage Change
 
 
  2002
  2001
  2000
  2002/2001
  2001/2000
 
 
  (in millions)

   
   
 
Condensed income statement:                            
  Net interest income (expense)   $ (765 ) $ 1,025   $ (436 ) - % - %
  Provision for loan and lease losses     2     2     (1 ) -   -  
  Noninterest income (expense)     (68 )   (88 )   (9 ) (23 ) 878  
  Noninterest expense     591     636     361   (7 ) 76  
  Income taxes (benefit)     (594 )   51     (350 ) -   -  
   
 
 
         
    Net income (loss)   $ (832 ) $ 248   $ (455 ) -   -  
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Average loans   $ 648   $ 829   $ -   (22 ) -  
  Average assets     36,945     30,199     27,588   22   9  
  Average deposits     4,901     3,665     798   34   359  

        Corporate Support/Treasury and Other had a net loss of $832 million in 2002 compared with net income of $248 million in 2001 and a net loss of $455 million in 2000. Net interest expense was $765 million in 2002 compared with net interest income of $1,025 million in 2001 and net interest expense of $436 million in 2000. The changes in net interest income were mostly due to the impact of the funds transfer pricing process to the results of our Treasury operations.

        Noninterest expense was $591 million in 2002 compared with $636 million in 2001 and $361 million in 2000. The decrease from 2001 in noninterest expense was driven by an increased allocation of corporate expenses to the operating segments.


Liquidity

        The objective of liquidity management is to ensure the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet obligations and other commitments on a timely and cost-effective basis. The Company establishes liquidity guidelines for both the consolidated enterprise as well as for the unconsolidated parent holding company, Washington Mutual, Inc., to ensure that Washington Mutual, Inc. can be utilized as a liquidity resource for its banking subsidiaries.

        The principal sources of liquidity for our banking subsidiaries are customer deposits, wholesale borrowings, the maturity and repayment of portfolio loans, securities held in our available-for-sale portfolio and mortgage loans designated as held for sale. Among these sources, transaction deposits and wholesale borrowings from FHLB advances and repurchase agreements continue to provide the Company with a significant source of stable funding. During 2002, those sources funded 71% of average total assets. Our continuing ability to retain our transaction-deposit customer base and to attract new deposits depends on various factors, such as customer service satisfaction levels and the competitiveness of interest rates offered on our deposit products. A decrease in rates offered on interest-bearing Platinum Accounts, in particular, may result in lower levels of interest-bearing checking deposit balances. The Company would primarily use wholesale borrowings to offset any potential declines in deposit balances. We expect that FHLB advances and repurchase agreements will continue to be our most significant sources of wholesale borrowings during 2003, and we expect to have the requisite assets available to pledge as collateral to obtain these funds.

        The continuing expansion of our mortgage banking business during 2002 resulted in higher volumes of loan originations and sales activity. In 2002, the Company's proceeds from the sale of loans held for sale was approximately $218 billion. These proceeds were, in turn, used as the primary funding source for the

51



origination or purchase (net of principal payments) of approximately $223 billion of loans held for sale during the same year. As this cyclical pattern of sales and originations/purchases repeats itself several times over during the course of a year, the amount of funding necessary to sustain our mortgage banking operations does not significantly affect the Company's overall level of liquidity resources.

        To supplement our funding sources, our bank subsidiaries also raise funds in domestic and international capital markets. In April 2001, WMBFA and Washington Mutual Bank ("WMB") established a $15 billion Global Bank Note Program for 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. As of December 31, 2002, our bank subsidiaries had issued $3.85 billion of senior notes and $1.75 billion of subordinated notes under the Program. At December 31, 2002, WMB had $4.75 billion available for issuance as senior debt. WMBFA had $4.65 billion available, of which $250 million was available for subordinated debt (until April 2003) and $650 million was available for issuances with maturities that exceed 270 days.

        At December 31, 2002 and 2001, the Company had unused secured borrowing lines with the Federal Reserve Bank discount window totaling $875 million and $960 million.

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

        Washington Mutual, Inc.'s primary funding source during 2002 was from dividends paid by our bank subsidiaries. Although we expect Washington Mutual, Inc. to continue to receive bank subsidiary dividends during 2003, various regulatory requirements related to capital adequacy and retained earnings limit the amount of dividends that can be paid. For more information on dividend restrictions applicable to our banking subsidiaries, refer to "Business – Regulation and Supervision" and Note 18 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."

        In November 2001, Washington Mutual, Inc. filed a shelf registration statement with the Securities and Exchange Commission that allowed for the issuance of $1.50 billion of senior and subordinated debt in the United States and in international capital markets and in a variety of currencies and structures. In January 2002, $1 billion of senior debt securities were issued under this shelf registration statement. In April 2002, Washington Mutual, Inc. filed a similar shelf registration statement with the Securities and Exchange Commission that allows for the issuance of an additional $1 billion of senior and subordinated debt. In November 2002, Washington Mutual, Inc. issued $750 million of senior debt securities under this shelf registration statement. At December 31, 2002, $750 million remained available for issuance. In February 2003, Washington Mutual, Inc. filed a similar shelf registration statement with the Securities and Exchange Commission that allows for the issuance of an additional $1.25 billion of debt securities, preferred stock and depository shares in the United States and in international capital markets and in a variety of currencies and structures. When the shelf registration statement is declared effective, the Company will have the ability to sell $2 billion of debt or preferred equity securities.

        On August 12, 2002, Washington Mutual, Inc. and Washington Mutual Finance entered into a new three-year revolving credit facility totaling $800 million. This credit facility replaced the two revolving credit facilities totaling $1.20 billion that were in effect until August 9, 2002 and provides back-up for the commercial paper programs of Washington Mutual, Inc. and Washington Mutual Finance as well as funds for general corporate purposes. The facility was arranged by J.P. Morgan Chase Bank and includes a syndicated group of banks. At December 31, 2002, Washington Mutual, Inc. had no commercial paper outstanding and Washington Mutual Finance had $440 million outstanding.

        Effective July 31, 2002, Washington Mutual Finance entered into an agreement with Westdeutsche Landesbank Girozentrale to participate in a $300 million asset-backed commercial paper conduit program. This program has a 364-day term with an option to extend for up to two 364-day periods and provides its own back-up liquidity arrangements, which are not covered by the $800 million credit facility. At

52



December 31, 2002, Washington Mutual Finance had borrowed $300 million and was not entitled to borrow more under this facility.

        The Company maintains a noncontributory cash balance defined benefit pension plan (the "Pension Plan") for substantially all eligible employees. In measuring the variables that determine the funded status of the Pension Plan, three of the more significant assumptions that must be estimated are the expected long-term rate of return on the plan's assets, the discount rate and the compensation rate increase that are used to calculate the accumulated benefit obligation. Due to the deterioration in equity market valuations that has occurred, in particular, over the past two years, the actual performance of the Company's Pension Plan assets for 2002 did not achieve the expected long-term rate of return. Additionally, due to the extremely low interest rate environment that has existed throughout 2002, the assumed discount rate for 2002 was lower than 2001, which increased the present value of the December 31, 2002 estimated accumulated benefit obligation. The Company contributed additional funding of $281 million to the Pension Plan during 2002, which was sufficient to prevent the recognition of a pension liability.

        The Company has used an assumed discount rate of 6.50%, an assumed rate of compensation increase of 5.50% and an expected return on assets of 8.00% to calculate a net periodic expense of $46 million for 2002 and a projected benefit obligation of $1,104 million as of December 31, 2002. Refer to Note 20 to the Consolidated Financial Statements – "Employee Benefits Programs and Other Expense" for further discussion.

        The table below illustrates the potential impact of 50 basis point increases and decreases in the key assumptions outlined above to the 2003 projected net periodic expense and the December 31, 2002 projected benefit obligation (50 basis points is equivalent to one-half of one percent). The 50 basis point increases and decreases represent the Company's estimate of the changes which may occur over a twelve month period.

 
  Basis Points
  Projected 2003
Net Periodic
Expense Impact

  Projected Benefit
Obligation Impact

 
 
  (dollars in millions)

 
Discount rate increase   +50   ($9.1 ) ($71.5 )
Discount rate decrease   -50   9.8   80.0  
Rate of compensation decrease (1)   -50   (2.8 ) (7.8 )
Return on assets increase   +50   (5.2 ) n/a  
Return on assets decrease   -50   5.1   n/a  

(1)
Only the rate of compensation decrease is provided because, due to the current economic conditions, it is not anticipated that the assumed rate of compensation increase will be greater than 5.50%.

53



Capital Adequacy

        Reflecting the effects of the Dime acquisition and strong earnings during 2002, the ratio of stockholders' equity to total assets increased to 7.50% at December 31, 2002 from 5.80% at December 31, 2001.

        The regulatory capital ratios of WMBFA, WMB and Washington Mutual Bank fsb ("WMBfsb") and minimum regulatory requirements to be categorized as well-capitalized were as follows:

 
  December 31, 2002
   
 
 
  Well-Capitalized
Minimum

 
 
  WMBFA
  WMB
  WMBfsb
 
Tier 1 capital to adjusted total assets (leverage)   5.77 % 8.00 % 8.87 % 5.00 %
Adjusted tier 1 capital to risk-weighted assets   9.25   10.27   16.07   6.00  
Total capital to risk-weighted assets   11.37   11.48   17.32   10.00  

        Our federal savings bank subsidiaries are also required by the Office of Thrift Supervision regulations to maintain tangible capital of at least 1.50% of assets. WMBFA and WMBfsb both satisfied this requirement at December 31, 2002.

        Our broker-dealer subsidiaries are also subject to capital requirements. At December 31, 2002, all of our securities subsidiaries were in compliance with their applicable capital requirements.

        During 2002, the Company repurchased 38.0 million shares of our common stock as part of our share repurchase program. On July 16, 2002, the Board of Directors approved an expansion to our share repurchase program thereby authorizing the Company to repurchase 41.2 million additional shares of common stock. At December 31, 2002, our remaining purchase authority was approximately 63.4 million shares. From January 1, 2003 through February 28, 2003, the Company repurchased an additional 6.3 million shares. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.


Market Risk Management

        Market risk is defined as the sensitivity of income, fair market values and capital to changes in interest rates, foreign currency exchange rates, commodity prices and other relevant market rates or prices. The primary market risk to which we are exposed is interest rate risk. Substantially all of our interest rate risk arises from instruments, positions and transactions entered into for purposes other than trading. They include loans, MSR, securities, deposits, borrowings, long-term debt and derivative financial instruments.

        We are exposed to different types of interest rate risks, including lag, repricing, basis, prepayment and lifetime cap risk. These risks are described in further detail in the following paragraphs. We manage interest rate risk within an overall asset/liability management framework. The principal objective of our asset/liability management is to manage the sensitivity of net income to changing interest rates. Asset/liability management is governed by a policy reviewed and approved annually by our Board. The Board has delegated the oversight of the administration of this policy to the Finance Committee.

    Overview of Our Interest Rate Risk Profile

        Increases or decreases in interest rates can cause changes in net income, fluctuations in the fair value of assets and liabilities, such as MSR, investment securities and derivatives, and changes in noninterest income and noninterest expense, particularly gain from mortgage loans, loan servicing fees and the amortization of MSR. Our interest rate risk arises because assets and liabilities reprice, mature, prepay or decay at different times or in accordance with different indices as market interest rates change.

        The slope of the yield curve and the speed of changes in interest rates affect our sensitivity to changes in interest rates. Changes in short-term rates generally have a more immediate effect on our borrowing and deposit rates than on our asset yields. Our deposits and borrowings typically reprice faster than our

54



mortgage loans and securities. The slower repricing of assets results mainly from the lag effect inherent in loans and mortgage-backed securities indexed to the 12-month average of the annual yields on actively traded U.S. Treasury securities adjusted to a constant maturity of one year ("MTA") and to the 11 th District FHLB monthly weighted average cost of funds index ("COFI"). For example, after short-term rates fall, the net interest margin rises and then tends to peak a few months after short-term rates stabilize and then trends downward until asset yields reprice to current market levels.

        Prepayments, loan production, loan mix and gain from mortgage loans are normally all affected by changes in long-term rates. When long-term rates decline, prepayments tend to accelerate and refinancing activity increases, leading to higher overall loan production. In a low rate environment, the proportion of new loans that are fixed-rate increases. This in turn leads to higher gain from mortgage loans, due to our practice of selling the majority of our fixed-rate volume through secondary market channels. Although balance sheet shrinkage may occur during periods of declining or low long-term rates, net interest income may increase due to the expansion of the net interest margin.

        Conversely, when long-term rates increase, prepayments slow and overall loan production is reduced. At the same time, the percentage of new loans that are adjustable-rate loans increases, and we generally retain these loans within our portfolio. Accordingly, balance sheet growth may occur in a rising long-term rate environment, although net interest income may decrease due to the contraction of the net interest margin.

        Changes in long-term rates also impact the fair value and the amortization rate of MSR. The fair value of MSR decreases and the amortization rate increases in a declining long-term interest rate environment due to the higher prepayment activity, resulting in the potential for impairment and a reduction in net loan servicing income. During periods of rising long-term interest rates, the amortization rate of MSR decreases and the fair value of MSR increases, resulting in the potential recovery of the MSR valuation allowance and an increase in net loan servicing income. The timing and amount of any potential MSR recovery cannot be predicted with precision because of its dependency on the timing and magnitude of future interest rate increases and the unpaid principal balances in the relevant interest rate strata at the time of the increase.

        Some of the components of our interest rate risk are counter cyclical. For example, in a declining interest rate environment our net interest income, gain on sale of mortgage instruments, mark-to-market adjustments of MSR risk management instruments and gain on sale of MSR risk management instruments tends to increase. This may be offset by increased amortization and impairment of MSR and reductions in loan servicing fees and increased operating expenses associated with the origination of mortgage loans. Conversely, in a rising interest rate environment our net interest income, gain on sale of mortgage instruments, mark-to-market adjustments of MSR risk management instruments and gain on sale of MSR risk management instruments tends to decrease. This may be offset by decreased amortization of MSR, recovery of MSR valuation allowances, increases in loan servicing fees and decreased operating expenses associated with the origination of mortgage loans. We may adjust the amount or mix of MSR risk management instruments based on the counter cyclical nature of some components of our activities.

    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 MTA. A sharp movement in interest rates will not be fully reflected in the index for

55



twelve months resulting in a lag in the repricing of loans and securities based on this index. This contrasts with borrowings which generally reprice fairly quickly 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 of our 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.

        Basis risk can also impact the ability to offset changes in the fair value of MSR with changes in fair value of MSR risk management instruments. The fair value of MSR is primarily affected by changes in prepayments resulting from shifts in mortgage rates. Changes in the fair value of the MSR risk management instruments vary based on the specific instrument. For example, changes in the fair value of interest rate swaps are driven by shifts in interest rate swap rates while the fair value of U.S. Treasury bonds is based on changes in U.S. Treasury rates. Mortgage rates may move more or less than the rates on Treasury or interest rate swaps. This could result in changes in the fair value of the MSR that differs from the change in fair value of the MSR risk management instruments.

        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 mortgage-backed securities portfolios during these periods. During such periods, it is likely that we would decrease the percentage of adjustable-rate loans that are sold. This may mitigate some of the potential balance sheet shrinkage that results 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 mortgage-backed securities portfolios. During these periods, we may increase the percentage of adjustable-rate loans that are sold. These additional sales may generate gain from mortgage loans 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 mortgage-backed securities 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 mortgage-

56



backed securities 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

        We manage our balance sheet to mitigate the impact of changes in market interest rates on net income. Key components of our balance sheet strategy include the origination and retention of short-term and adjustable-rate assets and the origination and sale of most fixed-rate and certain hybrid adjustable-rate mortgage loans and the management of MSR. We may also modify our interest rate risk profile with interest rate contracts, embedded derivatives and forward purchase commitments.

        The interest rate contracts that are classified as asset/liability management instruments are intended to assist in the management of our net interest income. These contracts are often used to lengthen the repricing period of our interest-bearing funding sources in order to partially offset the temporary compression of the net interest margin that occurs during periods of rising short-term interest rates. The types of contracts used for this purpose consist of interest rate caps, corridors, pay-fixed swaps and payor (pay-fixed) swaptions. The aggregate notional amount of these contracts totaled $45.06 billion at December 31, 2002. None of the interest rate caps had strike rates that were in effect at December 31, 2002. Some of these interest rate contracts are embedded in borrowings.

        The stand alone and embedded payor swaptions are exercisable upon maturity, which ranges from March 2003 to February 2004. The embedded payor swaptions provide protection in rapidly rising interest rate environments, because these instruments offer a mechanism for fixing the rate on our interest-bearing borrowings to an interest rate that could be lower than eventual market levels.

        We also held $5.91 billion of receive-fixed interest rate swaps classified as asset/liability management instruments at December 31, 2002. These instruments, which are indexed to one and three-month LIBOR, are intended to reduce the interest expense on long-term, fixed-rate borrowings during stable or falling interest rate environments. Although these borrowings provide a source for long-term funds, the average life of these long-term borrowings typically exceeds the expected life of our assets and the interest rates on these borrowings may be significantly higher than the interest rate on shorter-term instruments. In addition, a portion of this long-term debt consists of subordinated debt, which the Company issued because it qualifies as a component of Tier 2 risk-based capital subject to regulatory prescribed limits. We purchased receive-fixed interest rate swaps with short-term repricing characteristics to improve the funding rate on these borrowings while maintaining the benefits noted above.

        As part of our overall approach to enterprise interest rate risk management, we manage potential impairment in the fair value of MSR and increased amortization levels of MSR by a comprehensive risk management program. Our intent is to offset the changes in fair value and higher amortization levels of MSR with changes in the fair value of risk management instruments, which include investment securities, interest rate contracts and forward purchase commitments. The goal is to offset decreases (increases) in the fair value of MSR with increases (decreases) in the fair value of the investment securities, interest rate contracts and forward contracts. The investment securities generally consist of fixed-rate debt securities, such as agency and treasury bonds and mortgage-backed securities, including principal-only strips. The interest rate contracts typically consist of interest rate floors, interest rate swaps and receiver (receive-fixed) swaptions. From time to time, we may choose to embed interest rate floor contracts into our borrowing instruments, such as repurchase agreements. The forward purchase commitments generally consist of agreements to purchase 15- and 30-year fixed-rate mortgage-backed securities. We classify the interest rate contracts and forward commitments used in this strategy as MSR risk management instruments. The Company has not attempted to achieve hedge accounting treatment under Statement No. 133 for these instruments.

        As derivatives, the interest rate swaps, receiver swaptions, stand alone interest rate floors and forward purchase commitments are accorded mark-to-market accounting treatment. Changes in the fair value of

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these instruments are recorded as components of non-interest income. For embedded floors with underlying rates that are below the strike rate of the contract, the resulting settlement income associated with the embedded floor is recorded as a component of the interest expense on the underlying repurchase agreement. Since embedded interest rate floor contracts are not considered to be derivatives, their fair values are not marked-to market through earnings. When a borrowing containing an embedded instrument is terminated, the resulting gain or loss on the extinguishment of the borrowing is recognized as a component of non-interest income.

        During the fourth quarter, we continued to reduce our holdings of fixed-rate bonds and receiver swaptions. We increased our holdings of mortgage-backed securities and forward purchase commitments. At December 31, 2002, we held $6.82 billion of U.S. Government and agency securities and $13.94 billion of mortgage-backed securities and forward purchase commitments that were designated as MSR risk management instruments. The increase in mortgage based instruments is intended to reduce the basis risk that results from variances in the changes in fair value of MSR and the hedging instruments. We acquired pay-fixed interest rate swaps in the purchase of HomeSide. The current mix of MSR risk management instruments is intended to enhance the efficiency of our MSR risk management program and to deploy capital more effectively.

        We adjust the mix of instruments used to manage MSR fair value changes as interest rate and market conditions warrant. The intent is to maintain an efficient and fairly liquid mix as well as a diverse portfolio of risk management instruments with broad maturity ranges that match the duration of the MSR on an overall basis. We may elect to increase or decrease our concentration of specific instruments during certain times based on the slope of the yield curve and other market conditions. We believe this approach will result in the most efficient strategy. However, our net income could be adversely affected if we are unable to execute or manage this strategy effectively.

        The mix of instruments is predicated, in part, on the requirement of lower of cost or market accounting treatment for MSR; i.e. each MSR strata is recorded at its fair market value unless the fair market value exceeds the amortized cost. This could result in increases in the fair value of MSR that are not marked-to-market through earnings. Therefore, management may elect to decrease the emphasis on risk management instruments accorded mark-to-market accounting treatment in periods in which the fair market value of MSR is approaching or exceeds its amortized cost.

        We also manage the size and risk profile of the MSR asset. Depending on market conditions and our desire to expand customer relationships, we may periodically sell or purchase additional servicing. We also may sell servicing rights and at times structure loan sales to reduce the size of the MSR asset.

        We also manage the risks associated with our mortgage warehouse and pipeline. The mortgage warehouse consists of fixed-rate and, to a lesser degree, adjustable-rate home loans to be sold in the secondary market. The pipeline consists of commitments to originate fixed-rate and, to a lesser degree, adjustable-rate home loans to be sold in the secondary market. The risk associated with the mortgage pipeline and warehouse is the potential change in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold. This period is usually 60 to 120 days.

        To manage the warehouse and pipeline 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. We also consider the fallout factor, which represents the percentage of loans that are not expected to close, when determining the appropriate amount of forward sales.

        Overall, we believe our risk management program will minimize net income sensitivity under most interest rate environments. However, the success of this program is dependent on the judgments we make regarding the direction and timing of changes in interest rates and the amount and mix of risk management

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instruments that we believe are appropriate to manage our interest rate risk. Our net income could be adversely affected if we are unable to effectively implement, execute or manage this strategy.

    January 1, 2003 and January 1, 2002 Sensitivity Comparison

        To analyze net income sensitivity, we project net income over a twelve month horizon based on parallel shifts in the yield curve. Management employs other analyses and interest rate scenarios to evaluate interest rate risk. For example, we project net income and net interest income under a variety of interest rate scenarios, including non-parallel shifts in the yield curve and more extreme non-parallel rising and falling rate environments. These additional scenarios address the risk exposure over longer periods of time. They also capture the net income sensitivity due to changes in the slope of the yield curve and changes in the spread between Treasury and LIBOR rates.

        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, 2003 and December 31, 2002. The analysis assumes increases in interest rates of 200 basis points and decreases of 100 basis points.

 
  Gradual Change in Rates
 
 
  -100 basis points
  +200 basis points
 
Net income change for the one-year period beginning:          
  January 1, 2003   11.18 % 3.90 %
  January 1, 2002   2.19   (2.76 )
Net interest income change for the one-year period beginning:          
  January 1, 2003   3.32   (5.71 )
  January 1, 2002   1.47   (5.18 )

        Net income and net interest income sensitivity changed since year-end 2001 mainly due to increases in the notional amount of asset/liability risk management instruments, the growth and change in mix of deposits and changes in the profile of the MSR and MSR risk management instruments. The projected profile may not be sustainable and may not be present for non-parallel shifts in the yield curve or changes in the spreads between mortgage, Treasury and LIBOR rates.

        The change in fair value of the MSR is projected to exceed the change in fair value of the MSR risk management instruments in the +200 basis point scenario, while the change in fair market value of the MSR risk management instruments is projected to exceed the change in the fair value of the MSR in the -100 basis point scenario. The net effect is a favorable impact on net income in the -100 and +200 basis point scenarios.

        This unusual profile of the MSR portfolio and related risk management instruments is unlikely to persist for long periods of time as the composition of the MSR portfolio will change due to prepayments and the addition of new production. In addition, changes in interest rates and or spreads between mortgage interest rates, Treasury rates or interest rate swaps could modify the profile of the MSR and the MSR risk management instruments. In addition, the composition of the MSR risk management instruments may change over time. Management may elect to modify or adjust the MSR risk management instruments to improve the performance in non-parallel rate movements.

        Currently, we project the fair value of the MSR to appreciate more in the rising interest rate scenario than the deterioration in the fair value in a comparable falling interest rate scenario. This is an inverse relationship from what we would typically expect, primarily due to the substantial refinancing activity caused by decreases in mortgage rates over the last two years. Due to the current interest rate environment and the weighted average coupon rate of our loans serviced for others portfolio, the assumptions for the valuation of our MSR use a fairly high prepayment rate. Although we project an increase in the

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prepayment rate if interest rates fall further, the change will not be as great as would be expected in a more typical environment. Conversely, we project that prepayment rates will decrease significantly more if interest rates rise than would otherwise be expected in a more typical environment. We do not anticipate that this valuation profile will continue over time.

        Net interest income is projected to decline in the +200 basis point interest environment due to decreases in the net interest margin. The decrease in the margin is somewhat offset by increased balance sheet growth. The projected decline in the net interest margin results from liability rates repricing faster than asset yields. The projected balance sheet growth results from a slowdown in prepayments and a shift to a higher proportion of adjustable rate loans. The slight increase in net interest income sensitivity since the January 1, 2002 projection is due to slight increases in the sensitivity of deposit rates resulting from the higher balances and rates paid on interest-bearing checking accounts. Net income is projected to increase despite the decline in net interest income mainly due to the favorable impact of the MSR and related risk management instruments as discussed above.

        Net interest income is projected to increase in the -100 basis point interest environment due to a slightly higher net interest margin somewhat offset by a reduction in balance sheet growth. The projected decline in the growth of the balance sheet results from faster prepayments and an increase in fixed-rate salable loan production. The projected nominal increase in the net interest margin results from liability rates repricing faster than asset yields. The increased sensitivity of net interest income since the January 1, 2002 projection is due to slight increases in the sensitivity of deposit rates resulting from the higher balances and rates paid on interest-bearing checking accounts. Net income is projected to increase by more than the increase in net interest income mainly due to the favorable impact of the MSR and related risk management instruments as discussed above.

        The projection of the sensitivity of net income requires numerous behavioral assumptions. Prepayment, decay rate (the estimated runoff of deposit accounts that do not have a stated maturity) and loan and deposit volume and mix projections are the most significant assumptions. Prepayments affect the size of the balance sheet, which impacts net interest income, and 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 various interest rate environments. The prepayment and decay rate assumptions reflect management's best estimate of future behavior. These assumptions are derived from internal and external analysis of customer behavior.

        The 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 also varies under different interest rate scenarios. Normally, the gain from mortgage loans 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 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 also involve estimates. The impairment and recovery of MSR is the most significant element of sensitivity in the projection of noninterest income. The fair value of MSR generally increases as interest rates rise and decreases as interest rates fall. The analysis assumes the change in the fair value of MSR and the related risk management instruments is recorded into income and assumes the composition of the MSR risk management instruments remains fairly constant. This assumption may not be realized. The analysis also assumes that mortgage and interest rate swap spreads remain constant in all interest rate environments. Changes in these spreads could result in significant changes in the projected net income sensitivity. For example, given our current mix of MSR risk management instruments, the projected net income would

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increase if market rates on interest rate swaps decreased by more than the decrease in mortgage rates, while the projected net income could decline if the rates on swaps increased by more than mortgage rates. The other components of noninterest income and expense, such as deposit and loan fees and expenses, generally increase or decrease in conjunction with depositor and loan volumes, although loan servicing fees and the amortization of MSR are also dependent on prepayment expectations.


Maturity and Repricing Information

        We use interest rate risk management contracts as tools to manage interest rate risk. The following tables summarize the key contractual terms associated with these contracts. Interest rate risk management contracts that are embedded within certain adjustable and fixed-rate borrowings, while not accounted for as derivatives under Statement No. 133, have been included in the tables since they also function as interest rate risk management tools. Substantially all of the pay-fixed swaps, receive-fixed swaps, payor swaptions, receiver swaptions and embedded derivatives at December 31, 2002 are indexed to three-month LIBOR with the primary exception of a $3.00 billion notional amount of MSR risk management floors which are indexed to the 10-year constant maturity swap.

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        The following estimated net fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies:

 
  December 31, 2002
 
 
  Maturity Range
 
 
  Net
Fair
Value

  Gross
Positive
Fair
Value

  Total
Notional
Amount

  2003
  2004
  2005
  2006
  2007
  After
2007

 
 
  (dollars in millions)

 
Interest Rate Risk Management Contracts:                                                        
  Asset/Liability Management                                                        
    Pay-fixed swaps:   $ (1,143 ) $ -                                            
      Contractual maturity               $ 29,742   $ 8,416   $ 8,834   $ 3,210   $ 4,709   $ 3,700   $ 873  
      Weighted average pay rate                 3.92 %   2.92 %   4.03 %   4.09 %   4.39 %   5.02 %   4.68 %
      Weighted average receive rate                 1.56 %   1.56 %   1.53 %   1.57 %   1.58 %   1.66 %   1.37 %
    Receive-fixed swaps:     591     591                                            
      Contractual maturity               $ 5,905   $ 825   $ 200   $ 530   $ 1,000     -   $ 3,350  
      Weighted average pay rate                 1.39 %   1.21 %   1.65 %   0.90 %   1.40 %   -     1.49 %
      Weighted average receive rate                 5.81 %   5.40 %   6.75 %   5.37 %   6.81 %   -     5.62 %
    Interest rate caps/corridors:     -     -                                            
      Contractual maturity               $ 526   $ 271   $ 191   $ 64     -     -     -  
      Weighted average strike rate                 7.61 %   7.62 %   8.14 %   5.94 %   -     -     -  
    Payor swaptions:     -     -                                            
      Contractual maturity (option)               $ 5,000   $ 5,000     -     -     -     -     -  
      Weighted average strike rate                 6.12 %   6.12 %   -     -     -     -     -  
      Contractual maturity (swap)                 -     -     -     -   $ 1,000   $ 750   $ 3,250  
      Weighted average pay rate                 -     -     -     -     6.05 %   6.26 %   6.11 %
    Embedded pay-fixed swaps:     (207 )   -                                            
      Contractual maturity               $ 2,750     -     -     -     -   $ 2,750     -  
      Weighted average pay rate                 4.73 %   -     -     -     -     4.73 %   -  
      Weighted average receive rate                 1.74 %   -     -     -     -     1.74 %   -  
    Embedded caps:     -     -                                            
      Contractual maturity               $ 641   $ 141   $ 500     -     -     -     -  
      Weighted average strike rate                 7.64 %   7.25 %   7.75 %   -     -     -     -  
    Embedded payor swaptions (1) :     4     4                                            
      Contractual maturity (option)