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


FORM 10-Q


QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

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)

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

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

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

        The number of shares outstanding of the issuer's classes of common stock as of July 30, 2004:

Common Stock – 872,552,275 (1)

(1)
Includes 6,000,000 shares held in escrow.





WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2004

TABLE OF CONTENTS

 
  Page
PART I – Financial Information   1
  Item 1. Financial Statements   1
    Consolidated Statements of Income –
Three and Six Months Ended June 30, 2004 and 2003 (Restated)
  1
    Consolidated Statements of Financial Condition –
June 30, 2004 and December 31, 2003
  3
    Consolidated Statements of Stockholders' Equity and Comprehensive Income –
Six Months Ended June 30, 2004 and 2003 (Restated)
  4
    Consolidated Statements of Cash Flows –
Six Months Ended June 30, 2004 and 2003 (Restated)
  5
    Notes to Consolidated Financial Statements   7
 
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

 

22
    Cautionary Statements   22
    Overview   23
    Controls and Procedures   25
    Critical Accounting Policies   25
    Recently Issued Accounting Standards   26
    Summary Financial Data   27
    Earnings Performance from Continuing Operations   28
    Review of Financial Condition   40
    Operating Segments   42
    Off-Balance Sheet Activities   46
    Asset Quality   47
    Liquidity   50
    Capital Adequacy   52
    Market Risk Management   52
    Maturity and Repricing Information   56
  Item 3. Quantitative and Qualitative Disclosures About Market Risk   52
  Item 4. Controls and Procedures   25

PART II – Other Information

 

62
  Item 1. Legal Proceedings   62
  Item 2. Changes in Securities and Use of Proceeds   62
  Item 4. Submission of Matters to a Vote of Security Holders   63
  Item 6. Exhibits and Reports on Form 8-K   63

i



PART I – FINANCIAL INFORMATION

WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  (Restated)
2003

  2004
  (Restated)
2003

 
 
  (in millions, except per share amounts)

 
Interest Income                          
  Loans held for sale   $ 396   $ 693   $ 724   $ 1,361  
  Loans held in portfolio     2,121     1,905     4,193     3,869  
  Available-for-sale securities     180     468     444     984  
  Other interest and dividend income     55     72     112     152  
   
 
 
 
 
    Total interest income     2,752     3,138     5,473     6,366  
Interest Expense                          
  Deposits     458     548     901     1,135  
  Borrowings     500     604     1,046     1,253  
   
 
 
 
 
    Total interest expense     958     1,152     1,947     2,388  
   
 
 
 
 
      Net interest income     1,794     1,986     3,526     3,978  
  Provision for loan and lease losses     60     81     116     169  
   
 
 
 
 
    Net interest income after provision for loan and lease losses     1,734     1,905     3,410     3,809  
Noninterest Income                          
  Home loan mortgage banking income (expense):                          
    Loan servicing fees     485     593     987     1,206  
    Amortization of mortgage servicing rights     (546 )   (1,032 )   (1,296 )   (2,000 )
    Net mortgage servicing rights valuation adjustments     (51 )   (309 )   (657 )   (272 )
    Revaluation gain (loss) from derivatives     (180 )   598     862     815  
    Net settlement income from certain interest-rate swaps     192     84     359     224  
    Gain from mortgage loans     113     747     284     1,391  
    Other home loan mortgage banking expense, net     (13 )   (70 )   (8 )   (127 )
   
 
 
 
 
      Total home loan mortgage banking income         611     531     1,237  
  Depositor and other retail banking fees     507     454     969     875  
  Securities fees and commissions     105     100     212     189  
  Insurance income     57     48     118     94  
  Portfolio loan related income     103     111     190     227  
  Gain from other available-for-sale securities     41     137     62     131  
  Loss on extinguishment of borrowings     (1 )   (49 )   (90 )   (136 )
  Other income     82     114     139     204  
   
 
 
 
 
    Total noninterest income     894     1,526     2,131     2,821  
Noninterest Expense                          
  Compensation and benefits     849     843     1,748     1,590  
  Occupancy and equipment     393     371     794     672  
  Telecommunications and outsourced information services     123     140     246     280  
  Depositor and other retail banking losses     40     37     80     78  
  Amortization of other intangible assets     14     15     29     31  
  Advertising and promotion     84     80     143     139  
  Professional fees     32     66     71     120  
  Other expense     313     298     617     586  
   
 
 
 
 
    Total noninterest expense     1,848     1,850     3,728     3,496  
   
 
 
 
 
      Income from continuing operations before income taxes     780     1,581     1,813     3,134  
      Income taxes     291     586     676     1,161  
   
 
 
 
 
        Income from continuing operations, net of taxes     489     995     1,137     1,973  
   
 
 
 
 
Discontinued Operations                          
      Income (loss) from discontinued operations before income taxes         34     (32 )   65  
      Gain on disposition of discontinued operations             676      
      Income taxes         12     245     24  
   
 
 
 
 
        Income from discontinued operations, net of taxes         22     399     41  
   
 
 
 
 
Net Income   $ 489   $ 1,017   $ 1,536   $ 2,014  
   
 
 
 
 

(This table is continued on the next page.)

See Notes to Consolidated Financial Statements

1



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME (Continued)
(UNAUDITED)

(This table is continued from the previous page.)

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
  2004
  (Restated)
2003

  2004
  (Restated)
2003

 
  (in millions, except per share amounts)

Basic Earnings Per Common Share:                        
  Income from continuing operations   $ 0.57   $ 1.09   $ 1.32   $ 2.15
  Income from discontinued operations, net         0.03     0.46     0.05
   
 
 
 
  Net income     0.57     1.12     1.78     2.20

Diluted Earnings Per Common Share:

 

 

 

 

 

 

 

 

 

 

 

 
  Income from continuing operations   $ 0.55   $ 1.07   $ 1.29   $ 2.12
  Income from discontinued operations, net         0.02     0.45     0.04
   
 
 
 
  Net income     0.55     1.09     1.74     2.16

Dividends declared per common share

 

 

0.43

 

 

0.30

 

 

0.85

 

 

0.59
Basic weighted average number of common shares outstanding (in thousands)     860,496     910,921     861,898     915,974
Diluted weighted average number of common shares outstanding (in thousands)     883,414     929,386     884,940     932,109

See Notes to Consolidated Financial Statements.

2



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(UNAUDITED)

 
  June 30,
2004

  December 31,
2003

 
 
  (dollars in millions)

 
Assets              
  Cash and cash equivalents   $ 5,133   $ 7,018  
  Federal funds sold and securities purchased under agreements to resell     70     19  
  Available-for-sale securities, total amortized cost of $19,392 and $36,858:              
    Mortgage-backed securities (including assets pledged of $3,157 and $3,642)     10,042     10,695  
    Investment securities (including assets pledged of $8,097 and $19,353)     9,337     26,012  
   
 
 
      Total available-for-sale securities     19,379     36,707  
  Loans held for sale     26,409     20,343  
  Loans held in portfolio     195,929     175,644  
  Allowance for loan and lease losses     (1,293 )   (1,250 )
   
 
 
      Total loans held in portfolio, net of allowance for loan and lease losses     194,636     174,394  
  Investment in Federal Home Loan Banks     3,965     3,462  
  Mortgage servicing rights     7,501     6,354  
  Goodwill     6,196     6,196  
  Assets of discontinued operations         4,184  
  Other assets     15,255     16,501  
   
 
 
      Total assets   $ 278,544   $ 275,178  
   
 
 

Liabilities

 

 

 

 

 

 

 
  Deposits:              
    Noninterest-bearing deposits   $ 33,343   $ 29,968  
    Interest-bearing deposits     129,123     123,213  
   
 
 
      Total deposits     162,466     153,181  
  Federal funds purchased and commercial paper     2,293     2,011  
  Securities sold under agreements to repurchase     15,764     28,333  
  Advances from Federal Home Loan Banks     61,379     48,330  
  Other borrowings     12,113     15,483  
  Liabilities of discontinued operations         3,578  
  Other liabilities     4,160     4,520  
   
 
 
      Total liabilities     258,175     255,436  

Stockholders' Equity

 

 

 

 

 

 

 
  Common stock, no par value: 1,600,000,000 shares authorized, 872,246,088 and 880,985,764 shares issued and outstanding          
  Capital surplus – common stock     3,210     3,682  
  Accumulated other comprehensive loss     (222 )   (524 )
  Retained earnings     17,381     16,584  
   
 
 
      Total stockholders' equity     20,369     19,742  
   
 
 
      Total liabilities and stockholders' equity   $ 278,544   $ 275,178  
   
 
 

See Notes to Consolidated Financial Statements.

3



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
(UNAUDITED)

 
  Number
of
Shares

  Capital
Surplus-
Common
Stock

  Accumulated
Other
Comprehensive
Income (Loss)

  Retained
Earnings

  Total
 
 
  (in millions)

 
BALANCE, December 31, 2002 (Restated)   944.0   $ 5,961   $ 175   $ 13,925   $ 20,061  
Comprehensive income:                              
  Net income               2,014     2,014  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized gain from securities arising during the period, net of reclassification adjustments           240         240  
    Net unrealized loss from cash flow hedging instruments           (25 )       (25 )
    Minimum pension liability adjustment           (4 )       (4 )
                         
 
Total comprehensive income                           2,225  
Cash dividends declared on common stock               (543 )   (543 )
Cash dividends returned (1)               4     4  
Common stock repurchased and retired   (25.5 )   (972 )           (972 )
Common stock returned from escrow   (0.9 )                
Common stock issued   6.6     203             203  
   
 
 
 
 
 
BALANCE, June 30, 2003 (Restated)   924.2   $ 5,192   $ 386   $ 15,400   $ 20,978  
   
 
 
 
 
 

BALANCE, December 31, 2003

 

881.0

 

$

3,682

 

$

(524

)

$

16,584

 

$

19,742

 
Comprehensive income:                              
  Net income               1,536     1,536  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized gain from securities arising during the period, net of reclassification adjustments           106         106  
    Net unrealized gain from cash flow hedging instruments           202         202  
    Minimum pension liability adjustment           (6 )       (6 )
                         
 
Total comprehensive income                           1,838  
Cash dividends declared on common stock               (739 )   (739 )
Common stock repurchased and retired   (16.1 )   (712 )           (712 )
Common stock issued   7.3     240             240  
   
 
 
 
 
 
BALANCE, June 30, 2004   872.2   $ 3,210   $ (222 ) $ 17,381   $ 20,369  
   
 
 
 
 
 

(1)
Represents accumulated dividends on shares returned from escrow.

See Notes to Consolidated Financial Statements.

4



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

 
  Six Months Ended
June 30,

 
 
  2004
  (Restated)
2003

 
 
  (in millions)

 
Cash Flows from Operating Activities              
  Net income   $ 1,536   $ 2,014  
  Income from discontinued operations, net of taxes     (399 )   (41 )
   
 
 
    Income from continuing operations, net of taxes     1,137     1,973  
  Adjustments to reconcile income from continuing operations to net cash used by operating activities:              
    Provision for loan and lease losses     116     169  
    Gain from mortgage loans     (284 )   (1,391 )
    Gain from available-for-sale securities     (62 )   (132 )
    Revaluation gain from derivatives     (862 )   (815 )
    Loss on extinguishment of borrowings     90     136  
    Depreciation and amortization     1,656     2,229  
    Provision for mortgage servicing rights impairment     379     272  
    Stock dividends from Federal Home Loan Banks     (34 )   (76 )
    Origination and purchases of loans held for sale, net of principal payments     (80,491 )   (181,275 )
    Proceeds from sales of loans held for sale     71,930     172,129  
    Decrease in other assets     421     786  
    Decrease in other liabilities     (688 )   (259 )
   
 
 
      Net cash used by operating activities     (6,692 )   (6,254 )
Cash Flows from Investing Activities              
  Purchases of securities     (11 )   (5,449 )
  Proceeds from sales and maturities of mortgage-backed securities     1,383     866  
  Proceeds from sales and maturities of other available-for-sale securities     16,848     940  
  Principal payments on securities     1,775     4,805  
  Purchases of Federal Home Loan Bank stock     (586 )   (279 )
  Redemption of Federal Home Loan Bank stock     117     463  
  Proceeds from sale of mortgage servicing rights         388  
  Origination and purchases of loans held in portfolio     (61,083 )   (48,200 )
  Principal payments on loans held in portfolio     39,442     40,817  
  Proceeds from sales of loans held in portfolio     277     432  
  Proceeds from sales of foreclosed assets     245     250  
  Net increase in federal funds sold and securities purchased under agreements to resell     (51 )   (70 )
  Purchases of premises and equipment, net     (363 )   (482 )
  Proceeds from sale of discontinued operations, net of cash sold     1,223      
   
 
 
    Net cash used by investing activities     (784 )   (5,519 )

(The Consolidated Statements of Cash Flows are continued on the next page.)

See Notes to Consolidated Financial Statements.

5



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)

(Continued from the previous page.)

 
  Six Months Ended
June 30,

 
 
  2004
  (Restated)
2003

 
 
  (in millions)

 
Cash Flows from Financing Activities              
  Net increase in deposits   $ 9,285   $ 10,941  
  Net (decrease) increase in short-term borrowings     (15,204 )   5,412  
  Proceeds from long-term borrowings     2,025     6,303  
  Repayments of long-term borrowings     (2,233 )   (4,165 )
  Proceeds from advances from Federal Home Loan Banks     43,695     42,421  
  Repayments of advances from Federal Home Loan Banks     (30,729 )   (47,548 )
  Cash dividends paid on common stock     (739 )   (543 )
  Repurchase of common stock     (712 )   (972 )
  Other     203     173  
   
 
 
    Net cash provided by financing activities     5,591     12,022  
   
 
 
    Increase (decrease) in cash and cash equivalents     (1,885 )   249  
    Cash and cash equivalents, beginning of period     7,018     7,084  
   
 
 
    Cash and cash equivalents, end of period   $ 5,133   $ 7,333  
   
 
 
Noncash Activities              
  Loans exchanged for mortgage-backed securities   $ 2,830   $ 1,639  
  Real estate acquired through foreclosure     223     239  
Cash Paid During the Period for              
  Interest on deposits   $ 852   $ 1,106  
  Interest on borrowings     1,104     1,243  
  Income taxes     1,058     2,575  

See Notes to Consolidated Financial Statements.

6



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1: Accounting Policies

    Basis of Presentation

        The accompanying Consolidated Financial Statements are unaudited and include the accounts of Washington Mutual, Inc. (together with its subsidiaries "Washington Mutual" or the "Company"). Washington Mutual's accounting and financial reporting policies are in accordance with accounting principles generally accepted in the United States of America. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such periods. Such adjustments are of a normal recurring nature unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with Washington Mutual, Inc.'s 2003 Annual Report on Form 10-K/A. Certain prior period amounts have been reclassified to conform to current period classifications.

    Recently Adopted Accounting Standards

        In December 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46R ("FIN 46R"), Consolidation of Variable Interest Entities , an interpretation of Accounting Research Bulletin No. 51. FIN 46R is a revision to the original FIN 46 that addresses the consolidation of certain variable interest entities. The revision clarifies how variable interest entities should be identified and evaluated for consolidation purposes. FIN 46R must be applied no later than March 31, 2004. The Company applied FIN 46 as of July 1, 2003 and FIN 46R for the quarter ended March 31, 2004. The application of FIN 46R did not have a material effect on the results of operations or financial condition.

        In March 2004, Securities and Exchange Commission ("SEC") Staff Accounting Bulletin No. 105, Loan Commitments Accounted for as Derivative Instruments ("SAB 105") was issued, which provides guidance regarding loan commitments that are accounted for as derivative instruments under Statement of Financial Accounting Standards ("Statement") No. 133 (as amended), Accounting for Derivative Instruments and Hedging Activities . In this Bulletin, the SEC stated that the amount of the expected servicing rights should not be included when determining the fair value of interest rate lock commitments that are considered to be derivatives. This guidance must be applied to rate locks issued after March 31, 2004. In anticipation of this Bulletin, the Company prospectively changed its accounting policy for such rate lock commitments on January 1, 2004. Under the new policy, gains resulting from the valuation of expected servicing rights that had previously been recorded at the issuance of the rate lock are recognized when the underlying loans are sold.

    Recently Issued Accounting Standards

        On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") was enacted into law. On May 19, 2004, the FASB issued Staff Position ("FSP") No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 , which supersedes FSP 106-1 which was issued on January 12, 2004. FSP 106-1 permitted employers that sponsor postretirement benefit plans that provide prescription drug benefits to retirees to make a one-time election to defer the accounting impact, if any, of the Act. The Company elected to defer recognition of the provisions of the Act as permitted by FSP 106-1. FSP 106-2 provides two transition options for companies that previously elected to defer the provisions of the Act, a retroactive application to the date of enactment or a prospective application from the date of adoption. The Company adopted FSP 106-2 as of July 1, 2004 and has elected to prospectively apply the provisions of the Act. The

7


Company is in the process of measuring the effects of the Act on its accumulated postretirement benefit obligation as of June 30, 2004, and as such, the net periodic benefit cost disclosed in Note 6 – "Employee Benefits Programs" does not reflect any amount associated with the subsidy under the Act. The Company does not expect the effects of the Act to have a significant impact on its results of operations or financial condition.

        In March of 2004, the Emerging Issues Task Force ("EITF") reached consensus on the guidance provided in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments . Among other investments, this guidance is applicable to debt and equity securities that are within the scope of Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities . EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. A company's liquidity and capital requirements should be considered when assessing its intent and ability to hold an investment for a reasonable period of time that would allow the fair value of the investment to recover up to or beyond its cost. Although not presumptive, a pattern of selling investments prior to the forecasted fair value recovery may call into question a company's intent. In addition, the severity and duration of the impairment should also be considered when determining whether the impairment is other-than-temporary. This new guidance is effective for reporting periods beginning after June 15, 2004 and the Company is currently evaluating the impact this guidance will have on its process for determining whether other-than-temporary declines exist within its debt and equity investment securities portfolio. Adoption of this guidance may accelerate the recognition of losses from declines in value on debt securities due to interest rates; however, it is not anticipated to have a significant impact on stockholders' equity as changes in market value of available-for-sale securities are already included in Accumulated Other Comprehensive Income.

    Mortgage Servicing Rights Hedging Activities

        The Company began applying fair value hedge accounting treatment, as prescribed by Statement No. 133, as of April 1, 2004 to most of its mortgage servicing rights ("MSR"). Applying fair value hedge accounting to the MSR results in the changes in fair value of the hedging derivatives being netted against the changes in fair value of the hedged MSR, to the extent the hedge relationship is determined to be highly effective. We use standard statistical methods of correlation to determine if the results of the changes in value of the hedging derivative and the hedged item meet the Statement No. 133 criteria for a highly effective hedge accounting relationship. Unlike the lower of cost or market value accounting methodology, the recorded value of the hedged MSR may exceed its original cost basis. The portion of the MSR in which the hedging relationship is determined not to be highly effective will continue to be accounted for at the lower of aggregate cost or market value.

        Hedge ineffectiveness from fair value hedges of MSR as well as any provision for impairment or reversal of such provision recognized on the MSR that are accounted for at the lower of aggregate cost or market value are reported as mortgage servicing rights valuation adjustments on the Consolidated Statements of Income.

        The change in fair value of certain MSR risk management derivatives in which the Company either has not attempted to achieve, or has attempted but did not achieve, hedge accounting treatment under Statement No. 133 is included in revaluation gain (loss) from derivatives on the Consolidated Statements of Income.

8



    Stock-Based Compensation

        In accordance with the transitional guidance of Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure , an amendment of FASB Statement No. 123, the Company elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. For such awards, fair value is estimated using a binomial option pricing model, with compensation expense recognized in earnings over the required service period. Stock-based awards granted prior to January 1, 2003, and not modified after December 31, 2002, will continue to be accounted for under Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees . The pro forma presentation of what the impact to the financial statements would be if these awards were accounted for on the fair value basis will continue to be disclosed in the Notes to Consolidated Financial Statements until the last of those awards vest in 2005.

        Had compensation cost for the Company's stock-based compensation plans been determined using the fair value method consistent with Statement No. 123 for all periods presented, the Company's net income and net income per common share would have been reduced to the pro forma amounts indicated below:

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions, except per share amounts)

 
Net income   $ 489   $ 1,017   $ 1,536   $ 2,014  
Add back: Stock-based employee compensation expense included in reported net income, net of related tax effects     19     22     40     33  
Deduct: Total stock-based employee compensation expense determined under the fair value method for all awards, net of related tax effects     (30 )   (39 )   (61 )   (69 )
   
 
 
 
 
Pro forma net income   $ 478   $ 1,000   $ 1,515   $ 1,978  
   
 
 
 
 

Net income per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 
Basic:                          
  As reported   $ 0.57   $ 1.12   $ 1.78   $ 2.20  
  Pro forma     0.55     1.10     1.76     2.16  
Diluted:                          
  As reported     0.55     1.09     1.74     2.16  
  Pro forma     0.54     1.07     1.71     2.12  

Note 2: Discontinued Operations

        During the first quarter of 2004 the Company sold its subsidiary, Washington Mutual Finance Corporation. Accordingly, Washington Mutual Finance has been accounted for as a discontinued operation and the results of operations and cash flows have been removed from the Company's results of continuing operations for all periods presented on the Consolidated Statements of Income, Cash Flows and Notes to the Consolidated Financial Statements, unless otherwise noted. Likewise, the assets and liabilities of Washington Mutual Finance are presented under separate captions on the Consolidated Statements of Financial Condition. The results from discontinued operations amounted to $399 million, net of tax, which includes a pretax gain of $676 million ($420 million, net of tax) that was recorded upon the sale of Washington Mutual Finance.

9



Note 3: Earnings Per Share

        Information used to calculate earnings per share was as follows:

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
  2004
  2003
  2004
  2003
Weighted average shares (in thousands)                
  Basic weighted average number of common shares outstanding   860,496   910,921   861,898   915,974
  Dilutive effect of potential common shares from:                
    Awards granted under equity incentive programs   13,580   9,435   13,093   8,403
    Trust Preferred Income Equity Redeemable Securities SM   9,338   9,030   9,949   7,732
   
 
 
 
  Diluted weighted average number of common shares outstanding   883,414   929,386   884,940   932,109
   
 
 
 

        For the three and six months ended June 30, 2004, options to purchase an additional 1,812,113 and 1,795,436 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because their inclusion would have had an antidilutive effect. Likewise, for the three and six months ended June 30, 2003, options to purchase an additional 41,700 and 1,907,973 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because their inclusion also would have had an antidilutive effect.

        Additionally, as part of the 1996 business combination with Keystone Holdings, Inc. (the parent of American Savings Bank, F.A.), 6 million shares of common stock, with an assigned value of $18.4944 per share, are being held in escrow for the benefit of certain of the former investors in Keystone Holdings, and their transferees. During 2003, the number of escrow shares was reduced from 18 million to 6 million as a result of the return and cancellation of 12 million shares to the Company. The escrow will expire on December 20, 2008, subject to certain limited extensions. The conditions under which these shares can be released from escrow are related to the outcome of certain litigation and not based on future earnings or market prices. At June 30, 2004, the conditions for releasing the shares from escrow had not occurred, and therefore none of those shares were included in the above computations.

10


Note 4: Mortgage Banking Activities

        Changes in the portfolio of loans serviced for others were as follows:

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Balance, beginning of period   $ 559,807   $ 591,917   $ 582,669   $ 604,504  
  Home loans:                          
    Additions     54,201     105,992     76,210     185,508  
    Sales         (2,960 )       (2,960 )
    Loan payments and other     (56,388 )   (110,867 )   (102,447 )   (203,423 )
  Net change in commercial real estate loans serviced for others     768     (259 )   1,956     194  
   
 
 
 
 
Balance, end of period   $ 558,388   $ 583,823   $ 558,388   $ 583,823  
   
 
 
 
 

        Changes in the balance of MSR, net of the valuation allowance, were as follows:

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Balance, beginning of period   $ 5,239   $ 5,210   $ 6,354   $ 5,341  
  Home loans:                          
    Additions     874     976     1,115     1,915  
    Amortization     (546 )   (1,032 )   (1,296 )   (2,000 )
    (Impairment) reversal     227     (309 )   (379 )   (272 )
    Statement No. 133 MSR accounting valuation adjustments     1,707         1,707      
    Sales         (247 )       (388 )
  Net change in commercial real estate MSR                 2  
   
 
 
 
 
Balance, end of period (1)   $ 7,501   $ 4,598   $ 7,501   $ 4,598  
   
 
 
 
 

(1)
At June 30, 2004 and 2003, the aggregate MSR fair value was $7.52 billion and $4.63 billion.

        Changes in the valuation allowance for MSR were as follows:

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Balance, beginning of period   $ 3,035   $ 3,864   $ 2,435   $ 4,521  
  Impairment (reversal)     (227 )   309     379     272  
  Other than temporary impairment     (388 )   (579 )   (388 )   (1,115 )
  Sales         (150 )       (234 )
  Other     (3 )       (9 )    
   
 
 
 
 
Balance, end of period   $ 2,417   $ 3,444   $ 2,417   $ 3,444  
   
 
 
 
 

11


        At June 30, 2004, the expected weighted average life of the Company's MSR was 4.2 years. Projected amortization expense for the gross carrying value of MSR at June 30, 2004 is estimated to be as follows (in millions):

Remainder of 2004   $ 1,003  
2005     1,652  
2006     1,283  
2007     1,030  
2008     841  
After 2008     4,109  
   
 
Gross carrying value of MSR     9,918  
Less: valuation allowance     (2,417 )
   
 
  Net carrying value of MSR   $ 7,501  
   
 

        The projected amortization expense of MSR is an estimate and should be used with caution. The amortization expense for future periods was calculated by applying the same quantitative factors, such as actual MSR prepayment experience and discount rates, as were used to determine amortization expense at the end of the second quarter of 2004. These factors are inherently subject to significant fluctuations, primarily due to the effect that changes in mortgage rates have on loan prepayment experience. Accordingly, any projection of MSR amortization in future periods is limited by the conditions that existed at the time the calculations were performed, and may not be indicative of actual amortization expense that will be recorded in future periods.

Note 5: Guarantees

        The Company sells loans without recourse that may have to be subsequently repurchased if a defect that occurred during the loan's origination process results in a violation of a representation or warranty made in connection with the sale of the loan. When a loan sold to an investor without recourse fails to perform according to its contractual terms, the investor will typically review the loan file to determine whether defects in the origination process occurred and if such defects constitute a violation of a representation or warranty made to the investor in connection with the sale. If such a defect is identified, the Company may be required to either repurchase the loan or indemnify the investor for losses sustained. If there are no such defects, the Company has no commitment to repurchase the loan. As of June 30, 2004 and December 31, 2003, the amount of loans sold without recourse totaled $552.93 billion and $578.71 billion, which substantially represents the unpaid principal balance of the Company's loans serviced for others portfolio. The Company has reserved $118 million as of June 30, 2004 and $112 million as of December 31, 2003 to cover the estimated loss exposure related to the loan origination process defects that are inherent within this portfolio.

        At June 30, 2004, the Company is the guarantor of five separate issues of trust preferred securities. The Company has issued subordinated debentures to wholly-owned special purpose trusts. Each trust has issued trust preferred securities. The sole assets of each trust are the subordinated debentures issued by the Company. The Company guarantees the accumulated and unpaid distributions of each trust, to the extent the Company provided funding to the trust per the Company's obligation under subordinated debentures, but the trust then failed to fulfill its distribution requirements to the security holders. The maximum potential amount of future payments the Company could be required to make under this guarantee is the expected principal and interest each trust is obligated to remit under the issuance of trust

12



preferred securities, which totaled $2.23 billion as of June 30, 2004. No liability has been recorded as the Company does not expect it will be required to perform under this guarantee.

Note 6: Employee Benefits Programs

    Pension Plan

        Washington Mutual maintains a noncontributory cash balance defined benefit pension plan (the "Pension Plan") for eligible employees. Benefits earned for each year of service are based primarily on the level of compensation in that year plus a stipulated rate of return on the benefit balance. It is the Company's policy to contribute funds to the Pension Plan on a current basis to the extent its contributions are deductible under federal income tax regulations.

    Nonqualified Defined Benefit Plans and Other Postretirement Benefit Plans

        The Company, as successor to previously acquired companies, has assumed responsibility for a number of nonqualified, noncontributory, unfunded postretirement benefit plans, including retirement restoration plans for certain employees, a number of supplemental retirement plans for certain officers and multiple outside directors' retirement plans. Benefits under the retirement restoration plans are generally determined by the Company. Benefits under the supplemental retirement plans and outside directors retirement plans are generally based on years of service.

        The Company, as successor to previously acquired companies, maintains unfunded defined benefit postretirement plans that make medical and life insurance coverage available to eligible retired employees and their beneficiaries and covered dependents. The expected cost of providing these benefits to retirees, their beneficiaries and covered dependents was accrued during the years each employee provided services.

13



        Components of net periodic benefit cost for the Pension Plan, Nonqualified Defined Benefit Plans and Other Postretirement Benefit Plans were as follows:

 
  Three Months Ended June 30,
 
  2004
  2003
 
  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

 
  (in millions)

Interest cost   $ 20   $ 2   $ 1   $ 17   $ 2   $ 1
Service cost     20             13        
Expected return on plan assets     (25 )           (19 )      
Amortization of prior service cost (credit)     1             (1 )      
Recognized net actuarial loss     10             6        
   
 
 
 
 
 
  Net periodic benefit cost   $ 26   $ 2   $ 1   $ 16   $ 2   $ 1
   
 
 
 
 
 
 
  Six Months Ended June 30,
 
  2004
  2003
 
  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

 
  (in millions)

Interest cost   $ 41   $ 4   $ 2   $ 32   $ 4   $ 2
Service cost     43         1     24         1
Expected return on plan assets     (52 )           (36 )      
Amortization of prior service cost (credit)     1         (1 )   (3 )      
Recognized net actuarial loss     18             13        
   
 
 
 
 
 
  Net periodic benefit cost   $ 51   $ 4   $ 2   $ 30   $ 4   $ 3
   
 
 
 
 
 

14


Note 7: Operating Segments

        The Company has grouped its products and services into two primary categories – those marketed to retail consumers and those marketed to commercial customers – and has established three operating segments for the purpose of management reporting: Retail Banking and Financial Services, Mortgage Banking and the Commercial Group. Unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The management reporting process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The Company's operating segments are defined by the products and services they offer.

        The Company uses various methodologies, and continues to enhance those methodologies, to assign certain balance sheet and income statement items to the responsible operating segment. When changes are made to the methodologies used to measure segment profitability, results for prior periods are restated for comparability. A significant change that occurred in the first quarter of 2004 that is reflected in the operating segment financial highlights tables is the modified calculation of the long-term, normalized net charge-off ratio that is used to measure each segment's provision for loan and lease losses. The revised methodology recalibrates this ratio more frequently to the latest available experience factors that are used to measure expected losses on the Company's loan products. In the second quarter of 2004, we applied this methodology change on prior years and reallocated the adjustments on a monthly basis from the original straight-line basis. This change did not have a material impact on 2003's results of operations, but did impact the quarterly results.

        Methodologies that are applied to the measurement of segment profitability include: (1) a funds transfer pricing system, which allocates interest income funding credits and funding charges between the operating segments and the Treasury Division. A segment will receive a funding credit from the Treasury Division for its liabilities. Conversely, a segment is assigned a charge by the Treasury Division to fund its assets. The system is based on the interest rate sensitivities of assets and liabilities and is designed to extract net interest income volatility from the business units and concentrate it in the Treasury Division, where it is managed. Certain basis and other residual risk remains in the operating segments; (2) a calculation of the provision for loan and lease losses based on management's current assessment of the long-term, normalized net charge-off ratio for loan products within each segment, which is recalibrated periodically to the latest available loan loss experience data. This process differs from the "losses inherent in the loan portfolio" methodology that is used to measure the allowance for loan and lease losses at the Corporate level. This methodology is used to provide segment management with provision information for strategic decision making; (3) the utilization of an activity-based costing approach to measure allocations of certain operating expenses that were not directly charged to the segments; (4) the allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; (5) capital charges for goodwill as a component of an internal measurement of return on the goodwill allocated to the operating segment; (6) an economic capital model which is the framework for assessing business performance on a risk-adjusted basis. Changing economic conditions, further research and new data may lead to the update of the capital allocation assumptions; and (7) inter-segment activities which include a process for transferring originated mortgage loans held in portfolio from the Mortgage Banking segment to the Retail Banking and Financial Services segment and a broker fee arrangement between Mortgage Banking and Retail Banking and Financial Services. The process for transferring originated mortgage loans involves Mortgage Banking recognizing a gain on the sale of loans to Retail Banking and Financial Services based on an assumed profit factor. This assumed profit factor is included in Retail Banking and Financial Services loan premiums and amortization of loan premiums. The elimination of

15



inter-segment gains on sale, loan premiums and amortization are included in the reconciliation adjustments column within these Note 7 tables and are described in the associated footnotes. The broker fee arrangement involves Retail Banking and Financial Services receiving revenue for the origination of home loans and Mortgage Banking receiving revenue for the origination of home equity loans and lines of credit. The net amount of the inter-segment broker fees is included in the inter-segment revenue (expense) line within these Note 7 tables.

        The Consumer Group provides access to customers through a wide range of channels, which encompass a network of retail banking stores, retail and wholesale home loan centers, ATMs and online banking. The Consumer Group consists of two distinct operating segments for which separate financial reports are prepared: the Retail Banking and Financial Services segment, and the Mortgage Banking segment.

        The Retail Banking and Financial Services segment offers a diversified set of deposits and consumer lending products and financial services to individual consumers. Loan products include home loans, home equity loans and lines of credit and consumer loans. This segment acquires home loans originated and serviced by the Mortgage Banking segment at a premium, which are amortized over the expected life of the loans. This segment's loan portfolio also includes purchased home loans made to higher risk borrowers. Financial services offered by this segment include the Company's mutual fund management business, WM Advisors, Inc., which provides investment advisory and mutual fund distribution services, and investment advisory and securities brokerage services that are offered by WM Financial Services, Inc., a licensed broker-dealer. Fixed annuities are also offered to the public through licensed bank employees.

        The Mortgage Banking segment originates and services home loans that are sold to secondary market participants and loans that are held in portfolio by the Retail Banking and Financial Services segment. The Mortgage Banking segment charges a servicing fee to the Retail Banking and Financial Services segment for servicing the Company's home loan portfolio. This fee is based on a monthly charge determined by the types of loans serviced. Insurance products that complement the mortgage process, such as private mortgage insurance and property and casualty insurance policies, are also made available through insurance agencies that are part of this segment. This segment also manages the Company's captive reinsurance activities and makes available a variety of life insurance policies.

        The Commercial Group's multiple business activities are managed as one operating segment. This group's products and services include loans made to developers of and investors in multi-family and real estate properties, commercial real estate loan servicing, selling commercial real estate loans to secondary market participants and mortgage banker financing. Through Long Beach Mortgage Company, a wholly-owned subsidiary of the Company and a component of the Company's specialty mortgage finance program, the Commercial Group originates and services home loans made to higher-risk borrowers that are sold to secondary market participants.

        In July 2004 the Company announced that the Commercial Group is exiting certain activities that are no longer strategically aligned with the Group's business objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million.

        The Corporate Support/Treasury and Other category includes management of the Company's interest rate risk, liquidity, capital, and borrowings and the investment securities and the mortgage-backed securities portfolios. This category also includes the costs of the Company's technology services, facilities, legal, accounting and finance, and human resources to the extent not allocated to the business segments. Also reported in this category is the net impact of funds transfer pricing for loan and deposit balances

16



including the effects of changes in interest rates on the Company's net interest margin and the effects of inter-segment allocations of gains and losses related to interest rate risk management instruments.

        Financial highlights by operating segment were as follows:

 
  Three Months Ended June 30, 2004
 
 
  Consumer Group
   
   
   
   
 
 
  Retail
Banking and
Financial
Services

  Mortgage
Banking

  Commercial
Group

  Corporate
Support/
Treasury
and Other

  Reconciling
Adjustments

  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                      
  Net interest income (expense)   $ 1,271   $ 358   $ 340   $ (281 ) $ 106 (1) $ 1,794  
  Provision for loan and lease losses     42     3     10         5 (2)   60  
  Noninterest income     702     199     103     33     (143 ) (3)   894  
  Inter-segment revenue (expense)     7     (7 )                
  Noninterest expense     1,120     649     145     144     (210 ) (4)   1,848  
   
 
 
 
 
 
 
  Income (loss) before income taxes     818     (102 )   288     (392 )   168     780  
  Income taxes (benefit)     310     (39 )   101     (146 )   65 (5)   291  
   
 
 
 
 
 
 
  Net income (loss)   $ 508   $ (63 ) $ 187   $ (246 ) $ 103   $ 489  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     50.07 % (6)   108.71 % (6)   26.10 % (6)   n/a     n/a     68.77 % (7)
  Average loans   $ 158,945   $ 26,999   $ 38,517   $   $ (1,553 ) (8) $ 222,908  
  Average assets     171,306     39,936     43,761     30,687     (1,750 ) (8) (9)   283,940  
  Average deposits     128,680     19,837     6,898     9,391     n/a     164,806  

(1)
Represents the difference between home loan premium amortization recorded by the Retail Banking and Financial Services segment and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, loans that are held in portfolio by the Retail Banking and Financial Services segment are treated as if they are purchased from the Mortgage Banking segment. Since the cost basis of these loans includes an assumed profit factor paid to the Mortgage Banking segment, the amortization of loan premiums recorded by the Retail Banking and Financial Services segment includes this assumed profit factor and must therefore be eliminated as a reconciling adjustment.

(2)
Represents the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.

(3)
Represents the difference between the gain from mortgage loans recorded by the Mortgage Banking segment and the gain from mortgage loans recognized in the Company's Consolidated Statements of Income. As the Mortgage Banking segment holds no loans in portfolio, all loans originated or purchased by this segment are considered to be salable for management reporting purposes.

(4)
Represents the corporate offset for the cost of capital related to goodwill that has been allocated to the segments.

(5)
Represents the tax effect of reconciling adjustments.

(6)
The efficiency ratio is defined as noninterest expense, excluding a cost of capital charge on goodwill, divided by total revenue (net interest income and noninterest income).

(7)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).

(8)
Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking and Financial Services segment recognized from the transfer of portfolio loans from the Mortgage Banking segment.

(9)
Includes the impact to the allowance for loan and lease losses of $197 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.

17


 
  Three Months Ended June 30, 2003
 
 
  Consumer Group
   
   
   
   
 
 
  Retail
Banking and
Financial
Services

  Mortgage
Banking

  Commercial
Group

  Corporate
Support/
Treasury
and Other

  Reconciling
Adjustments

  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                      
  Net interest income (expense)   $ 975   $ 668   $ 316   $ (59 ) $ 86 (1) $ 1,986  
  Provision for loan and lease losses     37     1     26         17 (2)   81  
  Noninterest income     625     953     122         (174 ) (3)   1,526  
  Inter-segment revenue (expense)     45     (45 )                
  Noninterest expense     958     786     139     177     (210 ) (4)   1,850  
   
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     650     789     273     (236 )   105     1,581  
  Income taxes (benefit)     245     300     97     (87 )   31 (5)   586  
   
 
 
 
 
 
 
  Income (loss) from continuing operations, net of taxes     405     489     176     (149 )   74     995  
  Income from discontinued operations, net of taxes             22             22  
   
 
 
 
 
 
 
  Net income (loss)   $ 405   $ 489   $ 198   $ (149 ) $ 74   $ 1,017  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     50.40 % (6)   46.58 % (6)   24.95 % (6)   n/a     n/a     52.66 % (7)
  Average loans   $ 114,390   $ 51,558   $ 34,480   $   $ (1,201 ) (8) $ 199,227  
  Average assets     125,666     73,411     43,133     43,492     (1,665 ) (8) (9)   284,037  
  Average deposits     123,767     30,039     4,868     5,006     n/a     163,680  

(1)
Represents the difference between home loan premium amortization recorded by the Retail Banking and Financial Services segment and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, loans that are held in portfolio by the Retail Banking and Financial Services segment are treated as if they are purchased from the Mortgage Banking segment. Since the cost basis of these loans includes an assumed profit factor paid to the Mortgage Banking segment, the amortization of loan premiums recorded by the Retail Banking and Financial Services segment includes this assumed profit factor and must therefore be eliminated as a reconciling adjustment.

(2)
Represents the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.

(3)
Represents the difference between the gain from mortgage loans recorded by the Mortgage Banking segment and the gain from mortgage loans recognized in the Company's Consolidated Statements of Income. As the Mortgage Banking segment holds no loans in portfolio, all loans originated or purchased by this segment are considered to be salable for management reporting purposes.

(4)
Represents the corporate offset for the cost of capital related to goodwill that has been allocated to the segments.

(5)
Represents the tax effect of reconciling adjustments.

(6)
The efficiency ratio is defined as noninterest expense, excluding a cost of capital charge on goodwill, divided by total revenue (net interest income and noninterest income).

(7)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).

(8)
Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking and Financial Services segment recognized from the transfer of portfolio loans from the Mortgage Banking segment.

(9)
Includes the impact to the allowance for loan and lease losses of $464 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.

18


 
  Six Months Ended June 30, 2004
 
 
  Consumer Group
   
   
   
   
 
 
  Retail
Banking and
Financial
Services

  Mortgage
Banking

  Commercial
Group

  Corporate
Support/
Treasury
and Other

  Reconciling
Adjustments

  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                      
  Net interest income (expense)   $ 2,507   $ 635   $ 680   $ (504 ) $ 208 (1) $ 3,526  
  Provision for loan and lease losses     80     5     25         6 (2)   116  
  Noninterest income (expense)     1,325     959     189     (35 )   (307 ) (3)   2,131  
  Inter-segment revenue (expense)     12     (12 )                
  Noninterest expense     2,191   1,320     297     340     (420 ) (4)   3,728  
   
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     1,573     257     547     (879 )   315     1,813  
  Income taxes (benefit)     596     97     192     (329 )   120 (5)   676  
   
 
 
 
 
 
 
  Income (loss) from continuing operations, net of taxes     977     160     355     (550 )   195     1,137  
  Income from discontinued operations, net of taxes                 399         399  
   
 
 
 
 
 
 
  Net income (loss)   $ 977   $ 160   $ 355   $ (151 ) $ 195   $ 1,536  
   
 
 
 
 
 
 

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Efficiency ratio     50.32% (6)   76.91% (6)   27.39% (6)   n/a     n/a     65.92% (7)
  Average loans   $ 154,150   $ 23,435   $ 37,761   $   $ (1,529 ) (8) $ 213,817  
  Average assets     166,302     37,706     43,316     32,052     (1,703 ) (8)(9)   277,673  
  Average deposits     128,340     17,357     6,474     7,209     n/a     159,380  

(1)
Represents the difference between home loan premium amortization recorded by the Retail Banking and Financial Services segment and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, loans that are held in portfolio by the Retail Banking and Financial Services segment are treated as if they are purchased from the Mortgage Banking segment. Since the cost basis of these loans includes an assumed profit factor paid to the Mortgage Banking segment, the amortization of loan premiums recorded by the Retail Banking and Financial Services segment includes this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(2)
Represents the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.
(3)
Represents the difference between the gain from mortgage loans recorded by the Mortgage Banking segment and the gain from mortgage loans recognized in the Company's Consolidated Statements of Income. As the Mortgage Banking segment holds no loans in portfolio, all loans originated or purchased by this segment are considered to be salable for management reporting purposes.
(4)
Represents the corporate offset for the cost of capital related to goodwill that has been allocated to the segments.
(5)
Represents the tax effect of reconciling adjustments.
(6)
The efficiency ratio is defined as noninterest expense, excluding a cost of capital charge on goodwill, divided by total revenue (net interest income and noninterest income).
(7)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(8)
Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking and Financial Services segment recognized from the transfer of portfolio loans from the Mortgage Banking segment.
(9)
Includes the impact to the allowance for loan and lease losses of $174 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.

19


 
  Six Months Ended June 30, 2003
 
 
  Consumer Group
   
   
   
   
 
 
  Retail
Banking and
Financial
Services

  Mortgage
Banking

  Commercial
Group

  Corporate
Support/
Treasury
and Other

  Reconciling
Adjustments

  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                      
  Net interest income (expense)   $ 1,909   $ 1,345   $ 635   $ (78 ) $ 167 (1) $ 3,978  
  Provision for loan and lease losses     73     1     62         33 (2)   169  
  Noninterest income (expense)     1,198     1,788     218     (63 )   (320 ) (3)   2,821  
  Inter-segment revenue (expense)     95     (95 )                
  Noninterest expense     1,886     1,446     265     317     (418 ) (4)   3,496  
   
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     1,243     1,591     526     (458 )   232     3,134  
  Income taxes (benefit)     468     605     188     (170 )   70 (5)   1,161  
   
 
 
 
 
 
 
  Income (loss) from continuing operations, net of taxes     775     986     338     (288 )   162     1,973  
  Income from discontinued operations, net of taxes             41             41  
   
 
 
 
 
 
 
  Net income (loss)   $ 775   $ 986   $ 379   $ (288 ) $ 162   $ 2,014  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     50.88% (6)   44.21% (6)   24.24% (6)   n/a     n/a     51.42% (7)
  Average loans   $ 115,297   $ 47,065   $ 34,427   $   $ (1,162 ) (8) $ 195,627  
  Average assets     126,861     70,245     42,833     44,076     (1,617 ) (8)(9)   282,398  
  Average deposits     123,503     27,497     4,670     5,139     n/a     160,809  

(1)
Represents the difference between home loan premium amortization recorded by the Retail Banking and Financial Services segment and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, loans that are held in portfolio by the Retail Banking and Financial Services segment are treated as if they are purchased from the Mortgage Banking segment. Since the cost basis of these loans includes an assumed profit factor paid to the Mortgage Banking segment, the amortization of loan premiums recorded by the Retail Banking and Financial Services segment includes this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(2)
Represents the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.
(3)
Represents the difference between the gain from mortgage loans recorded by the Mortgage Banking segment and the gain from mortgage loans recognized in the Company's Consolidated Statements of Income. As the Mortgage Banking segment holds no loans in portfolio, all loans originated or purchased by this segment are considered to be salable for management reporting purposes.
(4)
Represents the corporate offset for the cost of capital related to goodwill that has been allocated to the segments.
(5)
Represents the tax effect of reconciling adjustments.
(6)
The efficiency ratio is defined as noninterest expense, excluding a cost of capital charge on goodwill, divided by total revenue (net interest income and noninterest income).
(7)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(8)
Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking and Financial Services segment recognized from the transfer of portfolio loans from the Mortgage Banking segment.
(9)
Includes the impact to the allowance for loan and lease losses of $455 million that results from the difference between the long-term, normalized net charge-off ratio used to assess expected loan and lease losses for the operating segments and the "losses inherent in the loan portfolio" methodology used by the Company.

20


Note 8: Restatement of Financial Statements

        During the fourth quarter of 2003, the Company concluded that the inclusion of certain components (i.e. deferred acquisition costs and claims stabilization reserves) in the cash surrender value of its bank-owned life insurance policies was incorrect.

        Deferred acquisition costs represent anticipated annual refunds of a lump-sum payment that the Company made to insurers at the inception of the policies to cover the insurers' related federal tax exposure. As the insurers realize the tax benefits of the acquisition costs over a 10-year period, the initial lump-sum payment is refunded to the Company. As the Company expects to receive a full refund of the initial lump-sum payment, the Company previously recorded the initial payment to the insurers as an asset. However, since the contractual agreement indicates the refunds will be made at the insurer's discretion, the immediate recognition of an asset was determined to not be appropriate. Under the revised accounting policy the Company records an expense for the initial lump-sum payments and records income as the payments are refunded.

        Claims stabilization reserves represent funds that have been set aside by the insurer from income earned on investments to be used to fund the Company's self-insured portion of death benefit payments. Provided that the Company holds the policies until all benefit payments have been made, all funds will be remitted to the Company. Since the Company has the intent and ability to hold those policies until such time, the Company previously recorded increases to claims stabilization reserves as assets and recognized income. However, in the event that the Company does not hold the policies until all benefit payments have been made, such funds may not be remitted to the Company. Accordingly, the Company has changed its accounting policy, which now defers the recognition of this asset until benefit payments or refunds from that reserve are received.

        The financial statement effect of the previous accounting treatment resulted in the overstatement of the cash surrender value component of the insurance policies and had the corresponding effect of overstating other noninterest income. Thus, the ensuing restatement decreased other assets and retained earnings by $83 million as of June 30, 2003. The Company has corrected its accounting for all affected prior reporting periods. The table below shows the impact of the restatements on net income and basic and diluted earnings per share for the three and six months ended June 30, 2003:

 
  Three Months
Ended
June 30, 2003

  Six Months
Ended
June 30, 2003

 
 
  (in millions, except per
share amounts)

 
Net Income:              
  Net income as previously reported   $ 1,020   $ 2,023  
  Restatement adjustment     (3 )   (9 )
   
 
 
  Net income as restated   $ 1,017   $ 2,014  
   
 
 
Basic Earnings Per Share:              
  Net income as previously reported   $ 1.12   $ 2.21  
  Restatement adjustment         (0.01 )
   
 
 
  Net income as restated   $ 1.12   $ 2.20  
   
 
 
Diluted Earnings Per Share:              
  Net income as previously reported   $ 1.10   $ 2.17  
  Restatement adjustment     (0.01 )   (0.01 )
   
 
 
  Net income as restated   $ 1.09   $ 2.16  
   
 
 

21


MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

    Restatement of Financial Statements

        During the fourth quarter of 2003, Washington Mutual, Inc. (together with its subsidiaries "Washington Mutual," or the "Company") concluded that the inclusion of certain components (i.e. deferred acquisition costs and claims stabilization reserves) in the cash surrender value of its bank-owned life insurance policies was incorrect. The accounting policy the Company previously used resulted in the overstatement of the cash surrender value of the policies and, accordingly, other noninterest income. This restatement also decreased other assets, and correspondingly, retained earnings by $83 million as of June 30, 2003. The restatement only affects periods commencing with the second quarter of 2000 when the policies were first acquired and had no tax effect. The Company has corrected its accounting for all affected prior reporting periods.

    Discontinued Operations

        On November 24, 2003 the Company announced a definitive agreement to sell its subsidiary, Washington Mutual Finance Corporation, for approximately $1.30 billion in cash. This sale was completed during the first quarter of 2004. Accordingly, Washington Mutual Finance is presented in this report as a discontinued operation with the results of operations and cash flows segregated from the Company's results of continuing operations for all periods presented on the Consolidated Statements of Income, Cash Flows and Notes to the Consolidated Financial Statements as well as the tables presented herein, unless otherwise noted. Likewise, the assets and liabilities of Washington Mutual Finance are presented as separate captions on the Consolidated Statements of Financial Condition.

Cautionary Statements

        Our Form 10-Q and other documents that we file with the Securities and Exchange Commission ("SEC") contain forward-looking statements. In addition, our senior management may make forward-looking statements orally to analysts, investors, the media and others. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may."

        Forward-looking statements provide our expectations or predictions of future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. These statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made. There are a number of factors, many of which are beyond our control, that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. Some of these factors are:

    General business and economic conditions may significantly affect our earnings;

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

    If we are unable to fully realize the operational and systems efficiencies sought to be achieved from our business segment realignment and our cost containment initiative, our earnings could be adversely affected;

    We face competition for loans and deposits from banking and nonbanking companies and national mortgage companies; and

    Changes in the regulation of financial services companies and housing government-sponsored enterprises could adversely affect our business.

22


Overview

        Net income for the second quarter of 2004 was $489 million, or $.55 per diluted share, a decrease from $995 million, or $1.07 per diluted share from continuing operations for the second quarter of 2003.

        Home loan mortgage banking income declined from $531 million in the first quarter of 2004 to zero in the second quarter due to increases in mortgage interest rates during the quarter. At June 30, 2004, the 30-year conforming Freddie Mac fixed mortgage rate was 6.29%, an increase of 84 basis points from 5.45% at March 31, 2004. The performance of the Company's MSR asset, net of hedging and risk management activities was adversely impacted by the sharp increase in rates. As interest rates increased, basis spreads between mortgage rates and interest rate swap indices tightened, resulting in losses on MSR hedging and risk management derivatives that exceeded the increase in value of the MSR.

        An important factor affecting the value of the MSR is the estimated prepayment speed of the underlying loan servicing portfolio. As interest rates increase the propensity for loans to be prepaid decreases as there is less incentive for customers to refinance. This lengthens the expected life of the loan and thus increases the value of the MSR. However, when interest rates increase beyond a point where the coupon rates in the loan servicing portfolio are lower than current market rates, the sensitivity of the MSR to further interest rate increases diminishes. At June 30, 2004, the weighted average coupon rate (annualized) of the loan servicing portfolio was 5.93%, 36 basis points below the 30-year conforming Freddie Mac fixed mortgage rate on that date. The corresponding MSR derivative instruments, in contrast, declined in value in a more linear fashion. Accordingly, these factors caused the decline in value of the derivatives to outpace the increase in value of the MSR.

        The Company began applying fair value hedge accounting treatment to most of its MSR asset on April 1, 2004. To the extent that the hedging relationship is determined to be highly effective, this treatment requires changes in value of the hedging derivatives to be offset by changes in fair value of the hedged MSR. Unlike lower of cost or market value accounting, the recorded value of the hedged MSR may exceed its original cost basis. Had the Company not applied fair value hedge accounting treatment to the MSR asset in the second quarter, the Company estimates that the aggregate amount of MSR valuation changes would have decreased from $1.93 billion to $1.77 billion, which would have decreased noninterest income by approximately $165 million.

        The following table presents the aggregate valuation adjustments for the MSR and the corresponding hedging and risk management derivative instruments during the first and second quarters of 2004 as well as the six months ended June 30, 2004:

 
  Quarter Ended
  Six Months
Ended

 
 
  June 30,
2004

  March 31,
2004

  June 30,
2004

 
 
  (in millions)

 
Statement No. 133 MSR accounting valuation adjustments   $ 1,707   $   $ 1,707  
Change in value of MSR accounted for under lower of aggregate cost or market value methodology     227     (606 )   (379 )
   
 
 
 
  Total MSR valuation changes     1,934     (606 )   1,328  
Statement No. 133 fair value hedging adjustments     (1,985 )       (1,985 )
Revaluation gain (loss) from derivatives – MSR risk management     (322 )   1,108     786  
Net settlement income from certain interest-rate swaps     195     160     355  
   
 
 
 
  Net valuation changes in hedging and risk management instruments     (2,112 )   1,268     (844 )
   
 
 
 
    Total changes in MSR valuation, net of hedging and risk management instruments   $ (178 ) $ 662   $ 484  
   
 
 
 

23


        Gain from mortgage loans, net of risk management instruments increased to $255 million, compared with a net gain of $105 million in the first quarter of 2004. Rates experienced a brief decline during March of 2004, spurring a small refinancing surge and resulting in an increase in home loan volume to $63.15 billion in the second quarter of 2004, up from $50.50 billion in the preceding quarter. However, as mortgage rates subsequently increased, the U.S. mortgage refinance index (seasonally adjusted) declined by 71% between April 1 and June 30, 2004, resulting in much lower home loan application volume during the latter part of the second quarter. Recent forecasts of mortgage industry home loan volume for the second half of 2004 have also been revised downward in anticipation of a continuing slowdown in refinancing activity. As the Company expects the trend of a sustained higher interest rate environment to continue for the remainder of 2004, we expect gain from mortgage loans to decline as home loan volume diminishes.

        A prominent management priority continues to be the cost containment initiative, originally announced in the fourth quarter of 2003. As of June 30, 2004, this initiative has resulted in cumulative headcount reductions of approximately 5,000, excluding temporary and contract workers, with approximately 1,300 additional employees who received termination notices as of that date. This initiative, which is not expected to be completed until the middle of 2005, is primarily directed at reducing the fixed cost structure of the mortgage banking business through employee headcount reductions and facilities closures. Until the cost structure approaches a level that is commensurate with the cost structures of other mortgage banking industry leaders, the profitability and the competitive position of our mortgage banking business will be adversely affected. The primary components of noninterest expense that are impacted by this initiative are compensation and benefits due to headcount reductions and severance charges associated with those reductions, and occupancy and equipment expenses due to facilities closures. A significant milestone within this initiative occurred in July 2004, when the Company completed its conversion of all home loan customer records onto a single servicing system.

        In July 2004, the Company announced that approximately 2,500 additional mortgage banking positions are to be eliminated by the end of the year. The Company also announced in July 2004 that its mortgage banking business will concentrate its activities in markets in which the Company believes it can optimize its retail banking cross-selling opportunities. Customers outside of these markets will continue to be served through existing wholesale and correspondent lending relationships. This initiative resulted in the sale of 94 retail mortgage lending offices in August 2004, with six additional offices expected to be closed or sold by September 30, 2004.

        In July 2004, the Company announced that the Commercial Group is exiting certain activities that are no longer strategically aligned with the Group's business objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million. This initiative will result in the closure, over time, of approximately 50 commercial banking locations and the elimination of approximately 850 positions.

        Ultimately, the reduced expenses to be realized in 2004 from the cost containment initiative are expected to offset this year's incremental costs from the continuing expansion of the retail banking franchise, thus producing a noninterest expense run rate in 2004 that is essentially flat when compared to the total noninterest expense incurred in 2003.

        The net interest margin was 2.86% for the second quarter of 2004, a decline of 36 basis points from the second quarter of 2003 as yields on interest-earning assets continued to decline, primarily from the sales and runoff of higher yielding debt securities and loans during the second half of 2003 and the first part of 2004. On a sequential quarter basis, the margin declined by only three basis points, as it was sustained by the first quarter 2004 termination of approximately $5 billion in higher costing floating-rate Federal Home Loan Bank ("FHLB") advances, along with certain interest rate swaps that had been used to synthetically convert these borrowings to fixed-rate instruments. The sequential quarter performance of the margin also benefited from a significant increase in average noninterest-bearing custodial and escrow

24



deposits, which resulted from the brief increase in refinancing activity during the earlier part of the second quarter. Although the Company expects the margin for the full year of 2004 to fall toward the lower end of our long-term target range of 2.80% to 3.10%, the margin for the subsequent quarters in 2004 is expected to dip below this low point as a result of the Federal Reserve's recent 25 basis point increase in the targeted federal funds rate and due to the significant decline in custodial and escrow deposits at the end of the second quarter, which occurred due to the diminishing levels of refinancing activity. At June 30, 2004, custodial and escrow deposits were $4.18 billion lower than the quarterly average. The margin may face further pressure if the future performance of the domestic economy prompts the Federal Reserve to initiate further rate increases.

        The Company continued to make progress in deepening its retail banking market penetration, as more than 200 net new retail banking stores were opened during the past twelve months and the number of retail checking accounts grew by nearly 800,000 during that period, which contributed to a $53 million increase in depositor and other retail banking fees in the second quarter of 2004 as compared with the same quarter in 2003. During the quarter the Company opened 61 net new retail banking stores, including 20 in the Company's newest market, Tampa-St. Petersburg, Florida and 20 in Chicago, Illinois.

CONTROLS AND PROCEDURES

    Disclosure Controls and Procedures

        The Company's management, under the direction of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or furnishes under the Securities Exchange Act of 1934.

        We review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis and improve our controls and procedures over time and correct any deficiencies that we may discover. While we believe the present design of our disclosure controls and procedures is effective, future events affecting our business may cause us to modify our disclosure controls and procedures.

    Internal Control Over Financial Reporting

        There have not been any changes in the Company's internal control environment over financial reporting during the second quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

Critical Accounting Policies

        The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our Consolidated Financial Statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances as of June 30, 2004.

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

25



valuation of our MSR, the methodology that determines our allowance for loan and lease losses and the assumptions used in the calculation of our net periodic benefit cost. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors. The Company no longer considers its accounting policy for interest rate lock commitments on loans to be held for sale to be critical as the valuation of the expected servicing rights that the Company retains when the underlying loans are sold is no longer recognized at the issuance of the rate lock as a result of the guidance issued in SEC Staff Accounting Bulletin No. 105.

        These policies and the judgments, estimates and assumptions are described in greater detail in the Company's 2003 Annual Report on Form 10-K/A in the "Critical Accounting Policies" section of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

Recently Issued Accounting Standards

        In March of 2004, the Emerging Issues Task Force ("EITF") reached consensus on the guidance provided in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments . Among other investments, this guidance is applicable to debt and equity securities that are within the scope of Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities . EITF 03-1 specifies that an impairment would be considered other-than-temporary unless (a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and (b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. A company's liquidity and capital requirements should be considered when assessing its intent and ability to hold an investment for a reasonable period of time that would allow the fair value of the investment to recover up to or beyond its cost. Although not presumptive, a pattern of selling investments prior to the forecasted fair value recovery may call into question a company's intent. In addition, the severity and duration of the impairment should also be considered when determining whether the impairment is other-than-temporary. This new guidance is effective for reporting periods beginning after June 15, 2004 and the Company is currently evaluating the impact this guidance will have on its process for determining whether other-than-temporary declines exist within its debt and equity investment securities portfolio. Adoption of this guidance may accelerate the recognition of losses from declines in value on debt securities due to interest rates; however, it is not anticipated to have a significant impact on stockholders' equity as changes in market value of available-for-sale securities are already included in Accumulated Other Comprehensive Income.

26


Summary Financial Data

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions, except per share amounts)

 
Profitability                          
  Net interest income   $ 1,794   $ 1,986   $ 3,526   $ 3,978  
  Net interest margin     2.86 %   3.22 %   2.88 %   3.25 %
  Noninterest income   $ 894   $ 1,526   $ 2,131   $ 2,821  
  Noninterest expense     1,848     1,850     3,728     3,496  
  Net income     489     1,017     1,536     2,014  
  Basic earnings per common share:                          
    Income from continuing operations   $ 0.57   $ 1.09   $ 1.32   $ 2.15  
    Income from discontinued operations, net         0.03     0.46     0.05  
   
 
 
 
 
      Net income     0.57     1.12     1.78     2.20  
  Diluted earnings per common share:                          
    Income from continuing operations   $ 0.55   $ 1.07   $ 1.29   $ 2.12  
    Income from discontinued operations, net         0.02     0.45     0.04  
   
 
 
 
 
      Net income     0.55     1.09     1.74     2.16  
  Basic weighted average number of common shares outstanding (in thousands)     860,496     910,921     861,898     915,974  
  Diluted weighted average number of common shares outstanding (in thousands)     883,414     929,386     884,940     932,109  
  Dividends declared per common share   $ 0.43   $ 0.30     0.85   $ 0.59  
  Return on average assets (1)     0.69 %   1.43 %   1.11 %   1.43 %
  Return on average common equity (1)     9.63     19.26     15.21     19.35  
  Efficiency ratio (2) (3)     68.77     52.66     65.92     51.42  
Asset Quality                          
  Nonaccrual loans (4) (5)   $ 1,396   $ 1,893   $ 1,396   $ 1,893  
  Foreclosed assets (5)     286     307     286     307  
   
 
 
 
 
    Total nonperforming assets (5)   $ 1,682   $ 2,200   $ 1,682   $ 2,200  
  Nonperforming assets/total assets (5)     0.60 %   0.78 %   0.60 %   0.78 %
  Restructured loans (5)   $ 79   $ 89   $ 79   $ 89  
   
 
 
 
 
    Total nonperforming assets and restructured loans (5)     1,761     2,289     1,761     2,289  
  Allowance for loan and lease losses (5)     1,293     1,530     1,293     1,530  
  Allowance as a percentage of total loans held in portfolio (5)     0.66 %   1.02 %   0.66 %   1.02 %
  Provision for loan and lease losses   $ 60   $ 81   $ 116   $ 169  
  Net charge-offs     24     81     70     139  
Capital Adequacy (5)                          
  Stockholders' equity/total assets     7.31 %   7.41 %   7.31 %   7.41 %
  Tangible common equity (6) /total tangible assets (6)     5.32     5.26     5.32     5.26  
  Estimated total risk-based capital/risk-weighted assets (7)     10.39     11.68     10.39     11.68  
Per Common Share Data                          
  Book value per common share (5) (8)   $ 23.51   $ 23.13   $ 23.51   $ 23.13  
  Market prices:                          
    High     44.25     43.90     45.28     43.90  
    Low     38.47     35.68     38.47     32.98  
    Period end     38.64     41.30     38.64     41.30  

(1)
Includes income from continuing and discontinued operations for the three months ended June 30, 2003 and six months ended June 30, 2004 and 2003.
(2)
Based on continuing operations.
(3)
The efficiency ratio is defined as noninterest expense, divided by total revenue (net interest income and noninterest income).
(4)
Excludes nonaccrual loans held for sale.
(5)
As of quarter end.
(6)
Excludes unrealized net gain/loss on available-for-sale securities and derivatives, goodwill and intangible assets, but includes MSR.
(7)
Estimate of what the total risk-based capital ratio would be if Washington Mutual, Inc. was a bank holding company that is subject to Federal Reserve Board capital requirements.
(8)
Excludes 6,000,000 shares held in escrow at June 30, 2004, and 17,100,000 shares held in escrow at June 30, 2003.

27


Summary Financial Data (Continued)

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
  2004
  2003
  2004
  2003
 
  (dollars in millions, except per share amounts)

Supplemental Data                        
  Average balance sheet:                        
    Total loans held for sale   $ 31,694   $ 51,519   $ 27,776   $ 49,422
    Total loans held in portfolio     191,214     147,708     186,041     146,205
    Total interest-earning assets     251,264     246,851     245,621     244,831
    Total assets     283,940     284,037     277,673     282,398
    Total interest-bearing deposits     127,670     120,144     125,503     119,560
    Total noninterest-bearing deposits     37,136     43,536     33,877     41,249
    Total stockholders' equity     20,288     21,112     20,188     20,819
  Period-end balance sheet:                        
    Loans held for sale     26,409     44,870     26,409     44,870
    Loans held in portfolio, net of allowance for loan and lease losses     194,636     148,520     194,636     148,520
    Total assets     278,544     283,120     278,544     283,120
    Total deposits     162,466     166,457     162,466     166,457
    Total stockholders' equity     20,369     20,978     20,369     20,978
  Loan volume:                        
    Home loans:                        
      Adjustable rate     29,753     24,847     51,575     48,278
      Fixed rate     26,076     80,107     47,640     152,139
      Specialty mortgage finance (1)     7,323     4,658     14,436     9,187
   
 
 
 
        Total home loan volume     63,152     109,612     113,651     209,604
    Total loan volume     79,521     121,625     141,686     230,404
    Home loan refinancing (2)     40,201     87,772     73,434     170,404
    Total refinancing (2)     42,244     89,881     77,171     173,925

(1)
Represents purchased Specialty Mortgage Finance loan portfolios and mortgages originated by Long Beach Mortgage Company.

(2)
Includes loan refinancing entered into by both new and pre-existing loan customers.

Earnings Performance from Continuing Operations

    Net Interest Income

        Net interest income decreased predominantly from contraction of the net interest margin, which declined by 36 and 37 basis points to 2.86% and 2.88% for the three and six months ended June 30, 2004 from 3.22% and 3.25% for the same periods in 2003, as yields on interest-earning assets continue to decline, primarily as a result of the sales and runoff of higher yielding loans and debt securities during the second half of 2003 and the first part of 2004. The decline in the net interest margin was partially offset by decreases in the cost of deposits. In particular, the average rate paid on interest-bearing checking (Platinum) accounts decreased to 1.39% from 1.89% on an average balance of $61.77 billion and $54.94 billion for the three months ended June 30, 2004 and 2003, and decreased to 1.38% from 1.99% on an average balance of $62.07 billion and $53.68 billion for the six months ended June 30, 2004 and 2003. Further offsetting the decline in the net interest margin was the termination of higher cost FHLB advances along with the termination of swaps hedging those advances. This contributed to the decrease in FHLB funding costs of 68 basis points, from 2.56% at the end of the second quarter 2003 to 1.88% at the end of the second quarter 2004.

        Interest rate contracts, including embedded derivatives, held for asset/liability interest rate risk management purposes decreased net interest income by $74 million and $201 million for the three and six months ended June 30, 2004, compared with $156 million and $304 million for the same periods in 2003.

28



        Detailed average balances of interest and noninterest-earning assets as well as interest income and expense and the weighted average interest rates, were as follows:

 
  Three Months Ended June 30,
 
  2004
  2003
 
  Average
Balance

  Rate
  Interest
Income

  Average
Balance

  Rate
  Interest
Income

 
   
  (dollars in millions)

   
   
Assets                                
Interest-earning assets:                                
  Federal funds sold and securities purchased under agreements to resell   $ 1,030   1.14 % $ 3   $ 3,448   1.29 % $ 11
  Available-for-sale securities (1) :                                
    Mortgage-backed securities     9,887   3.92     97     24,087   5.22     314
    Investment securities     11,975   2.76     83     14,880   4.14     154
  Loans held for sale (2)     31,694   5.00     396     51,519   5.38     693
  Loans held in portfolio (2) (3) :                                
    Loans secured by real estate:                                
      Home     105,360   4.12     1,086     83,426   4.95     1,033
      Purchased specialty mortgage finance     15,361   4.77     183     10,475   5.50     144
   
     
 
     
          Total home loans     120,721   4.20     1,269     93,901   5.01     1,177
      Home equity loans and lines of credit     33,716   4.53     381     19,238   5.13     246
      Home construction:                                
        Builder (4)     1,211   4.35     13     1,103   4.77     13
        Custom (5)     1,299   6.16     20     927   7.48     17
      Multi-family     20,809   4.97     259     19,036   5.34     255
      Other real estate     6,502   6.05     98     7,306   6.25     114
   
     
 
     
          Total loans secured by real estate     184,258   4.43     2,040     141,511   5.15     1,822
    Consumer     927   9.92     23     1,253   8.93     28
    Commercial business     6,029   3.83     58     4,944   4.38     55
   
     
 
     
          Total loans held in portfolio     191,214   4.44     2,121     147,708   5.16     1,905
  Other     5,464   3.84     52     5,209   4.69     61
   
     
 
     
          Total interest-earning assets     251,264   4.38     2,752     246,851   5.08     3,138
Noninterest-earning assets:                                
  Mortgage servicing rights     7,128               4,754          
  Goodwill     6,196               6,196          
  Other (6)     19,352               26,236          
   
           
         
          Total assets   $ 283,940             $ 284,037          
   
           
         

(This table is continued on the next page.)


(1)
The average balance and yield 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 $91 million and $76 million for the three months ended June 30, 2004 and 2003.

(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.

(6)
Includes assets of continuing and discontinued operations for the quarter ended June 30, 2003.

29


(Continued from the previous page.)

 
  Three Months Ended June 30,
 
  2004
  2003
 
  Average
Balance

  Rate
  Interest
Expense

  Average
Balance

  Rate
  Interest
Expense

 
   
  (dollars in millions)

   
   
Liabilities                                
Interest-bearing liabilities:                                
  Deposits:                                
    Interest-bearing checking deposits   $ 65,468   1.28 % $ 208   $ 60,597   1.74 % $ 262
    Savings and money market deposits     29,328   0.82     60     28,229   0.98     69
    Time deposits     32,874   2.31     190     31,318   2.77     217
   
     
 
     
      Total interest-bearing deposits     127,670   1.44     458     120,144   1.83     548
  Federal funds purchased and commercial paper     3,029   1.07     8     2,972   1.27     10
  Securities sold under agreements to repurchase     17,004   2.28     98     20,040   2.66     134
  Advances from Federal Home Loan Banks     59,233   1.88     281     51,916   2.56     334
  Other     12,774   3.56     113     13,297   3.80     126
   
     
 
     
      Total interest-bearing liabilities     219,710   1.74     958     208,369   2.21     1,152
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     37,136               43,536          
  Other liabilities (7)     6,806               11,020          
  Stockholders' equity     20,288               21,112          
   
           
         
      Total liabilities and stockholders' equity   $ 283,940             $ 284,037          
   
           
         
Net interest spread and net interest income         2.64   $ 1,794         2.87   $ 1,986
             
           
Impact of noninterest-bearing sources         0.22               0.35      
Net interest margin         2.86               3.22      

(7)
Includes liabilities of continuing and discontinued operations for the quarter ended June 30, 2003.

30


 
  Six Months Ended June 30,
 
  2004
  2003
 
  Average
Balance

  Rate
  Interest
Income

  Average
Balance

  Rate
  Interest
Income

 
  (dollars in millions)

Assets                                
Interest-earning assets:                                
  Federal funds sold and securities purchased under agreements to resell   $ 1,028   1.24 % $ 6   $ 4,286   1.27 % $ 27
  Available-for-sale securities (1) :                                
    Mortgage-backed securities     9,943   4.14     205     25,142   5.26     661
    Investment securities     15,524   3.08     239     14,903   4.34     323
  Loans held for sale (2)     27,776   5.21     724     49,422   5.51     1,361
  Loans held in portfolio (2) (3) :                                
    Loans secured by real estate:                                
      Home     104,025   4.18     2,174     83,255   5.08     2,116
      Purchased specialty mortgage finance     14,689   4.98     366     10,286   5.72     294
   
     
 
     
          Total home loans     118,714   4.28     2,540     93,541   5.15     2,410
      Home equity loans and lines of credit     31,489   4.62     725     18,248   5.28     480
      Home construction:                                
        Builder (4)     1,164   4.38     26     1,080   4.90     27
        Custom (5)     1,249   6.16     38     923   7.61     35
      Multi-family     20,592   5.02     517     18,758   5.50     516
      Other real estate     6,546   5.91     194     7,525   6.30     237
   
     
 
     
          Total loans secured by real estate     179,754   4.50     4,040     140,075   5.29     3,705
    Consumer     962   10.04     48     1,293   8.94     57
    Commercial business     5,325   3.91     105     4,837   4.42     107
   
     
 
     
          Total loans held in portfolio     186,041   4.51     4,193     146,205   5.30     3,869
  Other     5,309   4.00     106     4,873   5.16     125
   
     
 
     
          Total interest-earning assets     245,621   4.46     5,473     244,831   5.20     6,366
Noninterest-earning assets:                                
  Mortgage servicing rights     6,500               5,103          
  Goodwill     6,196               6,202          
  Other (6)     19,356               26,262          
   
           
         
          Total assets   $ 277,673             $ 282,398          
   
           
         

(This table is continued on the next page.)


(1)
The average balance and yield 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 $160 million and $134 million for the six months ended June 30, 2004 and 2003.

(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.

(6)
Includes assets of continuing and discontinued operations for the six months ended June 30, 2003.

31


(Continued from the previous page.)

 
  Six Months Ended June 30,
 
  2004
  2003
 
  Average
Balance

  Rate
  Interest
Expense

  Average
Balance

  Rate
  Interest
Expense

 
  (dollars in millions)

Liabilities                                
Interest-bearing liabilities:                                
  Deposits:                                
    Interest-bearing checking deposits   $ 66,449   1.28 % $ 422   $ 59,416   1.83 % $ 538
    Savings and money market deposits     28,122   0.79     110     28,056   1.03     143
    Time deposits     30,932   2.39     369     32,088   2.85     454
   
     
 
     
      Total interest-bearing deposits     125,503   1.44     901     119,560   1.91     1,135
  Federal funds purchased and commercial paper     3,261   1.07     18     2,339   1.29     15
  Securities sold under agreements to repurchase     19,479   2.08     205     20,205   2.71     274
  Advances from Federal Home Loan Banks     56,077   2.07     586     53,869   2.64     712
  Other     13,403   3.56     237     13,694   3.66     252
   
     
 
     
      Total interest-bearing liabilities     217,723   1.79     1,947     209,667   2.29     2,388
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     33,877               41,249          
  Other liabilities (7)     5,885               10,663          
  Stockholders' equity     20,188               20,819          
   
           
         
      Total liabilities and stockholders' equity   $ 277,673             $ 282,398          
   
           
         
Net interest spread and net interest income         2.67   $ 3,526         2.91   $ 3,978
             
           
Impact of noninterest-bearing sources         0.21               0.34      
Net interest margin         2.88               3.25      

(7)
Includes liabilities of continuing and discontinued operations for the six months ended June 30, 2003.

32


    Noninterest Income

        Noninterest income from continuing operations consisted of the following:

 
  Three Months Ended June 30,
   
  Six Months Ended June 30,
   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

 
Home loan mortgage banking income (expense):                                  
  Loan servicing income:                                  
    Loan servicing fees   $ 485   $ 593   (18 )% $ 987   $ 1,206   (18 )%
    Amortization of mortgage servicing rights     (546 )   (1,032 ) (47 )   (1,296 )   (2,000 ) (35 )
    MSR valuation adjustments:                                  
      MSR net ineffectiveness under Statement No. 133     (278 )         (278 )      
      MSR lower of cost or market adjustment     227     (309 )     (379 )   (272 ) 39  
   
 
     
 
     
        Net MSR valuation adjustments     (51 )   (309 ) (84 )   (657 )   (272 ) 142  
    Other, net     (89 )   (161 ) (45 )   (155 )   (294 ) (47 )
   
 
     
 
     
          Net home loan servicing expense     (201 )   (909 ) (78 )   (1,121 )   (1,360 ) (18 )
  Revaluation gain (loss) from derivatives     (180 )   598       862     815   6  
  Net settlement income from certain interest-rate swaps     192     84   129     359     224   61  
  Gain from mortgage loans     113     747   (85 )   284     1,391   (80 )
  Loan related income     76     91   (17 )   147     166   (12 )
  Gain from sale of originated mortgage-backed securities                   1   (100 )
   
 
     
 
     
          Total home loan mortgage banking income         611   (100 )   531     1,237   (57 )
Depositor and other retail banking fees     507     454   12     969     875   11  
Securities fees and commissions     105     100   6     212     189   12  
Insurance income     57     48   20     118     94   26  
Portfolio loan related income     103     111   (6 )   190     227   (16 )
Gain from other available-for-sale securities     41     137   (70 )   62     131   (53 )
Loss on extinguishment of borrowings     (1 )   (49 ) (99 )   (90 )   (136 ) (34 )
Other income     82     114   (29 )   139     204   (32 )
   
 
     
 
     
          Total noninterest income   $ 894   $ 1,526   (41 ) $ 2,131   $ 2,821   (24 )
   
 
     
 
     

    Home Loan Mortgage Banking Income

        The decrease in home loan servicing fees for the three and six months ended June 30, 2004 was the result of the decrease in our loans serviced for others portfolio and a decline in the weighted average servicing fee. Our loans serviced for others portfolio decreased as the Company's loan volume mix began to shift from salable production to balance sheet portfolio lending during the second half of 2003 due to the end of the refinancing boom. This caused the volume of new, salable loan production to be lower than the paydown rate of the servicing portfolio.

        The weighted average servicing fee decreased from 36 basis points at June 30, 2003 to 34 basis points at June 30, 2004 largely due to transactions entered into, from time to time, in which a portion of the future contractual servicing cash flows are securitized and sold to third parties. These transactions decreased the net MSR balance by $248 million during the twelve months ending June 30, 2004, but had no impact on the unpaid principal balance of the loans serviced for others portfolio. Additionally, the Company has entered into loan sales and securitizations with certain government-sponsored and private enterprises in which it has retained a smaller servicing fee than is common in the industry. The smaller servicing fee leads to a lower value for the resulting MSR and greater cash proceeds when the loans or securities are sold.

33



        The following table presents the aggregate valuation adjustments for the MSR and the corresponding hedging and risk management derivative instruments during the three and six months ended June 30, 2004 and 2003:

 
  Three Months Ended June 30,
  Six Months Ended June 30,
 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Statement No. 133 MSR accounting valuation adjustments   $ 1,707   $   $ 1,707   $  
Change in value of MSR accounted for under lower of aggregate cost or market value methodology     227     (309 )   (379 )   (272 )
   
 
 
 
 
  Total MSR valuation changes     1,934     (309 )   1,328     (272 )
Statement No. 133 fair value hedging adjustments     (1,985 )       (1,985 )    
Revaluation gain (loss) from derivatives – MSR risk management     (322 )   745     786     1,157  
Net settlement income from certain interest-rate swaps     195     84     355     224  
   
 
 
 
 
    Net valuation change in hedging and risk management instruments     (2,112 )   829     (844 )   1,381  
   
 
 
 
 
      Total change in MSR valuation, net of hedging and risk management instruments   $ (178 ) $ 520   $ 484   $ 1,109  
   
 
 
 
 

        The following tables separately present the risk management results associated with the economic hedges of MSR, loans held for sale and other risk management activities included within noninterest income for the three and six months ended June 30, 2004 and June 30, 2003:

 
  Three Months Ended June 30, 2004
  Six Months Ended June 30, 2004
 
  MSR
  Loans
Held
for Sale

  Other
  Total
  MSR
  Loans
Held
for Sale

  Other
  Total
 
  (in millions)

Revaluation gain (loss) from derivatives   $ (322 ) $ 142   $   $ (180 ) $ 786   $ 76   $   $ 862
Net settlement income (loss) from certain interest-rate swaps     195     (3 )       192     355     4         359
Gain from other available-for-sale securities             41     41     5         57     62
   
 
 
 
 
 
 
 
  Total   $ (127 ) $ 139   $ 41   $ 53   $ 1,146   $ 80   $ 57   $ 1,283
   
 
 
 
 
 
 
 
 
  Three Months Ended
June 30, 2003

  Six Months Ended June 30, 2003
 
  MSR
  Loans
Held
for Sale

  Other
  Total
  MSR
  Loans
Held
for Sale

  Other
  Total
 
  (in millions)

Revaluation gain (loss) from derivatives   $ 745   $ (147 ) $   $ 598   $ 1,157   $ (342 ) $   $ 815
Net settlement income from certain interest-rate swaps     84             84     224             224
Gain (loss) from other available-for-sale securities     140         (3 )   137     140         (9 )   131
   
 
 
 
 
 
 
 
  Total   $ 969   $ (147 ) $ (3 ) $ 819   $ 1,521   $ (342 ) $ (9 ) $ 1,170
   
 
 
 
 
 
 
 

        Revaluation gain (loss) from derivatives is the earnings impact of the changes in fair value from certain derivatives where the Company either has not attempted to achieve, or has attempted but did not achieve, hedge accounting treatment under Statement of Financial Accounting Standards ("Statement") No. 133.

        The Company began applying fair value hedge accounting treatment, as prescribed by Statement No. 133, as of April 1, 2004 to most of its MSR. Applying fair value hedge accounting to the MSR results in the changes in fair value of the hedging derivatives to be netted against the changes in fair value of the hedged MSR, to the extent the hedge relationship is determined to be highly effective. We use standard

34



statistical methods of correlation to determine if the results of the changes in value of the hedging derivative and the hedged item meet the Statement No. 133 criteria for a highly effective hedge accounting relationship. Unlike the lower of cost or market value accounting methodology, the recorded value of the hedged MSR may exceed its original cost basis. The portion of the MSR in which the hedging relationship is determined not to be highly effective will continue to be accounted for at the lower of aggregate cost or market value.

        The total change in MSR valuation, net of hedging and risk management instruments was a loss of $178 million in the second quarter of 2004, compared with a gain of $520 million in the second quarter of 2003. The hedging performance of the MSR asset was affected by the significant increase in mortgage interest rates during the quarter. At June 30, 2004, the 30-year conforming Freddie Mac fixed mortgage rate was 6.29%, an increase of 84 basis points from 5.45% at March 31, 2004. As interest rates increased, basis spreads between mortgage rates and interest rate swap indices tightened, resulting in losses on MSR hedging and risk management derivatives that exceeded the increase in value of the MSR.

        An important factor affecting the value of the MSR is the estimated prepayment speed of the underlying loan servicing portfolio. As interest rates increase the propensity for loans to be prepaid decreases as there is less incentive for customers to refinance. This lengthens the expected life of the loan and thus increases the value of the MSR. However, when interest rates increase beyond a point where the coupon rates in the loan servicing portfolio are lower than current market rates, the sensitivity of the MSR to further interest rate increases diminishes. At June 30, 2004, the weighted average coupon rate (annualized) of the loan servicing portfolio was 5.93%, 36 basis points below the 30-year conforming Freddie Mac fixed mortgage rate on that date. The corresponding MSR derivative instruments, in contrast, declined in value in a more linear fashion. Accordingly, these factors caused the decline in value of the derivatives to outpace the increase in value of the MSR.

        MSR amortization expense was lower in the first half of 2004, compared with the same period in 2003, due to a decline in the high prepayment rates experienced in the first half of 2003 and the large other than temporary MSR impairment recorded in that year.

        During the second quarter of 2004, we recorded other than temporary MSR impairment of $388 million on the MSR asset. This amount was determined by applying an appropriate interest rate shock to the MSR in order to estimate the amount of the valuation allowance we may expect to recover in the foreseeable future. To the extent that the gross carrying value of the MSR, including the Statement No. 133 valuation adjustments, exceeded the estimated recoverable amount, that portion of the gross carrying value was written off as other than temporary impairment. The initial application of fair value hedge accounting treatment to most of the Company's MSR during the second quarter of 2004 effectively resulted in the Company recording much of the recovery in the value as a Statement No. 133 valuation adjustment. Absent the application of Statement 133 to the Company's MSR asset, most of the MSR recovery recognized during the second quarter would have been recorded as a reversal of the valuation allowance.

        The decrease in other home loan servicing expense for the three and six months ended June 30, 2004 resulted from lower loan pool expenses due to the reduction in refinancing activity. Loan pool expenses represent the amount of interest expense that the Company incurs for the elapsed time between the borrower payoff date and the next monthly investor pool cutoff date.

35


        In measuring the fair value of MSR, we stratify the loans in our servicing portfolio based on loan type and coupon rate. For the portion of the MSR that is accounted for under the lower of aggregate cost or market value methodology, an impairment valuation allowance for a stratum is recorded when, and in the amount by which, its fair value is less than its gross carrying value. A reversal of the impairment allowance for a stratum is recorded when its fair value exceeds its net carrying value. However, a reversal in any particular stratum cannot exceed its valuation allowance. At June 30, 2004, we stratified the loans in our servicing portfolio as follows:

 
   
  June 30, 2004
 
  Rate Band
  Gross
Carrying
Value

  Valuation
Allowance

  Net
Carrying
Value

  Fair
Value

 
   
  (in millions)

Primary Servicing:                            
  Adjustable   All loans   $ 1,723   $ 461   $ 1,262   $ 1,262
  Government-sponsored enterprises   6.00% and below     3,324     459     2,865     2,865
  Government-sponsored enterprises   6.01% to 7.49%     1,838     729     1,109     1,109
  Government-sponsored enterprises   7.50% and above     249     92     157     157
  Government   6.00% and below     565     63     502     502
  Government   6.01% to 7.49%     670     231     439     439
  Government   7.50% and above     313     127     186     186
  Private   6.00% and below     536     62     474     474
  Private   6.01% to 7.49%     309     117     192     192
  Private   7.50% and above     115     33     82     82
       
 
 
 
    Total primary servicing         9,642     2,374     7,268     7,268
Master servicing   All loans     110     40     70     70
Specialty home loans   All loans     136         136     155
Multi-family   All loans     30     3     27     27
       
 
 
 
    Total       $ 9,918   $ 2,417   $ 7,501   $ 7,520
       
 
 
 

        At June 30, 2004, key economic assumptions and the sensitivity of the current fair value of home loan MSR to immediate changes in those assumptions were as follows:

 
  June 30, 2004
 
 
  Mortgage Servicing Rights
 
 
  Fixed-Rate
Mortgage Loans

  Adjustable-Rate
Mortgage Loans

   
 
 
  Government and
Government-
Sponsored
Enterprises

  Privately
Issued

  All
Types

  Specialty
Home Loans

 
 
   
  (dollars in millions)

   
 
Fair value of home loan MSR   $ 5,258   $ 748   $ 1,262   $ 155  
Expected weighted-average life (in years)     4.2     4.2     3.9     2.7  

Constant prepayment rate ("CPR") (1)

 

 

14.22

%

 

15.21

%

 

19.10

%

 

30.40

%
  Impact on fair value of 25% decrease in CPR   $ 773   $ 132   $ 224   $ 27  
  Impact on fair value of 50% decrease in CPR     1,802     308     538     66  
  Impact on fair value of 25% increase in CPR     (600 )   (102 )   (167 )   (21 )
  Impact on fair value of 50% increase in CPR     (1,079 )   (186 )   (296 )   (38 )

Discounted cash flow rate ("DCF")

 

 

8.71

%

 

10.19

%

 

9.99

%

 

20.00

%
  Impact on fair value of 10% decrease in DCF     n/a     n/a     n/a   $ 5  
  Impact on fair value of 25% decrease in DCF   $ 448   $ 71   $ 48     12  
  Impact on fair value of 50% decrease in DCF     980     156     155     n/a  
  Impact on fair value of 25% increase in DCF     (383 )   (59 )   (119 )   (10 )
  Impact on fair value of 50% increase in DCF     (713 )   (109 )   (187 )   (18 )

(1)
Represents the expected lifetime average.

36


        These sensitivities are hypothetical and should be used with caution. As the table above demonstrates, our methodology for estimating the fair value of MSR is highly sensitive to changes in assumptions. For example, our determination of fair value uses anticipated prepayment speeds. Actual prepayment experience may differ and any difference may have a material effect on MSR fair value. Changes in fair value based on a variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the MSR is calculated without changing any other assumption; in reality, changes in one factor may be associated with changes in another (for example, increases in market interest rates may result in lower prepayments, but credit losses may increase), which may magnify or counteract the sensitivities. Thus, any measurement of MSR fair value is limited by the conditions existing and assumptions made as of a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time. Refer to "Market Risk Management" for discussion of how MSR prepayment risk is managed and to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" in the Company's 2003 Annual Report on Form 10-K/A for further discussion of how MSR impairment is measured.

        The Company recorded a gain from mortgage loans, net of revaluation gain from derivatives used as loans held for sale risk management instruments, of $255 million and $360 million for the three and six months ended June 30, 2004, compared with a net gain of $600 million and $1.05 billion for the same periods in 2003. Historically low mortgage interest rates during the first part of 2003 generated extremely high levels of salable fixed-rate home loan volume, most of which was the result of refinancing activity. When the industry-wide refinancing boom ended later that year, customer preferences began to shift away from fixed-rate loans to adjustable-rate products. Accordingly, the Company's fixed-rate home loan volume declined from $155.07 billion in the first half of 2003 to $52.09 billion in the same period of 2004. Conversely, short-term adjustable-rate loan volume, which the Company generally retains in its loan portfolio, increased from $10.94 billion in the first half of 2003 to $31.21 billion in the same period of 2004.

        As part of its mortgage banking activities, the Company enters into commitments to originate or purchase loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Changes in fair value that occur subsequent to the issuance of these rate lock commitments are recorded in gain from mortgage loans on the Consolidated Statements of Income. For all reporting periods prior to the first quarter of 2004, the amount of the expected servicing rights to be retained upon the sale of the loans was included in the initial valuation. In March 2004, SEC Staff Accounting Bulletin No. 105 ("SAB 105") was issued, which provided guidance regarding loan commitments that are intended to be sold. In this Bulletin, the SEC stated that the amount of the expected servicing rights should not be included when determining the fair value of interest rate lock commitments on mortgage loans that are intended to be sold. The guidance in SAB 105 must be applied to such interest rate locks issued after March 31, 2004. In anticipation of this Bulletin, the Company prospectively changed its accounting policy for rate lock commitments on January 1, 2004. Under the new policy, gains resulting from the valuation of expected servicing rights that had previously been recorded at the issuance of the rate lock are not recognized until the underlying loans are sold or securitized. Generally, loans held for sale are sold within 60 to 120 days after the issuance of the rate lock commitment.

        As part of its normal servicing activities, the Company repurchases delinquent mortgages contained within Government National Mortgage Association ("GNMA") loan servicing pools and, in general, resells them to secondary market participants. Accordingly, gains from the resale of these mortgages are reported as gain from mortgage loans. In one part of the Company's program, certain loans that have been 30 days past due for three consecutive months (referred to as "rolling 30 loans") are repurchased from GNMA and then resold in the secondary market. In the other, certain loans that have missed three consecutive payments are likewise purchased and resold. Gain from the sale of these loans was $45 million and $100 million for the three and six months ended June 30, 2004 and $152 million and $228 million for the

37



same periods in 2003. The Company does not have the option of repurchasing "rolling 30 loans" from pools created after January 1, 2003, but continues to make such purchases from previously created pools. Over time, we expect gains from the repurchase of "rolling 30 loans" to diminish as the pools that are eligible for repurchase are depleted.

        The fair value changes in loans held for sale and the offsetting changes in the derivative instruments used as fair value hedges are recorded within gain from mortgage loans when hedge accounting treatment is achieved. Loans held for sale where hedge accounting treatment is not achieved ("nonqualifying" loans held for sale) are not recorded at fair value and are instead recorded at the lower of aggregate cost or market value. Due to changes in the fair value of derivatives acquired to mitigate the risk of fair value changes to these nonqualifying loans, net gains of $142 million and $76 million were recognized as revaluation gains from derivatives during the three and six months ended June 30, 2004, compared with revaluation losses of $147 million and $342 million for the same periods in 2003. A gain may be recognized when the loans are subsequently sold if the fair value of those loans is higher than the carrying amount. As of June 30, 2004, the fair value of loans held for sale was $26.53 billion with a carrying amount of $26.41 billion, and as of December 31, 2003, the fair value and carrying amount were $20.34 billion.

        Net settlement income from certain interest-rate swaps consisted of receive-fixed swaps, which were used predominantly as MSR risk management derivatives. At June 30, 2004, the total notional amount of these receive-fixed swaps was $34.13 billion, compared with $8.15 billion at June 30, 2003.

    All Other Noninterest Income Analysis

        The increase in depositor and other retail banking fees for the three and six months ended June 30, 2004, compared with the same periods in 2003, was largely due to higher levels of checking fees that resulted from an increase in the number of noninterest-bearing checking accounts and an increase in ATM and debit card related income. The number of noninterest-bearing checking accounts at June 30, 2004 totaled approximately 6.8 million, compared with approximately 6.1 million at June 30, 2003.

        Insurance income increased during the three and six months ended June 30, 2004 substantially due to the continued growth in our captive reinsurance programs.

        Gain from other available-for-sale securities decreased to $41 million for the second quarter of 2004 from $137 million for the same period in 2003. During the second quarter of 2003, sales of approximately $1.69 billion in mortgage-backed securities and investment securities resulted in gains of $140 million, all of which were designated as MSR risk management instruments. There was no comparable activity for the same period in 2004. During the second quarter of 2004, the Company sold mortgage-backed securities retained from a fourth quarter 2003 multi-family securitization and recognized a gain of $25 million.

        During the first half of 2004, the Company terminated certain pay-fixed swaps hedging variable rate FHLB advances, resulting in a loss on extinguishment of borrowings of approximately $90 million. Several securities sold under agreements to repurchase ("repurchase agreements") that contained embedded pay-fixed swaps were restructured during the first half of 2003, resulting in losses on extinguishment of borrowings of $49 million and $136 million for the three and six months ended June 30, 2003. The restructured repurchase agreements contain embedded pay-fixed swaps with the same terms except with a lower pay rate.

        The decrease in other income for the three and six months ended June 30, 2004 was largely due to a decline in the income recorded on residual interests in collateralized mortgage obligations and an increase in losses on sales of mortgage-backed securities classified as trading securities.

38


    Noninterest Expense

        Noninterest expense from continuing operations consisted of the following:

 
  Three Months Ended
June 30,

   
  Six Months Ended
June 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

 
Compensation and benefits   $ 849   $ 843   1 % $ 1,748   $ 1,590   10 %
Occupancy and equipment     393     371   6     794     672   18  
Telecommunications and outsourced information services     123     140   (12 )   246     280   (12 )
Depositor and other retail banking losses     40     37   10     80     78   3  
Amortization of other intangible assets     14     15   (5 )   29     31   (8 )
Advertising and promotion     84     80   6     143     139   3  
Professional fees     32     66   (51 )   71     120   (41 )
Postage     58     59   (1 )   116     113   2  
Loan expense     56     61   (8 )   109     120   (10 )
Travel and training     33     41   (18 )   63     73   (14 )
Reinsurance expense     19     15   26     38     31   22  
Other expense     147     122   19     291     249   19  
   
 
     
 
     
  Total noninterest expense   $ 1,848   $ 1,850     $ 3,728   $ 3,496   7  
   
 
     
 
     

        A significant portion of the increase in employee compensation and benefits for the six months ended June 30, 2004 over the same period in 2003 was due to lower levels of compensation expense that are deferrable as direct loan origination costs. Also contributing to the increase was the continued expansion of the retail banking network. Partially offsetting the increase was a decrease in incentive and commission compensation, resulting from lower loan volumes, and a reduction in temporary help expense. The number of employees was 57,274 at June 30, 2004, compared with 61,374 at December 31, 2003 and 57,769 at June 30, 2003. A $43 million charge was also recorded for severance expense related to staffing reductions that occurred as part of the Company's ongoing cost containment initiative.

        The increase in occupancy and equipment expense for the three and six months ended June 30, 2004 resulted primarily from higher equipment depreciation expense and building rent expense. Depreciation expense increased due to the completion of technology projects that were placed in service during the second quarter of 2003. The increase in rent expense was due to the continued expansion of new retail banking stores throughout 2003 and the first half of 2004. In addition, a $37 million charge was recognized for the discontinued use of facilities, including lease terminations and the write-off of surplus property during the first half of 2004.

        Substantially all of the decrease in professional fees for the three and six months ended June 30, 2004 compared to the same periods in 2003 resulted from decreases in fees associated with technology-related projects.

39


Review of Financial Condition

    Assets

        At June 30, 2004, our assets increased from year-end predominantly due to an increase in loans held for sale and loans held in portfolio, largely offset by a decrease in investment securities and the sale of Washington Mutual Finance.

    Securities

        Securities consisted of the following:

 
  June 30, 2004
 
  Amortized
Cost

  Unrealized
Gains

  Unrealized
Losses

  Fair
Value

 
  (in millions)

Available-for-sale securities                        
Mortgage-backed securities:                        
  U.S. Government and agency   $ 8,475   $ 152   $ (29 ) $ 8,598
  Private issue     1,406     38         1,444
   
 
 
 
    Total mortgage-backed securities     9,881     190     (29 )   10,042
Investment securities:                        
  U.S. Government and agency     9,097         (194 )   8,903
  Other debt securities     290     15         305
  Equity securities     124     6     (1 )   129
   
 
 
 
    Total investment securities     9,511     21     (195 )   9,337
   
 
 
 
      Total available-for-sale securities   $ 19,392   $ 211   $ (224 ) $ 19,379
   
 
 
 
 
  December 31, 2003
 
  Amortized
Cost

  Unrealized
Gains

  Unrealized
Losses

  Fair
Value

 
  (in millions)

Available-for-sale securities                        
Mortgage-backed securities:                        
  U.S. Government and agency   $ 8,687   $ 140   $ (26 ) $ 8,801
  Private issue     1,849     46     (1 )   1,894
   
 
 
 
    Total mortgage-backed securities     10,536     186     (27 )   10,695
Investment securities:                        
  U.S. Government and agency     25,950     5     (340 )   25,615
  Other debt securities     247     17     (2 )   262
  Equity securities     125     11     (1 )   135
   
 
 
 
    Total investment securities     26,322     33     (343 )   26,012
   
 
 
 
      Total available-for-sale securities   $ 36,858   $ 219   $ (370 ) $ 36,707
   
 
 
 

        The realized gross gains and losses of securities for the periods indicated were as follows:

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Available-for-sale securities                          
Realized gross gains   $ 123   $ 175   $ 198   $ 177  
Realized gross losses     (82 )   (38 )   (136 )   (45 )
   
 
 
 
 
  Realized net gain   $ 41   $ 137   $ 62   $ 132  
   
 
 
 
 

40


        Our investment securities decreased predominantly due to the sale of U.S. Government and agency bonds. The proceeds from the sales of these securities were used, in part, to allow for the growth in the loan portfolio.

    Loans

        Loans held in portfolio consisted of the following:

 
  June 30,
2004

  December 31,
2003

 
  (in millions)

Loans secured by real estate:            
  Home   $ 106,312   $ 100,043
  Purchased specialty mortgage finance     16,217     12,973
   
 
      Total home loans     122,529     113,016
  Home equity loans and lines of credit     36,077     27,647
  Home construction:            
    Builder (1)     1,241     1,052
    Custom (2)     1,364     1,168
  Multi-family     21,156     20,324
  Other real estate     6,513     6,649
   
 
      Total loans secured by real estate     188,880     169,856
Consumer     892     1,028
Commercial business     6,157     4,760
   
 
        Total loans held in portfolio   $ 195,929   $ 175,644
   
 

(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.

        Our loans held in portfolio increased predominantly due to an increase in home loans and home equity loans and lines of credit. Substantially all of the growth in the home loan and home equity loans and lines of credit portfolios resulted from the origination of short-term adjustable-rate products.

    Other Assets

        Other assets consisted of the following:

 
  June 30,
2004

  December 31,
2003

 
  (in millions)

Premises and equipment   $ 3,311   $ 3,286
Investment in bank-owned life insurance     2,624     2,582
Accrued interest receivable     1,477     1,558
Foreclosed assets     286     311
Other intangible assets     222     251
Derivatives     1,105     1,457
Trading securities     1,336     1,381
Accounts receivable     3,577     4,309
Other     1,317     1,366
   
 
  Total other assets   $ 15,255   $ 16,501
   
 

41


    Deposits

        Deposits consisted of the following:

 
  June 30,
2004

  December 31,
2003

 
  (in millions)

Retail deposits:            
  Checking deposits:            
    Noninterest bearing   $ 15,666   $ 13,724
    Interest bearing     59,395     67,990
   
 
      Total checking deposits     75,061     81,714
  Savings and money market deposits     30,413     22,131
  Time deposits     23,990     24,605
   
 
      Total retail deposits     129,464     128,450
Commercial business deposits     7,925     7,159
Wholesale deposits     8,874     2,579
Custodial and escrow deposits (1)     16,203     14,993
   
 
      Total deposits   $ 162,466   $ 153,181
   
 

(1)
Substantially all custodial and escrow deposits reside in noninterest-bearing checking accounts.

        The overall increase in deposits was substantially the result of the $6.30 billion increase in wholesale deposits from year-end 2003, which was predominantly due to an upgrade in our credit rating from a major agency, making the Company more attractive to institutional investors and increased marketing levels for brokered certificates of deposit. Retail deposits increased primarily due to the new Platinum Savings account, substantially offset by a decline in Platinum Checking accounts.

        Checking, savings and money market deposits composed 81% of retail deposits at June 30, 2004, unchanged from year-end 2003. These products generally have the benefit of lower interest costs, compared with time deposits. Even though checking, savings and money market deposits are more liquid, we consider them to be the core relationship with our customers. At June 30, 2004, deposits funded 58% of total assets, compared with 56% at December 31, 2003.

    Borrowings

        At June 30, 2004, our borrowings were largely in the form of advances from the Federal Home Loan Banks ("FHLBs") of Seattle, San Francisco, Dallas and New York and repurchase agreements. Although the Company acquired advances from the FHLBs of Dallas and New York during its acquisitions of Bank United in 2001 and Dime Bancorp, Inc. in 2002, the Company does not have continuing borrowing privileges at these FHLBs. The mix of our borrowing sources at any given time is dependent on market conditions.

Operating Segments

        We manage and report information concerning the Company's activities, operations, products and services around two primary categories: consumers and commercial customers and have established three operating segments for the purpose of management reporting: Retail Banking and Financial Services, Mortgage Banking and the Commercial Group. Results for Corporate Support/Treasury and Other are also presented. Refer to Note 7 to the Consolidated Financial Statements – "Operating Segments" for information regarding the key elements of our management reporting methodologies used to measure segment performance.

42



    Consumer Group

    Retail Banking and Financial Services

 
  Three Months Ended
June 30,

   
  Six Months Ended
June 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income   $ 1,271   $ 975   30 % $ 2,507   $ 1,909   31 %
  Provision for loan and lease losses     42     37   14     80     73   10  
  Noninterest income     702     625   12     1,325     1,198   11  
  Inter-segment revenue     7     45   (85 )   12     95   (87 )
  Noninterest expense     1,120     958   17     2,191     1,886   16  
   
 
     
 
     
  Income before income taxes     818     650   26     1,573     1,243   27  
  Income taxes     310     245   27     596     468   27  
   
 
     
 
     
    Net income   $ 508   $ 405   25   $ 977   $ 775   26  
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio (1)     50.07 %   50.40 % (1 )   50.32 %   50.88 % (1 )
  Average loans   $ 158,945   $ 114,390   39   $ 154,150   $ 115,297   34  
  Average assets     171,306     125,666   36     166,302     126,861   31  
  Average deposits     128,680     123,767   4     128,340     123,503   4  

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

        The increases in net interest income were largely due to increases in interest income from higher levels of mortgage loans and home equity loans and lines of credit balances and decreased interest expense on deposits resulting from lower interest rates.

        The increases in noninterest income were mostly due to increases in depositor and other retail banking fees resulting from higher numbers of checking accounts. Securities fees and commissions also increased due to an increase in advisory fee income earned from managing the Company's proprietary mutual fund family.

        Inter-segment revenue decreased due to lower origination broker fees received from the Mortgage Banking Group for the origination of mortgage loans resulting from the overall decline of refinancing activity, compared with the first half of 2003.

        Increases in noninterest expense were primarily driven by employee base compensation and benefits, occupancy and equipment and advertising expense resulting from expansion of the Company's distribution network, which included the opening of more than 60 stores in the second quarter of 2004.

        The increases in average assets were predominantly driven by higher home loan mortgages and home equity loans and lines of credit. Home loan mortgages have increased $25.75 billion and $22.51 billion, or 32% and 27%, for the three and six months ended June 30, 2004, compared with the same periods in 2003, resulting from increased growth in adjustable-rate mortgages held in portfolio. Home equity loans and lines of credit increased $14.50 billion and $13.26 billion or 75% and 73%, for the three and six months ended June 30, 2004, compared with the same periods in 2003.

43



    Mortgage Banking

 
  Three Months Ended
June 30,

   
  Six Months Ended
June 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income   $ 358   $ 668   (46 )% $ 635   $ 1,345   (53 )%
  Provision for loan and lease losses     3     1   338     5     1   781  
  Noninterest income     199     953   (79 )   959     1,788   (46 )
  Inter-segment expense     7     45   (85 )   12     95   (87 )
  Noninterest expense     649     786   (17 )   1,320     1,446   (9 )
   
 
     
 
     
  Income (loss) before income taxes     (102 )   789       257     1,591   (84 )
  Income taxes (benefit)     (39 )   300       97     605   (84 )
   
 
     
 
     
    Net income (loss)   $ (63 ) $ 489     $ 160   $ 986   (84 )
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio (1)     108.71 %   46.58 % 133     76.91 %   44.21 % 74  
  Average loans   $ 26,999   $ 51,558   (48 ) $ 23,435   $ 47,065   (50 )
  Average assets     39,936     73,411   (46 )   37,706     70,245   (46 )
  Average deposits     19,837     30,039   (34 )   17,357     27,497   (37 )

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

        The decreases in net interest income were mostly due to declining average loans held for sale balances, resulting from a shift in volume mix from fixed-rate loans to adjustable-rate loans, which are held in portfolio.

        The decreases in noninterest income were primarily due to the difference in the performance of the MSR asset and the corresponding hedging and risk management derivatives, which reflected both tightening basis spreads (the difference between the mortgage and interest rate swap indices) during the quarter and rising interest rates. This caused the loss in hedge value to exceed the increase in MSR value, thus reducing Mortgage Banking income. The second quarter of 2004 includes a $143 million gain from mortgage loans from the intersegment sale of loans originated for the home loan portfolio to the Retail Banking and Financial Services segment, compared with a $174 million gain in the second quarter of 2003.

        The decrease in noninterest expense for the three months ended June 30, 2004 was primarily due to lower employee base compensation and benefits expense and technology expense resulting from the Company's ongoing cost containment initiative. The decrease for the six months ended June 30, 2004, resulted primarily from lower technology expense and advertising and promotion expense.

        Inter-segment expense has decreased due to lower origination broker fees paid to the Retail Banking and Financial Services Group for the origination of mortgage loans resulting from the overall decline of refinancing activity, compared with the first half of 2003.

        The decreases in average assets were largely due to lower average loans held for sale and investment securities acquired to economically hedge the MSR asset.

        The decreases in average deposits were predominantly due to lower custodial and escrow balances resulting from a decline in refinancing activity.

44



    Commercial Group

 
  Three Months Ended
June 30,

   
  Six Months Ended
June 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income   $ 340   $ 316   7 % $ 680   $ 635   7 %
  Provision for loan and lease losses     10     26   (62 )   25     62   (60 )
  Noninterest income     103     122   (16 )   189     218   (13 )
  Noninterest expense     145     139   5     297     265   12  
   
 
     
 
     
  Income from continuing operations before income taxes     288     273   5     547     526   4  
  Income taxes     101     97   4     192     188   2  
   
 
     
 
     
  Income from continuing operations     187     176   6     355     338   5  
  Income from discontinued operations, net of taxes         22   (100 )       41   (100 )
   
 
     
 
     
      Net income   $ 187   $ 198   (6 ) $ 355   $ 379   (6 )
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio (1)     26.10 %   24.95 % 5     27.39 %   24.24 % 13  
  Average loans   $ 38,517   $ 34,480   12   $ 37,761   $ 34,427   10  
  Average assets     43,761     43,133   1     43,316     42,833   1  
  Average deposits     6,898     4,868   42     6,474     4,670   39  

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

        The increases in net interest income were predominantly due to lower funding costs resulting from reduced interest rates and increased interest income from higher average loans held for sale balances. These increases were partially offset by lower interest income from investment securities and loans held in portfolio and lower interest rates.

        The decreases in provision for loan and lease losses were driven by stronger credit performance resulting in lower expected loss rates, compared with the first half of 2003.

        The decreases in noninterest income were substantially due to a reduction in income from residual interests in collateralized mortgage obligations and lower gains from the sale of specialty mortgage finance loans. These decreases were partially offset by increased gains from the sale of originated mortgage-backed securities and the securitization and sale of multi-family and commercial real estate loans.

        The increases in noninterest expense were predominantly due to increased employee base compensation and benefits, technology and occupancy and equipment expense due to growth in the Commercial group network.

        In July 2004, the Company announced that the Commercial Group is exiting certain activities that are no longer strategically aligned with the Group's business objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million. This initiative will result in the closure, over time, of approximately 50 commercial banking locations and the elimination of approximately 850 positions during the remainder of 2004.

45


    Corporate Support/Treasury and Other

 
  Three Months Ended
June 30,

   
  Six Months Ended June 30,
   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income (expense)   $ (281 ) $ (59 ) 373 % $ (504 ) $ (78 ) 551 %
  Noninterest income (expense)     33           (35 )   (63 ) (44 )
  Noninterest expense     144     177   (18 )   340     317   7  
   
 
     
 
     
  Loss from continuing operations before income taxes     (392 )   (236 ) 66     (879 )   (458 ) 92  
  Income tax benefit     (146 )   (87 ) 67     (329 )   (170 ) 94  
   
 
     
 
     
  Loss from continuing operations     (246 )   (149 ) 65     (550 )   (288 ) 91  
  Income from discontinued operations, net of taxes               399        
   
 
     
 
     
      Net loss   $ (246 ) $ (149 ) 65   $ (151 ) $ (288 ) (47 )
   
 
     
 
     
Performance and other data:                                  
  Average assets   $ 30,687   $ 43,492   (29 ) $ 32,052   $ 44,076   (27 )
  Average deposits     9,391     5,006   88     7,209     5,139   40  

        The increases in net interest expense were substantially due to lower interest income from available-for-sale securities, the balances of which declined due to sales of mortgage-backed securities and prepayment of these securities that occurred from refinancing activity. The increases were also attributable to the impact of the funds transfer pricing process. This increase was partially offset by a reduction in interest expense from borrowed funds, as a result of lower interest rates and higher levels of lower-costing average deposit balances.

        The decrease in noninterest expense for the three months ended June 30, 2004 was primarily due to lower employee base compensation and benefits and professional fees, resulting from the Company's ongoing cost containment initiative.

        The decreases in average assets were mostly due to the sale of mortgage-backed available-for-sale securities during the preceding twelve months.

        Income from discontinued operations resulted from the sale of the Company's subsidiary, Washington Mutual Finance, in the first quarter of 2004.

Off-Balance Sheet Activities

    Asset Securitization

        We transform loans into securities, which are sold to investors – a process known as securitization. Securitization involves the sale of loans to a qualifying special-purpose entity ("QSPE"), typically a trust. The QSPE, in turn, issues interest-bearing securities, commonly called asset-backed securities, which are secured by future collections on the sold loans. The QSPE sells securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These QSPEs are not consolidated within our financial statements since they satisfy the criteria established by Statement No. 140, Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities . In general, these criteria require the QSPE to be legally isolated from the transferor (the Company), be

46


limited to permitted activities, and have defined limits on the assets it can hold and the permitted sales, exchanges or distributions of its assets.

        When we sell or securitize loans, we generally retain the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the sold or securitized assets. Retained interests may provide credit enhancement to the investors and, absent the violation of representations and warranties, generally represent the Company's maximum risk exposure associated with these transactions. Retained interests in securitizations were $1.77 billion at June 30, 2004, of which $1.74 billion have either a AAA credit rating or are agency insured. Additional information concerning securitization transactions is included in Note 7 to the Consolidated Financial Statements – "Mortgage Banking Activities" of the Company's 2003 Annual Report on Form 10-K/A.

    Guarantees

        The Company may incur liabilities under certain contractual agreements contingent upon the occurrence of certain events. A discussion of these contractual arrangements under which the Company may be held liable is included in Note 5 to the Consolidated Financial Statements – "Guarantees."

Asset Quality

    Nonaccrual Loans, Foreclosed Assets and Restructured Loans

        Loans are generally placed on nonaccrual status when they are 90 days or more past due. Additionally, loans in non-homogeneous portfolios are placed on nonaccrual status prior to becoming 90 days past due when payment in full of principal and interest is not expected. Management's classification of a loan as nonaccrual or restructured does not necessarily indicate that the principal or interest of the loan is uncollectible in whole or in part.

47


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

 
  June 30,
2004

  March 31,
2004

  December 31,
2003

 
 
  (dollars in millions)

 
Nonperforming assets and restructured loans:                    
  Nonaccrual loans:                    
    Loans secured by real estate:                    
      Home   $ 535   $ 622   $ 736  
      Purchased specialty mortgage finance     585     615     597  
   
 
 
 
            Total home nonaccrual loans     1,120     1,237     1,333  
      Home equity loans and lines of credit     48     45     47  
      Home construction:                    
        Builder (1)     18     23     25  
        Custom (2)     6     8     10  
      Multi-family     20     23     19  
      Other real estate     133     153     153  
   
 
 
 
            Total nonaccrual loans secured by real estate     1,345     1,489     1,587  
    Consumer     9     7     8  
    Commercial business     42     46     31  
   
 
 
 
            Total nonaccrual loans held in portfolio     1,396     1,542     1,626  
  Foreclosed assets     286     307     311  
   
 
 
 
            Total nonperforming assets   $ 1,682   $ 1,849   $ 1,937  
            As a percentage of total assets     0.60 %   0.66 %   0.70 %
  Restructured loans   $ 79   $ 107   $ 111  
   
 
 
 
                Total nonperforming assets and restructured loans   $ 1,761   $ 1,956   $ 2,048  
   
 
 
 

(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.

        The reduction in nonaccrual loans during the first six months of 2004 was predominantly driven by declines in nonaccrual home loans. The Company continued its program of selling packages of nonperforming loans that it holds in portfolio, including $66 million of such nonperforming loans sold during the second quarter. Year-to-date, $246 million of nonperforming loans held in portfolio were sold which resulted in $15 million in related charge-offs. We will continue to periodically evaluate nonperforming loan sales as part of our ongoing portfolio management strategy.

        Nonaccrual home equity loans and lines of credit remained flat in dollars during the first six months of 2004, but as a percentage to total loans in this portfolio declined to 0.13% at June 30, 2004 from 0.17% at December 31, 2003. Other real estate nonaccrual loans declined $20 million during the quarter and first half of 2004, primarily resulting from the payoff of a $23 million healthcare-related loan.

        Foreclosed assets totaled $286 million at June 30, 2004, compared with $307 million at March 31, 2004 and $311 million at December 31, 2003. The Company's foreclosed assets include residential and commercial real estate as well as a small amount of personal property. Driving the decline during the six months ended were the sales of several commercial foreclosed assets.

        Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $99 million, $135 million and $66 million at June 30, 2004, March 31, 2004 and December 31, 2003.

48



    90 or More Days Past Due

        The amount of loans held in portfolio which were 90 or more days contractually past due and still accruing interest was $53 million at June 30, 2004, compared with $76 million at March 31, 2004 and $46 million at December 31, 2003. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest.

    Provision and Allowance for Loan and Lease Losses

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

 
  Three Months Ended
June 30,

  Six Months Ended
June 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

 
Balance, beginning of period   $ 1,260   $ 1,530   $ 1,250   $ 1,503  
Allowance for certain loan commitments/other     (3 )       (3 )   (3 )
Provision for loan and lease losses     60     81     116     169  
   
 
 
 
 
      1,317     1,611     1,363     1,669  
Loans charged off:                          
  Loans secured by real estate:                          
    Home     (8 )   (9 )   (24 )   (25 )
    Purchased specialty mortgage finance     (9 )   (9 )   (18 )   (19 )
   
 
 
 
 
        Total home loan charge-offs     (17 )   (18 )   (42 )   (44 )
    Home equity loans and lines of credit     (5 )   (4 )