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


FORM 10-Q

Commission File Number 1-14667


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

Washington   91-1653725
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)

1201 Third Avenue, Seattle, Washington

 

98101
(Address of principal executive offices)   (Zip Code)

(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 October 29, 2004:

Common Stock – 873,079,411 (1)

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




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004


TABLE OF CONTENTS

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

 

21
    Cautionary Statements   21
    Overview   22
    Controls and Procedures   24
    Critical Accounting Policies   25
    Recently Issued Accounting Standards   25
    Summary Financial Data   26
    Earnings Performance from Continuing Operations   27
    Review of Financial Condition   39
    Operating Segments   42
    Off-Balance Sheet Activities   47
    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   24

PART II – Other Information

 

63
  Item 1. Legal Proceedings   63
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   63
  Item 4. Submission of Matters to a Vote of Security Holders   63
  Item 6. Exhibits   63

i



PART I – FINANCIAL INFORMATION

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

 
  Three Months Ended
September 30,

  Nine Months Ended
September 30,

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

 
Interest Income                          
  Loans held for sale   $ 341   $ 689   $ 1,079   $ 2,061  
  Loans held in portfolio     2,226     1,843     6,404     5,701  
  Available-for-sale securities     163     401     607     1,384  
  Other interest and dividend income     81     65     194     218  
   
 
 
 
 
    Total interest income     2,811     2,998     8,284     9,364  
Interest Expense                          
  Deposits     539     538     1,440     1,674  
  Borrowings     532     551     1,578     1,803  
   
 
 
 
 
    Total interest expense     1,071     1,089     3,018     3,477  
   
 
 
 
 
      Net interest income     1,740     1,909     5,266     5,887  
  Provision for loan and lease losses     56     76     172     244  
   
 
 
 
 
    Net interest income after provision for loan and lease losses     1,684     1,833     5,094     5,643  
Noninterest Income                          
  Home loan mortgage banking income (expense):                          
    Loan servicing fees     482     542     1,469     1,748  
    Amortization of mortgage servicing rights     (589 )   (665 )   (1,884 )   (2,665 )
    Net mortgage servicing rights valuation adjustments     165     368     (493 )   96  
    Revaluation gain (loss) from derivatives     107     (172 )   969     643  
    Net settlement income from certain interest-rate swaps     126     130     485     354  
    Gain (loss) from mortgage loans     210     (204 )   494     1,186  
    Other home loan mortgage banking income (expense), net     3     146     (5 )   19  
   
 
 
 
 
      Total home loan mortgage banking income     504     145     1,035     1,381  
  Depositor and other retail banking fees     514     471     1,484     1,346  
  Securities fees and commissions     104     103     315     291  
  Insurance income     61     45     179     139  
  Portfolio loan related income     109     116     299     344  
  Gain from other available-for-sale securities     11     557     73     689  
  Gain (loss) on extinguishment of borrowings     (147 )   7     (237 )   (129 )
  Other income     108     120     247     323  
   
 
 
 
 
    Total noninterest income     1,264     1,564     3,395     4,384  
Noninterest Expense                          
  Compensation and benefits     841     837     2,589     2,427  
  Occupancy and equipment     404     352     1,197     1,024  
  Telecommunications and outsourced information services     118     150     364     429  
  Depositor and other retail banking losses     54     35     134     113  
  Amortization of other intangible assets     14     15     42     46  
  Advertising and promotion     76     51     219     190  
  Professional fees     34     69     105     189  
  Other expense     328     301     947     888  
   
 
 
 
 
    Total noninterest expense     1,869     1,810     5,597     5,306  
   
 
 
 
 
      Income from continuing operations before income taxes     1,079     1,587     2,892     4,721  
      Income taxes     405     588     1,081     1,749  
   
 
 
 
 
        Income from continuing operations, net of taxes     674     999     1,811     2,972  
   
 
 
 
 
Discontinued Operations                          
    Income (loss) from discontinued operations before income taxes         38     (32 )   102  
    Gain on disposition of discontinued operations             676      
    Income taxes         14     245     37  
   
 
 
 
 
        Income from discontinued operations, net of taxes         24     399     65  
   
 
 
 
 
Net Income   $ 674   $ 1,023   $ 2,210   $ 3,037  
   
 
 
 
 

(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
September 30,

  Nine Months Ended
September 30,

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

Basic Earnings Per Common Share:                        
  Income from continuing operations   $ 0.78   $ 1.11   $ 2.10   $ 3.27
  Income from discontinued operations, net         0.03     0.46     0.07
   
 
 
 
    Net Income     0.78     1.14     2.56     3.34
Diluted Earnings Per Common Share:                        
  Income from continuing operations   $ 0.76   $ 1.09   $ 2.05   $ 3.20
  Income from discontinued operations, net         0.02     0.45     0.07
   
 
 
 
    Net Income     0.76     1.11     2.50     3.27

Dividends declared per common share

 

 

0.44

 

 

0.40

 

 

1.29

 

 

0.99
Basic weighted average number of common shares outstanding (in thousands)     862,004     899,579     861,933     910,449
Diluted weighted average number of common shares outstanding (in thousands)     882,323     918,372     884,068     927,470

See Notes to Consolidated Financial Statements.

2



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

 
  September 30,
2004

  December 31,
2003

 
 
  (dollars in millions)

 
Assets              
  Cash and cash equivalents   $ 4,689   $ 7,018  
  Federal funds sold and securities purchased under agreements to resell     30     19  
  Available-for-sale securities, total amortized cost of $16,312 and $36,858:              
    Mortgage-backed securities (including assets pledged of $3,483 and $3,642)     10,168     10,695  
    Investment securities (including assets pledged of $5,256 and $19,353)     6,319     26,012  
   
 
 
      Total available-for-sale securities     16,487     36,707  
  Loans held for sale     29,184     20,837  
  Loans held in portfolio     206,158     175,150  
  Allowance for loan and lease losses     (1,322 )   (1,250 )
   
 
 
      Total loans held in portfolio, net of allowance for loan and lease losses     204,836     173,900  
  Investment in Federal Home Loan Banks     3,883     3,462  
  Mortgage servicing rights     6,112     6,354  
  Goodwill     6,196     6,196  
  Assets of discontinued operations         4,184  
  Other assets     17,411     16,501  
   
 
 
      Total assets   $ 288,828   $ 275,178  
   
 
 

Liabilities

 

 

 

 

 

 

 
  Deposits:              
    Noninterest-bearing deposits   $ 32,250   $ 29,968  
    Interest-bearing deposits     136,445     123,213  
   
 
 
      Total deposits     168,695     153,181  
  Federal funds purchased and commercial paper     7,025     2,011  
  Securities sold under agreements to repurchase     15,611     28,333  
  Advances from Federal Home Loan Banks     59,758     48,330  
  Other borrowings     12,747     15,483  
  Liabilities of discontinued operations         3,578  
  Other liabilities     4,172     4,520  
   
 
 
      Total liabilities     268,008     255,436  

Stockholders' Equity

 

 

 

 

 

 

 
  Common stock, no par value: 1,600,000,000 shares authorized, 873,085,462 and 880,985,764 shares issued and outstanding          
  Capital surplus – common stock     3,270     3,682  
  Accumulated other comprehensive loss     (124 )   (524 )
  Retained earnings     17,674     16,584  
   
 
 
      Total stockholders' equity     20,820     19,742  
   
 
 
      Total liabilities and stockholders' equity   $ 288,828   $ 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   944.0   $ 5,961   $ 175   $ 13,925   $ 20,061  
Comprehensive income:                              
  Net income               3,037     3,037  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized loss from securities arising during the period, net of reclassification adjustments           (707 )       (707 )
    Net unrealized gain from cash flow hedging instruments           117         117  
    Minimum pension liability adjustment           (4 )       (4 )
                         
 
Total comprehensive income                           2,443  
Cash dividends declared on common stock               (906 )   (906 )
Cash dividends returned (1)               8     8  
Common stock repurchased and retired   (39.0 )   (1,430 )           (1,430 )
Common stock returned from escrow                    
Common stock issued   8.9     265             265  
   
 
 
 
 
 

BALANCE, September 30, 2003

 

913.9

 

$

4,796

 

$

(419

)

$

16,064

 

$

20,441

 
   
 
 
 
 
 

BALANCE, December 31, 2003

 

881.0

 

$

3,682

 

$

(524

)

$

16,584

 

$

19,742

 
Comprehensive income:                              
  Net income               2,210     2,210  
  Other comprehensive income, net of tax:                              
    Net unrealized gain from securities arising during the period, net of reclassification adjustments           201         201  
    Net unrealized gain from cash flow hedging instruments           205         205  
    Minimum pension liability adjustment           (6 )       (6 )
                         
 
Total comprehensive income                           2,610  
Cash dividends declared on common stock               (1,120 )   (1,120 )
Common stock repurchased and retired   (16.1 )   (712 )           (712 )
Common stock issued   8.2     300             300  
   
 
 
 
 
 
BALANCE, September 30, 2004   873.1   $ 3,270   $ (124 ) $ 17,674   $ 20,820  
   
 
 
 
 
 

(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)

 
  Nine Months Ended
September 30,

 
 
  2004
  2003
 
 
  (in millions)

 
Cash Flows from Operating Activities              
  Net income   $ 2,210   $ 3,037  
  Income from discontinued operations, net of taxes     (399 )   (65 )
   
 
 
    Income from continuing operations, net of taxes     1,811     2,972  
  Adjustments to reconcile income from continuing operations to net cash used by operating activities:              
    Provision for loan and lease losses     172     244  
    Gain from mortgage loans     (494 )   (1,186 )
    Gain from available-for-sale securities     (73 )   (949 )
    Revaluation gain from derivatives     (969 )   (643 )
    Loss on extinguishment of borrowings     237     129  
    Depreciation and amortization     2,412     2,930  
    Provision for mortgage servicing rights impairment (recovery)     646     (96 )
    Stock dividends from Federal Home Loan Banks     (40 )   (101 )
    Origination and purchases of loans held for sale, net of principal payments     (112,179 )   (279,301 )
    Proceeds from sales of loans held for sale     100,962     274,626  
    Increase in other assets     (697 )   (1,663 )
    (Decrease) increase in other liabilities     (748 )   700  
   
 
 
      Net cash used by operating activities     (8,960 )   (2,338 )

Cash Flows from Investing Activities

 

 

 

 

 

 

 
  Purchases of securities     (1,021 )   (22,344 )
  Proceeds from sales and maturities of mortgage-backed securities     1,399     8,907  
  Proceeds from sales and maturities of other available-for-sale securities     20,090     14,693  
  Principal payments on securities     2,617     7,816  
  Purchases of Federal Home Loan Bank stock     (616 )   (279 )
  Redemption of Federal Home Loan Bank stock     235     663  
  Proceeds from sale of mortgage servicing rights         406  
  Origination and purchases of loans held in portfolio     (92,079 )   (80,036 )
  Principal payments on loans held in portfolio     59,546     64,411  
  Proceeds from sales of loans held in portfolio     386     708  
  Proceeds from sales of foreclosed assets     355     377  
  Net (increase) decrease in federal funds sold and securities purchased under agreements to resell     (11 )   2,003  
  Purchases of premises and equipment, net     (484 )   (748 )
  Proceeds from sale of discontinued operations, net of cash sold     1,223      
   
 
 
    Net cash used by investing activities     (8,360 )   (3,423 )

(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.)

 
  Nine Months Ended
September 30,

 
 
  2004
  2003
 
 
  (in millions)

 
Cash Flows from Financing Activities              
  Net increase in deposits   $ 15,514   $ 8,625  
  Net (decrease) increase in short-term borrowings     (8,180 )   8,311  
  Proceeds from long-term borrowings     3,227     8,751  
  Repayments of long-term borrowings     (5,331 )   (11,656 )
  Proceeds from advances from Federal Home Loan Banks     62,095     62,118  
  Repayments of advances from Federal Home Loan Banks     (50,752 )   (69,622 )
  Cash dividends paid on common stock     (1,120 )   (906 )
  Repurchase of common stock     (712 )   (1,430 )
  Other     250     230  
   
 
 
    Net cash provided by financing activities     14,991     4,421  
   
 
 
    Decrease in cash and cash equivalents     (2,329 )   (1,340 )
    Cash and cash equivalents, beginning of period     7,018     7,084  
   
 
 
    Cash and cash equivalents, end of period   $ 4,689   $ 5,744  
   
 
 

Noncash Activities

 

 

 

 

 

 

 
  Loans exchanged for mortgage-backed securities   $ 2,828   $ 2,179  
  Real estate acquired through foreclosure     329     359  

Cash Paid During the Period for

 

 

 

 

 

 

 
  Interest on deposits   $ 1,368   $ 1,642  
  Interest on borrowings     1,651     1,886  
  Income taxes     1,962     2,658  

See Notes to Consolidated Financial Statements.

6



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Accounting Policies

    Basis of Presentation

        The accompanying Consolidated Financial Statements are unaudited and include the accounts of Washington Mutual, Inc. and 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. 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 Consolidated Statements of Income or the Consolidated Statements of 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.

        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 impact 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 impact 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 Company has determined the passage of the Act does not significantly affect the Company's retiree drug plan benefit obligations. Consequently, as permitted by FSP 106-2, the Company will incorporate the effects of the Act in its next measurement of plan assets and benefit obligations in

7



December 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 adoption of FSP 106-2 did not have a material effect on the Consolidated Statements of Income or the Consolidated Statements of 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 . Paragraph 10 of 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 guidance was effective for reporting periods beginning after June 15, 2004 with the exception of paragraphs 10 - 20 of EITF 03-1, which will be deliberated further. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. After the FASB completes their deliberations with respect to paragraphs 10 - 20, the Company will evaluate the potential impact of those paragraphs on its process for determining whether other-than-temporary declines exist within its debt and equity investment securities portfolio. The outcome of this deliberation 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.

    Recently Issued Accounting Standards

        In September of 2004, the EITF reached consensus on the guidance provided in EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share . EITF 04-8 addresses the issue of when the dilutive effect of contingently convertible debt instruments should be included in diluted earnings per share. The new guidance is effective for reporting periods ending after December 15, 2004, however at this time the Company does not expect the adoption of EITF 04-8 to have any effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition as the Company has not issued contingently convertible debt instruments.

    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 MSR 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

8


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.

    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
September 30,

  Nine Months Ended
September 30,

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

 
Net income   $ 674   $ 1,023   $ 2,210   $ 3,037  
Add back: Stock-based employee compensation expense included in reported net income, net of related tax effects     14     10     54     43  
Deduct: Total stock-based employee compensation expense determined under the fair value method for all awards, net of related tax effects     (26 )   (28 )   (87 )   (97 )
   
 
 
 
 
Pro forma net income   $ 662   $ 1,005   $ 2,177   $ 2,983  
   
 
 
 
 

Net income per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 
Basic:                          
  As reported   $ 0.78   $ 1.14   $ 2.56   $ 3.34  
  Pro forma     0.77     1.12     2.52     3.28  
Diluted:                          
  As reported     0.76     1.11     2.50     3.27  
  Pro forma     0.75     1.09     2.46     3.22  

9


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.

Note 3: Earnings Per Share

        Information used to calculate earnings per share was as follows:

 
  Three Months
Ended
September 30,

  Nine Months
Ended
September 30,

 
  2004
  2003
  2004
  2003
Weighted average shares (in thousands)                
  Basic weighted average number of common shares outstanding   862,004   899,579   861,933   910,449
  Dilutive effect of potential common shares from:                
    Awards granted under equity incentive programs   11,744   9,774   12,644   8,860
    Trust Preferred Income Equity Redeemable Securities SM   8,575   9,019   9,491   8,161
   
 
 
 
  Diluted weighted average number of common shares outstanding   882,323   918,372   884,068   927,470
   
 
 
 

        For the three and nine months ended September 30, 2004, options to purchase an additional 11,599,147 and 1,657,852 shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because their inclusion would have had an antidilutive effect. Likewise, for the three and nine months ended September 30, 2003, options to purchase an additional 54,700 and 1,891,409 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 September 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
September 30,

  Nine Months Ended
September 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Balance, beginning of period   $ 558,388   $ 583,823   $ 582,669   $ 604,504  
  Home loans:                          
    Additions     29,699     105,883     105,909     291,391  
    Sales                 (2,960 )
    Loan payments and other     (37,035 )   (111,834 )   (139,481 )   (315,257 )
  Net change in commercial real estate loans serviced for others     193     (50 )   2,148     144  
   
 
 
 
 
Balance, end of period   $ 551,245   $ 577,822   $ 551,245   $ 577,822  
   
 
 
 
 

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

 
  Three Months Ended
September 30,

  Nine Months Ended
September 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Balance, beginning of period   $ 7,501   $ 4,598   $ 6,354   $ 5,341  
  Home loans:                          
    Additions     348     1,587     1,463     3,502  
    Amortization     (589 )   (665 )   (1,884 )   (2,665 )
    (Impairment) reversal     (266 )   368     (646 )   96  
    Statement No. 133 MSR accounting valuation adjustments     (885 )       822      
    Sales         (18 )       (406 )
  Net change in commercial real estate MSR     3         3     2  
   
 
 
 
 
Balance, end of period (1)   $ 6,112   $ 5,870   $ 6,112   $ 5,870  
   
 
 
 
 

(1)
At September 30, 2004 and 2003, the aggregate MSR fair value was $6.11 billion and $5.90 billion.

        Changes in the valuation allowance for MSR were as follows:

 
  Three Months Ended
September 30,

  Nine Months Ended
September 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Balance, beginning of period   $ 2,417   $ 3,444   $ 2,435   $ 4,521  
  Impairment (reversal)     266     (368 )   646     (96 )
  Other than temporary impairment     (22 )       (410 )   (1,115 )
  Sales         (1 )       (235 )
  Other     (8 )       (18 )    
   
 
 
 
 
Balance, end of period   $ 2,653   $ 3,075   $ 2,653   $ 3,075  
   
 
 
 
 

11


        At September 30, 2004, the expected weighted average life of the Company's MSR was 3.7 years. Projected amortization expense for the gross carrying value of MSR at September 30, 2004 is estimated to be as follows (in millions):

Remainder of 2004   $ 602  
2005     1,936  
2006     1,363  
2007     1,007  
2008     772  
After 2008     3,085  
   
 
Gross carrying value of MSR     8,765  
Less: valuation allowance     (2,653 )
   
 
  Net carrying value of MSR   $ 6,112  
   
 

        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 projected MSR prepayment estimates and discount rates, as were used to determine amortization expense at the end of the third 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 September 30, 2004 and December 31, 2003, the amount of loans sold without recourse totaled $545.03 billion and $578.71 billion, which substantially represents the unpaid principal balance of the Company's loans serviced for others portfolio. The Company has accrued $122 million as of September 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 September 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 $2.24 billion as of September 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 the amounts are sufficient to meet minimum funding requirements as set forth in employee benefit and tax laws plus such additional amounts the Company determines to be appropriate.

    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.

        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 September 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   $ 21   $ 2   $ 1
Service cost     20             16         1
Expected return on plan assets     (25 )           (24 )      
Amortization of prior service cost (credit)     1             (1 )      
Recognized net actuarial loss     10             8        
   
 
 
 
 
 
  Net periodic benefit cost   $ 26   $ 2   $ 1   $ 20   $ 2   $ 2
   
 
 
 
 
 
                                     

13



 


 

Nine Months Ended September 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   $ 61   $ 5   $ 3   $ 53   $ 6   $ 4
Service cost     63         1     40         1
Expected return on plan assets     (77 )           (60 )      
Amortization of prior service cost (credit)     2             (4 )      
Recognized net actuarial loss     28     1         20        
   
 
 
 
 
 
  Net periodic benefit cost   $ 77   $ 6   $ 4   $ 49   $ 6   $ 5
   
 
 
 
 
 

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 to prior years and reallocated the adjustments from the original straight-line basis. This change did not have a material impact on 2003's results of operations, but has materially impacted 2004's quarterly results of operations.

        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

14



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 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 and small business. 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

15



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 aligned with the Company's strategic 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 and restructuring charges incurred from the Company's cost containment initiative. Also reported in this category is the net impact of funds transfer pricing for loan and deposit balances including the effects of changes in interest rates on the Company's net interest margin and the effects of inter-segment allocations of gains and losses related to interest rate risk management instruments.

16



        Financial highlights by operating segment were as follows:

 
  Three Months Ended September 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)   $ 1,295   $ 274   $ 324   $ (263 ) $ 110 (1) $ 1,740  
  Provision for loan and lease losses     43     2     10         1 (2)   56  
  Noninterest income (expense)     713     769     66     (122 )   (162 ) (3)   1,264  
  Inter-segment revenue (expense)     3     (3 )                
  Noninterest expense     1,116     602     160     203     (212 ) (4)   1,869  
   
 
 
 
 
 
 
  Income (loss) before income taxes     852     436     220     (588 )   159     1,079  
  Income taxes (benefit)     323     165     75     (221 )   63 (5)   405  
   
 
 
 
 
 
 
  Net income (loss)   $ 529   $ 271   $ 145   $ (367 ) $ 96   $ 674  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     49.02 % (6)   52.89 % (6)   33.45 % (6)   n/a     n/a     62.19 (7)
  Average loans   $ 167,539   $ 22,611   $ 38,829   $   $ (1,600 ) (8) $ 227,379  
  Average assets     179,950     36,343     43,745     25,452     (1,821 ) (8)(9)   283,669  
  Average deposits     131,850     15,385     7,811     13,820     n/a     168,866  
  Employees at end of period     29,963     16,786     3,270     5,469     n/a     55,488  

(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. Those loans that are retained in the Company's loan portfolio are treated as if they have been sold to the Retail Banking and Financial Services segment.
(4)
Represents the corporate offset for the cost of capital related to goodwill that has been charged 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 $221 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 September 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)   $ 994   $ 683   $ 324   $ (183 ) $ 91 (1) $ 1,909  
  Provision for loan and lease losses     40     1     24         11 (2)   76  
  Noninterest income     653     288     204     611     (192 ) (3)   1,564  
  Inter-segment revenue (expense)     63     (63 )                
  Noninterest expense     980     729     142     171     (212 ) (4)   1,810  
   
 
 
 
 
 
 
  Income from continuing operations before income taxes     690     178     362     257     100     1,587  
  Income taxes     274     61     130     95     28 (5)   588  
   
 
 
 
 
 
 
  Income from continuing operations, net of taxes     416     117     232     162     72     999  
  Income from discontinued operations, net of taxes             24             24  
   
 
 
 
 
 
 
  Net income   $ 416   $ 117   $ 256   $ 162   $ 72   $ 1,023  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     49.65 % (6)   74.66 % (6)   21.39 % (6)   n/a     n/a     52.13 % (7)
  Average loans   $ 118,295   $ 51,648   $ 35,318   $   $ (1,293 ) (8) $ 203,968  
  Average assets     130,046     78,806     44,017     39,108     (1,762 ) (8)(9)   290,215  
  Average deposits     126,040     35,120     6,131     6,654     n/a     173,945  
  Employees at end of period     28,802     22,527     5,594 (10)   5,978     n/a     62,901 (10)

(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. Those loans that are retained in the Company's loan portfolio are treated as if they have been sold to the Retail Banking and Financial Services segment.
(4)
Represents the corporate offset for the cost of capital related to goodwill that has been charged 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 $469 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.
(10)
Includes 2,352 employees reported as part of discontinued operations.

18


 
  Nine Months Ended September 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)   $ 3,802   $ 908   $ 1,004   $ (767 ) $ 319 (1) $ 5,266  
  Provision for loan and lease losses     123     7     34         8 (2)   172  
  Noninterest income (expense)     2,038     1,728     256     (158 )   (469 ) (3)   3,395  
  Inter-segment revenue (expense)     15     (15 )                
  Noninterest expense     3,303     1,921     458     548     (633 ) (4)   5,597  
   
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     2,429     693     768     (1,473 )   475     2,892  
  Income taxes (benefit)     920     262     268     (551 )   182 (5)   1,081  
   
 
 
 
 
 
 
  Income (loss) from continuing operations, net of taxes     1,509     431     500     (922 )   293     1,811  
  Income from discontinued operations, net of taxes                 399         399  
   
 
 
 
 
 
 
  Net income (loss)   $ 1,509   $ 431   $ 500   $ (523 ) $ 293   $ 2,210  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     49.81 % (6)   67.33 % (6)   29.25 % (6)   n/a     n/a     64.63 % (7)
  Average loans   $ 158,646   $ 23,158   $ 38,120   $   $ (1,553 ) (8) $ 218,371  
  Average assets     170,881     37,243     43,460     29,845     (1,743 ) (8)(9)   279,686  
  Average deposits     129,518     16,695     6,922     9,429     n/a     162,564  
  Employees at end of period     29,963     16,786     3,270     5,469     n/a     55,488  

(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. Those loans that are retained in the Company's loan portfolio are treated as if they have been sold to the Retail Banking and Financial Services segment.
(4)
Represents the corporate offset for the cost of capital related to goodwill that has been charged 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 $190 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


 
  Nine Months Ended September 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)   $ 2,902   $ 2,028   $ 959   $ (261 ) $ 259 (1) $ 5,887  
  Provision for loan and lease losses     113     1     86         44 (2)   244  
  Noninterest income     1,851     2,076     421     548     (512 ) (3)   4,384  
  Inter-segment revenue (expense)     159     (159 )                
  Noninterest expense     2,860     2,180     406     490     (630 ) (4)   5,306  
   
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     1,939     1,764     888     (203 )   333     4,721  
  Income taxes (benefit)     744     664     317     (75 )   99 (5)   1,749  
   
 
 
 
 
 
 
  Income (loss) from continuing operations, net of taxes     1,195     1,100     571     (128 )   234     2,972  
  Income from discontinued operations, net of taxes             65             65  
   
 
 
 
 
 
 
  Net income (loss)   $ 1,195   $ 1,100   $ 636   $ (128 ) $ 234   $ 3,037  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     50.35 % (6)   51.31 % (6)   23.13 % (6)   n/a     n/a     51.66 % (7)
  Average loans   $ 116,307   $ 48,610   $ 34,728   $   $ (1,206 ) (8) $ 198,439  
  Average assets     127,934     73,130     43,231     42,403     (1,666 ) (8)(9)   285,032  
  Average deposits     124,358     30,066     5,163     5,649     n/a     165,236  
  Employees at end of period     28,802     22,527     5,594 (10)   5,978     n/a     62,901 (10)

(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. Those loans that are retained in the Company's loan portfolio are treated as if they have been sold to the Retail Banking and Financial Services segment.
(4)
Represents the corporate offset for the cost of capital related to goodwill that has been charged 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 $460 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.
(10)
Includes 2,352 employees reported as part of discontinued operations.

20


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

    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, including movements in interest rates, 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 our planned operational and system efficiencies as well as our cost containment initiative, our earnings could be adversely affected;

    Our retail banking business faces competition for loans and deposits from banking and nonbanking companies, which may have a disparate impact on our operations in our emerging markets; and

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

21


Overview

        Net income for the third quarter of 2004 was $674 million, or $0.76 per diluted share, a decrease from $999 million, or $1.09 per diluted share from continuing operations for the third quarter of 2003.

        Net interest income was $1.74 billion in the third quarter of 2004, compared with $1.91 billion in the third quarter of 2003 and $1.79 billion in the second quarter of 2004. The decrease was primarily due to contraction in the net interest margin, which declined from 3.07% in the third quarter of 2003 to 2.86% in the second quarter of 2004 and 2.77% in the current period. Declining asset yields and lower custodial and escrow balances were the primary factors that led to the 30 basis point decline in the margin from the third quarter of 2003. An increase in higher costing savings and time deposits and the recent steps taken by the Federal Reserve to increase the targeted federal funds rate contributed to an increase during the third quarter of 2004 in the cost of the Company's interest-bearing liabilities, which accounted for the majority of the nine basis point contraction from the second quarter of 2004. We expect the margin to contract further as the Company's adjustable rate loan portfolio reprices to current market levels more slowly than our wholesale borrowing sources. This contraction is likely to be more significant if the Federal Reserve initiates further interest rate increases or if the yield curve flattens further.

        Near the end of the quarter, the Company terminated $1.75 billion of repurchase agreements, along with certain pay-fixed interest rate swaps that were embedded in those borrowings, prior to their maturity. Although this resulted in a loss on their extinguishment of $155 million, the termination of these higher-cost borrowings will partially mitigate the anticipated margin compression in future periods.

        Home loan mortgage banking income increased from zero in the second quarter of 2004 to $504 million in the third quarter of 2004 primarily as a result of improved MSR risk management performance. The total change in MSR valuation, net of hedging and risk management instruments, was a gain of $466 million, an increase of $644 million from a loss of $178 million that was sustained in the second quarter of 2004. The improved performance of the Company's MSR asset, net of hedging and risk management instruments, is largely attributable to a widening of basis spreads, as the interest rate decline on LIBOR-based interest rate swap contracts exceeded the decline in mortgage interest rates. During the latter part of the quarter, the Company took steps to reduce its exposure to this element of risk by purchasing additional forward commitments to purchase and sell mortgage-backed securities and adding principal-only mortgage-backed securities to its MSR risk management program, while reducing its reliance on interest rate swaps. The change in value of the mortgage-based instruments should correlate more closely with the change in value of the MSR asset since the sensitivity of these instruments are more aligned with movements in mortgage rates. At September 30, 2004, mortgage-based products composed approximately 86% of the Company's MSR risk management instruments, as compared with 51% at June 30, 2004. While this change in the mix of risk management instruments is expected to moderate the volatility of the Company's MSR performance, it will not eliminate the variability in our earnings from period to period that results from the substantial size of our MSR asset.

22



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

 
  Quarter Ended
  Nine Months
Ended

 
 
  September 30,
2004

  June 30,
2004

  March 31,
2004

  September 30,
2004

 
 
  (in millions)

 
Statement No. 133 MSR accounting valuation adjustments   $ (885 ) $ 1,707   $   $ 822  
Change in value of MSR accounted for under lower of aggregate cost or market value methodology     (266 )   227     (606 )   (646 )
   
 
 
 
 
  Total MSR valuation changes     (1,151 )   1,934     (606 )   176  
Statement No. 133 fair value hedging adjustments     1,316     (1,985 )       (669 )
Revaluation gain (loss) from derivatives – MSR risk management     130     (322 )   1,108     917  
Net settlement income from certain interest-rate swaps     126     195     160     481  
Gain from securities     45         5     50  
   
 
 
 
 
  Net valuation change in hedging and risk management instruments     1,617     (2,112 )   1,273     779  
   
 
 
 
 
      Total change in MSR valuation, net of hedging and risk management instruments   $ 466   $ (178 ) $ 667   $ 955  
   
 
 
 
 

        Loans held in portfolio totaled $206.16 billion at September 30, 2004, compared with $194.54 billion at June 30, 2004 and $160.23 billion at September 30, 2003. Continued strong levels of home sales, coupled with stable or rising home prices in most of the Company's markets and a modest upward-sloping yield curve fueled strong demand for adjustable-rate home mortgages. The Company's short-term adjustable rate home loan volume was $19.07 billion in the third quarter of 2004, compared with $17.45 billion in the preceding quarter and $7.54 billion in the third quarter of 2003. The Company retained approximately 52% of the third quarter 2004 volume, or $9.96 billion, for its home loan portfolio and designated the remainder to be sold through secondary market channels. Strong volume on home equity loan and line of credit products that was generated primarily through the Company's retail banking network also resulted in a $4.43 billion increase in the loan portfolio during the third quarter of 2004. Outstanding balances of home equity loans and lines of credit have increased by $16.45 billion, or 68%, since September 30, 2003.

        The Company continues to grow its retail banking business by opening new stores and enhancing its product suite. During the third quarter, the Company opened a net total of 56 retail banking stores and added over 142,000 net new retail checking accounts. Growth was particularly strong in small business checking accounts, as approximately 32,000 of these accounts were opened during the quarter, bringing the total of net new small business checking account openings to over 85,000 during the first nine months of 2004. Since the beginning of the year, the Company has opened over 180 new stores and expects to achieve its 2004 target of opening 250 stores by the end of this year.

        A prominent management priority continues to be the Company's cost containment initiative, which was originally announced in the fourth quarter of 2003. As of September 30, 2004, this initiative has resulted in cumulative headcount reductions of approximately 8,000 with an additional 1,900 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.

23



        Until the cost structure of the Company's mortgage banking business approaches a level that is commensurate with the cost structures of other mortgage banking industry leaders, the profitability 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 expense due to facilities closures. Two significant milestones within this initiative occurred during the third quarter, when the Company completed its conversion of all home loan customer records onto a single servicing system and consolidated 12 mortgage banking loan fulfillment centers into the 34 remaining centers and reduced staffing levels at those remaining locations. 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. This initiative resulted in the sale or closure of approximately 100 retail mortgage lending offices during the third quarter.

        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.

        In July 2004, the Company announced that the Commercial Group is exiting certain activities that are no longer aligned with the Company's strategic objectives. These activities include home construction loans made to builders and commercial loans made to companies whose annual revenues typically exceed $5 million. Over time, this initiative will result in the closure of 53 commercial banking locations and the elimination of approximately 850 positions.

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 third quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

        The Company is currently undergoing a comprehensive effort to ensure compliance with the new regulations under Section 404 of the Sarbanes-Oxley Act that take effect for the Company's fiscal year ending December 31, 2004. This effort includes internal control documentation and review under the direction of senior management. In the course of its ongoing evaluation, management has identified certain areas requiring improvement, which the Company is addressing. Management routinely reviews potential internal control issues with the Company's Audit Committee.

24



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 September 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 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 Company's Audit Committee. 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 September of 2004, the Emerging Issues Task Force ("EITF") reached consensus on the guidance provided in EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share . EITF 04-8 addresses the issue of when the dilutive effect of contingently convertible debt instruments should be included in diluted earnings per share. The new guidance is effective for reporting periods ending after December 15, 2004, however at this time the Company does not expect the adoption of EITF 04-8 to have any effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition as the Company has not issued contingently convertible debt instruments.

25


Summary Financial Data

 
  Three Months Ended
September 30,

  Nine Months Ended
September 30,

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

 
Profitability                          
  Net interest income   $ 1,740   $ 1,909   $ 5,266   $ 5,887  
  Net interest margin     2.77 %   3.07 %   2.84 %   3.19 %
  Noninterest income   $ 1,264   $ 1,564   $ 3,395   $ 4,384  
  Noninterest expense     1,869     1,810     5,597     5,306  
  Net income     674     1,023     2,210     3,037  
  Basic earnings per common share:                          
    Income from continuing operations   $ 0.78   $ 1.11   $ 2.10   $ 3.27  
    Income from discontinued operations, net         0.03     0.46     0.07  
   
 
 
 
 
      Net income     0.78     1.14     2.56     3.34  
  Diluted earnings per common share:                          
    Income from continuing operations   $ 0.76   $ 1.09   $ 2.05   $ 3.20  
    Income from discontinued operations, net         0.02     0.45     0.07  
   
 
 
 
 
      Net income     0.76     1.11     2.50     3.27  
  Basic weighted average number of common shares outstanding (in thousands)     862,004     899,579     861,933     910,449  
  Diluted weighted average number of common shares outstanding (in thousands)     882,323     918,372     884,068     927,470  
  Dividends declared per common share   $ 0.44   $ 0.40   $ 1.29   $ 0.99  
  Return on average assets (1)     0.95 %   1.41 %   1.05 %   1.42 %
  Return on average common equity (1)     13.03     19.82     14.47     19.50  
  Efficiency ratio (2)(3)     62.19     52.13     64.63     51.66  
Asset Quality                          
  Nonaccrual loans (4)(5)   $ 1,471   $ 1,813   $ 1,471   $ 1,813  
  Foreclosed assets (5)     281     293     281     293  
   
 
 
 
 
    Total nonperforming assets (5)   $ 1,752   $ 2,106   $ 1,752   $ 2,106  
  Nonperforming assets/total assets (5)     0.61 %   0.73 %   0.61 %   0.73 %
  Restructured loans (5)   $ 38   $ 118   $ 38   $ 118  
   
 
 
 
 
    Total nonperforming assets and restructured loans (5)     1,790     2,224     1,790     2,224  
  Allowance for loan and lease losses (5)     1,322     1,549     1,322     1,549  
  Allowance as a percentage of total loans held in portfolio (5)     0.64 %   0.97 %   0.64 %   0.97 %
  Provision for loan and lease losses   $ 56   $ 76   $ 172   $ 244  
  Net charge-offs     27     74     97     213  
Capital Adequacy (5)                          
  Stockholders' equity/total assets     7.21 %   7.13 %   7.21 %   7.13 %
  Tangible common equity (6) /total tangible assets (6)     5.26     5.26     5.26     5.26  
  Estimated total risk-based capital/risk-weighted assets (7)     10.64     11.54     10.64     11.54  
Per Common Share Data                          
  Book value per common share (5)(8)   $ 24.01   $ 22.77   $ 24.01   $ 22.77  
  Market prices:                          
    High     40.19     42.75     45.28     43.90  
    Low     37.63     36.92     37.63     32.98  
    Period end     39.08     39.37     39.08     39.37  

(1)
Includes income from continuing and discontinued operations for the three months ended September 30, 2003 and nine months ended September 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 September 30, 2004, and 16,200,000 shares held in escrow at September 30, 2003.

26


Summary Financial Data (Continued)

 
  Three Months Ended
September 30,

  Nine Months Ended
September 30,

 
  2004
  2003
  2004
  2003
 
  (in millions)

Supplemental Data                        
  Average balance sheet:                        
    Total loans held for sale   $ 28,220   $ 51,950   $ 28,592   $ 50,773
    Total loans held in portfolio     199,159     152,018     189,779     147,666
    Total interest-earning assets     252,235     249,892     247,842     246,537
    Total assets     283,669     290,215     279,686     285,032
    Total interest-bearing deposits     135,600     124,488     128,893     121,221
    Total noninterest-bearing deposits     33,266     49,457     33,671     44,015
    Total stockholders' equity     20,703     20,657     20,361     20,764
  Period-end balance sheet:                        
    Loans held for sale     29,184     35,820     29,184     35,820
    Loans held in portfolio, net of allowance for loan and lease losses     204,836     158,680     204,836     158,680
    Total assets     288,828     286,631     288,828     286,631
    Total deposits     168,695     164,141     168,695     164,141
    Total stockholders' equity     20,820     20,441     20,820     20,441
  Loan volume:                        
    Home loans:                        
      Adjustable rate     25,589     28,225     77,164     76,503
      Fixed rate     14,635     83,360     62,275     235,499
      Specialty mortgage finance (1)     7,536     5,460     21,972     14,647
   
 
 
 
        Total home loan volume     47,760     117,045     161,411     326,649
    Total loan volume     61,825     131,938     203,511     362,342
    Home loan refinancing (2)     23,834     90,762     97,268     261,166
    Total refinancing (2)     24,824     93,972     101,995     267,897

(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 largely from contraction of the net interest margin, which declined by 30 and 35 basis points to 2.77% and 2.84% for the three and nine months ended September 30, 2004 from 3.07% and 3.19% for the same periods in 2003, as yields on interest-earning assets continued to decline through the first half of 2004, primarily as a result of the sales and runoff of higher yielding loans and debt securities. Reduced levels of refinancing activity during the third quarter of 2004 also contributed to margin compression, as average noninterest-bearing custodial and escrow deposits declined by approximately $20 billion as compared with the third quarter of 2003.

        Interest rate contracts, including embedded derivatives, held for asset/liability interest rate risk management purposes decreased net interest income by $39 million and $240 million for the three and nine months ended September 30, 2004, compared with $158 million and $462 million for the same periods in 2003.

27



        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 September 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   $ 922   1.44 % $ 3   $ 1,350   2.16 % $ 7
  Available-for-sale securities (1) :                                
    Mortgage-backed securities     9,726   3.85     94     21,174   4.51     239
    Investment securities     7,597   3.62     69     17,652   3.66     162
  Loans held for sale (2)     28,220   4.83     341     51,950   5.31     689
  Loans held in portfolio (2)(3) :                                
    Loans secured by real estate:                                
      Home     108,594   4.19     1,137     84,456   4.56     963
      Purchased specialty mortgage finance     16,279   4.57     186     10,777   5.30     143
   
     
 
     
          Total home loans     124,873   4.24     1,323     95,233   4.64     1,106
      Home equity loans and lines of credit     38,329   4.55     438     22,209   4.79     266
      Home construction:                                
        Builder (4)     1,288   4.68     15     1,105   4.47     13
        Custom (5)     1,405   6.07     21     977   6.90     17
      Multi-family     21,240   4.90     260     19,920   5.16     258
      Other real estate     6,364   5.78     93     6,989   6.31     111
   
     
 
     
          Total loans secured by real estate     193,499   4.44     2,150     146,433   4.83     1,771
    Consumer     860   10.17     22     1,178   8.55     25
    Commercial business     4,800   4.43     54     4,407   4.18     47
   
     
 
     
          Total loans held in portfolio     199,159   4.46     2,226     152,018   4.84     1,843
  Other     6,611   4.70     78     5,748   3.99     58
   
     
 
     
          Total interest-earning assets     252,235   4.45     2,811     249,892   4.79     2,998
Noninterest-earning assets:                                
  Mortgage servicing rights     6,698               6,250          
  Goodwill     6,196               6,196          
  Other (6)     18,540               27,877          
   
           
         
          Total assets   $ 283,669             $ 290,215          
   
           
         

(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 $80 million and $94 million for the three months ended September 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 September 30, 2003.

28


(Continued from the previous page.)

 
  Three Months Ended September 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   $ 54,377   1.25 % $ 172   $ 64,057   1.68 % $ 272
    Savings and money market deposits     43,278   1.27     138     28,674   0.88     63
    Time deposits     37,945   2.40     229     31,757   2.53     203
   
     
 
     
      Total interest-bearing deposits     135,600   1.58     539     124,488   1.72     538
  Federal funds purchased and commercial paper     2,733   1.54     10     4,057   1.12     12
  Securities sold under agreements to repurchase     14,213   2.75     100     21,399   2.19     120
  Advances from Federal Home Loan Banks     59,227   2.02     306     45,334   2.59     300
  Other     12,922   3.62     116     12,203   3.94     119
   
     
 
     
      Total interest-bearing liabilities     224,695   1.89     1,071     207,481   2.07     1,089
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     33,266               49,457          
  Other liabilities (7)     5,005               12,620          
  Stockholders' equity     20,703               20,657          
   
           
         
      Total liabilities and stockholders' equity   $ 283,669             $ 290,215          
   
           
         
Net interest spread and net interest income         2.56   $ 1,740         2.72   $ 1,909
             
           
Impact of noninterest-bearing sources         0.21               0.35      
Net interest margin         2.77               3.07      

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

29


 
  Nine Months Ended September 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   $ 993   1.30 % $ 10   $ 3,297   1.39 % $ 35
  Available-for-sale securities (1) :                                
    Mortgage-backed securities     9,870   4.04     299     23,805   5.04     900
    Investment securities     12,862   3.19     308     15,829   4.08     484
  Loans held for sale (2)     28,592   5.03     1,079     50,773   5.41     2,061
  Loans held in portfolio (2)(3) :                                
    Loans secured by real estate:                                
      Home     105,559   4.18     3,311     83,656   4.91     3,079
      Purchased specialty mortgage finance     15,223   4.83     552     10,456   5.57     437
   
     
 
     
          Total home loans     120,782   4.26     3,863     94,112   4.98     3,516
      Home equity loans and lines of credit     33,786   4.59     1,162     19,583   5.09     747
      Home construction:                                
        Builder (4)     1,205   4.49     41     1,088   4.75     39
        Custom (5)     1,302   6.13     60     942   7.36     52
      Multi-family     20,810   4.98     777     19,149   5.38     773
      Other real estate     6,484   5.87     287     7,344   6.30     348
   
     
 
     
          Total loans secured by real estate     184,369   4.48     6,190     142,218   5.13     5,475
  Consumer     928   10.08     70     1,255   8.82     83
  Commercial business     4,482   4.24     144     4,193   4.49     143
   
     
 
     
          Total loans held in portfolio     189,779   4.50     6,404     147,666   5.15     5,701
  Other     5,746   4.27     184     5,167   4.72     183
   
     
 
     
          Total interest-earning assets     247,842   4.46     8,284     246,537   5.06     9,364
Noninterest-earning assets:                                
  Mortgage servicing rights     6,566               5,490          
  Goodwill     6,196               6,199          
  Other (6)     19,082               26,806          
   
           
         
          Total assets   $ 279,686             $ 285,032          
   
           
         

(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 $240 million and $228 million for the nine months ended September 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 nine months ended September 30, 2003.

30


(Continued from the previous page.)

 
  Nine Months Ended September 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   $ 62,396   1.27 % $ 593   $ 60,980   1.78 % $ 810
    Savings and money market deposits     33,211   1.00     249     28,265   0.98     207
    Time deposits     33,286   2.39     598     31,976   2.74     657
   
     
 
     
      Total interest-bearing deposits     128,893   1.49     1,440     121,221   1.85     1,674
  Federal funds purchased and commercial paper     3,084   1.21     28     2,917   1.21     26
  Securities sold under agreements to repurchase     17,711   2.26     304     20,607   2.52     394
  Advances from Federal Home Loan Banks     57,135   2.05     892     50,993   2.62     1,012
  Other     13,241   3.58     354     13,192   3.76     371
   
     
 
     
      Total interest-bearing liabilities     220,064   1.82     3,018     208,930   2.21     3,477
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     33,671               44,015          
  Other liabilities (7)     5,590               11,323          
  Stockholders' equity     20,361               20,764          
   
           
         
      Total liabilities and stockholders' equity   $ 279,686             $ 285,032          
   
           
         
Net interest spread and net interest income         2.64   $ 5,266         2.85   $ 5,887
             
           
Impact of noninterest-bearing sources         0.20               0.34      
Net interest margin         2.84               3.19      

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

31


    Noninterest Income

        Noninterest income from continuing operations consisted of the following:

 
  Three Months Ended
September 30,

   
  Nine Months Ended
September 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

 
Home loan mortgage banking income (expense):                                  
  Loan servicing income (expense):                                  
    Loan servicing fees   $ 482   $ 542   (11 )% $ 1,469   $ 1,748   (16 )%
    Amortization of mortgage servicing rights     (589 )   (665 ) (11 )   (1,884 )   (2,665 ) (29 )
    MSR valuation adjustments:                                  
      MSR net ineffectiveness under Statement No. 133     431           153        
      MSR lower of cost or market adjustment     (266 )   368       (646 )   96    
   
 
     
 
     
        Net MSR valuation adjustments     165     368   (55 )   (493 )   96    
    Other, net     (62 )   (220 ) (72 )   (217 )   (515 ) (58 )
   
 
     
 
     
          Net home loan servicing income (expense)     (4 )   25       (1,125 )   (1,336 ) (16 )
  Revaluation gain (loss) from derivatives     107     (172 )     969     643   51  
  Net settlement income from certain interest-rate swaps     126     130   (3 )   485     354   37  
  Gain (loss) from mortgage loans     210     (204 )     494     1,186   (58 )
  Loan related income     65     108   (40 )   212     274   (23 )
  Gain from sale of originated mortgage-backed securities         258   (100 )       260   (100 )
   
 
     
 
     
          Total home loan mortgage banking income     504     145   248     1,035     1,381   (25 )
Depositor and other retail banking fees     514     471   9     1,484     1,346   10  
Securities fees and commissions     104     103   1     315     291   8  
Insurance income     61     45   36     179     139   29  
Portfolio loan related income     109     116   (7 )   299     344   (13 )
Gain from other available-for-sale securities     11     557   (98 )   73     689   (89 )
Gain (loss) on extinguishment of borrowings     (147 )   7       (237 )   (129 ) 84  
Other income     108     120   (10 )   247     323   (24 )
   
 
     
 
     
          Total noninterest income   $ 1,264   $ 1,564   (19 ) $ 3,395   $ 4,384   (23 )
   
 
     
 
     

    Home Loan Mortgage Banking Income

        The decrease in home loan servicing fees for the three and nine months ended September 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. The volume of new, salable loan production was lower than the paydown rate of the servicing portfolio.

        The weighted average servicing fee decreased from 35 basis points at September 30, 2003 to 33 basis points at September 30, 2004 primarily 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 $230 million during the twelve months ending

32



September 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.

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

 
  Three Months Ended
September 30,

  Nine Months Ended
September 30,

 
  2004
  2003
  2004
  2003
 
  (in millions)

Statement No. 133 MSR accounting valuation adjustments   $ (885 ) $   $ 822   $
Change in value of MSR accounted for under lower of aggregate cost or market value methodology     (266 )   368     (646 )   96
   
 
 
 
  Total MSR valuation changes     (1,151 )   368     176     96
Statement No. 133 fair value hedging adjustments     1,316         (669 )  
Revaluation gain (loss) from derivatives – MSR risk management     130     (317 )   917     840
Net settlement income from certain interest-rate swaps     126     120     481     344
Gain from securities     45     176     50     316
   
 
 
 
  Net valuation change in hedging and risk management instruments     1,617     (21 )   779     1,500
   
 
 
 
    Total change in MSR valuation, net of hedging and risk management instruments   $ 466   $ 347   $ 955   $ 1,596
   
 
 
 

        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 nine months ended September 30, 2004 and 2003:

 
  Three Months Ended
September 30, 2004

  Nine Months Ended
September 30, 2004

 
  MSR
  Loans
Held
for Sale

  Other
  Total
  MSR
  Loans
Held
for Sale

  Other
  Total
 
  (in millions)

Revaluation gain (loss) from derivatives   $ 130   $ (23 ) $   $ 107   $ 917   $ 52   $   $ 969
Net settlement income from certain interest-rate swaps     126             126     481     4         485
Gain from securities:                                                
  Gain from other available-for-sale securities             11     11     5         68     73
  Revaluation gain from principal-only mortgage-backed trading securities (1)     45             45     45             45
   
 
 
 
 
 
 
 
    Total   $ 301   $ (23 ) $ 11   $ 289   $ 1,448   $ 56   $ 68   $ 1,572
   
 
 
 
 
 
 
 

(1)
Reported within other noninterest income on the Consolidated Statements of Income.

33


 
  Three Months Ended September 30, 2003
  Nine Months Ended
September 30, 2003

 
  MSR
  Loans
Held
for Sale

  Other
  Total
  MSR
  Loans
Held
for Sale

  Other
  Total
 
  (in millions)

Revaluation gain (loss) from derivatives   $ (317 ) $ 145   $   $ (172 ) $ 840   $ (197 ) $   $ 643
Net settlement income from certain interest-rate swaps     120     10         130     344     10         354
Gain from other available-for-sale securities     176         381     557     316         373     689
   
 
 
 
 
 
 
 
  Total   $ (21 ) $ 155   $ 381   $ 515   $ 1,500   $ (187 ) $ 373   $ 1,686
   
 
 
 
 
 
 
 

        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 statistical methods of correlation to determine if the results of the changes in value of the hedging derivative and the hedged MSR 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 gain of $466 million in the third quarter of 2004, compared with a gain of $347 million in the third quarter of 2003. The hedging performance of the MSR asset was affected by the significant decrease in mortgage interest rates during the quarter. At September 30, 2004, the Federal National Mortgage Association ("FNMA") 30-year current coupon fixed mortgage rate was 5.24%, a decrease of 38 basis points from 5.62% at June 30, 2004. As interest rates decreased, basis spreads between mortgage rates and interest rate swap indices widened, resulting in gains on MSR hedging and risk management instruments that exceeded the decrease in value of the MSR.

        During the nine months ended September 30, 2004, we recorded other than temporary MSR impairment of $410 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 Company recorded other than temporary MSR impairment of $1.11 billion for the nine months ended September 30, 2003.

34


        MSR amortization expense was lower in the first nine months 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.

        The decrease in "Other, net" home loan servicing income (expense) for the three and nine months ended September 30, 2004 resulted from lower loan pool expenses due to the reduction in refinancing activity. Loan pool expenses represent the amount of expense that the Company incurs for the elapsed time between the borrower payoff date and the next monthly investor pool cutoff date.

        In measuring the fair value of MSR, we stratify the loans in our servicing portfolio based on loan type and coupon rate. 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 September 30, 2004, we stratified the loans in our servicing portfolio as follows:

 
   
  September 30, 2004
 
  Rate Band
  Gross
Carrying
Value

  Valuation
Allowance

  Net
Carrying
Value

  Fair
Value

 
   
  (in millions)

Primary Servicing:                            
  Adjustable   All loans   $ 1,653   $ 647   $ 1,006   $ 1,006
  Government-sponsored enterprises   6.00% and below     2,888     510     2,378     2,378
  Government-sponsored enterprises   6.01% to 7.49%     1,563     706     857     857
  Government-sponsored enterprises   7.50% and above     203     81     122     122
  Government   6.00% and below     495     85     410     410
  Government   6.01% to 7.49%     551     237     314     314
  Government   7.50% and above     262     115     147     147
  Private   6.00% and below     476     83     393     393
  Private   6.01% to 7.49%     275     121     154     154
  Private   7.50% and above     97     32     65     65
       
 
 
 
    Total primary servicing         8,463     2,617     5,846     5,846
Master servicing   All loans     111     30     81     81
Specialty home loans   All loans     159     4     155     155
Multi-family   All loans     32     2     30     30
       
 
 
 
    Total       $ 8,765   $ 2,653   $ 6,112   $ 6,112
       
 
 
 

35


        At September 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:

 
  September 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   $ 4,228   $ 612   $ 1,006   $ 155  
Expected weighted-average life (in years)     3.8     3.8     3.2     2.5  
Constant prepayment rate ("CPR") (1)     18.55 %   19.94 %   28.12 %   32.37 %
  Impact on fair value of 25% decrease in CPR   $ 789   $ 136   $ 217   $ 33  
  Impact on fair value of 50% decrease in CPR     1,885     328     538     81  
  Impact on fair value of 25% increase in CPR     (592 )   (101 )   (158 )   (25 )
  Impact on fair value of 50% increase in CPR     (1,051 )   (179 )   (282 )   (44 )
Discounted cash flow rate ("DCF")     8.31 %   9.81 %   9.58 %   19.75 %
  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   $ 300   $ 48   $ 57     13  
  Impact on fair value of 50% decrease in DCF     654     106     122     n/a  
  Impact on fair value of 25% increase in DCF     (258 )   (41 )   (50 )   (11 )
  Impact on fair value of 50% increase in DCF     (482 )   (75 )   (94 )   (20 )

(1)
Represents the expected lifetime average.

        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 gain from mortgage loans, net of risk management instruments, of $187 million and $550 million for the three and nine months ended September 30, 2004, compared with a net loss of $49 million and a net gain of $999 million for the same periods in 2003. The increase of $236 million from the three months ended September 30, 2003 to the same period in 2004 was primarily the result of losses incurred from various market volatility and operational issues experienced during the third quarter of 2003, including unhedged rate lock extensions granted to customers, a diminished level of market liquidity for certain instruments used to manage interest rate risk on rate locks and loans held for sale, and systems issues that caused data interruptions during the period. The decrease of $449 million from the nine months ended September 30, 2003 to the same period in 2004 was primarily the result of

36



historically low mortgage interest rates during the first part of 2003 which 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 $240.44 billion in the first nine months of 2003 to $67.91 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 $18.47 billion in the first nine months of 2003 to $50.29 billion in the same period of 2004.

        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 or more past due for four consecutive months with at least one payment that remains uncured (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 $30 million and $130 million for the three and nine months ended September 30, 2004 and $81 million and $309 million for the 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, a net loss of $23 million and a net gain of $52 million were recognized as revaluation gain/loss from derivatives during the three and nine months ended September 30, 2004, compared with a revaluation gain of $145 million and a net loss of $197 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 September 30, 2004, the fair value of loans held for sale was $29.32 billion with a carrying amount of $29.18 billion, and as of December 31, 2003, the fair value and carrying amount were $20.84 billion.

        Net settlement income from certain interest-rate swaps primarily represents income from our interest-rate swaps that are designated as MSR risk management instruments. At September 30, 2004, the total notional amount of such swaps was $41.99 billion, compared with $24.73 billion at September 30, 2003.

        Loan related income decreased for the three and nine months ended September 30, 2004 primarily due to decreased loan transfer fees charged to our correspondent lenders resulting from decreased loan volume.

    All Other Noninterest Income Analysis

        The increase in depositor and other retail banking fees for the three and nine months ended September 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 September 30, 2004 totaled approximately 7.0 million, compared with approximately 6.3 million at September 30, 2003.

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

37



        Gain from other available-for-sale securities decreased to $11 million for the third quarter of 2004 from $557 million for the same period in 2003. During the third quarter of 2003, sales of $28.10 billion in mortgage-backed securities and investment securities resulted in total gains of approximately $815 million and included $176 million designated as MSR risk management instruments and $381 million related to securities acquired for asset-liability risk management. The remaining gains of $258 million are reflected as gain from sale of originated mortgage-backed securities within home loan mortgage banking income. There were no similar sales for the same period in 2004.

        Several securities sold under agreements to repurchase ("repurchase agreements") with associated pay-fixed swaps were terminated during the third quarter of 2004, resulting in a net loss on extinguishment of borrowings of $147 million. During the first half of 2004, the Company terminated certain pay-fixed swaps hedging variable rate Federal Home Loan Bank ("FHLB") advances, resulting in a loss of $90 million. During the nine months ended September 30, 2003, the Company restructured certain repurchase agreements containing embedded pay-fixed swaps resulting in a loss of $129 million. Each of these transactions had the immediate effect of reducing the Company's wholesale borrowing costs.

        Other income included $45 million of income recognized from revaluation gains on principal-only mortgage-backed trading securities in the third quarter of 2004, which were acquired as MSR risk management instruments. In the third quarter of 2003, other income included a $55 million fee received from the Federal Home Loan Mortgage Corporation ("FHLMC" or "Freddie Mac") for swapping certain multi-family loans for 100% of the beneficial interest in those loans in the form of mortgage-backed securities. The decrease for the nine months ended September 30, 2004 as compared with the same period in 2003 was primarily due to a decline in the income recorded on residual interests in collateralized mortgage obligations and other trading securities.

    Noninterest Expense

        Noninterest expense from continuing operations consisted of the following:

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

 
Compensation and benefits   $ 841   $ 837   % $ 2,589   $ 2,427   7 %
Occupancy and equipment     404     352   15     1,197     1,024   17  
Telecommunications and outsourced information services     118     150   (21 )   364     429   (15 )
Depositor and other retail banking losses     54     35   54     134     113   18  
Amortization of other intangible assets     14     15   (8 )   42     46   (8 )
Advertising and promotion     76     51   49     219     190   15  
Professional fees     34     69   (51 )   105     189   (44 )
Postage     58     51   14     174     164   6  
Loan expense     57     71   (19 )   166     192   (13 )
Travel and training     26     38   (31 )   89     111   (20 )
Reinsurance expense     21     12   73     59     44   35  
Other expense     166     129   27     459     377   22  
   
 
     
 
     
  Total noninterest expense   $ 1,869   $ 1,810   3   $ 5,597   $ 5,306   5  
   
 
     
 
     

        The increase in employee compensation and benefits for the nine months ended September 30, 2004, compared with the same period in 2003 was primarily due to lower levels of compensation expense that are deferrable as direct loan origination costs and an $84 million charge for severance expense related to staffing reductions that occurred as part of the Company's ongoing cost containment initiative. The

38



number of employees was 55,488 at September 30, 2004, compared with 61,374 at December 31, 2003 and 60,549 at September 30, 2003.

        The increase in occupancy and equipment expense for the three months ended September 30, 2004, compared with the same period in 2003 resulted primarily from restructuring activities and increased rent expense. Restructuring activities included a $14 million charge for the discontinued use of facilities and a $14 million loss on the disposal of furniture and equipment. The increase in rent expense was due to the continued expansion of new retail banking stores throughout the twelve month period ending September 30, 2004. The majority of the increase for the nine months ended September 30, 2004 was from higher equipment depreciation expense, building rent expense and the costs related to the discontinued use of facilities and losses on the disposal of equipment. Depreciation expense increased due to the completion of technology projects that were placed in service during the second quarter of 2003.

        The increase in depositor and other retail banking losses was primarily due to higher levels of overdraft charge-offs, losses from returned deposited checks and a general increase in check fraud.

        The increase in advertising and promotion expense for the three months ended September 30, 2004 was primarily due to additional direct mailing costs for the Free Checking campaign and other local marketing and community relations expense.

        The decrease in professional fees for the three and nine months ended September 30, 2004 was mostly due to decreases in fees associated with technology-related projects.

        The increase in other expense for the three and nine months ended September 30, 2004 was partly due to an increase in the accrual for estimated losses related to certain outstanding litigation settlements, judgments and potential environmental claims.

Review of Financial Condition

    Securities

        Securities consisted of the following:

 
  September 30, 2004
 
  Amortized
Cost

  Unrealized
Gains

  Unrealized
Losses

  Fair
Value

 
  (in millions)

Available-for-sale securities                        
Mortgage-backed securities:                        
  U.S. Government and agency   $ 8,801   $ 138   $ (21 ) $ 8,918
  Private issue     1,220     30         1,250
   
 
 
 
    Total mortgage-backed securities     10,021     168     (21 )   10,168
Investment securities:                        
  U.S. Government and agency     5,842     38     (36 )   5,844
  Other debt securities     326     19         345
  Equity securities     123     8     (1 )   130
   
 
 
 
    Total investment securities     6,291     65     (37 )   6,319
   
 
 
 
      Total available-for-sale securities   $ 16,312   $ 233   $ (58 ) $ 16,487
   
 
 
 

39


 
  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
September 30,

  Nine Months Ended
September 30,

 
 
  2004
  2003
  2004
  2003
 
 
  (in millions)

 
Available-for-sale securities                          
Realized gross gains   $ 41   $ 905   $ 238   $ 1,083  
Realized gross losses     (30 )   (90 )   (165 )   (134 )
   
 
 
 
 
  Realized net gain   $ 11   $ 815   $ 73   $ 949  
   
 
 
 
 

        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.

40


    Loans

        Loans held in portfolio consisted of the following:

 
  September 30,
2004

  December 31,
2003

 
  (in millions)

Loans secured by real estate:            
  Home   $ 112,230   $ 100,043
  Purchased specialty mortgage finance     17,305     12,973
   
 
      Total home loans     129,535     113,016
  Home equity loans and lines of credit     40,505     27,647
  Home construction:            
    Builder (1)     1,248     1,052
    Custom (2)     1,484     1,168
  Multi-family     21,640     20,324
  Other real estate     6,268     6,649
   
 
      Total loans secured by real estate     200,680     169,856
Consumer     831     1,028
Commercial business     4,647     4,266
   
 
        Total loans held in portfolio   $ 206,158   $ 175,150
   
 

(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:

 
  September 30,
2004

  December 31,
2003

 
  (in millions)

Premises and equipment   $ 3,279   $ 3,286
Investment in bank-owned life insurance     2,655     2,582
Accrued interest receivable     1,453     1,558
Foreclosed assets     281     311
Other intangible assets     208     251
Derivatives     1,488     1,457
Trading securities     3,113     1,381
Accounts receivable     3,653     4,309
Other     1,281     1,366
   
 
  Total other assets   $ 17,411   $ 16,501
   
 

        A majority of the increase in trading securities was due to the purchase of principal-only mortgage backed securities that are being used for MSR risk management purposes.

41



    Deposits

        Deposits consisted of the following:

 
  September 30,
2004

  December 31,
2003

 
  (in millions)

Retail deposits:            
  Checking deposits:            
    Noninterest bearing   $ 16,178   $ 13,724
    Interest bearing     52,378     67,990
   
 
        Total checking deposits     68,556     81,714
  Savings and money market deposits     38,620     22,131
  Time deposits     24,825     24,605
   
 
        Total retail deposits     132,001     128,450
Commercial business deposits     8,117     7,159
Wholesale deposits     14,052     2,579
Custodial and escrow deposits (1)     14,525     14,993
   
 
        Total deposits   $ 168,695   $ 153,181
   
 

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

        The increase in retail deposits was primarily the result of the $16.49 billion increase in savings and money market deposits from year-end 2003, which was predominantly due to the introduction of the Platinum Savings account, substantially offset by a decline in Platinum Checking account balances. The $11.47 billion increase in wholesale deposits from year-end 2003 was predominantly due to an increase in our investor base resulting from an upgrade in our credit rating from a major agency in the early part of 2004, making the Company more attractive to institutional investors.

        Checking, savings and money market deposits composed 81% of retail deposits at September 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 September 30, 2004, deposits funded 58% of total assets, compared with 56% at December 31, 2003.

    Borrowings

        At September 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
September 30,

   
  Nine Months Ended
September 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income   $ 1,295   $ 994   30 % $ 3,802   $ 2,902   31 %
  Provision for loan and lease losses     43     40   9     123     113   10  
  Noninterest income     713     653   9     2,038     1,851   10  
  Inter-segment revenue     3     63   (96 )   15     159   (90 )
  Noninterest expense     1,116     980   14     3,303     2,860   15  
   
 
     
 
     
  Income before income taxes     852     690   23     2,429     1,939   25  
  Income taxes     323     274   18     920     744   24  
   
 
     
 
     
    Net income   $ 529   $ 416   27   $ 1,509   $ 1,195   26  
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio (1)     49.02 %   49.65 % (1 )   49.81 %   50.35 % (1 )
  Average loans   $ 167,539   $ 118,295   42   $ 158,646   $ 116,307   36  
  Average assets     179,950     130,046   38     170,881     127,934   34  
  Average deposits     131,850     126,040   5     129,518     124,358   4  
  Employees at end of period     29,963     28,802   4     29,963     28,802   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 increase in net interest income was mostly due to higher average balances of home loans and home equity loans and lines of credit. Average home loans have increased $27.93 billion and $24.28 billion, or 34% and 30%, for the three and nine months ended September 30, 2004, compared with the same periods in 2003 resulting from increased growth in short-term adjustable-rate mortgages typically held in portfolio. Average home equity loans and lines of credit increased $16.12 billion and $14.27 billion, or 73%, for the three and nine months ended September 30, 2004, compared with the same periods in 2003.

        The increase in noninterest income was primarily due to depositor and other retail banking fees resulting from higher numbers of net new retail checking accounts, which increased by approximately 142,000 in the third quarter of 2004 and 755,000 in the preceding twelve months.

        Inter-segment revenue decreased due to lower broker fees received from the Mortgage Banking segment for the origination of mortgage loans, which resulted from the overall decline in refinancing activity.

        The increase in noninterest expense was primarily driven by employee compensation and benefits and occupancy and equipment expense resulting from expansion of the Company's distribution network, which included the opening of 56 net new stores in the third quarter of 2004 and 195 net new stores in the preceding twelve months.

        The increase in average deposits was primarily due to higher levels of interest-bearing Platinum Savings accounts.

43



    Mortgage Banking

 
  Three Months Ended
September 30,

   
  Nine Months Ended
September 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income   $ 274   $ 683   (60 )% $ 908   $ 2,028   (55 )%
  Provision for loan and lease losses     2     1   143     7     1   433  
  Noninterest income     769     288   167     1,728     2,076   (17 )
  Inter-segment expense     3     63   (96 )   15     159   (90 )
  Noninterest expense     602     729   (17 )   1,921     2,180   (12 )
   
 
     
 
     
  Income before income taxes     436     178   146     693     1,764   (61 )
  Income taxes     165     61   171     262     664   (61 )
   
 
     
 
     
    Net income   $ 271   $ 117   133   $ 431   $ 1,100   (61 )
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio (1)     52.89 %   74.66 % (29 )   67.33 %   51.31 % 31  
  Average loans   $ 22,611   $ 51,648   (56 ) $ 23,158   $ 48,160   (52 )
  Average assets     36,343     78,806   (54 )   37,243     73,130   (49 )
  Average deposits     15,385     35,120   (56 )   16,695     30,066   (44 )
  Employees at end of period     16,786     22,527   (25 )   16,786     22,527   (25 )

(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 decrease in net interest income was mostly due to a decline in the average balances of loans held for sale. This occurred due to a reduction in refinancing activity, compared with 2003 when interest rates were at record low levels and a shift in loan volume mix from fixed-rate loans to adjustable-rate loans that are generally held in portfolio. Total loan volume for the three months ended September 30, 2004 was $40.49 billion, compared with $111.95 billion for the same period in 2003. Adjustable-rate loan mortgage volume increased for the three months ended September 30, 2004 to 63% of total loan volume from 25% in 2003.

        The increase in noninterest income for the three months ended September 30, 2004 was primarily due to losses from mortgage loans incurred during the third quarter of 2003, resulting from various market volatility and operational issues, including unhedged rate lock extensions granted to customers, a diminished level of market liquidity for certain instruments used to manage interest rate risk on rate locks and loans held for sale, and systems issues that caused data interruptions during the period. The decrease in noninterest income for the nine months ended September 30, 2004 was mostly due to gains from other available-for-sale securities resulting from sales of investment securities designated as MSR risk management instruments during the second and third quarters of 2003. There was no comparable activity for the same periods in 2004.

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

        The decrease in noninterest expense for the three and nine months ended September 30, 2004 was primarily due to lower technology and compensation and benefits expense. This reflects the consolidation of various locations and functions, the conversion to a single loan servicing platform, headcount reductions, which decreased to 16,786 at September 30, 2004 from 22,527 at September 30, 2003, and the sale or closure of approximately 100 home loan offices in non-strategic markets.

44



        The decrease in average deposits was predominantly due to lower custodial and escrow balances resulting from the overall decline in refinancing activity, compared with 2003.

    Commercial Group

 
  Three Months Ended
September 30,

   
  Nine Months Ended
September 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income   $ 324   $ 324   % $ 1,004   $ 959   5 %
  Provision for loan and lease losses     10     24   (59 )   34     86   (60 )
  Noninterest income     66     204   (67 )   256     421   (39 )
  Noninterest expense     160     142   13     458     406   12  
   
 
     
 
     
  Income from continuing operations before income taxes     220     362   (39 )   768     888   (14 )
  Income taxes     75     130   (42 )   268     317   (16 )
   
 
     
 
     
  Income from continuing operations     145     232   (38 )   500     571   (12 )
  Income from discontinued operations, net of taxes         24   (100 )       65   (100 )
   
 
     
 
     
      Net income   $ 145   $ 256   (44 ) $ 500   $ 636   (21 )
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio (1)     33.45 %   21.39 % 56     29.25 %   23.13 % 26  
  Average loans   $ 38,829   $ 35,318   10   $ 38,120   $ 34,728   10  
  Average assets     43,745     44,017   (1 )   43,460     43,231   3  
  Average deposits     7,811     6,131   27     6,922     5,163   34  
  Employees at end of period (2)     3,270     5,594   (42 )   3,270     5,594   (42 )

(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).
(2)
Includes 2,352 employees reported as part of discontinued operations as of the three and nine months ended September 30, 2003.

        The decrease in the provision for loan and lease losses resulted from lower actual charge-offs and lower expected charge-off rates of commercial and multi-family loans, compared with 2003.

        The decrease in noninterest income for the three and nine months ended September 30, 2004 was primarily due to transactions during the third quarter of 2003 that resulted in a gain of $70 million recognized from the sale of mortgage-backed securities and a nonrefundable fee of $55 million received as consideration for swapping approximately $3.3 billion of multi-family loans with Freddie Mac.

        The increase in noninterest expense was mostly due to increased compensation and benefits, technology and occupancy and equipment expense and other expenses due to growth in Long Beach Mortgage, part of the Company's specialty mortgage finance program.

45



    Corporate Support/Treasury and Other

 
  Three Months Ended
September 30,

   
  Nine Months Ended
September 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2004
  2003
  2004
  2003
 
 
  (dollars in millions)

   
  (dollars in millions)

   
 
Condensed income statement:                                  
  Net interest income (expense)   $ (263 ) $ (183 ) 43 % $ (767 ) $ (261 ) 194 %
  Noninterest income (expense)     (122 )   611       (158 )   548    
  Noninterest expense     203     171   18     548     490   12  
   
 
     
 
     
  Income (loss) from continuing operations before income taxes     (588 )   257       (1,473 )   (203 ) 627  
  Income taxes (benefit)     (221 )   95       (551 )   (75 ) 634  
   
 
     
 
     
  Income (loss) from continuing operations     (367 )   162       (922 )   (128 ) 624  
  Income from discontinued operations, net of taxes               399        
   
 
     
 
     
      Net income (loss)   $ (367 ) $ 162     $ (523 ) $ (128 ) 310  
   
 
     
 
     
Performance and other data:                                  
  Average assets   $ 25,452   $ 39,108   (35 ) $ 29,845   $ 42,403   (30 )
  Average deposits     13,820     6,654   108     9,429     5,649   67  
  Employees at end of period     5,469     5,978   (9 )   5,469     5,978   (9 )

        The increase in net interest expense was primarily due to lower interest income from declining balances of available-for-sale securities.

        The decrease in noninterest income was substantially due to gains realized on the sale of available-for-sale securities during the third quarter of 2003 and losses of $237 million that resulted from the termination of certain wholesale borrowings with associated pay-fixed interest rate swaps during the nine months ended September 30, 2004.

        A significant portion of the increase in noninterest expense was due to severance and facility closures related to the Company's cost containment initiative. All such restructuring charges incurred from this initiative are charged to this unit.

        The decrease in average assets was mostly due to the sales and paydowns of 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.

46


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 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 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 $1.79 billion at September 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:

 
  September 30,
2004

  June 30,
2004

  December 31,
2003

 
 
  (dollars in millions)

 
Nonperforming assets and restructured loans:                    
  Nonaccrual loans:                    
    Loans secured by real estate:                    
      Home   $ 538   $ 535   $ 736  
      Purchased specialty mortgage finance     608     585     597  
   
 
 
 
          Total home nonaccrual loans     1,146     1,120     1,333  
      Home equity loans and lines of credit     50     48     47  
      Home construction:                    
        Builder (1)     23     18     25  
        Custom (2)     8     6     10  
      Multi-family     23     20     19  
      Other real estate     173     133     153  
   
 
 
 
          Total nonaccrual loans secured by real estate     1,423