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


FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005

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 April 29, 2005:

Common Stock – 877,243,302 (1)

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




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2005


TABLE OF CONTENTS

 
  Page
PART I – Financial Information   1
  Item 1. Financial Statements   1
    Consolidated Statements of Income –
Three Months Ended March 31, 2005 and 2004
  1
    Consolidated Statements of Financial Condition –
March 31, 2005 and December 31, 2004
  3
    Consolidated Statements of Stockholders' Equity and Comprehensive Income –
Three Months Ended March 31, 2005 and 2004
  4
    Consolidated Statements of Cash Flows –
Three Months Ended March 31, 2005 and 2004
  5
    Notes to Consolidated Financial Statements   7
 
Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations

 

17
          Cautionary Statements   17
          Overview   18
          Controls and Procedures   19
          Critical Accounting Policies   20
          Recently Issued Accounting Standards   20
          Summary Financial Data   22
          Earnings Performance from Continuing Operations   23
          Review of Financial Condition   31
          Operating Segments   34
          Risk Management   38
          Credit Risk Management   39
          Liquidity Risk Management   41
          Off-Balance Sheet Activities   43
          Capital Adequacy   43
          Market Risk Management   44
          Maturity and Repricing Information   48
          Operational Risk Management   54
  Item 3.    Quantitative and Qualitative Disclosures About Market Risk   44
  Item 4.    Controls and Procedures   19

PART II – Other Information

 

55
  Item 1.    Legal Proceedings   55
  Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds   55
  Item 4.    Submission of Matters to a Vote of Security Holders   56
  Item 6.    Exhibits   56

i



PART I – FINANCIAL INFORMATION

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

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions, except
per share amounts)

 
Interest Income              
  Loans held for sale   $ 470   $ 332  
  Loans held in portfolio     2,544     2,067  
  Available-for-sale securities     224     265  
  Trading securities     79     24  
  Other interest and dividend income     43     33  
   
 
 
    Total interest income     3,360     2,721  
Interest Expense              
  Deposits     696     443  
  Borrowings     774     546  
   
 
 
    Total interest expense     1,470     989  
   
 
 
      Net interest income     1,890     1,732  
  Provision for loan and lease losses     16     56  
   
 
 
    Net interest income after provision for loan and lease losses     1,874     1,676  
Noninterest Income              
  Home loan mortgage banking income (expense):              
    Loan servicing fees     489     502  
    Amortization of mortgage servicing rights     (570 )   (750 )
    Net mortgage servicing rights valuation adjustments     539     (606 )
    Revaluation gain from derivatives     63     1,042  
    Net settlement income from certain interest-rate swaps     51     167  
    Gain from mortgage loans     178     171  
    Other home loan mortgage banking income, net     26     5  
   
 
 
      Total home loan mortgage banking income     776     531  
  Depositor and other retail banking fees     490     463  
  Securities fees and commissions     110     107  
  Insurance income     46     61  
  Portfolio loan related income     85     87  
  Trading securities income (loss)     (89 )   8  
  Gain (loss) from other available-for-sale securities     (122 )   21  
  Loss on extinguishment of borrowings         (89 )
  Other income     112     48  
   
 
 
    Total noninterest income     1,408     1,237  
Noninterest Expense              
  Compensation and benefits     876     899  
  Occupancy and equipment     402     400  
  Telecommunications and outsourced information services     104     123  
  Depositor and other retail banking losses     55     40  
  Advertising and promotion     55     58  
  Professional fees     34     39  
  Other expense     313     321  
   
 
 
    Total noninterest expense     1,839     1,880  
   
 
 
      Income from continuing operations before income taxes     1,443     1,033  
      Income taxes     541     385  
   
 
 
        Income from continuing operations, net of taxes     902     648  

(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
March 31,

 
 
  2005
  2004
 
 
  (in millions, except
per share amounts)

 
Discontinued Operations              
  Loss from discontinued operations before income taxes       $ (32 )
  Gain on disposition of discontinued operations         676  
  Income taxes         245  
   
 
 
    Income from discontinued operations, net of taxes         399  
   
 
 
Net Income   $ 902   $ 1,047  
   
 
 
Basic earnings per common share:              
  Income from continuing operations   $ 1.04   $ 0.75  
  Income from discontinued operations, net         0.46  
   
 
 
    Net Income     1.04     1.21  
Diluted earnings per common share:              
  Income from continuing operations   $ 1.01   $ 0.73  
  Income from discontinued operations, net         0.45  
   
 
 
    Net Income     1.01     1.18  

Dividends declared per common share

 

 

0.46

 

 

0.42

 
Basic weighted average number of common shares outstanding (in thousands)     864,933     863,299  
Diluted weighted average number of common shares outstanding (in thousands)     888,789     886,467  

See Notes to Consolidated Financial Statements.

2



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

 
  March 31,
2005

  December 31,
2004

 
 
  (dollars in millions)

 
Assets              
  Cash and cash equivalents   $ 4,811   $ 4,455  
  Federal funds sold and securities purchased under agreements to resell     1,152     82  
  Trading securities     6,066     5,588  
  Available-for-sale securities, total amortized cost of $20,569 and $19,047:              
    Mortgage-backed securities (including assets pledged of $6,664 and $5,716)     15,947     14,923  
    Investment securities (including assets pledged of $2,480 and $3,344)     4,756     4,296  
   
 
 
      Total available-for-sale securities     20,703     19,219  
  Loans held for sale     41,197     42,743  
  Loans held in portfolio     214,114     207,071  
  Allowance for loan and lease losses     (1,280 )   (1,301 )
   
 
 
      Total loans held in portfolio, net of allowance for loan and lease losses     212,834     205,770  
  Investment in Federal Home Loan Banks     3,973     4,059  
  Mortgage servicing rights     6,802     5,906  
  Goodwill     6,196     6,196  
  Other assets     15,962     13,900  
   
 
 
      Total assets   $ 319,696   $ 307,918  
   
 
 

Liabilities

 

 

 

 

 

 

 
  Deposits:              
    Noninterest-bearing deposits   $ 34,941   $ 32,780  
    Interest-bearing deposits     148,690     140,878  
   
 
 
      Total deposits     183,631     173,658  
  Federal funds purchased and commercial paper     2,053     4,045  
  Securities sold under agreements to repurchase     16,716     15,944  
  Advances from Federal Home Loan Banks     66,730     70,074  
  Other borrowings     21,938     18,498  
  Other liabilities     6,861     4,473  
   
 
 
      Total liabilities     297,929     286,692  

Stockholders' Equity

 

 

 

 

 

 

 
  Common stock, no par value: 1,600,000,000 shares authorized, 877,286,984 and 874,261,898 shares issued and outstanding          
  Capital surplus – common stock     3,399     3,350  
  Accumulated other comprehensive loss     (84 )   (76 )
  Retained earnings     18,452     17,952  
   
 
 
      Total stockholders' equity     21,767     21,226  
   
 
 
      Total liabilities and stockholders' equity   $ 319,696   $ 307,918  
   
 
 

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, 2003   881.0   $ 3,682   $ (524 ) $ 16,584   $ 19,742  
Comprehensive income:                              
  Net income               1,047     1,047  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized gain from securities arising during the period, net of reclassification adjustments           388         388  
    Net unrealized gain from cash flow hedging instruments           130         130  
    Minimum pension liability adjustment           (6 )       (6 )
                         
 
Total comprehensive income                           1,559  
Cash dividends declared on common stock               (367 )   (367 )
Common stock repurchased and retired   (16.1 )   (712 )           (712 )
Common stock issued   4.1     161             161  
   
 
 
 
 
 

BALANCE, March 31, 2004

 

869.0

 

$

3,131

 

$

(12

)

$

17,264

 

$

20,383

 
   
 
 
 
 
 

BALANCE, December 31, 2004

 

874.3

 

$

3,350

 

$

(76

)

$

17,952

 

$

21,226

 
Comprehensive income:                              
  Net income               902     902  
  Other comprehensive income (loss), net of tax:                              
    Net unrealized loss from securities arising during the period, net of reclassification adjustments           (25 )       (25 )
    Net unrealized gain from cash flow hedging instruments           17         17  
                         
 
Total comprehensive income                           894  
Cash dividends declared on common stock               (402 )   (402 )
Common stock repurchased and retired   (2.6 )   (100 )           (100 )
Common stock issued   5.6     149             149  
   
 
 
 
 
 
BALANCE, March 31, 2005   877.3   $ 3,399   $ (84 ) $ 18,452   $ 21,767  
   
 
 
 
 
 

See Notes to Consolidated Financial Statements.

4



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

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions)

 
Cash Flows from Operating Activities              
  Net income   $ 902   $ 1,047  
  Income from discontinued operations, net of taxes         (399 )
   
 
 
    Income from continuing operations     902     648  
  Adjustments to reconcile income from continuing operations to net cash used by operating activities:              
    Provision for loan and lease losses     16     56  
    Gain from mortgage loans     (178 )   (171 )
    Loss (gain) from available-for-sale securities     119     (21 )
    Revaluation gain from derivatives     (63 )   (1,042 )
    Loss on extinguishment of borrowings         89  
    Depreciation and amortization     688     916  
    Provision for mortgage servicing rights (reversal) impairment     (427 )   606  
    Stock dividends from Federal Home Loan Banks     (5 )   (27 )
    Origination and purchases of loans held for sale, net of principal payments     (39,278 )   (32,813 )
    Proceeds from sales of loans held for sale     35,033     18,962  
    Net (increase) decrease in trading securities     (344 )   413  
    (Increase) decrease in other assets     (474 )   2,562  
    Increase (decrease) in other liabilities     1,001     (603 )
   
 
 
      Net cash used by operating activities     (3,010 )   (10,425 )

Cash Flows from Investing Activities

 

 

 

 

 

 

 
  Purchases of securities     (5,964 )   (11 )
  Proceeds from sales and maturities of mortgage-backed securities     2,447     255  
  Proceeds from sales and maturities of other available-for-sale securities     874     14,027  
  Principal payments on securities     749     860  
  Purchases of Federal Home Loan Bank stock         (441 )
  Redemption of Federal Home Loan Bank stock     91     14  
  Origination and purchases of loans held in portfolio     (21,653 )   (28,847 )
  Principal payments on loans held in portfolio     18,988     16,624  
  Proceeds from sales of loans held in portfolio     138     197  
  Proceeds from sales of foreclosed assets     102     123  
  Net increase in federal funds sold and securities purchased under agreements to resell     (1,070 )   (1,764 )
  Purchases of premises and equipment, net     (59 )   (214 )
  Proceeds from sale of discontinued operations, net of cash sold         1,223  
   
 
 
    Net cash (used) provided by investing activities     (5,357 )   2,046  

(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.)

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions)

 
Cash Flows from Financing Activities              
  Increase in deposits   $ 9,973   $ 7,800  
  Increase (decrease) in short-term borrowings     1,386     (10,910 )
  Proceeds from long-term borrowings     1,294     1,475  
  Repayments of long-term borrowings     (216 )   (100 )
  Proceeds from advances from Federal Home Loan Banks     23,404     26,605  
  Repayments of advances from Federal Home Loan Banks     (26,745 )   (16,521 )
  Cash dividends paid on common stock     (402 )   (367 )
  Repurchase of common stock     (100 )   (712 )
  Other     129     136  
   
 
 
    Net cash provided by financing activities     8,723     7,406  
   
 
 
    Increase (decrease) in cash and cash equivalents     356     (973 )
    Cash and cash equivalents, beginning of period     4,455     7,018  
   
 
 
    Cash and cash equivalents, end of period   $ 4,811   $ 6,045  
   
 
 

Noncash Activities

 

 

 

 

 

 

 
  Loans exchanged for mortgage-backed securities   $ 668   $ 1,067  
  Real estate acquired through foreclosure     106     121  

Cash Paid During the Year For

 

 

 

 

 

 

 
  Interest on deposits   $ 616   $ 394  
  Interest on borrowings     731     566  
  Income taxes     244     33  

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 2004 Annual Report on Form 10-K. Certain prior period amounts have been reclassified to conform to current period classifications.

    Recently Adopted Accounting Standards

        In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 ("SOP 03-3"), Accounting for Certain Loans or Debt Securities Acquired in a Transfer . SOP 03-3 addresses the accounting for differences between the contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 does not permit the carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 is effective for loans and debt securities acquired after December 31, 2004. The adoption of SOP 03-3 did not have a material effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

    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 modified Black-Scholes 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 the impact these awards would have on the consolidated financial statements, if they 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 December 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

7



income attributable to common stock and net income per common share would have been reduced to the pro forma amounts indicated below:

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (dollars in millions, except per share amounts)

 
Net income attributable to common stock   $ 902   $ 1,047  
Add back: Stock-based employee compensation expense included in reported net income, net of related tax effects     22     21  
Deduct: Total stock-based employee compensation expense determined under the fair value method for all awards, net of related tax effects     (28 )   (31 )
   
 
 
Pro forma net income attributable to common stock   $ 896   $ 1,037  
   
 
 

Net income per common share:

 

 

 

 

 

 

 
Basic:              
  As reported   $ 1.04   $ 1.21  
  Pro forma     1.04     1.20  
Diluted:              
  As reported     1.01     1.18  
  Pro forma     1.01     1.17  

    Recently Issued Accounting Standards

        In March 2005, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 47 ("FIN 47"), Accounting for Conditional Asset Retirement Obligations , an interpretation of FASB Statement of Financial Accounting Standards ("Statement") No. 143, Accounting for Asset Retirement Obligations . FIN 47 generally applies to long-lived assets and requires a liability to be recognized for a conditional asset retirement obligation if the fair value of that liability can be reasonably estimated. A conditional asset retirement obligation is defined as a legal obligation to perform an activity associated with an asset retirement in which the timing and/or method of settlement are conditional on a future event that may or may not occur or be within the control of the company. A liability should be recognized when incurred (based on its fair value at that date), which generally would be upon acquisition or construction of the related asset. Upon recognition, the offset to the liability would be capitalized as part of the cost of the asset and depreciated over the estimated useful life of that asset. The Interpretation is effective no later than December 31, 2005, with early application encouraged. The Company is still in the process of evaluating the impact of FIN 47; however, at this time the Company does not expect the impact to have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

        In March 2005, the FASB issued FASB Staff Position EITF 85-24-1 ("FSP EITF 85-24-1"), Distribution Fees by Distributors of Mutual Funds That Do Not Have a Front-End Sales Charge . FSP EITF 85-24-1 considers the appropriate accounting for cash received from a third party for a distributor's right to future cash flows relating to distribution fees for shares previously sold. The FASB staff concluded that revenue recognition is appropriate when cash is received from a third party if the distributor no longer has any continuing involvement or recourse associated with the rights. FSP EITF 85-24-1 must be applied for the quarter ended June 30, 2005. The Company is still in the process of evaluating the impact of the FSP; however, at this time the Company does not expect the impact to have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

8



        In December 2004, the FASB issued a revised version of the original Statement No. 123, Accounting for Stock-Based Compensation . Statement No. 123R, Share-Based Payment , supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees . This Statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair value-based measurement method in accounting for share-based payment transactions with employees, except for equity instruments held by employee stock ownership plans. Effective January 1, 2003 and in accordance with the transitional guidance of Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, the Company elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. The Company will prospectively apply Statement No. 123R to its financial statements as of January 1, 2006. However, as the Company has already adopted Statement No. 148 and substantially all stock-based awards granted prior to its adoption will be fully vested by the end of this year, Statement No. 123R will not have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

        In March 2005, Securities and Exchange Commission ("SEC") Staff Accounting Bulletin No. 107 ("SAB 107") was issued, which expresses views of the staff regarding the interaction between Statement No. 123R, Share Based Payment , and certain SEC rules and regulations and provides the staff's views regarding the valuation of share-based payment arrangements for public companies. The Company will review the guidance provided by SAB 107 as part of its adoption of Statement No. 123R.

Note 2: Discontinued Operations

        During the first quarter of 2004 the Company sold its consumer finance subsidiary, Washington Mutual Finance Corporation. Accordingly, this former subsidiary 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. The results from discontinued operations in 2004 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 Corporation.

Note 3: Earnings Per Share

        Information used to calculate earnings per share was as follows:

 
  Three Months Ended
March 31,

 
  2005
  2004
 
  (in thousands)

Weighted average shares        
  Basic weighted average number of common shares outstanding   864,933   863,299
  Dilutive effect of potential common shares from:        
    Awards granted under equity incentive programs   14,270   12,607
    Trust Preferred Income Equity Redeemable Securities SM   9,586   10,561
   
 
  Diluted weighted average number of common shares outstanding   888,789   886,467
   
 

9


        For the three months ended March 31, 2005 and 2004, options to purchase an additional 8,956,920 and 56,254 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.

        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 March 31, 2005, the conditions for releasing the shares from escrow had not occurred, and therefore, none of the shares in the escrow were included in the above computations.

Note 4: Mortgage Banking Activities

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

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions)

 
Balance, beginning of period   $ 540,392   $ 582,669  
  Home loans:              
    Additions     34,533     22,009  
    Loan payments and other     (32,861 )   (46,058 )
  Net change in commercial real estate loans serviced for others     733     1,187  
   
 
 
Balance, end of period   $ 542,797   $ 559,807  
   
 
 

        Changes in the balance of mortgage servicing rights ("MSR"), net of the valuation allowance, were as follows:

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions)

 
Balance, beginning of period   $ 5,906   $ 6,354  
  Home loans:              
    Additions     490     241  
    Amortization     (570 )   (750 )
    (Impairment) reversal     427     (606 )
    Statement No. 133 MSR accounting valuation adjustments     545      
  Net change in commercial real estate MSR     4      
   
 
 
Balance, end of period (1)   $ 6,802   $ 5,239  
   
 
 

(1)
At March 31, 2005 and 2004, aggregate MSR fair value was $6.81 billion and $5.25 billion.

10


        Changes in the valuation allowance for MSR were as follows:

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions)

 
Balance, beginning of period   $ 1,981   $ 2,435  
  Impairment (reversal)     (427 )   606  
  Other-than-temporary impairment     (34 )    
  Other     (7 )   (6 )
   
 
 
Balance, end of period   $ 1,513   $ 3,035  
   
 
 

        At March 31, 2005, the expected weighted average life of the Company's MSR was 3.8 years. Projected amortization expense for the gross carrying value of MSR at March 31, 2005 is estimated to be as follows (in millions):

Remainder of 2005   $ 1,420  
2006     1,459  
2007     1,079  
2008     830  
2009     652  
After 2009     2,875  
   
 
Gross carrying value of MSR     8,315  
Less: valuation allowance     (1,513 )
   
 
  Net carrying value of MSR   $ 6,802  
   
 

        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 first quarter of 2005. 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 March 31, 2005 and December 31, 2004, the amount of loans sold without recourse totaled $535.98 billion and $533.51 billion, which substantially represents the unpaid principal balance of the Company's loans serviced for others portfolio. The Company has accrued $190 million as of March 31, 2005 and $148 million as of December 31, 2004 to cover the estimated loss exposure related to the loan origination process defects that are inherent within this portfolio.

11


        At March 31, 2005, the Company was 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 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 obligations under subordinated debentures, but the trust fails 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 preferred securities, which totaled $2.24 billion as of March 31, 2005. 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, 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 March 31,
 
  2005
  2004
 
  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

 
  (in millions)

Interest cost   $ 22   $ 2   $ 1   $ 21   $ 2   $ 1
Service cost     21             22        
Expected return on plan assets     (26 )           (27 )      
Amortization of prior service cost     2             1        
Amortization of net loss     7     1         9        
   
 
 
 
 
 
  Net periodic benefit cost   $ 26   $ 3   $ 1   $ 26   $ 2   $ 1
   
 
 
 
 
 

12


Note 7: Operating Segments

        The Company has three operating segments for the purpose of management reporting: the Retail Banking and Financial Services Group, the Mortgage Banking Group 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 Retail Banking and Financial Services Group's principal activities include: (1) offering a comprehensive line of deposit and other retail banking products and services to consumers and small businesses; (2) originating, managing and servicing home equity loans and lines of credit; (3) providing investment advisory and brokerage services, sales of annuities, mutual fund management and other financial services; and (4) holding the Company's portfolio of home loans held for investment. This segment's home loan portfolio consists of home loans purchased from both the Mortgage Banking segment and secondary market participants as well as purchased home loans made to subprime borrowers.

        The Mortgage Banking Group's principal activities include: (1) originating and servicing home loans; (2) buying and selling home loans in the secondary market; and (3) selling insurance-related products and participating in reinsurance activities with other insurance companies. For management reporting purposes, home loans originated by this segment are either sold to the Retail Banking and Financial Services Group or are sold to secondary market participants. The segment typically retains the rights to service these loans and receives fees and other forms of remuneration for providing this service. The Mortgage Banking Group performs home loan servicing activities for substantially all of the Company's managed portfolio – whether the home loans are held in portfolio or have been sold to secondary market participants. Insurance products that complement the mortgage lending process, such as private mortgage insurance and property and casualty insurance, are also made available. This segment also manages the Company's captive reinsurance activities.

        The Commercial Group's principal activities include: (1) providing financing to developers and investors for the acquisition or construction of multi-family dwellings and, to a lesser extent, other commercial properties; (2) originating and servicing multi-family and other commercial real estate loans and either holding such loans in portfolio as part of its commercial asset management business or selling them in the secondary market; (3) providing financing to mortgage bankers for the origination of residential loan products; and (4) originating and servicing home loans made to subprime borrowers through the Company's subsidiary, Long Beach Mortgage Company.

        The Corporate Support/Treasury and Other category includes enterprise-wide management of the Company's interest rate risk, liquidity, capital, borrowings, and a majority of the Company's investment securities. As part of the Company's asset and liability management process, the Treasury function provides oversight and direction across the enterprise over matters that impact the profile of the Company's balance sheet, such as product composition of loans that the Company holds in the portfolio, the appropriate mix of wholesale and capital markets borrowings at any given point in time, and the allocation of capital resources to the business segments. This category also includes the costs of the Company's technology services, facilities, legal, human resources and accounting and finance functions to the extent not allocated to the business segments. Also reported in this category is the net impact of funds transfer pricing for loan and deposit balances and all charges incurred from the Company's cost containment initiative.

        The Company uses various management accounting methodologies, which are enhanced from time to time, to assign certain balance sheet and income statement items to the responsible operating segment.

13



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 and its share of risk-adjusted economic capital. 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 for consolidated reporting purposes. This methodology is used to provide segment management with provision information for strategic decision making; (3) the utilization of an activity-based costing approach to measure allocations of certain operating expenses that were not directly charged to the segments; (4) the allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; (5) capital charges for goodwill as a component of an internal measurement of return on the goodwill allocated to the operating segment; and (6) inter-segment activities which include the transfer of originated mortgage loans that are to be held in portfolio from the Mortgage Banking Group to the Retail Banking and Financial Services Group and a broker fee arrangement between Mortgage Banking and Retail Banking and Financial Services. When originated mortgage loans are transferred, the Mortgage Banking Group records a gain on the sale of the loans based on an assumed profit factor. This profit factor is included in the value of the transferred loans and is amortized as an adjustment to the net interest income recorded by the Retail Banking and Financial Services Group. Inter-segment broker fees are recorded by the Retail Banking and Financial Services Group when home loans are initiated through retail banking stores, while the Mortgage Banking Group records a broker fee when the origination of home equity loans and lines of credit are initiated through home loan stores. The results of all inter-segment activities are eliminated as reconciling adjustments that are necessary to conform the presentation of management accounting policies to the accounting principles used in the Company's consolidated financial statements.

14


        Financial highlights by operating segment were as follows:

 
  Three Months Ended March 31, 2005
 
 
  Retail
Banking and
Financial
Services
Group

  Mortgage
Banking
Group

  Commercial
Group

  Corporate
Support/
Treasury
and Other

  Reconciling
Adjustments

  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                      
  Net interest income (expense)   $ 1,343   $ 286   $ 323   $ (175 ) $ 113    (1) $ 1,890  
  Provision for loan and lease losses     37         2         (23 ) (2)   16  
  Noninterest income (expense)     695     682     158     (65 )   (62 ) (3)   1,408  
  Inter-segment revenue (expense)     12     (12 )                
  Noninterest expense     1,148     566     175     158     (208 ) (4)   1,839  
   
 
 
 
 
 
 
  Income (loss) before income taxes     865     390     304     (398 )   282     1,443  
  Income taxes (benefit)     327     147     104     (149 )   112    (5)   541  
   
 
 
 
 
 
 
  Net income (loss)   $ 538   $ 243   $ 200   $ (249 ) $ 170   $ 902  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     49.78 % (6)   53.83 % (6)   30.36 % (6)   n/a     n/a     55.77 % (7)
  Average loans   $ 177,635   $ 27,765   $ 41,783     n/a   $ (1,556 ) (8) $ 245,627  
  Average assets     190,479     49,019     46,647   $ 23,809     (1,782 ) (8)(9)   308,172  
  Average deposits     132,982     13,107     7,308     21,788     n/a     175,185  
  Loan volume     12,493     38,498     8,524     n/a     n/a     59,515  
  Employees at end of period     31,152     12,626     3,530     5,180     n/a     52,488  

(1)
Represents the difference between home loan premium amortization recorded by the Retail Banking and Financial Services Group 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 Group are treated as if they are purchased from the Mortgage Banking Group. Since the cost basis of these loans includes an assumed profit factor paid to the Mortgage Banking Group, the amortization of loan premiums recorded by the Retail Banking and Financial Services Group 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 gain from mortgage loans recorded by the Mortgage Banking Group and the gain from mortgage loans recognized in the Company's Consolidated Statements of Income. As the Mortgage Banking Group holds no loans in portfolio, all loans originated or purchased by this segment are considered to be salable for management reporting purposes.
(4)
Represents the corporate offset for cost of capital related to goodwill that has been allocated to the segments.
(5)
Represents the tax effect of reconciling adjustments.
(6)
The efficiency ratio is defined as noninterest expense, excluding a cost of capital charge on goodwill, divided by total revenue (net interest income and noninterest income).
(7)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(8)
Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking and Financial Services Group recognized from the transfer of portfolio loans from the Mortgage Banking Group.
(9)
Includes the impact to the allowance for loan and lease losses of $226 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.

15


 
  Three Months Ended March 31, 2004
 
 
  Retail
Banking and
Financial
Services
Group

  Mortgage
Banking
Group

  Commercial
Group

  Corporate
Support/
Treasury
and Other

  Reconciling
Adjustments

  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                      
  Net interest income (expense)   $ 1,187   $ 288   $ 343   $ (189 ) $ 103    (1) $ 1,732  
  Provision for loan and lease losses     58         16         (18 ) (2)   56  
  Noninterest income (expense)     623     761     86     (69 )   (164 ) (3)   1,237  
  Inter-segment revenue (expense)     6     (6 )                
  Noninterest expense     1,071     677     156     186     (210 ) (4)   1,880  
   
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     687     366     257     (444 )   167     1,033  
  Income taxes (benefit)     260     138     90     (165 )   62    (5)   385  
   
 
 
 
 
 
 
  Income (loss) from continuing operations     427     228     167     (279 )   105     648  
  Income from discontinued operations, net of taxes                 399         399  
   
 
 
 
 
 
 
  Net income   $ 427   $ 228   $ 167   $ 120   $ 105   $ 1,047  
   
 
 
 
 
 
 
Performance and other data:                                      
  Efficiency ratio     51.86 % (6)   59.98 % (6)   29.57 % (6)   n/a     n/a     63.34 % (7)
  Average loans   $ 149,377   $ 19,871   $ 36,984     n/a   $ (1,505 ) (8) $ 204,727  
  Average assets     161,359     38,914     42,805   $ 29,996     (1,668 ) (8)(9)   271,406  
  Average deposits     128,000     14,877     6,049     5,028     n/a     153,954  
  Loan volume     12,778     43,720     5,667     n/a     n/a     62,165  
  Employees at end of period     29,077     21,203     3,130     5,763     n/a     59,173  

(1)
Represents the difference between home loan premium amortization recorded by the Retail Banking and Financial Services Group 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 Group are treated as if they are purchased from the Mortgage Banking Group. Since the cost basis of these loans includes an assumed profit factor paid to the Mortgage Banking Group, the amortization of loan premiums recorded by the Retail Banking and Financial Services Group 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 gain from mortgage loans recorded by the Mortgage Banking Group and the gain from mortgage loans recognized in the Company's Consolidated Statements of Income. As the Mortgage Banking Group holds no loans in portfolio, all loans originated or purchased by this segment are considered to be salable for management reporting purposes.
(4)
Represents the corporate offset for cost of capital related to goodwill that has been allocated to the segments.
(5)
Represents the tax effect of reconciling adjustments.
(6)
The efficiency ratio is defined as noninterest expense, excluding a cost of capital charge on goodwill, divided by total revenue (net interest income and noninterest income).
(7)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(8)
Includes the inter-segment offset for inter-segment loan premiums that the Retail Banking and Financial Services Group recognized from the transfer of portfolio loans from the Mortgage Banking Group.
(9)
Includes the impact to the allowance for loan and lease losses of $163 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.

16


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

    Discontinued Operations

        In January 2004, the Company sold its subsidiary, Washington Mutual Finance Corporation, for approximately $1.30 billion in cash. Accordingly, this former subsidiary 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.

Cautionary Statements

        The Company's Form 10-Q and other documents that it files with the Securities and Exchange Commission ("SEC") have forward-looking statements. In addition, 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 management's 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. Management does 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 management's control, which could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements. Some of these factors are:

    Volatile interest rates impact the mortgage banking business and could adversely affect earnings;

    Rising unemployment or a decrease in housing prices could adversely affect credit performance;

    The potential for negative amortization in the Option ARM product could have an adverse affect on the Company's credit performance;

    The Company faces competition from banking and nonbanking companies;

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

    General business and economic conditions, including movements in interest rates, may significantly affect the Company's business activities and earnings; and

    Negative public opinion could damage the Company's reputation and adversely affect earnings.

17


Overview

        Net income from continuing operations for the first quarter of 2005 was $902 million, or $1.01 per diluted share, an increase from $648 million, or $0.73 per diluted share from continuing operations for the first quarter of 2004. Total net income during the first quarter of 2004 was $1.05 billion, or $1.18 per diluted share and included an after-tax gain of $399 million, or 45 cents per diluted share from discontinued operations from the sale of the Company's former subsidiary, Washington Mutual Finance Corporation.

        Net interest income was $1.89 billion for the first quarter of 2005, compared with $1.73 billion for the first quarter of 2004. The increase was primarily due to growth in home equity loans and lines of credit and loans held-for-sale balances, which contributed to a 15% increase in average total interest-earning assets. Largely offsetting the growth in interest-earning assets was contraction in the net interest margin. The net interest margin in the first quarter of 2005 was 2.73%, a decline of 6 basis points from the fourth quarter of 2004 and 16 basis points from 2.89% in the first quarter of 2004. The decrease in the net interest margin was due to an increase in the cost of the Company's interest-bearing liabilities, which was driven by increases in short-term interest rates since June of 2004. As domestic economic indicators continued to strengthen during 2004 and into the first quarter of 2005, the Federal Reserve initiated a series of 25 basis point increases in the targeted federal funds rate to reduce the potential threat of inflation. This benchmark interest rate has increased from 1.00% in the second quarter of 2004 to 2.75% at the end of the first quarter of 2005. Since our adjustable-rate home loans and securities reprice to current market rates more slowly than our wholesale borrowing sources, the Company expects the net interest margin will contract further during 2005 as its interest-bearing assets and liabilities adjust to the higher interest rate environment. The contraction is likely to be more significant if the Federal Reserve accelerates the pace of further rate increases.

        Partially mitigating the disparity in repricing speeds is the growth in home equity line of credit balances, which have repricing frequencies that are more closely aligned with the faster repricing behavior of the Company's wholesale borrowings. The average balance of home equity loans and lines of credit was $44.68 billion in the first quarter of 2005, an increase of $15.42 billion, or 53% from the first quarter of 2004, while the yield on this portfolio increased from 4.72% to 5.37% in these two quarterly periods. Additionally, during the first quarter of 2005, the Company restructured a portion of its available-for-sale securities portfolio by selling approximately $3 billion of lower-yielding debt securities and replacing those assets by the purchase of debt securities with comparatively higher yields. While the Company realized a loss of approximately $75 million on the sale of the lower-yielding securities, the positive effect on the margin of this restructuring will be realized beginning in the second quarter of 2005.

        Home loan mortgage banking income was $776 million for the first quarter of 2005, an increase of $245 million from $531 million in the first quarter of 2004. The increase was primarily the result of higher gain from mortgage loans, net of risk management instruments, in the first quarter of 2005. The continuing customer demand for the Company's option adjustable-rate mortgage product ("Option ARM") and the improved liquidity of this product in the secondary market enabled the Company to direct approximately $10 billion (or 66%) of Option ARM volume for sale during the quarter, while still retaining a significant portion of the volume for the home loan portfolio. The increase was also the result of applying the interest rate lock accounting guidance issued in the first quarter of 2004 by the Securities and Exchange Commission. This guidance, which the Company implemented at the beginning of 2004, delayed the recognition of the servicing rights for loans that are being originated for sale until the loans are sold or securitized. This change in accounting reduced the gain from mortgage loans by approximately $100 million in the first quarter of 2004.

        The continuing strength of the U.S. housing market and a modestly upward-sloping yield curve facilitated adjustable-rate mortgage growth in the total home loan portfolio. Total home loans held in portfolio increased from $129.13 billion at December 31, 2004 to $133.98 billion at March 31, 2005. In

18



addition to the strong demand for adjustable-rate mortgages, the Company also grew its portfolio of specialty mortgage finance home loans during the quarter. This portfolio, which totaled $15.44 billion at March 31, 2004, increased to $19.18 billion at December 31, 2004 and to $21.54 billion at March 31, 2005. Higher home equity loan and line of credit balances from loan volume that was generated through the Company's retail banking network and an increase in multi-family loan balances were also significant contributors to growth in the loan portfolio.

        During the first quarter of 2005, the spread between short-term and long-term interest rates compressed, thus resulting in a flattening of the yield curve. Generally, as the yield curve flattens, fixed-rate mortgages become more attractive to U.S. consumers for the financing of home purchases. Additionally, consumers with existing adjustable-rate loans may refinance their mortgages into fixed-rate products. As the Company typically sells its fixed-rate loan production in the secondary market, the growth rate of the Company's home loan portfolio may be slower in future periods if the yield curve continues to flatten.

        The provision for loan and lease losses was $16 million in the first quarter of 2005, compared with $56 million in the first quarter of 2004. During the first quarter of 2005, the Company benefited from the continuing positive trends in certain key domestic economic indicators that affect its credit risk profile. Those indicators included a stable and relatively low mortgage interest rate environment, continuing housing price appreciation in most of the Company's markets and a lower national unemployment rate. The $16 million provision that was recorded in the first quarter of 2005 was the result of a slight change in the mix of the Company's home loan portfolio toward its subprime lending programs. The Company's specialty mortgage finance portfolio, which is comprised of purchased subprime home loans and loans originated to subprime borrowers by the Company's wholly-owned subsidiary, Long Beach Mortgage Company, represented 16.1% of the total home loan portfolio at March 31, 2005, compared with 14.9% at December 31, 2004 and 12.8% at March 31, 2004.

        The Company continues to grow its retail banking business by opening new stores and enhancing its array of products. During the first quarter of 2005, depositor and other retail banking fees increased 6% from the same period in the prior year, driven by an increase in the number of noninterest-bearing checking accounts as well as an increase in debit card interchange and ATM-related income. The number of noninterest-bearing checking accounts at March 31, 2005 totaled approximately 7.2 million, compared with approximately 6.7 million at March 31, 2004. Total retail deposit accounts, which consist of checking, savings and time deposit accounts for consumers and small businesses, increased by over 434,000 during the first quarter of 2005. Since the beginning of the year, the Company has opened 29 new stores, with a target of opening 250 stores within its existing markets during 2005.

        Noninterest expense was $1.8 billion for the first quarter, a decrease of $100 million from the prior quarter and $41 million from the first quarter of 2004. This decrease is attributable to the Company's progress in productivity improvements and its continuous focus on expense management discipline.

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 submits under the Securities Exchange Act of 1934.

        Management reviews and evaluates the design and effectiveness of disclosure controls and procedures on an ongoing basis, and improves controls and procedures over time and corrects any deficiencies that may be discovered. While management believes the present design of the disclosure controls and

19



procedures is effective, future events affecting the Company may cause the disclosure controls and procedures to be modified.

        There have not been any changes in the Company's internal controls over financial reporting during the first quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. For additional discussion of the Company's internal controls over financial reporting, refer to the Company's 2004 Annual Report on Form 10-K, "Management's Report on Internal Control Over Financial Reporting."

Critical Accounting Policies

        The preparation of financial statements, in accordance with accounting principles generally accepted in the United States of America, requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the Consolidated Financial Statements and accompanying Notes to the Consolidated Financial Statements. The Company believes that the judgments, estimates and assumptions used in the preparation of its Consolidated Financial Statements are appropriate given the facts and circumstances as of March 31, 2005.

        Various elements of the Company's accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, the Company has identified two accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, and the sensitivity of its Consolidated Financial Statements to those judgments, estimates and assumptions, are critical to an understanding of its Consolidated Financial Statements. These policies relate to the valuation of its MSR and the methodology that determines its allowance for loan and lease losses.

        Management has discussed the development and selection of these critical accounting policies with the Company's Audit Committee. These policies and the judgments, estimates and assumptions are described in greater detail in the Company's 2004 Annual Report on Form 10-K in the "Critical Accounting Policies" section of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

Recently Issued Accounting Standards

        In March 2005, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 47 ("FIN 47"), Accounting for Conditional Asset Retirement Obligations , an interpretation of FASB Statement of Financial Accounting Standards ("Statement") No. 143, Accounting for Asset Retirement Obligations . FIN 47 generally applies to long-lived assets and requires a liability to be recognized for a conditional asset retirement obligation if the fair value of that liability can be reasonably estimated. A conditional asset retirement obligation is defined as a legal obligation to perform an activity associated with an asset retirement in which the timing and/or method of settlement are conditional on a future event that may or may not occur or be within the control of the company. A liability should be recognized when incurred (based on its fair value at that date), which generally would be upon acquisition or construction of the related asset. Upon recognition, the offset to the liability would be capitalized as part of the cost of the asset and depreciated over the estimated useful life of that asset. The Interpretation is effective no later than December 31, 2005, with early application encouraged. The Company is still in the process of evaluating the impact of FIN 47; however, at this time the Company does not expect the impact to have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

        In March 2005, the FASB issued FASB Staff Position EITF 85-24-1 ("FSP EITF 85-24-1"), Distribution Fees by Distributors of Mutual Funds That Do Not Have a Front-End Sales Charge . FSP EITF 85-24-1 considers the appropriate accounting for cash received from a third party for a distributor's right to future cash flows relating to distribution fees for shares previously sold. The FASB staff concluded

20


that revenue recognition is appropriate when cash is received from a third party if the distributor no longer has any continuing involvement or recourse associated with the rights. FSP EITF 85-24-1 must be applied for the quarter ended June 30, 2005. The Company is still in the process of evaluating the impact of the FSP; however, at this time the Company does not expect the impact to have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

        In December 2004, the FASB issued a revised version of the original Statement No. 123, Accounting for Stock-Based Compensation. Statement No. 123R, Share-Based Payment , supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. This Statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair value-based measurement method in accounting for share-based payment transactions with employees, except for equity instruments held by employee stock ownership plans. Effective January 1, 2003 and in accordance with the transitional guidance of Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, the Company elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. The Company will prospectively apply Statement No. 123R to its financial statements as of January 1, 2006. However, as the Company has already adopted Statement No. 148 and substantially all stock-based awards granted prior to its adoption will be fully vested by the end of this year, Statement No. 123R will not have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

        In March 2005, Securities and Exchange Commission ("SEC") Staff Accounting Bulletin No. 107 ("SAB 107") was issued, which expresses views of the staff regarding the interaction between Statement No. 123R, Share Based Payment , and certain SEC rules and regulations and provides the staff's views regarding the valuation of share-based payment arrangements for public companies. The Company will review the guidance provided by SAB 107 as part of its adoption of Statement No. 123R.

21


Summary Financial Data

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (dollars in millions, except per share amounts)

 
Profitability              
  Net interest income   $ 1,890   $ 1,732  
  Net interest margin     2.73 %   2.89 %
  Noninterest income   $ 1,408   $ 1,237  
  Noninterest expense     1,839     1,880  
  Net income     902     1,047  
  Basic earnings per common share:              
    Income from continuing operations   $ 1.04   $ 0.75  
    Income from discontinued operations, net         0.46  
   
 
 
      Net income     1.04     1.21  
  Diluted earnings per common share:              
    Income from continuing operations   $ 1.01   $ 0.73  
    Income from discontinued operations, net         0.45  
   
 
 
      Net income     1.01     1.18  
  Basic weighted average number of common shares outstanding (in thousands)     864,933     863,299  
  Diluted weighted average number of common shares outstanding (in thousands)     888,789     886,467  
  Dividends declared per common share   $ 0.46   $ 0.42  
  Return on average assets (1)     1.17 %   1.54 %
  Return on average common equity (1)     16.63     20.85  
  Efficiency ratio (2)     55.77     63.34  
Asset Quality              
  Nonaccrual loans (3)(4)   $ 1,569   $ 1,542  
  Foreclosed assets (4)     264     307  
   
 
 
    Total nonperforming assets (3)(4)     1,833     1,849  
  Nonperforming assets/total assets (3)(4)     0.57 %   0.66 %
  Restructured loans (4)   $ 27   $ 107  
   
 
 
    Total nonperforming assets and restructured loans (3)(4)     1,860     1,956  
  Allowance for loan and lease losses (4)     1,280     1,260  
  Allowance as a percentage of total loans held in portfolio (4)     0.60 %   0.68 %
  Provision for loan and lease losses   $ 16   $ 56  
  Net charge-offs     37     46  
Capital Adequacy (4)              
  Stockholders' equity/total assets     6.81 %   7.26 %
  Tangible common equity (5) /total tangible assets (5)     5.03     5.21  
  Estimated total risk-based capital/risk-weighted assets (6)     11.21     10.53  
Per Common Share Data              
  Book value per common share (4)(7)   $ 24.98   $ 23.62  
  Market prices:              
    High     42.55     45.28  
    Low     38.96     39.61  
    Period end     39.50     42.71  

(1)
Includes income from continuing and discontinued operations for the period ending March 31, 2004.
(2)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(3)
Excludes nonaccrual loans held for sale.
(4)
As of quarter end.
(5)
Excludes unrealized net gain/loss on available-for-sale securities and derivatives, goodwill and intangible assets, but includes MSR.
(6)
Estimate of what the total risk-based capital ratio would be if Washington Mutual, Inc. were a bank holding company that is subject to Federal Reserve Board capital requirements.
(7)
Excludes 6 million shares held in escrow at March 31, 2005 and 2004.

22


Summary Financial Data (Continued)

 
  Three Months Ended
March 31,

 
  2005
  2004
 
  (dollars in millions)

Supplemental Data            
  Average balance sheet:            
    Total loans held for sale   $ 38,307   $ 24,464
    Total loans held in portfolio     207,320     180,263
    Total interest-earning assets     277,080     239,979
    Total assets     308,172     271,406
    Total interest-bearing deposits     142,639     123,336
    Total noninterest-bearing deposits     32,546     30,618
    Total stockholders' equity     21,680     20,088
  Period-end balance sheet:            
    Loans held for sale     41,197     34,207
    Loans held in portfolio, net of allowance for loan and lease losses     212,834     185,120
    Total assets     319,696     280,768
    Total deposits     183,631     160,981
    Total stockholders' equity     21,767     20,383
  Loan volume:            
    Home loans:            
      Adjustable rate     22,947     21,822
      Fixed rate     17,147     21,564
      Specialty mortgage finance (1)     7,656     7,113
        Total home loan volume     47,750     50,499
    Total loan volume     59,515     62,165
    Home loan refinancing (2)     28,641     33,233
    Total refinancing (2)     29,703     34,927

(1)
Represents purchased subprime 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 increased $158 million, or 9%, for the three months ended March 31, 2005, compared with the same period in 2004. The increase resulted from growth in home equity loans and lines of credit and loans held for sale balances, which contributed to a 15% increase in average total interest-earning assets. The growth in interest-earning assets was partially offset by compression in the net interest margin, which was 2.73% during the first quarter of 2005, down 16 basis points from 2.89% during the first quarter of 2004. Compression in the net interest margin was due primarily to an increase in the cost of funds from wholesale borrowings and Platinum checking and savings accounts, which outpaced the increase in yields from interest-earning assets.

        Interest rate contracts, including embedded derivatives, held for asset/liability interest rate risk management purposes increased net interest income by $17 million for the three months ended March 31, 2005, compared with a decrease of $123 million for the same period in 2004.

23


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

 
  Three Months Ended March 31,
 
  2005
  2004
 
  Average
Balance

  Rate
  Interest
Income

  Average
Balance

  Rate
  Interest
Income

 
  (dollars in millions)

Assets                                
Interest-earning assets:                                
  Federal funds sold and securities purchased under agreements to resell   $ 1,354   2.55 % $ 9   $ 1,026   1.34 % $ 3
  Trading securities     5,713   5.55     79     1,228   7.91     24
  Available-for-sale securities (1) :                                
    Mortgage-backed securities     15,487   4.45     173     9,999   4.35     109
    Investment securities     4,627   4.44     51     19,073   3.29     156
  Loans held for sale (2)     38,307   4.91     470     24,464   5.43     332
  Loans held in portfolio (2)(3) :                                
    Loans secured by real estate:                                
      Home     110,131   4.59     1,263     102,691   4.24     1,089
      Specialty mortgage finance (4)     18,554   5.05     234     14,016   5.21     182
   
     
 
     
        Total home loans     128,685   4.65     1,497     116,707   4.36     1,271
      Home equity loans and lines of credit     44,679   5.37     593     29,262   4.72     344
      Home construction (5)     2,242   5.77     32     2,317   5.33     31
      Multi-family     22,667   5.00     283     20,376   5.06     258
      Other real estate     5,425   6.02     82     6,589   5.77     95
   
     
 
     
        Total loans secured by real estate     203,698   4.90     2,487     175,251   4.57     1,999
    Consumer     770   10.50     20     997   10.15     25
    Commercial business     2,852   5.19     37     4,015   4.19     43
   
     
 
     
        Total loans held in portfolio     207,320   4.92     2,544     180,263   4.59     2,067
  Other     4,272   3.21     34     3,926   3.00     30
   
     
 
     
        Total interest-earning assets     277,080   4.86     3,360     239,979   4.54     2,721
Noninterest-earning assets:                                
  Mortgage servicing rights     6,090               5,872          
  Goodwill     6,196               6,196          
  Other assets     18,806               19,359          
   
           
         
        Total assets   $ 308,172             $ 271,406          
   
           
         

(This table is continued on the next page.)


(1)
The average balance and yield are based on average amortized cost balances.
(2)
Nonaccrual loans and related income, if any, are included in their respective loan categories.
(3)
Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $78 million and $73 million for the three months ended March 31, 2005 and 2004.
(4)
Represents purchased subprime loan portfolios and certain mortgages originated by Long Beach Mortgage Company.
(5)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

24


(Continued from the previous page.)

 
  Three Months Ended March 31,
 
  2005
  2004
 
  Average
Balance

  Rate
  Interest
Expense

  Average
Balance

  Rate
  Interest
Expense

 
  (dollars in millions)

Liabilities                                
Interest-bearing liabilities:                                
  Deposits:                                
    Interest-bearing checking deposits   $ 49,917   1.63 % $ 201   $ 67,431   1.28 % $ 214
    Savings and money market deposits     41,997   1.42     147     26,915   0.75     50
    Time deposits     50,725   2.77     348     28,990   2.48     179
   
     
 
     
      Total interest-bearing deposits     142,639   1.97     696     123,336   1.45     443
  Federal funds purchased and commercial paper     3,486   2.49     22     3,493   1.08     10
  Securities sold under agreements to repurchase     16,621   2.65     110     21,954   1.93     107
  Advances from Federal Home Loan Banks     66,591   2.82     469     52,921   2.28     305
  Other     18,400   3.78     173     14,032   3.56     124
   
     
 
     
      Total interest-bearing liabilities     247,737   2.39     1,470     215,736   1.83     989
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     32,546               30,618          
  Other liabilities     6,209               4,964          
  Stockholders' equity     21,680               20,088          
   
           
         
      Total liabilities and stockholders' equity   $ 308,172             $ 271,406          
   
           
         
Net interest spread and net interest income         2.47   $ 1,890         2.71   $ 1,732
             
           
Impact of noninterest-bearing sources         0.26               0.18      
Net interest margin         2.73               2.89      

25


    Noninterest Income

        Noninterest income from continuing operations consisted of the following:

 
  Three Months Ended March 31,
   
 
 
  Percentage
Change

 
 
  2005
  2004
 
 
  (in millions)

   
 
Home loan mortgage banking income (expense):                  
  Loan servicing income (expense):                  
    Loan servicing fees   $ 489   $ 502   (3 )%
    Amortization of MSR     (570 )   (750 ) (24 )
    MSR valuation adjustments:                  
      Statement No. 133 MSR accounting valuation adjustments     545        
      Statement No. 133 fair value hedging adjustments (1)     (433 )      
   
 
     
        MSR net ineffectiveness under Statement No. 133     112        
      MSR lower of cost or market adjustment     427     (606 )  
   
 
     
        Net MSR valuation adjustments     539     (606 )  
    Other, net (2)     (51 )   (66 ) (22 )
   
 
     
        Net home loan servicing income (expense)     407     (920 )  
  Revaluation gain from derivatives     63     1,042   (94 )
  Net settlement income from certain interest-rate swaps     51     167   (69 )
  Gain from mortgage loans     178     171   4  
  Loan related income     74     71   5  
  Gain from sale of originated mortgage-backed securities     3        
   
 
     
        Total home loan mortgage banking income     776     531   46  
Depositor and other retail banking fees     490     463   6  
Securities fees and commissions     110     107   3  
Insurance income     46     61   (24 )
Portfolio loan related income     85     87   (2 )
Trading securities income (loss)     (89 )   8    
Gain (loss) from other available-for-sale securities     (122 )   21    
Loss on extinguishment of borrowings         (89 ) (100 )
Other income     112     48   125  
   
 
     
        Total noninterest income   $ 1,408   $ 1,237   14  
   
 
     

(1)
Represents changes in fair value of derivatives designated as MSR fair value hedges.
(2)
Includes loan pool expenses, which represent the shortfall of the scheduled interest required to be remitted to investors compared to what is collected from the borrowers upon payoff.

26


    Home Loan Mortgage Banking Income

        The following table presents the aggregate valuation adjustments for the MSR and the corresponding hedging and risk management derivative instruments and securities, and amortization of the MSR during the three months ended March 31, 2005 and 2004:

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (dollars in millions)

 
Statement No. 133 MSR accounting valuation adjustments   $ 545   $  
Statement No. 133 fair value hedging adjustment (1)     (433 )    
   
 
 
  MSR net ineffectiveness under Statement No. 133     112      
Change in value of MSR accounted for under lower of cost or market value methodology     427     (606 )
   
 
 
    Net MSR valuation adjustments     539     (606 )
MSR risk management:              
  Revaluation gain (loss) from derivatives     (23 )   1,108  
  Net settlement income from certain interest-rate swaps     58     160  
  Gain (loss) from securities     (153 )   5  
   
 
 
      Net valuation change in hedging and risk management instruments     421     667  
Amortization of MSR     (570 )   (750 )
   
 
 
      Total change in MSR valuation, net of hedging and risk management instruments and amortization   $ (149 ) $ (83 )
   
 
 

(1)
Represents changes in fair value of derivatives designated as MSR fair value hedges.

        Several factors affected the results of the total change in MSR valuation, net of hedging and risk management instruments and amortization, when comparing the first quarter of 2005 to the first quarter of 2004. The Company did not apply Statement No. 133 fair value hedge accounting to its MSR asset until April 1, 2004. As such, the risk management results for the first quarter of 2004 entirely reflect the performance of economic hedges, which were substantially comprised of derivative instruments. The results for the first quarter of 2005 reflect the application of fair value hedge accounting to most of the MSR asset. This results in the netting of changes in fair value of the hedged MSR with the changes in fair value of the hedging derivative, to the extent the hedge relationship is determined to be highly effective. Gains and losses from derivative instruments used as economic hedges are not netted with the change in value of the MSR and are instead reported in the "revaluation gain (loss) from derivatives' line item, which is notably larger in the first quarter of 2004 due, in part, to the difference in accounting treatment applied in the two periods. Additionally, during the latter part of 2004, the Company altered the composition of its MSR hedging and risk management instruments in order to reduce its exposure to basis risk by purchasing available-for-sale and trading mortgage-backed securities, while reducing its reliance on interest rate swaps. As these securities are non-derivative financial instruments, they cannot be designated as fair value hedging instruments under Statement No. 133 and thus represent economic hedges that are included in the above table as MSR risk management components.

27


        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 during the three months ended March 31, 2005 and 2004:

 
  Three Months Ended March 31, 2005
 
 
  MSR
  Loans Held
for Sale

  Other
  Total
 
 
  (in millions)

 
Revaluation gain (loss) from derivatives   $ (23 ) $ 86   $   $ 63  
Net settlement income (loss) from certain interest-rate swaps     58     (7 )       51  
Gain (loss) from securities:                          
  Loss from other available-for-sale securities     (44 )       (78 )   (122 )
  Trading securities income (loss)     (109) (1)       20     (89 )
   
 
 
 
 
    Total   $ (118 ) $ 79   $ (58 ) $ (97 )
   
 
 
 
 

(1)
Represents revaluation gains (losses) from mortgage-backed securities, including those that are principal-only.

 
  Three Months Ended March 31, 2004
 
  MSR
  Loans Held
for Sale

  Other
  Total
 
  (in millions)

Revaluation gain (loss) from derivatives   $ 1,108   $ (66 ) $   $ 1,042
Net settlement income from certain interest-rate swaps     160     7         167
Gain from securities:                        
  Gain from other available-for-sale securities     5         16     21
   
 
 
 
    Total   $ 1,273   $ (59 ) $ 16   $ 1,230
   
 
 
 

        "Other net" home loan servicing expense declined from $66 million in the first quarter of 2004 to $51 million in the first quarter of 2005. The decrease was the result of lower levels of refinancing activity in the first quarter of 2005, which led to lower loan pool expense in that quarter. When loans that have been sold to investors are prepaid, certain pools governed by the requirements of the pooling and servicing agreements stipulate that the Company remit a full month of interest to those investors during the month when a loan has prepaid, even though the borrower only pays interest through the payoff date. Pool expense represents the shortfall of what is remitted to those investors compared to what is collected from the borrowers.

        The Company recorded gain from mortgage loans, net of hedging and risk management instruments, of $257 million in the first quarter of 2005 compared with a net gain of $112 million for the same period in 2004, which was reduced by approximately $100 million as a result of the one-time effect of the Company's change in accounting for gain from mortgage loans in the first quarter of 2004. The increase in gain from mortgage loans, net of hedging and risk management instruments, was a result of the sale of the Company's Option ARM product, as strong customer demand for this product allowed the Company to direct a larger portion of these loans to held-for-sale to the secondary market.

        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 recorded at the lower of 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 gain of $86 million was recognized as revaluation gain/loss from derivatives during the three months ended March 31, 2005, compared with a net loss of $66 million during the same period in 2004. A gain may be

28



recognized when the loans are subsequently sold if the fair value of those loans is higher than the carrying amount.

        In evaluating the MSR for impairment, loans are stratified in the 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 March 31, 2005, loans in the servicing portfolio were stratified as follows:

 
   
  March 31, 2005
 
  Rate Band
  Gross
Carrying
Value

  Valuation
Allowance

  Net
Carrying
Value

  Fair
Value

 
   
  (in millions)

Primary Servicing:                            
  Adjustable   All loans   $ 1,375   $ 83   $ 1,292   $ 1,292
  Government-sponsored enterprises   6.00% and below     3,031     345     2,686     2,686
  Government-sponsored enterprises   6.01% to 7.49%     1,405     549     856     856
  Government-sponsored enterprises   7.50% and above     150     51     99     99
  Government   6.00% and below     518     84     434     434
  Government   6.01% to 7.49%     492     191     301     301
  Government   7.50% and above     176     66     110     110
  Private   6.00% and below     510     18     492     492
  Private   6.01% to 7.49%     269     92     177     177
  Private   7.50% and above     77     21     56     56
       
 
 
 
    Total primary servicing         8,003     1,500     6,503     6,503
Master servicing   All loans     114     7     107     107
Subprime   All loans     162     6     156     156
Multi-family   All loans     36         36     40
       
 
 
 
    Total       $ 8,315   $ 1,513   $ 6,802   $ 6,806
       
 
 
 

29


        At March 31, 2005, key economic assumptions and the sensitivity to immediate changes in those assumptions of the fair value of home loan MSRs were as follows:

 
  March 31, 2005
 
 
  Mortgage Servicing Rights
 
 
  Fixed-Rate
Mortgage Loans

  Adjustable-Rate
Mortgage Loans

 
 
  Government and
Government-
Sponsored
Enterprise

  Privately
Issued

  All Types
 
 
  (dollars in millions)

 
Fair value of home loan MSR   $ 4,486   $ 725   $ 1,292  
Expected weighted-average life (in years)     4.8     4.7     2.8  
Constant prepayment rate (1)     15.34 %   16.45 %   28.85 %
  Impact on fair value of 25% decrease   $ 719   $ 121   $ 283  
  Impact on fair value of 50% decrease     1,674     283     712  
  Impact on fair value of 25% increase     (559 )   (94 )   (201 )
  Impact on fair value of 50% increase     (1,005 )   (170 )   (354 )
Discounted cash flow rate     8.54 %   10.06 %   9.88 %
  Impact on fair value of 25% decrease   $ 350   $ 62   $ 71  
  Impact on fair value of 50% decrease     767     138     154  
  Impact on fair value of 25% increase     (298 )   (52 )   (63 )
  Impact on fair value of 50% increase     (554 )   (95 )   (119 )

(1)
Represents the expected lifetime average.

        These sensitivities are hypothetical and should be used with caution. As the table above demonstrates, the Company's methodology for estimating the fair value of MSR is highly sensitive to changes in assumptions. For example, the Company's determination of fair values 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 resulting from changes 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 2004 Annual Report on Form 10-K for further discussion of how MSR fair value is measured.

    All Other Noninterest Income Analysis

        The increase in depositor and other retail banking fees in the first quarter of 2005, as compared with the same period in 2004, was largely due to increased debit card interchange and ATM related income and higher volumes of checking fees that resulted from the increase in the number of noninterest-bearing checking accounts. The number of noninterest-bearing checking accounts at March 31, 2005 totaled approximately 7.2 million, compared with approximately 6.7 million at March 31, 2004.

        During the first quarter of 2004, the Company terminated certain pay-fixed swaps hedging variable rate Federal Home Loan Bank ("FHLB") advances, resulting in a loss of $89 million. This transaction had the immediate effect of reducing the Company's wholesale borrowing costs.

30



        Other income increased in the first quarter of 2005, as compared with 2004 primarily due to the sale of a real estate investment property, which resulted in a gain of $59 million.

    Noninterest Expense

        Noninterest expense from continuing operations consisted of the following:

 
  Three Months Ended March 31,
   
 
 
  Percentage
Change

 
 
  2005
  2004
 
 
  (in millions)

   
 
Compensation and benefits   $ 876   $ 899   (3 )%
Occupancy and equipment     402     400    
Telecommunications and outsourced information services     104     123   (15 )
Depositor and other retail banking losses     55     40   37  
Advertising and promotion     55     58   (6 )
Professional fees     34     39   (12 )
Postage     63     58   10  
Loan expense     23     28   (19 )
Other expense     227     235   (4 )
   
 
     
  Total noninterest expense   $ 1,839   $ 1,880   (2 )
   
 
     

        Telecommunications and outsourced information services expense decreased for the three months ended March 31, 2005, compared with the same period in 2004 largely due to negotiated reductions in vendor charges, reduced call center volume, and lower costs due to the consolidation of information system platforms.

        The increase in depositor and other retail banking losses for the three months ended March 31, 2005, was primarily due to an increase in debit card and check fraud.

Review of Financial Condition

    Assets

        At March 31, 2005, assets increased from year-end primarily due to an increase in loans held in portfolio, partially offset by a decrease in loans held for sale.

31


    Securities

        Securities consisted of the following:

 
  March 31, 2005
 
  Amortized
Cost

  Unrealized
Gains

  Unrealized
Losses

  Fair
Value

 
  (in millions)

Available-for-sale securities                        
Mortgage-backed securities:                        
  U.S. Government   $ 137   $   $ (2 ) $ 135
  Agency     12,079     130     (70 )   12,139
  Private issue     3,592     82     (1 )   3,673
   
 
 
 
    Total mortgage-backed securities     15,808     212     (73 )   15,947
Investment securities:                        
  U.S. Government     442         (1 )   441
  Agency     3,726     51     (68 )   3,709
  Other debt securities     498     14     (3 )   509
  Equity securities     95     2         97
   
 
 
 
    Total investment securities     4,761     67     (72 )   4,756
   
 
 
 
      Total available-for-sale securities   $ 20,569   $ 279   $ (145 ) $ 20,703
   
 
 
 
 
  December 31, 2004
 
  Amortized
Cost

  Unrealized
Gains

  Unrealized
Losses

  Fair
Value

 
  (in millions)

Available-for-sale securities                        
Mortgage-backed securities:                        
  U.S. Government   $ 149   $   $ (1 ) $ 148
  Agency     12,938     133     (24 )   13,047
  Private issue     1,702     27     (1 )   1,728
   
 
 
 
    Total mortgage-backed securities     14,789     160     (26 )   14,923
Investment securities:                        
  U.S. Government     994         (18 )   976
  Agency     2,796     36     (4 )   2,828
  Other debt securities     373     18         391
  Equity securities     95     7     (1 )   101
   
 
 
 
    Total investment securities     4,258     61     (23 )   4,296
   
 
 
 
      Total available-for-sale securities   $ 19,047   $ 221   $ (49 ) $ 19,219
   
 
 
 

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

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (in millions)

 
Available-for-sale securities              
Realized gross gains   $ 33   $ 75  
Realized gross losses     (152 )   (54 )
   
 
 
  Realized net gain (loss)   $ (119 ) $ 21  
   
 
 

32


    Loans

        Loans held in portfolio consisted of the following:

 
  March 31,
2005

  December 31,
2004

 
  (in millions)

Loans secured by real estate:            
  Home   $ 112,444   $ 109,950
  Specialty mortgage finance (1)     21,539     19,184
   
 
      Total home loans     133,983     129,134
  Home equity loans and lines of credit     45,849     43,650
  Home construction (2)     2,170     2,344
  Multi-family     23,247     22,282
  Other real estate     5,311     5,664
   
 
      Total loans secured by real estate     210,560     203,074
Consumer     747     792
Commercial business     2,807     3,205
   
 
        Total loans held in portfolio   $ 214,114   $ 207,071
   
 

(1)
Represents purchased subprime loan portfolios and certain mortgages originated by Long Beach Mortgage Company.
(2)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

        Loans held in portfolio increased predominantly due to an increase in adjustable-rate home loans and home equity loans and lines of credit. Short-term adjustable-rate home loans (excluding specialty mortgage finance loans) increased from $70.56 billion at December 31, 2004 to $72.62 billion at March 31, 2005. These balances were substantially comprised of Option ARM loans.

    Other Assets

        Other assets consisted of the following:

 
  March 31,
2005

  December 31,
2004

 
  (in millions)

Premises and equipment   $ 3,042   $ 3,140
Investment in bank-owned life insurance     2,702     2,678
Accrued interest receivable     1,700     1,428
Foreclosed assets     264     261
Other intangible assets     181     195
Derivatives     1,126     893
Accounts receivable     5,382     3,917
Other     1,565     1,388
   
 
  Total other assets   $ 15,962   $ 13,900
   
 

        Substantially all of the increase in accounts receivable was due to the timing of the sale of available-for-sale securities which had not yet settled with the counterparties.

33



    Deposits

        Deposits consisted of the following:

 
  March 31,
2005

  December 31,
2004

 
  (in millions)

Retail deposits:            
  Checking deposits:            
    Noninterest bearing   $ 18,599   $ 17,463
    Interest bearing     48,988     51,099
   
 
        Total checking deposits     67,587     68,562
  Savings and money market deposits     35,184     36,836
  Time deposits     31,819     27,268
   
 
        Total retail deposits     134,590     132,666
Commercial business deposits     8,447     7,611
Wholesale deposits     24,969     18,448
Custodial and escrow deposits (1)     15,625     14,933
   
 
        Total deposits   $ 183,631   $ 173,658
   
 

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

        The increase in noninterest-bearing retail checking deposits was driven by an increase in the number of individual and small business checking accounts. Interest-bearing checking, savings and money market deposits decreased as customers shifted from Platinum checking and savings accounts to time deposits. The increase in time deposits reflects renewed customer interest as a result of higher interest rates offered for these products. Wholesale deposits increased 35% from year-end 2004, due predominantly to an increase in institutional investor certificates of deposits. The Company continued to balance its mix of funding sources between wholesale deposits and other borrowings such as FHLB advances and securities sold under agreements to repurchase ("repurchase agreements").

        Transaction accounts (checking, savings and money market deposits) comprised 76% of retail deposits at March 31, 2005, compared with 79% at year-end 2004. These products generally have the benefit of lower interest costs, compared with time deposits. These products represent the core customer relationship that is maintained within the retail banking franchise. At March 31, 2005, deposits funded 57% of total assets, compared with 56% at December 31, 2004.

    Borrowings

        At March 31, 2005, the Company's borrowings were largely comprised of advances from the FHLBs of San Francisco and Seattle and repurchase agreements. Advances from the San Francisco FHLB represented 87% of total FHLB advances at March 31, 2005. The mix of borrowing sources at any given time is dependent on market conditions.

Operating Segments

        The Company has three operating segments for the purpose of management reporting: the Retail Banking and Financial Services Group, the Mortgage Banking Group and the Commercial Group. Refer to Note 7 to the Consolidated Financial Statements – "Operating Segments" for information regarding the key elements of management reporting methodologies used to measure segment performance.

34



        The Company serves the needs of its 11.7 million consumer households through multiple distribution channels including 1,968 retail banking stores, 484 lending stores and centers, 3,389 ATMs, correspondent lenders, telephone call centers and online banking.

        Financial highlights by operating segment were as follows:

    Retail Banking and Financial Services Group

 
  Three Months Ended
March 31,

   
 
 
  Percentage
Change

 
 
  2005
  2004
 
 
  (in millions)

   
 
Condensed income statement:                  
  Net interest income   $ 1,343   $ 1,187   13 %
  Provision for loan and lease losses     37     58   (37 )
  Noninterest income     695     623   11  
  Inter-segment revenue     12     6   108  
  Noninterest expense     1,148     1,071   7  
   
 
     
  Income before income taxes     865     687   26  
  Income taxes     327     260   26  
   
 
     
    Net income   $ 538   $ 427   26  
   
 
     
Performance and other data:                  
  Efficiency ratio (1)     49.78 %   51.86 % (4 )
  Average loans   $ 177,635   $ 149,377   19  
  Average assets     190,479     161,359   18  
  Average deposits     132,982     128,000   4  
  Loan volume     12,493     12,778   (2 )
  Employees at end of period     31,152     29,077   7  

(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 primarily due to higher average balances of home loans and home equity loans and lines of credit, substantially offset by higher funding costs resulting from increasing interest rates. Average home loans increased $8.50 billion, or 8%, and average home equity loans and lines of credit increased $15.42 billion, or 53%, compared with the first quarter of 2004.

        The increase in noninterest income was primarily due to growth in depositor and other retail banking fees that resulted from growth in the number of retail checking accounts, higher debit card interchange and ATM-related fees, and an $11 million member distribution resulting from the merger of Pulse EFT Association into Discover Financial Services. Noninterest-bearing retail checking accounts totaled approximately 7 million at March 31, 2005, a 9% increase from March 31, 2004.

        The increase in noninterest expense was primarily due to higher employee compensation and benefits expense and occupancy and equipment expense, all of which resulted from the continued expansion of the Group's distribution network, which included the opening of 29 net new retail banking stores in the first quarter of 2005 and a total of 213 net new retail banking stores in the preceding twelve months.

35



    Mortgage Banking Group

 
  Three Months Ended
March 31,

   
 
 
  Percentage
Change

 
 
  2005
  2004
 
 
  (in millions)

   
 
Condensed income statement:                  
  Net interest income   $ 286   $ 288   (1 )%
  Noninterest income     682     761   (10 )
  Inter-segment expense     12     6   108  
  Noninterest expense     566     677   (16 )
   
 
     
  Income before income taxes     390     366   7  
  Income taxes     147     138   7  
   
 
     
    Net income   $ 243   $ 228   7  
   
 
     
Performance and other data:                  
  Efficiency ratio (1)     53.83 %   59.98 % (10 )
  Average loans   $ 27,765   $ 19,871   40  
  Average assets     49,019     38,914   26  
  Average deposits     13,107     14,877   (12 )
  Loan volume     38,498     43,720   (12 )
  Employees at end of period     12,626     21,203   (40 )

(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).

        Net interest income was flat in the first quarter of 2005, compared with the same period in 2004, as increased income from higher average balances of loans held for sale and investment securities was substantially offset by higher funding costs due to increasing interest rates.

        The decline in noninterest income was predominantly due to lower loan volume, which resulted in a decline of inter-segment gains from the sale of mortgage loans to the Retail Banking and Financial Services Group, and losses from mortgage-backed securities designated as MSR risk management instruments.

        The decrease in noninterest expense was largely due to lower employee compensation and benefits expense, technology expense and occupancy and equipment expense, compared with the first quarter of 2004. These decreases resulted from the consolidation of various locations and functions, the conversion to a single loan servicing platform and headcount reductions, which decreased to 12,626 at March 31, 2005 from 21,203 at March 31, 2004.

36



    Commercial Group

 
  Three Months Ended
March 31,

   
 
 
  Percentage
Change

 
 
  2005
  2004
 
 
  (in millions)

   
 
Condensed income statement:                  
  Net interest income   $ 323   $ 343   (6 )%
  Provision for loan and lease losses     2     16   (89 )
  Noninterest income     158     86   84  
  Noninterest expense     175     156   12  
   
 
     
  Income before income taxes     304     257   18  
  Income taxes     104     90   15  
   
 
     
      Net income   $ 200   $ 167   20  
   
 
     
Performance and other data:                  
  Efficiency ratio (1)     30.36 %   29.57 % 3  
  Average loans   $ 41,783   $ 36,984   13  
  Average assets     46,647     42,805   9  
  Average deposits     7,308     6,049   21  
  Loan volume     8,524     5,667   50  
  Employees at end of period     3,530     3,130   13  

(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 resulted largely from higher funding costs due to the increasing rate environment, primarily offset by increased interest income from higher average balances of multi-family loans and home loans.

        The increase in noninterest income was primarily due to a $59 million pretax gain on the sale of a real estate investment property during the first quarter of 2005.

        The increase in noninterest expense was primarily due to higher employee compensation and benefits expense and loan servicing expense resulting from the growth in loan volume from Long Beach Mortgage Company. The number of employees in this entity increased by approximately 700 during the previous twelve months.

        The increase in average deposits was due to growth in Mortgage Banker Finance customer deposits.

37


    Corporate Support/Treasury and Other

 
  Three Months Ended
March 31,

   
 
 
  Percentage
Change

 
 
  2005
  2004
 
 
  (in millions)

   
 
Condensed income statement:                  
  Net interest income (expense)   $ (175 ) $ (189 ) (8 )%
  Noninterest income (expense)     (65 )   (69 ) (6 )
  Noninterest expense     158     186   (15 )
   
 
     
  Loss from continuing operations before income taxes     (398 )   (444 ) (10 )
  Income tax benefit     (149 )   (165 ) (10 )
   
 
     
  Loss from continuing operations     (249 )   (279 ) (11 )
  Income from discontinued operations, net of taxes         399   (100 )
   
 
     
      Net income (loss)   $ (249 ) $ 120    
   
 
     
Performance and other data:                  
  Average assets   $ 23,809   $ 29,996   (21 )
  Average deposits     21,788     5,028   333  
  Employees at end of period     5,180     5,763   (10 )

        The decrease in noninterest expense was primarily due to lower restructuring and technology-related expenses from the Company's ongoing expense management efforts. All such expenses are charged to this unit.

        The increase in average deposits was predominantly due to growth in brokered certificates of deposits held by institutional investors.

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

Risk Management

        The Company is exposed to four major categories of risk: credit, liquidity, market and operational.

        The Company's Chief Enterprise Risk Officer is responsible for enterprise-wide risk assessment. The Company's Enterprise Risk Management function oversees the identification, measurement, monitoring, control and reporting of credit, market and operational risks. The Company's Treasury function is responsible for the measurement, management and control of liquidity risk. The Internal Audit function, which reports to the Audit Committee of the Board of Directors, provides independent assessment of the Company's compliance with risk management controls, policies and procedures.

        Enterprise Risk Management works with the lines of business to establish appropriate policies, standards and limits designed to maintain risk exposures within the Company's risk tolerance. Significant risk management policies approved by the relevant management committees are also reviewed and approved by the Audit and Finance Committees of the Board of Directors. Enterprise Risk Management also provides objective oversight of risk elements inherent in the Company's business activities and practices and oversees compliance with laws and regulations.

        Business lines are responsible for determining and executing business strategies that may give rise to one or more types of risk; their return on economic and other forms of capital is measured and compared to targets with the overall objective of ensuring that the risk/reward balance is acceptable. Business lines, Enterprise Risk Management and Treasury divide the responsibilities of conducting measurement and monitoring of the Company's risk exposures. Risk exceptions, depending on their type and significance, are elevated to management or Board committees responsible for oversight.

38



Credit Risk Management

        Credit risk is the risk of loss arising from adverse changes in a borrower's ability to meet its financial obligations under agreed upon terms and exists primarily in lending and derivative portfolios. The degree of credit risk will vary based on many factors, including the size of the asset or transaction, the credit characteristics of the borrower, the contractual terms of the agreement and the availability and quality of collateral.

        Credit risk management is based on analyzing the creditworthiness of the borrower, the adequacy of underlying collateral given current events and conditions and the existence and strength of any guarantor support. Trends in these factors are dynamic and are reflected in the tables and commentary that follow.

    Nonaccrual Loans, Foreclosed Assets and Restructured Loans

        Loans are generally placed on nonaccrual status upon reaching 90 days 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 or 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. Nonaccrual loans and foreclosed assets ("nonperforming assets") and restructured loans consisted of the following:

 
  March 31,
2005

  December 31,
2004

 
 
  (dollars in millions)

 
Nonperforming assets and restructured loans:              
  Nonaccrual loans (1) :              
    Loans secured by real estate:              
      Home   $ 495   $ 534  
      Specialty mortgage finance (2)     734     682  
   
 
 
          Total home nonaccrual loans     1,229     1,216  
      Home equity loans and lines of credit     74     66  
      Home construction (3)     25     28  
      Multi-family     15     12  
      Other real estate     159     162  
   
 
 
          Total nonaccrual loans secured by real estate     1,502     1,484  
    Consumer     8     9  
    Commercial business     59     41  
   
 
 
          Total nonaccrual loans held in portfolio     1,569     1,534  
  Foreclosed assets     264     261  
   
 
 
          Total nonperforming assets   $ 1,833   $ 1,795  
          As a percentage of total assets     0.57 %   0.58 %
  Restructured loans   $ 27   $ 34  
   
 
 
          Total nonperforming assets and restructured loans   $ 1,860   $ 1,829  
   
 
 

(1)
Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $112 million and $76 million at March 31, 2005 and December 31, 2004.
(2)
Represents purchased subprime loan portfolios and certain mortgages originated by Long Beach Mortgage Company.
(3)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

39


    Provision and Allowance for Loan and Lease Losses

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

 
  Three Months Ended
March 31,

 
 
  2005
  2004
 
 
  (dollars in millions)

 
Balance, beginning of period   $ 1,301   $ 1,250  
Provision for loan and lease losses     16     56  
   
 
 
      1,317     1,306  
Loans charged off:              
  Loans secured by real estate:              
    Home     (11 )   (16 )
    Specialty mortgage finance (1)     (10 )   (9 )
   
 
 
          Total home loans charged off     (21 )   (25 )
    Home equity loans and lines of credit     (5 )   (7 )
    Home construction (2)         (1 )
    Other real estate     (1 )   (8 )
   
 
 
          Total loans secured by real estate     (27 )   (41 )
  Consumer     (13 )   (14 )
  Commercial business     (6 )   (6 )
   
 
 
          Total loans charged off     (46 )   (61 )
Recoveries of loans previously charged off:              
  Loans secured by real estate:              
    Specialty mortgage finance (1)     1     1  
    Home equity loans and lines of credit         1  
    Multi-family         2  
    Other real estate     1     2  
   
 
 
          Total loans secured by real estate     2     6  
  Consumer     5     5  
  Commercial business     2     4  
   
 
 
        Total recoveries of loans previously charged off     9     15  
   
 
 
          Net charge-offs     (37 )   (46 )
   
 
 
Balance, end of period   $ 1,280   $ 1,260  
   
 
 
Net charge-offs (annualized) as a percentage of average loans held in portfolio     0.07 %   0.10 %
Allowance as a percentage of total loans held in portfolio     0.60     0.68  

(1)
Represents purchased subprime loan portfolios and certain mortgages originated by Long Beach Mortgage Company.
(2)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

        During the first quarter of 2005, a number of indicators that affect the risk of credit loss in the Company's loan portfolio improved or sustained the improvements observed during 2004. Total net charge-offs were $37 million, representing an annualized 0.07% of the portfolio. These results compare to $46 million and 0.10%, respectively, during the first quarter of 2004.

        The allowance for loan and lease losses represents management's estimate of incurred credit losses inherent in the Company's loan and lease portfolios as of the balance sheet date. The estimation of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect the borrowers' ability to repay, the estimated value of underlying collateral, the interest rate climate as it affects adjustable-rate loans and general economic conditions.

40



        In determining the allowance for loan and lease losses, the Company allocates a portion of the allowance to its various loan product categories based on an analysis of individual loans and pools of loans. The tools utilized for this determination include statistical forecasting models that estimate the default and loss outcomes based on an evaluation of past performance of loans in the Company's portfolio and other factors as well as industry historical loss data (primarily for homogeneous loan portfolios). Non-homogeneous loans are individually reviewed and assigned loss factors commensurate with the applicable level of estimated risk.

        Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" in the Company's 2004 Annual Report on Form 10-K for further discussion of the Allowance for Loan and Lease Losses.

    90 or More Days Past Due

        Loans held in portfolio that were 90 or more days contractually past due and still accruing interest were $94 million and $85 million at March 31, 2005 and December 31, 2004. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest.

Liquidity Risk Management

        The objective of liquidity management is to ensure the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet its other obligations on a timely and cost-effective basis. The Company establishes liquidity guidelines for the parent holding company, Washington Mutual, Inc., as well as for its principal operating subsidiaries. The Company also maintains contingency liquidity plans that outline alternative actions and enable appropriate and timely responses under stress scenarios.

    Washington Mutual, Inc.

        Liquidity for Washington Mutual, Inc. ("the Parent Company") is generated through its ability to raise funds through dividends from subsidiaries and in various capital markets such as unsecured debt and commercial paper.

        One of Washington Mutual, Inc.'s key funding sources is from dividends paid by its banking subsidiaries. The Parent Company received dividends from its subsidiaries during the first quarter of 2005 and expects to continue to receive dividends in the future. Banking subsidiaries dividends may be reduced from time to time to ensure that internal capital targets are met. Various regulatory requirements related to capital adequacy and retained earnings also limit the amount of dividends that can be paid by the Parent Company's banking subsidiaries. For more information on such dividend limitations, refer to the Company's 2004 Annual Report on Form 10-K, "Business – Regulation and Supervision" and Note 18 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."

        During 2003, Washington Mutual, Inc. filed two shelf registration statements with the Securities and Exchange Commission, registering a total of $7 billion in debt securities, preferred stock and depositary shares in the United States and in international capital markets. At March 31, 2005, the Company had $2.65 billion available for issuance under these registration statements.

        Washington Mutual, Inc. also has a commercial paper program and a revolving credit facility that are sources of liquidity. At March 31, 2005, the commercial paper program provided for up to $500 million in funds, but it was subsequently increased to a maximum of $1 billion. In addition, the Company's revolving credit facility of $800 million provides credit support for Washington Mutual, Inc.'s commercial paper program as well as funds for general corporate purposes. At March 31, 2005, Washington Mutual, Inc. had no commercial paper outstanding and the entire amount of the revolving credit facility was available.

41



        The Parent Company's senior debt and commercial paper was rated A and F1 by Fitch, A3 and P2 by Moody's and A- and A2 by Standard and Poor's.

        Washington Mutual, Inc. maintains sufficient liquidity to cover all debt obligations maturing over the next twelve months.

    Banking Subsidiaries

        The principal sources of liquidity for the Company's banking subsidiaries are customer deposits, wholesale borrowings, the maturity and repayment of portfolio loans, securities held in the available-for-sale portfolio and mortgage loans designated as held for sale. Among these sources, transaction deposits and wholesale borrowings from FHLB advances and repurchase agreements continue to provide the Company with a significant source of stable funding. During the first three months of 2005, those sources funded 67% of average total assets. The Company's continuing ability to retain its transaction deposit base and to attract new deposits depends on various factors, such as customer service satisfaction levels and the competitiveness of interest rates offered on deposit products. The Company continues to have the necessary assets available to pledge as collateral to obtain FHLB advances and repurchase agreements to offset any potential declines in deposit balances.

        At March 31, 2005, the Company's proceeds from the sales of loans were approximately $35 billion. These proceeds were, in turn, used as the primary funding source for the origination and purchases, net of principal payments, of approximately $39 billion of loans held for sale during the same period. Typically, a cyclical pattern of sales and originations/purchases repeats itself during the course of a period and the amount of funding necessary to sustain mortgage banking operations does not significantly affect the Company's overall level of liquidity resources. At March 31, 2005, originations/ purchases of loans held for sale, net of principal payments, exceeded the proceeds from the sale of loans held for sale by approximately $4 billion.

        The Company's banking subsidiaries also raise funds in domestic and international capital markets to supplement their primary funding sources. In August 2003, the Company established a Global Bank Note Program that allows Washington Mutual Bank ("WMB," f/k/a "Washington Mutual Bank, FA") to issue senior and subordinated notes in the United States and in international capital markets in a variety of currencies and structures. Under this program, WMB may issue up to $15 billion in notes, of which $5 billion can be issued as subordinated notes subject to regulatory approval. The maximum aggregate principal amount of notes with maturities greater than 270 days from the date of issue offered by WMB may not exceed $7.5 billion. At March 31, 2005, WMB had $12.50 billion available under this program, including $2.5 billion of subordinated notes.

        Senior unsecured long-term obligations of WMB were rated A by Fitch, A2 by Moody's and A by Standard and Poor's. Short-term obligations were rated F1 by Fitch, P1 by Moody's and A1 by Standard and Poor's.

    Non-banking Subsidiaries

        Long Beach Mortgage has revolving credit facilities with non-affiliated lenders totaling $8.0 billion that are used to fund loans held for sale. At March 31, 2005, Long Beach Mortgage had borrowings outstanding of $6.5 billion under these credit facilities.

42


Off-Balance Sheet Activities

    Asset Securitization

        The Company transforms 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 the 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 the Company sells or securitizes loans, it generally retains the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the sold or securitized assets. Retained interests may provide credit enhancement to the investors and, absent the violation of representations and warranties, generally represent the Company's maximum risk exposure associated with these transactions. Retained interests in securitizations were $1.77 billion at March 31, 2005, of which $1.76 billion have either a AAA credit rating or are agency insured. Additional information concerning securitization transactions is included in Note 6 to the Consolidated Financial Statements – "Mortgage Banking Activities" in the Company's 2004 Annual Report on Form 10-K.

    Guarantees

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

Capital Adequacy

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

 
  March 31, 2005
   
 
 
  Well-Capitalized
Minimum

 
 
  WMB
  WMBfsb
 
Tier 1 capital to adjusted total assets (leverage)   5.69 % 87.41 % 5.00 %
Adjusted tier 1 capital to total risk-weighted assets   8.40   376.04   6.00 %
Total risk-based capital to total risk-weighted assets   11.68   376.07   10.00 %

        The Company's federal savings bank subsidiaries are also required by Office of Thrift Supervision regulations to maintain tangible capital of at least 1.50% of assets. WMB and WMBfsb satisfied this requirement at March 31, 2005.

        The Company's broker-dealer subsidiaries are also subject to capital requirements. At March 31, 2005, all of its broker-dealer subsidiaries were in compliance with their applicable capital requirements.

        On February 1, 2004, WMBfsb became a subsidiary of WMB. This reorganization was followed by the contribution of $23.27 billion of mortgage-backed and investment securities by WMB to WMBfsb on March 1, 2004. Due to the low risk weights assigned to these securities under the federal banking agency regulatory capital guidelines, their contribution to WMBfsb's capital base substantially increased that entity's risk-based capital ratios.

43



        In 2003, the Company adopted a share repurchase program approved by the Board of Directors. Under the program, the Company is authorized to repurchase up to 100 million shares of its common stock, as conditions warrant. In the first quarter of 2005, the Company repurchased approximately 2.5 million shares of its common stock at an average price of $39.31. At March 31, 2005, the total remaining common stock repurchase authority under the 2003 program was approximately 40.9 million shares. Management may engage in future share repurchases as liquidity conditions permit and market conditions warrant.

Market Risk Management

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

        The Company's trading securities are primarily comprised of financial instruments, such as principal-only mortgage-backed securities, used for MSR risk management activities. As such, the related interest rate risk of those financial instruments used for MSR risk management activities is considered within the sensitivity comparison, presented later within this section.

        Interest rate risk is managed within a consolidated enterprise risk management framework that includes the measurement and management of specific portfolios (MSR and Other Mortgage Banking) discussed below. The principal objective of asset/liability management is to manage the sensitivity of net income to changing interest rates. Asset/liability management is governed by a policy reviewed and approved annually by the Board. The Board has delegated the oversight of the administration of this policy to the Finance Committee of the Board.

    MSR Risk Management

        The Company manages potential impairment in the fair value of MSR and increased amortization levels of MSR through a comprehensive risk management program. The intent is to offset the changes in MSR fair value and changes in MSR amortization above anticipated levels with changes in the fair value of risk management instruments. The risk management instruments include interest rate contracts, forward purchase commitments and available-for-sale and trading securities. The securities generally consist of fixed-rate debt securities, such as U.S. Government and agency obligations and mortgage-backed securities, including principal-only strips. The interest rate contracts typically consist of interest rate swaps, interest rate swaptions, interest rate floors and interest rate caps. The Company also enters into forward commitments to purchase mortgage-backed securities, which generally are agreements to purchase 15- and 30-year fixed-rate mortgage-backed securities.

        The fair value of MSR is primarily affected by changes in prepayments that result from shifts in mortgage rates. Changes in the value of MSR risk management instruments due to changes in interest rates vary based on the specific instrument. For example, changes in the fair value of interest rate swaps are driven by shifts in interest rate swap rates and the fair value of U.S. Treasury securities is based on changes in U.S. Treasury rates. Mortgage rates may move more or less than the rates on Treasury bonds or interest rate swaps. This could result in a change in the fair value of the MSR that differs from the change in fair value of the MSR risk management instruments. This difference in market indices between the MSR and the risk management instruments results in what is referred to as basis risk.

        During the third quarter of 2004, the Company adopted an MSR risk management approach that reduces its exposure to basis risk. As a result, the amount of mortgage based risk management products, such as forward commitments to purchase and sell mortgage-backed securities, was increased, while the

44



amount of LIBOR based products, such as interest rate swap contracts, decreased. Due to the inherent optionality in mortgage-based products, additional derivatives were also purchased to mitigate the optionality risk created by these products. This change in approach resulted in a significant increase in the total notional balance of derivative contracts that are designated as MSR risk management instruments.

        The fair value of MSR decreases and the amortization rate increases in a declining interest rate environment due to the higher prepayment activity, resulting in the potential for loss of value and a reduction in net loan servicing income. During periods of rising interest rates, the amortization rate of MSR decreases and the fair value of MSR increases due to lower prepayment activity.

        The Company manages the MSR daily and adjusts the mix of instruments used to manage MSR fair value changes as interest rates and market conditions warrant. The objective is to maintain an efficient and fairly liquid mix as well as a diverse portfolio of risk management instruments with maturity ranges that correspond well to the anticipated behavior of the MSR. For that portion of the MSR which qualifies for hedge accounting treatment, all changes in fair value of the MSR, even when the fair value is higher than amortized cost, will be recorded through earnings. MSR which do not qualify for hedge accounting treatment must be accounted for at the lower of cost or market value. The Company also manages the size of the MSR asset. Depending on market conditions and the desire to expand customer relationships, management may periodically sell or purchase additional servicing. Management may also structure loan sales to control the size of the MSR asset created by any particular transaction.

        The Company believes this overall risk management strategy is the most efficient approach to managing MSR fair value risk. The success of this strategy, however, is dependent on management's decisions regarding the amount, type and mix of MSR risk management instruments that are selected to manage the changes in fair value of the mortgage servicing asset. If this strategy is not successful, net income could be adversely affected.

    Other Mortgage Banking Risk Management

        The Company also manages the risks associated with its home loan mortgage warehouse and pipeline. The mortgage warehouse consists of funded loans intended for sale in the secondary market. The pipeline consists of commitments to originate or purchase mortgages to be sold in the secondary market. The risk associated with the mortgage pipeline and warehouse is the potential for changes in interest rates between the time the customer locks in the rate on the loan and the time the loan is sold.

        The Company measures the risk profile of the mortgage warehouse and pipeline daily. As needed, to manage the warehouse and pipeline risk, management executes forward sales commitments, interest rate contracts and mortgage option contracts. A forward sales commitment protects against a rising interest rate environment, since the sales price and delivery date are already established. A forward sales commitment is different, however, from an option contract in that the Company is obligated to deliver the loan to the third party on the agreed-upon future date. Management also estimates the fallout factor, which represents the percentage of loans that are not expected to be funded, when determining the appropriate amount of pipeline risk management instruments.

    Asset/Liability Risk Management

        The purpose of asset/liability risk management is to assess the aggregate risk profile of the Company. Asset/liability risk analysis combines the MSR and Other Mortgage Banking activities with substantially all of the other remaining interest rate risk positions inherent in the Company's operations.

        To analyze net income sensitivity, management projects net income in a variety of interest rate scenarios, assuming both parallel and non-parallel shifts in the yield curve. These scenarios also capture the net interest income sensitivity due to changes in the slope of the yield curve and changes in the spread between Treasury and LIBOR rates. Additionally, management measures the sensitivity of asset and liability fair value changes to changes in interest rates to analyze risk exposure over longer periods of time.

45



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

        The slope of the yield curve, current interest rate conditions and the speed of changes in interest rates all affect sensitivity to changes in interest rates. Borrowings and, to a lesser extent, interest-bearing deposits typically reprice faster than the Company's adjustable-rate assets. An additional lag effect is inherent in adjustable-rate loans and mortgage-backed securities indexed to the 12-month average of the annual yields on actively traded U.S. Treasury securities adjusted to a constant maturity of one year and those indexed to the 11th District FHLB monthly weighted average cost of funds index.

        The sensitivity of new loan volume and mix to changes in market interest rate levels is also projected. Management generally assumes a reduction in total loan production in rising interest rate scenarios accompanied by a shift towards a greater proportion of adjustable-rate production. Conversely, the Company generally assumes an increase in total loan production in falling interest rate scenarios accompanied by a shift towards a greater proportion of fixed-rate loans. The gain from mortgage loans also varies under different interest rate scenarios. Normally, the gain from mortgage loans increases in falling interest rate environments primarily from high fixed-rate mortgage refinancing activity. Conversely, the gain from mortgage loans may decline when interest rates increase if management chooses to retain more loans in the portfolio.

        In periods of rising interest rates, the net interest margin normally contracts since the repricing period of the Company's liabilities is shorter than the repricing period of its assets. The net interest margin generally expands in periods of falling interest rates as borrowing costs reprice downward faster than asset yields.

        To manage interest rate sensitivity, management first utilizes the interest rate risk characteristics of the balance sheet assets and liabilities to offset each other as much as possible. Balance sheet products have a variety of risk profiles and sensitivities. Some of the components of interest rate risk are countercyclical. Management may adjust the amount or mix of risk management instruments based on the countercyclical behavior of the balance sheet products.

        When the countercyclical behavior inherent in portions of the Company's balance sheet does not result in an acceptable risk profile, management utilizes investment securities and interest rate contracts to mitigate this situation. The interest rate contracts used for this purpose are classified as asset/liability risk management instruments. These contracts are often used to modify the repricing period of interest-bearing funding sources with the intention of reducing the volatility of net interest income. The types of contracts used for this purpose consist of interest rate swaps, interest rate corridors, interest rate swaptions and certain derivatives that are embedded in borrowings. Management also uses receive-fixed swaps as part of the asset/liability risk management strategy to help modify the repricing characteristics of certain long-term liabilities to match those of the assets. Typically, these are swaps of long-term fixed-rate debt to a short-term adjustable-rate, which more closely resembles asset repricing characteristics.

    April 1, 2005 and January 1, 2005 Sensitivity Comparison

        The table below indicates the sensitivity of net interest income and net income as a result of interest rate movements on market risk sensitive instruments. The base case used for this sensitivity analysis is similar to the Company's most recent earnings plan for the respective twelve month periods as of the date the analysis was performed. The comparative results assume parallel shifts in the yield curve with interest rates rising 200

46


basis points in even quarterly increments over the twelve month periods ending March 31, 2006 and December 31, 2005 and interest rates decreasing by 50 basis points in even quarterly increments over the first six months of the twelve month periods. The analysis also incorporates assumptions about balance sheet dynamics such as loan and deposit growth and pricing, changes in funding mix and asset and liability repricing and maturity characteristics. The projected interest rate sensitivities of net interest income and net income shown below may differ significantly from actual results, particularly with respect to non-parallel shifts in the yield curve or changes in the spreads between mortgage, Treasury and LIBOR rates.

 
  Gradual Change in Rates
 
 
  -50 basis points
  +200 basis points
 
Net interest income change for the one-year period beginning:          
  April 1, 2005   1.49 % (2.14 )%
  January 1, 2005   2.61   (2.18 )
Net income change for the one-year period beginning:          
  April 1, 2005   2.02   (3.08 )
  January 1, 2005   (0.95 ) (1.37 )

        Net income sensitivity changed from the prior quarter as movements in the value of MSR-related risk management instruments mostly offset movements in the value of the MSR asset and a significant portion of MSR amortization expense in both scenarios. In the January 1, 2005 simulation the MSR-related risk management instruments offset most of the change in the value of the MSR asset but offset changes in amortization expense to a lesser extent, which resulted in lower net income sensitivity in the -50 basis point scenario and a corresponding decrease in the rising interest rate scenario.

        Net interest income sensitivity in the current quarter approximated the sensitivity projected in the prior quarter in the +200 basis point scenario and declined slightly in the -50 basis point scenario. The net duration of earning assets and costing liabilities was not substantially different than at year-end. However, the decline in the -50 basis point scenario was mainly due to projected changes in the composition of the loans-held-for-sale portfolio in this environment. In the current period simulation, adjustable-rate loans were projected to comprise a higher proportion of the loans-held-for-sale portfolio than the January 1 simulation, reducing the increase in net interest income in the falling interest rate scenario.

        These sensitivity analyses are limited in that they were performed at a particular point in time, are subject to the accuracy of various assumptions used, including prepayment forecasts and discount rates, and do not incorporate other factors that would impact the Company's overall financial performance in such scenarios, most significantly the impact of changes in gain from mortgage loans that result from changes in interest rates. In addition, not all of the changes in fair value may impact current period earnings. For example, the portion of the MSR that does not qualify for fair value hedge accounting treatment may increase in value, but the amount of the increase that is recorded in current period earnings may be limited to the recovery of the impairment reserve within each stratum. These analyses also assume that the MSR risk management strategy is constant and that mortgage and interest rate swap spreads are constant in all interest rate environments. These assumptions may not be realized. For example, changes in spreads between interest rate indices could result in significant changes in projected net income sensitivity. Projected net income may increase if market rates on interest rate swaps decrease by more than the decrease in mortgage rates, while the projected net income may decline if the rates on swaps increase by more than mortgage rates. For all of these reasons, the preceding sensitivity estimates should not be viewed as an earnings forecast.

47


Maturity and Repricing Information

        The Company uses interest rate risk management contracts and available-for-sale and trading securities as tools to manage its interest rate risk profile. The following tables summarize the key contractual terms associated with these contracts and securities. Substantially all of the interest rate risk management swaps, swaptions and caps at March 31, 2005 are indexed to three-month LIBOR.

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

 
  March 31, 2005
 
 
  Maturity Range
 
 
  Net
Fair
Value

  Total
Notional
Amount

  2005
  2006
  2007
  2008
  2009
  After
2009

 
 
  (dollars in millions)

 
Interest Rate Risk Management Contracts:                                                  
  Asset/Liability Risk Management                                                  
    Pay-fixed swaps:   $ 6                                            
      Contractual maturity         $ 24,733   $ 10,000   $ 11,933   $ 2,800              
      Weighted average pay rate           3.52 %   2.90 %   3.69 %   5.01 %            
      Weighted average receive rate           2.81 %   2.73 %   2.89 %   2.79 %            
    Receive-fixed swaps:     (123 )                                          
      Contractual maturity         $ 24,775   $ 80   $ 1,000   $ 10,975   $ 4,850   $ 1,175   $ 6,695  
      Weighted average pay rate           2.91 %   1.04 %   2.79 %   2.90 %   2.72 %   3.31 %   3.05 %
      Weighted average receive rate           4.33 %   5.41 %   6.81 %   3.53 %   4.10 %   4.25 %   5.44 %
    Basis swaps:     7                                            
      Contractual maturity         $ 5,000       $ 3,500   $ 500   $ 1,000          
      Weighted average pay rate           2.68 %       2.68 %   2.64 %   2.72 %        
      Weighted average receive rate           2.71 %       2.69 %   2.69 %   2.81 %        
    Interest rate caps:     24                                            
      Contractual maturity         $ 16,375       $ 12,875   $ 1,250   $ 2,250          
      Weighted average strike rate           4.98 %       4.73 %   5.65 %   6.04 %        
    Payor swaptions:     11                                            
      Contractual maturity (option)         $ 4,000       $ 4,000                  
      Weighted average strike rate           5.50 %       5.50 %                
      Contractual maturity (swap)                         $ 4,000          
      Weighted average pay rate                           5.50 %        
    Receiver swaptions:     9                                            
      Contractual maturity (option)         $ 2,795   $ 250   $ 2,545                  
      Weighted average strike rate           3.72 %   3.75 %   3.72 %                
      Contractual maturity (swap)                             $ 450   $ 2,345  
      Weighted average receive rate                               3.52 %   3.76 %
   
 
                                     
        Total asset/liability risk management   $ (66 ) $ 77,678                                      
   
 
                                     

(This table is continued on the next page.)

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(Continued from the previous page.)

 
  March 31, 2005
 
 
  Maturity Range
 
 
  Net
Fair
Value

  Total
Notional
Amount

  2005
  2006
  2007
  2008
  2009
  After
2009

 
 
  (dollars in millions)

 
Interest Rate Risk Management Contracts:                                                  
  Other Mortgage Banking Risk Management                                                  
    Forward purchase commitments:   $ (73 )                                          
      Contractual maturity         $ 20,118   $ 20,118                      
      Weighted average price           99.42     99.42                      
    Forward sales commitments:     178                                            
      Contractual maturity         $ 45,145   $ 45,145                      
      Weighted average price           99.57     99.57                      
    Interest rate futures:                                                
      Contractual maturity         $ 20,712   $ 5,623   $ 7,209   $ 4,970   $ 1,886   $ 929   $ 95  
      Weighted average price           95.51     96.09     95.48     95.25     95.10     94.92     94.83  
    Interest rate corridors:     4                                            
      Contractual maturity         $ 2,843               $ 2,445       $ 398  
      Weighted average strike rate – long cap           4.28 %               4.15 %       5.05 %
      Weighted average strike rate – short cap           9.69 %               9.88 %       8.55 %
    Mortgage put options:     30                                            
      Contractual maturity         $ 256   $ 256                      
      Weighted average strike price           100.24     100.24                      
    Mortgage call options:     2                                            
      Contractual maturity         $ 56   $ 56                      
      Weighted average strike price           101.10     101.10                      
    Pay-fixed swaps:     87                                            
      Contractual maturity         $ 12,795   $ 2,460   $ 4,635   $ 3,610   $ 870   $ 210   $ 1,010  
      Weighted average pay rate           3.57 %   2.60 %   3.43 %   3.97 %   4.15 %   3.88 %   4.56 %
      Weighted average receive rate           2.95 %   2.88 %   3.00 %   2.93 %   2.98 %   2.81 %   2.87 %
    Receive-fixed swaps:     (13 )                                          
      Contractual maturity         $ 2,535       $ 300   $ 1,200   $ 500       $ 535  
      Weighted average pay rate           2.88 %       2.61 %   2.92 %   2.96 %       2.87 %
      Weighted average receive rate           3.96 %       2.19 %   3.87 %   4.13 %       4.97 %
    Payor swaptions:     15                                            
      Contractual maturity (option)         $ 3,495   $ 2,820   $ 675                  
      Weighted average strike rate           5.65 %   5.76 %   5.21 %                
      Contractual maturity (swap)                     $ 1,000   $ 200   $ 400   $ 1,895  
      Weighted average pay rate                       5.13 %   4.58 %   5.18 %   6.15 %
    Receiver swaptions:     1                                            
      Contractual maturity (option)         $ 700   $ 600   $ 100                  
      Weighted average strike rate           3.73 %   3.64 %   4.28 %                
      Contractual maturity (swap)                     $ 300           $ 400  
      Weighted average receive rate                       3.64 %           3.80 %
   
 
                                     
      Total other mortgage banking risk management   $ 231   $ 108,655                                      
   
 
                                     

(This table is continued on the next page.)

49


(Continued from the previous page.)

 
  March 31, 2005
 
 
  Maturity Range
 
 
  Net
Fair
Value

  Total
Notional
Amount

  2005
  2006
  2007
  2008
  2009
  After
2009

 
 
  (dollars in millions)

 
Interest Rate Risk Management Contracts:                                                  
  MSR Risk Management                                                  
    Pay-fixed swaps:   $ 12                                            
      Contractual maturity         $ 3,500   $ 3,000   $ 500                  
      Weighted average pay rate           2.70 %   2.37 %   4.66 %                
      Weighted average receive rate           3.03 %   3.03 %   3.06 %                
    Receive-fixed swaps:     (115 )                                          
      Contractual maturity         $ 20,561           $ 4,600   $ 4,155   $ 75   $ 11,731  
      Weighted average pay rate           2.95 %           2.93 %   2.99 %   2.66 %   2.95 %
      Weighted average receive rate           4.46 %           3.95 %   4.25 %   3.38 %   4.74 %
    Constant maturity mortgage swaps:     1                                            
      Contractual maturity         $ 100               $ 100          
      Weighted average pay rate           541 %               5.41 %        
      Weighted average receive rate           5.61 %               5.61 %        
    Payor swaptions:     208                                            
      Contractual maturity (option)         $ 56,525   $ 34,925   $ 21,600                  
      Weighted average strike rate           5.55 %   5.57 %   5.52 %                
      Contractual maturity (swap)                     $ 4,000   $ 13,300   $ 3,000   $ 36,225  
      Weighted average pay rate                       5.15 %   5.18 %   5.40 %   5.75 %
    Written payor swaptions:     (66 )                                          
      Contractual maturity (option)         $ 4,625   $ 1,700       $ 300   $ 2,625          
      Weighted average strike rate           4.99 %   4.69 %       5.26 %   5.16 %        
      Contractual maturity (swap)                     $ 750   $ 450       $ 3,425  
      Weighted average strike rate                       4.40 %   4.73 %       5.16 %
    Written receiver swaptions:     (36 )                                          
      Contractual maturity (option)         $ 7,775   $ 4,850       $ 300   $ 2,625          
      Weighted average strike rate           3.98 %   3.75 %       4.26 %   4.38 %        
      Contractual maturity (swap)                     $ 750   $ 600       $ 6,425  
      Weighted average strike rate                       3.40 %   3.73 %       4.07 %
    Interest rate caps:     33                                            
      Contractual maturity         $ 2,250               $ 1,000       $ 1,250  
      Weighted average strike rate           5.09 %               4.76 %       5.35 %
    Interest rate futures:                                                
      Contractual maturity         $ 30   $ 30                      
      Weighted average price           96.49     96.49                      
    Forward purchase commitments:     (247 )                                          
      Contractual maturity         $ 37,587   $ 37,587                      
      Weighted average price           99.31     99.31                      
    Forward sales commitments:     (21 )                                          
      Contractual maturity         $ 7,305   $ 7,305                      
      Weighted average price           98.88     98.88                      
   
 
                                     
        Total MSR risk management   $ (231 ) $ 140,258                                      
   
 
                                     
          Total interest rate risk management contracts   $ (66 ) $ 326,591                                      
   
 
                                     
 
  March 31, 2005
 
  Amortized
Cost

  Net
Unrealized
Gain

  Fair Value
 
  (in millions)

MSR Risk Management:                
  Available-For-Sale Securities:                
    Mortgage-backed securities – U.S. Government and agency (1)   $ 176   $9   $ 185
  Trading Securities:                
    Mortgage-backed securities – U.S. Government and agency     n/a   n/a     4,004
             
          Total MSR risk management securities             $ 4,189
             

(1)
Mortgage-backed securities mature after 2009.

50


 
  December 31, 2004
 
 
  Maturity Range
 
 
  Net
Fair
Value

  Total
Notional
Amount

  2005
  2006
  2007
  2008
  2009
  After
2009

 
 
  (dollars in millions)

 
Interest Rate Risk Management Contracts:                                                  
  Asset/Liability Risk Management                                                  
    Pay-fixed swaps:   $ (112 )                                          
      Contractual maturity         $ 16,013   $ 11,780   $ 1,433   $ 2,800              
      Weighted average pay rate           3.51 %   3.08 %   4.18 %   5.01 %            
      Weighted average receive rate           2.34 %   2.39 %   2.13 %   2.24 %            
    Receive-fixed swaps:     218                                            
      Contractual maturity         $ 19,930   $ 80   $ 1,000   $ 10,950   $ 850   $ 1,150   $ 5,900  
      Weighted average pay rate           2.53 %   0.62 %   2.29 %   2.53 %   2.46 %   2.74 %   2.55 %
      Weighted average receive rate           4.35 %   5.41 %   6.81 %   3.53 %   3.99 %   4.25 %   5.51 %
    Interest rate caps:     21                                            
      Contractual maturity         $ 26,075   $ 3,000   $ 19,875   $ 3,200              
      Weighted average strike rate           4.38 %   3.30 %   4.46 %   4.91 %            
    Interest rate corridors:     2                                            
      Contractual maturity         $ 2,585   $ 7                   </