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 SEPTEMBER 30, 2006

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

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

1301 Second Avenue, Seattle, Washington

 

98101

(Address of principal executive offices)

 

(Zip Code)

 

(206) 461-2000

(Registrant’s telephone number, including area code)

1201 Third Avenue, Seattle, Washington

(Registrant’s former address)


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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer x    Accelerated filer o    Non-accelerated filer o .

Indicate by check mark whether the registrant is a shell company (as defined in 12b-2 of the Exchange Act.)  Yes o    No x .

The number of shares outstanding of the issuer’s classes of common stock as of October 31, 2006:

Common Stock – 945,221,245 (1)

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

 




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2006
TABLE OF CONTENTS

 

Page

 

PART I – Financial Information

 

 

1

 

 

Item 1.     Financial Statements

 

 

1

 

 

Consolidated Statements of Income –
Three and Nine Months Ended September 30, 2006 and 2005

 

 

1

 

 

Consolidated Statements of Financial Condition –
September 30, 2006 and December 31, 2005

 

 

2

 

 

Consolidated Statements of Stockholders’ Equity and Comprehensive Income –
Nine Months Ended September 30, 2006 and 2005

 

 

3

 

 

Consolidated Statements of Cash Flows –
Nine Months Ended September 30, 2006 and 2005

 

 

4

 

 

Notes to Consolidated Financial Statements

 

 

6

 

 

Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

33

 

 

Cautionary Statements

 

 

33

 

 

Controls and Procedures

 

 

34

 

 

Overview

 

 

34

 

 

Critical Accounting Estimates

 

 

36

 

 

Recently Issued Accounting Standards Not Yet Adopted

 

 

36

 

 

Summary Financial Data

 

 

37

 

 

Earnings Performance from Continuing Operations

 

 

38

 

 

Review of Financial Condition

 

 

49

 

 

Operating Segments

 

 

52

 

 

Off-Balance Sheet Activities

 

 

57

 

 

Capital Adequacy

 

 

58

 

 

Risk Management

 

 

58

 

 

Credit Risk Management

 

 

59

 

 

Liquidity Risk Management

 

 

63

 

 

Market Risk Management

 

 

65

 

 

Operational Risk Management

 

 

68

 

 

Item 3.     Quantitative and Qualitative Disclosures About Market Risk

 

 

65

 

 

Item 4.     Controls and Procedures

 

 

34

 

 

PART II Other Information

 

 

69

 

 

Item 1.     Legal Proceedings

 

 

69

 

 

Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds

 

 

70

 

 

Item 4.     Submission of Matters to a Vote of Security Holders

 

 

71

 

 

Item 6.     Exhibits

 

 

71

 

 

 

i




Part I – FINANCIAL INFORMATION

WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005__

 

 

 

(in millions, except per share amounts)

 

Interest Income

 

 

 

 

 

 

 

 

 

Loans held for sale

 

$

439

 

$

665

 

$

1,304

 

$

1,719

 

Loans held in portfolio

 

4,008

 

2,947

 

11,468

 

8,395

 

Available-for-sale securities

 

379

 

238

 

1,068

 

695

 

Trading assets

 

140

 

114

 

503

 

284

 

Other interest and dividend income

 

139

 

65

 

354

 

159

 

Total interest income

 

5,105

 

4,029

 

14,697

 

11,252

 

Interest Expense

 

 

 

 

 

 

 

 

 

Deposits

 

1,739

 

996

 

4,420

 

2,544

 

Borrowings

 

1,419

 

1,028

 

4,154

 

2,731

 

Total interest expense

 

3,158

 

2,024

 

8,574

 

5,275

 

Net interest income

 

1,947

 

2,005

 

6,123

 

5,977

 

Provision for loan and lease losses

 

166

 

52

 

472

 

99

 

Net interest income after provision for loan and lease losses

 

1,781

 

1,953

 

5,651

 

5,878

 

Noninterest Income

 

 

 

 

 

 

 

 

 

Revenue from sales and servicing of home mortgage loans

 

118

 

710

 

603

 

1,600

 

Revenue from sales and servicing of consumer loans

 

355

 

2

 

1,155

 

4

 

Depositor and other retail banking fees

 

655

 

578

 

1,875

 

1,608

 

Credit card fees

 

165

 

 

456

 

 

Securities fees and commissions

 

52

 

48

 

161

 

142

 

Insurance income

 

31

 

42

 

97

 

135

 

Trading assets income (loss)

 

68

 

(171

)

(74

)

15

 

Loss from sales of other available-for-sale securities

 

(1

)

(32

)

(8

)

(129

)

Other income

 

127

 

31

 

521

 

197

 

Total noninterest income

 

1,570

 

1,208

 

4,786

 

3,572

 

Noninterest Expense

 

 

 

 

 

 

 

 

 

Compensation and benefits

 

939

 

930

 

2,992

 

2,673

 

Occupancy and equipment

 

408

 

372

 

1,235

 

1,122

 

Telecommunications and outsourced information services

 

142

 

107

 

421

 

310

 

Depositor and other retail banking losses

 

57

 

61

 

165

 

165

 

Advertising and promotion

 

124

 

78

 

335

 

206

 

Professional fees

 

57

 

47

 

138

 

119

 

Other expense

 

457

 

265

 

1,265

 

812

 

Total noninterest expense

 

2,184

 

1,860

 

6,551

 

5,407

 

Minority interest expense

 

34

 

 

71

 

 

Income from continuing operations before income taxes

 

1,133

 

1,301

 

3,815

 

4,043

 

Income taxes

 

394

 

488

 

1,341

 

1,507

 

Income from continuing operations, net of taxes

 

739

 

813

 

2,474

 

2,536

 

Discontinued Operations

 

 

 

 

 

 

 

 

 

Income from discontinued operations before income taxes

 

14

 

12

 

42

 

47

 

Income taxes

 

5

 

4

 

15

 

16

 

Income from discontinued operations, net of taxes

 

9

 

8

 

27

 

31

 

Net Income

 

$

748

 

$

821

 

$

2,501

 

$

2,567

 

Basic Earnings Per Common Share:

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

$

0.78

 

$

0.94

 

$

2.59

 

$

2.93

 

Income from discontinued operations

 

0.01

 

0.01

 

0.03

 

0.04

 

Net income

 

0.79

 

0.95

 

2.62

 

2.97

 

Diluted Earnings Per Common Share:

 

 

 

 

 

 

 

 

 

Income from continuing operations

 

0.76

 

0.91

 

2.51

 

2.86

 

Income from discontinued operations

 

0.01

 

0.01

 

0.03

 

0.03

 

Net income

 

0.77

 

0.92

 

2.54

 

2.89

 

Dividends declared per common share

 

0.52

 

0.48

 

1.53

 

1.41

 

Basic weighted average number of common shares outstanding (in thousands)

 

941,898

 

866,541

 

954,062

 

865,571

 

Diluted weighted average number of common shares outstanding (in thousands)

 

967,376

 

888,495

 

981,997

 

888,184

 

 

See Notes to Consolidated Financial Statements.

1




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(UNAUDITED)

 

 

September 30,
2006

 

December 31,
2005

 

 

 

(dollars in millions)

 

Assets

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

$

6,649

 

 

 

$

6,214

 

 

Federal funds sold and securities purchased under agreements to resell

 

 

5,102

 

 

 

2,137

 

 

Trading assets (including securities pledged of $198 and $3,281)

 

 

5,391

 

 

 

10,999

 

 

Available-for-sale securities, total amortized cost of $29,136 and $24,810:

 

 

 

 

 

 

 

 

 

Mortgage-backed securities (including securities pledged of $2,837 and $3,950)

 

 

22,353

 

 

 

20,648

 

 

Investment securities (including securities pledged of $2,042 and $2,773)

 

 

6,664

 

 

 

4,011

 

 

Total available-for-sale securities

 

 

29,017

 

 

 

24,659

 

 

Loans held for sale

 

 

23,720

 

 

 

33,582

 

 

Loans held in portfolio

 

 

241,765

 

 

 

229,632

 

 

Allowance for loan and lease losses

 

 

(1,550

)

 

 

(1,695

)

 

Total loans held in portfolio, net of allowance for loan and lease losses

 

 

240,215

 

 

 

227,937

 

 

Investment in Federal Home Loan Banks

 

 

3,013

 

 

 

4,257

 

 

Mortgage servicing rights

 

 

6,288

 

 

 

8,041

 

 

Goodwill

 

 

8,368

 

 

 

8,298

 

 

Other assets

 

 

21,114

 

 

 

17,449

 

 

Total assets

 

 

$

348,877

 

 

 

$

343,573

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

Noninterest-bearing deposits

 

 

$

34,667

 

 

 

$

34,014

 

 

Interest-bearing deposits

 

 

176,215

 

 

 

159,153

 

 

Total deposits

 

 

210,882

 

 

 

193,167

 

 

Federal funds purchased and commercial paper

 

 

5,282

 

 

 

7,081

 

 

Securities sold under agreements to repurchase

 

 

13,665

 

 

 

15,532

 

 

Advances from Federal Home Loan Banks

 

 

47,247

 

 

 

68,771

 

 

Other borrowings

 

 

33,883

 

 

 

23,777

 

 

Other liabilities

 

 

9,501

 

 

 

7,951

 

 

Minority interests

 

 

1,959

 

 

 

15

 

 

Total liabilities

 

 

322,419

 

 

 

316,294

 

 

Stockholders’ Equity

 

 

 

 

 

 

 

 

 

Preferred stock, no par value: 600 and zero shares authorized, 500 and zero shares issued and outstanding ($1,000,000 per share liquidation preference)

 

 

492

 

 

 

 

 

Common stock, no par value: 1,600,000,000 shares authorized, 945,098,276 and 993,913,800 shares issued and outstanding

 

 

 

 

 

 

 

Capital surplus – common stock

 

 

5,761

 

 

 

8,176

 

 

Accumulated other comprehensive loss

 

 

(180

)

 

 

(235

)

 

Retained earnings

 

 

20,385

 

 

 

19,338

 

 

Total stockholders’ equity

 

 

26,458

 

 

 

27,279

 

 

Total liabilities and stockholders’ equity

 

 

$

348,877

 

 

 

$

343,573

 

 

p

See Notes to Consolidated Financial Statements.

2




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME
(UNAUDITED)

 

 

Number
of
Common
Shares

 

Preferred
Stock

 

Capital
Surplus

Common
Stock

 

Accumulated
Other
Comprehensive
Income (Loss)

 

Retained
Earnings

 

Total

 

 

 

 

(in millions)

 

 

BALANCE, December 31, 2004

 

 

874.3

 

 

 

$

 

 

 

$

3,350

 

 

 

$

(76

)

 

 

$

17,615

 

 

$

20,889

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,567

 

 

2,567

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net unrealized loss from securities arising during the period, net of reclassification adjustments

 

 

 

 

 

 

 

 

 

 

 

(105

)

 

 

 

 

(105

)

Net unrealized gain from cash flow hedging instruments

 

 

 

 

 

 

 

 

 

 

 

37

 

 

 

 

 

37

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,499

 

Cash dividends declared on common stock

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1,230

)

 

(1,230

)

Common stock repurchased and retired

 

 

(4.9

)

 

 

 

 

 

(198

)

 

 

 

 

 

 

 

(198

)

Common stock issued

 

 

8.3

 

 

 

 

 

 

299

 

 

 

 

 

 

 

 

299

 

BALANCE, September 30, 2005

 

 

877.7

 

 

 

$

 

 

 

$

3,451

 

 

 

$

(144

)

 

 

$

18,952

 

 

$

22,259

 

BALANCE, December 31, 2005

 

 

993.9

 

 

 

$

 

 

 

$

8,176

 

 

 

$

(235

)

 

 

$

19,338

 

 

$

27,279

 

Cumulative effect from the adoption of Statement No. 156, net of income taxes

 

 

 

 

 

 

 

 

 

 

 

6

 

 

 

29

 

 

35

 

Adjusted balance

 

 

993.9

 

 

 

 

 

 

8,176

 

 

 

(229

)

 

 

19,367

 

 

27,314

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,501

 

 

2,501

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net unrealized gain from securities arising during the period, net of reclassification adjustments

 

 

 

 

 

 

 

 

 

 

 

2

 

 

 

 

 

2

 

Net unrealized gain from cash flow hedging instruments

 

 

 

 

 

 

 

 

 

 

 

48

 

 

 

 

 

48

 

Minimum pension liability adjustments

 

 

 

 

 

 

 

 

 

 

 

(1

)

 

 

 

 

(1

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2,550

 

Cash dividends declared on common stock

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1,483

)

 

(1,483

)

Common stock repurchased and retired

 

 

(65.8

)

 

 

 

 

 

(3,039

)

 

 

 

 

 

 

 

(3,039

)

Common stock issued

 

 

17

 

 

 

 

 

 

624

 

 

 

 

 

 

 

 

624

 

Preferred stock issued

 

 

 

 

 

492

 

 

 

 

 

 

 

 

 

 

 

492

 

BALANCE, September 30, 2006

 

 

945.1

 

 

 

$

492

 

 

 

$

5,761

 

 

 

$

(180

)

 

 

$

20,385

 

 

$

26,458

 

 

See Notes to Consolidated Financial Statements.

3




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

 

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

 

 

(in millions)

 

Cash Flows from Operating Activities

 

 

 

 

 

Net income

 

$

2,501

 

$

2,567

 

Adjustments to reconcile net income to net cash provided (used) by operating activities:

 

 

 

 

 

Provision for loan and lease losses

 

472

 

99

 

Gain from mortgage loans

 

(552

)

(632

)

Loss from sales of available-for-sale securities

 

2

 

124

 

Depreciation and amortization

 

639

 

2,040

 

Provision for mortgage servicing rights reversal

 

 

(590

)

Stock dividends from Federal Home Loan Banks

 

(89

)

(102

)

Capitalized interest income from option adjustable-rate mortgages

 

(706

)

(159

)

Origination and purchases of loans held for sale, net of principal
payments

 

(93,662

)

(128,520

)

Proceeds from sales of loans held for sale

 

100,412

 

118,007

 

Excess tax benefits from stock-based payment arrangement

 

(16

)

 

Net decrease (increase) in trading assets

 

6,875

 

(1,416

)

Increase in other assets

 

(1,706

)

(1,877

)

Increase in other liabilities

 

1,153

 

1,694

 

Net cash provided (used) by operating activities

 

15,323

 

(8,765

)

Cash Flows from Investing Activities

 

 

 

 

 

Purchases of available-for-sale securities

 

(12,375

)

(14,033

)

Proceeds from sales and maturities of mortgage-backed securities

 

5,556

 

4,834

 

Proceeds from sales and maturities of other available-for-sale securities

 

1,140

 

4,615

 

Principal payments on available-for-sale securities

 

2,208

 

2,570

 

Purchases of Federal Home Loan Bank stock

 

(38

)

(163

)

Redemption of Federal Home Loan Bank stock

 

1,368

 

96

 

Proceeds from sale of mortgage servicing rights

 

2,527

 

 

Restricted cash pursuant to Commercial Capital Bancorp acquisition

 

(960

)

 

Origination and purchases of loans held in portfolio

 

(67,787

)

(72,589

)

Principal payments on loans held in portfolio

 

52,247

 

64,456

 

Proceeds from sales of loans held in portfolio

 

2,750

 

173

 

Proceeds from sales of foreclosed assets

 

354

 

321

 

Net increase in federal funds sold and securities purchased under agreements to resell

 

(2,965

)

(3,112

)

Purchases of premises and equipment, net

 

(314

)

(398

)

Net cash used by investing activities

 

(16,289

)

(13,230

)

 

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

See Notes to Consolidated Financial Statements.

4




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(UNAUDITED)

(Continued from the previous page.)

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2006

 

2005

 

 

 

(in millions)

 

Cash Flows from Financing Activities

 

 

 

 

 

Increase in deposits

 

$

17,715

 

$

16,754

 

(Decrease) increase in short-term borrowings

 

(1,394

)

887

 

Proceeds from long-term borrowings

 

25,054

 

12,416

 

Repayments of long-term borrowings

 

(16,742

)

(5,737

)

Proceeds from advances from Federal Home Loan Banks

 

30,660

 

57,738

 

Repayments of advances from Federal Home Loan Banks

 

(52,185

)

(58,404

)

Preferred securities issued by subsidiary

 

1,959

 

 

Proceeds from issuance of preferred stock

 

492

 

 

Excess tax benefits from stock-based payment arrangement

 

16

 

 

Cash dividends paid on common stock

 

(1,483

)

(1,230

)

Repurchase of common stock

 

(3,039

)

(198

)

Other

 

348

 

238

 

Net cash provided by financing activities

 

1,401

 

22,464

 

Increase in cash and cash equivalents

 

435

 

469

 

Cash and cash equivalents, beginning of period

 

6,214

 

4,455

 

Cash and cash equivalents, end of period

 

$

6,649

 

$

4,924

 

Noncash Activities

 

 

 

 

 

Loans exchanged for mortgage-backed securities

 

$

1,952

 

$

802

 

Real estate acquired through foreclosure

 

485

 

317

 

Loans transferred (to) from held for sale (from) to held in portfolio, net

 

(388

)

3,457

 

Mortgage-backed securities transferred from available-for-sale to trading

 

858

 

 

Cash Paid During the Period For

 

 

 

 

 

Interest on deposits

 

$

4,050

 

$

2,425

 

Interest on borrowings

 

4,062

 

2,569

 

Income taxes

 

736

 

1,535

 

 

See Notes to Consolidated Financial Statements.

5




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1:  Summary of Significant 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”). The Company’s financial reporting and accounting policies conform to accounting principles generally accepted in the United States of America (“GAAP”). All intercompany transactions and balances have been eliminated. Certain amounts in prior periods have been reclassified to conform to the current period’s presentation. In particular, prepayment fees were reclassified from noninterest income to interest income and losses related to low income housing partnerships were reclassified from noninterest expense to other income.

The reclassification of prepayment fees was made in conjunction with changes made to regulatory financial reporting standards by the Office of Thrift Supervision. The amount reclassified to interest income totaled $89 million and $245 million for the three and nine months ended September 30, 2005. Prepayment fees totaled $57 million and $188 million for the three and nine months ended September 30, 2006.

In the second quarter of 2006, the Company reclassified losses related to its investments in low income housing partnerships. The amount reclassified to other income totaled $13 million and $39 million for the three and nine months ended September 30, 2005 and $20 million for the three months ended March 31, 2006. Such losses totaled $68 million for the nine months ended September 30, 2006.

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 2005 Annual Report on Form 10-K/A.

Recently Issued Accounting Standards Not Yet Adopted

In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“Statement”) No. 155, Accounting for Certain Hybrid Financial Instruments . This Statement amends Statements No. 133, Accounting for Derivative Instruments and Hedging Activities and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities to simplify and achieve more consistency in the accounting for certain financial instruments. This Statement permits fair value remeasurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided the entire instrument is accounted for on a fair value basis and establishes a requirement to evaluate interests in securitized financial assets to separately identify interests that are freestanding derivatives from those that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. Statement No. 155 is effective for all of the Company’s financial instruments acquired or issued after December 31, 2006. The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.

In June 2006, the FASB issued Interpretation 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes , an interpretation of FASB Statement No. 109, Accounting for Income Taxes. This Interpretation requires that a tax benefit be recognized only if it is “more likely than not” of being realized, based solely on its technical merits, as of the reporting date. A tax position that meets the more-likely-than-not criterion shall be measured at the largest amount of benefit that is more than 50 percent likely of being realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006.

6




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements . Statement No. 157 prescribes a definition of the term “fair value”, establishes a framework for measuring fair value and expands disclosure about fair value measurements. Statement No. 157 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted as of January 1, 2007. The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.

In September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans , an amendment of Statements No. 87, 88, 106 and 132(R). Statement No. 158 requires that the funded status of a defined benefit plan (generally measured as the difference between plan assets at fair value and the benefit obligation) be recognized in the Company’s Consolidated Statements of Financial Condition at December 31, 2006. Statement No. 158 also requires an employer to disclose additional information about certain effects on net periodic benefit cost expected to be recognized over the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits and transition amounts. The Company is currently evaluating the impact this guidance will have on its financial statements.

In September 2006, Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”) was issued. SAB 108 prescribes two methods that must be used for quantifying the effects of financial statement misstatements. The first method quantifies a misstatement based on the amount of the error applicable to the current year income statement and the second method quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current period, irrespective of the misstatement’s year(s) of origination. If a misstatement amount is deemed material to the financial statements under either method, SAB 108 provides guidance for recognizing that adjustment and correcting any misstatements in the current or prior period financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006 and is not expected to have a material effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition.

In September 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force in Issue No. 06-5, Accounting for Purchases of Life Insurance Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance (“EITF 06-5”). EITF 06-5 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact this guidance will have on the Consolidated Statements of Income and the Consolidated Statements of Financial Condition.

Note 2:  Discontinued Operations

In July 2006 the Company announced its exit from the retail mutual fund management business and subsequently entered into a definitive agreement to sell its subsidiary, WM Advisors, Inc. WM Advisors provides investment management, distribution and shareholder services to the WM Group of Funds. Accordingly, the results of its operations have been removed from the Company’s results of continuing operations for all periods presented on the Consolidated Statements of Income and in Notes 7 and 8 to the Consolidated Financial Statements – “Operating Segments” and “Condensed Consolidating Financial Statements”, and are presented in the aggregate as discontinued operations. Assets and liabilities of WM Advisors have been reclassified to other assets and other liabilities on the Consolidated Statements of

7




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

Financial Condition. The sale is expected to close late in the fourth quarter of 2006. Estimated charges of $37 million, which represent substantially all of the costs associated with the sale, are expected to be incurred during the fourth quarter of 2006 and will be reported as discontinued operations in the Company’s Consolidated Statements of Income.

Results of operations for WM Advisors were as follows:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

    2006    

 

    2005    

 

    2006    

 

    2005    

 

 

 

(in millions)

 

Net interest income

 

 

$

1

 

 

 

$

1

 

 

 

$

2

 

 

 

$

1

 

 

Noninterest income

 

 

68

 

 

 

63

 

 

 

204

 

 

 

192

 

 

Noninterest expense

 

 

55

 

 

 

52

 

 

 

164

 

 

 

146

 

 

Income taxes

 

 

5

 

 

 

4

 

 

 

15

 

 

 

16

 

 

Net income

 

 

$

9

 

 

 

$

8

 

 

 

$

27

 

 

 

$

31

 

 

 

Note 3:  Earnings Per Common Share

Information used to calculate earnings per common share was as follows:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

Weighted average common shares:

 

 

 

 

 

 

 

 

 

Basic weighted average number of common shares outstanding

 

941,898

 

866,541

 

954,062

 

865,571

 

Dilutive effect of potential common shares from:

 

 

 

 

 

 

 

 

 

Awards granted under equity incentive programs

 

13,145

 

12,165

 

15,054

 

13,034

 

Common stock warrants

 

10,698

 

9,789

 

10,736

 

9,579

 

Convertible debt

 

1,178

 

 

1,674

 

 

Accelerated share repurchase program

 

457

 

 

471

 

 

Diluted weighted average number of common shares outstanding

 

967,376

 

888,495

 

981,997

 

888,184

 

 

For the three months and nine months ended September 30, 2006, options to purchase approximately 14.1 million and 14.9 million shares of common stock were outstanding, but were not included in the computation of diluted earnings per share because their inclusion would have had an antidilutive effect. Likewise, for the three and nine months ended September 30, 2005, options to purchase approximately 8.5 million and 8.6 million 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., 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 to certain of the former investors in Keystone Holdings and their transferees are related to the outcome of certain litigation and not based on future earnings or market prices. At September 30, 2006, the conditions for releasing the shares from escrow did not exist, and therefore, none of the shares in escrow were included in the above computations.

8




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

Accelerated Share Repurchases

On March 16, 2006, the Company repurchased 34 million shares of its common stock at an initial cost of $1.48 billion. The shares were purchased from a broker-dealer counterparty under an accelerated share repurchase transaction at an initial settlement price of $43.61 per share. The Company simultaneously entered into a forward contract indexed to the price of the Company’s common stock. Upon completion of this forward contract on July 31, 2006, a net settlement amount, referred to as the purchase price adjustment, was calculated based upon the difference between the counterparty’s average actual purchase price of the Company’s shares during the repurchase period and the initial purchase price of $43.61 per share. As the counterparty’s average actual purchase price of the Company’s shares exceeded the initial purchase price, the Company was required to pay the counterparty the purchase price adjustment and had the option to settle the forward contract in shares or cash. At the election of the Company, a final cash settlement payment of $60 million was made to the counterparty and was recorded as a reduction of capital surplus.

On August 21, 2006, the Company repurchased 16 million shares of its common stock under an accelerated share repurchase transaction. The Company simultaneously entered into a forward contract indexed to the price of the Company’s common stock, which subjects the accelerated share repurchase program to future price adjustments during the contractually-specified time period between the initiation and the final settlement date. The initial price of the repurchased shares, before the effects of any such adjustments, was $753 million, or $47.06 per share. Under the terms of the contract, the Company will not be required to make any additional payments to the counterparty. However, depending on fluctuations in the weighted average price of the Company’s common stock between the initiation and the final settlement date, the Company may receive up to 9 million additional shares of its common stock from the counterparty in settlement of the contract. While the scheduled termination date of the forward contract is December 5, 2006, the counterparty may, at any time, exercise its right to accelerate the termination date. For example, if this contract had actually been settled at September 30, 2006, the Company would have received approximately 1.82 million additional common shares from the counterparty, thereby reducing the price of the shares repurchased to $42.26 per share. As the purchase price adjustment cannot result in the issuance of additional common shares, there was no impact on diluted earnings per share for the three and nine months ended September 30, 2006.

Note 4:  Mortgage Banking Activities

In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets, which amends Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. For each class of separately recognized servicing asset, this Statement permits an entity to choose either to amortize such assets in proportion to and over the period of estimated net servicing income and perform an impairment assessment at each reporting date, or to report servicing assets at fair value at each reporting date and record changes in fair value in earnings in the period in which the changes occur. At its initial adoption, the Statement permits a one-time reclassification of available-for-sale securities to trading securities, provided that the securities are identified as offsetting the entity’s exposure to changes in fair value of servicing assets that are reported at fair value.

As permitted by the early adoption provisions of this accounting standard, the Company applied Statement No. 156 to its financial statements on January 1, 2006 and elected to measure all classes of mortgage servicing assets at fair value. The Company also elected to transfer its January 1, 2006 portfolio of available-for-sale mortgage servicing rights (“MSR”) risk management securities to trading. As the retrospective application of the Statement to prior periods is not permitted, these changes were recorded

9




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

as a cumulative effect of a change in accounting principle to retained earnings as of January 1, 2006 and were comprised of a $35 million adjustment, net of taxes, from the MSR fair value election and a $(6) million adjustment, net of taxes, from the transfer of available-for-sale securities, designated as MSR risk management instruments, to the trading portfolio. Upon electing the fair value method of accounting for its mortgage servicing assets, the Company discontinued the application of fair value hedge accounting. Accordingly, beginning in 2006, all derivatives held for MSR risk management are treated as economic hedges, with valuation changes recorded as revaluation gain (loss) from derivatives economically hedging MSR. Additionally, upon the change from the lower of cost or fair value accounting method to fair value accounting under Statement No. 156, the calculation of amortization and the assessment of impairment were discontinued and the MSR valuation allowance was written off against the recorded value of the MSR. Those measurements have been replaced by fair value adjustments that encompass market-driven valuation changes and the runoff in value that occurs from the passage of time, which are each separately reported.

Revenue from sales and servicing of home mortgage loans, including the effects of derivative risk management instruments, consisted of the following:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

    2006    

 

   2005   

 

    2006   

 

   2005   

 

 

 

(in millions)

 

Revenue from sales and servicing of home mortgage loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales activity:

 

 

 

 

 

 

 

 

 

 

 

 

 

Gain from home mortgage loans and originated mortgage-backed securities

 

 

$

217

 

 

 

$

206

 

 

$

558

 

$

637

 

Revaluation gain (loss) from derivatives economically hedging loans held for sale

 

 

(98

)

 

 

73

 

 

22

 

74

 

Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments

 

 

119

 

 

 

279

 

 

580

 

711

 

Servicing activity:

 

 

 

 

 

 

 

 

 

 

 

 

 

Home mortgage loan servicing revenue (1)

 

 

525

 

 

 

534

 

 

1,683

 

1,567

 

Change in MSR fair value due to payments on loans and other

 

 

(410

)

 

 

 

 

(1,279

)

 

Change in MSR fair value due to valuation inputs or assumptions

 

 

(469

)

 

 

 

 

379

 

 

MSR valuation adjustments (2)

 

 

 

 

 

412

 

 

 

874

 

Amortization of MSR

 

 

 

 

 

(555

)

 

 

(1,689

)

Revaluation gain (loss) from derivatives economically hedging MSR

 

 

353

 

 

 

40

 

 

(603

)

137

 

Adjustment to MSR fair value for MSR sale

 

 

 

 

 

 

 

(157

)

 

Home mortgage loan servicing revenue (expense), net of MSR valuation changes and derivative risk management instruments

 

 

(1

)

 

 

431

 

 

23

 

889

 

Total revenue from sales and servicing of home mortgage loans

 

 

$

118

 

 

 

$

710

 

 

$

603

 

$

1,600

 


(1)                  Includes late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors compared to what is collected from the borrowers upon payoff).

(2)          Net of fair value hedge ineffectiveness as well as any impairment/reversal recognized on MSR that results from the application of the lower of cost or fair value accounting methodology in 2005.

10




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

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

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in millions)

 

Balance, beginning of period

 

$

570,352

 

$

543,324

 

$

563,208

 

$

540,392

 

Home loans:

 

 

 

 

 

 

 

 

 

Additions

 

29,899

 

43,418

 

95,873

 

114,124

 

Sale of servicing

 

(141,842

)

 

(141,851

)

 

Loan payments and other

 

(19,288

)

(39,005

)

(78,719

)

(107,555

)

Net change in commercial real estate loans

 

87

 

(159

)

697

 

617

 

Balance, end of period

 

$

439,208

 

$

547,578

 

$

439,208

 

$

547,578

 

 

Changes in the balance of MSR were as follows:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

     2006     

 

2005

 

2006

 

2005

 

 

 

(in millions)

 

Balance, beginning of period (1)

 

 

$

9,162

 

 

$

5,730

 

$

8,041

 

$

5,906

 

Home loans:

 

 

 

 

 

 

 

 

 

 

 

Additions

 

 

533

 

 

605

 

1,773

 

1,651

 

Change in MSR fair value due to payments on loans and other

 

 

(410

)

 

 

(1,279

)

 

Change in MSR fair value due to valuation inputs or assumptions

 

 

(469

)

 

 

379

 

 

Adjustment to MSR fair value for MSR sale

 

 

 

 

 

(157

)

 

Fair value basis adjustment (2)

 

 

 

 

 

57

 

 

Amortization

 

 

 

 

(555

)

 

(1,689

)

Impairment reversal

 

 

 

 

413

 

 

590

 

Statement No. 133 MSR accounting valuation adjustments

 

 

 

 

849

 

 

580

 

Sale of MSR

 

 

(2,527

)

 

 

(2,527

)

 

Net change in commercial real estate MSR

 

 

(1

)

 

 

1

 

4

 

Balance, end of period (1)

 

 

$

6,288

 

 

$

7,042

(3)

$

6,288

 

$

7,042

(3)


(1)                  Net of valuation allowance for all periods in 2005.

(2)                  Pursuant to the adoption of Statement No. 156 on January 1, 2006, the $57 million difference between the net carrying value and fair value was recorded as an increase to the basis of the Company’s MSR.

(3)                  At September 30, 2005, aggregate MSR fair value was $7.06 billion.

11




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

Changes in the valuation allowance for MSR were as follows:

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2005

 

     2006     

 

2005

 

 

 

(in millions)

 

Balance, beginning of period

 

 

$

1,746

 

 

 

$

914

 

 

$

1,981

 

Impairment reversal

 

 

(413

)

 

 

 

 

(590

)

Other-than-temporary impairment

 

 

(18

)

 

 

 

 

(63

)

Other

 

 

(3

)

 

 

(914

) (1)

 

(16

)

Balance, end of period

 

 

$

1,312

 

 

 

$

 

 

$

1,312

 


(1)                  Pursuant to the adoption of Statement No. 156, the valuation allowance was written off against the recorded value of the MSR.

In July 2006, the Company sold $2.53 billion of mortgage servicing rights, representing substantially all of the Company’s government loan servicing and a portion of its conforming, fixed-rate servicing which is predominantly comprised of customers whose only relationship with the Company consisted of a serviced home mortgage loan. During the third quarter of 2006 the Company incurred transaction-related costs of $58 million, substantially all of which are reported as part of “other expense” on the Consolidated Statements of Income. The principal activities associated with these costs included preparing and recording mortgage servicing assignment documentation, and securing and transferring actual loan files to the purchaser. For management reporting purposes, all such transaction-related costs are recorded in Corporate Support/Treasury and Other. Approximately $10 million in additional costs are expected to be incurred over the next two quarters, at which time the transfer of loans to the purchaser is expected to be complete. Substantially all of the transaction costs recognized in the third quarter were included in other liabilities on the Consolidated Statements of Financial Condition at September 30, 2006.

Note 5: Guarantees

In the ordinary course of business, the Company sells loans to third parties and in certain circumstances, such as in the event of early or first payment default, retains credit risk exposure on those loans. Whether or not the Company retains credit risk exposure on sold loans, it may be required to repurchase sold loans in the event of a violation of a representation or warranty made in connection with the sale of the loan if the violation has a material adverse effect on the value of the loan. When a loan sold to an investor fails to perform according to its contractual terms the investor will typically review the loan file to search for errors that may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a violation of a representation or warranty made to the investor in connection with the loan’s sale, then the Company will be required to either repurchase the loan or indemnify the investor for losses sustained if the violation had a material adverse effect on the value of the loan. The Company has recorded loss contingency reserves of $131 million as of September 30, 2006 and $173 million as of December 31, 2005 to cover the estimated loss exposure related to potential loan repurchases.

Note 6: Stock-Based Compensation

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. Effective January 1, 2006, the Company adopted Statement No. 123R, Share-Based Payment , using the modified prospective application transition method. As the Company had already adopted Statement No. 148 and substantially all stock-based awards granted prior to its adoption are fully

12




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

vested at December 31, 2005, Statement No. 123R did not have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition. Prior to the Company’s adoption of Statement No. 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows in the Consolidated Statements of Cash Flows. Statement No. 123R requires excess tax benefits to be reported as a financing cash inflow rather than as a reduction of taxes paid.

Statement No. 123R requires an entity that previously had a policy of recognizing the effect of forfeitures as they occurred to estimate the number of outstanding instruments for which the requisite service is not expected to be rendered. The effect of this change in accounting principle amounted to $25 million and has been reflected as a decrease to compensation and benefits expense in the three months ended March 31, 2006.

Net income for the three and nine months ended September 30, 2006 included $53 million and $167 million of compensation costs and $20 million and $63 million of income tax benefits related to the Company’s stock-based compensation arrangements. Net income for the three and nine months ended September 30, 2005 included $45 million and $112 million of compensation costs and $17 million and $43 million of income tax benefits related to the Company’s stock-based compensation arrangements. As the Company elected to use the modified prospective application method, results for the three and nine months ended September 30, 2005 do not reflect any restated amounts.

Washington Mutual maintains an equity incentive plan and an employee stock purchase plan. For further discussion of the Company’s equity incentive plan and employee stock purchase plan, refer to Note 20 to the Consolidated Financial Statements – “Stock-Based Compensation Plan and Shareholder Rights Plan” of Washington Mutual, Inc.’s 2005 Annual Report on Form 10-K/A.

13




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

The following table presents the status of all stock option plans at September 30, 2006 during the nine months then ended:

 

 

Number

 

Weighted
Average
Exercise
Price

 

Weighted Average
Remaining
Contractual
Term
(in years)

 

Aggregate
Intrinsic Value
(in millions)

 

1994 Stock Option Plan:

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

19,590,567

 

$

31.40

 

5.15

 

$

237

 

Granted

 

 

 

 

 

 

 

 

Exercised

 

(4,794,456

)

30.72

 

 

 

 

 

Forfeited

 

(3,841

)

34.40

 

 

 

 

 

Outstanding at September 30, 2006

 

14,792,270

 

31.62

 

4.56

 

175

 

Outstanding options exercisable as of September 30, 2006

 

14,792,270

 

31.62

 

4.56

 

175

 

WAMU Shares Stock Option Plan:

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

4,869,410

 

$

36.59

 

4.22

 

$

34

 

Granted

 

 

 

 

 

 

 

 

Exercised

 

(1,717,717

)

36.07

 

 

 

 

 

Forfeited

 

(207,954

)

35.51

 

 

 

 

 

Outstanding at September 30, 2006

 

2,943,739

 

36.97

 

4.11

 

19

 

Outstanding options exercisable as of September 30, 2006

 

2,943,739

 

36.97

 

4.11

 

19

 

Acquired Plans:

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

8,217,386

 

$

51.98

 

4.74

 

$

104

 

Granted

 

 

 

 

 

 

 

 

Exercised

 

(2,101,593

)

20.21

 

 

 

 

 

Forfeited

 

(393,332

)

97.39

 

 

 

 

 

Outstanding at September 30, 2006

 

5,722,461

 

60.52

 

3.91

 

55

 

Outstanding options exercisable as of September 30, 2006

 

5,722,461

 

60.52

 

3.91

 

55

 

2003 Equity Incentive Plan:

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

17,271,539

 

$

40.91

 

8.38

 

$

45

 

Granted

 

7,086,091

 

43.39

 

 

 

 

 

Exercised

 

(1,356,206

)

40.45

 

 

 

 

 

Forfeited

 

(1,786,167

)

42.15

 

 

 

 

 

Outstanding at September 30, 2006

 

21,215,257

 

41.65

 

7.93

 

39

 

Outstanding options exercisable as of September 30, 2006

 

7,968,121

 

40.59

 

6.72

 

23

 

 

14




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

The fair value of the options granted under the Company’s stock options plans is estimated on the date of the grant using a binomial model that used the assumptions noted in the following table. Expected volatilities are based on implied volatilities from traded options on the Company’s stock, the historical volatility of the Company’s stock and other factors. Employees that have similar historical exercise behavior are grouped together for valuation purposes. The expected term of options granted is derived from historical exercise behavior combined with possible option lives based on remaining contractual terms of unexercised and outstanding options. The range given below results from certain groups of employees exhibiting different behavior. The risk-free rate for periods within the contractual life of the option is based on the rate available on zero-coupon government issues in effect at the time of the grant.

 

 

Nine Months Ended September 30,

 

 

 

2006

 

2005

 

Weighted average grant-date fair value:

 

 

 

 

 

2003 Equity Incentive Plan

 

$

8.06

 

$

8.39

 

Dividend yield

 

4.70

%

4.17 – 4.28

%

Expected volatility

 

21.90 – 25.50

 

25.45 – 30.74

 

Risk free interest rate

 

4.22 – 5.02

 

3.55 – 4.21

 

Expected life (in years)

 

5.1 – 6.2 years

 

4.5 – 7.0 years

 

 

The total intrinsic value of options exercised under the plans during the three and nine months ended September 30, 2006 was $20 million and $137 million. The total intrinsic value of options exercised under the plans during the three and nine months ended September 30, 2005 was $20 million and $65 million. As of September 30, 2006, there was $74 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 1.8 years.

Cash received from stock options exercised for the three and nine months ended September 30, 2006 was $38 million and $307 million. The income tax benefits from stock options exercised total $9 million and $50 million for the same periods.

Equity Incentive Plan

The 2003 Equity Incentive Plan (“2003 EIP”) and two of its predecessor plans (the Equity Incentive Plan and the Restricted Stock Plan) permit grants of restricted stock, with or without performance-based vesting restrictions, for the benefit of all employees, officers, directors, consultants and advisors of the Company. The Company measures the fair value of the 2003 EIP restricted stock awards based upon the market price of the underlying common stock as of the date of grant. The 2003 EIP restricted stock awards are amortized over their applicable vesting period (generally three years) using the straight-line method.

The following table presents the status and changes in restricted stock awards issued under all plans:

 

 

Shares

 

Weighted Average
Grant-Date
Fair Value

 

Restricted stock awards:

 

 

 

 

 

Nonvested balance at December 31, 2005

 

6,388,821

 

$

40.80

 

Granted

 

3,879,168

 

43.35

 

Vested

 

(1,660,839

)

41.52

 

Forfeited

 

(1,128,713

)

41.53

 

Nonvested balance at September 30, 2006

 

7,478,437

 

41.85

 

 

15




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

As of September 30, 2006, there was $202 million of total unrecognized compensation cost related to unvested restricted stock awards. The cost is expected to be recognized over a weighted average period of 2.0 years.

During the three and nine months ended September 30, 2006, 2003 EIP restricted stock and awards of 27,000 and 3.9 million were granted with a weighted average grant-date per share fair value of $42.95 and $43.35. During the three and nine months ended September 30, 2005, 2003 EIP restricted stock and awards of 75,000 and 3.6 million were granted with a weighted average grant-date per share fair value of $41.57 and $40.45. The total fair value of EIP restricted stock and awards vested during the three and nine months ended September 30, 2006 was $1 million and $71 million. The total fair value of EIP restricted stock and awards vested during the three and nine months ended September 30, 2005 was $4 million and $47 million.

The 2003 Equity Incentive Plan also allows for awards denominated in units of stock (“performance units”).  These awards are paid out at the Company’s discretion in cash or shares of Washington Mutual common stock at the end of a three-year period only if the Company achieves specified performance goals compared to the performance of a peer group in the S&P Financial Index. The fair value of performance awards is estimated at grant date utilizing a Monte Carlo valuation methodology to determine the value of the market condition, which is combined with the estimated value of the performance conditions.  The total value of the award will be determined at the end of the three-year performance period based on the actual results of the performance conditions and the value of the market condition determined at the grant date.

The following table presents the status and changes in performance unit awards:

 

 

Shares

 

Weighted Average
Grant-Date
Fair Value

 

Performance Unit awards:

 

 

 

 

 

Nonvested balance at December 31, 2005

 

1,086,348

 

$              40.65

 

Granted

 

545,809

 

46.21

 

Vested

 

 

 

Forfeited

 

(201,674

)

42.04

 

Nonvested balance at September 30, 2006

 

1,430,483

 

42.58

 

 

As of September 30, 2006, there was $9 million of total unrecognized compensation cost related to unvested performance unit awards. The cost is expected to be recognized over a weighted average period of 2.0 years.

The Long-Term Cash Incentive program (“LTCIP”) provides eligible employees the opportunity to earn cash awards aligned with the Company’s common stock performance over a three-year period. Participants are awarded a number of units and on each of the three award anniversaries, participants receive a cash payment equal to the value of one-third of the participant’s units multiplied by the average closing price of Washington Mutual’s common stock over a period preceding the award anniversary date. These awards are classified as liabilities and are valued at each reporting period, based on the closing price of the Company’s common stock.

16




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

The following table presents the status and changes in LTCIP awards:

 

 

Shares

 

Weighted Average
Grant-Date
Fair Value

 

LTCIP awards:

 

 

 

 

 

Nonvested balance at December 31, 2005

 

1,429,180

 

$               40.91

 

Granted

 

1,255,535

 

43.09

 

Vested

 

(490,865

)

40.93

 

Forfeited

 

(148,589

)

42.07

 

Nonvested balance at September 30, 2006

 

2,045,261

 

42.16

 

 

As of September 30, 2006, there was $56 million of total unrecognized compensation cost related to unvested LTCIP awards. The cost is expected to be recognized over a weighted average period of 1.5 years. Cash used to settle vested LTCIP awards was $226,000 and $21 million for the three and nine months ended September 30, 2006.

Employee Stock Purchase Plan

The Employee Stock Purchase Plan (“ESPP”) was amended effective January 1, 2004, and the Plan Administrator exercised its discretion under the Plan to change certain terms. The ESPP no longer permits lump sum contributions, excludes employees who work for less than 5 months per year, has twelve monthly offering periods, and provides for purchase of stock at a 5% discount from the price at the end of the offering period. The Company pays for the program’s administrative expenses. The plan is open to all employees who are at least 18 years old, work at least 20 hours per week and have completed three months of service with the Company. Participation is through payroll deductions with a maximum annual contribution of 10% of each employee’s eligible cash compensation. Under the ESPP, dividends may be automatically reinvested at the discretion of the participant. The Company sold 117,306 and 409,167 shares to employees during the three and nine months ended September 30, 2006 and 114,314 and 372,063 shares to employees during the three and nine months ended September 30, 2005. At September 30, 2006, 2 million shares were reserved for future issuance under this plan.

Note 7: Operating Segments

The Company has four operating segments for the purpose of management reporting:  the Retail Banking Group, the Card Services Group, the Commercial Group and the Home Loans Group. The results of these operating segments are based on the Company’s management accounting process. Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting that is equivalent to generally accepted accounting principles . The management accounting 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 principal activities of the Retail Banking Group 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 and other financial services; and (4) holding the Company’s portfolio of home loans held for investment, including certain subprime home loans. The Company has entered into an agreement to sell the retail mutual fund management business, WM Advisors, Inc., whose activities are reported within this segment’s results as discontinued operations. The gain on disposition of these discontinued operations will be reported as part of the Corporate Support/Treasury and Other category.

17




WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

Deposit products offered to consumers and small businesses include the Company’s signature free checking and interest-bearing Platinum checking accounts, as well as other personal checking, savings, money market deposit and time deposit accounts. Such products are offered online and in retail banking stores. Financial consultants provide investment advisory and securities brokerage services to the public while appropriately licensed bank employees offer fixed annuities and mutual funds.

This segment’s home loan portfolio consists of home loans purchased from both the Home Loans Group and secondary market participants. Loans to subprime borrowers purchased prior to 2006 are also held in the segment’s home loan portfolio. Loans held in portfolio generate interest income, including prepayment fees, and loan-related noninterest income, such as late fees.

The Card Services Group manages the Company’s credit card operations. The segment’s principal activities include (1) originating credit card loans; (2) either holding such loans in portfolio or securitizing and selling them; (3) servicing credit card loans; and (4) providing other cardholder services. Credit card loans that are held in the Company’s loan portfolio generate interest income from finance charges on outstanding card balances, and noninterest income from the collection of fees associated with the credit card portfolio, such as performance fees (late, overlimit, and returned check charges), annual membership fees, and cash advance and balance transfer fees. Losses from credit risk that are inherent in the credit card loan portfolio are charged to the provision for loan and lease losses on the income statement and the allowance for loan and lease losses on the balance sheet.

When credit card loans are securitized, the loans are sold to a qualifying special-purpose entity (“QSPE”), typically a securitization trust. The QSPE issues asset-backed securities that are secured by the future expected cash flows on the sold loans, and cash proceeds from the sale of those securities to third parties are received by the Company. When such loans are transferred to held for sale, any reduction in the loan’s value that is attributable to a decline in credit quality is reflected as an adjustment to the loan’s cost basis and a corresponding reduction in the allowance for loan and lease losses. Any remaining loan loss allowance that was associated with those loans prior to the transfer is reversed through the provision for loan and lease losses. The resulting gain from the securitization and sale, along with the ensuing fee income associated with the Company’s retention of servicing responsibilities on the securitized loans, are reported as revenue from sales and servicing of consumer loans in noninterest income. Certain interests in the securitized loans are retained by the Company and are classified as trading assets on the balance sheet, with changes in the fair value of those retained interests recognized in current period earnings. The mix at any point in time between the amount of credit card loans held in the loan portfolio and those that have been securitized and sold is influenced by market conditions, the Company’s evaluation of capital deployment alternatives, and liquidity factors.