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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 SEPTEMBER 30, 2007

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)

1301 Second 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 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  ý     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  ý .

        The number of shares outstanding of the issuer's classes of common stock as of October 31, 2007:


 

 

Common Stock – 868,722,736 (1)

 

 

 

 

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

 

 





WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2007
TABLE OF CONTENTS

 
  Page
PART I – Financial Information   1
  Item 1. Financial Statements   1
    Consolidated Statements of Income (Unaudited) –
Three and Nine Months Ended September 30, 2007 and 2006
  1
    Consolidated Statements of Financial Condition (Unaudited) –
September 30, 2007 and December 31, 2006
  2
    Consolidated Statements of Stockholders' Equity and Comprehensive Income (Unaudited) –
Nine Months Ended September 30, 2007 and 2006
  3
    Consolidated Statements of Cash Flows (Unaudited) –
Nine Months Ended September 30, 2007 and 2006
  4
    Notes to Consolidated Financial Statements (Unaudited)   6
  Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations   24
        Cautionary Statements   25
        Controls and Procedures   26
        Overview   26
        Critical Accounting Estimates   28
        Recently Issued Accounting Standards Not Yet Adopted   29
        Summary Financial Data   30
        Earnings Performance from Continuing Operations   31
        Review of Financial Condition   41
        Operating Segments   44
        Off-Balance Sheet Activities   49
        Capital Adequacy   50
        Risk Management   50
        Credit Risk Management   51
        Liquidity Risk and Capital Management   57
        Market Risk Management   61
        Operational Risk Management   66
        Regulation and Supervision   67
  Item 3. Quantitative and Qualitative Disclosures About Market Risk   61
  Item 4. Controls and Procedures   26

PART II – Other Information

 

68
  Item 1. Legal Proceedings   68
  Item 1A. Risk Factors   25
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   69
  Item 4. Submission of Matters to a Vote of Security Holders   70
  Item 6. Exhibits   70

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,

 
 
  2007
  2006
  2007
  2006
 
 
  (in millions, except per share amounts)

 
Interest Income                          
  Loans held for sale   $ 248   $ 435   $ 1,232   $ 1,292  
  Loans held in portfolio     3,992     4,012     11,678     11,480  
  Available-for-sale securities     392     379     1,075     1,068  
  Trading assets     108     140     329     503  
  Other interest and dividend income     116     139     299     354  
   
 
 
 
 
    Total interest income     4,856     5,105     14,613     14,697  
Interest Expense                          
  Deposits     1,650     1,739     5,145     4,420  
  Borrowings     1,192     1,419     3,337     4,154  
   
 
 
 
 
    Total interest expense     2,842     3,158     8,482     8,574  
   
 
 
 
 
      Net interest income     2,014     1,947     6,131     6,123  
  Provision for loan and lease losses     967     166     1,574     472  
   
 
 
 
 
      Net interest income after provision for loan and lease losses     1,047     1,781     4,557     5,651  
Noninterest Income                          
  Revenue from sales and servicing of home mortgage loans     161     118     586     603  
  Revenue from sales and servicing of consumer loans     418     355     1,264     1,155  
  Depositor and other retail banking fees     740     655     2,125     1,875  
  Credit card fees     209     165     564     456  
  Securities fees and commissions     67     52     197     161  
  Insurance income     29     31     87     97  
  Gain (loss) on trading assets     (153 )   68     (406 )   (74 )
  Loss on other available-for-sale securities     (99 )   (1 )   (58 )   (8 )
  Other income     7     127     319     521  
   
 
 
 
 
    Total noninterest income     1,379     1,570     4,678     4,786  
Noninterest Expense                          
  Compensation and benefits     910     939     2,889     2,992  
  Occupancy and equipment     371     408     1,102     1,235  
  Telecommunications and outsourced information services     135     142     396     421  
  Depositor and other retail banking losses     71     57     190     165  
  Advertising and promotion     125     124     337     335  
  Professional fees     52     57     145     138  
  Other expense     527     457     1,375     1,265  
   
 
 
 
 
    Total noninterest expense     2,191     2,184     6,434     6,551  
  Minority interest expense     53     34     138     71  
   
 
 
 
 
      Income from continuing operations before income taxes     182     1,133     2,663     3,815  
      Income taxes     (4 )   394     862     1,341  
   
 
 
 
 
        Income from continuing operations     186     739     1,801     2,474  
Discontinued Operations                          
      Income from discontinued operations before income taxes         14         42  
      Income taxes         5         15  
   
 
 
 
 
        Income from discontinued operations         9         27  
   
 
 
 
 
Net Income   $ 186   $ 748   $ 1,801   $ 2,501  
   
 
 
 
 
Net Income Available to Common Stockholders   $ 178   $ 748   $ 1,778   $ 2,501  
   
 
 
 
 
Basic Earnings Per Common Share:                          
  Income from continuing operations   $ 0.21   $ 0.78   $ 2.05   $ 2.59  
  Income from discontinued operations         0.01         0.03  
   
 
 
 
 
    Net income     0.21     0.79     2.05     2.62  
Diluted Earnings Per Common Share:                          
  Income from continuing operations   $ 0.20   $ 0.76   $ 1.99   $ 2.51  
  Income from discontinued operations         0.01         0.03  
   
 
 
 
 
    Net income     0.20     0.77     1.99     2.54  

Dividends declared per common share

 

 

0.56

 

 

0.52

 

 

1.65

 

 

1.53

 
Basic weighted average number of common shares outstanding (in thousands)     857,005     941,898     866,864     954,062  
Diluted weighted average number of common shares outstanding (in thousands)     876,002     967,376     889,534     981,997  

See Notes to Consolidated Financial Statements.

1



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(UNAUDITED)

 
  September 30, 2007
  December 31, 2006
 
 
  (dollars in millions)

 
Assets              
  Cash and cash equivalents   $ 11,370   $ 6,948  
  Federal funds sold and securities purchased under agreements to resell     4,042     3,743  
  Trading assets (including securities pledged of $1,191 and $1,868)     3,797     4,434  
  Available-for-sale securities, total amortized cost of $28,725 and $25,073: Mortgage-backed securities (including securities pledged of $1,206 and $3,864)     20,562     18,601  
    Investment securities (including securities pledged of $1,285 and $3,481)     7,844     6,377  
   
 
 
      Total available-for-sale securities     28,406     24,978  
    Loans held for sale     7,586     44,970  
    Loans held in portfolio     237,132     224,960  
    Allowance for loan and lease losses     (1,889 )   (1,630 )
   
 
 
      Loans held in portfolio, net     235,243     223,330  
    Investment in Federal Home Loan Banks     2,808     2,705  
    Mortgage servicing rights     6,794     6,193  
    Goodwill     9,062     9,050  
    Other assets     21,002     19,937  
   
 
 
      Total assets   $ 330,110   $ 346,288  
   
 
 
Liabilities              
  Deposits:              
    Noninterest-bearing deposits   $ 31,341   $ 33,386  
    Interest-bearing deposits     162,939     180,570  
   
 
 
      Total deposits     194,280     213,956  
  Federal funds purchased and commercial paper     2,482     4,778  
  Securities sold under agreements to repurchase     4,732     11,953  
  Advances from Federal Home Loan Banks     52,530     44,297  
  Other borrowings     40,887     32,852  
  Other liabilities     8,313     9,035  
  Minority interests     2,945     2,448  
   
 
 
      Total liabilities     306,169     319,319  
Stockholders' Equity              
  Preferred stock, no par value: 600 shares authorized, 500 shares issued and outstanding ($1,000,000 per share liquidation preference)     492     492  
  Common stock, no par value: 1,600,000,000 shares authorized, 868,802,015 and 944,478,961 shares issued and outstanding          
  Capital surplus – common stock     2,575     5,825  
  Accumulated other comprehensive loss     (390 )   (287 )
  Retained earnings     21,264     20,939  
   
 
 
      Total stockholders' equity     23,941     26,969  
   
 
 
      Total liabilities and stockholders' equity   $ 330,110   $ 346,288  
   
 
 

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, 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 adjustment               (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  
   
 
 
 
 
 
 

BALANCE, December 31, 2006

 

944.5

 

$

492

 

$

5,825

 

$

(287

)

$

20,939

 

$

26,969

 
Cumulative effect from the adoption of FASB Interpretation No. 48                   (6 )   (6 )
   
 
 
 
 
 
 
Adjusted balance   944.5     492     5,825     (287 )   20,933     26,963  
Comprehensive income:                                    
  Net income                   1,801     1,801  
  Other comprehensive income (loss), net of tax:                                    
    Net unrealized loss from securities arising during the period, net of reclassification adjustments               (140 )       (140 )
    Net unrealized gain from cash flow hedging instruments               35         35  
    Amortization of net loss and prior service cost from defined benefit plans               2         2  
                               
 
Total comprehensive income                       1,698  
Cash dividends declared on common stock                   (1,447 )   (1,447 )
Cash dividends declared on preferred stock                   (23 )   (23 )
Common stock repurchased and retired   (82.1 )       (3,497 )           (3,497 )
Common stock issued   6.4         247             247  
   
 
 
 
 
 
 
BALANCE, September 30, 2007   868.8   $ 492   $ 2,575   $ (390 ) $ 21,264   $ 23,941  
   
 
 
 
 
 
 

See Notes to Consolidated Financial Statements.

3



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW

(UNAUDITED)

 
  Nine Months Ended September 30,
 
 
  2007
  2006
 
 
  (in millions)

 
Cash Flows from Operating Activities              
  Net income   $ 1,801   $ 2,501  
  Adjustments to reconcile net income to net cash provided by operating activities:              
    Provision for loan and lease losses     1,574     472  
    Gain from home mortgage loans     (45 )   (557 )
    Gain from credit card loans     (409 )   (183 )
    Loss on available-for-sale securities     58     2  
    Depreciation and amortization     417     639  
    Change in fair value of MSR     889     1,062  
    Stock dividends from Federal Home Loan Banks     (70 )   (89 )
    Capitalized interest income from option adjustable-rate mortgages     (1,051 )   (735 )
    Origination and purchases of loans held for sale, net of principal payments     (68,930 )   (93,662 )
    Proceeds from sales of loans originated and held for sale     68,373     100,412  
    Net decrease in trading assets     1,437     6,875  
    Increase in other assets     (658 )   (2,779 )
    (Decrease) increase in other liabilities     (819 )   1,153  
   
 
 
      Net cash provided by operating activities     2,567     15,111  
Cash Flows from Investing Activities              
  Purchases of available-for-sale securities     (11,563 )   (12,375 )
  Proceeds from sales of available-for-sale securities     6,610     6,682  
  Principal payments and maturities on available-for-sale securities     1,880     2,222  
  Purchases of Federal Home Loan Bank stock     (1,263 )   (38 )
  Redemption of Federal Home Loan Bank stock     1,230     1,368  
  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, net of principal payments     (1,216 )   (15,370 )
  Proceeds from sales of loans     22,530     2,792  
  Proceeds from sales of foreclosed assets     553     354  
  Net increase in federal funds sold and securities purchased under agreements to resell     (299 )   (2,965 )
  Purchases of premises and equipment, net     (189 )   (314 )
   
 
 
      Net cash provided (used) by investing activities     18,273     (16,077 )

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

See Notes to Consolidated Financial Statements.

4


(Continued from the previous page.)

 
  Nine Months Ended September 30,
 
 
  2007
  2006
 
 
  (in millions)

 
Cash Flows from Financing Activities              
  (Decrease) increase in deposits   $ (19,676 ) $ 17,715  
  Decrease in short-tem borrowings     (2,788 )   (1,394 )
  Proceeds from long-term borrowings     14,191     25,054  
  Repayments of long-term borrowings     (12,111 )   (16,742 )
  Proceeds from advances from Federal Home Loan Banks     59,173     30,660  
  Repayments of advances from Federal Home Loan Banks     (50,944 )   (52,185 )
  Proceeds from issuance of preferred securities by subsidiary     497     1,959  
  Proceeds from issuance of preferred stock         492  
  Cash dividends paid on preferred and common stock     (1,470 )   (1,483 )
  Repurchase of common stock     (3,497 )   (3,039 )
  Other     207     364  
   
 
 
    Net cash (used) provided by financing activities     (16,418 )   1,401  
   
 
 
    Increase in cash and cash equivalents     4,422     435  
    Cash and cash equivalents, beginning of period     6,948     6,214  
   
 
 
    Cash and cash equivalents, end of period   $ 11,370   $ 6,649  
   
 
 

Noncash Activities

 

 

 

 

 

 

 
  Loans exchanged for mortgage-backed securities   $ 973   $ 1,952  
  Real estate acquired through foreclosure     954     485  
  Loans transferred from held for sale to held in portfolio     19,626     3,262  
  Loans transferred from held in portfolio to held for sale     5,015     3,650  
  Mortgage-backed securities transferred from available-for-sale to trading         858  

Cash Paid During the Period For

 

 

 

 

 

 

 
  Interest on deposits   $ 5,368   $ 4,050  
  Interest on borrowings     3,374     4,062  
  Income taxes     1,346     736  

See Notes to Consolidated Financial Statements.

5



WASHINGTON MUTUAL, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

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," the "Company," "we," "us" or "our"). The Company's financial reporting and accounting policies conform to accounting principles generally accepted in the United States of America ("GAAP"), which include certain practices of the banking industry. In the opinion of management, all normal recurring adjustments have been included for a fair statement of the interim financial information. All significant intercompany transactions and balances have been eliminated in preparing the consolidated financial statements.

        Certain amounts in prior periods have been reclassified to conform to the current period's presentation. In particular, certain securities were reclassified from Available-for-sale securities – Investment securities to Available-for-sale securities – Mortgage-backed securities. The amount of such securities reclassified totaled $538 million at December 31, 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 2006 Annual Report on Form 10-K.

    Fair Value of Certain Financial Instruments

        A portion of the Company's assets are carried at fair value, including: mortgage servicing rights, trading assets including certain retained interests from securitization activities, available-for-sale securities and derivatives. In addition, loans held for sale are recorded at the lower of carrying value or fair value. Changes in fair value of those instruments that qualify as hedged items under fair value hedge accounting are recognized in earnings and offset the changes in fair value of derivatives used as hedge accounting instruments.

        Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Generally, for assets that are reported at fair value, the Company uses quoted market prices or internal valuation models to estimate their fair value. These models incorporate inputs such as forward yield curves, loan prepayment assumptions, market volatilities and pricing spreads, utilizing market-based inputs where readily available. The degree of management judgment involved in determining the fair value of a financial instrument or other asset is dependent upon the availability of quoted market prices or observable market value inputs. For financial instruments that are actively traded in the marketplace or whose values are based on readily available market value data, little, if any, subjectivity is applied when determining the instrument's fair value. When observable market prices and data are not readily available, significant management judgment often is necessary to estimate fair value. In those cases, different assumptions could result in significant changes in valuation.

        During the third quarter of 2007, deteriorating credit conditions caused significant disruptions in the secondary mortgage market. Credit quality concerns prompted market participants to avoid purchasing mortgage investment products backed by nonconforming loan collateral. As market activity slowed, the availability of observable market prices was reduced, and the spreads between estimated bid and ask prices widened significantly. Accordingly, in the estimation of fair value during the third quarter of 2007, there was less market data available for use by management in the judgments applied to key valuation inputs, such as discount rates.

6



    Recently Issued Accounting Standards Not Yet Adopted

        In September 2006, the Financial Accounting Standards Board ("FASB") issued Statement No. 157, Fair Value Measurements ("Statement No. 157"). 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. The Company does not expect the application of Statement No. 157 to have a material effect on the Consolidated Financial Statements.

        In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities ("Statement No. 159"). Statement No. 159 permits, at the Company's option, an instrument by instrument election to account for certain financial assets and liabilities at fair value. Statement No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is assessing certain financial instruments to determine how their election to fair value accounting under this standard would affect the Consolidated Financial Statements.

        In June 2007, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 07-1 ("SOP 07-1"), Clarification of the Scope of the Audit and Accounting Guide "Investment Companies" and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies . SOP 07-1 is effective for fiscal years beginning on or after December 15, 2007. In October 2007, the FASB decided to indefinitely defer the required effective date of SOP 07-1 to allow the FASB staff to address certain implementation issues. As a result, the FASB also determined that early adoption of SOP 07-1 would be prohibited. These decisions by the FASB are expected to be issued in a forthcoming FASB Staff Position.

        On November 5, 2007, Securities and Exchange Commission Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings ("SAB 109"), was issued. SAB 109 provides the staff's views on the accounting for written loan commitments recorded at fair value. To make the staff's views consistent with Statement No. 156, Accounting for Servicing of Financial Assets , and Statement No. 159, SAB 109 revises and rescinds portions of SAB No. 105, Application of Accounting Principles to Loan Commitments , and specifically states that the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The provisions of SAB 109 are applicable to written loan commitments issued or modified beginning on January 1, 2008. The Company is currently evaluating the impact that SAB 109 may have on its Consolidated Financial Statements.


Note 2: Discontinued Operations

        On December 31, 2006, the Company exited the retail mutual fund management business and completed the sale of WM Advisors, Inc., realizing a pretax gain of $667 million ($415 million, net of tax). WM Advisors provided investment management, distribution and shareholder services to the WM Group of Funds. This former subsidiary has been accounted for as a discontinued operation and its results of operations have been removed from the Company's results of continuing operations for all periods presented on the Consolidated Statements of Income and in Note 8 to the Consolidated Financial Statements – "Operating Segments," and are presented in the aggregate as discontinued operations.

7



Note 3: Mortgage Banking Activities

        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,
 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
Revenue from sales and servicing of home mortgage loans:                          
  Sales activity:                          
    Gain (loss) from home mortgage loans and originated mortgage-backed securities (1)   $ (169 ) $ 206   $ 45   $ 563  
    Revaluation gain (loss) from derivatives economically hedging loans held for sale     (53 )   (87 )   20     17  
   
 
 
 
 
      Gain (loss) from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments     (222 )   119     65     580  
  Servicing activity:                          
    Home mortgage loan servicing revenue (2)     516     525     1,557     1,683  
    Change in MSR fair value due to payments on loans and other     (351 )   (410 )   (1,109 )   (1,279 )
    Change in MSR fair value due to valuation inputs or assumptions     (201 )   (469 )   233     379  
    Revaluation gain (loss) from derivatives economically hedging MSR     419     353     (160 )   (603 )
    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     383     (1 )   521     23  
   
 
 
 
 
        Total revenue from sales and servicing of home mortgage loans   $ 161   $ 118   $ 586   $ 603  
   
 
 
 
 

(1)
Originated mortgage-backed securities represent available-for-sale securities retained on the balance sheet subsequent to the securitization of mortgage loans that were originated by the Company.
(2)
Includes contractually specified servicing fees (net of guarantee fees paid to housing government-sponsored enterprises, where applicable), late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors and that which is collected from borrowers upon payoff).

8


        Changes in the balance of MSR were as follows:

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
Balance, beginning of period   $ 7,231   $ 9,162   $ 6,193   $ 8,041  
  Home loans:                          
    Additions     116     533     1,468     1,773  
    Change in MSR fair value due to payments on loans and other     (351 )   (410 )   (1,109 )   (1,279 )
    Change in MSR fair value due to valuation inputs or assumptions     (201 )   (469 )   233     379  
    Adjustment to MSR fair value for MSR sale (1)                 (157 )
    Fair value basis adjustment (2)                 57  
    Sale of MSR         (2,527 )       (2,527 )
  Net change in commercial real estate MSR     (1 )   (1 )   9     1  
   
 
 
 
 
Balance, end of period   $ 6,794   $ 6,288   $ 6,794   $ 6,288  
   
 
 
 
 

(1)
Reflects the sale of $2.53 billion of MSR in July 2006.
(2)
Pursuant to the adoption of Statement No. 156 on January 1, 2006, the Company applied the fair value method of accounting to its mortgage servicing assets, and the $57 million difference between amortized cost and fair value was recorded as an increase to the basis of the Company's MSR.

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

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
Balance, beginning of period   $ 474,867   $ 570,352   $ 444,696   $ 563,208  
  Home loans:                          
    Additions     8,700     29,899     83,200     95,873  
    Sale of servicing         (141,842 )       (141,851 )
    Loan payments and other     (20,716 )   (19,288 )   (67,398 )   (78,719 )
  Net change in commercial real estate loans     585     87     2,938     697  
   
 
 
 
 
Balance, end of period   $ 463,436   $ 439,208   $ 463,436   $ 439,208  
   
 
 
 
 


Note 4: Income Taxes

        The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), on January 1, 2007. FIN 48 requires that a tax benefit be recognized only if it is "more likely than not" that it will be 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% likely of being realized upon settlement. As a result of the implementation of FIN 48, the Company recognized a $6 million increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to the January 1, 2007 balance of retained earnings.

9



        The total amount of unrecognized tax benefits as of the date of adoption on January 1, 2007 was $1.41 billion, of which $814 million of unrecognized tax benefits would favorably affect the effective tax rate if recognized. At September 30, 2007, the total amount of unrecognized tax benefits was $1.38 billion, of which $757 million would favorably affect the effective tax rate if recognized.

        The Company records interest expense and penalties related to unrecognized tax benefits as a component of income tax expense. As of January 1, 2007 and September 30, 2007, the Company had accrued $105 million and $152 million for the potential payments of interest, and $47 million for the potential payments of penalties.

        The Company has recorded income tax receivables representing tax refund claims for periods through December 31, 2005. Interest income is accrued on these receivables and is reported as a component of noninterest income. As of January 1, 2007 and September 30, 2007, accrued interest income totaled $295 million and $414 million.

        The Company, including certain of its subsidiaries, files income tax returns in the U.S. federal jurisdiction, various state jurisdictions, and the United Kingdom. Some acquired subsidiaries continue to be subject to both federal and state examinations for periods prior to their acquisition. Generally, the Company is no longer subject to U.S. federal, state, or United Kingdom income tax examinations by tax authorities for years prior to 1998.

        In 2005, the Internal Revenue Service ("IRS") completed the examination of the Company's federal income tax returns for the years 1998 through 2000. Selected issues were referred to the IRS Appeals Division for review. During 2006 all asserted deficiencies were resolved in principle, and their resolution did not materially affect the Company's 2006 Consolidated Financial Statements. The remaining issue involves a claim for refund with respect to certain tax sharing payments to the FDIC. It is reasonably possible that this issue could be resolved within the next twelve months. At this point in time the Company is unable to estimate a range of possible settlements.

        In addition, it is reasonably possible that within the next twelve months the Company will settle an asserted deficiency by the UK Inland Revenue with respect to tax due on the sale of credit card operations by a subsidiary of the former Providian Financial Corporation. The range of the possible settlement is estimated to be $21 million to $32 million.


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 first payment default, retains credit risk exposure on those loans and may be required to repurchase them. The Company may also be required to repurchase sold loans when representations and warranties made by the Company in connection with those sales are breached. 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 breach of a representation or warranty made to the investor in connection with the Company's sale of the loan, then if the breach had a material adverse effect on the value of the loan, the Company will be required to either repurchase the loan or indemnify the investors for losses sustained. In connection with the sales of mortgage servicing rights, the Company may be required to indemnify the purchaser for losses that resulted from deficiencies associated with the Company's prior servicing obligations. The Company has recorded reserves of $239 million as of September 30, 2007 and $220 million as of

10



December 31, 2006, to cover its estimated exposure related to all of the aforementioned loss contingencies.

        In connection with the sale of its retail mutual fund management business, WM Advisors, Inc., the Company provided a guarantee under which it is committed to make certain payments to the purchaser in each of the four years following the closing of the sale on December 31, 2006 in the event that certain fee revenue targets are not met. The fee revenue targets are based on the Company's sales of mutual funds and other financial products that are managed by the purchaser. The Company's maximum potential future payments total $30 million per year for each of the four years following the sale. At the end of the four-year period, the Company can recover all or a portion of the payments made under the guarantee if the aforementioned fee revenues during the four-year period meet or exceed certain targets. The estimated fair value of the guarantee was recorded at December 31, 2006. The carrying amount of the guarantee is being amortized ratably over the four-year period and at each reporting date the Company will evaluate the recognition of a loss contingency. The loss contingency is measured as the probable and reasonably estimable amount, if any, that exceeds the amortized value of the remaining guarantee.


Note 6: Common Stock

        At September 30, 2007, the Company was authorized to issue 1.6 billion shares with no par value. Share activity is as follows:

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
Shares outstanding, beginning of period   875.7   962.9   944.5   993.9  
Issued:                  
  Stock-based compensation plans   0.2   0.9   6.0   12.1  
  Employee stock purchase plan   0.1   0.1   0.4   0.4  
  Subordinated note conversion         4.5  
   
 
 
 
 
    Total shares issued   0.3   1.0   6.4   17.0  
Repurchased and retired (1)   (7.2 ) (18.8 ) (82.1 ) (65.8 )
   
 
 
 
 
Shares outstanding, end of period   868.8   945.1   868.8   945.1  
   
 
 
 
 

(1)
Includes shares repurchased through accelerated share repurchase programs of 1.9 million and 16.0 million during the three months ended September 30, 2007 and 2006 and 74.9 million and 50.0 million during the nine months ended September 30, 2007 and 2006.

    Share Repurchases

        As part of its capital management activities, from time to time the Company will repurchase its shares to deploy excess capital. Share repurchases can occur in the open market or through accelerated share repurchase ("ASR") programs.

        On January 3, 2007, the Company repurchased 59.5 million shares of its common stock from a broker-dealer counterparty under an ASR program at an initial cost of $2.72 billion (the "January ASR"). The repurchased shares were retired by the Company during the first quarter of 2007.

11



In connection with the January ASR, the counterparty was expected to purchase an equivalent number of shares in the open market over time, which subjected the transaction to a future price adjustment. At the end of the program, the Company or the counterparty was required to settle the price adjustment to the other party based on the volume weighted average price of the Company's shares traded during the purchase period.

        On May 23, 2007, the Company and counterparty terminated the January ASR and simultaneously entered into two new ASR programs covering 34.75 million shares in the aggregate (the "May ASRs"). In connection with and pursuant to the termination of the January ASR and execution of the May ASRs, the Company and the counterparty did the following:

    (i)
    They settled the January ASR price adjustment with respect to the shares deemed purchased by the counterparty on the open market prior to termination. This settlement required that the counterparty transfer 2.55 million shares of Washington Mutual, Inc. common stock to the Company.

    (ii)
    They settled the January ASR with respect to the shares deemed not yet purchased by the counterparty on the open market prior to termination. This settlement required that the Company transfer 23.8 million shares of its common stock to the counterparty and that the counterparty pay $1.08 billion to the Company.

    (iii)
    They entered into the May ASRs.

        The foregoing obligations in connection with the termination and settlement of the January ASR were setoff against the share delivery and payment obligations under the May ASRs. Accordingly, on a net settlement basis, the Company received 2.55 million shares of its common stock in settlement of the January ASR and repurchased and received an additional net 10.95 million shares of its common stock from the counterparty at a net cost of $500 million, which was recorded as a reduction of capital surplus.

        The May ASRs were settled in July, and resulted in the Company's receipt of an additional 1.91 million shares of its common stock from the counterparty.

        In addition, during the nine months ended September 30, 2007, the Company purchased 7.17 million of its shares in open market repurchases.

12



Note 7: 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,
 
  2007
  2006
  2007
  2006
 
  (dollars in millions, shares in thousands)

Income from continuing operations   $ 186   $ 739   $ 1,801   $ 2,474
Income from discontinued operations         9         27
Preferred dividends     (8 )       (23 )  
   
 
 
 
Income available to common stockholders for basic EPS     178     748     1,778     2,501
Effect of dilutive securities     (2 )       (4 )  
   
 
 
 
Net income available to common stockholders for diluted EPS   $ 176   $ 748   $ 1,774   $ 2,501
   
 
 
 
Basic weighted average number of common shares outstanding     857,005     941,898     866,864     954,062
Dilutive effect of potential common shares from:                        
  Awards granted under equity incentive programs     9,913     13,145     12,024     15,054
  Common stock warrants     7,907     10,698     9,469     10,736
  Convertible debt     1,177     1,178     1,177     1,674
  Accelerated share repurchase program         457         471
   
 
 
 
Diluted weighted average number of common shares outstanding     876,002     967,376     889,534     981,997
   
 
 
 
Basic earnings per common share:                        
  Income from continuing operations   $ 0.21   $ 0.78   $ 2.05   $ 2.59
  Income from discontinued operations         0.01         0.03
   
 
 
 
    Net income   $ 0.21   $ 0.79   $ 2.05   $ 2.62
   
 
 
 
Diluted earnings per common share:                        
  Income from continuing operations   $ 0.20   $ 0.76   $ 1.99   $ 2.51
  Income from discontinued operations         0.01         0.03
   
 
 
 
    Net income   $ 0.20   $ 0.77   $ 1.99   $ 2.54
   
 
 
 

        For the three and nine months ended September 30, 2007, options to purchase an additional 28.5 million and 22.2 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, 2006, options to purchase an additional 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.

        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. The escrow was scheduled to expire on December 20, 2008, subject to certain limited extensions. In September 2007,

13



the escrow agreement was amended to extend the expiration date to June 30, 2020. As part of the amendment, in October 2007, Washington Mutual received cash payments totaling $14.1 million from the escrow account, which holds both cash dividends paid on escrowed shares as well as interest accumulated on those cash dividends. Additionally, the Company is entitled to receive quarterly cash payments from the escrow from September 30, 2007 through December 31, 2008, in an amount equal to approximately 2% of the then value of the escrow. Thereafter, Washington Mutual is entitled to receive quarterly distributions from the escrow, each consisting of 130,435 shares of Washington Mutual common stock and the cash then in the escrow that is attributable to such shares. The conditions under which the Washington Mutual shares in the escrow can be released to certain of the former investors in Keystone Holdings and their transferees are related to the outcome of certain litigation and are not based on future earnings or market prices. At September 30, 2007, the conditions for releasing the shares from escrow to those investors and their transferees were not satisfied and therefore none of the shares in the escrow were included in the above computations.


Note 8: 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 Company's operating segments are defined by the products and services they offer. The Retail Banking Group, the Card Services Group and the Home Loans Group are consumer-oriented while the Commercial Group serves commercial customers. In addition, the category of Corporate Support/Treasury and Other includes the community lending and investment operations as well as the Treasury function, which manages the Company's interest rate risk, liquidity position and capital. The Corporate Support function provides facilities, legal, accounting and finance, human resources and technology services. The activities of the Enterprise Risk Management function, which oversees the identification, measurement, monitoring, control and reporting of credit, market and operational risk, are also reported in this category.

        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) holding the substantial majority of the Company's portfolio of home loans held for investment and its portfolio of home equity loans and lines of credit (but not the Company's portfolio of mortgage loans to higher risk borrowers that were offered through the subprime mortgage channel); (3) originating home equity loans and lines of credit; and (4) providing investment advisory and brokerage services, sales of annuities and other financial services.

        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. Many products are offered online and in retail banking stores. Financial consultants provide investment advisory and securities brokerage services to the public.

        On December 31, 2006, the Company sold its retail mutual fund management business, WM Advisors, Inc. The results of operations of WM Advisors for the three and nine months ended September 30, 2006 are reported within the Retail Banking Group's results as discontinued operations.

        The Card Services Group manages the Company's credit card operations. The segment's principal activities include: (1) issuing credit cards; (2) either holding outstanding balances on credit cards in portfolio or securitizing and selling them; (3) servicing credit card accounts; and (4) providing other

14



cardholder services. Credit card balances 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) and cash advance and balance transfer fees.

        The Card Services Group acquires new customers primarily by leveraging the Company's retail banking distribution network and through direct mail solicitations, augmented by online and telemarketing activities and other marketing programs including affinity programs. In addition to credit cards, this segment markets a variety of other products to its customer base.

        The Company evaluates the performance of the Card Services Group on a managed asset basis. Managed financial information is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and provision for credit losses.

        The principal activities of the Commercial Group include: (1) providing financing to developers and investors, or acquiring loans for the purchase or refinancing of multi-family dwellings and other commercial properties; (2) either holding multi-family and other commercial real estate loans in portfolio or selling these loans while retaining the servicing rights; (3) providing limited deposit services to commercial customers; and (4) providing Internal Revenue Service Section 1031 exchange services to income property investors.

        The principal activities of the Home Loans Group include: (1) originating and servicing home loans; (2) managing the Company's capital market operations – which includes the buying and selling of all types of real estate secured loans in the secondary market; (3) the origination, fulfillment and servicing of home equity loans and lines of credit; (4) holding certain residential mortgages in its loan portfolio, including mortgage loans to higher risk borrowers that were offered through the subprime mortgage channel; (5) providing financing and other banking services to mortgage bankers for the origination of mortgage loans (these activities are winding down in light of recent market conditions); and (6) making available insurance-related products and participating in reinsurance activities with other insurance companies.

        The segment offers a wide variety of real estate secured residential loan products and services. Such loans are either held in portfolio by the Home Loans Group, sold to secondary market participants or transferred through inter-segment sales to the Retail Banking Group. During the third quarter of 2007, loans that historically had been transferred to the held for investment portfolio within the Retail Banking Group were retained within the held for investment portfolio within the Home Loans Group. The decision to retain or sell loans, and the related decision to retain or not retain servicing when loans are sold, involves the analysis and comparison of expected interest income and the interest rate and credit risks inherent with holding loans in portfolio, with the expected servicing fees, the size of the gain or loss that would be realized if the loans were sold and the expected expense of managing the risk related to any retained mortgage servicing rights.

        When market conditions warrant, the Home Loans Group generates revenue through its conduit operations. Under the conduit program, the Company purchases loans from other lenders, warehouses the loans for a period of time and sells the loans in the form of whole loans, private label mortgage-backed securities or agency-guaranteed securities. The Company recognizes a gain or loss at the time the loans are sold and receives interest income while the loans are held for sale. The Company also provides ongoing servicing and bond administration for all securities issued. This activity has been curtailed in light of recent market conditions.

15



        The principal activities of, and charges reported in, the Corporate Support/Treasury and Other category include:

    management of the Company's interest rate risk, liquidity position and capital. These responsibilities involve managing a majority of the Company's portfolio of investment securities and providing oversight and direction across the enterprise over matters that impact the profile of the Company's balance sheet. Such matters include determining the optimal product composition of loans that the Company holds in 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;

    enterprise-wide management of the identification, measurement, monitoring, control and reporting of credit, market and operational risk;

    community lending and investment activities, which help fund the development of affordable housing units in traditionally underserved communities;

    general corporate overhead costs associated with the Company's facilities, legal, accounting and finance functions, human resources and technology services;

    costs that the Company's chief operating decision maker did not consider when evaluating the performance of the Company's four operating segments, including costs associated with the Company's productivity and efficiency initiatives;

    the impact of changes in the unallocated allowance for loan and lease losses; and

    the net impact of funds transfer pricing for loan and deposit balances.

        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. Methodologies that are applied to the measurement of segment profitability include:

    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 takes into account the interest rate risk profile of the Company's assets and liabilities and concentrates their sensitivities within the Treasury Division, where the risk profile is centrally managed. Certain basis and other residual risk remains in the operating segments;

    the allocation of charges for services rendered to certain segments by functions centralized within another segment, as well as the allocation of certain operating expenses that are not directly charged to the segments (i.e., corporate overhead), which generally are based on each segment's consumption patterns;

    the allocation of goodwill and other intangible assets to the operating segments based on benefits received from each acquisition; and

    the accounting for inter-segment transactions, which include the transfer of certain originated home and home equity loans that are to be held in portfolio from the Home Loans Group to the Retail Banking Group and a broker fee arrangement between Home Loans and Retail Banking. When originated home and home equity loans are transferred to the Retail Banking

16


      Group, the Home Loans Group records a gain on the sale of the loans based on an assumed profit factor. This profit factor is included as a premium to the value of the transferred loans, which is amortized as an adjustment to the net interest income recorded by the Retail Banking Group while the loan is held for investment. With the severe contraction in secondary mortgage market liquidity during the third quarter of 2007, management determined that it was more relevant to measure the performance of the Home Loans Group without considering the assumed profit factor. Accordingly, home loans originated by the Home Loans Group during the third quarter of 2007 were retained within its portfolio, thereby not subjecting those loans to the inter-segment transfer profit factor. If a loan that was designated as held for investment within the Retail Banking Group is subsequently transferred to held for sale, the inter-segment premium is written off through Corporate Support/Treasury and Other. Inter-segment broker fees are recorded by the Retail Banking Group when home loans initiated through retail banking stores are transferred to held for sale. 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.

17


        Financial highlights by operating segment were as follows:

 
  Three Months Ended September 30, 2007
 
 
   
   
   
   
  Corporate
Support/
Treasury
and
Other

   
   
   
 
 
   
   
   
   
  Reconciling Adjustments
   
 
 
  Retail
Banking
Group

  Card
Services
Group (1)

  Commercial
Group

  Home
Loans
Group

   
 
 
  Securitization (2)
  Other
  Total
 
 
  (dollars in millions)

 
Condensed income statement:                                                  
  Net interest income (expense)   $ 1,302   $ 689   $ 193   $ 183   $ (35 ) $ (456 ) $ 138 (3) $ 2,014  
  Provision for loan and lease losses     318     611     12     323     (9 )   (288 )       967  
  Noninterest income (expense)     833     399     (34 )   184     (108 )   168     (63 ) (4)   1,379  
  Inter-segment revenue (expense)     14     (5 )       (9 )                
  Noninterest expense     1,155     358     67     554     57             2,191  
  Minority interest expense                     53             53  
   
 
 
 
 
 
 
 
 
  Income (loss) before income taxes     676     114     80     (519 )   (244 )       75     182  
  Income taxes (benefit)     223     37     26     (171 )   (46 )       (73 ) (5)   (4 )
   
 
 
 
 
 
 
 
 
  Net income (loss)   $ 453   $ 77   $ 54   $ (348 ) $ (198 ) $   $ 148   $ 186  
   
 
 
 
 
 
 
 
 

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Average loans   $ 147,357   $ 25,718   $ 38,333   $ 43,737   $ 1,420   $ (14,488 ) $ (1,385 ) (6) $ 240,692  
  Average assets     157,196     28,206     40,661     61,068     47,570     (12,841 )   (1,385 ) (6)   320,475  
  Average deposits     144,921     n/a     7,851     13,745     32,132     n/a     n/a     198,649  

(1)
Operating results for the Card Services Group are presented on a managed basis as the Company treats securitized and sold credit card receivables as if they were still on the balance sheet in evaluating the overall performance of this operating segment.
(2)
The managed basis presentation of the Card Services Group is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and provision for credit losses. Such adjustments to arrive at the reported GAAP results are eliminated within Securitization Adjustments.
(3)
Represents the difference between mortgage loan premium amortization recorded by the Retail Banking Group and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, certain mortgage loans that are held in portfolio by the Retail Banking Group are treated as if they are purchased from the Home Loans Group. Since the cost basis of these loans includes an assumed profit factor paid to the Home Loans Group, the amortization of loan premiums recorded by the Retail Banking Group reflects this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(4)
Represents the difference between gain from mortgage loans recorded by the Home Loans Group and gain from mortgage loans recognized in the Company's Consolidated Statement of Income.
(5)
Represents the tax effect of reconciling adjustments.
(6)
Represents the inter-segment offset for inter-segment loan premiums that the Retail Banking Group recognized upon transfer of portfolio loans from the Home Loans Group.

18


 
  Three Months Ended September 30, 2006
 
   
   
   
   
  Corporate
Support/
Treasury
and
Other

   
   
   
 
   
   
   
   
  Reconciling Adjustments
   
 
  Retail
Banking
Group

  Card
Services
Group (1)

  Commercial
Group

  Home
Loans
Group

   
 
  Securitization (2)
  Other
  Total
 
  (dollars in millions)

Condensed income statement:                                                
  Net interest income (expense)   $ 1,260   $ 633   $ 159   $ 276   $ (107 ) $ (411 ) $ 137 (3) $ 1,947
  Provision for loan and lease losses     53     345     (2 )   84     (94 )   (220 )       166
  Noninterest income (expense)     738     343     25     314     75     191     (116 ) (4)   1,570
  Inter-segment revenue (expense)     17     (2 )       (15 )              
  Noninterest expense     1,079     294     60     528     223             2,184
  Minority interest expense                     34             34
   
 
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     883     335     126     (37 )   (195 )       21     1,133
  Income taxes (benefit)     337     128     48     (14 )   (90 )       (15 ) (5)   394
   
 
 
 
 
 
 
 
  Income (loss) from continuing operations     546     207     78     (23 )   (105 )       36     739
  Income from discontinued operations, net of taxes     9                             9
   
 
 
 
 
 
 
 
  Net income (loss)   $ 555   $ 207   $ 78   $ (23 ) $ (105 ) $   $ 36   $ 748
   
 
 
 
 
 
 
 

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Average loans   $ 180,829   $ 21,706   $ 32,414   $ 45,407   $ 1,245   $ (12,169 ) $ (1,600 ) (6) $ 267,832
  Average assets     191,288     24,236     34,560     70,563     40,825     (10,330 )   (1,600 ) (6)   349,542
  Average deposits     139,954     n/a     2,323     20,659     45,976     n/a     n/a     208,912

(1)
Operating results for the Card Services Group are presented on a managed basis as the Company treats securitized and sold credit card receivables as if they were still on the balance sheet in evaluating the overall performance of this operating segment.
(2)
The managed basis presentation of the Card Services Group is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and provision for credit losses. Such adjustments to arrive at the reported GAAP results are eliminated within Securitization Adjustments.
(3)
Represents the difference between mortgage loan premium amortization recorded by the Retail Banking Group and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, certain mortgage loans that are held in portfolio by the Retail Banking Group are treated as if they are purchased from the Home Loans Group. Since the cost basis of these loans includes an assumed profit factor paid to the Home Loans Group, the amortization of loan premiums recorded by the Retail Banking Group reflects this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(4)
Represents the difference between gain from mortgage loans recorded by the Home Loans Group and gain from mortgage loans recognized in the Company's Consolidated Statement of Income.
(5)
Represents the tax effect of reconciling adjustments.
(6)
Represents the inter-segment offset for inter-segment loan premiums that the Retail Banking Group recognized upon transfer of portfolio loans from the Home Loans Group.

19


 
  Nine Months Ended September 30, 2007
 
   
   
   
   
  Corporate
Support/
Treasury
and
Other

   
   
   
 
   
   
   
   
  Reconciling Adjustments
   
 
  Retail
Banking
Group

  Card
Services
Group (1)

  Commercial
Group

  Home
Loans
Group

   
 
  Securitization (2)
  Other
  Total
 
  (dollars in millions)

Condensed income statement:                                                
  Net interest income (expense)   $ 3,861   $ 2,004   $ 588   $ 644   $ (49 ) $ (1,330 ) $ 413 (3) $ 6,131
  Provision for loan and lease losses     471     1,523     5     474     (34 )   (865 )       1,574
  Noninterest income (expense)     2,404     1,267     41     736     16     465     (251 ) (4)   4,678
  Inter-segment revenue (expense)     57     (14 )       (43 )              
  Noninterest expense     3,367     984     214     1,622     247             6,434
  Minority interest expense                     138             138
   
 
 
 
 
 
 
 
  Income (loss) before income taxes     2,484     750     410     (759 )   (384 )       162     2,663
  Income taxes (benefit)     901     276     150     (261 )   (157 )       (47 ) (5)   862
   
 
 
 
 
 
 
 
  Net income (loss)   $ 1,583   $ 474   $ 260   $ (498 ) $ (227 ) $   $ 209   $ 1,801
   
 
 
 
 
 
 
 

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Average loans   $ 150,731   $ 24,527   $ 38,586   $ 46,733   $ 1,377   $ (13,635 ) $ (1,388 ) (6) $ 246,931
  Average assets     160,559     27,010     40,946     64,212     43,450     (12,036 )   (1,388 ) (6)   322,753
  Average deposits     144,738     n/a     5,939     15,995     38,676     n/a     n/a     205,348

(1)
Operating results for the Card Services Group are presented on a managed basis as the Company treats securitized and sold credit card receivables as if they were still on the balance sheet in evaluating the overall performance of this operating segment.
(2)
The managed basis presentation of the Card Services Group is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and provision for credit losses. Such adjustments to arrive at the reported GAAP results are eliminated within Securitization Adjustments.
(3)
Represents the difference between mortgage loan premium amortization recorded by the Retail Banking Group and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, certain mortgage loans that are held in portfolio by the Retail Banking Group are treated as if they are purchased from the Home Loans Group. Since the cost basis of these loans includes an assumed profit factor paid to the Home Loans Group, the amortization of loan premiums recorded by the Retail Banking Group reflects this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(4)
Represents the difference between gain from mortgage loans recorded by the Home Loans Group and gain from mortgage loans recognized in the Company's Consolidated Statement of Income.
(5)
Represents the tax effect of reconciling adjustments.
(6)
Represents the inter-segment offset for inter-segment loan premiums that the Retail Banking Group recognized upon transfer of portfolio loans from the Home Loans Group.

20


 
  Nine Months Ended September 30, 2006
 
   
   
   
   
  Corporate
Support/
Treasury
and
Other

   
   
   
 
   
   
   
   
  Reconciling Adjustments
   
 
  Retail
Banking
Group

  Card
Services
Group (1)

  Commercial
Group

  Home
Loans
Group

   
 
  Securitization (2)
  Other
  Total
 
  (dollars in millions)

Condensed income statement:                                                
  Net interest income (expense)   $ 3,929   $ 1,866   $ 488   $ 904   $ (210 ) $ (1,249 ) $ 395 (3) $ 6,123
  Provision for loan and lease losses     120     1,092     (12 )   141     (207 )   (662 )       472
  Noninterest income (expense)     2,140     1,076     54     1,176     137     587     (384 ) (4)   4,786
  Inter-segment revenue (expense)     47     (4 )       (43 )              
  Noninterest expense     3,268     884     184     1,765     450             6,551
  Minority interest expense                     71             71
   
 
 
 
 
 
 
 
  Income (loss) from continuing operations before income taxes     2,728     962     370     131     (387 )       11     3,815
  Income taxes (benefit)     1,043     368     141     50     (197 )       (64 ) (5)   1,341
   
 
 
 
 
 
 
 
  Income (loss) from continuing operations     1,685     594     229     81     (190 )       75     2,474
  Income from discontinued operations, net of taxes     27                             27
   
 
 
 
 
 
 
 
  Net income (loss)   $ 1,712   $ 594   $ 229   $ 81   $ (190 ) $   $ 75   $ 2,501
   
 
 
 
 
 
 
 

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Average loans   $ 179,216   $ 20,762   $ 31,774   $ 46,419   $ 1,063   $ (11,947 ) $ (1,591 ) (6) $ 265,696
  Average assets     189,587     23,354     33,997     73,199     38,865     (10,101 )   (1,591 ) (6)   347,310
  Average deposits     139,276     n/a     2,274     19,120     39,461     n/a     n/a     200,131

(1)
Operating results for the Card Services Group are presented on a managed basis as the Company treats securitized and sold credit card receivables as if they were still on the balance sheet in evaluating the overall performance of this operating segment.
(2)
The managed basis presentation of the Card Services Group is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and provision for credit losses. Such adjustments to arrive at the reported GAAP results are eliminated within Securitization Adjustments.
(3)
Represents the difference between mortgage loan premium amortization recorded by the Retail Banking Group and the amount recognized in the Company's Consolidated Statements of Income. For management reporting purposes, certain mortgage loans that are held in portfolio by the Retail Banking Group are treated as if they are purchased from the Home Loans Group. Since the cost basis of these loans includes an assumed profit factor paid to the Home Loans Group, the amortization of loan premiums recorded by the Retail Banking Group reflects this assumed profit factor and must therefore be eliminated as a reconciling adjustment.
(4)
Represents the difference between gain from mortgage loans recorded by the Home Loans Group and gain from mortgage loans recognized in the Company's Consolidated Statement of Income.
(5)
Represents the tax effect of reconciling adjustments.
(6)
Represents the inter-segment offset for inter-segment loan premiums that the Retail Banking Group recognized upon transfer of portfolio loans from the Home Loans Group.

21



Note 9: 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 cash 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.

        During the third quarter of 2007, the Company elected to make an additional $445 million contribution to the Pension Plan as permitted by the funding policy. Total contributions for the nine months ended September 30, 2007 were $491 million. The Company anticipates no additional contributions to its Pension Plan in 2007.

    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 (the "Nonqualified Defined Benefit 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 (the "Other Postretirement Benefit 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. A 1% change in assumed health care cost trend rates would not have a material impact on the service and interest cost or postretirement benefit obligation.

22



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

 
  Three Months Ended September 30,
 
  2007
  2006
 
  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

 
  (in millions)

Net periodic benefit cost:                                    
Interest cost   $ 24   $ 2   $ 1   $ 22   $ 2   $ 1
Service cost     20     1         23     1    
Expected return on plan assets     (36 )           (32 )      
Amortization of prior service cost     3             3        
Recognized net actuarial loss                 4        
   
 
 
 
 
 
  Net periodic benefit cost   $ 11   $ 3   $ 1   $ 20   $ 3   $ 1
   
 
 
 
 
 
 
  Nine Months Ended September 30,
 
  2007
  2006
 
  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

  Pension
Plan

  Nonqualified
Defined
Benefit Plans

  Other
Postretirement
Benefit Plans

 
  (in millions)

Net periodic benefit cost:                                    
Interest cost   $ 71   $ 6   $ 2   $ 67   $ 6   $ 2
Service cost     62     2         66     2    
Expected return on plan assets     (107 )           (97 )      
Amortization of prior service cost     8             8        
Recognized net actuarial loss         1         13     1    
   
 
 
 
 
 
  Net periodic benefit cost   $ 34   $ 9   $ 2   $ 57   $ 9   $ 2
   
 
 
 
 
 


Note 10: Subsequent Event

        On November 7, 2007, American Express issued a press release announcing that it has reached an agreement with Visa Inc., Visa USA and Visa International to drop Visa and five of its member banks, including the Company, as defendants in a lawsuit alleging that MasterCard, Visa and their member banks had blocked American Express from the bank-issued card business in the United States. The settlement amounts totaling $2.25 billion due to American Express under the agreement will be paid by Visa USA. Pursuant to separate agreements between Visa USA and the Company, the Company will be liable to Visa USA for $38 million of the settlement payments. In connection with the settlement, the Company recognized a $38 million charge to noninterest expense in its third quarter 2007 results of operations, representing $24 million, or $0.03 per diluted share, on an after-tax basis and recorded a corresponding liability at September 30, 2007 to establish a litigation settlement reserve, representing the Company's share of the settlement liability. The financial statements and other financial information included in this Quarterly Report on Form 10-Q include the effects of this agreement, which updates the preliminary third quarter 2007 financial results furnished on Form 8-K on October 17, 2007.

23



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

    Credit Card Industry Litigation

        Over the past several years, MasterCard International and Visa U.S.A., Inc., as well as several of their member banks, including, in certain instances, the Company, have been involved in several different lawsuits challenging various practices of MasterCard and Visa. In November 2004, American Express filed an antitrust lawsuit (the "American Express Litigation") against the associations and several member banks, including the Company, alleging, among other things, that the defendants jointly and severally implemented and enforced illegal exclusionary agreements that prevented member banks from issuing American Express cards. Separately, a number of entities, each purporting to represent a class of retail merchants, have also filed antitrust lawsuits against the associations and several member banks, including the Company, alleging among other things, that the defendants conspired to fix the level of interchange fees. In addition, a number of cardholder class actions were filed against the associations and several member banks, including the Company, alleging that the associations, together with their member banks, conspired to fix the price of currency conversion services for credit card purchases made in a foreign currency by United States cardholders.

        On November 7, 2007, American Express issued a press release announcing that it has reached an agreement with Visa Inc., Visa USA and Visa International to drop Visa and five of its member banks, including the Company, as defendants in the American Express Litigation. The settlement amounts totaling $2.25 billion due to American Express under the agreement will be paid by Visa USA. Pursuant to separate agreements between Visa USA and the Company, the Company will be liable to Visa USA for $38 million of the settlement payments. Management believes that settlement of the American Express Litigation upon the foregoing terms is in the Company's best interest and results in a favorable outcome for the Company.

        In connection with the settlement, the Company recognized a $38 million charge to noninterest expense in its third quarter 2007 results of operations, and recorded a corresponding liability at September 30, 2007 to establish a litigation settlement reserve, representing the Company's share of the settlement liability. The financial statements and other financial information included in this Quarterly Report on Form 10-Q include the effects of this agreement, which updates the preliminary third quarter 2007 financial results furnished on Form 8-K on October 17, 2007.

        The lawsuits described above other than the American Express Litigation remain unresolved. At the present time, given the complexity of the issues raised in these remaining lawsuits, the Company is not in a position to predict with any degree of certainty the outcome of these lawsuits or estimate the impact of any potential losses, nor can it determine the effect, if any, these lawsuits and others involving the associations and banks may have on the competitive environment in the credit card industry.

    Discontinued Operations

        On December 31, 2006, Washington Mutual, Inc. ("Washington Mutual" or the "Company") exited the retail mutual fund management business and completed the sale of WM Advisors, Inc. WM Advisors provided investment management, distribution and shareholder services to the WM Group of Funds. Accordingly, this former subsidiary has been accounted for as a discontinued operation and its results of operations have been removed from the Company's results of continuing operations for all periods presented on the Consolidated Statements of Income and in Note 8 to the Consolidated Financial Statements – "Operating Segments," and are presented in the aggregate as discontinued operations.

24


Cautionary Statements

        The Company's Form 10-Q and other documents that it files with the Securities and Exchange Commission ("SEC") contain forward-looking statements. In addition, the Company's 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 current expectations or predictions of future conditions, events or results. They may include projections of the Company's revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items, descriptions of management's plans or objectives for future operations, products or services, or descriptions of assumptions underlying or relating to the foregoing. 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 made and management does not undertake to update them to reflect changes or events that occur after that date. There are a number of significant factors which could cause actual conditions, events or results to differ materially from those described in the forward-looking statements, many of which are beyond management's control or its ability to accurately forecast or predict. Significant among the factors are the following which are described in greater detail in "Business – Factors That May Affect Future Results" in the Company's 2006 Annual Report on Form 10-K:

      Volatile interest rates and their impact on the mortgage banking business;

      Credit risk;

      Operational risk;

      Risks related to credit card operations;

      Changes in the regulation of financial services companies, housing government-sponsored enterprises and credit card lenders;

      Competition from banking and nonbanking companies;

      General business, economic and market conditions; and

      Reputational risk.

        Other significant factors are the following:

    Liquidity risk.

        Liquidity is essential to the Company's business. The Company's liquidity may be affected by an inability to access the capital markets or by unforeseen demands on cash. This situation may arise due to circumstances beyond the Company's control, such as a general market disruption. During 2007, there has been significant volatility in the capital markets. In the third quarter of 2007, this volatility led to a severe secondary mortgage market disruption resulting in an illiquid market for loans backed by nonconforming mortgage collateral. While these market conditions persist, the Company's ability to raise liquidity through the sale of mortgage loans in the secondary market will be adversely affected. The Company cannot predict with any degree of certainty how long these market conditions may continue, nor can it anticipate the degree of impact such market conditions will have on loan origination volumes and gain on sale results. In response to market conditions and events affecting the Company subsequent to the end of the quarter, (see Part II, Item 1 – "Legal Proceedings") several rating agencies have assigned a negative outlook to the Company. The Company cannot predict

25


whether rating agencies will take further negative actions with respect to the Company's outlook or credit ratings. Such actions could have the effect of increasing the Company's borrowing costs. For further discussion of liquidity, see Management's Discussion and Analysis – "Liquidity Risk and Capital Management."

    Valuation risk.

        A portion of the Company's assets are carried at fair value, including: mortgage servicing rights, trading assets including certain retained interests from securitization activities, available-for-sale securities and derivatives. Generally, for assets that are reported at fair value, the Company uses quoted market prices or internal valuation models that utilize observable market data inputs to estimate their fair value. In certain cases observable market prices and data may not be readily available or availability may be diminished due to market conditions. In those cases, different assumptions could result in significant changes in valuation.

        Each of the factors can significantly impact the Company's businesses, operations, activities, condition and results in significant ways that are not described in the foregoing discussion and which are beyond the Company's ability to anticipate or control, and could cause actual results to differ materially from the outcomes described in the forward-looking statements.

Controls and Procedures

    Disclosure Controls and Procedures

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

        Management reviews and evaluates the design and effectiveness of the Company's disclosure controls and procedures on an ongoing basis, which may result in the discovery of deficiencies, and improves its controls and procedures over time, correcting any deficiencies, as needed, that may have been discovered.

    Changes in Internal Control Over Financial Reporting

        Management reviews and evaluates the design and effectiveness of the Company's internal control over financial reporting on an ongoing basis, which may result in the discovery of deficiencies, some of which may be significant. Management changes its internal control over financial reporting as needed to maintain its effectiveness, correcting any deficiencies, as needed, in order to ensure the continued effectiveness of the Company's internal control over financial reporting. There have not been any changes in the Company's internal control over financial reporting during the third quarter of 2007 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. For management's assessment of the Company's internal control over financial reporting, refer to the Company's 2006 Annual Report on Form 10-K, "Management's Report on Internal Control Over Financial Reporting."

Overview

        Net income in the third quarter of 2007 was $186 million, a 75% decline from $748 million in the third quarter of 2006. The decline was largely the result of significant credit deterioration in the

26



Company's single-family residential mortgage loan portfolio and significant disruptions in the capital markets, including the severe contraction in secondary mortgage market liquidity for nonconforming residential loan products.

        Reflecting the significant credit deterioration, the Company recorded a provision for loan and lease losses of $967 million in the third quarter of 2007, compared with $166 million in the same quarter of the prior year. Growing inventories of unsold homes, rising foreclosure rates and a significant contraction in the availability of credit for nonconforming mortgage products exerted significant downward pressure on home prices in many parts of the country during the most recent quarter. Nationwide sales volume of existing homes in September 2007 was 19% lower than in September 2006, leading to a supply of unsold homes of approximately 10.5 months, a 44% increase from September 2006, while the national median sales price for existing homes declined by 4.2% between those same periods. With the downturn in the housing market, single-family residential mortgage delinquency levels have increased substantially and loss severity rates have grown significantly. These conditions resulted in an increase in the Company's nonperforming assets to total assets ratio from 0.69% at September 30, 2006 to 1.65% at September 30, 2007, while annualized net mortgage loan charge-offs as a percentage of the Company's average real estate loan portfolio increased from 0.12% in the third quarter of 2006 to 0.55% in the third quarter of 2007. The increase in loss severity rates was particularly evident in the subprime mortgage channel and home equity loans and lines of credit portfolios. With housing market conditions expected to deteriorate further, the Company expects that delinquencies and loss severities throughout its single-family residential mortgage portfolios will continue to increase in the fourth quarter of 2007.

        Noninterest income for the third quarter of 2007 was $1.38 billion, compared with $1.57 billion in the third quarter of 2006. Deteriorating credit conditions also caused significant disruptions in the secondary mortgage market, which adversely affected the Company's noninterest income results. Credit quality concerns and market uncertainty prompted market participants to avoid purchasing mortgage investment products backed by nonconforming loan collateral. As a result of the severe contraction in secondary market liquidity, the Company transferred approximately $17 billion of real estate loans to its loan portfolio during the third quarter of 2007, which represented substantially all of the Company's nonconforming loans that had been designated as held for sale prior to the market disruption. A downward adjustment of $147 million was recorded on the transferred loans as a result of widening credit spreads that were induced by the illiquid market conditions. Widening credit spreads also reduced the value of the Company's trading assets related to mortgage loan and credit card securitizations, leading to a net loss of $153 million in the most recent quarter, while a $104 million impairment charge was recognized on certain available-for-sale, investment-grade mortgage-backed securities. The Company generally expects the market-induced adjustments recorded on the transferred loans and the investment-grade mortgage-backed securities will be accreted through interest income in future periods with the appropriate accounting for any further credit-related deterioration. Disruptions in the capital markets have persisted into the fourth quarter of 2007, with continuing illiquid market conditions for nonconforming loans.

        Partially offsetting the losses were strong results from MSR valuation and risk management of $222 million for the third quarter of 2007, compared with a loss of $78 million in the same quarter of the prior year, as gains from the Company's MSR risk management instruments outpaced the decline in MSR fair value in the most recent quarter. While lower mortgage interest rates led to an overall increase in expected loan prepayment speeds, the detrimental effect to the MSR value from the increase was softened by the weakening housing market and the industry-wide contraction in home mortgage credit availability, both of which significantly reduced home loan refinancing volume.

        Net interest income was $2.01 billion in the third quarter of 2007, compared with $1.95 billion in the same quarter of 2006. The increase was due to the expansion of the net interest margin, which increased from 2.53% to 2.86% between those periods. The increase was primarily due to the upward

27



repricing of the loan portfolio, reflecting, in part, the $17.5 billion sale of lower yielding, medium-term adjustable-rate home loans in the first quarter of 2007. The Company's wholesale borrowings continue to be primarily indexed to 3-month LIBOR. Citing the deterioration in housing market conditions, the Federal Reserve has reduced the target Federal Funds rate by 75 basis points to 4.50% since the end of the second quarter of 2007. Although a rate cut of this magnitude would normally elicit a favorable response in the margin, spreads between the Federal Funds rate and 3-month LIBOR, which averaged 11 basis points during the first half of 2007, widened to 48 basis points at the end of the third quarter as a result of the significant disruptions in the capital markets. Accordingly, the Company's wholesale borrowing costs will be marginally higher until spreads return to a more normalized range.

        At September 30, 2007, the Company's estimated total risk-based capital ratio was 10.67% and its estimated Tier 1 leverage ratio was 5.86%, exceeding the minimum regulatory guidelines of 8% and 4%, respectively, for bank holding companies. The Company continues to retain sufficient capital and ready access to diversified sources of liquidity to enable asset growth and other capital deployment activities.

Critical Accounting Estimates

        The preparation of financial statements in accordance with the accounting principles generally accepted in the United States of America ("GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the financial statements. Various elements of the Company's accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain inherent uncertainties. It is possible that, in some instances, different estimates and assumptions could reasonably have been made and used by management, instead of those the Company applied, which might have produced different results that could have had a material effect on the financial statements.

        The Company has identified three accounting estimates that, due to the judgments and assumptions inherent in those estimates, and the potential sensitivity of its financial statements to those judgments and assumptions, are critical to an understanding of its financial statements. These estimates are: the fair value of certain financial instruments and other assets; the determination of whether a derivative qualifies for hedge accounting; and the allowance for loan and lease losses and contingent credit risk liabilities.

        Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Company's Board of Directors. The Company believes that the judgments, estimates and assumptions used in the preparation of its financial statements are appropriate given the facts and circumstances as of September 30, 2007. The nature of these judgments, estimates and assumptions are described in greater detail in the Company's 2006 Annual Report on Form 10-K in the "Critical Accounting Estimates" section of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

        An important change to the Company's critical accounting estimates since December 31, 2006 involves the valuation methodology used to estimate the fair value of its MSR asset, as discussed below:

    Fair Value of Certain Financial Instruments and Other Assets

    Mortgage Servicing Rights

        In June 2007, the Company implemented a model that is based on an option-adjusted spread ("OAS") valuation methodology to estimate the fair value of substantially all of its MSR asset. The model projects cash flows over multiple interest rate scenarios and discounts these cash flows using

28


risk-adjusted discount rates to arrive at an estimate of the fair value of the MSR asset. Models used to value MSR assets, including those employing the OAS valuation methodology, are highly sensitive to changes in certain assumptions. Different expected prepayment speeds, in particular, can result in substantial changes in the estimated fair value of MSR. If actual prepayment experience differs materially from the expected prepayment speeds used in the Company's model, this difference may result in a material change in MSR fair value. In response to the weakening housing market during the third quarter of 2007, the Company updated its prepayment assumptions. Independent broker surveys of the fair value of the mortgage servicing rights are obtained at least quarterly, and are used by management in conjunction with other available market-based evidence including pricing of similar securities to evaluate the reasonableness of the fair value estimate. Changes in MSR value are reported in the Consolidated Statements of Income under the noninterest income caption "Revenue from sales and servicing of home mortgage loans."

Recently Issued Accounting Standards Not Yet Adopted

        Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

29


Summary Financial Data

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
  (dollars in millions, except per share amounts)

 
Profitability                          
  Net interest income   $ 2,014   $ 1,947   $ 6,131   $ 6,123  
  Net interest margin     2.86 %   2.53 %   2.85 %   2.64 %
  Noninterest income   $ 1,379   $ 1,570   $ 4,678   $ 4,786  
  Noninterest expense     2,191     2,184     6,434     6,551  
  Net income     186     748     1,801     2,501  
  Basic earnings per common share:                          
    Income from continuing operations   $ 0.21   $ 0.78   $ 2.05   $ 2.59  
    Income from discontinued operations         0.01         0.03  
   
 
 
 
 
      Net income     0.21     0.79     2.05     2.62  
  Diluted earnings per common share:                          
    Income from continuing operations     0.20     0.76     1.99     2.51  
    Income from discontinued operations         0.01         0.03  
   
 
 
 
 
      Net income     0.20     0.77     1.99     2.54  
  Basic weighted average number of common shares outstanding (in thousands)     857,005     941,898     866,864     954,062  
  Diluted weighted average number of common shares outstanding (in thousands)     876,002     967,376     889,534     981,997  
  Dividends declared per common share   $ 0.56   $ 0.52   $ 1.65   $ 1.53  
  Return on average assets     0.23 %   0.86 %   0.74 %   0.96 %
  Return on average common equity     3.03     11.47     9.96     12.68  
  Efficiency ratio (1)(2)     64.55     62.09     59.53     60.05  
Asset Quality (at period end)                          
  Nonaccrual loans (3)   $ 4,577   $ 1,987   $ 4,577   $ 1,987  
  Foreclosed assets     874     405     874     405  
   
 
 
 
 
    Total nonperforming assets (3)     5,451     2,392     5,451     2,392  
  Nonperforming assets (3) to total assets     1.65 %   0.69 %   1.65 %   0.69 %
  Allowance for loan and lease losses   $ 1,889   $ 1,550   $ 1,889   $ 1,550  
  Allowance as a percentage of loans held in portfolio     0.80 %   0.64 %   0.80 %   0.64 %
Credit Performance                          
  Provision for loan and lease losses   $ 967   $ 166   $ 1,574   $ 472  
  Net charge-offs     421     154     876     375  
Capital Adequacy (at period end)                          
  Stockholders' equity to total assets     7.25 %   7.58 %   7.25 %   7.58 %
  Tangible equity to total tangible assets (4)     5.60     5.86     5.60     5.86  
  Total risk-based capital to total risk-weighted assets (5)     10.67     11.10     10.67     11.10  
  Tier 1 leverage (5)     5.86     6.28     5.86     6.28  
Per Common Share Data                          
  Book value per common share (at period end) (6)   $ 27.18   $ 27.65   $ 27.18   $ 27.65  
  Market prices:                          
    High     43.68     46.42     45.56     46.48  
    Low     32.57     41.47     32.57     41.47  
    Period end     35.31     43.47     35.31     43.47  
Supplemental Data                          
  Total home loan volume     22,329     37,168     83,568     124,210  
  Total loan volume (7)     37,070     49,368     125,978     159,309  

(1)
Based on continuing operations.
(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)
Excludes unrealized net gain/loss on available-for-sale securities and cash flow hedging instruments, goodwill and intangible assets (except MSR) and the impact from the adoption and application of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans . Minority interests of $2.94 billion for September 30, 2007 and $1.96 billion for September 30, 2006 are included in the numerator.
(5)
The capital ratios are estimated as if Washington Mutual, Inc. were a bank holding company subject to Federal Reserve Board capital requirements.
(6)
Excludes six million shares held in escrow.
(7)
Includes mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name of $483 million and $9.40 billion for the three months ended September 30, 2007 and 2006, and $6.42 billion and $24.69 billion for the nine months ended September 30, 2007 and 2006.

30


Earnings Performance from Continuing Operations

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

 
  Three Months Ended September 30,
 
  2007
  2006
 
  Average Balance
  Rate
  Interest Income
  Average Balance
  Rate
  Interest Income
 
  (dollars in millions)

Assets                                
Interest-earning assets (1) :                                
  Federal funds sold and securities purchased under agreements to resell   $ 4,349   5.43 % $ 60   $ 5,085   5.38 % $ 70
  Trading assets     4,509   9.54     108     6,264   8.92     140
  Available-for-sale securities (2) :                                
    Mortgage-backed securities     20,815   5.60     291     21,770   5.42     295
    Investment securities     7,721   5.21     101     6,628   5.04     84
  Loans held for sale     13,344   7.41     248     25,667   6.75     435
  Loans held in portfolio (3) :                                
    Loans secured by real estate:                                
      Home loans (4)(5)     97,398   6.48     1,579     123,355   5.94     1,830
      Home equity loans and lines of credit (5)     57,469   7.56     1,094     52,646   7.53     998
      Subprime mortgage channel (6)     20,405   6.63     338     20,207   6.26     316
      Home construction (7)     2,056   6.90     35     2,059   6.41     33
      Multi-family     30,058   6.63     498     27,100   6.42     435
      Other real estate     7,418   6.99     131     5,696   6.76     98
   
     
 
     
        Total loans secured by real estate     214,804   6.83     3,675     231,063   6.41     3,710
    Consumer:                                
      Credit card     10,332   10.28     268     9,058   11.39     260
      Other     233   14.83     8     284   12.57     9
    Commercial     1,979   8.25     41     1,760   7.33     33
   
     
 
     
        Total loans held in portfolio     227,348   7.01     3,992     242,165   6.61     4,012
  Other     5,177   4.33     56     5,248   5.21     69
   
     
 
     
        Total interest-earning assets     283,263   6.84     4,856     312,827   6.51     5,105
Noninterest-earning assets:                                
  Mortgage servicing rights     6,901               7,201          
  Goodwill     9,056               8,339          
  Other assets     21,255               21,175          
   
           
         
        Total assets   $ 320,475             $ 349,542          
   
           
         
(This table is continued on the next page.)                                

(1)
Nonaccrual assets and related income, if any, are included in their respective categories.
(2)
The average balance and yield are based on average amortized cost balances.
(3)
Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $94 million and $119 million for the three months ended September 30, 2007 and 2006.
(4)
Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $345 million and $296 million for the three months ended September 30, 2007 and 2006.
(5)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(6)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(7)
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.

31


(Continued from the previous page.)

 
  Three Months Ended September 30,
 
  2007
  2006
 
  Average Balance
  Rate
  Interest Expense
  Average Balance
  Rate
  Interest Expense
 
  (dollars in millions)

Liabilities                                
Interest-bearing liabilities:                                
  Deposits:                                
    Interest-bearing checking deposits   $ 28,492   2.36 % $ 169   $ 34,866   2.90 % $ 255
    Savings and money market deposits     57,377   3.32     480     49,144   3.19     396
    Time deposits     80,719   4.92     1,001     90,001   4.76     1,088
   
     
 
     
      Total interest-bearing deposits     166,588   3.93     1,650     174,011   3.95     1,739
  Federal funds purchased and commercial paper     2,991   5.40     41     7,382   5.31     99
  Securities sold under agreements to repurchase     8,617   5.34     116     15,676   5.39     216
  Advances from Federal Home Loan Banks     34,128   5.39     464     52,886   5.28     711
  Other     40,567   5.60     571     27,815   5.59     393
   
     
 
     
      Total interest-bearing liabilities     252,891   4.46     2,842     277,770   4.48     3,158
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     32,061               34,901          
  Other liabilities     8,584               8,765          
  Minority interests     2,945               1,959          
  Stockholders' equity     23,994               26,147          
   
           
         
      Total liabilities and stockholders' equity   $ 320,475             $ 349,542          
   
           
         
Net interest spread and net interest income         2.38   $ 2,014         2.03   $ 1,947
             
           
Impact of noninterest-bearing sources         0.48               0.50      
Net interest margin         2.86               2.53      

32


 
  Nine Months Ended September 30,
 
  2007
  2006
 
  Average Balance
  Rate
  Interest Income
  Average Balance
  Rate
  Interest Income
 
   
   
  (dollars in millions)

   
   
Assets                                
Interest-earning assets (1) :                                
  Federal funds sold and securities purchased under agreements to resell   $ 4,083   5.41 % $ 165   $ 4,422   5.04 % $ 169
  Trading assets     5,029   8.73     329     8,831   7.60     503
  Available-for-sale securities (2) :                                
    Mortgage-backed securities     19,493   5.49     803     21,318   5.35     854
    Investment securities     7,100   5.10     272     5,842   4.88     214
  Loans held for sale     24,924   6.59     1,232     26,659   6.45     1,292
  Loans held in portfolio (3) :                                
    Loans secured by real estate:                                
      Home loans (4)(5)     95,194   6.46     4,611     122,232   5.76     5,282
      Home equity loans and lines of credit (5)     54,988   7.57     3,114     52,068   7.26     2,830
      Subprime mortgage channel (6)     20,389   6.70     1,025     19,939   6.14     918
      Home construction (7)     2,053   6.72     103     2,062   6.41     99
      Multi-family     29,768   6.61     1,476     26,388   6.19     1,226
      Other real estate     7,011   7.02     368     5,482   6.85     284
   
     
 
     
        Total loans secured by real estate     209,403   6.82     10,697     228,171   6.22     10,639
    Consumer:                                
      Credit card     10,443   10.78     842     8,442   11.16     704
      Other     251   13.37     25     499   10.84     40
    Commercial     1,910   7.98     114     1,925   6.67     97
   
     
 
     
        Total loans held in portfolio     222,007   7.02     11,678     239,037   6.41     11,480
  Other     3,585   5.01     134     5,191   4.74     185
   
     
 
     
        Total interest-earning assets     286,221   6.81     14,613     311,300   6.30     14,697
Noninterest-earning assets:                                
  Mortgage servicing rights     6,665               8,151          
  Goodwill     9,054               8,313          
  Other assets     20,813               19,546          
   
           
         
        Total assets   $ 322,753             $ 347,310          
   
           
         
(This table is continued on the next page.)                                

(1)
Nonaccrual assets and related income, if any, are included in their respective categories.
(2)
The average balance and yield are based on average amortized cost balances.
(3)
Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $328 million and $334 million for the nine months ended September 30, 2007 and 2006.
(4)
Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $1.05 billion and $735 million for the nine months ended September 30, 2007 and 2006.
(5)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(6)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(7)
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.

33


(Continued from the previous page.)

 
  Nine Months Ended September 30,
 
  2007
  2006
 
  Average Balance
  Rate
  Interest Expense
  Average Balance
  Rate
  Interest Expense
 
  (dollars in millions)

Liabilities                                
Interest-bearing liabilities:                                
  Deposits:                                
    Interest-bearing checking deposits   $ 30,216   2.50 % $ 566   $ 37,615   2.59 % $ 728
    Savings and money market deposits     57,079   3.31     1,413     47,367   2.81     997
    Time deposits     85,520   4.95     3,166     80,970   4.42     2,695
   
     
 
     
      Total interest-bearing deposits     172,815   3.98     5,145     165,952   3.55     4,420
  Federal funds purchased and commercial paper     2,999   5.43     122     7,537   4.92     279
  Securities sold under agreements to repurchase     9,698   5.40     392     16,294   4.95     612
  Advances from Federal Home Loan Banks     30,740   5.38     1,237     60,197   4.84     2,203
  Other     37,782   5.61     1,586     26,901   5.23     1,060
   
     
 
     
      Total interest-bearing liabilities     254,034   4.46     8,482     276,881   4.11     8,574
             
           
Noninterest-bearing sources:                                
  Noninterest-bearing deposits     32,533               34,179          
  Other liabilities     9,222               8,445          
  Minority interests     2,686               1,497          
  Stockholders' equity     24,278               26,308          
   
           
         
      Total liabilities and stockholders' equity   $ 322,753             $ 347,310          
   
           
         
Net interest spread and net interest income         2.35   $ 6,131         2.19   $ 6,123
             
           
Impact of noninterest-bearing sources         0.50               0.45      
Net interest margin         2.85               2.64      

    Net Interest Income

        Net interest income increased $67 million and $8 million for the three and nine months ended September 30, 2007 compared with the same periods in 2006 due to an increase in the net interest margin, partially offset by a decline in average interest-earning assets and average interest-bearing liabilities. The increase in the net interest margin from 2.53 percent in the third quarter of last year to 2.86 percent in the third quarter of 2007 was primarily due to the upward repricing of the loan portfolio, reflecting, in part, the $17.5 billion sale of lower yielding, medium-term adjustable-rate home loans in the first quarter of 2007.

34


    Noninterest Income

        Noninterest income from continuing operations consisted of the following:

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
   
   
  (dollars in millions)

   
   
 
Revenue from sales and servicing of home mortgage loans   $ 161   $ 118   37 % $ 586   $ 603   (3 )%
Revenue from sales and servicing of consumer loans     418     355   18     1,264     1,155   9  
Depositor and other retail banking fees     740     655   13     2,125     1,875   13  
Credit card fees     209     165   27     564     456   24  
Securities fees and commissions     67     52   28     197     161   23  
Insurance income     29     31   (6 )   87     97   (10 )
Gain (loss) on trading assets     (153 )   68       (406 )   (74 ) 453  
Loss on other available-for-sale securities     (99 )   (1 )     (58 )   (8 ) 611  
Other income     7     127   (95 )   319     521   (39 )
   
 
     
 
     
  Total noninterest income   $ 1,379   $ 1,570   (12 ) $ 4,678   $ 4,786   (2 )
   
 
     
 
     

35


    Revenue from sales and servicing of home mortgage loans

        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,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
   
   
  (dollars in millions)

   
   
 
Revenue from sales and servicing of home mortgage loans:                                  
  Sales activity:                                  
    Gain (loss) from home mortgage loans and originated mortgage-backed securities (1)   $ (169 ) $ 206   % $ 45   $ 563   (92 )%
    Revaluation gain (loss) from derivatives economically hedging loans held for sale     (53 )   (87 ) (40 )   20     17   14  
   
 
     
 
     
        Gain (loss) from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments     (222 )   119       65     580   (89 )
  Servicing activity:                                  
    Home mortgage loan servicing revenue (2)     516     525   (2 )   1,557     1,683   (7 )
    Change in MSR fair value due to payments on loans and other     (351 )   (410 ) (14 )   (1,109 )   (1,279 ) (13 )
    Change in MSR fair value due to valuation inputs or assumptions     (201 )   (469 ) (57 )   233     379   (39 )
    Revaluation gain (loss) from derivatives economically hedging MSR     419     353   19     (160 )   (603 ) (73 )
    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     383     (1 )     521     23    
   
 
     
 
     
          Total revenue from sales and servicing of home mortgage loans   $ 161   $ 118   37   $ 586   $ 603   (3 )
   
 
     
 
     

(1)
Originated mortgage-backed securities represent available-for-sale securities retained on the balance sheet subsequent to the securitization of mortgage loans that were originated by the Company.
(2)
Includes contractually specified servicing fees (net of guarantee fees paid to housing government-sponsored enterprises, where applicable), late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors and that which is collected from borrowers upon payoff).

36


        The following table presents MSR valuation and the corresponding risk management derivative instruments and securities during the three and nine months ended September 30, 2007 and 2006:

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
MSR Valuation and Risk Management:                          
  Change in MSR fair value due to valuation inputs or assumptions   $ (201 ) $ (469 ) $ 233   $ 379  
Gain (loss) on MSR risk management instruments:                          
  Revaluation gain (loss) from derivatives     419     353     (160 )   (603 )
  Revaluation gain (loss) from certain trading securities     4     39     4     (50 )
  Loss from certain available-for-sale securities         (1 )       (1 )
   
 
 
 
 
    Total gain (loss) on MSR risk management instruments     423     391     (156 )   (654 )
   
 
 
 
 
      Total changes in MSR valuation and risk management   $ 222   $ (78 ) $ 77   $ (275 )
   
 
 
 
 

        The following tables reconcile gains (losses) on investment securities that are designated as MSR risk management instruments to gain (loss) on trading assets and loss on other available-for-sale securities that are reported within noninterest income during the three and nine months ended September 30, 2007 and 2006:

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
Gain (loss) on trading assets resulting from:                          
  MSR risk management instruments   $ 4   $ 39   $ 4   $ (50 )
  Other     (157 )   29     (410 )   (24 )
   
 
 
 
 
    Total gain (loss) on trading assets   $ (153 ) $ 68   $ (406 ) $ (74 )
   
 
 
 
 

 


 

Three Months Ended September 30,


 

Nine Months Ended September 30,


 
 
  2007
  2006
  2007
  2006
 
 
   
  (in millions)

   
 
Loss on other available-for-sale securities resulting from:                          
  MSR risk management instruments   $   $ (1 ) $   $ (1 )
  Other     (99 )       (58 )   (7 )
   
 
 
 
 
    Total loss on other available-for-sale securities   $ (99 ) $ (1 ) $ (58 ) $ (8 )
   
 
 
 
 

        Gain (loss) from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments (net gain on sale), was a loss of $222 million in the third quarter of 2007, compared with a gain of $119 million in the same period of the prior year, and a gain of $65 million for the nine months ended September 30, 2007, compared with a gain of $580 million for the same period in 2006. As mortgage delinquencies and loss severities across all single-family residential borrower classes accelerated during 2007, risk tolerances among secondary market participants significantly contracted in the third quarter, resulting in an illiquid market for substantially all loans not eligible for purchase by the housing government-sponsored enterprises. The Company responded to the liquidity contraction that developed during the third quarter by transferring into its loan portfolio approximately $15 billion of single-family residential loans, which were substantially

37



comprised of nonconforming products that had initially been designated as held for sale prior to the contraction. A $139 million downward adjustment on the transferred loans was recorded in the third quarter, reflecting the widening of secondary market credit spreads that accompanied the liquidity disruption. With the decrease in liquidity for nonconforming loans, home loan sales volume totaled $9.03 billion in the third quarter, a 70% decline from $30.24 billion in the third quarter of 2006.

        The fair value changes in home mortgage loans held for sale and the offsetting changes in the derivative instruments used as fair value hedges are recorded within gain from home mortgage loans when hedge accounting treatment is achieved. Home mortgage loans held for sale where hedge accounting treatment is not achieved are recorded at the lower of cost or fair value. This accounting method requires declines in the fair value of these loans, to the extent such value is below their cost basis, to be immediately recognized within gain from home mortgage loans, but any increases in the value of these loans that exceed their original cost basis may not be recorded until the loans are sold. However, all changes in the value of derivative instruments that are used to manage the interest rate risk of these loans must be recognized in earnings as those changes occur.

        The value of the MSR asset is subject to prepayment risk. Future expected net cash flows from servicing a loan in the servicing portfolio will not be realized if the loan pays off earlier than expected. Moreover, since most loans within the servicing portfolio do not impose prepayment fees for early payoff, a corresponding economic benefit will not be received if the loan pays off earlier than expected. The fair value of the MSR is estimated from the present value of the future net cash flows the Company expects to receive from the servicing portfolio. Accordingly, prepayment risk subjects the MSR to potential declines in fair value. During the second quarter of 2007, the Company adopted an option-adjusted spread ("OAS") valuation methodology for estimating the fair value of substantially all of its MSR asset. This methodology projects MSR cash flows over multiple interest rate scenarios, and discounts those cash flows using risk-adjusted discount rates to arrive at an estimate of the fair value of the MSR asset. As the Company's OAS model was calibrated to the prior model's valuation results, the conversion to the new methodology did not result in a fair value adjustment to the Company's MSR asset upon its implementation.

        MSR valuation and risk management results were gains of $222 million and $77 million for the three and nine months ended September 30, 2007, compared with losses of $78 million and $275 million for the same periods in 2006. Decreases in mortgage interest rates during the third quarters of 2007 and 2006 led to a decline in MSR value, as expected prepayment speeds increased, and a corresponding increase in value of risk management instruments. However, the impact of lower interest rates on projected MSR prepayment speeds in the third quarter of 2007 was mitigated by the weakening housing market, tighter underwriting standards across the mortgage banking industry and higher rates for nonconforming loan products, all of which reduced the opportunity for borrowers to refinance. The performance of the MSR risk management instruments was adversely affected by the flat-to-inverted slope of the yield curve for the three and nine months ended September 30, 2006, which had the effect of increasing hedging costs during both of those periods.

        Home mortgage loan servicing revenue decreased by $9 million and $126 million for the three and nine months ended September 30, 2007, compared with the same periods in 2006. The decrease for the nine month period was largely the result of the sale of $2.53 billion of mortgage servicing rights in July 2006. Those declines were more than offset by a decrease in the rate of MSR fair value changes from loan payments of $59 million and $170 million for the same comparative periods, as actual payment rates on the servicing portfolio decreased in the third quarter of 2007 due to significantly lower levels of refinancing activity.

38



    All Other Noninterest Income Analysis

        Revenue from sales and servicing of consumer loans increased $63 million and $109 million for the three and nine months ended September 30, 2007 compared with the same periods in 2006. The increase was due to growth in sales revenue as a result of higher credit card securitization volume, which increased 15% and 10% for the three and nine months ended September 30, 2007, compared with the same periods in 2006.

        Depositor and other retail banking fees increased $85 million and $250 million for the three and nine months ended September 30, 2007, compared with the same periods in 2006, predominantly due to higher transaction fees and an increase in the number of noninterest-bearing checking accounts. The number of noninterest-bearing checking accounts at September 30, 2007 totaled approximately 10.8 million compared with approximately 9.4 million at September 30, 2006.

        Credit card fees increased $44 million and $108 million for the three and nine months ended September 30, 2007, compared with the same periods in 2006, reflecting growth in the average balance of the credit card portfolio.

        Securities fees and commissions increased $15 million and $36 million for the three and nine months ended September 30, 2007 due to an increase in the volume of mutual fund and annuity sales.

        Gain (loss) on trading assets decreased $221 million and $332 million for the three and nine months ended September 30, 2007. As credit spreads widened, the value of trading assets related to mortgage loan and credit card securitizations decreased, resulting in a net loss of $153 million during the most recent quarter. At September 30, 2007, the fair value of subprime residuals was $37 million.

        Loss on other available-for-sale securities increased $98 million and $50 million for the three and nine months ended September 30, 2007, compared with the same periods in 2006, resulting from impairment of $104 million, primarily from investment-grade mortgage-backed securities, during the third quarter of 2007. For the nine months ended September 30, 2007, the impairment was partially offset by gains from sales of mortgage-backed securities during the first half of the year.

        The decrease in other income of $120 million and $202 million for the three and nine months ended September 30, 2007, compared with the same periods in 2006, primarily resulted from revaluation losses in the current quarter on derivatives held for interest-rate risk management purposes. Also contributing to the decrease were increased losses related to equity method investments. In addition, included in the nine months ended September 30, 2006 was a $134 million goodwill litigation award recorded in the first quarter of 2006 from the partial settlement of the Company's claim against the U.S. Government with regard to the Home Savings supervisory goodwill lawsuit.

39



    Noninterest Expense

        Noninterest expense from continuing operations consisted of the following:

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
   
   
  (dollars in millions)

   
   
 
Compensation and benefits   $ 910   $ 939   (3 )% $ 2,889   $ 2,992   (3 )%
Occupancy and equipment     371     408   (9 )   1,102     1,235   (11 )
Telecommunications and outsourced information services     135     142   (5 )   396     421   (6 )
Depositor and other retail banking losses     71     57   23     190     165   15  
Advertising and promotion     125     124   1     337     335    
Professional fees     52     57   (10 )   145     138   5  
Postage     112     110   1     325     356   (8 )
Foreclosed asset expense     82     32   154     177     83   112  
Other expense     333     315   6     873     826   6  
   
 
     
 
     
  Total noninterest expense   $ 2,191   $ 2,184     $ 6,434   $ 6,551   (2 )
   
 
     
 
     

        Occupancy and equipment expense decreased $37 million and $133 million for the three and nine months ended September 30, 2007, compared with the same periods in 2006. The decrease was primarily due to expenses incurred of $28 million and $85 million for the three and nine months ended September 30, 2006 related to the Company's productivity and efficiency initiatives.

        The increase in depositor and other retail banking losses for the three and nine months ended September 30, 2007, compared with the same periods in 2006, was primarily due to the increase in higher loss levels for returned deposited items and overdrawn account losses.

        The increase in foreclosed asset expense for the three and nine months ended September 30, 2007, compared with the same periods in 2006, was due to higher foreclosures reflecting the deterioration in the credit environment and further weakening in the housing market. The total number of foreclosed properties has increased as has the average number of days properties have been held in inventory.

    Income Taxes

        For the three months ended September 30, 2007, a tax benefit of $4 million was recorded, compared with a provision of $394 million for the same period in the prior year. The three months ended September 30, 2007 includes an adjustment that reduced income tax expense for the first nine months of the year to reflect the Company's best estimate of the full year 2007 effective income tax rate as required by accounting rules.

40


Review of Financial Condition

        Available-for-sale securities consisted of the following:

 
  September 30, 2007
 
  Amortized Cost
  Unrealized Gains
  Unrealized Losses
  Fair Value
 
  (in millions)

Mortgage-backed securities:                        
  U.S. Government   $ 28   $   $ (1 ) $ 27
  Agency     7,509     28     (83 )   7,454
  Private label     13,295     28     (242 )   13,081
   
 
 
 
    Total mortgage-backed securities     20,832     56     (326 )   20,562
Investment securities:                        
  U.S. Government     12             12
  Agency     3,977     6     (15 )   3,968
  U.S. states and political subdivisions     1,824     9     (26 )   1,807
  Other debt securities     1,777     7     (29 )   1,755
  Equity securities     303         (1 )   302
   
 
 
 
    Total investment securities     7,893     22     (71 )   7,844
   
 
 
 
      Total available-for-sale securities   $ 28,725   $ 78   $ (397 ) $ 28,406
   
 
 
 
 
  December 31, 2006
 
  Amortized
Cost

  Unrealized
Gains

  Unrealized
Losses

  Fair
Value

 
  (in millions)

Mortgage-backed securities:                        
  U.S. Government   $ 28   $   $ (1 ) $ 27
  Agency     8,657     55     (85 )   8,627
  Private label     10,008     43     (104 )   9,947
   
 
 
 
    Total mortgage-backed securities     18,693     98     (190 )   18,601
Investment securities:                        
  U.S. Government     403         (6 )   397
  Agency     3,350     9     (33 )   3,326
  U.S. states and political subdivisions     1,330     18     (3 )   1,345
  Other debt securities     1,209     16     (4 )   1,221
  Equity securities     88     1     (1 )   88
   
 
 
 
    Total investment securities     6,380     44     (47 )   6,377
   
 
 
 
      Total available-for-sale securities   $ 25,073   $ 142   $ (237 ) $ 24,978
   
 
 
 

        Unrealized losses on available-for-sale securities were $397 million at September 30, 2007, primarily due to private label mortgage-backed securities. Declines in the fair value of available-for-sale securities resulted, in part, from wider credit spreads that resulted from the downturn in the housing market.

41


        The realized gross gains and losses on available-for-sale securities for the periods indicated were as follows:

 
  Three Months Ended September 30,
  Nine Months Ended September 30,
 
 
  2007
  2006
  2007
  2006
 
 
  (in millions)

 
Realized gross gains   $ 12   $ 20   $ 71   $ 120  
Realized gross losses     (111 )   (21 )   (129 )   (122 )
   
 
 
 
 
  Realized net loss   $ (99 ) $ (1 ) $ (58 ) $ (2 )
   
 
 
 
 

        The Company monitors securities in its available-for-sale investment portfolio for impairment. Impairment may result from either credit deterioration or from changes in market rates relative to the interest rate of the instrument. The Company considers many factors in determining whether the impairment is other than temporary, including but not limited to the length of time the security has had a market value less than the cost basis, the severity of the unrealized loss, the Company's intent and ability to hold the security for a period of time sufficient for a recovery in value, issuer-specific factors such as the issuer's financial condition, external credit ratings and general market conditions. The Company recognized losses of $104 million in earnings, representing impairment on certain investment-grade mortgage-backed securities where the reduction in fair value was deemed to be other than temporary at September 30, 2007.

    Loans

        Total loans consisted of the following:

 
  September 30, 2007
  December 31, 2006
 
  (in millions)

Loans held for sale   $ 7,586   $ 44,970
   
 
Loans held in portfolio:            
  Loans secured by real estate:            
    Home loans (1)   $ 105,860   $ 99,479
    Home equity loans and lines of credit (1)     59,120     52,882
    Subprime mortgage channel (2) :            
      Home loans     17,285     18,725
      Home equity loans and lines of credit     2,711     2,042
    Home construction (3)     2,110     2,082
    Multi-family     30,831     30,161
    Other real estate     8,335     6,745
   
 
      Total loans secured by real estate     226,252     212,116
  Consumer:            
    Credit card     8,791     10,861
    Other     224     276
  Commercial     1,865     1,707
   
 
      Total loans held in portfolio (4)   $ 237,132   $ 224,960
   
 

(1)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(2)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(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.
(4)
Includes net unamortized deferred loan costs of $1.33 billion and $1.48 billion at September 30, 2007 and December 31, 2006.

42


        Due to the illiquid market, residential mortgage loans designated as held for sale at September 30, 2007 were largely limited to those loans eligible for purchase by the housing government-sponsored enterprises. The December 31, 2006 balance of loans held for sale included approximately $17.5 billion of medium-term adjustable-rate home loans which were transferred during the fourth quarter of 2006 from loans held in portfolio to loans held for sale. These loans were subsequently sold during the first quarter of 2007.

        Total home loans held in portfolio consisted of the following:

 
  September 30, 2007
  December 31, 2006
 
  (in millions)

Home loans:            
  Short-term adjustable-rate loans (1) :            
    Option ARMs (2)   $ 57,846   $ 63,557
    Other ARMs     8,468     6,791
   
 
      Total short-term adjustable-rate loans     66,314     70,348
  Medium-term adjustable-rate loans (3)     34,359     26,232
  Fixed-rate loans     5,187     2,899
   
 
      Home loans held in portfolio (4)     105,860     99,479
  Subprime mortgage channel     17,285     18,725
   
 
      Total home loans held in portfolio   $ 123,145   $ 118,204
   
 

(1)
Short-term adjustable-rate loans reprice within one year.
(2)
The total amount by which the unpaid principal balance of Option ARM loans exceeded their original principal amount was $1.50 billion and $888 million at September 30, 2007 and December 31, 2006.
(3)
Medium-term adjustable-rate loans reprice after one year.
(4)
Excludes home loans in the subprime mortgage channel.

        The loans held in portfolio balance at September 30, 2007 includes approximately $17 billion of nonconforming loans previously designated as loans held for sale prior to the market disruption experienced during the third quarter of 2007. The transferred loans were comprised of approximately $15 billion of single-family residential mortgages and approximately $2 billion of multi-family and other real estate loans. Partially offsetting this increase was a decrease in Option ARM loans, reflecting the slowdown in the housing market and an interest rate environment in which loan products with longer repricing frequencies are priced more favorably than short-term adjustable-rate loans.

    Other Assets

        Other assets consisted of the following:

 
  September 30, 2007
  December 31, 2006
 
  (in millions)

Accounts receivable   $ 4,881   $ 5,566
Investment in bank-owned life insurance     5,018     4,373
Premises and equipment     2,870     3,042
Accrued interest receivable     1,942     1,941
Derivatives     1,451     748
Identifiable intangible assets     423     556
Foreclosed assets     874     480
Other     3,543     3,231
   
 
  Total other assets   $ 21,002   $ 19,937
   
 

43


    Deposits

        Deposits consisted of the following:

 
  September 30, 2007
  December 31, 2006
 
  (in millions)

Retail deposits:            
  Checking deposits:            
    Noninterest bearing   $ 23,721   $ 22,838
    Interest bearing     27,277     32,723
   
 
      Total checking deposits     50,998     55,561
  Savings and money market deposits     43,360     41,943
  Time deposits     50,740     46,821
   
 
      Total retail deposits     145,098     144,325
Commercial business and other deposits     16,536     15,175
Brokered deposits:            
  Consumer     17,484     22,299
  Institutional     8,107     22,339
Custodial and escrow deposits     7,055     9,818
   
 
    Total deposits   $ 194,280   $ 213,956
   
 

        Institutional brokered deposits decreased $14.23 billion or 64% from December 31, 2006, largely due to the reduced funding needs during the first half of the year.

        Transaction accounts (checking, savings and money market deposits) comprised 65% of retail deposits at September 30, 2007 and 68% at December 31, 2006. These products generally have the benefit of lower interest costs, compared with time deposits, and represent the core customer relationship that is maintained within the retail banking franchise. Average total deposits funded 70% of average total interest-earning assets in the third quarter of 2007, compared with 68% in the fourth quarter of 2006.

    Borrowings

        FHLB advances of $52.53 billion at September 30, 2007 increased $8.23 billion from December 31, 2006, and $31.12 billion from June 30, 2007. In response to the diminished liquidity in the secondary market for loans backed by nonconforming mortgage collateral, the Company increased its FHLB advances during the third quarter to provide funding for the origination of nonconforming mortgage loans, which were added to the loan portfolio. The advances were also used to augment the amount of cash and cash equivalents on hand at September 30, 2007.

    Capital Surplus-Common Stock

        The Company's capital surplus totaled $2.58 billion at September 30, 2007, compared with $5.83 billion at December 31, 2006. The decrease was due to the Company's common stock repurchase transactions. During the nine months ended September 30, 2007, the Company repurchased approximately 82 million of its common shares.

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 Company's operating segments are defined by the products and services they offer. The Retail Banking

44



Group, the Card Services Group and the Home Loans Group are consumer-oriented while the Commercial Group serves commercial customers. In addition, the category of Corporate Support/Treasury and Other includes the community lending and investment operations as well as the Treasury function, which manages the Company's interest rate risk, liquidity position and capital. The Corporate Support function provides facilities, legal, accounting and finance, human resources and technology services. The activities of the Enterprise Risk Management function, which oversees the identification, measurement, monitoring, control and reporting of credit, market and operational risk, are also reported in this category. Refer to Note 8 to the Consolidated Financial Statements – "Operating Segments" for information regarding the key elements of management reporting methodologies used to measure segment performance.

        The Company serves the needs of 19.9 million consumer households through its 2,212 retail banking stores, 463 lending stores and centers, 3,968 ATMs, telephone call centers and online banking.

        Financial highlights by operating segment were as follows:

    Retail Banking Group

 
  Three Months Ended
September 30,

   
  Nine Months Ended
September 30,

   
 
 
  Percentage
Change

  Percentage
Change

 
 
  2007
  2006
  2007
  2006
 
 
  (dollars in millions)

 
Condensed income statement:                                  
  Net interest income   $ 1,302   $ 1,260   3 % $ 3,861   $ 3,929   (2 )%
  Provision for loan and lease
losses
    318     53   495     471     120   291  
  Noninterest income     833     738   13     2,404     2,140   12  
  Inter-segment revenue     14     17   (14 )   57     47   23  
  Noninterest expense     1,155     1,079   7     3,367     3,268   3  
   
 
     
 
     
  Income from continuing operations before income taxes     676     883   (23 )   2,484     2,728   (9 )
  Income taxes     223     337   (34 )   901     1,043   (14 )
   
 
     
 
     
  Income from continuing operations     453     546   (17 )   1,583     1,685   (6 )
  Income from discontinued operations         9           27    
   
 
     
 
     
    Net income   $ 453   $ 555   (18 ) $ 1,583   $ 1,712   (8 )
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio     53.75 %   53.55 %     53.26 %   53.44 %  
  Average loans   $ 147,357   $ 180,829   (19 ) $ 150,731   $ 179,216   (16 )
  Average assets     157,196     191,288   (18 )   160,559     189,587   (15 )
  Average deposits     144,921     139,954   4     144,738     139,276   4  
  Loan volume     6,469     4,965   30     17,301     16,274   6  
  Employees at end of period     28,263     27,998   1     28,263     27,998   1  

45


        Net interest income increased $42 million, or 3%, for the three months ended September 30, 2007, compared with the same period in 2006, predominantly due to higher transfer pricing credits and average balances of deposits. Partially offsetting this increase was a decline in the average balance of home mortgage loans. During the third quarter of 2007, approximately $7 billion of originated home mortgage loans were designated as held for investment and retained by the Home Loans Group rather than sold to the Retail Banking Group. The decrease in net interest income for the nine months ended September 30, 2007, compared with the same period in 2006, was substantially due to a decline in the average balance of home mortgage loans, reflecting the transfer of approximately $17.5 billion medium-term adjustable-rate portfolio home loans in the fourth quarter of 2006 to held for sale in the Home Loans Group, which were subsequently sold in the first quarter of 2007, and a decline in Option ARM average balances. Partially offsetting this decrease were higher average balances of deposits.

        The provision for loan and lease losses increased in response to the weakness in the housing market, resulting in higher delinquencies in both home equity and home mortgage loans.

        The increase in noninterest income was substantially due to growth in depositor and other retail banking fees of 13% during the three and nine months ended September 30, 2007, reflecting higher transaction fee volume that was largely attributable to higher transaction fees and the strong increase in the number of noninterest-bearing checking accounts. The number of noninterest-bearing retail checking accounts at September 30, 2007 totaled approximately 10.8 million, compared with approximately 9.4 million at September 30, 2006. Noninterest income for the nine months ended September 30, 2006 included a $21 million incentive payment received as part of the Company's migration of its debit card business to MasterCard.

        Noninterest expense increased due to higher performance-based incentive compensation and benefits among employees within the retail banking franchise and an increase in foreclosed asset expense and depositor losses. Partially offsetting this increase was a decrease in technology expense resulting from operating efficiencies.

    Card Services Group (Managed basis)

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
   
   
  (dollars in millions)

   
   
 
Condensed income statement:                                  
  Net interest income   $ 689   $ 633   9 % $ 2,004   $ 1,866   7 %
  Provision for loan and lease losses     611     345   77     1,523     1,092   39  
  Noninterest income     399     343   16     1,267     1,076   18  
  Inter-segment expense     5     2   255     14     4   322  
  Noninterest expense     358     294   22     984     884   11  
   
 
     
 
     
  Income before income taxes     114     335   (66 )   750     962   (22 )
  Income taxes     37     128   (71 )   276     368   (25 )
   
 
     
 
     
    Net income   $ 77   $ 207   (63 ) $ 474   $ 594   (20 )
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio     33.11 %   30.16 % 10     30.24 %   30.08 % 1  
  Average loans   $ 25,718   $ 21,706   18   $ 24,527   $ 20,762   18  
  Average assets     28,206     24,236   16     27,010     23,354   16  
  Employees at end of period     2,878     2,667   8     2,878     2,667   8  

        The Company evaluates the performance of the Card Services Group on a managed basis. Managed financial information is derived by adjusting the GAAP financial information to add back securitized loan balances and the related interest, fee income and provision for credit losses.

46


        The increase in net interest income was substantially due to growth in average loan balances. Partially offsetting this increase was a decline in yields.

        The increase in the provision for loan and lease losses reflects recent increases in delinquencies and lower levels of anticipated recoveries, as the increase in average loan balances was primarily driven by growth in newer loan vintages, which tend to be more promotionally priced.

        Noninterest income increased for the three and nine months ended September 30, 2007, compared with the same periods in 2006, substantially due to higher fee income from growth in managed credit card receivables and higher securitization volume, partially offset by downward adjustments to credit card securitization retained interests resulting from the disruption in the capital markets.

        Higher noninterest expense resulted primarily from a $38 million credit card litigation settlement agreement, increased marketing and postage expenses supporting the increase in the number of credit card accounts and the transfer of certain back office functions from the Retail Banking Group to the Card Services Group.

    Commercial Group

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
   
   
  (dollars in millions)

   
   
 
Condensed income statement:                                  
  Net interest income   $ 193   $ 159   22 % $ 588   $ 488   20 %
  Provision for loan and lease losses     12     (2 )     5     (12 )  
  Noninterest income     (34 )   25       41     54   (22 )
  Noninterest expense     67     60   12     214     184   17  
   
 
     
 
     
  Income before income taxes     80     126   (37 )   410     370   11  
  Income taxes     26     48   (46 )   150     141   6  
   
 
     
 
     
    Net income   $ 54   $ 78   (32 ) $ 260   $ 229   14  
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio     41.88 %   32.21 % 30     34.03 %   33.92 %  
  Average loans   $ 38,333   $ 32,414   18   $ 38,586   $ 31,774   21  
  Average assets     40,661     34,560   18     40,946     33,997   20  
  Average deposits     7,851     2,323   238     5,939     2,274   161  
  Loan volume     4,054     3,104   31     12,073     8,835   37  
  Employees at end of period     1,421     1,242   14     1,421     1,242   14  

        The increase in net interest income was primarily due to increased interest income resulting from growth in multi-family and non-residential real estate loan balances. Also contributing to the increase was growth in average balances of money market deposits. Average loan balances at September 30, 2007 reflect the acquisition of Commercial Capital Bancorp, Inc. on October 1, 2006.

        The increase in provision for loan and lease losses was primarily due to higher balances of loans and higher delinquencies.

        The decrease in noninterest income was primarily due to revaluation losses on derivatives held to economically hedge loans held for sale.

        The increase in noninterest expense primarily reflects the addition of Commercial Capital Bancorp, Inc. on October 1, 2006 and higher compensation and benefits and commission expense due to an increase in employee headcount and higher loan volume.

47


    Home Loans Group

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
  (dollars in millions)

 
Condensed income statement:                                  
  Net interest income   $ 183   $ 276   (34 )% $ 644   $ 904   (29 )%
  Provision for loan and lease losses     323     84   286     474     141   235  
  Noninterest income     184     314   (41 )   736     1,176   (37 )
  Inter-segment expense     9     15   (42 )   43     43    
  Noninterest expense     554     528   5     1,622     1,765   (8 )
   
 
     
 
     
  Income (loss) before income taxes     (519 )   (37 )     (759 )   131    
  Income taxes (benefit)     (171 )   (14 )     (261 )   50    
   
 
     
 
     
    Net income (loss)   $ (348 ) $ (23 )   $ (498 ) $ 81    
   
 
     
 
     
Performance and other data:                                  
  Efficiency ratio     154.63 %   92.00 % 68     121.30 %   86.65 % 40  
  Average loans   $ 43,737   $ 45,407   (4 ) $ 46,733   $ 46,419   1  
  Average assets     61,068     70,563   (13 )   64,212     73,199   (12 )
  Average deposits     13,745     20,659   (33 )   15,995     19,120   (16 )
  Loan volume     26,434     41,241   (36 )   96,312     134,037   (28 )
  Employees at end of period     12,167     13,857   (12 )   12,167     13,857   (12 )

        The decrease in net interest income was substantially due to a decrease in the funds transfer pricing credit resulting from a decline in the average balance of custodial and escrow deposits and the transfer of approximately $15 billion of loans held for sale to this segment's held for investment portfolio during the third quarter of 2007. The spread between the yield and the funds transfer charge on loans held for investment is not as favorable as on loans held for sale.

        The increase in the provision for loan and lease losses reflects the impact of transferring loans that were not agency-conforming to the held for investment portfolio and the downturn in the housing market. This downturn resulted in increased delinquencies and higher loss severities as certain customers were unable to meet their mortgage payments.

        The decrease in noninterest income for the three and nine months ended September 30, 2007, compared with the same periods in 2006, was primarily due to reduced gain on sale from an illiquid secondary market and decreased sales volume, including a reduced volume of loans sold to the Retail Banking Group. Partially offsetting this decrease was increased income from MSR valuation and risk management activities.

        The increase in noninterest expense for the three months ended September 30, 2007, compared with the same period in 2006, was primarily due to an increase in foreclosed asset expense resulting from increased defaults and downward valuation adjustments. This increase was partially offset by a decline in loan originations and related expenses, including a reduction in headcount. The decrease in noninterest expense for the nine months ended September 30, 2007, compared with the same period in 2006, was primarily due to lower incentive compensation expense from a decline in the number of loan originations and also reflects a reduction in employee headcount as a result of the Company's 2006 productivity and efficiency initiatives.

48



    Corporate Support/Treasury and Other

 
  Three Months Ended September 30,
   
  Nine Months Ended September 30,
   
 
 
  Percentage Change
  Percentage Change
 
 
  2007
  2006
  2007
  2006
 
 
   
   
  (dollars in millions)

   
   
 
Condensed income statement:                                  
  Net interest income (expense)   $ (35 ) $ (107 ) (67 )% $ (49 ) $ (210 ) (77 )%
  Provision for loan and lease losses     (9 )   (94 ) (90 )   (34 )   (207 ) (84 )
  Noninterest income     (108 )   75       16     137   (88 )
  Noninterest expense     57     223   (75 )   247     450   (45 )
  Minority interest expense     53     34   56     138     71   94  
   
 
     
 
     
  Loss before income taxes     (244 )   (195 ) 25     (384 )   (387 ) (1 )
  Income taxes (benefit)     (46 )   (90 ) (49 )   (157 )   (197 ) (20 )
   
 
     
 
     
    Net loss   $ (198 ) $ (105 ) 88   $ (227 ) $ (190 ) 19  
   
 
     
 
     
Performance and other data:                                  
  Average loans   $ 1,420   $ 1,245   14   $ 1,377   $ 1,063   30  
  Average assets     47,570     40,825   17     43,450     38,865   12  
  Average deposits     32,132     45,976   (30 )   38,676     39,461