1.

Prepare journal entries to record the following hypothetical2006events:

a. A customer deposits $50,000 in a WaMu savings account on 1/1/2006

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b. WaMu pays 1% (annual) interest on that deposit at 3/31/06

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c. WaMu lends the $50,000 to another customer for a 6% home loan on 1/1/06

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d. WaMu accrues interest on that loan as of 3/31/06

.

2.

How much net interest income (profit) did WaMu earn in the first quarter of 2006 on thisdeposit andthecorresponding loan?

WaMu's Option-ARM Strategy1 1. INTRODUCTION \"The option-ARM product is the key flagship product for our company.\" Kerry Killinger, CEO Washington Mutual, Inc. (generally known as \"WaMu\") called itself \"the bank for everyday people\" because it focused on consumers and small-to-medium-sized businesses. With this strategy, WaMu evolved from its humble start in 1889 as a local bank headquartered in Seattle, Washington, to become the nation's largest savings and loan in both assets ($328 billion) and revenues ($25.5 billion) by the end of 2007 - see Exhibit 1.2 [insert Exhibit 1 and Figure 1 about here] Along with growth came attention from Wall Street analysts and investors. An investment of $10,000 on the day WaMu went public on March 31, 1983 was worth $760,704 at December 31, 2006. In contrast, the same investment in the S&P 500 Financials was worth $221,394 while the broader S&P 500 index was worth only $172,239.3 However, U.S. housing prices began to fall in 2007 (Figure 1) putting severe pressure on financial institutions. Kerry Killinger, WaMu CEO, described the situation in excerpts from his 2007 letter to shareholders: Dear fellow shareholders, 2007 was one of the most challenging years in our history. We faced a national housing crisis, rising foreclosures, credit concerns and a weakening economy. (letter to shareholders, p. 1) 1 This case was prepared using public sources by Robert Bowen, Jane Jollineau and Barbara Lougee of the University of San Diego. Revised September 2013. 2 Savings and loan associations are also called thrift institutions. Thrifts were originally established to promote personal savings through savings accounts and home ownership through mortgage lending, but now provide a range of services similar to many commercial banks. 3 These calculations assume interim reinvestment of dividends (WaMu 2006 Annual Report, p. 15). 1 It's important to understand that our business is cyclical. We are impacted by the recurring and fluctuating levels of economic activity over long periods of time. These cycles come and go. Today, the sharply declining housing market is working against us. A couple of years ago, the housing cycle was at a high point. (p. 2) We expected a downturn in 2007, but it hit with much more severe consequences for the industry than anyone anticipated. Over the course of my 30-plus years in banking and finance, including 18 years as CEO of WaMu, I have managed through many cycles. But this is the most difficult period I have seen for the housing market, and WaMu in particular. (p. 2) Instead, after several years of double-digit price appreciation, home values in most parts of the country actually declined in the second half of 2007. And by the end of 2007, home price appreciation was negative nationally, a phenomenon we hadn't seen since the Great Depression. (p. 3) By yearend 2007, the hypothetical $10,000 investment at March 31, 1983 had fallen to $241,606 for WaMu and to $180,150 for the S&P 500 Financials - see Figure 2. Despite the emerging housing recession, Killinger expressed confidence in the bank's future citing WaMu's (i) discontinuance of all remaining subprime lending,4 closure of more than half of the mortgage loan centers and sales offices, closure of nine home loans processing and call centers, and elimination of over 3000 positions (letter to shareholders, p. 5), (ii) \"strategic decision to avoid or significantly limit our exposure to many high-risk asset categories\" (p. 6), (iii) favorable capital position (p. 6 and Figure 3), (iv) strong management team (p. 8), (v) stellar reputation among consumers (p. 11),5 and (vi) \"unique and powerful brand\" (p. 13). [insert Figure 2 and Figure 3 about here] In discussing the \"path forward,\" Killinger stated \"2007 can be characterized as a year of responding to change. 2008 will be an even more challenging period as we expect to feel the The term 'subprime' refers to the credit quality of particular borrowers. Subprime borrowers tend to have poor credit histories and thus a greater risk of default compared to prime borrowers (FDIC 2010). 5 \"In 2007, we received the \"Highest in Customer Satisfaction with Retail Banking in the Midwest and West/Pacific\" from J.D. Power and Associates in its proprietary Retail Banking Satisfaction Study. We were the only bank to take the top spot in more than one region. BusinessWeek magazine also named us \"A Top 25 Service Champ.\" We were the only bank to make the list in 2007. And WaMu was judged by consumers to be the most highly regarded banking company in the United States, based on corporate reputation. According to the Reputation Institute, WaMu commanded the highest score of all banking companies and was the only bank included in the list of top 50 corporate reputations.\" (WaMu 2007 Annual Report, p. 11) 4 2 effects of very weak housing conditions and extraordinarily high loan loss provisioning\" (p. 13). HOW A SAVINGS AND LOAN BANK WORKS In simple terms, a savings and loan bank serves as an intermediary between those who have money (and want to invest it) and those who want to borrow money. The bank pays interest to depositors (a.k.a., investors or 'savers'), and earns interest on loans to individuals and businesses (a.k.a., borrowers). Bank profits are affected by the \"spread\" between the interest rate paid to depositors and the interest rate charged to borrowers. Other things equal, banks make more money when deposit interest rates are low and lending interest rates are high. Banks earn additional revenue for other services such as charging fees for originating loans. Banks may also sell their loans or investments to other financial institutions or investors rather than holding them to maturity. If the proceeds from the sale exceed the book value of the loan or investment, the bank recognizes a gain on the sale. Thus, WaMu's sources of revenue included: (1) interest income generated from loans to customers and from investment securities, (2) fees for originating and servicing loans, (3) gains from loan sales, and (4) fees for other financial services provided to customers. WaMu's costs included: (1) interest paid on customer deposits and other borrowing, (2) losses due to loan defaults, and (3) administrative costs. WaMu's financial statements are included in Exhibits 2 through 5. [insert Exhibits 2, 3, 4 and 5 about here] TYPES OF LOANS AT WAMU Overwhelmingly, WaMu was a home lender. At yearend 2007, over 95% of WaMu's loan portfolio was loans secured by real estate (a.k.a., mortgages) of various types with the remainder being consumer and commercial loans (Exhibit 6).6 Of the loans secured by real estate, the 6 The proportions of different types of loans held in a bank's portfolio are an important determinant of risk. 3 majority (54%) were 'home loans,' i.e., first mortgages to individuals who used the funds to buy a home. The next largest category (27%) was 'home equity loans and lines of credit,' i.e., second mortgages that allowed homeowners to pull money out of their home for assorted purposes such as remodeling, paying college tuition for a child, or purchasing another asset such as a car or boat. 'Multi-family' (14%), 'home construction' (1%) and 'other real estate' (4%) loans comprised the remaining categories. [insert Exhibit 6 about here] Mortgage loans vary dramatically in their structure and are generally categorized as 'fixedrate' or 'adjustable-rate.' Within adjustable-rate mortgages (ARMs), some banks allow borrowers various options for their monthly payments (option-ARMs). Fixed-Rate Mortgages The traditional fixed-rate mortgage requires a down payment, e.g., 20%, and has a constant monthly payment calculated to pay off both the loan balance and interest over the term of the loan, which is typically 30 years. Fixed-rate borrowers tend to have lower risk of default compared to ARM borrowers (Finke et al. 2006). However, fixed-rate mortgages expose the bank to interest rate risk. When interest rates fall, some fixed-rate borrowers refinance at lower rates, reducing the bank's interest income. When interest rates rise, borrowers tend to keep their mortgages, but the market value of the bank's fixed-rate loan portfolio falls because the old fixed-rate interest is inadequate to justify current values.7 Relative to conservative key competitor Wells Fargo, WaMu held a higher proportion of loans secured by real estate (95.5% vs. 53.0%) and a higher proportion of home loans (51.8% vs. 38.5%) in its loan portfolio. 7 Loans are investments made by the bank. When interest rates increase, banks have an opportunity cost as existing fixed-rate loans lose value because the rate of return on the loan (its interest rate) is below the current market rate. Fixed-rate lending also exposes banks to asset-liability mis-matches. If a bank makes long-term fixed-rate home loans (an asset) but is funded by short-term customer deposits (a liability), it is exposed to interest rate risk and asset-liability mis-match. An increase in short term interest rates drives up deposit rates (increasing interest expense) with no change in interest income from the fixed-rate loan portfolio. In the extreme, interest received from the bank's mortgage portfolio could be less than interest paid to its depositors. Banks offer 4 Adjustable-Rate Mortgages (ARM) With an adjustable-rate mortgage (ARM), the interest rate on the principal balance resets or 'adjusts' periodically, shifting interest rate risk from the bank to the borrower. ARMs that adjust in less than one year are classified as short-term ARMs in Exhibit 7. Those that adjust after one year are classified as medium-term ARMs. For example, the interest rate may start at 5% for five years and then adjust at the five-year anniversary to a new rate based on then-current market conditions. [insert Exhibit 7 about here] Option ARM The option-ARM loan is a variation of the ARM that allows the borrower 'options' each month to pay the 'fully-amortizing'8 amount or lesser amounts, such as 'interest only,' or 'minimum payments.' Based on a low introductory ('teaser') rate, the minimum payment is often less than the interest on the loan.9 When borrowers choose to pay less than the fully accrued interest, the unpaid interest increases the principal amount owed by the borrower, which is referred to as \"negative amortization\" or \"neg-am.\" ARM and especially option-ARM borrowers tend to be higher risk; they generally have less equity in their home and less ability to repay the loan. Further, option-ARM borrowers who pay less than the full interest due each month are borrowing more money, yet are more likely to be in personal financial trouble or adjustable-rate mortgages because it reduces this risk and matches the source of funding (the liability for customer deposits) to the bank's loan portfolio (asset). 8 A 'fully-amortizing' payment includes principal and interest based on the loan's amortization schedule and will repay the loan by the end of its set term. 9 The minimum payment adjusts annually on the anniversary date of the loan or when a 'recasting event' takes place. The loan recasts every 60 months or when the negative amortization reaches a cap, (typically 110% to 125% of the original loan balance), whichever occurs sooner. For an annual adjustment on the loan anniversary date, the change is capped at 7.5% of the original minimum payment. In contrast, for a recasting event, the adjustment to the minimum payment has no cap. A recasting event resets the minimum payment to equal the fully-amortizing payment, which can result in a sudden, large increase in the minimum payment. 5 underwater on their loan10 (Massachusetts Office of Consumer Affairs and Business Regulation, 2013). For each month of negative amortization, the situation is exacerbated. The loan balance grows; the borrower's equity in the home decreases; and the lender's exposure to default risk increases.11 Lower equity in the home increases the likelihood that the loan exceeds the market value of the home, thereby reducing the borrower's incentive to pay off the loan. If home prices decline, the situation becomes worse. THE OPTION-ARM STRATEGY AT WAMU In 2004 WaMu was under pressure from shareholders to turn around its lagging mortgage division, which had closed 100 home loan centers and laid off over 13,000 employees in response to system wide IT problems and declining profits (Reckard, 2004). A key initiative, beyond cost control, was to emphasize higher margin loan products, most notably ARMs. In prepared remarks for the 2004 third-quarter conference call, CEO Kerry Killinger said: \"We are paying closer attention than ever to product mix to assess our profit by product and distribution channels, and exercise stronger controls than ever. The goal is to ensure that we are disciplined about originating higher margin product whenever we can. In this market our emphasis is ARM product origination, principally for our balance sheet.\" During the same third-quarter 2004 conference call, Killinger said \"The option-ARM product is the key flagship product for our company.\" Option-ARM loans proved extraordinarily popular during the housing boom. Between April 2004 and the end of 2007, WaMu underwrote $184.8 billion in option-ARMs and another $9.5 billion in ARMs that reset within a year. The company also earned fees for bundling these loans and selling them as mortgage-backed securities.12 10 Being underwater means the market value of the home is less than the outstanding loan balance. This is a particular problem for negatively amortizing loans as the loan balance grows when the borrower's payments are less than the accrued monthly interest. 11 Due to the rapid increase in housing prices during the housing bubble, lenders became more willing to make larger loans and accept smaller down payments. Smaller down payments exposed lenders to greater risk because it reduced the protective buffer, all else equal. 12 \"Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage 6 As the housing boom faded in 2006 and 2007, nearly one half of all option-ARM borrowers made minimum negative amortization payments. Despite recording $1.4 billion of negative amortization interest revenue in 2007 (Exhibit 8),13 WaMu reported a net loss of $67 million in 2007, compared with a net income of $3.56 billion in 2006. This precipitous decline was primarily the result of significant deterioration in the quality of the company's residential mortgage loan portfolio and a sudden and severe contraction in secondary mortgage market liquidity (i.e., through Fannie Mae and Freddie Mac) for residential loan products such as ARMs.14 [insert Exhibit 8 about here] ACCOUNTING FOR LOAN LOSSES When banks lend money, they expect the borrower will repay the loan with interest according to the agreed-upon payment schedule. Inevitably though, some borrowers fail to meet this obligation and ultimately default on the loan. Accounting for uncollectible loans by financial institutions is similar to accounting for uncollectible accounts receivables by nonfinancial businesses. Under Generally Accepted Accounting Principles, it is not permissible for companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization\" (http://www.sec.gov/answers/mortgagesecurities.htm). Mortgage-backed securities were typically purchased as lowrisk investments by institutions such as banks, corporations, and pension funds. 13 The $1.4 billion of unpaid interest increased the asset, loans held in portfolio, and thus was treated as current period revenue, interest income. For example, the journal entry would look something like: DR: Cash (A) $x billion DR: Loans held in portfolio (A) $1.4 billion CR: Interest income (OE, revenue) $x+1.4 billion By purchasing 'conforming' mortgage loans and selling them to investors, two government-sponsored enterprises, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), increase the supply of funding available for home loans. Fannie Mae and Freddie Mac purchase only 'conforming loans', which are mortgage loans that meet certain guidelines. 'Non-conforming' loans include mortgage loans that do not meet these guidelines. The maximum loan amount, which was $417,000 (in 2006 until 2008) for most single-family homes in the U.S., is the most widely-known of these guidelines. However, even loans below the maximum are nonconforming if they do not satisfy guidelines pertaining to loan-to-value ratio, borrower's credit score and history, proper documentation, borrower's total debt, or borrower's debt-to-income ratio. 14 7 banks to wait until borrowers default on their loans to recognize uncollectible accounts. Instead, each period management must estimate an expense that anticipates loan defaults by borrowers. Although management cannot know in advance which borrowers will not pay, reasonable estimates can be made using models that predict loan defaults. WaMu's allowance for loan losses is shown in Exhibit 9 and is described as follows: The allowance for loan losses represents management's estimate of incurred credit losses inherent in the Company's loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower's ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and unemployment levels have on a borrower's ability to repay adjustable-rate loans. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. The Company maintains a comprehensive governance structure and a certification and validation process that is designed to support, among other things, the appropriateness of the estimate of the allowance for loan losses. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. (2007 10-K, MD&A, p. 63) [insert Exhibit 9 about here] The expense that results from this estimate reduces current period income and is typically called the 'provision for loan losses,' as shown in WaMu's income statement (Exhibit 2).15 To adjust the asset side of the balance sheet for this contingency, banks set up a contra-asset to loans held in portfolio typically called 'allowance for loan losses,' as shown in WaMu's balance sheet (Exhibit 3).16 The purpose of this allowance is to reduce the balance of the asset, loans held in portfolio, to the amount expected to be collected in the future, i.e., its net realizable value. Thus, the generic journal entry for the periodic estimate of loan losses is: DR: Provision for loan losses (OE, expense) CR: Allowance for loan losses (contra A) xxx xxx This expense account is similar to 'bad debt expense' or 'uncollectible accounts expense' or 'provision for uncollectible accounts' used by non-financial businesses to recognize estimated bad debts related to their accounts receivable on credit sales. 16 This contra-asset account is similar to 'allowance for doubtful accounts' used by non-financial businesses to reduce their accounts receivable to the net realizable value. 15 8 When an actual borrower's account is determined to be uncollectible, it is written off against the allowance account as follows: DR: Allowance for loan losses (contra A) CR: Loans held in portfolio - acct #10101 (A) yyy yyy This journal entry removes customer loan #10101 from the books. Banks refer to this as a 'charge off;' loans charged off are shown in Exhibit 9. Charge offs represent loans that are deemed to be in default. Note that the expense associated with a specific current period charge off was likely recorded in an earlier period when the original provision for loan losses was estimated. Nonaccrual Loans The allowance for loan losses attempts to anticipate future loan defaults by borrowers. Banks typically classify nonaccrual loans as those that are 90 or more days past due - see Exhibit 10. These loans are unlikely to be collected because borrowers have missed interest or principal payments. WaMu labels these loans as 'nonaccrual' as the bank is no longer recording interest income due to their high probability of default. Exhibit 10 shows that the level of nonaccrual loans secured by real estate was relatively constant in 2003 through 2005, but increased in 2006 by over $600 million (to a total of $2.3 billion) and increased again in 2007 by over $3.8 billion (to a total of $6.1 billion). [insert Exhibit 10 about here] ANALYZING A BANK Due to the nature of the business, being subject to additional regulation and the use of industry-specific accounting rules, the financial statements of banks differ from those of other types of businesses. As a result, the metrics used to evaluate banks differ from those used to evaluate other types of businesses. Both profitability and financial condition are important 9 considerations when analyzing a bank. For banks, the tradeoff between profitability and assuming risk is especially important. Growing its loan portfolio with increasingly risky lending might help a bank grow its balance sheet and revenues in the short-run but will also expose a bank to higher default risk and render it more vulnerable in an economic downturn. To assess the health of a particular bank, the analyst must examine trends in the values of relevant metrics for that bank, compare those values to those for similar institutions, and identify outliers. Outliers should be investigated further because they might indicate a problem. The FDIC publishes data that aid regulators and analysts in assessing the financial condition and performance of banks. Among the reported 'performance and condition ratios' are those that allow analysts to assess the quality of the assets and the adequacy of the loan loss allowance (FDIC 2013). Analysts who follow financial institutions evaluate the allowance for loan losses to determine whether it adequately conveys the risks inherent in the bank's loan portfolio. An inadequate allowance for loan losses can lead to inaccurate inferences about the bank's performance and financial condition, and can ultimately harm shareholders and other stakeholders. Comparison to Wells Fargo Bank and FDIC averages WaMu listed Wells Fargo Bank as one of its key competitors (WaMu 2007 10-K, p. 86). Wells Fargo was founded in 1852 and had grown to be the largest financial institution headquartered in California and the second-largest mortgage lender nationally. Wells Fargo management took pride in being conservative, e.g., in 2007 Wells Fargo was the only U.S. bank to be rated AAA by Standard & Poor's (Wells Fargo, 2/14/2007). In November 2007, CFO Howard Atkins stated that \"the bank had largely avoided many of the credit and capital market 10 problem areas in the industry,\" including those arising from option ARMs (Fabrikant, 11/28/2007). "We do not make or purchase option adjustable-rate mortgage products (option ARMs) or variable-rate mortgage products with fixed payment amounts, commonly referred to within the financial services industry as negative amortizing mortgage loans, as we believe these products rarely provide a benefit to our customers." (2007 10-K, p. 54) Exhibit 11 presents summary data for Wells Fargo, the average of FDIC large banks and partial data for WaMu. At yearend 2006, WaMu was smaller than Wells Fargo but larger than the average FDIC large bank (those with assets over $10B) in net income, return on average common equity, total deposits and total stockholders' equity. [insert Exhibit 11 about here] Despite having a smaller ratio of nonaccrual loans to total loans than the FDIC average large bank, Wells Fargo reported a larger allowance for loan losses as a percentage of total loans in the portfolio and a much larger allowance as a percentage of nonaccrual loans. For example, Wells Fargo's ratio of allowance for loan losses to nonaccrual loans was roughly twice that of the average large FDIC bank at yearend 2007 and 2006. Thus, while Wells Fargo experienced lower levels of past due loans relative to the size its loan portfolio, management established relatively conservative estimates for future loan losses. Can the same be said for WaMu? 11 REQUIRED: Discuss in a paragraph: WaMu's strategy relative to other banks at the date of the case. Answer the following questions: 1. Prepare journal entries to record the following hypothetical 2006 events: a. A customer deposits $50,000 in a WaMu savings account on 1/1/2006. b. WaMu pays 1% (annual) interest on that deposit at 3/31/06. c. WaMu lends the $50,000 to another customer for a 6% home loan on 1/1/06. d. WaMu accrues interest on that loan as of 3/31/06. 2. How much net interest income (profit) did WaMu earn in the first quarter of 2006 on this deposit and the corresponding loan? 12 Figures and Exhibits include: Figure 1: U.S. Home Prices: 1987 to 2007 Figure 2: Stock prices of WaMu versus the S&P 500, 1983-2007 Figure 3: WaMu capital position relative to regulatory target at December 31, 2007 Exhibit 1: Rankings of U.S. Thrifts by (A) assets and (B) revenues, 2007 Exhibit 2: Income from continuing operations, 2005-2007 Exhibit 3: Balance sheets for the years ended December 31, 2006 and 2007 Exhibit 4: Statement of Cash Flows, Operating and Investing Sections Exhibit 5: Statement of Cash Flows, Financing Section Exhibit 6: Loans by category Exhibit 7: Home loans by category (excluding home equity loans and lines of credit) Exhibit 8: Option-ARM Home Loans (excluding subprime loans) Exhibit 9: Changes in the Allowance for Loan Losses Account, 2003-2007 Exhibit 10: Nonperforming Assets (i.e., loans over 90 days past due and foreclosed assets) Exhibit 11: Summary data comparing WaMu (partially complete), Wells Fargo Bank and FDIC large bank averages at yearend 2006 and 2007 13 REFERENCES Fabrikant, G., November 28, 2007. Bracing for Home Loan Losses, Wells Fargo to Take Big Charge. New York Times. http://www.nytimes.com/2007/11/28/business/28bank.html?_r=0 Federal Deposit Insurance Corporation. 2013 (and updated quarterly). Statistics on Depository Institutions Report. http://www2.fdic.gov/SDI/SOB/ Finke, M., Huston, S., Siman, E., and M. Corlija, 2006. Characteristics of Recent Adjustablerate Mortgage Borrowers. Journal of Financial Counseling and Planning, Vol. 16, No. 2. Killinger, K., 2004. Remarks from Washington Mutual's CEO during third quarter conference call. Massachusetts Office of Consumer Affairs and Business Regulation, 2013. Interest-Only Mortgages and Option ARMs: Are They Right For You? http://www.mass.gov/ocabr/consumer/banks-banking/education/interest-only-mortgagesand-option-arms-are.html Reckard, E.S., August 25, 2004. Washington Mutual's Growth Strategy Plagued by Missteps. Los Angeles Times. Washington Mutual, Inc. 2006. Washington Mutual, Inc. 2006 Form 10-K. Seattle, WA. Securities and Exchange Commission, Washington, DC. Washington Mutual, Inc. 2006. Washington Mutual, Inc. 2006 Annual Report Letter to Shareholders. Seattle, WA. http://quicktake.morningstar.com/stocknet/secdocuments.aspx?symbol=wamuq Washington Mutual, Inc. 2007. Washington Mutual, Inc. 2007 Form 10-K. Seattle, WA. Securities and Exchange Commission, Washington, DC. Washington Mutual, Inc. 2007. Washington Mutual, Inc. 2006 Annual Report Letter to Shareholders. Seattle, WA. http://quicktake.morningstar.com/stocknet/secdocuments.aspx?symbol=wamuq Wells Fargo Bank. 2007. Wells Fargo Bank, Inc. 2007 Form 10-K. San Francisco, CA. Securities and Exchange Commission, Washington, DC. Wells Fargo Bank News Release, February 14, 2007. Wells Fargo Bank Becomes S&P's Only \"AAA\" Credit-Rated U.S. Bank. https://www.wellsfargo.com/press/20070214_SandPupgrade 14 Figure 1: U.S. Home Prices, 1987-2007 200 180 160 140 120 100 80 60 40 20 0 Home prices are based on S&P/Case-Shiller index values (U.S. National Index Levels, Not-Seasonally Adjusted). Case-Shiller indices are calculated from data on repeat sales of single-family homes. Source: http://en.wikipedia.org/wiki/Case%E2%80%93Shiller_index 15 Figure 2 Stock prices of WaMu versus the S&P 500 and the S&P 500 financials, 1983-2007 Prices assume \"an initial investment of $10,000 at 3/31/83 when WaMu went public and reinvestment of dividends through 12/31/07.\" The S&P 500 index comprises 500 large-capitalization companies in assorted industries. The S&P 500 Financials index comprises approximately 80 companies included in the S&P 500 that are classified as members of the financial sector. Sources: Graph from WaMu 2007 Annual Report, p. 9. Definitions of S&P indices from http://us.spindices.com/indices/equity/sp-500 16 Figure 3 WaMu capital position relative to regulatory target at December 31, 2007 Source: WaMu 2007 Annual Report, p. 6. 17 Exhibit 1 Rankings of U.S. Savings and Loan Banks by (A) assets and (B) revenues, 2007 A. Top Ten U.S. Savings and Loan Banks by Assets (in $ millions) Rank Company Assets 1 Washington Mutual, Inc. 2 Countrywide Financial Corp. (1) 3 Sovereign Bancorp, Inc. 84,746.4 4 ING Bank, FSB 79,986.1 5 E*TRADE Bank 51,623.3 6 Hudson City Bancorp, Inc. 44,424.0 7 Merrill Lynch Bank & Trust Co., FSB 37,832.4 8 IndyMac Bancorp Inc. (2) 32,734.5 9 New York Community Bancorp, Inc. 30,579.8 10 USAA Federal Savings Bank 30,219.5 $327,913.0 208,366.9 Source: SNL Financial LC. B. Top Five U.S. Savings and Loan Banks by Revenues (in $ millions)1 Rank Company 1 Washington Mutual, Inc. 2 Sovereign Bancorp 5,011 3 Hudson City Bancorp 2,135 4 IndyMac Bancorp 2,020 5 New York Community Bancorp 1,678 1 Revenues $25,531 Based on an analysis of companies in the Fortune 500. Source: Fortune. 18 Exhibit 2 Income from continuing operations, 2005-2007 Source: WaMu 10-K for fiscal 2007. 19 Exhibit 3 Balance Sheets for the years ended December 31, 2006 and 2007 Source: WaMu 10-K for fiscal 2007. 20 Exhibit 4 Statement of Cash Flows, Operating and Investing Sections Source: WaMu 10-K for fiscal 2007. 21 Exhibit 5 Statement of Cash Flows, Financing Section Source: WaMu 10-K for fiscal 2007. 22 Exhibit 6 Loans by category Source: WaMu 10-K for fiscal 2007. 23 Exhibit 7 Home loans by category (including home equity loans and lines of credit) Total home loans held in portfolio consisted of the following: at December 31 2006 2005 2007 Home Loans: Short-term adjustable-rate loans Option ARMs Other ARMs Total short-term adjustable-rate loans Medium-term adjustable-rate loans Fixed-rate loans Home equity loans and lines of credit Prime home loans held in portfolio Subprime home loans Subprime home equity loans and lines of credit Total home loans held in portfolio 2004 $ $ 58,870 9,551 $ $ 63,557 6,791 $ $ 70,191 14,666 $ $ 66,310 9,065 $ 68,421 $ 70,348 $ 84,857 $ 75,375 $ $ $ 36,507 5,459 60,963 $ $ $ 26,232 2,899 52,882 $ $ $ 41,511 8,922 50,840 $ $ $ 45,197 8,562 43,648 $ 171,350 $ 152,361 $ 186,130 $ 172,782 $ $ 16,092 2,525 $ $ 18,725 2,042 $ $ 21,146 11 $ $ 19,184 2 $ 189,967 $ 173,128 $ 207,287 $ 191,968 (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 $1.73 billion, $888 million, $157 million and $11 million at December 31, 2007, 2006, 2005 and 2004, respectively. (3) Medium-term adjustable-rate loans reprice after one year. (4) Option-ARMs exclude home loans in the subprime mortgage channel. Source: WaMu 10-K for fiscal 2007 and 2005 24 Exhibit 8 Option-ARM Home Loans (excluding subprime loans) Note the discrepancy between the Option-ARM unpaid balance of $58,396 at 12/31/07 shown in the top half of the Exhibit and the Option-ARM loan balance of $58,870 shown in the lower part of the Exhibit (and in Exhibit 7). We speculate that the unpaid balance may be smaller because of advance payments from borrowers. Source: WaMu 10-K for fiscal 2007. 25 Exhibit 9 Changes in the Allowance for Loan Losses Account, 2003-2007 Source: WaMu 10-K for fiscal 2007. 26 Exhibit 10 Nonperforming Assets (i.e., noncurrent loans over 90 days past due and foreclosed assets) Source: WaMu 10-K for fiscal 2007. 27 Exhibit 11 Summary data comparing WaMu, Wells Fargo Bank and FDIC averages at yearend 2007 and 2006 FDIC FDIC WaMu WaMu Wells Fargo (86 institutions) (88 institutions) December 2007 December 2006 December 2007 December 2006 December 2007 December 2006 PROFITABILITY (in $millions) Net income (loss) Net interest income Noninterest income Noninterest expense Return on average assets Return on average common equity Efficiency ratio (noninterest expense/total revenue) $ (67) $ 8,177 $ 6,042 $ 10,600 (0.02) % (0.42) % 74.55 % $ $ $ $ $ 8,057 $ 20,974 $ 18,416 $ 22,824 1.55 % 17.12 % 57.90 % $ 8,420 $ 19,951 $ 15,740 $ 20,837 1.73 % 19.52 % 58.40 % $ $ $ $ $ $ $ $ SUPPLEMENTAL BALANCE SHEET DATA (in $millions) Total loans held in portfolio, net of allowance Allowance for loan losses Total loans held in portfolio, gross (before Allowance) Total home loans (includes home equity loans and lines of credit) Total assets Total deposits Total stockholders' equity $ 241,815 $ 2,571 $ 244,386 $ 189,967 $ 327,913 $ 181,926 $ 24,584 $ 223,330 $ 1,630 $ 224,960 $ 173,128 $ 346,288 $ 213,956 $ 26,969 $ 376,888 $ 5,307 $ 382,195 $ 146,980 $ 575,442 $ 311,731 $ 47,628 $ 315,352 $ 3,764 $ 319,116 $ 122,154 $ 481,996 $ 288,068 $ 45,814 $ 57,399 $ 782 $ 58,181 $ 49,824 $ 562 $ 50,387 $ $ $ $ 19,369 102,764 64,283 10,272 $ 17,646 $ 88,698 $ 56,538 $ 8,909 CREDIT PERFORMANCE Provision for loan losses Net charge-offs Nonperforming assets Nonaccrual loans Nonaccrual home loans (incl. home equity and lines of credit) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 564 378 479 473 204 CAPITAL ADEQUACY Tier 1 capital to average total assets (leverage) Total risk-based capital to total risk-weighted assets ASSET QUALITY and LOAN LOSS RATIOS Nonperforming assets to total assets 3,107 1,623 7,102 6,123 5,858 3,114 8,121 6,377 8,807 1.02 % 13.52 % 60.75 % 816 510 2,775 2,295 2,154 4,939 3,539 3,868 2,679 1,552 Wells Fargo Commercial Banks Assets over $10 billion 2,204 2,254 2,416 1,666 900 869 2,581 2,100 2,843 0.91 % 9.08 % 58.69 % 1,145 2,318 2,169 2,522 1.35 % 13.36 % 55.26 % $ $ $ $ $ 240 232 217 211 85 6.84 % 12.34 % 6.35 % 11.77 % 6.83 % 10.68 % 7.88 % 12.49 % 8.66 % 11.85 % 8.96 % 11.92 % 0.67 % 0.50 % 0.47 % 0.24 % % % Nonaccrual loans to total loans held in portfolio, gross Nonaccrual home loans to total home loans* Allowance for loan losses to loans held in portfolio, gross % % % % % % Allowance for loan losses to nonaccrual loans Net charge-offs to loans held in portfolio, gross Provision for loan losses to net charge-offs % % % % % % 0.70 1.06 1.39 198.10 0.93 % % % % % 139.56 % *total home loans includes home equity loans and lines of credit for prime and subprime borrowers Sources: WaMu 10-K for fiscal 2007 Wells Fargo Bank 10-K for fiscal 2007 Federal Deposit Insurance Corporation (FDIC) website, http://www2.fdic.gov/SDI/SOB/ 28 0.52 0.74 1.18 225.93 0.71 % % % % % 97.78 % 0.81 1.05 1.34 165.20 0.65 % % % % % 149.34 % 0.42 0.48 1.12 266.48 0.46 % % % % % 103.17 %