ITEM 1. BUSINESS
OVERVIEW
With a history dating back to 1889, Washington Mutual, Inc. is a financial services company committed to serving consumers and small to mid-sized businesses. At December 31, 1998, we had deposits of $85.49 billion and stockholders' equity of $9.34 billion. Based on our consolidated assets of $165.49 billion at December 31, 1998, we were the largest savings institution and the eighth largest banking company in the United States.
We operate principally in California, Washington, Oregon, Florida, Texas and Utah, and have operations in 31 other states and the District of Columbia. Through our subsidiaries, we engage in the following business activities:
- Mortgage Banking
- Consumer Banking
- Commercial Banking
- Financial Services
- Consumer Finance
Our principal business offices are located at 1201 Third Avenue, Seattle, Washington 98101. When we refer to "we" or "Washington Mutual" or the "Company" in this Form 10-K, we mean Washington Mutual, Inc., as well as its consolidated subsidiaries. When we refer to WMI, we mean Washington Mutual, Inc. exclusively.
Mortgage Banking
We conduct mortgage banking through our banking subsidiaries, Washington Mutual Bank, FA ("WMBFA"), Washington Mutual Bank ("WMB"), and Washington Mutual Bank fsb ("WMBfsb"). The principal activities conducted by our mortgage banking operations are the origination of single-family residential mortgages and residential construction loans and the associated loan servicing activities. For the year ended December 31, 1998, this group originated $43.62 billion of SFR loans (including residential construction), making us the nation's fourth largest single-family residential mortgage originator. At December 31, 1998, we had a servicing portfolio of $154.24 billion of single-family residential mortgage loans and residential construction loans. When we refer to "single-family residential mortgage" loans or "SFR" loans in this Form 10-K, we mean first lien mortgage loans on owner-occupied one-to-four-family residences.
Consumer Banking
The consumer banking business includes the sale of all consumer deposit products, including checking accounts, and the associated servicing activities as well as the origination of consumer loans through our consumer financial centers. These consumer loan products include second equity mortgage loans and lines of credit, manufactured housing loans, automobile, boat and recreational vehicle loans and education loans. We conduct consumer banking in eight states through 1,173 financial centers. The consumer banking group also has approximately 1,200 employees in its telephone banking centers. At December 31, 1998, we had $85.49 billion in deposits and a consumer loan portfolio of $5.48 billion.
Commercial Banking
This business line is comprised of our commercial real estate group and Western Bank, a separately named division of Washington Mutual Bank. This business segment offers commercial business loans and commercial real estate loans, comprised of multi-family residential loans and loans for nonresidential real estate. The Western Bank division operates primarily in Washington and Oregon and commenced operations
in California as of the beginning of 1999 under the name WM Business Bank. The commercial banking group provides personalized commercial banking services to small to mid-sized businesses and makes available multi-family shelter-based lending, commercial construction financing and other commercial real estate loans. For the year ended December 31, 1998, Western Bank had average commercial business loans outstanding of $1.49 billion compared with $1.14 billion for 1997. We also had $18.13 billion of commercial real estate loans in our portfolio.
Financial Services
The financial services business consists of WM Financial Services, Inc., a licensed broker-dealer; WM Advisors, Inc., the investment adviser to the WM Group of Funds; WM Funds Distributor, Inc., the distributor of the WM Group of Funds; and Washington Mutual Insurance Services, Inc. Through our broker- dealer, WM Financial Services, we offer a wide range of investment products to our customers, including mutual funds, variable and fixed annuities and general securities.
The WM Group of Funds is a proprietary mutual fund complex formed through the consolidation of the Composite Funds and the Sierra Trust Funds. At December 31, 1998, the WM Group of Funds consisted of 18 mutual funds, 18 variable annuities and five managed asset funds. At that date, it had 215,052 accounts and $4.93 billion in assets under management. As part of the acquisition of H. F. Ahmanson & Company ("Ahmanson") in 1998, we acquired Griffin Financial Investment Advisers, which is the investment adviser to The Griffin Funds, a mutual fund family with $1.09 billion in assets under management at December 31, 1998. The Griffin Investment Advisers merged into WM Advisors and The Griffin Funds merged into the WM Group of Funds in 1999.
Washington Mutual Insurance Services, Inc. supports the mortgage lending process by offering customers property and casualty insurance products. The group also offers insurance products to existing mortgage and deposit customers, which includes mortgage life and accidental death and dismemberment, property and casualty, and life insurance.
Consumer Finance
We conduct our consumer finance business through Aristar, Inc. and its subsidiaries ("Aristar"). Through those companies, we make direct consumer installment loans and purchase retail installment contracts from local retail establishments through a network of over 500 branch offices located in 24 states, primarily in the southeastern United States. Aristar also accepts deposits in Colorado and Utah through its industrial bank subsidiary. Aristar generally conducts its business under the names Blazer Financial, City Finance and First Community Industrial Bank. At December 31, 1998, Aristar had assets of $2.77 billion and deposits of $187.5 million.
CORPORATE DEVELOPMENTS
Acquisitions
The Keystone Transaction. In December 1996, Keystone Holdings, Inc. ("Keystone Holdings") merged into WMI. As a result of the merger and related transactions, all of Keystone Holdings subsidiaries, including American Savings Bank, F.A. ("ASB"), became our subsidiaries.
The Great Western Merger. In July 1997, Great Western Financial Corporation ("Great Western") merged into New American Capital, Inc., our wholly-owned subsidiary. As a result, all of the subsidiaries of Great Western, including Great Western Bank, a Federal Savings Bank ("GWB"), and Aristar, became our subsidiaries. In October 1997, Great Western Bank merged into American Savings Bank, which changed its name to Washington Mutual Bank, FA.
The Ahmanson Merger. On October 1, 1998, Ahmanson merged into WMI. As a result, Home Savings of America, FSB ("Home Savings") became our subsidiary. On October 3, 1998, Home Savings merged into WMBFA. Prior to our merger with Ahmanson, Ahmanson had acquired Coast Savings Financial, Inc. ("Coast"). We anticipate that the complete integration of Home Savings into WMBFA's systems will occur
in mid-1999. For purposes of segment reporting under the newly effective accounting standard, SFAS 131, Ahmanson is being treated as a separate segment for the time periods discussed. See "Notes to Consolidated Financial Statements -- Note 2: Business Combinations/Restructuring and Note 27: Lines of Business."
Other Significant Actions
On April 20, 1998, our Board of Directors declared a 3-for-2 common stock split in the form of a 50% stock dividend payable on June 1, 1998 to shareholders of record as of May 18, 1998.
On May 22, 1998, we announced a new ten-year community reinvestment commitment to the communities in which we do business. The new $120 billion pledge targets loans and other financial support to traditionally underserved communities. The pledge will take effect beginning in 1999 and replaces earlier pledges made both by us and by the companies we acquired.
On August 28, 1998, our shareholders approved an amendment to our Restated Articles of Incorporation to increase the number of authorized shares of common stock from 800 million shares to 1.60 billion shares.
On January 1, 1998, we redeemed our Series C Preferred Stock at $25.00 per share, plus unpaid dividends up to the redemption date.
On September 16, 1998, we redeemed our Series E Preferred Stock at $25.00 per share, plus unpaid dividends up to the redemption date.
On December 9, 1998, our common stock began trading on the New York Stock Exchange under the trading symbol "WM." As a result, our common stock no longer trades on The Nasdaq Stock Market.
INTEGRATION OF OPERATIONS
This section contains forward-looking statements that we have based on our best judgments and currently available information. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Accordingly, we cannot assure you that we will achieve the cost savings that we describe in the amounts or within the time periods currently estimated. See "Risk Factors" beginning on page 4 for a discussion of factors that may cause these forward-looking statements to differ from actual results.
Operations
The integration of Great Western and its subsidiaries into our operations is complete. We consolidated the administration of Great Western's payroll, employee benefit plans, incentive compensation systems, and accounts payable effective January 1, 1998. In the first and second quarters of 1998, we consolidated 86 consumer financial centers of ASB and GWB. During the second quarter of 1998, we converted 4.7 million deposit accounts representing $24.0 billion in deposits, and 1.5 million transaction card accounts at nearly 370 Great Western locations in Florida and northern and southern California. In addition, we consolidated the approximately 650,000 mortgage and consumer loans that made up the Great Western and ASB loan portfolios. By the end of third quarter 1998, we had made all staff reductions related to the Great Western Merger.
The decision in March 1998 to pursue the merger with Ahmanson caused management to revise its plan for the integration of Great Western facilities, staffing levels and the geographic location of corporate support functions. These changes affected both the cost savings that were expected to be realized from the Great Western Merger and the amount of transaction-related expenses for the Great Western Merger. In addition, certain of these charges were factored into the transaction-related expenses for the Ahmanson Merger.
We have identified 162 consumer financial centers in California to be consolidated into neighboring offices as a result of the Ahmanson Merger. We have scheduled the consolidations for mid-1999 to coincide with the projected conversion of Home Savings branches in California to Washington Mutual systems and
signage. Conversion of Home Savings branches in Texas occurred in February 1999. The conversion of all Ahmanson systems is expected to be completed in the third quarter of 1999. Upon completion of all systems conversions, it is anticipated that the Company will no longer operate from Ahmanson's Irwindale campus.
Cost Savings
Before the Great Western Merger, we projected annual pretax cost savings of $340 million as part of the benefit of the merger. We originally anticipated approximately $208 million in savings for 1998, with the full savings of $340 million being realized in 1999. Actual cost savings related to financial center consolidations and improved productivity of the mortgage banking operations were $243 million in 1998. These savings were significantly offset by an increase in volume-related expenses of $194 million and investments in de novo financial centers, upgraded information systems and other infrastructure related costs of $57 million. We expect to achieve the full projected consolidation and productivity savings of $340 million in 1999. However, expected increases in volume-related expenses resulting from increases in internal growth and market expansion, along with other increases in infrastructure-related expenses, could reduce the amount of actual cost savings that we realize in 1999. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Other Expense."
Before the Ahmanson Merger, we projected annual pretax savings of operating costs of $199 million in 1999 and $330 million in 2000 and each year thereafter as part of the benefits of that merger. We expect to achieve cost savings of $199 million in 1999. We also expect volume-related expenses to increase from internal growth and market expansion.
RISK FACTORS
COST SAVINGS MAY NOT BE REALIZED We cannot assure you that we will achieve the cost savings we anticipate through the consolidation of administrative functions or consumer financial centers, nor can we assure you that any cost savings will occur in the anticipated time periods. In addition, when consumer financial centers are closed or consolidated, financial institutions often lose customers and deposits as a result. To the extent that we lose customers or deposits significantly in excess of the amount we anticipated, our operations could be materially adversely affected, particularly in the short term. The forward-looking statements assume, based on our historical experience following acquisitions, that our customer base will remain substantially intact during the period presented in the forward-looking statements. To the extent that the change in ownership of GWB and Home Savings, the consolidation of branches of WMBFA, or other factors result in a significant temporary or long-term loss of customers, actual results of our operations may vary materially from the forward-looking information presented.
CONSUMER BANKING EXPANSION RISKS Our business plan includes increased fee income from our consumer banking operations. The sources of these fee increases include revised policies for checking account services in new consumer financial centers in California and Texas in accordance with our programs, implementation of our checking programs throughout the WMBFA system, introduction of a debit card to former Home Savings customers, improved revenues in financial services subsidiaries, and the introduction of consumer loan products in consumer financial centers. We have relatively limited experience with these business initiatives in California, Florida and Texas, where we expect the greatest expansion of our consumer banking activities to occur. Accordingly, we cannot assure you that
our emphasis on consumer banking activities will be successful in the California, Florida or Texas markets or that we will achieve the increase in fee income anticipated by our business plan.
CONCENTRATION OF OPERATIONS IN CALIFORNIA At December 31, 1998, 60% of our loan portfolio and 73% of our deposits were concentrated in California. As a result, our financial condition and results of operations will be particularly subject to the conditions in the single-family and multi-family residential markets in California. If economic conditions generally, or in California in particular, worsen or if the market for residential real estate declines, we may suffer decreased net income or losses associated with higher default rates and decreased collateral values on our existing portfolio. We might also not be able to originate the volume or type of loans or achieve the level of deposits that we currently anticipate. The forward-looking statements regarding our results of operations assume that the California economy and real estate market will remain healthy. A worsening of current economic conditions or a significant decline in real estate values in California could cause actual results to vary materially from the forward-looking statements.
INTEREST RATE RISK We realize our income principally from the differential between the interest earned on loans and investments and the interest paid on deposits and borrowings. The difference between the repricing characteristics of interest-earning assets and interest-bearing liabilities affects net interest spreads. Market interest rates have an impact on the volume and rates on loans, investments, deposits and borrowings. Significant fluctuations in interest rates and spreads may adversely affect net income. At the end of 1997, long-term interest rates declined dramatically and the yield curve (the difference between short-term and long-term interest rates) became much flatter. This interest rate environment continues. In this type of interest rate environment, our customers tend to prefer fixed-rate loans to adjustable-rate mortgages ("ARMs") and thus during 1998, originations of fixed-rate loans were substantially higher than in previous years. Lower long-term interest rates resulted in refinancing activity in 1998 that was higher than historical averages. As a result, our ability to grow our asset size by retaining ARMs in our portfolio has been and could continue to be adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset and Liability Management Strategy."
COMPETITION We face significant competition both in attracting and retaining deposits and in making loans in all of our markets. Our most direct competition for deposits has historically come from other savings institutions, credit unions and commercial banks doing business in our primary market areas of California, Washington, Oregon, Florida, Texas and Utah. As with all banking organizations, we have also experienced competition from nonbanking sources, including mutual funds and securities brokerage companies. Our most direct competition for loans comes from other savings institutions, national mortgage companies, insurance companies, commercial banks and government-sponsored enterprises ("GSEs")
such as the Fannie Mae and Freddie Mac. Competition from such sources could increase in the future and could adversely affect our ability to achieve our financial goals. In addition, competitive factors such as the lower cost structure of less regulated originators and the influence of the GSEs in establishing rates heavily influence our lending activities.
READINESS FOR THE YEAR 2000 We are taking what we believe to be the appropriate steps to avoid customer disruption from the "Year 2000 Problem." The Year 2000 Problem could cause our information systems and facilities, and those of our vendors, to malfunction or fail in 1999 and 2000. Any disruption could cause numerous problems for us, such as diminished service levels, some customer inconvenience and additional costs, which we cannot estimate now. Our failure to make our systems, or the failure of our vendors to make their systems Year 2000 ready could result in our inability to process our daily business for some period of time or in other significant business interruptions.
During 1998, we incurred expenses of $11.8 million to complete the inventory and assessment and the renovation phases of our "Year 2000 Project" to become Year 2000 ready. We have finished the testing of internal systems, the failure of which would have a major impact on customers. Work on the final phases involving validation, due diligence on third-party services, testing of interactions between our most critical internal systems, testing of interactions with service providers and vendors and development of contingency plans is proceeding. We expect to incur additional expenses of approximately $15.6 million in 1999.
We have adopted business contingency plans for our most critical information systems and facilities. If we are required to implement these contingency plans, we believe that we will minimize the effect on customers that would occur in a temporary disruption in services. If a prolonged disruption or failure occurs, our contingency plans may not operate as anticipated and our results of operations may be adversely affected.
Despite our efforts, there is always the possibility that we may not identify and correct a Year 2000 Problem in our information systems and facilities and those of our suppliers before they occur or that our contingency plans may not be adequate. Our efforts to identify and address these problems, and the expenses or liabilities we may incur to fix them, could materially and adversely affect our financial condition and results of operations. In addition, federal regulators may issue new regulations that require us to perform additional work. If issued, new regulations could increase the cost or delay completion of our Year 2000 Project.
Although we are reviewing the Year 2000 compliance efforts of our vendors, we cannot be sure that their efforts will be sufficient to avoid a Year 2000 Problem.
MORTGAGE BANKING
General
Our mortgage banking activities are carried out by our banking subsidiaries, WMBFA, WMB and WMBfsb. Each of our banking subsidiaries has broad lending powers, but statutory restrictions limit total investment in different types of loans. All of our residential mortgage lending is subject to nondiscriminatory underwriting standards. All loans are subject to underwriting review and approval by various levels of our personnel, depending on the size and characteristics of the loan.
We require title insurance on all first liens on real property securing loans. We also require our borrowers to maintain property and casualty insurance in an amount at least equal to the total of our loan amount plus all prior liens on the property or the replacement cost of the property, whichever is less.
Federal guidelines require depository institutions to adopt written policies that establish appropriate limits and standards for real estate loans consistent with regulatory guidelines. According to these guidelines:
- we should not originate any commercial, multi-family or nonowner-occupied SFR loan (including builder construction loans) with an initial loan-to-value ratio in excess of 85%;
- we should not originate any owner-occupied SFR loan with a loan-to-value ratio of 90% or above at origination, unless such loan is protected by appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral; and
- in appropriate circumstances, we may originate mortgage loans with loan-to-value ratios exceeding these specified levels, if (i) the aggregate amount of all loans in excess of these limits does not exceed a specified level of our total capital and (ii) such loans are identified in our records and reported at least quarterly to our Board of Directors.
At December 31, 1998, 6% of our SFR loan portfolio had loan-to-value ratios of 90% or above at origination and were without mortgage insurance.
SFR Lending
In 1998, we were the leading originator of SFR loans in Washington and Oregon and the second leading originator in California. We make available to borrowers a full range of SFR loans, including FHA-insured and VA-guaranteed loans, conventional fixed-rate loans with a variety of maturities and amortization schedules, and ARMs. ARMs are advantageous to us because adjustable-rate loans better match the interest rate characteristics of our liability base. In recent years, and particularly in the California market, we have emphasized the origination of ARMs. As a result of the interest rate environment that began in 1997 and is continuing, however, our customers have preferred fixed-rate loans and accordingly, 56% of our SFR loan originations in 1998 were fixed rate.
The primary ARM products that we currently offer are indexed to the 12-month average of annual yields on actively traded United States Treasury securities adjusted to a constant maturity of one year ("MTA"). Under our current ARM programs, the borrower may choose among loans that have the initial interest rate fixed for one, three or five years before the adjustments begin. With some products, the borrower may elect, between the sixth and the 60th months, to convert to a fixed-rate loan payable over the remainder of the original term. There is no conversion fee, and the fixed interest rate is indexed to the then current required net yield for loans sold to Fannie Mae. There are a variety of payment options, some of which permit negative amortization.
We originate loans through our consumer financial centers in Washington, Oregon, Utah, Idaho and Montana and through home loan centers and mortgage brokers in 29 states and the District of Columbia. In 1998, we originated loans for the first time through our consumer financial centers in California and Florida. Nearly half of our loans were originated through mortgage brokers. To monitor credit quality, we conduct extensive due diligence and review the stability and credit experience of each broker prior to accepting any
loan packages. We subject loan production from the wholesale channel to the same underwriting standards as loan production from our internal channels.
We originate loans that meet GSE standards for sale in the secondary market ("conforming loans") as well as loans that meet our underwriting standards but not the secondary market standards of the GSEs ("nonconforming loans"). Nonconforming loans constituted approximately half of 1998's total SFR originations. These loans may be nonconforming because:
- they exceed the maximum amount allowed by the secondary market ("jumbo loans");
- the loan documentation lacks some information relating to the borrower's credit or employment history but not the value of the collateral; or
- the borrower's credit history fails to meet secondary market standards.
All nonconforming loans are fully supported by appraisals and title insurance. In addition, the permitted loan-to-value ratios are generally lower for nonconforming loans than for conforming loans, and they decrease as the amount of the loan increases.
SFR Construction Loans
We finance two different categories of SFR construction loans. We make custom construction loans to the intended occupant of a house to finance the house's construction. We typically combine construction phase financing with permanent financing of the completed home. We make builder construction loans to borrowers that are in the business of building homes for resale. We make builder construction loans on a house-by-house basis or, in certain circumstances, through a collateralized, limited line of credit. Builder construction loans involve somewhat more risk and different underwriting considerations than custom construction loans.
Before we make an SFR construction loan, the borrower must obtain the approval of various levels of our personnel, depending on the size and characteristics of the loan. The approval requirements for SFR construction loans are more stringent for properties other than single-family detached houses than for single-family detached houses.
SFR construction loans are an integral part of our overall lending program. Builder construction loans are of short duration, generally 12 to 18 months and are generally priced at a higher rate than permanent residential loans. Custom construction loans may also be of short duration, generally 9 to 12 months, or may be 15 to 30 years if combined with permanent financing.
At December 31, 1998, 51% of our SFR construction portfolio was custom construction loans and 49% was builder construction loans. Originations of SFR construction loans for 1998 totaled $1.75 billion, an increase of 21% from $1.45 billion in 1997. We made substantially all of our 1998 SFR construction loan originations in Washington, Oregon, Utah, Idaho and California.
CONSUMER BANKING
Through our banking subsidiaries, we offer consumer loan programs in California, Washington, Oregon, Utah, Idaho, Montana, Florida and Texas. These consumer loan programs include:
- manufactured housing loans;
- second mortgage loans for purposes unrelated to the property securing the loan and for a variety of purposes related to the property, including its renovation or remodeling;
- purchase money loans for automobiles, pleasure boats and recreational vehicles;
- student loans;
- loans secured by deposit accounts;
- secured and unsecured loans made under our line of credit programs; and
- small business lines of credit of $100,000 or less.
In addition to being an important part of our orientation toward consumer financial services, consumer loans provide greater net interest income due to their generally higher yields. The size of our consumer loan portfolio has grown in recent years as we have begun to introduce these products into WMBFA's service area.
Consumer loans generally are secured loans. Our decision to make a consumer loan is based on an evaluation of the collateral and the borrower's creditworthiness, including such factors as income, other indebtedness and credit history. Lines of credit are subject to our periodic review. If a borrower's financial circumstances change, then we may revise or cancel the borrower's line of credit as we deem appropriate. Consumer lending may involve special risks, including decreases in the value of collateral and transaction costs associated with realization on the collateral.
Our consumer banking operations also offer various consumer deposit products, including money market deposit accounts ("MMDAs") and checking accounts as well as the more traditional savings accounts and time deposit accounts. MMDAs generally require higher minimum balances and offer higher yields than savings accounts. We offer interest-bearing and noninterest-bearing checking accounts. We assess monthly service charges on interest-bearing checking accounts, unless the depositor maintains a minimum balance. We assess no monthly fees on the vast majority of our noninterest-bearing checking accounts.
At December 31, 1998, we had $85.49 billion in deposits as follows:
Since 1995, we have been actively promoting a checking account product called "Free Checking" which we introduced into our California and Florida operations during 1997. This account has helped to reduce our overall cost of funds by increasing the percentage of deposits that are noninterest bearing. We expect to continue actively promoting our "Free Checking" account throughout our markets. We also actively have promoted MMDAs because they have the advantage of being variable-rate liabilities and are generally lower costing than time deposits.
COMMERCIAL BANKING
We offer a full range of commercial banking products and services, primarily through the Western Bank division of WMB. Our commercial business loans are mainly loans to individuals and to small to mid-sized businesses. Some of these loans are unsecured. A variety of business and personal assets secure the others. In 1998, we originated $1.01 billion of commercial business loans. Our commercial business loan portfolio totaled $1.13 billion at December 31, 1998.
In addition, we provide loans to commercial real estate owners and developers. Commercial real estate lending generally entails greater risks than residential mortgage lending, although less risk than commercial business lending. Commercial real estate loans typically involve large loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment experience on loans secured by income-producing properties usually depends on the successful operation of the real estate project that secures the loan and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy, particularly the interest rate environment. Commercial real estate values tend to be cyclical and, while commercial real estate values trended upward in many areas of the country in 1998, we carefully monitor the commercial real estate environment to determine the level of our activity in this area.
In all commercial real estate lending, we consider the location, marketability and overall attractiveness of the project. Our current underwriting guidelines for commercial real estate loans require us to perform an economic analysis of each property with regard to the annual revenue and expenses, debt service coverage and fair value to determine the maximum loan amount. Before we make a commercial real estate loan, the borrower must obtain the approval of various levels of our personnel, depending on the size and characteristics of the loan.
Historically, we focused our commercial real estate lending on small to mid-sized apartment lending (loans of $2.5 million or less). Beginning in 1996, we broadened our lending scope by increasing our nonresidential real estate lending at a faster pace than our apartment lending. This change in emphasis reflected, in part, the development of our commercial banking operations which we began in 1995. Home Savings, however, had restricted its commercial real estate lending to apartments since 1990. The acquisition of Home Savings has substantially changed the makeup of our commercial real estate loan portfolio. At December 31, 1998, our commercial real estate portfolio contained $14.55 billion in apartment loans and $3.58 billion in nonresidential commercial real estate loans.
FINANCIAL SERVICES
Our financial services business consists of WM Financial Services, Inc., a licensed broker-dealer; WM Advisors, Inc., the investment adviser to WM Group of Funds; WM Funds Distributor, Inc., the distributor of the WM Group of Funds; and Washington Mutual Insurance Services, Inc. Through our broker-dealer, WM Financial Services, we offer a wide range of investment products to our customers, including mutual funds, variable and fixed annuities and general securities. At December 31, 1998, we operated in seven states and had 319 financial consultants and 559 licensed personal financial representatives. On January 1, 1999, the broker-dealer formerly owned by Ahmanson, Griffin Financial Services, merged into WM Financial Services, so that our broker-dealer now operates in one additional state, has 159 additional financial consultants and has 55 additional personal financial representatives.
Our WM Group of Funds is a proprietary mutual fund complex formed through the consolidation of our Composite Funds and Great Western's Sierra Trust Funds. At December 31, 1998, the WM Group of Funds consisted of 18 mutual funds, 18 variable annuities and five managed asset funds, and had 215,052 accounts and $4.93 billion in assets under management. We distribute these mutual funds, non-proprietary mutual funds and variable annuities to our customers through the WM Financial Services network located in the branches of our subsidiary banks and to non-customers through a network of unaffiliated broker-dealers. Ahmanson's mutual fund group, The Griffin Funds, merged with the WM Group of Funds during March of 1999. At December 31, 1998, The Griffin Funds had $1.09 billion in assets.
Washington Mutual Insurance Services supports the mortgage lending process by offering property and casualty insurance products. The group also offers mortgage life and accidental death and dismemberment, property and casualty, and life insurance products to existing mortgage and deposit customers.
CONSUMER FINANCE
Aristar makes direct consumer installment loans, including real estate secured loans, and purchases retail installment contracts from local retail establishments. Aristar also issues a credit card to facilitate revolving credit transactions. These consumer credit transactions are primarily for personal, family or household purposes. Installment loans typically have original terms ranging from 12 to 360 months. In 1998, originations had an average original term of 63 months. In the year ended December 31, 1998, 72% of the originations of all installment loans were unsecured or secured by luxury goods, automobiles or other personal property. The remaining 28% were secured by real estate. We generally acquire retail installment contracts without recourse to the originating merchant. These contracts are typically written with original terms of three to 60 months and for 1998 had an average original term of 27 months.
The loans made by Aristar have a higher yield than the SFR loans and consumer loans made by our banking subsidiaries, because these loans tend to have higher risk. Many of Aristar's borrowers would not qualify for a loan from our banking subsidiaries due to high debt-to-income ratios. In addition, Aristar makes home equity loans primarily where the proceeds are used for purposes unrelated to the property securing the loan, and thus bears more risk relating to declining collateral values.
Aristar currently operates in 24 states, primarily in the southeastern United States. In 1998, Aristar significantly increased its lending volume in Texas as a result of changes in state law, which permitted non-purchase money home equity lending in Texas beginning January 1, 1998. For the first time in Texas, lenders may make home equity loans for purposes unrelated to the property.
TREASURY ACTIVITIES
Our treasury department has three primary responsibilities:
- interest rate risk management;
- acquisition of funds; and
- investment of excess funds.
It manages these responsibilities primarily through the purchase and sale of mortgage-backed securities and whole loans in the secondary market and through its borrowing practices.
Investing Activities
One way in which we manage our interest rate risk is by purchasing and selling mortgage-backed securities in the secondary market. Mortgage-backed securities ("MBS") are pools of loans that are transferred to a single purpose trust or other special purpose entity created for the securitization. Certificates issued by the trust or other special purpose entity represent undivided ownership interests in those loans transferred to the trust or other special purpose entity. Securitization of our loans provides us with increased liquidity both because MBS are more readily marketable than the underlying loans and because MBS can be used more readily as collateral for borrowing. During 1998, we also purchased a substantial amount of MBS and whole loans in the secondary market in order to increase our asset base.
Prior to 1998, the primary ARM product originated by our operations in California was indexed to the Cost of Funds Index of the Eleventh District Federal Home Loan Bank (San Francisco) ("COFI"). At December 31, 1998, approximately 49% of our real estate loan portfolio and 58% of our MBS were indexed to COFI. The MBS we purchased in 1998 were both fixed rate and adjustable rate tied to indices other than COFI. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset and Liability Management Strategy."
We generally securitize a substantial portion of our fixed-rate SFR loan production in order to sell the MBS in the secondary market. When we securitize and sell these fixed-rate loans without recourse, as we generally do, they become obligations of the applicable GSE. Generally, we retain the right to service these loans for a fee fixed by the GSE.
Beginning in 1995, we securitized loans with Fannie Mae and Freddie Mac under programs in which they have recourse against us as the originator of the loans ("Recourse MBS"). These securitizations primarily involve ARMs. They generally are less costly and sometimes require less documentation than securitizations without recourse. We generally can sell these Recourse MBS in the secondary market or use them to collateralize borrowings and to meet regulatory liquidity requirements. We have retained the majority of Recourse MBS in our portfolio. The remainder were sold to third parties. We establish a recourse liability to cover the estimated loss on these obligations.
We also purchase private issue MBS, collateralized mortgage obligations ("CMOs"), and loan pools in the secondary market. The yield on these assets generally exceeds the yield on agency MBS because they expose us to certain risks that are not inherent in agency MBS, such as credit risk and liquidity risk. Neither the U.S. government nor any of its agencies guarantees these assets, because the loan size, underwriting or underlying collateral often does not meet set industry standards. Consequently, the potential for loss of the principal investment is higher than for agency MBS. Furthermore, the complex structure of certain CMOs in our portfolio increases the difficulty in assessing the portfolio's risk and its fair value. Examples of some of the more complex structures include certain CMOs where we hold subordinated tranches, certain CMOs that have been resecuritized and certain securities that contain a significant number of loans with principal balances in amounts larger than can be sold as agency MBS.
Beginning in 1999, we began to acquire sub-prime single-family mortgage loans in order to increase the yield in our loan portfolio. Loans are classified as sub-prime because the borrowers have had past credit problems or have high debt-to-income ratios. These borrowers would typically not qualify for conforming
loans. We anticipate that we will purchase increased amounts of sub-prime loans in 1999. While we screen the portfolios of sub-prime loans we purchase for unacceptable credit risk, these loans by their nature bear more credit risk than is found in conforming loans that we originate or in agency MBS and, accordingly, we expect that loan charge offs on these portfolios will be higher than on our other portfolios.
We have instituted a policy of performing credit reviews on each individual security or loan pool prior to purchase. Such a review includes consideration of the collateral characteristics, borrower payment histories and information concerning loan delinquencies and losses of the underlying collateral. After a security is purchased, similar information is monitored on a periodic basis. Furthermore, we have established internal guidelines limiting the geographic concentration of the underlying collateral.
Under federal and state law, our banking subsidiaries must maintain a minimum amount of assets that qualify as liquid for regulatory purposes. WMBFA and WMBfsb have authority to make investments specified by the Home Owners' Loan Act ("HOLA") and applicable regulations, including the purchase of governmental obligations, investment grade commercial paper, and investment grade corporate debt securities. Under Washington state law, WMB has authority, subject to a numerical limit, to make any investment deemed prudent by its board of directors, and may invest in commercial paper, corporate bonds, mutual fund shares, debt and equity securities issued by creditworthy entities and interests in real estate located inside or outside of Washington State. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), however, prohibits a state bank (such as WMB) from making or retaining equity investments that are not permissible for a national bank, subject to certain exceptions. Despite these broad investment powers, at December 31, 1998, MBS accounted for $46.42 billion or 99% of our total investment portfolio. At December 31, 1998, 75% of MBS were agency MBS. The remainder, $11.73 billion, were private issue MBS and CMOs. See "Notes to Consolidated Financial Statements -- Note 4: Securities."
Borrowing Activities
Because deposits have generally declined in recent years, we increasingly have relied on wholesale borrowings to fund our asset growth. Borrowings include securities sold under agreements to repurchase ("reverse repurchase agreements"), the purchase of federal funds, the issuance of mortgage-backed bonds or notes, capital notes and other types of debt securities, the issuance of commercial paper, and funds obtained as advances from the Federal Home Loan Bank ("FHLB") of Seattle, the FHLB of San Francisco and the FHLB of Topeka. We also have access to the Federal Reserve Bank's discount window. Under Washington state law, WMB may borrow up to 30% of its total assets, but reverse repurchase agreements are not deemed borrowings under such law, and the 30% does not apply to borrowings from federal, state or municipal governments, agencies or instrumentalities, including the FHLBs.
We actively engage in reverse repurchase agreements with authorized broker-dealers and major customers, selling U.S. government and corporate debt securities and MBS under agreements to repurchase them or similar securities at a future date. At December 31, 1998, we had $17.52 billion of such borrowings.
WMB and WMBfsb are members of the FHLB of Seattle and WMBFA is a member of the FHLB of San Francisco. As members, each company maintains a credit line that is a percentage of its total regulatory assets, subject to collateralization requirements. At year-end 1998, WMBFA, WMB and WMBfsb had credit lines ranging from 40% to 50% of total assets. At December 31, 1998, advances under these credit lines totaled $39.75 billion and were secured by mortgage loans, MBS and U.S. government and agency securities.
A member of an FHLB is generally required to purchase stock of the FHLB in an amount equal to at least 5% of the aggregate outstanding advances made by the FHLB to the member. At December 31, 1998, we held stock in FHLBs with an aggregate value of $2.03 billion.
We offer wholesale deposits, primarily time deposit accounts, to political subdivisions and public agencies. Generally, these deposits must be collateralized. We consider wholesale deposits to be a borrowing source rather than a customer relationship.
In addition to the borrowings discussed above, at December 31, 1998, we were in a position to borrow an additional $33.66 billion, primarily through the use of collateralized borrowings using unpledged mortgage-
backed securities and other wholesale borrowing sources. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity."
ASSET QUALITY
We maintain an allowance to absorb credit losses inherent in the loan portfolio. The allowance is based on an ongoing, quarterly assessment of the probable estimated losses inherent in the loan portfolio, and to a lesser extent, unused commitments to provide financing. This quarterly analysis provides a mechanism for ensuring that estimated losses reasonably approximate actual observed losses, as any differences between estimated and actual losses will be immediately addressed in the assessment and resulting loan loss provision.
In analyzing our existing loan portfolios, we apply specific monitoring policies and procedures which vary according to the relative risk profile and other characteristics of the loans within the various portfolios. Our SFR, consumer loans, consumer finance loans and commercial real estate loans under $1 million are relatively homogeneous, and no single loan is individually significant in terms of its size or potential risk of loss. Therefore, we review these portfolios by analyzing their performance as a pool of loans and no reserves are allocated to any specific loan. Our determination of the level of the reserve and, correspondingly, the provision for loan losses for these homogenous loan pools rests upon various judgments and assumptions used to determine the risk characteristics of the portfolio. These judgments are supported by analyses that fall into three general categories: (i) current and anticipated economic conditions; (ii) a predictive analysis of the outcome of the current portfolio (a migration analysis); and (iii) our prior loan loss experience. These systematic analyses provide a self-correcting mechanism to reduce differences between estimated and actual observed losses in the portfolios.
In contrast, our monitoring process for the commercial real estate over $1 million, commercial business and builder construction loan portfolios includes a periodic review of individual loans. Loans that are performing but have shown some signs of weakness are evaluated under more stringent reporting and oversight. We review these loans to assess the ability of the borrowing entity to continue to service all of its interest and principal obligations and, as a result, may adjust the risk grade accordingly. In the event that we believe that full collection of principal and interest is not reasonably assured, the loan will be appropriately downgraded and, if warranted, placed on nonaccrual status. In that event, an allocated reserve will be established for it, even though the loan may be current as to principal and interest payments.
We have a Credit Policy Committee ("CPC") that provides reports to the Board of Directors and continuously reviews loan quality. We also have internal staff regularly review the classification of commercial business loans and commercial real estate loans over $1 million and report such classification to the CPC. Such reviews also assist management in establishing the level of the reserve. We are also examined by our primary regulators. These examinations generally occur annually and target various of our activities, including specific segments of the loan portfolio.
EMPLOYEES
Our number of full-time equivalent employees decreased from 27,661 at December 31, 1997 to 27,330 at December 31, 1998. We believe that we have been successful in attracting quality employees and that our employee relations are good.
BUSINESS COMBINATIONS
Most of our growth since 1988 has occurred as a result of banking business combinations. The following table summarizes our business combinations since April 1988:
See "Notes to Consolidated Financial Statements -- Note 2: Business Combinations/Restructuring" for a discussion of accounting treatment for certain of the acquisitions.
TAXATION
General
For federal income tax purposes, we report our income and expenses using the accrual method of tax accounting and use the calendar year as our tax year. Except for the interest expense rules pertaining to certain tax-exempt income applicable to banks and the bad debt reserve deduction repealed in 1996, we are subject to federal income tax, under existing provisions of the Internal Revenue Code of 1986, as amended (the "Code"), in generally the same manner as other corporations.
Tax Bad Debt Reserve Recapture
The Small Business Job Protection Act of 1996 (the "Job Protection Act") requires that qualified thrift institutions, such as WMBFA, WMB and WMBfsb, generally recapture for federal income tax purposes that portion of the balance of their tax bad debt reserves that exceeds the December 31, 1987 balance, with certain adjustments. Such recaptured amounts generally are to be taken into ordinary income ratably over a six-year
period beginning in 1997. The amount we would have to pay (based upon current federal income tax rates) in federal income taxes each year of the six-year period due to the Job Protection Act is not material.
The Job Protection Act also repeals the reserve method of accounting for tax bad debt deductions. Thus, it requires thrifts to calculate the tax bad debt deduction based on actual current loan losses.
State Income Taxation
The states of California, Oregon, Florida, Utah, Idaho and Montana, as well as many other states in which we do business, have corporate income taxes, which are imposed on companies doing business in those states. Our operations in California, Oregon and Florida result in substantial corporate income tax expense in those states. As our operations in the remaining states increase, these state corporate income taxes will have an increasing effect on our results of operations or financial condition.
The state of Washington does not currently have a corporate income tax. Washington imposes on businesses a business and occupation tax based on a percentage of gross receipts. Currently, the tax does not apply to interest received on loans secured by first mortgages or deeds of trust on residential properties. However, it is possible that legislation will be introduced that would repeal or limit this exemption.
Assistance Agreement
As a result of the Keystone Transaction and related transactions in 1996, WMI and certain of its affiliates are parties to an agreement (the "Assistance Agreement") with a predecessor of the Federal Savings & Loan Insurance Corporation ("FSLIC") Resolution Fund (the "FRF"). The Assistance Agreement provides, in part, for the payment to the FRF over time of 75% of most of the federal tax savings and 19.5% of most of the California tax savings (in each case computed in accordance with specific provisions contained in the Assistance Agreement) attributable to the utilization of certain tax loss carryforwards of New West Federal Savings and Loan Association ("New West"). The provision for such payments is reflected in the financial statements as a part of the line item -- income taxes. See "Notes to Consolidated Financial Statements -- Note 17: Income Taxes."
ENVIRONMENTAL REGULATION
Our business and properties are subject to federal and state laws and regulations governing environmental matters, including the regulation of hazardous substances and wastes. For example, under the federal Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") and similar state laws, owners and operators of contaminated properties may be liable for the costs of cleaning up hazardous substances without regard to whether such persons actually caused the contamination. Such laws may affect us both as an owner of properties used in or held for our business, and as a secured lender of property that is found to contain hazardous substances or wastes.
Although CERCLA and similar state laws generally exempt holders of security interests, the exemption may not be available if a secured party engages in the management of its borrower or the collateral property in a manner deemed beyond the protection of the secured party's interest. Recent federal and state legislation, as well as guidance issued by the United States Environmental Protection Agency and a number of court decisions, have provided assurance to lenders regarding the activities they may undertake and remain within CERCLA's secured party exemption. However, these assurances are not absolute and generally will not protect a lender or fiduciary that participates or otherwise involves itself in the management of its borrower, particularly in foreclosure proceedings. As a result, CERCLA and similar state statutes may influence our decision whether to foreclose on property that is found to be contaminated. Our general policy is to obtain an environmental assessment prior to foreclosure on commercial property. The existence of hazardous substances or wastes on such property may cause us to elect not to foreclose on the property, thereby limiting, and in some instances precluding, us from realizing on such loans.
REGULATION AND SUPERVISION
References in this section to applicable statutes and regulations are brief and incomplete summaries only. You should consult the statutes and regulations for a full understanding of the details of their operation.
General
As a savings and loan holding company, WMI is subject to regulation by the Office of Thrift Supervision ("OTS"). WMBFA and WMBfsb are federal savings associations and are subject to extensive regulation and examination by the OTS, which is their primary federal regulator. Their deposit accounts are insured through the Savings Association Insurance Fund (the "SAIF") and, to a lesser extent, the Bank Insurance Fund (the "BIF") by the FDIC, which also has some authority to regulate WMBFA and WMBfsb. WMB is subject to regulation and supervision by the Director of Financial Institutions of the State of Washington ("State Director"). The FDIC insures the deposit accounts of WMB through both the BIF and SAIF. The FDIC examines and regulates WMB and other state-chartered banks that are not members of the Federal Reserve System ("FDIC-regulated banks"). Federal and state laws and regulations govern, among other things, investment powers, deposit activities, borrowings, maintenance of guaranty funds and retained earnings.
We also own a small industrial bank, First Community Industrial Bank ("FCIB"), in Denver, Colorado. FCIB is a state-chartered institution that is regulated by Colorado state authorities in addition to the FDIC. State law specifies the investments that this institution may make and the activities in which it may engage.
State and federal laws govern our consumer finance subsidiaries. Federal laws relate primarily to fair credit practice matters. State laws establish applicable licensing requirements, provide for periodic examinations and establish maximum finance charges on credit extensions.
Holding Company Regulation
WMI is a multiple savings and loan holding company, as defined by federal law, because it owns three savings associations: WMB, WMBFA and WMBfsb. WMB is a state-chartered savings bank that has elected to be treated as a savings association for purposes of the federal savings and loan holding company law. WMI is treated as a unitary savings and loan holding company, because WMBFA and WMBfsb are deemed to have been acquired in supervisory transactions. Therefore, certain restrictions under federal law on the activities and investments of multiple savings and loan holding companies do not apply to WMI. These restrictions will apply to WMI if WMB, WMBFA or WMBfsb fails to be a qualified thrift lender ("QTL"). By this we mean generally that:
- at least 65% of a specified asset base must consist of: loans to small businesses, including credit card loans; education loans; or certain assets related to domestic residential real estate, including residential mortgage loans and mortgage securities; or
- at least 60% of total assets must consist of cash, government or agency debt or equity securities, fixed assets, or loans secured by: deposits; real property used for residential, educational, church, welfare or health purposes; or real property in certain urban renewal areas.
Each of WMB, WMBFA and WMBfsb is currently in compliance with QTL standards. Failure to remain a QTL would restrict the ability of WMBFA, WMBfsb or WMB to obtain advances from the FHLB. Failure to remain a QTL also would restrict the ability of WMBFA or WMBfsb to branch and pay dividends. The OTS
has recently proposed a regulation that could affect WMI's treatment as a unitary savings and loan holding company. See "-- Recent and Proposed Federal Legislation and Regulation."
Acquisitions by Savings and Loan Holding Companies. Neither WMI nor any other person may acquire control of a savings institution or a savings and loan holding company without the prior approval of the OTS, or, if the acquirer is an individual, the OTS' lack of disapproval. In either case, the public must have an opportunity to comment on the proposed acquisition, and the OTS must complete an application review. Without prior approval from the OTS, WMI may not acquire more than 5% of the voting stock of any savings institution that is not one of its subsidiaries.
Annual Reporting; Examinations. Under HOLA and OTS regulations WMI, as a savings and loan holding company, must file periodic reports with the OTS. In addition, WMI must comply with OTS recordkeeping requirements.
WMI is subject to holding company examination by the OTS. The OTS may take enforcement action if the activities of a savings and loan holding company constitute a serious risk to the financial safety, soundness or stability of a subsidiary savings association.
Commonly Controlled Depository Institutions; Affiliate Transactions. Depository institutions are "commonly controlled" if they are controlled by the same holding company or if one depository institution controls another depository institution. WMI controls WMB, WMBFA, WMBfsb and FCIB. The FDIC has authority to require FDIC-insured banks and savings associations to reimburse the FDIC for losses it incurs in connection either with the default of a "commonly controlled" depository institution or with the FDIC's provision of assistance to such an institution.
WMB, WMBFA and WMBfsb, as holding company subsidiaries that are depository institutions, are subject to both qualitative and quantitative limitations on the transactions they conduct with WMI and its other subsidiaries.
Capital Adequacy. WMI is not subject to any regulatory capital requirements, but each of its subsidiary depository institutions is subject to various capital requirements. See "-- Capital Requirements."
Subsidiary Savings Institution Regulation. As federally-chartered savings associations, WMBFA and WMBfsb are subject to regulation and supervision by the OTS. As a state-chartered savings bank, WMB is subject to regulation and supervision by the State Director and the FDIC.
State Regulation and Supervision. State statutes empower savings banks in Washington, such as WMB, to conduct, subject to various conditions and limitations, business activities that include the following:
- accept deposits and pay interest on them;
- make loans on or invest in residential and other real estate;
- make consumer loans;
- make commercial loans;
- invest in corporate obligations, government debt securities, and other securities; and
- offer various trust and banking services to their customers.
Under state law, savings banks in Washington also generally have all of the powers that federal mutual savings banks have under federal laws and regulations.
Restrictions on Subsidiary Savings Institution Dividends. WMI's principal sources of funds are cash dividends paid to it by its banking and other subsidiaries, investment income and borrowings. Federal and state law limits the ability of a depository institution, such as WMB, WMBFA or WMBfsb, to pay dividends or make other capital distributions.
Washington state law prohibits WMB from declaring or paying a dividend greater than its retained earnings if doing so would cause its net worth to be reduced below (i) the amount required for the protection of preconversion depositors or (ii) the net worth requirements, if any, imposed by the State Director.
OTS regulations limit the ability of savings associations such as WMBFA and WMBfsb to pay dividends and make other capital distributions. The regulations currently establish a three-tiered system of regulation, with the greatest flexibility afforded to institutions that meet or exceed the capital requirements.
A savings association that has capital immediately prior to, and on a pro forma basis after giving effect to, a proposed capital distribution that is at least equal to its capital requirements is considered a "Tier 1 association." At December 31, 1998, WMBFA and WMBfsb were Tier 1 associations. Unless the OTS has notified a Tier 1 association that it requires more than normal supervision, the association may make capital distributions during a calendar year up to the greater of:
- 100% of its net income to date during the calendar year plus the amount that would reduce the association's "surplus capital ratio" (the institution's excess capital over its capital requirement) to one-half of its surplus capital ratio at the beginning of the calendar year, or
- 75% of the association's net income over the most recent four-quarter period.
The association must give 30 days' prior notice to the OTS, but OTS approval is not required. In addition, a Tier 1 association may make capital distributions in excess of the foregoing limits if the OTS does not object within a 30-day period following notice by the association.
The OTS has amended its capital distribution regulation effective April 1, 1999. Associations (such as WMBFA and WMBfsb) that are subsidiaries of a savings and loan holding company must file a notice with the OTS at least 30 days before the proposed declaration of a dividend or approval of the proposed capital distribution by its Board of Directors. In addition, the savings institution now must obtain prior approval from the OTS if it fails to meet certain regulatory conditions or if, after giving effect to the proposed distribution, the institution's capital distributions in a calendar year would exceed its year-to-date net income plus retained net income for the preceding two years or the association would not be at least adequately capitalized.
FDIC Insurance
The FDIC insures the deposits of each of our banking subsidiaries to the applicable maximum in each institution. The FDIC administers two separate deposit insurance funds, the BIF and the SAIF. The BIF is a deposit insurance fund for commercial banks and some state-chartered savings banks. The SAIF is a deposit insurance fund for most savings associations. WMB and FCIB are members of the BIF, but a portion of WMB's deposits is insured through the SAIF. WMBFA and WMBfsb are members of the SAIF, but a portion of WMBFA's deposits is insured through the BIF. WMB and WMBFA are subject to payment of annual assessments ratably to both funds.
The FDIC has established a risk-based system for setting deposit insurance assessments. Under the risk-based assessment system, an institution's insurance assessments vary according to the level of capital the institution holds and the degree to which it is the subject of supervisory concern. In addition, regardless of the potential risk to the insurance fund, federal law requires the FDIC to establish assessment rates that will maintain each insurance fund's ratio of reserves to insured deposits at $1.25 per $100. Both funds currently meet this reserve ratio. During 1998, the assessment rate for both SAIF and BIF deposits ranged from 0% to 0.27% of covered deposits. WMB, WMBFA and FCIB qualify for the lowest rate on their BIF deposits, and WMB, WMBFA and WMBfsb qualify for the lowest rate on their SAIF deposits. Accordingly, none of these institutions paid any deposit insurance assessments in 1998.
In addition to deposit insurance assessments, the FDIC is authorized to collect assessments against insured deposits to be paid to the Finance Corporation ("FICO") to service FICO debt incurred in the 1980s. The FICO assessment rate is adjusted quarterly. The current FICO assessment rate for BIF-insured deposits is 1.22 cents per $100 of deposits per year and 6.10 cents per $100 of deposits per year for SAIF-insured deposits.
Capital Requirements
Each of our subsidiary depository institutions is subject to various capital requirements. WMB and FCIB are each subject to FDIC capital requirements, while WMBFA and WMBfsb are subject to OTS capital requirements.
WMB and FCIB. FDIC regulations recognize two types or tiers of capital: core ("Tier 1") capital and supplementary ("Tier 2") capital. Tier 1 capital generally includes common stockholders' equity and noncumulative perpetual preferred stock less most intangible assets. Tier 2 capital, which is limited to 100% of Tier 1 capital, includes such items as qualifying general loan loss reserves, cumulative perpetual preferred stock, mandatory convertible debt, term subordinated debt and limited life preferred stock; however, the amount of term subordinated debt and intermediate term preferred stock (original maturity of at least five years but less than 20 years) that may be included in Tier 2 capital is limited to 50% of Tier 1 capital.
The FDIC uses a combination of risk-based guidelines and leverage ratios to evaluate capital adequacy. Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. For example, U.S. Treasury bills and GNMA securities are placed in the 0% risk category, Fannie Mae and Freddie Mac securities are placed in the 20% risk category, loans secured by SFR properties and certain private issue MBS are generally placed in the 50% risk category, and commercial real estate and consumer loans are generally placed in the 100% risk category. These risk weights are multiplied by corresponding asset balances to determine a risk-weighted asset base. Certain off-balance sheet items are added to the risk-weighted asset base by converting them to a balance sheet equivalent and assigning them the appropriate risk weight in one of four categories.
Under FDIC guidelines, the ratio of total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8.00%, and the ratio of Tier I capital to risk-weighted assets must be at least 4.00%.
In addition to the risk-based capital guidelines, the FDIC uses a leverage ratio to evaluate a bank's capital adequacy. Most banks are required to maintain a minimum leverage ratio of Tier 1 capital to average assets of at least 4.00% to 5.00%. The FDIC retains the right to require a particular institution to maintain a higher capital level based on the institution's particular risk profile.
The FDIC may consider other factors that may affect a bank's financial condition. These factors may include interest rate risk exposure, liquidity, funding and market risks, the quality and level of earnings, concentration of credit risk, risks arising from nontraditional activities, loan and investment quality, the effectiveness of loan and investment policies, and management's ability to monitor and control financial operating risks.
The following table sets forth the current regulatory requirement for capital ratios for FDIC-regulated banks as compared with our capital ratios at December 31, 1998:
WMBFA and WMBfsb. The OTS requires savings associations, such as WMBFA and WMBfsb, to meet each of three separate capital adequacy standards:
- a core capital leverage requirement;
- a tangible capital requirement; and
- a risk-based capital requirement.
For a limited time, core capital may include certain amounts of qualifying supervisory goodwill.
OTS regulations incorporate a risk-based capital requirement that is designed to be no less stringent than the capital standard applicable to national banks. It is modeled in many respects on, but not identical to, the risk-based capital requirements adopted by the FDIC. Associations whose exposure to interest rate risk is deemed to be above normal will be required to deduct a portion of such exposure in calculating their risk-based capital. The OTS may establish, on a case-by-case basis, individual minimum capital requirements for a savings association that vary from the requirements that otherwise would apply under the OTS capital regulations. The OTS has not established such individual minimum capital requirements for WMBFA or WMBfsb.
The following table sets forth the current regulatory requirement for capital ratios for savings associations as compared with our capital ratios at December 31, 1998:
FDICIA Requirements and Prompt Corrective Action
FDICIA created a statutory framework that increased the importance of meeting applicable capital requirements. FDICIA established five capital categories:
- well capitalized;
- adequately capitalized;
- undercapitalized;
- significantly undercapitalized; and
- critically undercapitalized.
An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure, and certain other factors. The federal banking agencies (including the FDIC and the OTS) have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10.00% or more, its ratio of core capital to risk-weighted assets is 6.00% or more, its ratio of core capital to adjusted total assets is 5.00% or more, and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capital ratio of not less than 4.00%, and a leverage ratio of not less than 4.00%. Any institution that is neither well capitalized nor adequately capitalized will be considered undercapitalized.
Federal law requires that the federal banking agencies risk-based capital guidelines take into account various factors including interest rate risk, concentration of credit risk, risks associated with nontraditional activities, and the actual performance and expected risk of loss of multi-family mortgages. In 1994, the federal banking agencies jointly revised their capital standards to specify that concentration of credit and nontraditional activities are among the factors that the agencies will consider in evaluating capital adequacy. In that year, the OTS and the FDIC amended their risk-based capital standards with respect to the risk weighting of loans made to finance the purchase or construction of multi-family residences. The OTS adopted final regulations adding an interest rate risk component to the risk-based capital requirements for savings associations (such as WMBFA and WMBfsb), although implementation of the regulation has been delayed. Management believes that the effect of including such an interest rate risk component in the calculation of risk-adjusted capital will not cause WMBFA or WMBfsb to cease to be well capitalized. In June 1996, the
FDIC and certain other federal banking agencies (not including the OTS) issued a joint policy statement providing guidance on prudent interest rate risk management principles. The agencies stated that they would evaluate the banks' interest rate risk on a case-by-case basis, and would not adopt a standardized measure or establish an explicit minimum capital charge for interest rate risk.
FDIC and OTS Regulation and Examination
The FDIC has adopted regulations to protect the deposit insurance funds and depositors, including regulations governing the deposit insurance of various forms of accounts. The FDIC also has adopted numerous regulations to protect the safety and soundness of FDIC-regulated banks. These regulations cover a wide range of subjects including financial reporting, change in bank control, affiliations with securities firms and capital requirements. In certain instances, these regulations restrict the exercise of powers granted by state law.
An FDIC regulation and a joint FDIC/OTS policy statement place a number of restrictions on the activities of WMB's and WMBFA's securities affiliates and on such affiliates' transactions with WMB, WMBFA and WMBfsb. These restrictions include requirements that such affiliates follow practices and procedures to distinguish them from WMB, WMBFA and WMBfsb and that such affiliates give customers notice from time to time of their separate corporate status and of the distinction between insured deposits and uninsured nondeposit products.
FDICIA also prohibited banks, such as WMB, and their subsidiaries from exercising certain powers that were granted by state law to make investments or carry on activities as principal (i.e., for their own account) unless either (i) national banks have power under federal law to make such investments or carry on such activities, or (ii) the bank and such investments or activities meet certain requirements established by FDICIA and the FDIC.
FDICIA imposed new supervisory standards requiring annual examinations, independent audits, uniform accounting and management standards, and prompt corrective action for problem institutions. As a result of FDICIA, depository institutions and their affiliates are subject to federal standards governing asset growth, interest rate exposure, executive compensation, and many other areas of depository institution operations. FDICIA contains numerous other provisions, including reporting requirements and revised regulatory standards for, among other things, real estate lending.
The FDIC may sanction any FDIC-regulated bank that does not operate in accordance with FDIC regulations, policies and directives. Proceedings may be instituted against any FDIC-regulated bank, or any institution-affiliated party, such as a trustee, director, officer, employee, agent, or controlling person of the bank, who engages in unsafe and unsound practices, including violations of applicable laws and regulations. The FDIC may revalue assets of an institution, based upon appraisals, and may require the establishment of specific reserves in amounts equal to the difference between such revaluation and the book value of the assets. The State Director has similar authority under Washington state law, and the OTS has similar authority under HOLA. The FDIC has additional authority to terminate insurance of accounts, after notice and hearing, upon a finding that the insured institution is or has engaged in any unsafe or unsound practice that has not been corrected, is operating in an unsafe or unsound condition, or has violated any applicable law, regulation, rule, or order of or condition imposed by the FDIC.
Federal savings associations, such as WMBFA and WMBfsb, are subject to regulatory oversight and examination by the OTS and the FDIC. HOLA and OTS regulations delineate such associations' investment and lending powers. Federal savings associations generally may not invest in noninvestment grade debt securities, nor may they generally make equity investments, other than investments in service corporations.
Federal law and regulations require that WMBFA and WMBfsb maintain liquid assets in excess of a specified limit. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity."
Federal regulation of depository institutions is intended for the protection of depositors (and the BIF and the SAIF), and not for the protection of stockholders or other creditors. In addition, a provision in the
Omnibus Budget Reconciliation Act of 1993 (the "Budget Act") requires that in any liquidation or other resolution of any FDIC-insured depository institution, claims for administrative expenses of the receiver and for deposits in U.S. branches (including claims of the FDIC as subrogee of the insured institution) shall have priority over the claims of general unsecured creditors.
Federal Reserve Regulation
Under Federal Reserve Board regulations, WMB, WMBFA, WMBfsb and FCIB are each required to maintain reserves against their transaction accounts (primarily interest-bearing and noninterest-bearing checking accounts). Because reserves must generally be maintained in cash or in noninterest-bearing accounts, the effect of the reserve requirements is to increase an institution's cost of funds. These regulations generally require that WMB, WMBFA, WMBfsb and FCIB each maintain reserves against net transaction accounts in the amount of 3% on amounts of $41.6 million or less, plus 10% on amounts in excess of $41.6 million. Institutions may designate and exempt $4.9 million of certain reservable liabilities from these reserve requirements. These amounts and percentages are subject to adjustment by the Federal Reserve Board. Savings banks and savings associations, like other depository institutions maintaining reservable accounts, may borrow from the Federal Reserve Bank discount window, but the Federal Reserve Board's regulations require the institution to exhaust other reasonable alternative sources before borrowing from the Federal Reserve Bank.
Numerous other regulations promulgated by the Federal Reserve Board affect the business operations of our banking subsidiaries. These include regulations relating to equal credit opportunity, electronic fund transfers, collection of checks, truth in lending, truth in savings and availability of funds.
Community Reinvestment Act
The Community Reinvestment Act ("CRA") requires financial institutions regulated by the federal financial supervisory agencies to ascertain and help meet the credit needs of their delineated communities, including low- to moderate-income neighborhoods within those communities, while maintaining safe and sound banking practices. The regulatory agency assigns one of four possible ratings to an institution's CRA performance and is required to make public an institution's rating and written evaluation. The four possible ratings of meeting community credit needs are outstanding, satisfactory, needs to improve, and substantial noncompliance.
Under regulations that apply to all CRA performance evaluations after July 1, 1997, many factors play a role in assessing a financial institution's CRA performance. The institution's regulator must consider its financial capacity and size, legal impediments, local economic conditions and demographics, including the competitive environment in which it operates. The evaluation does not rely on absolute standards, and the institutions are not required to perform specific activities or to provide specific amounts or types of credit.
Under the regulations applicable before July 1, 1997, WMBFA and WMBfsb each received an "outstanding" CRA rating from the OTS, and WMB and FCIB received an "outstanding" CRA rating from the FDIC. These ratings reflect our commitment to meeting the credit needs of the communities we serve. Although subsequent CRA examinations have occurred, we have not yet received the final results. We maintain a CRA statement for public viewing, as well as an annual CRA highlights document. These documents describe our credit programs and services, community outreach activities, public comments and other efforts to meet community credit needs.
In May 1998, we announced a ten-year, $120 billion community reinvestment commitment to the communities in which we do business. This commitment replaces prior commitments made by us and the companies we have acquired.
The $120 billion commitment targets single-family lending, small business and consumer lending, multi-family lending and community investment at the following levels:
- Single-family lending -- $81.6 billion in affordable housing loans to minority racial and ethnic borrowers, borrowers in low- to moderate- income census tracts and borrowers earning less than 80% of median income. Of this amount, $30 billion will target low- to moderate-income borrowers.
- Small business and consumer lending -- $25 billion in loans to small businesses and consumers with low to moderate incomes, including consumer loans and lines of credit to borrowers with low to moderate incomes and in low- to moderate-income census tracts and to small businesses with an emphasis on loans and lines of credit of $50,000 or less and on loans to people of color, women and disabled persons.
- Multi-family lending -- $12.1 billion for apartment and manufactured home park developments in low- to moderate-income census tracts or serving families earning less than 80% of median income.
- Community investment -- $1.3 billion in investments and loans to community development and low-income housing initiatives, tax-exempt housing revenue bonds, minority financial institutions and community banks and financial institutions targeting minority racial and ethnic communities or other community needs.
As part of this commitment, we expect to continue our long-standing target of returning 2% of our pretax earnings in contributions to the communities we serve, with an emphasis on underserved areas. We will target 3% of our after-tax earnings, plus an additional 10% of any net recovery from the resolution of Ahmanson's goodwill litigation against the U.S. government, if that total exceeds 2% of pretax earnings. These contributions are made through grants, sponsorships, loans at below-market rates, in-kind donations, volunteer time and other financial support.
Recent and Proposed Federal Legislation and Regulation
Effective June 1, 1997, federal legislation repealed certain restrictions on the establishment of interstate branches by national banks and state-chartered banks. In addition, bank holding companies are now generally permitted to buy banks in any state. WMBFA and WMBfsb already had authority to establish interstate branches under existing federal law and regulations, so management expects that such legislation will primarily benefit our competitors.
In February 1999, the OTS proposed a regulation which could affect WMI's ability to engage in certain nonbanking activities. If a savings and loan holding company ("SLHC") owns more than one savings association, it is a multiple SLHC. HOLA generally restricts multiple SLHCs and their non-association subsidiaries to traditional savings association activities and services and to activities permitted bank holding companies. These restrictions do not apply to a multiple SLHC if all, or all but one, of its subsidiary savings associations were acquired in transactions involving a sale or transfer from an ailing or failing institution ("supervisory acquisition"). Such a multiple SLHC is sometimes referred to as an "exempt" multiple SLHC. The OTS proposal states that, under certain circumstances, an exempt multiple SLHC could lose its exempt status if it or one of its subsidiary associations is involved in a merger.
WMI has had the status of an exempt multiple SLHC because two of its three subsidiary associations -- WMBFA and WMBfsb -- were acquired in supervisory acquisitions. However, both WMBFA and WMBfsb, as well as WMI, have been involved in subsequent merger transactions. Accordingly, it is possible that, if the proposed regulation were adopted, the OTS could assert that WMI is not an exempt multiple SLHC. If that were to occur, WMI would have to merge its subsidiary associations or discontinue activities not permitted to multiple SLHCs.
Various legislative proposals relating to financial services companies have been or are expected to be introduced in the current session of Congress. These include proposals to restrict affiliations between banks and nonbanking corporations including life insurance companies, and to require federal savings institutions,
such as WMBFA and WMBfsb, to convert to commercial banks. The outcome of these legislative proposals cannot be forecast reliably.
Regulation of Nonbanking Affiliates
As a broker-dealer registered with the Securities and Exchange Commission ("SEC") and a member of the National Association of Securities Dealers, Inc. ("NASD"), WM Financial Services is subject to various regulations and restrictions imposed by those entities, as well as by various state authorities. As a registered investment advisor, WM Advisors is subject to various federal and state securities regulations and restrictions.
The NASD has adopted and forwarded to the SEC for approval rules concerning NASD member operations conducted in branches of depository institutions. Although many of the NASD's proposed requirements are substantially similar to the joint FDIC/OTS policy statement governing the activities of our securities affiliates, the NASD proposal, if approved by the SEC, could impose additional restrictions on these affiliates.
COMPETITIVE ENVIRONMENT
We face significant competition in attracting and retaining deposits and making loans in all of our market areas. Our most direct competition for deposits has historically come from savings institutions, credit unions and commercial banks doing business in our primary market areas of California, Washington, Oregon, Florida, Texas and Utah. As with all banking organizations, however, we have also experienced competition from nonbanking sources, including mutual funds, corporate and governmental debt securities and other investment alternatives. Our most direct competition for loans comes from other savings institutions, national mortgage companies, insurance companies, commercial banks and GSEs. Our competitors' activities may make it difficult for us to achieve our financial goals. In addition to the normal competitive factors described above, our management at the holding company level has limited operating experience in California, Florida and Texas.
Although consolidation has decreased the number of institutions competing in our markets, both savings associations and commercial banks have reemphasized their focus on the consumer, making competition for retail deposits and loans extremely fierce. While the increased competitive pressures make the banking environment more difficult, we remain a strong market force. For 1998, our originations of SFR loans ranked first in both Washington and Oregon, and second in California.
PRINCIPAL OFFICERS
The following table sets forth certain information regarding the principal officers of Washington Mutual:
Mr. Killinger has been Chairman, President and Chief Executive Officer of WMI since its organization as a holding company in 1994. He has been Chairman of the Board of Directors of WMB since 1991 and Chief Executive Officer since 1990. Mr. Killinger became an Executive Vice President of WMB in 1983, a Senior Executive Vice President of WMB in 1986 and the President and a director of WMB in 1988.
Ms. Chapman became an Executive Vice President and General Counsel and member of the Executive Committee of WMI in September 1997. Prior to that, Ms. Chapman had been a partner with Foster Pepper & Shefelman PLLC, a Seattle, Washington law firm, since 1979.
Mr. Davis became an Executive Vice President and member of the Executive Committee in January 1997, following our merger with Keystone Holdings. In his capacity as Executive Vice President, Mr. Davis is responsible for SFR lending and financial services. He was Director of Mortgage Origination of American Savings Bank from 1993 through 1996 and served as President of ASB Financial Services, Inc. from 1989 to 1993.
Mr. Freimuth became an Executive Vice President and member of the Executive Committee in 1997. In this capacity, he is responsible for corporate lending administration and human resources. He joined WMB as a Vice President in 1988 and became a Senior Vice President in 1991.
Mr. Longbrake rejoined WMI in October 1996 as Executive Vice President and Chief Financial Officer and a member of the Executive Committee. In his capacity as Executive Vice President, Mr. Longbrake is responsible for corporate finance. From March of 1995 through September of 1996, he served as Deputy to the Chairman for Finance and Chief Financial Officer of the FDIC. Mr. Longbrake was Senior Executive Vice President and Chief Financial Officer of WMI from its organization through February 1995. He was Chief Financial Officer of WMB from 1988 to 1995 and a member of our Executive Committee from its formation in 1990 until 1995 and again since 1996.
Ms. Oppenheimer has been an Executive Vice President of WMI since its organization. She has been an Executive Vice President of WMB since 1993 and a member of the Executive Committee since its formation in 1990. In this capacity, Ms. Oppenheimer is responsible for corporate marketing and consumer bank distribution. She has been an officer of WMB since 1985. She became an Assistant Vice President of WMB in 1986, a Vice President in 1987 and a Senior Vice President in 1989.
Mr. Tall has been an Executive Vice President of WMI since its organization. He had been an Executive Vice President of WMB since 1987 and a member of the Executive Committee since its formation in 1990. In his capacity as Executive Vice President, Mr. Tall is responsible for corporate development, corporate properties, commercial banking and consumer finance.
Ms. Wilson has been an Executive Vice President of WMI since its organization. She has been an Executive Vice President of WMB since 1988 and a member the Executive Committee since its formation in 1990. In her capacity as Executive Vice President, Ms. Wilson is responsible for corporate operations.
Mr. Levy has been a Senior Vice President and Controller of WMI since February 1998. In this capacity, he is Washington Mutual's principal accounting officer. Prior to joining the Company, Mr. Levy was Executive Vice President and Chief Financial Officer of Community Trust Bancorp from 1995 to 1997. Prior to that, he was the Controller of Bank of America Texas, N.A.
Mr. Swick has been a Senior Vice President of WMI since its organization. He became Chief Risk Officer in 1998 and prior to that time was the Company's General Auditor. He has been an officer of WMB since 1980. Mr. Swick became a Vice President in 1984 and Senior Vice President in 1988. In this capacity, he monitors our internal controls and credit risk.
Mr. Wisdorf has been Deputy Chief Financial Officer since 1996 and Senior Vice President of WMI since its organization. Mr. Wisdorf was Controller of WMI from 1994 to February 1998. He became Vice President and Controller of WMB in 1986 and has been an officer since 1978.
ITEM 2.
ITEM 2. PROPERTIES
As of December 31, 1998, the Company's banking subsidiaries conducted business from 1,173 consumer financial centers, 55 Western Bank financial centers, 16 business banking centers and 273 home loan centers and wholesale loan centers in 37 states and the District of Columbia. Consumer finance operations were conducted in over 500 locations in 24 states.
Washington Mutual's administrative offices are located at 1201 Third Avenue, Seattle, Washington, 98101 where, as of December 31, 1998, the Company leased approximately 236,000 square feet pursuant to a lease agreement that starts to terminate in 2007. The Company also leases approximately 158,000 square feet of space in Seattle in the Second and Seneca Building pursuant to a lease agreement that starts to terminate in 2001; approximately 75,000 square feet in the adjoining building pursuant to a lease agreement that starts to terminate in 2006; approximately 100,000 square feet in Seattle in the First Interstate Building at 999 Third Avenue pursuant to a lease agreement that starts to terminate in 1999; approximately 76,000 square feet in Seattle in the 1111 Third Avenue Building pursuant to a lease agreement that starts to terminate in 2004; approximately 59,000 square feet in the Rainer Tower Building at 1301 Fifth Avenue pursuant to a lease agreement that starts to terminate in 2003; and approximately 110,000 square feet in Bothell, Washington pursuant to a lease agreement that terminates in 2009. The Company has multiple options to renew leases at all locations.
WMBFA administrative and subsidiary operations are conducted from owned office space totaling 280,000 square feet in Irvine, California; 237,000 square feet in Stockton, California; and 305,000 square feet in Chatsworth, California; and 87,000 square feet in Baldwin Park, California. WMBFA administrative and subsidiary operations are also conducted from leased office space totaling approximately 11,000 square feet in Los Angeles pursuant to a lease agreement that terminates in 2002; approximately 722,000 square feet in Chatsworth pursuant to a lease agreement that starts to terminate in 2005; 691,000 square feet in Irwindale pursuant to a lease agreement that terminates in 2010; 465,000 square feet in the City of Industry, California pursuant to a lease agreement that terminates in 2005 and 82,000 square feet in St. Louis, Missouri pursuant to a lease agreement that terminates in 2007.
Offices used by the Company on the Irwindale-Baldwin Park, City of Industry and St. Louis campuses (the "Home Savings Campuses") are being closed in order to consolidate operations there with similar operations on other administrative campuses, which will make more efficient use of building space. As a result of this consolidation, the Company anticipates that the approximately 1,325,000 square feet located on the
Home Savings Campuses will become available to sublet to third party tenants beginning in mid-1999. In addition, the Company has identified 162 consumer financial centers that will be closed and will have their operations consolidated with neighboring financial centers by mid-1999.
WMBFA also owned a vacant administrative facility totaling approximately 385,000 square feet located in Canoga Park, California that housed the Coast operations and administration prior to its acquisition by Home Savings in 1998. This facility was sold in February 1999.
Aristar administrative operations are conducted from owned office space totaling 71,000 square feet in Tampa, Florida.
See "Notes to Consolidated Financial Statements -- Note 10: Premises and Equipment."
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Washington Mutual has certain litigation and negotiations in progress resulting from activities arising from normal operations. In the opinion of management, none of these matters is likely to have a materially adverse effect on the Company's results of operations or financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to shareholders during the fourth quarter of 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR WASHINGTON MUTUAL'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
COMMON STOCK
Washington Mutual's common stock trades on The New York Stock Exchange under the symbol WM. Prior to December 9, 1998, the Company's common stock traded on The Nasdaq Stock Market under the symbol WAMU. As of February 26, 1999, there were 593,989,545 shares issued and outstanding held by 40,181 shareholders of record. The closing price of the Company's common stock on March 9, 1999 was $42.44 per share.
The high and low common stock prices by quarter were as follows:
The cash dividends declared by quarter were as follows:
These dividends have not been restated to reflect pooling combinations.
PREFERRED STOCK
At December 31, 1998, the Company had no preferred stock outstanding.
PAYMENT OF DIVIDENDS AND POLICY
Payment of future dividends is subject to declaration by Washington Mutual's Board of Directors. Factors considered in determining the size of dividends are the amount and stability of profits, adequacy of capitalization, and expected asset and deposit growth of its subsidiaries. The dividend policy of Washington Mutual is also dependent on the ability of WMB, WMBFA and WMBfsb to pay dividends to their respective parent company, which is influenced by legal, regulatory and economic restrictions. See "Business -- Regulation and Supervision -- Restrictions on Subsidiary Savings Institution Dividends."
Retained earnings of the Company at December 31, 1998 included a pre-1988 thrift bad debt reserve for tax purposes of $2.01 billion for which no federal income taxes have been provided. In the future, if the thrift bad debt reserve is used for any purpose other than to absorb bad debt losses, or if any of the thrift subsidiaries no longer qualifies as either a bank or a qualified thrift lender, the Company will incur a federal income tax liability, at the then prevailing corporate tax rate, to the extent of such subsidiary's pre-1988 thrift bad debt reserve. As a result, the Company's ability to pay dividends in excess of current earnings may be limited.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected consolidated financial data for Washington Mutual and is derived from and should be read in conjunction with the Consolidated Financial Statements of Washington Mutual and the Notes thereto, which are included in this Annual Report on Form 10-K. The Ahmanson Merger in 1998, the Great Western Merger in 1997 and the Keystone Transaction in 1996 were accounted for as poolings of interests. The assets, liabilities, stockholders' equity, and results of operations of the pooled companies have been included in the Company's financial statements on a consolidated basis at their book values for all periods, and no goodwill was created. Washington Mutual's financial information contained herein has been restated as if the respective companies had been combined for all periods presented unless otherwise noted. Prior to the Ahmanson Merger, Ahmanson acquired Coast Savings Financial, Inc. in a transaction accounted for by the purchase method. As a result, Coast's financial information has been included only from the date of its acquisition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- General." As such, the information presented herein is not comparable with that reflected in the Company's Annual Report on Form 10-K/A for the year ended December 31, 1997.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto presented elsewhere in this report.
GENERAL
Washington Mutual is a financial services company committed to serving consumers and small to mid-sized businesses. The Company's banking subsidiaries accept deposits from the general public, make residential loans, consumer loans, limited types of commercial real estate loans (primarily loans secured by multi-family properties), and engage in certain commercial banking activities. The Company's consumer finance operations provide direct installment loans and related credit insurance services and purchase retail installment contracts. Washington Mutual also markets annuities and other insurance products, offers full service securities brokerage, and acts as the investment advisor to and the distributor of mutual funds.
During the past three years, the transactions described below transformed the Company from a regional financial services company whose activities were concentrated in Washington, Oregon and Utah to a company with operations in 37 states and the District of Columbia, including California, Florida and Texas. At December 31, 1998, the Company was the largest savings institution and the eighth largest banking company in the United States.
The Keystone Transaction. On December 20, 1996, Keystone Holdings merged with and into WMI, and all of the subsidiaries of Keystone Holdings, including ASB, became subsidiaries of WMI.
The Great Western Merger. On July 1, 1997, Great Western merged with and into New American Capital, Inc. ("NACI"), a wholly-owned subsidiary of WMI, and all of the subsidiaries of Great Western, including GWB and Aristar, became subsidiaries of NACI. On October 1, 1997, GWB was merged with and into ASB; simultaneously, the name of ASB was changed to Washington Mutual Bank, FA. Great Western was a diversified financial services company with more than 1,000 mortgage lending, retail banking and consumer finance offices nationwide.
The Ahmanson Merger. On October 1, 1998, Ahmanson merged with and into WMI. On October 3, 1998, Ahmanson's banking subsidiary, Home Savings, was merged with and into WMBFA. Ahmanson conducted the majority of its business in California, with operations in eight other states.
The Coast Acquisition. On February 13, 1998, Ahmanson acquired Coast in a transaction accounted for as a purchase (the "Coast Acquisition"). Under this method of accounting, periods prior to the acquisition were not restated, the assets and liabilities of Coast were adjusted to their estimated fair values and any excess of the purchase price over the fair value of the assets acquired, net of the fair value of the liabilities assumed, was recognized as goodwill. At the date of the Coast Acquisition, Coast had total assets of $8.90 billion and deposits of $6.40 billion. The value of Ahmanson common stock issued to effect the transaction was $925.1 million as of the purchase date. Ahmanson recorded $516.5 million in goodwill and core deposit intangibles.
The Keystone Transaction, the Great Western Merger, the Ahmanson Merger and the Coast Acquisition are collectively referred to herein as the "Transactions."
RESULTS OF OPERATIONS
Overview
Washington Mutual's net income for 1998 was $1.49 billion compared with $885.1 million in 1997 and $375.4 million in 1996. Net income during 1998 was reduced by charges associated with the Ahmanson Merger and the Great Western Merger totaling $508.3 million for transaction-related expenses, but was enhanced by income of $289.0 million from the sale of certain retail branches in Florida. Net income during 1997 was reduced by charges associated primarily with the Great Western Merger totaling $431.1 million for transaction-related expenses and $100.0 million for the write down of one tranche of a security created with loans acquired from GWB. Net income during 1996 was reduced by charges of $556.4 million for the special
SAIF assessment, $158.1 million for transaction-related expenses in the Keystone Transaction, $68.3 million for restructuring expense at Great Western prior to the Great Western Merger, a $125.0 million loan loss provision for loans acquired from Keystone Holdings, and a $50.0 million loan loss provision for the bulk sale by GWB of nonperforming loans prior to the Great Western Merger. Diluted earnings per share were $2.56 in 1998, $1.52 in 1997 and $0.54 in 1996. The various transaction-related expenses, the special SAIF assessment and the addition to the loan loss reserve and loan write downs discussed above negatively affected the various financial ratios that are commonly used to assess the performance of financial institutions. Due to the effect of adjustments related to the merger activity in the past three years, the Company does not believe that the 1998, 1997 and 1996 ratios are indicative of the Company's overall performance in those years, nor does the Company believe they are indicative of the Company's performance in 1999 and subsequent years.
Net Interest Income
Net interest income for 1998 of $4.29 billion increased from $3.92 billion in 1997 and $3.87 billion in 1996. The net interest margin for 1998 was 2.88% compared with 2.91% in 1997 and 2.96% in 1996.
The 1998 increase in net interest income was due to an 11% rise in average interest-earning assets to $149.08 billion in 1998 compared with $134.44 billion in 1997. The net interest spread, however, declined slightly to 2.70% in 1998 from 2.74% in 1997. The 1997 increase in net interest income was due to a 3% rise in average interest-earning assets from $130.71 billion in 1996. The net interest spread declined to 2.74% in 1997 from 2.78% in 1996. To a certain extent, the Company's net interest spread is affected by changes in the yield curve. During 1998, the difference between the yields on a three-month U.S. Treasury bill and a ten-year U.S. government note averaged 37 basis points compared with 116 basis points a year earlier, and 128 basis points in 1996. This substantial flattening in the slope of the yield curve began in late 1997 and continued throughout 1998.
Approximately 80% of the Company's interest-sensitive assets have adjustable rates that change with movements in short- to mid-term market interest rates as do the majority of the liabilities contributing to the Company's cost of funds. Market interest rates generally declined during 1996 and then remained low within a narrow range during 1997 and 1998, which was reflected in the relative stability of the Company's yields, rates and net interest spread during the same period.
Average statements of financial condition, together with the total dollar amounts of interest income and expense and the weighted average interest rates were as follows:
The dollar amounts of interest income and interest expense fluctuate depending upon changes in interest rates and upon changes in amounts (volume) of the Company's interest-earning assets and interest-bearing liabilities. Changes attributable to (i) changes in volume (changes in average outstanding balances multiplied by the prior period's rate), (ii) changes in rate (changes in average interest rate multiplied by the prior period's volume), and (iii) changes in rate/volume (changes in rate times the change in volume that were allocated proportionately to the changes in volume and the changes in rate) were as follows:
Provision for Loan Losses
The provision for loan losses during 1998 was $162.0 million compared with $246.6 million in 1997 and $498.6 million in 1996, reflecting a continued declining trend in nonperforming assets, nonaccrual loans and charge offs. In addition, in 1996, the provision reflected an additional charge of $125.0 million related to the Keystone Transaction and a bulk sale of $50.0 million of nonperforming loans by GWB prior to the Great Western Merger. The provisions in both 1998 and 1997 were lower than the levels of charge offs, reflecting improved credit quality in the loan portfolio caused primarily by the general improvement in the California economy.
Other Income
Other income consisted of the following:
Depositor and other retail banking fees of $568.4 million in 1998 increased from $478.7 million in 1997 and $358.9 million in 1996. The increases reflected the collection of overdraft protection, nonsufficient funds ("NSF") and other fees on a greatly increased number of checking accounts and MMDAs. The number of checking accounts increased during 1998 by nearly 550,000 or 16% to approximately 3,899,000.
The growth in depositor and other retail banking fees has been offset somewhat by an increase in the amount of deposit account-related losses (included in other operating expense) incurred by the Company resulting from the increased number of checking accounts. For 1998 (excluding Ahmanson), depositor fees averaged $149.18 per checking account compared with losses of $25.46 per checking account.
Loan servicing income totaled $117.4 million in 1998, compared with $141.3 million in 1997 and $143.8 million in 1996. The 17% decline in 1998 reflected an increase in the amortization of mortgage servicing rights from $64.2 million in 1997 to $89.3 million in 1998 related to the higher rate of prepayments in the portfolio of loans serviced.
Loan related income consists of late charges, prepayment fees, reconveyance fees and miscellaneous income. The increases in loan related income were primarily the result of growth in the loan portfolio and the Coast Acquisition.
During 1998, the Company had net mortgage banking income of $133.1 million, compared with a net loss of $44.4 million in 1997 and net income of $49.2 million in 1996. Included in the net loss in 1997 was a $100.0 million write down of one tranche of a security created from loans acquired from GWB. This tranche was held in the trading portfolio. Excluding this transaction, the Company would have had net mortgage banking income of $55.6 million in 1997. The Company sold SFR loans of $18.11 billion in 1998 and $7.41 billion in 1997, primarily from its fixed-rate loan production. During 1996, GWB sold a substantial portion of its student loan portfolio for $356.6 million, realizing a gain of $22.5 million. Most of the remaining gains recognized during 1996 were the result of selling $6.20 billion of fixed-rate loans.
Ahmanson had a consistent strategy to engage in retail branch purchases and sales to consolidate its presence in key geographic locations. Pretax gain on sale of retail deposit branch systems was $289.0 million in 1998, up from $57.6 million in 1997 and $6.9 million in 1996. In 1998, Ahmanson sold deposits of $3.24 billion and the remainder of its branch premises in Florida. In 1997, Ahmanson sold deposits of $251.4 million and
branch premises in Arizona for a pretax gain of $16.0 million, and deposits of $916.3 million and certain branch premises in Florida for a pretax gain of $41.6 million. In 1996, Ahmanson sold deposits of $197.4 million and certain branch premises in Texas for a pretax gain of $6.9 million.
Net gain on the sale of other assets was $27.0 million during 1998, compared with $41.2 million during 1997 and $43.5 million during 1996. On December 31, 1997, the Company recorded a $20.8 million gain on the sale of its insurance subsidiary, WM Life Insurance Company, to SAFECO Life Insurance Company.
Charge offs on loans securitized with recourse are reported in the line item -- provision for recourse liability -- as a charge to earnings in other income. The provision for recourse liability was $52.9 million for 1998, compared with $76.6 million in 1997 and $113.7 million in 1996. The provision for recourse liability is established through the same guidelines used to determine the provision for loan losses.
Other operating income totaled $79.7 million in 1998, compared with $64.3 million in 1997 and $35.4 million in 1996. Other operating income includes nonrecurring income as well as various types of miscellaneous income that tend to grow with the size of the Company.
Other Expense
Other expense consisted of the following:
Salaries and employee benefits totaled $1.19 billion during 1998, compared with $1.17 billion during 1997 and $1.18 billion during 1996. Full-time equivalent employees were 27,330 at December 31, 1998, compared with 27,661 at year-end 1997 and 28,077 at year-end 1996. During 1998, staff reductions in connection with the Great Western and Ahmanson Mergers and sales of branches were offset by increased staff levels resulting from the Coast Acquisition and required to support the Company's increased loan production.
Expense for telecommunications and outsourced information services was $255.6 million in 1998, compared with $213.4 million in 1997 and $178.5 million in 1996. In general, the year-to-year increases reflected growth in deposit accounts and loan originations, higher levels of customer support services during account conversions and increased use of outsourced data processing services.
Regulatory assessments were $63.2 million in 1998 and $59.9 million in 1997, down from $168.9 million in 1996, reflecting a reduction in the assessment rate paid on the Company's deposits as a result of the recapitalization of the SAIF. During 1996, Washington Mutual was subject to a special assessment on SAIF deposits held by its banking subsidiaries which resulted in a charge of $556.4 million.
Amortization of intangible assets increased to $104.3 million in 1998, from $89.4 million in 1997 and $84.2 million in 1996. The 17% increase in 1998 was due to the Coast Acquisition in February 1998 under the purchase accounting method, which created intangible assets of $516.5 million.
Foreclosed asset expense declined to $23.4 million in 1998, from $80.7 million in 1997 and $124.2 million in 1996. The decrease in foreclosed asset expense from 1997 to 1998 reflected the elimination of outsourcing activities, a decrease in the number of foreclosed assets, increased gain on sales of properties and a net loss on foreclosed asset sales in 1997.
Other operating expense increased to $640.8 million in 1998, from $583.6 million in 1997 and $583.2 million in 1996. Contributing to the rise in advertising costs in 1998 and 1997 were marketing campaigns designed to introduce the Company's products to the California market. Operating losses and settlements increased in 1998 primarily due to an increase in deposit account-related losses resulting from the growth in the number of checking accounts. Postage costs increased due to the system conversions related to the Transactions which required several special customer notifications as well as increased mailings related to various marketing campaigns. Other operating expense in 1998 included $30.0 million of expense for the donation of land for open space to support further development of property owned by Ahmanson as a real estate investment. It also included $28.5 million in write downs on other Ahmanson real estate investment properties.
As a result of the Transactions, the Company recorded transaction-related expenses of $508.3 million, $431.1 million and $226.4 million during 1998, 1997 and 1996. The majority of the expenses were for severance and related payments, facilities and equipment impairment, and various investment banking, legal and contract exit fees. The accruals of $262.0 million at year-end 1998, $196.1 million at year-end 1997 and $126.6 million at year-end 1996 related primarily to expenses for specifically identified severance programs, the impairment of premises and equipment and the liability for contract exit fees for duplicate services.
The Company expected staff reductions related to the Keystone Transaction and the Great Western Merger of approximately 2,850 and an additional 3,400 staff reductions related to the Ahmanson Merger. As of December 31, 1998, all staff reductions related to the Keystone Transaction and the Great Western Merger were completed and approximately 800 employee separations had occurred as a result of the Ahmanson Merger. The remaining employee separations are planned to be completed by the end of September 1999.
During 1998, these transaction-related expenses were partially offset by reductions in the estimates of contract cancellation fees of $13.6 million, severance of $8.7 million and other accruals of $3.6 million, and from gains on the disposition of surplus real estate of $12.8 million. The reduction in estimates for contract cancellation fees was largely a result of maintaining certain contracts in place for longer periods than originally anticipated, thereby reducing the cancellation penalties. The reduction in severance estimates was primarily the result of more employees voluntarily terminating without severance than was originally estimated. The gains from the disposition of surplus real estate were a result of the value of excess branch properties being higher than originally estimated due to increases in real estate values in southern California.
Offices used by the Company on the Irwindale campus are expected to be closed by the end of the third quarter of 1999. The office space at the Irwindale campus is expected to become available over time to sublet to third party tenants beginning in July 1999. During 1998, the Company consolidated consumer financial centers with neighboring financial centers in conjunction with the Great Western Merger. The Company has also identified 162 branch consolidations in California that will result from the Ahmanson Merger. The
consolidations are scheduled for mid-1999 and will coincide with the conversion of the Home Savings branches in California to Washington Mutual's systems and signage. The carrying amount of assets held for disposal at December 31, 1998 was $80.2 million.
In order to meet the Company's goal to consolidate its current systems platform, certain computer hardware and software equipment has been or will be abandoned and written off. The consolidation of systems will allow the Company to increase operational efficiency, improve processing capacity and establish a common user workstation environment.
Reconciliations of the transaction-related expenses and accrual activity were as follows:
Taxation. Income taxes include federal and applicable state income taxes and payments in lieu of taxes. The provision for income taxes was $882.5 million for 1998, which represented an effective tax rate of
37.25%. The provision was lower due to a one-time favorable adjustment in the Company's deferred tax assets attributable to the Keystone Transaction, partially offset by nondeductible transaction-related expenses associated with the Ahmanson Merger.
The provision for income taxes of $653.2 million for 1997 represented an effective tax rate of 42.46%, due in part to the nondeductibility of certain transaction-related expenses at Washington Mutual, Ahmanson and Great Western, and a settlement with the Internal Revenue Service (the "Service") for 1986 and 1987 for Great Western.
The provision for income taxes of $201.7 million in 1996 represented an effective tax rate of 34.15%. The primary reason for the lower effective tax rate in 1996 as compared with 1997 and 1998 was the realization of deductions for state tax purposes relating to basis differences of certain subsidiary corporations.
Keystone Holdings commenced operations in December 1988 as an indirect holding company for ASB. ASB was formed to effect the December 1988 acquisition (the "1988 Acquisition") of certain assets and liabilities of the failed savings and loan association subsidiary (the "Failed Association") of Financial Corporation of America. The 1988 Acquisition had a "good bank/bad bank" structure, with ASB, the "good bank," acquiring substantially all of the Failed Association's performing loans and fixed assets and assuming substantially all of its deposit liabilities. New West Federal Savings and Loan Association ("New West"), the "bad bank," was formed to acquire the Failed Association's other assets (including nonperforming loans) and liabilities with a view toward their liquidation. New West was transferred to the FDIC as manager of the FRF, prior to the Keystone Transaction.
In connection with the 1988 Acquisition, the Service entered into a closing agreement (the "Closing Agreement") with respect to the federal income tax consequences of the 1988 Acquisition and certain aspects of the taxation of Keystone Holdings and certain of its affiliates. The Closing Agreement contains provisions that were intended to ensure that losses generated by New West would be available to offset income of ASB for federal income tax purposes. In connection with the 1988 Acquisition, Keystone Holdings and certain of its affiliates entered into a number of continuing agreements with the predecessor to the FRF. These agreements were designed, in part, to provide that over time 75% of most of the federal income tax savings and 19.5% of most of the California tax savings (in each case computed in accordance with specific provisions contained in the Assistance Agreement) attributable to the utilization of certain tax loss carryforwards of New West are paid ultimately to the FRF. The provision for such payments is reported in the line item -- income taxes.
See "Notes to Consolidated Financial Statements -- Note 17: Income Taxes."
QUARTERLY RESULTS OF OPERATIONS
The results of operations on a quarterly basis have been restated to give effect to the business combination with Ahmanson. Results of operations on a quarterly basis were as follows:
Net interest income increased in the fourth quarter of 1998 compared with the third quarter of 1998 and the fourth quarter of 1997 primarily due to an increase in interest-earning assets, partially offset by decreases in the net interest spread to 2.66% for the fourth quarter of 1998 from 2.69% in the third quarter of 1998 and 2.77% in the fourth quarter of 1997. Provision for loan losses decreased throughout the quarterly periods reflecting the declining trend in nonperforming assets and improvement in the California economy. Other income included a gain on sale of retail deposit branch systems of $289.0 million in the third quarter of 1998, $41.6 million in the second quarter of 1997 and $16.0 million in the first quarter of 1997. Other expense included transaction-related expenses of $431.5 million in the fourth quarter of 1998 for the Ahmanson Merger and $366.9 million in the third quarter of 1997 related to the Great Western Merger. Income taxes in the fourth quarter of 1998 reflected an unusually low tax rate resulting from a one-time favorable adjustment in the Company's deferred tax assets attributable to the Keystone Transaction, partially offset by nondeductible transaction-related expenses associated with the Ahmanson Merger.
REVIEW OF FINANCIAL CONDITION
Assets. At December 31, 1998, the Company's assets were $165.49 billion, an increase of $21.97 billion or 15% from $143.52 billion at December 31, 1997. The increase was primarily the result of the Coast Acquisition and the purchase of MBS and whole loans in the secondary market. The Company purchased $19.77 billion of MBS and $2.98 billion of loans during 1998. The Company has historically increased asset size by emphasizing the origination of ARMs and retaining these loans in its portfolio. During 1998, however, fixed-rate originations accounted for 56% of total SFR originations, and, in keeping with the Company's policy, most of the conforming loans were sold. In addition, due to lower mortgage rates throughout 1998, prepayments were higher than historical averages. Accordingly, the Company used the purchases of MBS and whole loans to increase its asset base.
Interest-Earning Assets. The Company's interest-earning assets consisted of the following:
Securities. The Company's trading, available-for-sale and held-to-maturity securities consisted of the following (at carrying value):
The Company's securities portfolio increased by $10.04 billion at December 31, 1998, compared with the prior year. The increase was due primarily to the purchase of agency and investment grade private issue MBS in the secondary market and $2.15 billion of MBS from the Coast Acquisition.
Securities classified as available for sale increased by $13.10 billion in 1998 while securities classified as held to maturity decreased by $3.08 billion. The increase in the available-for-sale category was primarily due to the purchase of agency and investment grade private issue MBS in the secondary market. The decline in the held-to-maturity category was due to paydowns on existing securities. This decline was offset, in part, through the securitization of $647.0 million of loans, which were classified as held to maturity during 1998.
Trading securities increased by $15.7 million due to initial investment in a Company-sponsored mutual fund and to unrealized gains on a REMIC created during 1997. The REMIC is made up of five tranches. The fifth tranche was classified as trading because this was a securitization of loans which management intended to sell when, in its judgment, the credit and interest rate factors affecting the value of this security create an appropriate economic return. The remaining four tranches were classified as available for sale, as management intended to hold these securities in a manner consistent with other internal securitizations.
At December 31, 1998, the Company held $11.73 billion of private issue MBS and CMOs (including the REMIC). Of this total, 93% were rated the highest investment grade (AAA), nearly 7% were rated investment grade (AA through BBB) and less than 1% were rated below investment grade.
At December 31, 1998, 71% of MBS were adjustable rate. Of the 71% indexed to an adjustable rate, 83% were indexed to COFI, 11% to U.S. Treasury indexes, and 6% to LIBOR. The remaining 29% of MBS were fixed rate.
Loans. Total loans (exclusive of the reserve for loan losses) at December 31, 1998 were $109.44 billion, up 11% from $98.67 billion at December 31, 1997. The increase in loan balances was primarily the result of the Coast Acquisition, originations of new loans and the purchase of loans.
Loans (exclusive of the reserve for loan losses) consisted of the following:
Real estate loans by product type were as follows:
Short-term ARMs reprice within a year. Medium-term ARMs have an initial fixed rate for more than one year and then convert to short-term ARMs.
Loan originations were as follows:
SFR originations by product type were as follows:
Liabilities
The Company uses customer deposits and wholesale borrowings to fund its operations. Due to increased market competition for customer deposits, the Company has increasingly relied on wholesale borrowings to fund its asset growth.
Deposits. Total deposits of $85.49 billion at December 31, 1998 increased $2.06 billion or 2% from year-end 1997.
Deposits consisted of the following:
The increase in deposits during 1998 was primarily due to the Coast Acquisition in the first quarter of 1998 with $6.40 billion of deposits, partially offset by the sale of 27 branches in Florida in the third quarter of 1998 with $3.24 billion of deposits. Excluding these transactions, deposits decreased $1.10 billion. This decrease in deposits was the result of lower time deposits, which reflected the competitive environment of banking institutions and the wide array of investment opportunities available to consumers, as well as the
Company's decision to reduce the amount of time deposits. Savings accounts, MMDAs and checking accounts have increased in amount and as a percentage of total deposits to 49% at year-end 1998 compared with 41% at year-end 1997 and 37% at year-end 1996. These latter three products have the benefit of lower interest costs compared with time deposit accounts. Even though savings accounts, MMDAs and checking accounts are liquid, they are considered by the Company to be the core relationship with its customers. In the aggregate, the Company views these core accounts to be a stable source of long-term funding.
While the vast majority of its deposits are retail in nature, the Company does engage in certain wholesale activities -- primarily accepting time deposits from political subdivisions and public agencies. The Company considers wholesale deposits to be an alternative borrowing source rather than a customer relationship, and as such, their levels are determined by management's decisions as to the most economic funding sources.
Borrowings. Washington Mutual's borrowings primarily take the form of reverse repurchase agreements and advances from the FHLBs of Seattle and San Francisco. The exact mix at any given time is dependent upon the market pricing of the individual borrowing sources.
Borrowings consisted of the following:
The Company's wholesale borrowing portfolio increased by $15.22 billion at December 31, 1998, compared with the prior year. The increase was due to the Company's use of wholesale borrowings as an alternative to retail deposits as a funding source for asset growth. Due to relative pricing advantages, the Company primarily used advances from FHLBs and reverse repurchase agreements as the primary funding vehicles.
WMBFA is a member of the FHLB of San Francisco, and as a regular part of its business obtains advances from this FHLB. WMB and WMBfsb are members of the FHLB of Seattle, and as a regular part of their businesses obtain advances from this FHLB. An institution is required to own stock in the FHLB of which it is a member.
Each institution obtaining FHLB advances is required to enter into a written agreement with the lending FHLB under which the borrowing institution is primarily and unconditionally obligated to repay such advances and all other amounts owing to the lending FHLB. All advances must be fully secured by eligible collateral. Eligible collateral includes whole first mortgage loans on improved residential real estate, mortgage-backed and other securities issued or guaranteed by the United States or any of its agencies, certain privately issued MBS and other real estate-related collateral acceptable to the lending FHLB.
FHLBs offer advances with maturities of up to ten years, and an FHLB is permitted to offer advances with longer maturities if such advances are consistent with the safe and sound operation of that FHLB. Each FHLB prices its advances to members by taking into account various factors, including the marginal cost to the FHLB of raising matching maturity funds in the market and the administrative and operating costs associated with making such advances to its members.
PROVISION AND RESERVE FOR LOAN LOSSES
The Company analyzes several important elements in determining the level of the provision for loan losses in any given year, such as current and anticipated economic conditions, nonperforming asset trends,
historical loan loss experience, and plans for problem loan administration and resolution. These elements are also captured in a migration analysis performed on the loan portfolio on a quarterly basis and used in determining the loan loss provision. During 1997 and continuing in 1998, the results of the migration analysis and the elements analyzed indicated continued improvement in loss experience.
Economically, California continued to improve significantly, resulting in a dramatic turnaround in the housing market. The median price for California homes had declined steadily from a high of $211,000 in 1991 to a low point of $168,000 in February 1997. By December 1998, the median price of homes had increased to $198,000, up $30,000 or 18% from the low point in 1997. The result has been a decline in residential loan charge offs and a slowing in foreclosure activity toward the end of 1997. Residential loan charge offs, net of recoveries, for 1998 totaled $46.8 million, which was less than net charge offs of $119.6 million in 1997 and $270.5 million in 1996.
Nonaccrual loans and nonperforming assets also continued to show improving trends. Although average loans continued to increase, nonaccrual loans decreased from $1.17 billion in 1996 to $1.03 billion in 1997 to $938.0 million in 1998. Total nonperforming assets decreased from $1.65 billion in 1996 to $1.37 billion in 1997 to $1.21 billion in 1998, and nonperforming assets as a percentage of total assets decreased from 1.20% in 1996 to 0.96% in 1997 to 0.73% in 1998. Actual loss experience, as measured by net charge offs, decreased as well. Net charge offs decreased from $427.1 million in 1996 to $251.5 million in 1997 to $175.5 million in 1998, despite an increase in average loans. As a result of these continuing improvements in loss experience, the provision for loan losses was less than net charge offs during 1997 and 1998. Net charge offs exceeded the provision by $4.8 million in 1997 and by $13.6 million in 1998.
The 1996 additional reserve for loan losses recorded at the date of the merger with Keystone Holdings was provided principally because a number of Washington Mutual's credit administration and asset management philosophies and procedures differed from those of ASB. Those differences consisted principally of the following: (i) Washington Mutual was more proactive in dealing with emerging credit problems and tended to prefer foreclosure actions to induce borrowers to correct defaults, whereas ASB was not as proactive and tended to prefer workouts in lieu of a more aggressive foreclosure stance; and (ii) ASB considered the risk characteristics of its portfolio of loans secured by apartment buildings of less than $1 million to be similar to its SFR portfolio; Washington Mutual, on the other hand, considered the risk characteristics of that portfolio to be more closely aligned with its commercial real estate loan portfolio, which tended to have a higher incidence of loan losses than the SFR portfolio. WMBFA's asset management practices, administration, philosophies and procedures are now the same as those of WMB and WMBfsb. The addition to the reserve for loan losses was to a lesser degree provided because Washington Mutual believed that, while there had been an increase in the value of residential real estate in certain California markets, a decline in collateral values for some portions of the California real estate market occurred in 1996. Management of the Company reviewed ASB's large performing and nonperforming loans on an individual loan basis, reviewed its other loan portfolios in the aggregate, and implemented appropriate strategies for such credits. As a result, Washington Mutual allocated approximately 43% of the additional $125.0 million provision to loans in the commercial real estate loan portfolio. The remainder was attributed to ASB's various residential loan portfolios, for which specific or allocated reserves were not recorded.
At December 31, 1998, the Company had specific or allocated reserves totaling $143.7 million, compared with $128.3 million at December 31, 1997 and $175.3 million at December 31, 1996. Of the amount added to allocated reserves during 1996, $53.8 million was attributable to the Company's review of ASB's commercial real estate loan portfolio as discussed above. During 1997 and 1998, the economy in California improved significantly and boosted the value of real estate across the state. This increase in real estate values resulted in a reduction in allocated reserves for commercial real estate loans during 1997.
The California economic growth and the recovery of commercial real estate markets nationwide also resulted in significant improvement in the quality of the apartment building and commercial real estate portfolio. At the end of 1996, management was particularly concerned about potential losses in this portfolio and had increased allocated reserves to it. Beginning in 1997 and continuing through 1998, the apartment building and commercial real estate portfolios have improved steadily reflecting the growth in jobs and
population. Average occupancy levels and rental rates have increased as has the average sales price per square foot. The result has been a reduction in the level of nonaccrual loans in these portfolios and reduced allocated reserves during 1997 and a small increase in 1998. Commercial real estate loan charge offs, net of recoveries, for 1998 totaled $17.7 million, which was less than net charge offs of $46.6 million in 1997 and $101.5 million in 1996.
Unallocated reserves are established for loss exposure that is not yet specifically identified but exists in the remainder of the loan portfolio. In determining the adequacy of unallocated reserves, management utilizes migration analysis and considers changes in the size and composition of the loan portfolio, historical loan loss experience, current and anticipated economic conditions, and the Company's credit administration and asset management philosophies and procedures.
Changes in the reserve for loan losses were as follows:
An analysis of the reserve for loan losses was as follows:
The Company considers the reserve for loan losses of $1.07 billion adequate to cover losses inherent in the loan portfolio at December 31, 1998. Although the reserve as a percentage of nonaccrual loans and nonperforming assets was higher at year-end 1998 than at year-end 1997, the reserve as a percentage of total loans was 0.98% at year-end 1998 compared with 1.06% at year-end 1997 and 1.13% at year-end 1996. The amount of nonperforming loans, nonaccrual loans and charge offs were each lower in 1998 than in 1997 despite a $10.75 billion increase in the size of the loan portfolio. In establishing the overall reserve level, management also took into account its uncertainty with the ultimate credit performance of loan portfolios recently acquired through the Coast Acquisition and the Ahmanson Merger. No assurance can be given that the Company will not, in any particular period, sustain loan losses that are sizable in relation to the amount reserved, or that subsequent evaluation of the loan portfolio, in light of the factors then prevailing, including economic conditions and the Company's ongoing examination process and that of its regulators, will not require significant increases in the reserve for loan losses.
The Company follows the practice of securitizing certain loans and retaining them in its investment portfolio. The Company's intent is to hold the majority of these securities to maturity. By remaining liable for potential losses on the loans underlying these securities, the Company believes it ultimately maintains higher yields. Because these loans are similar in all respects to the loans in its loan portfolio, the Company estimates its recourse obligation on these securities in a manner similar to the method it uses for the reserve for losses on its loan portfolio.
The liability for this recourse is included in other liabilities. Certain of the companies that have merged with Washington Mutual recorded the provision or liability differently. These differences were eliminated and the treatment of the liabilities conformed when the mergers were completed.
The Company has previously sold certain securities with recourse. The recourse obligation on these securities is also accounted for in a manner similar to the liability for recourse on securities the Company has originated and retained.
At December 31, 1998 and 1997, the Company had $18.62 billion and $15.00 billion of loans securitized and retained with recourse, and $5.83 billion and $5.90 billion of loans sold with recourse. At December 31, 1998 and 1997, the liability for this recourse was $144.3 million and $80.2 million.
The economic and credit conditions affecting these liabilities and provisions are similar to those affecting the Company's single-family loan portfolio.
Nonperforming Assets
Assets considered to be nonperforming include nonaccrual loans and foreclosed assets. When loans securitized or sold on a recourse basis are nonperforming, they are repurchased by the Company and included in nonaccrual loans. Management's classification of a loan as nonaccrual does not necessarily indicate that the
principal of the loan is uncollectible in whole or in part. Loans are generally placed on nonaccrual status when they are four payments or more past due. See "Notes to Consolidated Financial Statements -- Note 1: Summary of Significant Accounting Policies."
Nonperforming assets were $1.21 billion or 0.73% of total assets at December 31, 1998, compared with $1.37 billion or 0.96% of total assets at December 31, 1997. During 1996, the Company sold $292.4 million of nonperforming SFR loans and real estate. The loans and properties were primarily associated with originations that occurred between 1989 and 1992. Primarily as a result of the improving economy in California, bulk sales of SFR loans and foreclosed properties were discontinued in mid-1997 and Washington Mutual began using retail sales channels to dispose of foreclosed SFR assets.
Nonperforming assets consisted of the following:
Loans (exclusive of the reserve for loan losses) and nonaccrual loans by geographic concentration at December 31, 1998 were as follows:
At December 31, 1998, nonaccrual loans in California accounted for 63% of total nonaccrual loans, down from 66% in 1997. Due to the concentration of the Company's loans in California, the California real estate market requires continual review. In general, real estate values have improved during 1998. However, there may be regional differences in economic performance within California and among property types which are attributable to differing recovery rates for the wide range of economic activities within California.
Impaired Loans
Commercial real estate over $1 million, commercial business and builder construction loans are individually evaluated for impairment. A loan in one of these categories is considered impaired when it is (i) probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement, or (ii) a substandard loan, whether or not performing. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, the value of the underlying collateral, and current economic conditions.
At December 31, 1998, loans totaling $719.2 million were impaired, of which $558.6 million had allocated reserves of $143.7 million. Of the $719.2 million of impaired loans, $46.6 million were on nonaccrual status.
The amount of impaired loans and the related allocated reserve for loan losses were as follows:
ASSET AND LIABILITY MANAGEMENT STRATEGY
The long-run profitability of the Company depends not only on the success of the services it offers to its customers and the credit quality of its loans and securities, but also the extent to which its earnings are not negatively affected by changes in interest rates. The Company engages in a comprehensive asset and liability management program that attempts to reduce the risk of significant decreases in net interest income caused by interest rate changes without unduly penalizing current earnings. As part of this strategy, the Company actively manages the amounts and maturities of its assets and liabilities.
An inherent characteristic of the Company's deposit structure is customers' preference for liquidity. This is apparent from the fact that at December 31, 1998, the Company's MMDAs accounted for $20.49 billion or 24% of total deposits, and time deposit accounts with maturities less than one year totaled $39.49 billion or 46% of total deposits. As a result, another key component of this program is the origination and retention of short-term and adjustable-rate assets whose repricing characteristics more closely match the repricing characteristics of the Company's liabilities. At December 31, 1998, approximately 80% of the Company's total SFR loan and MBS portfolio had adjustable rates.
During periods of moderate to high market interest rates, originations of ARMs have been well received by customers. When interest rates are relatively low, however, unless long-term rates remain appreciably higher than short-term rates, borrowers show a preference for fixed-rate loans. During 1998, market interest rates were low and the difference between the yields on a three-month U.S. Treasury bill and a ten-year U.S. government note averaged only 37 basis points. The effect of this interest rate environment in 1998 was that 56% of the Company's SFR loan originations were fixed rate while 44% were ARMs. Because it is the Company's practice to sell conforming fixed-rate loans, lower levels of ARM originations can have an adverse effect on the Company's asset size, especially when combined with relatively high levels of prepayments, such as those experienced in 1998.
In order to maintain the balance between interest-sensitive liabilities and interest-sensitive assets, the Company continued to sell fixed-rate conforming loans and, at the same time, bought, in the secondary market, adjustable-rate MBS, pools of adjustable-rate loans and shorter duration tranches of CMOs, and has committed to further such purchases in 1999. See "Business -- Treasury Activities -- Investing Activities."
A conventional measure of interest rate sensitivity for savings institutions is the one-year gap, which is calculated by dividing the difference between assets maturing or repricing within one year and total liabilities
maturing or repricing within one year by total assets. The Company's assets and liabilities that mature or reprice within one year were as follows:
While the one-year gap helps provide some information about a financial institution's interest sensitivity, it does not predict the trend of future earnings. This is due, in part, to the lag risk, described below in "Item 7A
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The tables below represent in tabular form contractual balances of the Company's financial instruments at their expected maturity dates as well as the fair value of those financial instruments at December 31, 1998 and 1997. The expected maturity categories take into consideration historical prepayment speeds as well as actual amortization of principal and do not take into consideration reinvestment of cash. Principal prepayments are the amounts of principal reduction over and above normal amortization. The Company has used prepayment assumptions that are materially higher than normal for this analysis because of the current yield curve environment. The weighted average interest rates for the various assets and liabilities presented are actual as of December 31, 1998 and 1997. The principal/notional amounts and fair values presented in the following tables do not include the reserve for loan losses or recourse liability. See "Notes to Consolidated Financial Statements -- Note 25: Fair Value of Financial Instruments."
The differences in the maturities of assets between December 31, 1997 and December 31, 1998 related primarily to the $21.4 billion increase in interest-sensitive assets due to purchases of MBS and loan pools in the secondary market and to a change in assumptions with regard to prepayment speed. Due to increased levels of refinancing during 1998, the Company assumed higher estimated prepayment speeds in 1998 than in 1997.
The differences in maturities of liabilities were the result of two factors. Due to the Company's emphasis on checking accounts and MMDAs, 1998 had a higher percentage of transaction accounts compared with time deposits than in 1997. In addition, the Company substantially increased its wholesale fundings in 1998. These borrowings were shorter in duration and thus caused an increase in maturities under one year.
The Company is subject to various types of interest rate risk. Management characterizes these types as repricing risk, lag risk, basis risk, and cap risk.
Repricing risk
Currently, repricing risk is the Company's primary interest rate risk. It is caused by the mismatch in the maturities or repricing periods between interest-earning assets and interest-bearing liabilities. In particular, in a low interest rate environment with a flat yield curve, customers' preference for fixed-rate loans may result in the prepayment and refinancing of existing loans, fixed-rate and ARMs, to lower, fixed-rate mortgage loans. This preference, when combined with its policy of selling most of its fixed-rate loan production, may make it more difficult for the Company to increase or even maintain the size of its loan and MBS portfolio during these periods. In addition, premiums related to loans and MBS on the Company's Consolidated Statement of Financial Condition, as well as the servicing rights attributed to loans serviced for others, must be written off at the time of repayment, and can have an adverse impact on earnings.
Lag risk
In times of rising interest rates, the Company is negatively affected by an inherent timing difference between the repricing of its adjustable-rate assets and its liabilities. The effect of this timing difference, or "lag," will be favorable during a period of declining interest rates. Although the effect of this lag generally balances out over the life of a given loan, it can produce short-term volatility in the Company's net interest income during periods of interest rate movement. One example of this is the delay in the repricing of COFI-based assets, commonly referred to as "COFI lag." This lag results from the two-month delay in reported COFI because of the time required to gather the data needed to compute the index. The COFI used to reprice ARMs and adjustable-rate MBS actually reflects the cost of funds for a two-month prior period. As a result, COFI loans reprice more slowly than the Company's liabilities.
Basis risk
The repricing of the Company's assets and liabilities is also at risk from interest rate movements because generally its assets and liabilities are tied to different indices which may react differently to changes in interest rates. Loans tied to the COFI index create a form of basis risk for the Company because the cost of the portion of the Company's liabilities that are borrowings rather than deposits is higher than the general cost of funds for most of the other savings institutions whose costs are a component of COFI. To reduce basis risk, during 1997, the Company introduced the MTA loan. This loan has all the same borrower advantages as the COFI product, such as a 7.5% annual payment cap and four payment options. However, the MTA loan is indexed to the 12-month moving average of the one-year U.S. Treasury bill, which more closely reflects the Company's borrowing costs. During 1998, $16.45 billion or 90% of all SFR ARM originations were MTA loans. Management hopes to reduce potential net interest income volatility caused by COFI basis risk by increasing its production of MTA and other non-COFI adjustable-rate products and short-term fixed-rate products, such as consumer loans.
Borrowings are generally more rate sensitive than deposits and reprice more quickly as market interest rates (such as treasury rates) change. To the extent that loan indexes move at a different rate or in a different direction from the Company's cost of funds, the general cost of funds basis risk may be realized.
Cap risk
The lifetime interest rate caps, which the Company offers to its ARM borrowers, introduce another element of interest rate risk to the Company. In periods of high interest rates, it is possible for market interest rates to exceed the lifetime interest rate caps of existing ARM loans.
Loan indexes
As discussed previously, the majority of the Company's loans and MBS have adjustable rates that are tied to a market index. The Company's cost of funds compared to various indexes was as follows:
MANAGEMENT OF INTEREST RATE RISK AND DERIVATIVE ACTIVITIES
To further manage interest rate risk, the Company uses derivative instruments, such as interest rate exchange agreements and interest rate cap agreements, to mitigate interest rate risk. At December 31, 1998, the Company had entered into interest rate exchange agreements and interest rate cap agreements with notional values of $7.41 billion. Derivative instruments, if not used appropriately, can subject a company to unintended financial exposure. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Statement of Financial Condition. The contract or notional amount of these instruments reflects the extent of involvement the Company has in particular classes of financial instruments.
Management, in conjunction with the Company's Board of Directors, has established strict policies and guidelines for the use of derivative instruments. Moreover, Washington Mutual has used these instruments for many years to mitigate interest rate risk. These instruments are not intended to be used as techniques to generate earnings by speculating on the movements of interest rates, nor does the Company act as a dealer of these instruments. See "Notes to Consolidated Financial Statements -- Note 24: Interest Rate Risk Management."
The Company's current strategy is to use derivative instruments to hedge interest rate risk associated with deposits and borrowings. For example, the Company has entered into interest rate cap agreements to provide an additional layer of interest rate protection should interest rates on deposits and borrowings rise. Through the use of these agreements, management attempts to offset increases in interest expense related to these deposits and borrowings and effectively lengthen the repricing period. Thus, the Company has a degree of interest rate protection when interest rates increase because the interest rate cap agreements provide a mechanism for repricing the deposits and borrowings generally on pace with current market rates. In a similar way, interest rate exchange agreements are utilized to provide protection in an increasing rate environment, and also result in sensitivity in a downward market. There can be no assurance that interest rate exchange agreements and interest rate cap agreements will provide the Company with protection in all scenarios or to the full extent of the Company's exposure.
The effect that interest rate exchange agreements and interest rate cap agreements would have had on the repricing period of deposits and borrowings in an increasing interest rate environment (up 200 basis points) for the period the derivatives were outstanding was as follows:
The effect that interest rate exchange agreements and interest rate cap agreements would have had on the repricing period of deposits and borrowings in a decreasing interest rate environment (down 200 basis points) for the period the derivatives were outstanding was as follows:
The Company also hedges the risks associated with the mortgage pipeline. The mortgage pipeline consists of fixed-rate SFR loans, which will be sold in the secondary market. The risk associated with the mortgage pipeline is that interest rates will rise between the time the customer locks in the interest rate on the loan and the time the loan is sold. This period is usually 30 to 60 days. To hedge this risk, the Company executes forward sales agreements. A forward sales agreement protects the Company in a rising interest rate environment since the sales price and delivery date have already been established. A forward sales agreement, however, is different than an option contract in that the Company is obligated to deliver the loan to the third party on the agreed upon future date. As a result, if the loans do not fund, the Company may not have the necessary assets to meet its commitment. Therefore, the Company would be required to purchase other assets, at current market prices, to satisfy the forward sales contract. To mitigate this risk, the Company uses fallout factors, which represent the percentage of loans which are not expected to close, when calculating the amount of forward sales agreements to execute.
The Company has previously executed derivative instruments to reduce the risk of the available-for-sale portfolio. Because the available-for-sale portfolio is required to be carried at fair value, its carrying value fluctuates with changes in market factors, primarily interest rates. This portfolio is substantially composed of MBS, of which the vast majority have adjustable rates and the remainder have fixed rates. In an attempt to modify the interest flows on these securities, as well as protect against market value changes, certain interest rate exchange agreements have been designated to the available-for-sale portfolio. The effect of such agreements in a rising interest rate environment is to shorten the effective repricing period of the underlying assets. At December 31, 1998, the effect of the Company's exchange agreements in an increasing or decreasing interest rate environment (up or down 200 basis points) would be to shorten the repricing period of $500.0 million of MBS from in excess of two years to three months.
Counterparty risk
The Company's borrowing activities (including reverse repurchase agreements) and derivative instruments generally involve an exchange of obligations with another financial institution, referred to in such transactions as a counterparty. If a counterparty were to default, the Company could be exposed to a financial loss. A loss would result to the extent that the value of the collateral or funds held by the counterparty exceeded the value of the collateral or funds held by the Company. In order to minimize the risk, all counterparties are evaluated for financial strength on at least an annual basis. Exposure limits are then established for each counterparty. The Company's primary focus is to deal with well-established reputable and financially strong firms. The majority of the counterparties are U.S.-based companies.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For financial statements, see Index to Consolidated Financial Statements on page 66.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
Part III is incorporated by reference from the Company's definitive proxy statement issued in conjunction with the Company's Annual Meeting of Shareholders to be held April 20, 1999. Certain information regarding the principal officers of Washington Mutual is set forth in "Business -- Principal Officers."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS
See Index to Consolidated Financial Statements on page 66.
(2) FINANCIAL STATEMENT SCHEDULES
All financial statement schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or the Notes thereto.
(b) REPORTS ON FORM 8-K:
Washington Mutual filed the following reports on Form 8-K during the fourth quarter of 1998:
1. Report filed October 15, 1998. Items included: Item 2. Acquisition or Disposition of Assets, and Item 7. Financial Statements and Exhibits. The report included the financial statements of H. F. Ahmanson & Company for the years ended December 31, 1997, 1996 and 1995. The report also included pro forma financial information for Washington Mutual, Inc. for the years ended December 31, 1997, 1996 and 1995 as though the acquisition of H. F. Ahmanson & Company had taken place on January 1, 1995.
2. Report filed November 17, 1998. Items included: Item 5. Other Events.
3. Amended report filed November 30, 1998. Items included: Item 7. Financial Statements and Exhibits. The report included the unaudited financial statements of H. F. Ahmanson & Company for the nine months ended September 30, 1998 and 1997, and pro forma financial statements for Washington Mutual, Inc. for the nine months ended September 30, 1998 and 1997.
4. Report filed December 22, 1998. Items included: Item 7. Financial Statement and Exhibits. Additional exhibits relating to employee benefit plans were included.
(c) EXHIBITS:
See Index of Exhibits on page 134.
SIGNATURES
Pursuant to the requirements of the Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 10, 1999.
WASHINGTON MUTUAL, INC.
/s/ KERRY K. KILLINGER -------------------------------------- Kerry K. Killinger President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated on February 16, 1999.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Washington Mutual, Inc.:
We have audited the accompanying consolidated statements of financial condition of Washington Mutual, Inc. and subsidiaries (the "Company") as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated financial statements give retroactive effect to the merger on October 1, 1998, of Washington Mutual, Inc. and subsidiaries and H. F. Ahmanson & Company and subsidiaries, and the merger, on July 1, 1997, of Washington Mutual, Inc. and subsidiaries and Great Western Financial Corporation and subsidiaries, both of which were accounted for as poolings of interests as described in Note 2 to the consolidated financial statements. We did not audit the consolidated statement of financial condition of H. F. Ahmanson & Company and subsidiaries as of December 31, 1997, or the related consolidated statements of operations, stockholders' equity, and cash flows for the year then ended, which statements reflect total assets constituting 32% of consolidated total assets as of December 31, 1997, and total net income constituting 46% of consolidated net income for the year then ended. Those statements were audited by other auditors whose report, dated January 15, 1998 (except as to Note 2 of Notes to Consolidated Financial Statements, which is as of February 13, 1998 and Note 19 of Notes to Consolidated Financial Statements, which is as of March 16, 1998) has been furnished to us, and our opinion, insofar as it relates to the amounts included for H. F. Ahmanson & Company and subsidiaries for 1997, is based solely on the report of such other auditors.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors, such consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial condition of Washington Mutual, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years then ended, in conformity with generally accepted accounting principles.
We previously audited and reported on the consolidated statements of income, stockholders' equity and cash flows of Washington Mutual, Inc. and subsidiaries for the year ended December 31, 1996, prior to their restatement for the 1998 and 1997 poolings of interests. The net income of Washington Mutual, Inc. and subsidiaries constituted $114.3 million of restated net income of $375.4 million for the year ended December 31, 1996. Separate financial statements of the other companies included in the 1996 restated consolidated statements of income, comprehensive income, stockholders' equity and cash flows were audited and reported on separately by other auditors. We also audited the combination of the accompanying consolidated statements of income, comprehensive income, stockholders' equity and cash flows for the year ended December 31, 1996, after restatement for the 1998 and 1997 poolings of interests; in our opinion, such consolidated statements have been properly combined on the basis described in Note 2 to the consolidated financial statements.
/s/ Deloitte & Touche LLP
February 26, 1999 Seattle, Washington
INDEPENDENT AUDITORS' REPORT
The Board of Directors H. F. Ahmanson & Company:
We have audited the consolidated statement of financial condition of H. F. Ahmanson & Company and subsidiaries as of December 31, 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the two-year period ended December 31, 1997, which are not presented separately herein. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of H. F. Ahmanson & Company and subsidiaries as of December 31, 1997, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 1997, in conformity with generally accepted accounting principles.
/s/ KPMG LLP
Los Angeles, California January 15, 1998, except as to Note 2 of Notes to Consolidated Financial Statements, which is as of February 13, 1998 and Note 19 of Notes to Consolidated Financial Statements, which is as of March 16, 1998
REPORT OF INDEPENDENT ACCOUNTANTS
To The Board of Directors and Stockholders Great Western Financial Corporation
In our opinion, the accompanying consolidated statements of operations, of changes in stockholders' equity and of cash flows present fairly, in all material respects the results of operations and cash flows of Great Western Financial Corporation and its subsidiaries ("the Company") for the year ended December 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit of these statements in accordance with generally accepted auditing standards, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
Los Angeles, California January 22, 1997, except as to Note 28, which is as of March 7, 1997
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
See Notes to Consolidated Financial Statements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See Notes to Consolidated Financial Statements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
See Notes to Consolidated Financial Statements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See Notes to Consolidated Financial Statements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
See Notes to Consolidated Financial Statements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Washington Mutual, Inc. ("WMI" and together with its subsidiaries, "Washington Mutual" or the "Company") is a financial services company committed to serving consumers and small to mid-sized businesses. Through its subsidiaries, Washington Mutual engages in the following lines of business: mortgage banking, consumer banking, commercial banking, financial services and consumer finance. The Company's principal banking subsidiaries are Washington Mutual Bank, FA ("WMBFA"), Washington Mutual Bank ("WMB") and Washington Mutual Bank fsb ("WMBfsb"). The banking subsidiaries accept deposits from the general public, make residential loans, consumer loans, and limited types of commercial real estate loans (primarily loans secured by multi-family properties), and engage in certain commercial banking activities. The Company provides consumer installment loans and purchases retail installment contracts through its consumer finance subsidiary, Aristar, Inc. and its subsidiaries ("Aristar"). Washington Mutual markets annuities and other insurance products, offers full-service securities brokerage, and acts as the investment advisor to and the distributor of mutual funds. Certain reclassifications have been made to the 1997 and 1996 financial statements to conform to the 1998 presentation. All significant intercompany transactions and balances have been eliminated.
All information, including that of prior periods, has been restated to reflect the Company's 3-for-2 stock split in June 1998.
On October 1, 1998, H.F. Ahmanson & Company ("Ahmanson") merged with and into WMI and all of the subsidiaries of Ahmanson, including Home Savings of America, FSB ("Home Savings"), became subsidiaries of the Company (the "Ahmanson Merger").
On July 1, 1997, Great Western Financial Corporation ("Great Western") merged with and into a subsidiary of WMI and all of the subsidiaries of Great Western, including Great Western Bank, a Federal Savings Bank ("GWB") and Aristar, became subsidiaries of the Company (the "Great Western Merger").
On December 20, 1996, Keystone Holdings, Inc. ("Keystone Holdings") merged with and into WMI, and all of the subsidiaries of Keystone Holdings, including American Savings Bank, F.A. ("ASB"), became subsidiaries of the Company (the "Keystone Transaction").
The Ahmanson Merger, the Great Western Merger and the Keystone Transaction were all accounted for as poolings of interests. When Washington Mutual acquires a company through a material pooling of interests, current and prior period financial statements are restated to include the accounts of merged companies. As a result, the accompanying financial statements and notes thereto are presented as if the companies were merged as of the beginning of the earliest period shown. Previously reported balances of the merged companies have been reclassified to conform to the Company's presentation and restated to give effect to the combinations.
On February 13, 1998, Ahmanson acquired Coast Savings Financial, Inc. ("Coast"), which was accounted for as a purchase (the "Coast Acquisition"). Under this method of accounting, the assets and liabilities of Coast were adjusted to their estimated fair values and any excess of the purchase price over the fair value of the assets acquired, net of the fair value of the liabilities assumed, was recognized as goodwill. The resulting goodwill and core deposit intangibles are being amortized over 25 years and ten years, respectively. The operating activities of Coast have been included in the Company's results of operations from the date of acquisition.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the financial
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the financial statements.
Derivative Instruments
The Company uses derivative instruments, such as interest rate exchange agreements, interest rate cap agreements, and forward sales contracts of financial instruments to reduce its exposure to interest rate risk. Interest rate exchange agreements and interest rate cap agreements are used only if they have the effect of changing the interest rate characteristics of the assets or liabilities to which they are designated. Such effect is measured through ongoing correlation or effectiveness tests.
Interest rate exchange agreements and interest rate cap agreements are designated against interest-earning assets, deposits and borrowings. Agreements designated against available-for-sale securities are included at fair value in the available-for-sale portfolio and any mark-to-market adjustments are reported with the change in value of the available-for-sale portfolio. Interest rate exchange agreements and interest rate cap agreements designated against cash equivalents, loans, deposits and borrowings are reported at historical cost.
Under settlement accounting, the interest differential paid or received on interest rate exchange agreements and interest rate cap agreements is recorded as an adjustment to interest income or interest expense. The purchase premium of interest rate cap agreements is capitalized and amortized and included as a component of interest income or interest expense over the original term of the interest rate cap agreement. No purchase premiums are paid at the time of entering into interest rate exchange agreements.
From time to time, the Company terminates interest rate exchange agreements and interest rate cap agreements prior to maturity. Such circumstances arise if, in the judgment of management, such instruments no longer cost effectively meet policy objectives. Often such instruments are within one year of maturity. Gains and losses from terminated interest rate exchange agreements and interest rate cap agreements are recognized, consistent with the gain or loss on the asset or liability associated with the agreement. When the asset or liability is not sold or paid off, the gains or losses are deferred and amortized as additional interest income or interest expense over the original terms of the agreements or the remaining life of the designated asset or liability, whichever is less.
From time to time, the Company redesignates interest rate exchange agreements and interest rate cap agreements between earning assets and deposits and borrowings. Such redesignations are recorded at fair value at the time of transfer.
The Company uses forward sales contracts to hedge its exposure to increasing interest rates with respect to fixed-rate loans, which the Company intends to sell in the secondary market. Forward sales contracts are used to sell fixed-rate loans at a future date for a specified price. Gains or losses are recognized at the time the contracts mature and are recorded as a component of mortgage banking income.
The Company may write covered call options on its available-for-sale portfolio. If the option is exercised, the option fee is recorded as an adjustment to the gain or loss on the sale of the security. If the option is not exercised, the option fee is recognized as fee income.
Trading Securities
Securities classified as trading are accounted for at fair value with changes in unrealized gains and losses included in current period earnings.
Available-for-Sale Securities
Securities not classified as either trading or held to maturity are considered to be available for sale. Gains and losses realized on the sale of these securities are based on the specific identification method. Unrealized WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
gains and losses from available-for-sale securities are excluded from earnings and reported (net of tax) in accumulated other comprehensive income until realized.
Held-to-Maturity Securities
Investments classified as held to maturity are accounted for at amortized cost, but the Company must have both the positive intent and the ability to hold those securities to maturity. Other than temporary declines in fair value are recognized as a reduction to current earnings.
Loans
Loans held in portfolio are stated at the principal amount outstanding, net of deferred loan costs or fees and any discounts or premiums on purchased loans. Deferred costs or fees, discounts and premiums are amortized using the interest method over the estimated life of the loan. The Company sells most of its conforming fixed-rate single-family residential mortgage ("SFR") loans in the secondary market. SFR loans are defined as first lien mortgages on owner-occupied one-to-four family residences. At the date of origination, the loans so designated are identified as loans held for sale and carried at the lower of net cost or fair value on an aggregate basis, net of their related forward sales hedge gains and losses.
Management generally ceases to accrue interest income on any loan that becomes four payments delinquent and reverses all interest accrued up to that time. Thereafter, interest income is accrued only if and when, in management's opinion, projected cash proceeds are deemed sufficient to repay both principal and interest. All loans for which interest is not being accrued are referred to as loans on nonaccrual status.
The Company evaluates commercial real estate loans over $1 million, commercial business loans and builder construction loans for impairment on an individual basis. A loan in one of these categories is considered impaired when it is (i) probable that the Company will be unable to collect all amounts due according to the terms of the loan agreement, or (ii) designated a substandard loan, whether or not performing. Factors involved in determining impairment include, but are not limited to: the financial condition of the borrower, the value of the underlying collateral, and current economic conditions. The valuation of impaired loans is based on (i) the present value of expected future cash flows discounted at the loan's effective interest rate, (ii) the loan's observable market price, or (iii) the fair value of the collateral if the loan is collateral dependent. The amount by which the recorded investment in the loan exceeds either the present value of expected future cash flows or the value of the impaired loan's collateral is included in the Company's allocated reserve for loan losses. Any portion of an impaired loan classified as loss under regulatory guidelines is charged off or specifically reserved.
Reserve for Loan Losses
The reserve for loan losses is maintained at a level sufficient to provide for estimated loan losses based on evaluating known and inherent risks in the loan portfolio. The reserve is based on management's continuing analysis of the pertinent factors and trends underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, loan loss experience, current and anticipated economic conditions, predictive analytical tools (migration analyses), and detailed analysis of individual loans and credits for which full collectibility may not be assured. The detailed analysis includes techniques to estimate the fair value of loan collateral and the existence of potential alternative sources of repayment.
When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the reserve for loan losses. The existence of some or all of the following criteria will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not evidenced the ability or intent to bring the loan current; the Company has no recourse to the borrower, or if it does, the borrower has insufficient assets to pay the debt; or the fair value of the loan
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
collateral is significantly below the current loan balance and there is little or no near-term prospect for improvement.
Commercial real estate loans are considered by the Company to have somewhat greater risk of uncollectibility than residential real estate loans due to the dependency on income production or future development of the real estate.
Consumer finance loans are reviewed on a collective basis. In evaluating the adequacy of the reserve, consideration is given to recent loan loss experience and such other factors as, in management's judgment, deserve current recognition in estimating losses. Loans secured by collateral other than real estate are charged off based on the number of days contractually delinquent (180 days for substantially all loans).
The ultimate recovery of all loans is susceptible to future market factors beyond the Company's control. These factors may result in losses or recoveries differing significantly from those provided in the Consolidated Financial Statements.
Recourse Liability
The Company records a recourse liability to cover potential losses on loans securitized and retained in its MBS portfolio. The recourse liability is also intended to cover potential losses on loans and MBS sold to third parties for which a recourse liability exists. On a quarterly basis, a review is performed to determine the adequacy of the recourse liability. Because the portfolio of loans and securities for which a recourse obligation exists is similar to the Company's SFR loan portfolio, the review for adequacy of the recourse liability is substantially similar to the review of the adequacy of the reserve for SFR loan losses. Adjustments to the recourse liability are recorded in the provision for recourse liability. In 1998, in connection with the Ahmanson Merger, an additional amount was transferred from the reserve for loan losses to the recourse liability to conform with Washington Mutual's policy.
Foreclosed Assets
Foreclosed assets include properties acquired through foreclosure that are transferred at the lower of cost or fair value, less estimated selling costs, which represents the new recorded basis of the property. Subsequently, properties are evaluated and any additional declines in value are provided for in a reserve for losses or through a direct charge off to the property. The amount the Company ultimately recovers from foreclosed assets may differ substantially from the net carrying value of these assets because of future market factors beyond the Company's control or because of changes in the Company's strategy for sale or development of the property.
Mortgage Servicing Rights
Servicing rights are created when mortgage loans are originated and the loans are subsequently sold or securitized (and held as available-for-sale securities) with the servicing rights retained. The total cost of the mortgage loans is allocated to the servicing rights and the loans (without the servicing rights) based on their relative fair values. Purchased servicing rights represent the cost of acquiring the right to service mortgage loans. The cost relating to purchased and originated servicing is capitalized and amortized in proportion to, and over the period of, estimated future net servicing income. Short servicing is recorded in other liabilities in instances where the cost of servicing exceeds the servicing fees received and is amortized in proportion to, and over the period of, estimated net servicing loss.
The Company assesses impairment of the capitalized servicing rights based on the fair value of those rights on a stratum-by-stratum basis, with any impairment recognized through a valuation allowance for each impaired stratum. For purposes of measuring impairment, the servicing rights are stratified based on the following predominant risk characteristics of the underlying loans: fixed-rate mortgage loans by coupon rate WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(less than 6%, 50 basis point increments between 6% and 12%, and greater than 12%) and adjustable-rate mortgage loans ("ARMs") by index, such as the FHLB 11th District Cost of Funds Index ("COFI"), U.S. Treasury, or the London Interbank Offering Rate ("LIBOR").
In order to determine the fair value of the servicing rights, the Company primarily uses a valuation model that calculates the present value of expected future cash flows. Assumptions used in the valuation model include market discount rates and anticipated prepayment speeds. The prepayment speeds are determined from market sources for fixed-rate mortgages with similar coupons and prepayment reports for comparable ARMs. In addition, the Company uses market comparables for estimates of the cost of servicing per loan, inflation rates, ancillary income per loan and default rates.
Premises and Equipment
Land, buildings, leasehold improvements and equipment are carried at amortized cost. Buildings and equipment are depreciated over their estimated useful lives using the straight-line method. Leasehold improvements are amortized over the shorter of their useful lives or lease terms. The Company periodically reviews buildings and improvements for impairment. Impairment exists when the estimated undiscounted cash flows for the property is less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.
Intangible Assets
Because of the potential earning power or other identifiable values of certain purchased companies or businesses, the Company paid amounts in excess of identifiable fair value for assets acquired. Such amounts are being amortized by systematic charges to earnings over the estimated remaining life of the assets acquired. The Company periodically reviews intangibles to assess recoverability and impairment is recognized through a charge to earnings if permanent loss of value occurs.
Real Estate Held for Investment
Real estate held for investment ("REI") consists of properties which the Company intends to develop and sell. The periods of development and eventual sale of these properties may extend over several years and are dependent upon economic and other conditions. Costs to acquire and develop the properties, including a financing cost, are capitalized as incurred during construction. REI is also reviewed for impairment and impairment losses, if any, are recognized through a charge to earnings. At December 31, 1998 and 1997, the Company had total REI of $222.4 million and $211.1 million, which was included in other assets.
Company-Owned Life Insurance
The Company purchased life insurance policies as a funding source for certain employees' and directors' benefit plans and is the sole owner and beneficiary of these company-owned life insurance policies. Premiums paid, net of changes in the estimated cash surrender value of the related policies, are included in salaries and employee benefits.
Trust Assets
Assets held by the Company in a fiduciary or agency capacity for customers are not included in the Consolidated Statements of Financial Condition as such items are not assets of the Company. Assets totaling $176.5 million and $137.5 million as of December 31, 1998 and 1997 were held by the Company in a fiduciary or agency capacity.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Reverse Repurchase Agreements
The Company enters into agreements under which the Company sells securities subject to an obligation to repurchase the same or similar securities. Under these arrangements, the Company transfers legal control over the assets but still retains effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, reverse repurchase agreements are accounted for as financing arrangements and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability in the Consolidated Statements of Financial Condition while the dollar amount of securities underlying the agreements remains in the respective asset accounts.
Transaction-Related Expenses
The Company records transaction-related expenses in conjunction with its major business combinations. Transaction-related expenses are comprised of three major categories: employee severance costs, the write down of duplicate or excess premises and equipment, and other expenses related to effecting a business combination.
A liability for the cost of employee termination benefits that management intends to provide to involuntarily terminated employees is recognized in the period in which management approves the specific plan of termination, if all of the following conditions exist: (i) management has the appropriate level of authority to involuntarily terminate employees, (ii) management approves and commits the enterprise to the plan of termination, (iii) management establishes the benefits that current employees will receive upon termination, (iv) the benefit arrangement has been communicated to employees, (v) the communication of the benefit arrangement includes sufficient detail to enable employees to determine the type and amount of benefits they will receive if they are terminated, (vi) the plan of termination specifically identifies the number of employees to be terminated, their job classifications or functions, and their locations, and (vii) the period of time to complete the plan of termination indicates that significant changes to the plan of termination are not likely.
Upon consummation of a business combination, the Company specifically identifies duplicate or excess facilities in the combined operations. Duplicate or excess facilities fall into two categories: facilities owned by the Company and facilities leased by the Company. Duplicate or excess facilities owned by the Company are recorded at the lower of cost or fair value. Fair value of duplicate or excess facilities is estimated based on the present value of the expected future cash flows using a discount rate commensurate with the risks involved. The loss estimated and recorded while these facilities remain in service does not include the portion of the cost that is properly allocable to anticipated future service of the facility. Depreciation is recorded on these facilities while they remain in service. The loss estimated and recorded on leased duplicate or excess facilities represents either costs to be incurred by the Company under contractual obligations or represents penalties that will be incurred to cancel the contractual obligations. Lease payments made on these facilities while they remain in service are included in occupancy and equipment expense and are not included in transaction-related expenses.
Other expenses related to effecting a business combination consist of both period costs and accrued contract exit fees for duplicate services provided. The period costs include actual fees of professional services firms (legal, investment banking, etc.) that were incurred in conjunction with the combinations, and one-time, nonrecurring costs associated with combining the entities which are being expensed as incurred. The liability for contract exit fees for duplicate services is recognized when management makes the decision to terminate such contracts.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income Taxes
Income taxes are accounted for using the asset and liability method. Under this method, a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax bases of existing assets and liabilities are expected to be reported in the Company's income tax returns. The comprehensive deferred tax provision for the year is equal to the change in the deferred tax liability from the beginning to the end of the year. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date of the change.
The Company reports income and expenses using the accrual method of accounting and files a consolidated tax return on that basis as well. The Company's tax filings generally include all subsidiaries.
Keystone Holdings, Great Western and Ahmanson filed separate consolidated tax returns prior to the mergers with the Company. For periods subsequent to the mergers with Washington Mutual, the Company's consolidated tax return included the merged companies.
Year 2000 Project
The Company expenses all costs related to making its information systems and facilities ready for the Year 2000 date change.
Average Balances
Average balances are obtained from the best available daily, weekly or monthly data, which management believes approximate the average balances calculated on a daily basis.
Recently Issued Accounting Standards Adopted in These Financial Statements
Statement of Financial Accounting Standards ("SFAS") No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, was issued in June 1996 and established, among other things, new criteria for determining whether a transfer of financial assets in exchange for cash or other consideration should be accounted for as a sale or as a pledge of collateral in a secured borrowing. As issued, SFAS No. 125 was effective for all transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. In December 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125, which deferred the adoption date of certain collateral recognition provisions of SFAS No. 125 until January 1, 1998. The Company adopted the relevant provisions of SFAS No. 125 effective January 1, 1997, and the deferred provisions effective January 1, 1998. There was no material impact on the Company's results of operations or financial condition due to the adoption of these statements.
SFAS No. 130, Reporting Comprehensive Income, was issued in June 1997 and requires businesses to disclose comprehensive income and its components in their financial statements. This statement does not affect the results of operations or financial condition of the Company. The Company adopted SFAS No. 130 on January 1, 1998.
SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, was issued in June 1997 and redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. This statement does not affect the results of operations or financial condition of the Company. SFAS No. 131 was adopted by the Company on January 1, 1998.
SFAS No. 132, Employers' Disclosure about Pensions and Other Postretirement Benefits, was issued in February 1998 and standardizes the annual disclosure requirements for pensions and other postretirement WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
benefits. This statement does not affect the results of operations or financial condition of the Company. SFAS No. 132 was adopted by the Company on January 1, 1998.
Recently Issued Accounting Standards Not Yet Adopted
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was issued in June 1998 and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The Company will implement this statement on January 1, 2000. The impact of the adoption of the provisions of this statement on the results of operations or financial condition of the Company has not yet been determined.
SFAS No. 134, Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, was issued in October 1998. Prior to issuance of SFAS No. 134, when a mortgage banking company securitized mortgage loans held for sale but did not sell the security in the secondary market, the security was classified as trading. SFAS No. 134 requires that the security be classified either trading, available for sale or held to maturity according to the Company's intent, unless the Company has already committed to sell the security before or during the securitization process. The statement is effective for all fiscal years beginning after December 15, 1998. This statement is not expected to have a material impact on the results of operations or financial condition of the Company.
NOTE 2: BUSINESS COMBINATIONS/RESTRUCTURING
On October 1, 1998, Washington Mutual completed its merger with Ahmanson. On that date, Ahmanson had assets of $50.35 billion, deposits of $33.97 billion and stockholders' equity of $3.61 billion. The Company issued 205,582,840 shares of common stock to complete the merger. The results of operations of Ahmanson for 1997 have been reduced as a result of reclassifying to equity the $10.4 million after-tax gain reported by Ahmanson in connection with its purchase and subsequent sale of common stock of Great Western.
Total revenue (defined as interest income plus other income) and net income of the Company and Ahmanson were as follows:
Reconciliations of total revenue and net income previously presented by the Company with the combined amounts presented in the accompanying Consolidated Statements of Income were as follows:
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On February 13, 1998, Ahmanson completed the Coast Acquisition. At the date of acquisition, Coast had total assets of $8.90 billion and deposits of $6.40 billion. Ahmanson reissued 16,263,796 shares of its common stock held in treasury to complete the acquisition. The value of Ahmanson common stock issued to complete the acquisition was $925.1 million as of the purchase date. Ahmanson recorded $431.5 million in goodwill, which included $79.0 million of transaction-related expenses, which were capitalized. In addition, Ahmanson recognized core deposit intangibles of $85.0 million.
On July 1, 1997, Washington Mutual completed the Great Western Merger. On that date, Great Western had assets of $43.77 billion, deposits of $27.79 billion and stockholders' equity of $2.69 billion. The Company issued 188,474,327 shares of common stock to complete the merger.
The conversion of 4.7 million deposit accounts and 1.5 million transaction card accounts at nearly 370 former GWB locations in Florida and northern and southern California was completed in three phases during the second quarter of 1998. In addition, 86 California financial centers were consolidated into existing Washington Mutual locations in 1998. The GWB and ASB loan portfolios were consolidated in a process that involved approximately 650,000 mortgage and consumer loans.
On December 20, 1996, the Company completed the Keystone Transaction. At November 30, 1996, Keystone Holdings had assets of $21.89 billion, deposits of $12.82 billion and stockholders' equity of $808.6 million. The Company issued 71,825,000 shares of common stock to complete the Keystone Transaction.
During 1996, Great Western implemented a restructuring plan to improve its competitive position, accelerate expense reduction and enhance future revenue growth by streamlining operations, making efficient use of premises and modernizing its systems platform. The Company recorded $68.3 million of restructuring charges in 1996. The components of the restructuring charges were severance and related payments, and facilities and equipment impairment. The incomplete Great Western restructuring activities have been integrated into the consolidation activities associated with the Great Western Merger and are now accounted for in connection with the transaction-related expenses discussed below.
As a result of the Ahmanson Merger and the Coast Acquisition in 1998, the Great Western Merger in 1997 and the Keystone Transaction in 1996, the Company recorded transaction-related expenses of $508.3 million, $431.1 million and $226.4 million (inclusive of $68.3 million of restructuring charges related to Great Western, as discussed above) during 1998, 1997 and 1996. The majority of the expenses were for severance and related payments, facilities and equipment impairment, and various investment banking, legal and contract exit fees. The accrual of $262.0 million at year-end 1998 and $196.1 million at year-end 1997 related primarily to expenses for specifically identified severance programs, the impairment of premises and equipment and the liability for contract exit fees for duplicate services.
The Company expected staff reductions related to the Keystone Transaction and Great Western Merger of approximately 2,850 and additional staff reductions of 3,400 related to the Ahmanson Merger. As of December 31, 1998, all staff reductions related to the Keystone Transaction and the Great Western Merger were completed and approximately 800 employee separations had occurred as a result of the Ahmanson Merger. The remaining employee separations are planned to be completed by the end of September 1999.
Offices used by the Company on the Irwindale, California campus are expected to be closed by the end of the third quarter of 1999. The 646,000 square feet of office space at the Irwindale campus is expected to become available to sublet to third party tenants beginning in mid-1999.
The Company has identified 162 branch consolidations in California that will result from the Ahmanson Merger. The consolidations are scheduled for mid-1999 and will coincide with the conversion of the Home Savings branches in California to Washington Mutual's systems and signage.
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The carrying amount of all assets acquired through mergers and held for disposal at December 31, 1998 was $80.2 million.
Reconciliations of the transaction-related expenses and accrual activity were as follows:
On December 31, 1998, the Company acquired Industrial Bank ("Industrial") of Van Nuys, California for $2.8 million in cash. The acquisition was effected by the merger of Industrial into WMB. At December 31, 1998, Industrial had assets of $27.2 million, deposits of $26.1 million and stockholders' equity of $355,000. The acquisition of Industrial was accounted for as a purchase for accounting purposes. Under purchase
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accounting, the assets, liabilities and stockholders' equity of the acquired entity were recorded on the books of Washington Mutual at their respective fair values at the time of the acquisition. The resulting goodwill was not material.
On January 15, 1997, Washington Mutual acquired United Western Financial Group, Inc. ("United Western") of Salt Lake City, Utah and its United Savings Bank and Western Mortgage Loan Corporation subsidiaries for $79.5 million in cash. At January 15, 1997, United Western had assets of $404.1 million, deposits of $299.9 million, and stockholders' equity of $53.7 million. The acquisition of United Western was accounted for as a purchase for accounting purposes. The resulting goodwill was not material.
On January 31, 1996, the Company acquired Western Bank ("Western") through a merger of Western with and into WMB. At January 31, 1996, Western had assets of $776.3 million, deposits of $696.4 million and stockholders' equity of $69.5 million. The Company issued 8,797,853 shares of common stock to complete the merger with Western. The merger was treated as a pooling of interests and the financial information presented in this document reflects the pooling of interests method of accounting for the merger of Western into the Company. Accordingly, the assets, liabilities and stockholders' equity of Western were recorded on the books of the Company at their values as reported on the books of Western immediately prior to consummation of the merger with Western. This presentation required the restatement of prior periods as if the companies had been combined for all years presented.
NOTE 3: CASH AND CASH EQUIVALENTS
Cash and cash equivalents consisted of the following:
For the purpose of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, U.S. Treasury bills, overnight investments, commercial paper and repurchase agreements.
Federal Reserve Board regulations require depository institutions to maintain certain minimum reserve balances. Included in cash were balances maintained at the Federal Reserve Bank of San Francisco of $146.5 million and $201.3 million at December 31, 1998 and 1997.
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NOTE 4: SECURITIES
The amortized cost, unrealized gains, unrealized losses, and fair values of securities (exclusive of trading securities) were as follows:
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Securities (exclusive of trading securities) by contractual maturity were as follows:
In addition to agency securities, the securities portfolio contained investment grade private issue MBS of $11.73 billion and $6.53 billion at December 31, 1998 and 1997. At December 31, 1998, the Company had private issue MBS with an amortized cost of $986.2 million and a fair value of $980.4 million from a single issuer, General Electric Capital Mortgage Services, which exceeded 10% of the Company's equity.
Proceeds from sales of securities in the available-for-sale portfolio during 1998, 1997 and 1996 were $2.16 billion, $2.36 billion and $4.76 billion. The Company realized $19.1 million in gains and $1.0 million in losses on these sales during 1998. The Company realized $8.3 million in gains and $0.9 million in losses on sales during 1997. Similarly, the Company realized $42.4 million in gains and $34.1 million in losses during 1996.
MBS with an amortized cost of $25.93 billion and a fair value of $26.10 billion at December 31, 1998 were pledged to secure public deposits, reverse repurchase agreements, other borrowings, interest rate exchange agreements, and access to the Federal Reserve discount window.
In connection with the Great Western Merger, the Company reclassified certain MBS from available for sale to held to maturity. The unrealized pretax gain at the time of the reclassification of $102.7 million was retained in equity and is being amortized over the life of the related securities. At December 31, 1998 and 1997, the unamortized pretax gain, included as a component of accumulated other comprehensive income, was $73.0 million and $99.4 million.
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NOTE 5: LOANS
Loans consisted of the following:
Real estate construction (including SFR construction and commercial real estate construction) and commercial business loans by maturity date were as follows:
Nonaccrual loans totaled $938.0 million and $1.03 billion at December 31, 1998 and 1997. If interest on nonaccrual loans had been recognized, such income would have been $66.4 million in 1998, $66.2 million in 1997 and $99.4 million in 1996.
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The amount of impaired loans and the related allocated reserve for loan losses were as follows:
The average balance of impaired loans and the related interest income recognized were as follows:
Loans totaling $47.70 billion and $30.14 billion at December 31, 1998 and 1997 were pledged to secure advances from FHLBs. At December 31, 1998, the Company had $2.86 billion in fixed-rate SFR loan commitments, $2.14 billion in ARM commitments, $882.3 million in SFR construction loan commitments, $627.2 million in commercial business loan commitments, $200.4 million in commercial real estate loan commitments, and $3.25 billion in undisbursed lines of credit.
The Company had net unamortized deferred loan costs of $68.2 million at the end of 1998. At December 31, 1997, the Company had net unamortized deferred loan fees of $56.1 million. The amortization of net deferred loan fees included in interest income totaled $6.6 million in 1998, $51.3 million in 1997 and $72.0 million in 1996.
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NOTE 6: RESERVE FOR LOAN LOSSES AND RECOURSE LIABILITY
Changes in the reserve for loan losses were as follows:
In connection with the Keystone Transaction, the Company provided an additional $125.0 million in loan loss provision. This additional loan loss provision was provided principally because a number of Washington Mutual credit administration and asset management philosophies and procedures differed from those of ASB. The provision in 1996 also included $50.0 million attributable to a bulk sale of loans at GWB.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As part of the ongoing process to determine the adequacy of the reserve for loan losses, the Company reviews the components of its loan portfolio for specific risk of principal loss. An analysis of the reserve for loan losses was as follows:
Changes in the recourse liability were as follows:
NOTE 7: MORTGAGE SERVICING
Loans serviced consisted of the following:
As of December 31, 1998, the Company serviced 385 Government National Mortgage Association ("GNMA") loan pools with an outstanding security balance of $269.3 million. The Company did not issue any additional GNMA loan pools during 1998.
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Changes in the balance of mortgage servicing rights were as follows:
Changes in the balance of short servicing were as follows:
Changes in the valuation for impairment of mortgage servicing rights were as follows:
NOTE 8: INVESTMENT IN FHLBS
The investment in the FHLBs of Seattle and San Francisco consisted of capital stock, at cost, totaling $2.03 billion at December 31, 1998 and $1.47 billion at December 31, 1997. The Company earned yields of 6.37% in 1998, 6.51% in 1997 and 6.52% in 1996 from its investment in FHLBs. The investment in FHLB stock is required to permit the Company to borrow from the FHLBs.
NOTE 9: FORECLOSED ASSETS
Foreclosed assets consisted of the following:
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Foreclosed asset operations were as follows:
Changes in the reserve for losses were as follows:
NOTE 10: PREMISES AND EQUIPMENT
Premises and equipment consisted of the following:
Depreciation expense for 1998, 1997 and 1996 was $145.9 million, $174.5 million and $180.7 million.
The Company leases various branch offices, office facilities and equipment under capital and noncancelable operating leases which expire at various dates through 2077. Some leases contain escalation provisions for adjustments in the consumer price index and provide for renewal options for five- to ten-year periods. Rental expense, including amounts paid under month-to-month cancelable leases, amounted to $182.8 million, $186.1 million and $175.8 million in 1998, 1997 and 1996.
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Future minimum net rental commitments, including maintenance and other associated costs, for all noncancelable leases were as follows:
NOTE 11: INTANGIBLE ASSETS
Intangible assets consisted of the following:
Intangible assets result from acquisitions accounted for as the purchase of assets and the assumption of liabilities and consist primarily of goodwill, core deposit intangibles and covenants not to compete. Intangible assets are amortized using the straight-line method over the period that is expected to be benefitted, generally from five to 25 years. In February 1998, the Company acquired Coast under the purchase accounting method, which created goodwill of $431.5 million and core deposit intangibles of $85.0 million. Intangible assets arising from business combinations were reduced by $42.0 million during 1998 as a result of a reduction in the deferred tax asset valuation allowance for net operating loss carryforwards the Company acquired in a business combination accounted for as a purchase. The average remaining amortization period at December 31, 1998 was approximately 15 years.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 12: DEPOSITS
Deposits consisted of the following:
Time deposit accounts in amounts of $100,000 or more totaled $6.42 billion and $6.32 billion at December 31, 1998 and 1997. At December 31, 1998, $2.44 billion of these deposits mature within three months or less, $1.53 billion mature in over three to six months, $1.73 billion mature in over six months to one year, and $721.7 million mature after one year.
Financial data pertaining to the weighted average cost of deposits were as follows:
The weighted average interest rate is based upon stated interest rates without giving consideration to daily compounding of interest or forfeiture of interest because of premature withdrawals. Accrued but unpaid interest on deposits included in other liabilities totaled $49.2 million and $80.0 million at December 31, 1998 and 1997.
Interest expense on deposits was as follows:
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NOTE 13: FEDERAL FUNDS PURCHASED AND COMMERCIAL PAPER
Federal funds purchased and commercial paper consisted of the following:
Federal funds purchased have maturities of up to 12 months, and at December 31, 1998, the average maturity was 37 days. Aristar issues commercial paper with original maturities of less than 90 days, with an average maturity at December 31, 1998 of 31 days.
Financial data pertaining to federal funds purchased and commercial paper were as follows:
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NOTE 14: REVERSE REPURCHASE AGREEMENTS
The Company sold, under agreements to repurchase, specific securities of the U.S. government and its agencies and other approved investments to broker-dealers and customers. Securities underlying the agreements with broker-dealers were delivered to the dealer who arranged the transaction or were held by a safekeeping agent for the Company's account. Securities delivered to broker-dealers may be loaned out in the ordinary course of operations.
Scheduled maturities or repricing of reverse repurchase agreements were as follows:
Financial data pertaining to reverse repurchase agreements were as follows:
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NOTE 15: ADVANCES FROM FHLBS
As members of the FHLBs of San Francisco and Seattle, WMBFA, WMB and WMBfsb maintain credit lines that are percentages of their total regulatory assets, subject to collateralization requirements. Advances are collateralized in the aggregate by all stock owned of the FHLBs, by deposits with the FHLBs, and by certain mortgages or deeds of trust and securities of the U.S. government and its agencies. The maximum amount of credit which the FHLBs will extend for purposes other than meeting withdrawals varies from time to time in accordance with their policies. The interest rates charged by the FHLBs for advances vary depending upon maturity, the cost of funds in the individual FHLB and the purpose of the borrowing.
Scheduled maturities of advances from FHLBs were as follows:
Financial data pertaining to advances from FHLBs were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 16: OTHER BORROWINGS
Other borrowings consisted of the following:
The Company is the guarantor of four separate issues of trust preferred securities, as discussed below:
On May 31, 1997, Washington Mutual Capital I ("WMC I"), a wholly-owned subsidiary of Washington Mutual, issued $400.0 million of 8.375% Subordinated Capital Income Securities. In connection with WMC I's issuance of these securities, Washington Mutual issued to WMC I $412.4 million principal amount of its 8.375% Junior Subordinated Debentures, due 2027 (the "subordinated debentures"). The sole assets of WMC I are and will be the subordinated debentures.
On January 27, 1997, Great Western Financial Trust II ("GWFT II"), a wholly-owned subsidiary of Great Western, issued $300.0 million of 8.206% Trust Originated Preferred Securities. In connection with GWFT II's issuance of these securities, Great Western issued to GWFT II $309.3 million principal amount of its 8.206% subordinated deferrable interest notes, due 2027 (the "subordinated notes due 2027"). The sole assets of GWFT II are and will be the subordinated notes due 2027.
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In December 1996, Ahmanson Trust I (the "capital trust"), a wholly-owned subsidiary of Ahmanson, issued $150.0 million of 8.36% Company-obligated mandatorily redeemable capital securities, Series A, of subsidiary trust holding solely Junior Subordinated Deferrable Interest Debentures of Ahmanson. In connection with the capital trust's issuance of these securities, Ahmanson issued to the capital trust $154.6 million principal amount of its 8.36% subordinated notes, due December 2026 (the "subordinated notes due 2026"). The sole assets of the capital trust are and will be the subordinated notes due 2026.
In December 1995, Great Western Financial Trust I ("GWFT I"), a wholly-owned subsidiary of Great Western, issued $100.0 million of 8.25% Trust Originated Preferred Securities. In connection with GWFT I's issuance of these securities, Great Western issued to GWFT I $103.1 million principal amount of its 8.25% subordinated deferrable interest notes, due 2025 (the "subordinated notes due 2025"). The sole assets of GWFT I are and will be the subordinated notes due 2025.
Obligations of Great Western and Ahmanson under the above described arrangements were assumed by the Company. Washington Mutual's obligations under these and related agreements, taken together, constitute a full and unconditional guarantee by the Company of the obligations specified above.
The Company has a right to defer payment of interest on the debentures at any time or from time to time for a period not exceeding the extension period described in the table below with respect to each deferral period, provided that no extension period may extend beyond the stated maturity of the respective debentures. Distributions paid on the securities are recorded as interest expense in the Consolidated Statements of Income.
Financial data pertaining to trust preferred securities were as follows:
At December 31, 1998 and 1997, the Company had outstanding and unused secured lines of credit totaling $150.0 million and $86.0 million with the Federal Reserve Bank to cover overdrafts.
In December 1996, the Company entered into two revolving credit facilities with The Chase Manhattan Bank ("Chase"): a $100.0 million 364-day facility and a $100.0 million four-year facility. In November 1997, these credit facilities were amended by increasing the amounts for each from $100.0 million to $200.0 million. The facilities are available for general corporate purposes, including providing capital to the Company's subsidiaries.
As of December 31, 1998 and 1997, the Company had entered into five other credit agreements with various parties permitting aggregate borrowing up to $986.0 million. The two largest of these agreements were a $550.0 million revolving credit facility with Bank of Montreal and Chase to back Aristar's commercial paper
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program and a $428.0 million letter of credit with the FHLB of San Francisco to provide credit enhancement on certain of the Company's private issue MBS.
As of December 31, 1998 and 1997, there were no outstanding borrowings under these facilities.
NOTE 17: INCOME TAXES
Income taxes (benefits) from continuing operations consisted of the following:
Income taxes (benefits) were allocated as follows:
Provisions of the Small Business Job Protection Act of 1996 (the "Job Protection Act") significantly altered the Company's tax bad debt deduction method and the circumstances that would require a tax bad debt reserve recapture. Prior to enactment of the Job Protection Act, savings institutions were permitted to compute their tax bad debt deduction through use of either the reserve method or the percentage of taxable income method. The Job Protection Act repealed both of these methods for large savings institutions and allows for bad debt deductions based only on actual current losses. While repealing the reserve method for computing tax bad debt deductions, the Job Protection Act allows thrifts to retain their existing base year bad debt reserves but requires that reserves in excess of the balance at December 31, 1987, be recaptured into taxable income. The tax liability for this recapture is included in the accompanying Consolidated Financial Statements.
The base year reserve is recaptured into taxable income only in limited situations, such as in the event of certain excess distributions or complete liquidation. None of the limited circumstances requiring recapture are contemplated by the Company. The amount of the Company's tax bad debt reserves subject to recapture in these circumstances approximates $2.01 billion at December 31, 1998. Due to the indefinite nature of the
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recapture provisions, no tax liability has been established in the accompanying Consolidated Financial Statements.
During 1998, the Company completed a settlement with the Internal Revenue Service (the "Service") for Great Western for 1987 and 1986, and Washington Mutual for 1993 and 1992. The Service is currently examining Great Western for 1988 through 1992 and Washington Mutual for 1994 through 1997. The Service is in the process of finalizing the Ahmanson 1990 through 1993 examination and has referred one issue to the Service's National Office for Technical Advice. The Service's National Office has notified the Company that they are tentatively issuing an adverse ruling. The Company has not recorded any benefit with respect to this issue. No additional adjustments were required as of December 31, 1998, from the above examinations.
The significant components of the Company's net deferred tax asset (liability) were as follows:
The Company establishes a valuation allowance for deferred tax assets when it is not determined that those assets are more likely than not to be realized. The valuation allowance of $188.7 million at December 31, 1998 and $615.5 million at December 31, 1997 relate primarily to net operating losses that are limited by Internal Revenue Code Section 382 as a result of the Keystone Transaction.
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As a result of the Keystone Transaction, the Company and certain of its affiliates are parties to an agreement (the "Assistance Agreement") with a predecessor of the Federal Savings and Loan Insurance Corporation ("FSLIC") Resolution Fund (the "FRF"), which generally provides that 75% of most of the federal tax savings and approximately 19.5% of most of the California tax savings (as computed in accordance with the Assistance Agreement), attributable to ASB's utilization of certain tax loss carryovers of New West Federal Savings and Loan Association, are to be paid by the Company to the FRF. The Assistance Agreement sets forth certain special adjustments to federal taxable income to arrive at "FSLIC taxable income," which is then offset by utilizable net operating losses to compute the benefit due to the FRF.
The decrease in the valuation allowance of $426.8 million and the increased payments in lieu liability during the year ended December 31, 1998 was due primarily to a one-time favorable adjustment in the Company's deferred tax asset attributable to the Keystone Transaction.
Federal and state income tax net operating loss carryforwards due to expire under current law during the years indicated were as follows:
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Reconciliations between income taxes computed at statutory rates and income taxes included in the Consolidated Statements of Income were as follows:
NOTE 18: CONTINGENCIES
The Company has certain litigation and negotiations in progress resulting from activities arising from normal operations. In the opinion of management, none of these matters is likely to have a materially adverse effect on the Company's results of operations or financial condition.
As part of the administration and oversight of the Assistance Agreement and other agreements among ASB, certain of its affiliates and the Federal Deposit Insurance Corporation ("FDIC"), the FDIC has a variety of review and audit rights, including the right to review and audit computations of payments in lieu of taxes.
At December 31, 1998, Washington Mutual (as successor to Coast) had letters of credit outstanding aggregating $235.8 million, which are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in these letters of credit is essentially the same as that involved in making real estate loans. The letters of credit generally expire from one to ten years after the date of issuance.
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NOTE 19: STOCKHOLDERS' EQUITY
Common Stock
Changes in common stock outstanding were as follows:
Cash dividends paid per share were as follows(1):
Prior to the business combination with Washington Mutual, acquired companies paid total common cash dividends of $69.6 million, $154.6 million and $288.3 million in 1998, 1997 and 1996.
In addition to being influenced by legal, regulatory and economic restrictions, WMI's ability to pay dividends is also predicated on the ability of its subsidiaries to declare and pay dividends to WMI. These subsidiaries are subject to legal, regulatory and debt covenant restrictions on their ability to pay dividends.
Retained earnings of the Company at December 31, 1998 included a pre-1988 thrift bad debt reserve for tax purposes of $2.01 billion for which no federal income taxes had been provided. In the future, if this thrift bad debt reserve is used for any purpose other than to absorb bad debt losses, or if any of the thrift subsidiaries no longer qualifies as either a bank or a qualified thrift lender, the Company will incur a federal income tax liability, at the then prevailing corporate tax rate, to the extent of such subsidiary's pre-1988 thrift bad debt reserve.
In 1990, the Company's Board of Directors adopted a Shareholder Rights Plan and declared a dividend of one right for each outstanding share of common stock to shareholders of record on October 31, 1990. The rights have certain anti-takeover effects. They are intended to discourage coercive or unfair takeover tactics
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and to encourage any potential acquirer to negotiate a price fair to all shareholders. The rights may cause substantial dilution to an acquiring party that attempts to acquire the Company on terms not approved by the Board of Directors, but they will not interfere with any friendly merger or other business combination. The plan was not adopted in response to any specific effort to acquire control of the Company.
See -- "Note 18: Contingencies" for discussion of the 12,000,000 shares of common stock held in escrow.
Preferred Stock
There was no preferred stock (10,000,000 shares authorized without regard to merged companies) issued or outstanding at December 31, 1998. Preferred stock at December 31, 1997 consisted of the following:
In 1993, the Company issued 2,000,000 shares of 7.60% Noncumulative Perpetual Preferred Stock, Series E ("Series E Preferred Stock"), at $25.00 per share for net proceeds of $48.2 million. The Series E Preferred Stock had a liquidation preference of $25.00 per share plus dividends accrued and unpaid for the then current dividend period. Dividends, if and when declared by Washington Mutual's Board of Directors, were at an annual rate of $1.90 per share. Dividends were declared and paid in all quarters from issuance to redemption. In November 1995, the Company purchased and retired 30,000 shares of the Series E Preferred Stock. The Company redeemed the remaining Series E Preferred Stock on September 16, 1998, at the redemption price of $25.00 per share plus unpaid dividends, for the then current dividend period up to the date fixed for redemption.
In 1993, Ahmanson issued 575,000 shares of 6.00% Cumulative Convertible Preferred Stock, Series D ("Series D Convertible Preferred Stock") and received net proceeds of $280.7 million. The Series D Convertible Preferred Stock was convertible into 11,814,238 million shares of Ahmanson's common stock at a rate of $24.335 per share of common stock. Dividends, if and when declared by Ahmanson's Board of Directors, were at an annual rate of $30.00 per share. Dividends were declared and paid in all quarters from issuance to redemption or conversion. On or before August 24, 1998, substantially all of these shares were converted to Ahmanson common stock.
In 1993, Ahmanson issued 780,000 shares of 8.40% Preferred Stock, Series C ("Series C Preferred Stock-Ahmanson") and received net proceeds of $188.4 million. The Series C Preferred Stock-Ahmanson had a liquidation preference of $195.0 million plus dividends accrued and unpaid for the then current dividend period. Dividends, if and when declared by Ahmanson's Board of Directors, were at an annual rate of $21.00 per share. Dividends were declared and paid in all quarters from issuance to redemption. On March 2, 1998, Ahmanson redeemed at par the entire $195.0 million of Series C Preferred Stock-Ahmanson.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In 1992, the Company issued 2,800,000 shares of 9.12% Noncumulative Perpetual Preferred Stock, Series C ("Series C Preferred Stock"), at $25.00 per share for net proceeds of $67.4 million. The Series C Preferred Stock had a liquidation preference of $25.00 per share plus dividends accrued and unpaid for the then current dividend period. Dividends were at an annual rate of $2.28 per share. Dividends were declared and paid in all quarters from issuance to redemption. In November 1995, the Company purchased and retired 47,500 shares of the Series C Preferred Stock. The Company redeemed the remaining Series C Preferred Stock on January 1, 1998, at the redemption price of $25.00 per share plus unpaid dividends, for the then current dividend period up to the date fixed for redemption.
In 1992, Great Western issued 6,600,000 depository shares, each representing a one-tenth interest in a share of 8.30% Cumulative Preferred Stock ("Cumulative Preferred Stock"). The Cumulative Preferred Stock had a liquidation value of $250.00 per share. Each share of Cumulative Preferred Stock was redeemable at the option of the Company on or after November 1, 1997, at $250.00 per share, plus accrued and unpaid dividends. Dividends were cumulative from the date of issue and were payable quarterly. Dividends were declared and paid in all quarters from issuance to redemption. On July 1, 1997, in connection with the Great Western Merger, each outstanding share of Cumulative Preferred Stock was converted into one share of WMI 8.30% Cumulative Preferred Stock, Series F ("Series F Preferred Stock"). The terms, preferences, limitations, privileges and rights of the Series F Preferred Stock were substantially identical to those of the Cumulative Preferred Stock. As in the case of the Cumulative Preferred Stock, each share of Series F Preferred Stock was represented by depository shares (the "New Washington Mutual Depository Shares"), each representing a one-tenth interest in a share of the Series F Preferred Stock. The Company redeemed the Series F Preferred Stock on November 1, 1997.
In 1992, the Company issued 1,400,000 shares of $6.00 Noncumulative Convertible Perpetual Preferred Stock, Series D ("Series D Preferred Stock"), at $100.00 per share for net proceeds of $136.4 million. The Series D Preferred Stock had a liquidation preference of $100.00 per share plus dividends accrued and unpaid for the then current dividend period. The Series D Preferred Stock was convertible at a rate of 5.8063 shares of common stock per share of Series D Preferred Stock. Dividends were at an annual rate of $6.00 per share. Dividends were declared and paid in all quarters from issuance to redemption or conversion. Prior to December 31, 1996, substantially all of the Series D Preferred Stock was converted into shares of common stock and the Company redeemed the remaining shares.
In 1991, Ahmanson issued 3,500,000 shares of 9.60% Preferred Stock, Series B ("Series B Preferred Stock") and received net proceeds of $169.1 million. The Series B Preferred Stock had a liquidation preference of $175.0 million plus dividends accrued and unpaid for the then current dividend period. Dividends, if and when declared by Ahmanson's Board of Directors, were at an annual rate of $4.80 per share. Dividends were declared and paid in all quarters from issuance to redemption. On September 3, 1996, Ahmanson redeemed at par the entire $175.0 million of Series B Preferred Stock.
In 1991, Great Western issued 2,587,500 depository shares, each representing a one-fifth interest in a share of 8.75% Cumulative Convertible Preferred Stock ("Convertible Preferred Stock"). The Convertible Preferred Stock had a liquidation value of $250.00 per share. The Convertible Preferred Stock was redeemable prior to May 1, 1996. Each share of Convertible Preferred Stock was redeemable at the option of Great Western, in whole or in part, at prices declining to $250.00 per share on or after May 1, 2001, from $260.94 per share on or after May 1, 1996, plus accrued and unpaid dividends. Each share of Convertible Preferred Stock was convertible at the option of the holder into shares of Great Western common stock at a conversion price of $20.40 per share of Great Western common stock, subject to adjustment in certain events. Dividends were cumulative from the date of issue and were payable quarterly. In September 1996, substantially all of the depository shares were converted to approximately 6,295,556 shares of Great Western common stock.
In 1988, a subsidiary of Keystone Holdings issued $80.0 million of Cumulative Redeemable Preferred Stock. The Cumulative Redeemable Preferred Stock was presented as a minority interest in the Company's WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Consolidated Financial Statements. The Cumulative Redeemable Preferred Stock was redeemed on December 20, 1996.
NOTE 20: EARNINGS PER SHARE
In February 1997, the FASB issued SFAS No. 128, Earnings per Share. This statement established standards for computing and presenting earnings per share ("EPS"). The statement simplified the standards for computing EPS and made them comparable with international EPS standards. It replaced the presentation of primary EPS with the presentation of basic EPS. Basic EPS excludes dilution and is computed by dividing income attributable to common stock by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. This statement required restatement of all prior periods.
Information used to calculate EPS was as follows:
Options to purchase 1,626,750 million shares of common stock at a weighted average exercise price of $44.92 per share were outstanding at December 31, 1998, but were not included in the computation of diluted EPS because the exercise price of the options was greater than the average market price of the common stock during the period. Additionally, as part of the Keystone Transaction, 12,000,000 shares of common stock, with an assigned value of $27.7417 per share, were issued to an escrow for the benefit of the general and limited partners of Keystone Holdings and the FRF and their transferees. The conditions upon which these shares are contingently issuable are not based on earnings or market price. The contingencies had not occurred at December 31, 1998, and therefore, the contingently issuable shares have not been included in the above computations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 21: REGULATORY CAPITAL REQUIREMENTS
WMI is not subject to any regulatory capital requirements. However, each of its subsidiary depository institutions is subject to various capital requirements. WMB is subject to FDIC capital requirements while WMBFA and WMBfsb are subject to Office of Thrift Supervision ("OTS") capital requirements. The Company also owns a small industrial bank that is subject to FDIC capital requirements.
The capital adequacy requirements are quantitative measures established by regulation that require WMBFA, WMB and WMBfsb to maintain minimum amounts and ratios of capital. The FDIC requires WMB to maintain minimum ratios of Tier 1 and total capital to risk-weighted assets as well as Tier 1 capital to average assets. The OTS requires WMBFA and WMBfsb to maintain minimum ratios of Tier 1 and total capital to risk-weighted assets, as well as Tier 1 capital to adjusted total assets.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") created a statutory framework that increased the importance of meeting applicable capital requirements. FDICIA established five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure, and certain other factors. The federal banking agencies (including the FDIC and the OTS) have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well capitalized if its ratio of total capital to risk-weighted assets is 10.00% or more, its ratio of Tier 1 capital to risk-weighted assets is 6.00% or more, its ratio of Tier 1 capital to adjusted total assets is 5.00% or more and it is not subject to any federal supervisory order or directive to meet a specific capital level.
In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capital ratio of not less than 4.00%, and a Tier 1 capital ratio of not less than 4.00%.
Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions, which become more extensive as an institution becomes more severely undercapitalized. Failure by any of the Company's depository institutions to comply with applicable capital requirements would, if unremedied, result in restrictions on its activities and lead to regulatory enforcement actions against such institution including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels. FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, FDIC or OTS approval of any regulatory application filed for their review may be dependent on compliance with capital requirements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The actual regulatory capital ratios calculated for WMBFA, WMB and WMBfsb, along with the minimum capital amounts and ratios for capital adequacy purposes and the minimum amounts required to be categorized as well capitalized under the regulatory framework for prompt corrective action were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Management believes that WMBFA, WMB and WMBfsb individually met all capital adequacy requirements, as of December 31, 1998, to which they were subject. Additionally, as of the most recent notifications from the FDIC (for WMB) and the OTS (for WMBFA, WMBfsb and Home Savings), the FDIC and OTS individually categorized WMBFA, WMB, WMBfsb and Home Savings as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, a bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 or leverage capital ratios as set forth in the table above. There are no conditions or events since that notification that management believes have changed the well capitalized status of WMBFA, WMB, WMBfsb and Home Savings.
Federal law requires that the federal banking agencies' risk-based capital guidelines take into account various factors including interest rate risk, concentration of credit risk, risks associated with nontraditional activities, and the actual performance and expected risk of loss of multi-family mortgages. In 1994, the federal banking agencies jointly revised their capital standards to specify that concentration of credit and nontraditional activities are among the factors that the agencies will consider in evaluating capital adequacy. In that year, the OTS and FDIC amended their risk-based capital standards with respect to the risk weighting of loans made to finance the purchase or construction of multi-family residences. The OTS adopted final
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
regulations adding an interest rate risk component to the risk-based capital requirements for savings associations (such as WMBFA and WMBfsb), although implementation of the regulation has been delayed. Management believes that the effect of including such an interest rate risk component in the calculation of risk-adjusted capital would not cause WMBFA or WMBfsb to cease to be well capitalized. In June 1996, the FDIC and certain other federal banking agencies (not including the OTS) issued a joint policy statement providing guidance on prudent interest rate risk management principles. The agencies stated that they would determine banks' interest rate risk on a case-by-case basis, and would not adopt a standardized measure or establish an explicit minimum capital charge for interest rate risk.
NOTE 22: STOCK OPTION PLANS, EMPLOYEE STOCK PURCHASE PLAN, AND RESTRICTED STOCK PLANS
On March 8, 1984, the Company's stockholders approved the adoption of the 1983 incentive stock option plan, providing for the award of incentive stock options or nonqualified stock options to certain officers of the Company at the discretion of the Board of Directors. On April 19, 1994, the Company's stockholders approved the adoption of the 1994 stock option plan (the "1994 Plan") in which the right to purchase common stock of WMI may be granted to officers, directors, consultants and advisers of the Company. The 1994 Plan is generally similar to the 1983 plan, which terminated according to its terms in 1993. The 1994 Plan does not affect any options granted under the 1983 plan.
Under the 1994 Plan, on the date of the grant, the exercise price of the option must at least equal the market value per share of WMI's common stock. The 1994 Plan provides for the granting of options for a maximum of 18,000,000 common shares.
On September 16, 1997, the Company's Board of Directors approved the adoption of a broad-based stock option plan called "WAMU Shares" as part of the Company's effort to build a unified team and to appropriately compensate its employees. This plan provides for an award of nonqualified stock options to all eligible employees who were employed by the Company on September 1, 1997. Generally, full-time employees have an option to purchase 150 shares of WMI common stock, while part-time employees have an option to purchase 75 shares, while employees who were designated to receive options under the 1994 Plan were excluded. All grants were made using the fair market value of WMI's common stock on September 1, 1997, and all options vest on September 1, 1999. The WAMU Shares plan provides for the granting of options for a maximum of 3,300,000 common shares.
On December 15, 1998, the Company's Board of Directors approved the adoption of a broad-based stock option plan ("WAMU Shares II") to provide a performance incentive and encourage stock ownership by employees of the Company. This plan provides for an award of nonqualified stock options to all eligible employees who were employed by the Company on January 4, 1999. Full-time employees received an option to purchase 100 shares of WMI common stock, while part-time employees received an option to purchase 50 shares, and employees who were designated to receive options under the 1994 Plan were excluded. These employee stock options were in addition to the Company's previous broad-based stock option plan described above. Options under the WAMU Shares II plan were granted at the fair market value of WMI's common stock on December 14, 1998, and all options vest on January 4, 2001. The WAMU Shares II plan provides for the granting of options up to a maximum of 3,300,000 common shares.
On April 26, 1988, Great Western stockholders approved the adoption of the 1988 Stock Option and Incentive Plan (the "Great Western Plan"). Options were granted at the market value of the Great Western common stock on the date of grant. The Great Western Plan consisted of two separate plans: the Key Employee Program, under which options (both incentive and nonqualified), stock appreciation rights, dividend equivalents and certain other performance and incentive awards were granted to officers, key employees and certain other individuals; and the Nonemployee Director Program, under which nonqualified options were granted to nonemployee directors under certain circumstances. Options may be exercised either by payment of cash, or the optionee may deliver WMI common stock of an equivalent market value at the WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
date of exercise. As of July 1, 1997, this plan was amended to eliminate further grants. At the close of the Great Western Merger, these options became fully vested.
On May 21, 1985, Ahmanson stockholders approved the adoption of the 1984 Stock Incentive Plan (the "1984 Ahmanson Stock Plan"). The 1984 Ahmanson Stock Plan provided for the issuance of incentive and nonqualified stock options, stock appreciation rights, and restricted stock awards to certain officers and employees at the discretion of Ahmanson's Board of Directors. On May 9, 1989, Ahmanson stockholders approved the adoption of the 1988 Directors' Stock Incentive Plan (the "1988 Ahmanson Directors' Stock Plan"). The 1988 Ahmanson Directors' Stock Plan provided for the issuance of nonqualified stock options to nonemployee directors. On May 10, 1994, Ahmanson stockholders approved the adoption of the 1993 Stock Incentive Plan (the "1993 Ahmanson Stock Plan"). The 1993 Ahmanson Stock Plan provided for the issuance of stock bonuses, incentive and nonqualified stock options, stock appreciation rights, and restricted stock awards to certain officers, employees and directors at the discretion of Ahmanson's Board of Directors. On May 13, 1996, Ahmanson stockholders approved the adoption of the 1996 Nonemployee Directors' Stock Incentive Plan (the "1996 Ahmanson Directors' Stock Plan"). The 1996 Ahmanson Directors' Stock Plan provided for the issuance of nonqualified stock options to nonemployee directors. Upon the close of the Ahmanson Merger, all options vested and restrictions on awards lapsed.
Stock options under all stock plans were generally exercisable on a phased-in schedule over two to five years, depending upon the terms of the grant, and expire three to ten years from the grant date. At December 31, 1998, options to purchase 7,728,919 shares were fully exercisable.
Stock options granted, exercised, or forfeited were as follows:
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Financial data pertaining to outstanding stock options were as follows:
Under the terms of the Company's Employee Stock Purchase Plan ("ESPP"), an employee may purchase WMI common stock at a 15% discount without paying brokerage fees or commissions on purchases. The Company pays for the program's administrative expenses. The plan is open to all employees who are at least 18 years old, have completed at least one year of service, and work at least 20 hours per week. Participation can be by either payroll deduction or lump sum payments with a maximum annual contribution of 10% of each employee's previous year's eligible cash compensation. Under the ESPP, dividends are automatically reinvested.
In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-based Compensation. The statement requires expanded disclosure of stock-based compensation arrangements with employees and encourages (but does not require) application of its fair value recognition provisions. SFAS No. 123 does not rescind or interpret the existing accounting rules for employee stock-based arrangements. Companies may continue following those rules to recognize and measure compensation as outlined in Accounting Principles Board ("APB") Opinion 25, Accounting for Stock Issued to Employees, but they are now required to disclose the pro forma amounts of net income and earnings per share that would have been reported had the Company elected to follow the fair value recognition provisions of SFAS No. 123. Effective January 1, 1996, the Company adopted the disclosure requirements of SFAS No. 123, but has determined that it will continue to measure its employee stock-based compensation arrangements under the provisions of APB Opinion 25. Accordingly, no compensation cost has been recognized for its stock option plans and its ESPP. Had compensation cost for the Company's compensation plans been determined consistent with SFAS No. 123,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the Company's net income attributable to common stock and net income per common share would have been reduced to the pro forma amounts indicated below:
The compensation expense included in the pro forma net income attributable to common stock is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year.
The fair value of options granted under the Company's stock option plans was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: annual dividend yield of 2.68% for 1998, 2.67% for 1997 and 2.50% for 1996; expected volatility of 27.71% for 1998, 27.37% for 1997 and 23.99% for 1996; risk free interest rate of 5.44% for 1998, 6.01% for 1997 and 5.78% for 1996; and expected life of five years for 1998, 1997 and 1996.
The Company maintains a restricted stock plan for the benefit of directors, key officers, loan officers and investment representatives. Under the plan, the Company granted 203,904, 331,936, and 644,163 shares of restricted stock in 1998, 1997, and 1996. Upon grant, shares are issued to a trustee and are released to recipients when the restrictions lapse. The restrictions are based upon either a continuous service or performance requirement. At the date of grant, unearned compensation is recorded as an offset to stockholders' equity and is amortized as compensation expense over the restricted period. The balance of unearned compensation related to these restricted shares as of December 31, 1998 was $18.8 million.
Great Western and Ahmanson maintained restricted stock plans for key officers. As of the date of the change in control, all restrictions on these shares lapsed.
The total compensation expense recognized for the restricted shares was $9.4 million, $3.3 million, and $5.1 million in 1998, 1997, and 1996. Restricted shares accrue dividends. All canceled or forfeited shares become available for future grants.
NOTE 23: EMPLOYEE BENEFITS PROGRAMS
Pension Plans
Washington Mutual maintains a noncontributory cash balance defined benefit pension plan (the "Pension Plan") for substantially all eligible employees. Benefits earned for each year of service are based primarily on the level of compensation in that year plus a stipulated rate of return on the benefit balance. It is the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Company's policy to fund the Pension Plan on a current basis to the extent deductible under federal income tax regulations. The Company maintained a substantially similar plan as a result of the Great Western Merger, (the "Great Western Plan" and together with the Pension Plan, the "Pension Plans"), which was merged into the Pension Plan effective July 1, 1998. On January 1 1997, the Great Western Plan was converted from a final average pay plan to a cash balance plan, under which participants' accounts are credited with pay-related contributions and interest. The Pension Plans' assets consist primarily of listed common stocks, U.S. government obligations, asset-backed securities, corporate debt obligations, and annuity contracts.
ASB provided a noncontributory defined benefit pension plan (the "ASB Plan"), which was terminated effective June 30, 1995. At the termination date of the ASB Plan, all participants' accrued benefits became fully vested. The net assets of the ASB Plan were allocated as prescribed by the Employee Retirement Income Security Act of 1974 and the Pension Benefit Guaranty Corporation and their related regulations. All participants received full benefits. The termination resulted in a settlement under SFAS No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits. The Company recognized a gain of $1.7 million as a result of the settlement. The benefit obligation was settled in 1996.
The Company, as successor to Ahmanson and Coast, maintains noncontributory defined benefit pension plans (the "Ahmanson Plan" and the "Coast Plan") covering eligible employees of Ahmanson or Coast who meet minimum service requirements. The benefits are generally based on years of service and the employee's average earnings in the final years of employment. Assets in the Ahmanson Plan and the Coast Plan consist primarily of listed common stocks, U.S. government obligations and corporate bonds and debentures. The Ahmanson Plan and the Coast Plan will be merged into the Company's Pension Plan on October 1, 1999.
Changes in the benefit obligation were as follows:
Changes in Pension Plans' assets were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Reconciliations of funded status were as follows:
Net periodic expense for the Pension Plans was as follows:
Weighted average assumptions used in accounting for the Pension Plans were as follows:
Nonqualified Defined Benefit Plans and Other Postretirement Benefit Plans
The Company, as successor to Ahmanson, Coast, and Great Western, has assumed responsibility for nonqualified, noncontributory unfunded postretirement benefit plans, including retirement restoration plans for certain employees, a number of supplemental retirement plans for certain officers, and multiple outside directors' retirement plans. Benefits under the retirement restoration plans are generally determined by the Company. Benefits under the supplemental retirement plans are generally based on years of service. Benefits under the outside directors' retirement plans generally are payable for a period equal to the participants' service on the Board of Directors, with a lifetime benefit payable to participants with 15 or more years of service.
The Company, as successor to Ahmanson and Great Western, maintains unfunded defined benefit postretirement plans that make medical and life insurance coverage available to eligible retired employees and dependents. The expected cost of providing these benefits to retirees, their beneficiaries and covered dependents was accrued during the years each employee provided services. During 1997, benefits provided under the Great Western plan were eliminated for current employees resulting in a $23.8 million curtailment gain. This gain was included as an offset in transaction-related expense.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Changes in the benefit obligation were as follows:
Changes in the fair value of plan assets were as follows:
Reconciliations of funded status were as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Amounts recognized in the Consolidated Statements of Financial Condition were as follows:
Net periodic expense for the benefit plans was as follows:
Weighted average assumptions used in accounting for the benefit plans were as follows:
The rate of compensation increase is not applicable to all nonqualified defined benefit plans.
For measurement of the net periodic cost of other postretirement benefit plans, a 7.75% annual increase in the medical care trend rate was assumed for 1998, thereafter decreasing 1% per year until a stable 5.75% medical inflation rate is reached in 2000. The effect of a 1% increase or decrease in the trend rates is not significant.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Account Balance Plans
Savings Plans. The Company sponsors a retirement savings and investment plan (the "RSIP") for all eligible employees that allows participants to make contributions by salary deduction equal to 15% or less of their salary pursuant to Section 401(k) of the Internal Revenue Code. Employee contributions vest immediately. The Company's matching contributions and any profit sharing contributions made to employees vest based on years of service.
The Company, as successor to Great Western, maintained a savings plan for substantially all eligible employees formerly of Great Western, which allowed participants to make contributions equal to 14% or less of their salary pursuant to Section 401(k) of the Internal Revenue Code. Contributions to this plan were frozen at December 31, 1997 and all participants became eligible to participate in the RSIP. The Great Western savings plan was merged into the RSIP on July 1, 1998. The Company, as successor to Ahmanson and Coast, maintains a savings plan for employees formerly of Ahmanson and Coast, which allows participants to make contributions equal to 15% or less of their salary pursuant to Section 401(k) of the Internal Revenue Code. Employees vest immediately in their own contributions and they vest in the Company's contributions based on years of service. The Coast savings plan was merged into the Ahmanson savings plan at the close of business on June 30, 1998.
Contributions to savings plans were $35.6 million, $27.4 million and $28.0 million in 1998, 1997 and 1996.
Other Account Balance Plans. The Company sponsors supplemental employee and executive retirement plans for the benefit of certain officers. The plans are designed to supplement the benefits that are accrued under the Pension Plans.
The Company provides an optional deferred compensation plan for certain employees and directors. Eligible participants can defer a portion of their compensation, and the Company agrees to pay interest on the balance of funds deferred. The Company also maintains similar optional deferred compensation plans for directors and certain employees formerly with Ahmanson, Coast, Great Western and ASB. No additional compensation may be deferred under the Coast, Great Western and ASB plans. Compensation may be deferred for another two years under the Ahmanson Plan. Expense related to deferred compensation plans was $8.1 million, $7.9 million and $9.1 million in 1998, 1997 and 1996.
The Company has purchased life insurance, primarily with two carriers, on the lives of the participants in certain nonqualified defined benefit plans and the deferred compensation plans (described above). The net cash surrender value of this life insurance, included in other assets, was $401.0 million at December 31, 1998 and $338.2 million at December 31, 1997 and net premium income related to insurance purchased was $5.0 million in 1998, $12.6 million in 1997 and $10.1 million in 1996.
In 1990, ASB implemented a Phantom Share Plan (the "PSP") for the benefit of certain of its officers. As a result of the Keystone Transaction, the benefits under the PSP were payable, and ASB incurred an expense of $12.0 million in December 1996.
NOTE 24: INTEREST RATE RISK MANAGEMENT
From time to time, the following strategies may be used by the Company to reduce its exposure to interest rate risk: the origination and purchase of ARMs and the purchase of adjustable-rate MBS; the sale of fixed-rate SFR loan production or fixed-rate MBS; and the use of derivative instruments, such as interest rate exchange agreements, interest rate cap agreements, and forward sales contracts.
The Company uses forward sales contracts to hedge its exposure to increasing interest rates with respect to fixed-rate loans which the Company intends to sell in the secondary market. Forward sales contracts are
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
used to sell fixed-rate loans at a future date for a specified price. Gains or losses are recognized at the time the contracts mature and are recorded as a component of mortgage banking income. As of December 31, 1998 and 1997, the Company had $2.50 billion and $1.55 billion in forward sales contracts to hedge fixed-rate SFR loan commitments, which were expected to close, and SFR loans, which were held for sale.
Interest rate exchange agreements, interest rate cap agreements, and forward sales contracts expose the Company to credit risk in the event of nonperformance by counterparties to such agreements. This risk consists primarily of the termination value of agreements where the Company is in a favorable position. The Company controls the credit risk associated with its various derivative agreements through counterparty credit review, counterparty exposure limits and monitoring procedures.
The Company's use of derivative instruments reduces the effect that changing interest rates may have on net interest income. The Company uses such instruments to reduce the volatility of net interest income over an interest rate cycle. The Company does not invest in leveraged derivative instruments. During 1998 and 1997, the Company did not terminate any interest rate exchange agreements or interest rate cap agreements.
Scheduled maturities of interest rate exchange agreements were as follows:
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Scheduled maturities of interest rate cap agreements were as follows:
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Financial data pertaining to interest rate exchange agreements were as follows:
Financial data pertaining to interest rate cap agreements were as follows:
Changes in interest rate exchange agreements and interest rate cap agreements were as follows:
NOTE 25: FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because an active secondary market does not exist for a portion of the Company's financial instruments, fair value estimates were based on management's judgment concerning future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. In addition, considerable judgment was required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Fair value estimates were determined for existing balance sheet and off-balance sheet financial instruments, including derivative instruments, without attempting to estimate the value of anticipated future business and the value of certain assets and liabilities that were not considered financial instruments. Significant assets that were not considered financial instruments include premises and equipment, net tax assets, REI, foreclosed assets and intangible assets. In addition, the tax ramifications related to the realization of the unrealized gains and losses could have a significant effect on fair value estimates and have not been considered in any of the valuations.
The following methods and assumptions were used to estimate the fair value of each class of financial instrument as of December 31, 1998 and 1997:
Cash and cash equivalents -- The carrying amount represented fair value.
Trading securities -- Fair values were based on quoted market prices.
Available-for-sale securities -- Fair values were based on quoted market prices. If a quoted market price was not available, fair value was estimated using market prices for similar securities, as well as internal analysis.
Held-to-maturity securities -- Fair values were based on quoted market prices. If a quoted market price was not available, fair value was estimated using market prices for similar securities, as well as internal analysis.
Loans -- Loans were priced using the discounted cash flow method. The discount rate used was the rate currently offered on similar products.
Investment in FHLBs -- The carrying amount represented fair value.
Mortgage servicing rights -- The fair value of mortgage servicing rights was estimated using projected cash flows, adjusted for the effects of anticipated prepayments, using a market discount rate.
Deposits -- The fair value of checking accounts, savings accounts and MMDAs was the amount payable on demand at the reporting date. For time deposit accounts, the fair value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on alternate funding sources with similar maturities. Core deposit intangibles were not included.
Federal funds purchased and commercial paper -- The value was determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.
Reverse repurchase agreements -- These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.
Advances from FHLBs -- These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.
Trust preferred securities -- Fair values were estimated using quoted market prices for similar securities.
Other borrowings -- These were valued using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar borrowings.
Derivative financial instruments -- The fair value for interest rate exchange agreements and interest rate cap agreements was determined using dealer quotations, when available, or the discounted cash flow method. The market prices for similar instruments were used to value interest rate cap agreements.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Forward sales contracts designated against loans -- The fair value of forward sales contracts purchased as a hedge of fixed-rate commitments and commitments to fund real estate loans was estimated using current market prices adjusted for various risk factors and market volatility.
Off-balance sheet loan commitments -- The fair value of loan commitments was estimated based on current levels of interest rates versus the committed interest rates. The balance shown represents the differential between committed value and fair value.
The estimated fair value of the Company's financial instruments was as follows:
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 26: FINANCIAL INFORMATION -- WMI
The following WMI (parent company only) financial information should be read in conjunction with the other Notes to Consolidated Financial Statements.
STATEMENTS OF INCOME
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
STATEMENTS OF FINANCIAL CONDITION
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
STATEMENTS OF CASH FLOWS
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 27: LINES OF BUSINESS
Washington Mutual is managed along five major lines of business: mortgage banking, consumer banking, commercial banking, financial services, and consumer finance. The treasury group, although not considered a line of business, is responsible for the management of investments and interest rate risk. Prior to the Ahmanson Merger and during the fourth quarter of 1998, Ahmanson was managed as a distinct business segment of Washington Mutual, and is therefore so presented. The financial performance of these business lines is measured by the Company's profitability reporting processes, which utilize various management accounting techniques to ensure that each business line's financial results reflect the underlying performance of that business.
The principal activities conducted by mortgage banking are the origination of SFR and residential construction loans, and the associated loan servicing activities. Consumer banking includes all deposit products, with their related fee income, and all consumer loan products offered in our financial centers. These consumer loan products include second equity mortgage loans and lines of credit, manufactured housing loans, automobile, boat and recreational vehicle loans, and education loans. Commercial banking offers commercial business loans, multi-family residential loans and loans secured by nonresidential real estate. Financial services offers a wide range of investment products to the Company's customers, including mutual funds, variable and fixed annuities and general securities. Consumer finance offers direct consumer installment loans and retail sales financing.
In June 1997, SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, was issued effective for fiscal years ending after December 15, 1998. This standard requires the Company to provide information on the performance of its reportable business segments, noted above, which are strategic lines of business managed by the Executive Committee under the direction of the Chief Executive Officer. The Executive Committee, which is the senior decision making group of the Company, is comprised of eight members including the Chairman, President and Chief Executive Officer.
During 1998, the Company developed a management reporting system that enables management to monitor the Company's performance on a line of business basis instead of on a traditional legal entity basis. To better assess the true profitability of its various business lines, the Company generates segment results that include balances directly attributable to business line activities as well as balances that are allocated from traditionally undistributed units. In this way, management can better assess the fully burdened financial performance of a particular business. Washington Mutual is constantly analyzing its line of business performance and developing better ways to measure profitability.
Each segment is managed by an executive team responsible for sales, marketing, sales support and operations, and certain administrative functions. Back office support is provided to each segment through executives responsible for lending administration, deposit operations, information systems, finance, legal, and administration.
The accounting policies of the segments are the same as those described in "Note 1: Summary of Significant Accounting Policies." Whenever feasible, revenues and expenses are directly assigned to business segments in determining their net income. Loans originated by the Company's mortgage lending operations are transferred to the consumer banking segment at a transfer price that reflects the risk-adjusted value of such loans. In addition, corporate overhead, centralized support costs, and other costs are allocated to each business segment based on appropriate allocation methodologies. The Company evaluates performance based on net income of the respective business segments.
The financial results of each segment were derived from the Company's general ledger system, and prepared using a profitability reporting system. The system makes certain adjustments to recorded general ledger accounts to appropriately reflect balance sheet and income statement transfers among segments. Since the Company was not specifically organized around lines of business, most segments were comprised of more WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
than one functional division. Expenses incurred directly by sales and back office support units were assigned directly to segments while support units were either apportioned based on specific services performed or allocated on another rational and systematic basis.
Since SFAS No. 131 requires no segmentation or methodology standardization, the organizational structure of the Company and the allocation methodologies it employs result in business line financial results that are not necessarily comparable across companies. As such, Washington Mutual's business line performance may not be directly comparable with similar information from other financial institutions.
Financial highlights by lines of business:
Prior to 1998, the Company was managed by legal entity, not by discrete operating segment. In addition, given the nature and magnitude of acquisition activity since 1996, the Company has determined that it is not possible to gather the information and data necessary to restate prior year segment results. For this reason, the Company has disclosed results by legal entity for both current and prior years.
Financial highlights by legal entity were as follows:
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
WASHINGTON MUTUAL, INC.
INDEX OF EXHIBITS