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Wmi Holdings Corp. – ‘10-K/A’ for 12/31/07

On:  Thursday, 5/22/08, at 6:00am ET   ·   For:  12/31/07   ·   Accession #:  1047469-8-6870   ·   File #:  1-14667

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  As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 5/22/08  Wmi Holdings Corp.                10-K/A     12/31/07    3:1.8M                                   Merrill Corp/New/FA

Amendment to Annual Report   —   Form 10-K
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K/A      Amendment to Annual Report                          HTML   1.57M 
 2: EX-31.1     Certification per Sarbanes-Oxley Act (Section 302)  HTML      8K 
 3: EX-31.2     Certification per Sarbanes-Oxley Act (Section 302)  HTML      8K 


10-K/A   —   Amendment to Annual Report
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
"Washington Mutual, Inc. 2007 Annual Report on Form 10-K/A Table of Contents
"Explanatory Note
"Part Ii
"Part Iii
"Standard & Poor's Financial Index Companies in the Performance Share Peer Group for Awards in the 2004-2006 Performance Cycle
"Part Iv
"Signatures
"Washington Mutual, Inc. Index of Exhibits Description
"QuickLinks

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

FORM 10-K/A
Amendment No. 1


ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007

Commission File Number 1-14667

WASHINGTON MUTUAL, INC.
(Exact name of registrant as specified in its charter)


Washington
(State or other jurisdiction of
incorporation or organization)
  91-1653725
(I.R.S. Employer
Identification Number)

1301 Second Avenue, Seattle, Washington
(Address of principal executive offices)

 

98101
(Zip Code)

Registrant's telephone number, including area code: (206) 461-2000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
  Name of each exchange on which registered
Common Stock   New York Stock Exchange
Depositary Shares each representing a 1/40,000th interest in a share of Series K Perpetual Preferred Non-Cumulative    
Floating Rate Stock   New York Stock Exchange
7.75% Series R Non-Cumulative Perpetual Convertible    
Preferred Stock   New York Stock Exchange

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
  Name of each exchange on which registered
Litigation Tracking Warrants™   NASDAQ

         Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.    Yes ý    No o.

         Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes o    No ý.

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

         Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ý.

         Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ý   Accelerated filer o   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o

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

         The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2007, based on the closing sale price as reported on the New York Stock Exchange:

Common Stock – $36,953,361,076(1)
(1) Does not include any value attributable to 6,000,000 shares held in escrow.

         The number of shares outstanding of the issuer's classes of common stock as of January 31, 2008:

Common Stock – 882,557,330(2)
(2) Includes 6,000,000 shares held in escrow.

Documents Incorporated by Reference

         Portions of the definitive proxy statement for the Annual Meeting of Shareholders to be held April 15, 2008, are incorporated by reference into Part III.





WASHINGTON MUTUAL, INC.
2007 ANNUAL REPORT ON FORM 10-K/A
TABLE OF CONTENTS

 
   
  Page
PART II   1
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations   1
        Controls and Procedures   1
        Overview   1
        Critical Accounting Estimates   4
        Recently Issued Accounting Standards Not Yet Adopted   8
        Five-Year Summary of Selected Financial Data   9
        Ratios and Other Supplemental Data   10
        Earnings Performance from Continuing Operations   11
        Review of Financial Condition   20
        Operating Segments   25
        Off-Balance Sheet Activities and Contractual Obligations   32
        Risk Management   35
        Credit Risk Management   36
        Liquidity Risk and Capital Management   56
        Market Risk Management   60
        Operational Risk Management   66
        Tax Uncertainties   67
        Goodwill Litigation   67
        Factors That May Affect Future Results   71
PART III   81
Item 11.   Executive Compensation   81
PART IV   138
Item 15.   Exhibits   138

i



Explanatory Note

        Washington Mutual, Inc. ("Washington Mutual" or the "Company") is filing this Amendment No. 1 to its Annual Report on Form 10-K for the year ended December 31, 2007 originally filed on February 29, 2008 ("Original Filing") to include additional disclosures to certain information presented in Parts II and III. Such additional disclosures have no effect on previously reported consolidated financial statements and notes to consolidated financial statements.

        This Amendment No. 1 on Form 10-K/A amends the Original Filing as follows:

Except for the foregoing additional Item 11 disclosures, revised page cross-references and including a list of peer companies on page 96 that was included as Appendix A to the Annual Proxy Statement, the Item 11 disclosures from the Annual Proxy Statement are repeated verbatim and, together with the foregoing additional Item 11 disclosures and list of peer companies, speak as of the date of the Annual Proxy Statement. Except for Item 7 of Part II and Item 11 of Part III , no other information in the Original Filing is being amended by this Amendment. This Amendment continues to speak as of the date of the Original Filing and the Company has not updated the disclosure in this Amendment to reflect any events which occurred at a date subsequent to the Original Filing.

ii



PART II

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

Controls and Procedures

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

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

        Management reviews and evaluates the design and effectiveness of the Company's internal control over financial reporting on an ongoing basis, which may result in the discovery of deficiencies, some of which may be significant. Management changes its internal control over financial reporting as needed to maintain its effectiveness, correcting any deficiencies, as needed, in order to ensure the continued effectiveness of the Company's internal control over financial reporting. There have not been any changes in the Company's internal control over financial reporting during the fourth quarter of 2007 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. For management's assessment of the Company's internal control over financial reporting, refer to Management's Report on Internal Control Over Financial Reporting on page 98.

Overview

        Washington Mutual, through its subsidiaries, is one of the nation's leading consumer and small business banks. At December 31, 2007, Washington Mutual and its subsidiaries had assets of $328 billion. The Company has a history dating back to 1889 and its subsidiary banks currently operate nearly 2,500 consumer and small business banking stores throughout the nation. When we refer to "the Company," "we," "our" and "us" in this Annual Report on Form 10-K, we mean Washington Mutual, Inc. and subsidiaries. When we refer to "the Parent," we mean Washington Mutual, Inc.

        The Company's sources of revenue are net interest income and noninterest income. Net interest income is generated by interest received from loans, investment securities and other interest-earning assets, less rates paid on deposits and borrowings. The primary sources of noninterest income are revenue from loan sales and servicing and fees from financial services provided to customers. A summary of the Company's key financial results are presented below:

        The Company recorded a net loss for 2007 of $67 million, or $0.12 per diluted share, compared with net income of $3.56 billion, or $3.64 per diluted share, in 2006. The decline was primarily the result of significant credit deterioration in the Company's single-family residential mortgage loan portfolio and significant disruptions in the capital markets, including a sudden and severe contraction in secondary mortgage market liquidity for nonconforming residential loan products. These conditions also

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contributed to the impairment of all goodwill associated with the Company's Home Loans business near the end of 2007.

        Reflecting the significant credit deterioration, the Company recorded a provision for loan losses of $3.11 billion in 2007, an increase of $2.29 billion from 2006 and about twice the level of 2007 net charge-offs, which totaled $1.62 billion. Adverse trends in key housing market indicators, including growing inventories of unsold homes, rising foreclosure rates and a significant contraction in the availability of credit for nonconforming mortgage products continued to deteriorate throughout 2007 and exerted significant downward pressure on home prices, particularly in areas of the country in which the Company's lending activities have been concentrated. Nationwide sales volume of existing homes in December 2007 was 22% lower than in December 2006, leading to a supply of unsold homes of approximately 9.7 months, a 47% increase from December 2006, while the national median sales price for existing homes declined by 7% between those same periods. Housing market weakness was also evident from the change in the national volume of foreclosure filings, which increased by 75% in 2007 compared with 2006. With the downturn in the housing market, single-family residential mortgage delinquency levels have increased substantially and loss severity rates have grown significantly. These conditions are reflected in the Company's nonperforming assets to total assets ratio, which increased from 0.80% at December 31, 2006 to 2.17% at December 31, 2007. Net mortgage loan charge-offs as a percentage of the average balance of the real estate loan portfolio increased from 0.09% in 2006 to 0.55% in 2007, and on an annualized basis, from 0.14% in the fourth quarter of 2006 to 1.08% in the fourth quarter of 2007, reflecting the accelerating pace of deterioration in the credit quality of the mortgage loan portfolio. The increase in loss severity rates was particularly evident in the subprime mortgage channel and home equity loans and lines of credit portfolios. With early indicators in 2008 suggesting that the housing market is continuing to deteriorate, the Company expects that it will experience significantly higher credit costs throughout its single-family residential mortgage portfolios.

        Net credit card charge-offs as a percentage of the average balance of the credit card portfolio were 3.08% in 2006 and 3.69% in 2007, reflecting a gradual downturn in credit quality as the U.S. economy softened. The national unemployment rate, which held steady in a range of 4.4% to 4.7% for most of 2007, increased to 4.9% in January 2008, while average net job growth for the three months ending January 31, 2008 was 42,000, compared with 121,000 for the three months ending January 31, 2007. The Company expects net credit card charge-off rates will continue to rise if the economy is pressured further by higher unemployment levels and sluggish job growth.

        Noninterest income was $6.04 billion in 2007, compared with $6.38 billion in 2006. Deteriorating credit conditions also caused significant disruptions in the secondary mortgage market, which adversely affected the Company's noninterest income results. Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments, totaled $59 million in 2007, compared with $735 million in 2006. Credit quality concerns created uncertainty in the market for subprime mortgage products during the first half of 2007. Those concerns intensified during the second half of the year and spread into the broader secondary market, resulting in a severe contraction of secondary market liquidity as investors avoided purchasing all mortgage products backed by nonconforming loan collateral. Because of this disruption, the Company transferred approximately $17 billion of real estate loans to its loan portfolio in the third quarter of 2007, representing substantially all of the Company's nonconforming loans that had been designated as held for sale. Illiquid secondary market conditions also affected the valuations of the Company's trading assets, which are primarily comprised of interests retained from mortgage loan and credit card securitizations. Widening credit spreads on these retained interests were primarily responsible for the loss on trading assets of $673 million in 2007, compared with a loss of $154 million in 2006. The Company also recognized other-than-temporary impairment losses of $375 million in the available-for-sale securities portfolio during the second half of 2007 on certain mortgage-backed securities.

2


        Partially offsetting the losses in noninterest income were gains from mortgage servicing rights ("MSR") valuation and risk management of $205 million in 2007, compared with a loss of $393 million in 2006, as gains from the Company's MSR risk management instruments outpaced the decline in MSR fair value. While lower mortgage interest rates during the latter part of 2007 increased expected loan prepayment speeds, their effect on the MSR value was softened by the weakening housing market and the severe contraction in home mortgage credit availability, both of which significantly reduced home loan refinancing volume.

        Noninterest expense totaled $10.60 billion in 2007, compared with $8.81 billion in 2006. The unprecedented challenges in the mortgage and credit markets during 2007 also had a significant effect on the Company's noninterest expense results. Noninterest expense in 2007 includes the fourth quarter effects from a $1.78 billion pre-tax impairment loss related to all goodwill associated with the Home Loans business. This non-cash charge did not affect the Company's tangible equity or regulatory capital ratios, or its liquidity position. With the fundamental shift in the mortgage market from credit disruptions and the expectation of a prolonged period of secondary mortgage market illiquidity, the Company took actions in the fourth quarter of 2007 to resize its home loans business in anticipation of continued declines in loan volume within the home mortgage industry, and to accelerate the direction of the home loans business to mortgage lending conducted through the Company's retail banking stores and other retail distribution channels. Among the actions taken by the Company were:

        The Company recorded $143 million of additional noninterest expense in the fourth quarter of 2007 as a result of these actions, which are expected to generate approximately $500 million of expense savings during 2008.

        Net interest income on a taxable-equivalent basis was $8.19 billion in 2007, compared with $8.13 billion in 2006. The increase was due to the expansion of the net interest margin, which increased, on a taxable-equivalent basis, from 2.60% in 2006 to 2.86% in 2007. The increase in the margin was primarily due to increases in the yields of mortgage loan products tied to short-term interest rate indices and the sales of lower-yielding mortgage loans. With the increasing deterioration in the housing market and the general softening of the economy, the Federal Reserve reduced the target Federal Funds rate by 100 basis points during the second half of 2007, and lowered this benchmark rate by another 125 basis points in January 2008, bringing the target rate down to 3.00%. As the Company's wholesale borrowing rates are usually correlated with interest rate policy changes made by the Federal Reserve and reprice to current market levels faster than most of the Company's interest-earning assets, the actions taken by the Fed are expected to further expand the margin in 2008.

        To bolster its capital levels and liquidity position, the Company issued a total of $3.9 billion of Tier 1 capital in the fourth quarter of 2007, comprised of $2.9 billion, net, of noncumulative, perpetual convertible preferred stock issued by the Parent and $1 billion of noncumulative, perpetual preferred shares issued by Washington Mutual Preferred Funding LLC, an indirect subsidiary of Washington Mutual Bank. Additionally, commencing in the first quarter of 2008, the Company reduced its quarterly cash dividend rate on the Company's common stock to 15 cents per share. At December 31, 2007, the Company's estimated total risk-based capital to total risk-weighted assets ratio was 12.34% and its

3



estimated Tier 1 capital to average total assets ratio was 6.84%, exceeding the minimum regulatory guidelines of 8% and 4%, respectively, while the Company's tangible equity to total tangible assets ratio was 6.67%, well above its established target of 5.50%.

Critical Accounting Estimates

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

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

        Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Company's Board of Directors. The Company believes that the judgments, estimates and assumptions used in the preparation of its financial statements are appropriate given the facts and circumstances as of December 31, 2007. The nature of these judgments, estimates and assumptions are described in greater detail in subsequent sections of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."

        The discussion below presents information about the nature of the Company's critical accounting estimates:

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

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

4



available, significant management judgment often is necessary to estimate fair value. In those cases, different assumptions could result in significant changes in valuation.

        During the latter half of 2007, deteriorating credit conditions caused significant disruptions in the secondary mortgage market. Credit quality concerns prompted market participants to avoid purchasing mortgage investment products backed by nonconforming loan collateral. As market activity slowed, the availability of observable market prices was reduced. Accordingly, there was less market data available for use by management in the judgments applied to key valuation inputs.

        The following financial instruments and other assets require the Company's most complex judgments and assumptions when estimating fair value:

        In June 2007, the Company implemented a model that is based on an option-adjusted spread ("OAS") valuation methodology to estimate the fair value of substantially all of its MSR asset. The model projects cash flows over multiple interest rate scenarios and discounts these cash flows using risk-adjusted discount rates. Additionally, an independent broker estimate of the fair values of the mortgage servicing rights is obtained quarterly along with other market-based evidence. Management uses this information together with its OAS valuation methodology to estimate the fair value of the MSR. Models used to value MSR assets, including those employing an OAS valuation methodology, are highly sensitive to changes in certain assumptions. Different expected prepayment speeds, in particular, can result in substantial changes in the estimated fair value of MSR. If actual prepayment experience differs materially from the expected prepayment speeds used in the Company's model, this difference may result in a material change in MSR fair value.

        Changes in MSR value are reported in the Consolidated Statements of Income under the noninterest income caption "Revenue from sales and servicing of home mortgage loans." Additional discussion regarding the estimation of MSR fair value, including limitations to the MSR fair value measurement process, are described in the subsequent section of Management's Discussion and Analysis – "Earnings Performance from Continuing Operations." Key economic assumptions and the sensitivity of MSR fair value to immediate changes in those assumptions are described in Note 8 to the Consolidated Financial Statements – "Mortgage Banking Activities."

        For other retained interests in securitization activities (such as interest-only strips and residual interests in mortgage and credit card securitizations), the discounted cash flow model used in estimating fair value utilizes projections of expected cash flows that are greatly influenced by expected prepayment speeds and, in some cases, expected net credit losses or finance charges related to the securitized assets. Key economic assumptions and the sensitivity of retained interests fair value to immediate changes in those assumptions are described in Note 7 to the Consolidated Financial Statements – "Securitizations." Changes in those and other assumptions used could have a significant effect on the valuation of these retained interests. Changes in the value of other retained interests in securitization activities are reported in the Consolidated Statements of Income under the noninterest income caption "Loss on trading assets" and in the Consolidated Statements of Financial Condition as "Trading assets."

        The fair value of loans designated as held-for-sale is generally based on observable market prices of securities that have loan collateral or interests in loans that are similar to the held-for-sale loans or whole loan sale prices if formally committed. If market prices are not readily available, fair value is based on a discounted cash flow model, which considers expected prepayment factors and the degree of credit risk associated with the loans and the estimated effects of changes in market interest rates relative to the loans' interest rates. When the estimated fair value of loans held for sale is lower than

5


their cost, including adjustments to cost if the loans were in a fair value hedge relationship under Financial Accounting Standards Board ("FASB") Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended ("Statement No. 133"), a valuation adjustment that accounts for this difference is reported in the Consolidated Statements of Income as a component within the noninterest income caption "Revenue from sales and servicing of home mortgage loans" for home loans. Valuation adjustments for consumer loans held for sale are recorded under the noninterest income caption "Revenue from sales and servicing of consumer loans." Valuation adjustments for multi-family and commercial real estate loans held for sale are recorded under the noninterest income caption "Other income."

        Under FASB Statement No. 142, Goodwill and Other Intangible Assets, goodwill must be allocated to reporting units and tested for impairment. The Company tests goodwill for impairment at least annually or more frequently if events or circumstances, such as adverse changes in the business, indicate that there may be justification for conducting an interim test. Impairment testing is performed at the reporting unit level (which is the same level as the Company's four major operating segments identified in Note 26 to the Consolidated Financial Statements – "Operating Segments"). The first part of the test is a comparison, at the reporting unit level, of the fair value of each reporting unit to its carrying value, including goodwill. If the fair value is less than the carrying value, then the second part of the test is needed to measure the amount of potential goodwill impairment. The implied fair value of the reporting unit goodwill is calculated and compared with the actual carrying value of goodwill recorded within the reporting unit. If the carrying value of reporting unit goodwill exceeds the implied fair value of that goodwill, then the Company would recognize an impairment loss for the amount of the difference, which would be recorded as a charge against net income.

        The fair value of the reporting units are determined primarily using discounted cash flow models based on each reporting unit's internal forecasts. In addition, analysis using market-based trading and transaction multiples, where available, is used to assess the reasonableness of the valuations derived from the discounted cash flow models.

        For additional information regarding the carrying values of goodwill by operating segment, see Note 9 to the Consolidated Financial Statements – "Goodwill and Other Intangible Assets."

        The allowance for loan losses represents management's estimate of incurred credit losses inherent in the Company's loan portfolio as of the balance sheet date. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods.

        The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower's ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and unemployment levels have on a borrower's ability to repay adjustable-rate loans.

        The Company allocates a portion of the allowance to the homogeneous loan portfolios and estimates this allocated portion using statistical estimation techniques. Loss estimation techniques used in statistical models are supplemented by qualitative information to assist in estimating the allocated allowance. When housing prices are volatile, lags in data collection and reporting increase the likelihood of adjustments being made to the allowance.

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        The Company also estimates an unallocated portion of the allowance that reflects management's assessment of various risk factors that are not fully captured by the statistical estimation techniques used to determine the allocated component of the allowance. The following factors are routinely and regularly reviewed in estimating the appropriateness of the unallocated allowance: national and local economic trends and conditions (such as gross domestic product and unemployment trends); market conditions (such as changes in housing prices); industry and borrower concentrations within portfolio segments (including concentrations by metropolitan statistical area); recent loan portfolio performance (such as changes in the levels and trends in delinquencies and impaired loans); trends in loan growth (including the velocity of change in loan growth); changes in underwriting criteria; and the regulatory and public policy environment.

        The allowance for loan losses is reported in the Consolidated Statements of Financial Condition and the provision for loan losses is reported in the Consolidated Statements of Income.

        The estimates and judgments are described in further detail in the subsequent section of Management's Discussion and Analysis—"Credit Risk Management" and in Note 1 to the Consolidated Financial Statements—"Summary of Significant Accounting Policies."

        In the ordinary course of business, the Company sells loans to third parties and in certain circumstances, such as in the event of early or first payment default, retains credit risk exposure on those loans. The Company may also be required to repurchase sold loans when representations and warranties made by the Company in connection with those sales are breached. Under certain circumstances, such as when a loan sold to an investor and serviced by the Company fails to perform according to its contractual terms within the six months after its origination or upon written request of the investor, the Company will review the loan file to determine whether or not errors may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a violation of a representation or warranty made to the investor in connection with the Company's sale of the loan, then the Company will be required to either repurchase the loan or indemnify the investor for losses sustained if the violation had a material adverse effect on the value of the loan.

        Reserves are established for the Company's exposure to the potential repurchase or indemnification liabilities described above as such liabilities are initially recorded at fair value. Throughout the life of these repurchase or indemnification liabilities, the Company may learn of additional information that can affect the assessment of loss probability or the estimation of the amounts involved. Changes in these assessments can lead to significant changes in the recorded reserves. Repurchase and indemnification liabilities are recorded within other liabilities in the Consolidated Statements of Financial Condition, and losses are recorded in the Consolidated Statements of Income under the noninterest income caption "Revenue from sales and servicing of home mortgage loans."

        The Company monitors securities in its available-for-sale investment portfolio for impairment. Impairment may result from credit deterioration of the issuer, from changes in market rates relative to the interest rate of the instrument, or from changes in prepayment speeds. The Company considers many factors in determining whether the impairment is other than temporary, including but not limited to adverse changes in expected cash flows, the length of time the security has had a fair value less than the cost basis, the severity of the unrealized loss, the Company's intent and ability to hold the security for a period of time sufficient for a recovery in value and issuer-specific factors such as the issuer's financial condition, external credit ratings and general market conditions. The determination of

7


other-than-temporary impairment is a subjective process, requiring the use of judgments and assumptions in interpreting relevant market data. Other-than-temporary valuation losses on available-for-sale securities are reported in the Consolidated Statements of Income under the noninterest income caption "Loss on other available-for-sale securities." For additional information regarding the amortized cost, unrealized gains, unrealized losses, and fair value of securities, see Note 5 to the Consolidated Financial Statements – "Available-for-Sale Securities."

        The Company enters into derivative contracts to manage the various risks associated with certain assets, liabilities, or probable forecasted transactions. When the Company enters into derivative contracts, the derivative instrument is designated as: (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (a "fair value" hedge); (2) a hedge of the variability in expected future cash flows associated with an existing recognized asset or liability or a probable forecasted transaction (a "cash flow" hedge); or (3) held for other risk management purposes ("risk management derivatives").

        All derivatives, whether designated in hedging relationships or not, are recorded at fair value as either assets or liabilities in the Consolidated Statements of Financial Condition. Changes in fair value of derivatives that are not in hedge accounting relationships (as in (3) above) are recorded in the Consolidated Statements of Income in the period in which the change in value occurs. Changes in the fair value of derivatives that are designated as cash flow hedges (as in (2) above), to the extent such hedges are deemed highly effective, are recorded as a separate component of accumulated other comprehensive income and reclassified into earnings when the earnings effect of the hedged cash flows is recognized. Changes in the fair value of derivatives in qualifying fair value hedge accounting relationships (as in (1) above) are recorded each period in earnings along with the change in fair value of the hedged item attributable to the risk being hedged.

        The determination of whether a derivative qualifies for hedge accounting requires complex judgments about the application of Statement No. 133. Additionally, this Statement requires contemporaneous documentation of the Company's hedge relationships. Such documentation includes the nature of the risk being hedged, the identification of the hedged item, or the group of hedged items that share the risk exposure that is designated as being hedged, the selection of the instrument that will be used to hedge the identified risk, and the method used to assess the effectiveness of the hedge relationship. The assessment of hedge effectiveness requires calculations that utilize standard statistical methods of correlation that must support the determination that the hedging relationship is expected to be highly effective, during the period that the hedge is designated, in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. If the Company's assessment of effectiveness is not considered to be adequate to achieve hedge accounting treatment, the derivative is treated as a free-standing risk management instrument.

Recently Issued Accounting Standards Not Yet Adopted

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

        In December 2006, the Company exited the retail mutual fund management business and completed the sale of WM Advisors, Inc. WM Advisors provided investment management, distribution and shareholder services to the WM Group of Funds. This former subsidiary has been accounted for as a discontinued operation and, accordingly, its results of operations have been removed from the Company's results of continuing operations for the years ended December 31, 2006 and 2005 in the

8


Consolidated Statements of Income and in Note 26 to the Consolidated Financial Statements – "Operating Segments."

Five-Year Summary of Selected Financial Data

 
  December 31,
 
  2007
  2006
  2005
  2004
  2003
 
  (in millions, except per share amounts)

Income Statement Data (for the year ended)                              
  Net interest income   $ 8,177   $ 8,121   $ 8,218   $ 7,411   $ 7,865
  Provision for loan losses     3,107     816     316     209     42
  Noninterest income     6,042     6,377     5,097     4,061     5,437
  Noninterest expense     10,600     8,807     7,620     7,332     7,267
  Net income (loss)     (67 )   3,558     3,432     2,878     3,880
  Basic earnings per common share:                              
    Income (loss) from continuing operations     (0.11 )   3.27     3.80     2.84     4.17
    Income from discontinued operations         0.47     0.04     0.50     0.12
   
 
 
 
 
      Net income (loss)     (0.11 )   3.74     3.84     3.34     4.29
  Diluted earnings per common share:                              
    Income (loss) from continuing operations     (0.12 )   3.18     3.69     2.77     4.09
    Income from discontinued operations         0.46     0.04     0.49     0.12
   
 
 
 
 
      Net income (loss)     (0.12 )   3.64     3.73     3.26     4.21
  Dividends declared per common share     2.21     2.06     1.90     1.74     1.40
Balance Sheet Data (at year end)                              
  Available-for-sale securities   $ 27,540   $ 24,978   $ 24,659   $ 19,219   $ 36,707
  Loans held for sale     5,403     44,970     33,582     42,743     20,837
  Loans held in portfolio     244,386     224,960     229,632     207,071     175,150
  Mortgage servicing rights     6,278     6,193     8,041     5,906     6,354
  Goodwill     7,287     9,050     8,298     6,196     6,196
  Total assets     327,913     346,288     343,573     307,581     275,178
  Total deposits     181,926     213,956     193,167     173,658     153,181
  Securities sold under agreements to repurchase     4,148     11,953     15,532     15,944     28,333
  Advances from Federal Home Loan Banks     63,852     44,297     68,771     70,074     48,330
  Other borrowings     38,958     32,852     23,777     18,498     15,483
  Minority interests     3,919     2,448     15     13    
  Stockholders' equity     24,584     26,969     27,279     20,889     19,405
Supplemental Data                              
  Loan volume:                              
    Home loans:                              
      Adjustable-rate   $ 70,324   $ 110,914   $ 125,758   $ 128,263   $ 113,677
      Fixed-rate     30,554     47,469     81,964     84,099     270,504
   
 
 
 
 
    Total home loan volume     100,878     158,383     207,722     212,362     384,181
    Total loan volume     151,502     205,085     260,770     266,397     431,906

9


Ratios and Other Supplemental Data

 
  Year Ended December 31,
 
 
  2007
  2006
  2005
 
 
  (dollars in millions,
except per share amounts)

 
Profitability                    
  Return on average assets     (0.02 )%   1.02 %   1.05 %
  Return on average common equity     (0.42 )   13.52     14.91  
  Net interest margin     2.85     2.60     2.79  
  Efficiency ratio(1)(2)     74.55     60.75     57.23  
Asset Quality (at year end)                    
  Nonaccrual loans   $ 6,123   $ 2,295   $ 1,686  
  Foreclosed assets     979     480     276  
   
 
 
 
    Total nonperforming assets(3)     7,102     2,775     1,962  
  Nonperforming assets(3) to total assets     2.17 %   0.80 %   0.57 %
  Allowance for loan losses   $ 2,571   $ 1,630   $ 1,695  
  Allowance as a percentage of total loans held in portfolio     1.05 %   0.72 %   0.74 %
Credit Performance                    
  Net charge-offs   $ 1,623   $ 510   $ 244  
Capital Adequacy (at year end)                    
  Stockholders' equity to total assets     7.50 %   7.79 %   7.94 %
  Tangible equity to total tangible assets(4)     6.67     6.04     5.62  
  Tier 1 capital to average total assets (leverage)(5)     6.84     6.35     5.83  
  Total risk-based capital to total risk-weighted assets(5)     12.34     11.77     10.80  
Per Common Share Data                    
  Common shares outstanding at the end of period (in thousands)(6)     869,036     944,479     993,914  
  Common stock dividend payout ratio     N/M     55.08 %   49.48 %
  Book value per common share (at year end)(7)   $ 24.55   $ 28.21   $ 27.61  
  Market prices:                    
    High     45.56     46.48     44.54  
    Low     13.07     41.47     36.92  
    Year end     13.61     45.49     43.50  

N/M = Not meaningful

(1)
Based on continuing operations.
(2)
The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income and noninterest income).
(3)
Excludes nonaccrual loans held for sale.
(4)
Excludes unrealized net gain/loss on available-for-sale securities and cash flow hedging instruments, goodwill and intangible assets (except MSR) and the impact from the adoption and application of FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans. Minority interests of $3.92 billion for December 31, 2007 and $2.45 billion for December 31, 2006 are included in the numerator.
(5)
The capital ratios are estimated as if Washington Mutual, Inc. were a bank holding company subject to Federal Reserve Board capital requirements.
(6)
Includes six million shares held in escrow.
(7)
Excludes six million shares held in escrow.

10


Earnings Performance from Continuing Operations

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

 
  Year Ended December 31,
 
  2007
  2006
  2005
 
  Average Balance
  Rate
  Interest Income/ Expense
  Average Balance
  Rate
  Interest Income/ Expense
  Average Balance
  Rate
  Interest Income/ Expense
 
  (dollars in millions)

Assets(1)                                                
Interest-earning assets(2):                                                
  Federal funds sold and securities purchased under agreements to resell   $ 3,475   5.31 % $ 184   $ 4,718   5.20 % $ 245   $ 2,154   3.42 % $ 74
  Trading assets     4,546   9.45     430     7,829   7.74     606     7,217   6.50     469
  Available-for-sale securities(3):                                                
    Mortgage-backed securities     19,647   5.49     1,078     21,534   5.41     1,165     16,359   4.81     786
    Investment securities     7,334   5.13     377     5,992   4.92     295     4,494   4.71     212
  Loans held for sale     20,421   6.81     1,391     27,791   6.50     1,807     44,847   5.34     2,394
  Loans held in portfolio(4):                                                
    Loans secured by real estate:                                                
      Home loans(5)(6)     98,547   6.49     6,396     120,320   5.83     7,011     110,326   4.97     5,485
      Home equity loans and lines of credit(6)     56,285   7.46     4,197     52,265   7.33     3,833     47,909   6.01     2,878
      Subprime mortgage channel(7)     20,125   6.62     1,333     20,202   6.31     1,275     20,561   5.90     1,214
      Home construction(8)     2,074   6.79     141     2,061   6.46     133     2,074   6.22     129
      Multi-family     30,162   6.59     1,988     27,386   6.28     1,721     24,070   5.41     1,303
      Other real estate     7,504   6.98     524     5,797   6.93     402     5,091   7.11     362
   
     
 
     
 
     
        Total loans secured by real estate     214,697   6.79     14,579     228,031   6.30     14,375     210,031   5.41     11,371
    Consumer:                                                
      Credit card     10,113   10.55     1,067     8,733   11.19     977     2,082   11.96     249
      Other     242   13.90     34     444   11.12     50     707   10.67     75
    Commercial     1,916   8.10     155     1,886   6.94     131     2,614   5.04     132
   
     
 
     
 
     
        Total loans held in portfolio     226,968   6.98     15,835     239,094   6.50     15,533     215,434   5.49     11,827
  Other     4,275   4.53     194     5,220   4.90     256     4,324   3.65     158
   
     
 
     
 
     
        Total interest-earning assets     286,666   6.80     19,489     312,178   6.38     19,907     294,829   5.40     15,920
Noninterest-earning assets:                                                
  Mortgage servicing rights     6,616               7,667               6,597          
  Goodwill     9,018               8,489               6,712          
  Other assets     21,089               20,424               18,095          
   
           
           
         
        Total assets   $ 323,389             $ 348,758             $ 326,233          
   
           
           
         
Liabilities(1)                                                
Interest-bearing liabilities:                                                
  Deposits:                                                
    Interest-bearing checking deposits   $ 29,261   2.42     709   $ 36,477   2.63     960   $ 46,524   1.95     906
    Savings and money market deposits     56,459   3.27     1,846     48,866   2.96     1,446     42,555   1.76     750
    Time deposits     82,551   4.91     4,055     84,106   4.59     3,857     62,175   3.33     2,072
   
     
 
     
 
     
        Total interest-bearing deposits     168,271   3.93     6,610     169,449   3.70     6,263     151,254   2.46     3,728
  Federal funds purchased and commercial paper     3,096   5.30     164     7,347   5.06     371     5,314   3.56     190
  Securities sold under agreements to repurchase     8,330   5.32     443     15,257   5.12     781     15,365   3.40     523
  Advances from Federal Home Loan Banks     37,144   5.28     1,963     56,619   4.99     2,828     68,713   3.46     2,377
  Other     38,157   5.59     2,132     28,796   5.36     1,543     21,603   4.09     884
   
     
 
     
 
     
        Total interest-bearing liabilities     254,998   4.44     11,312     277,468   4.25     11,786     262,249   2.94     7,702
             
           
           
Noninterest-bearing sources:                                                
  Noninterest-bearing deposits     32,109               34,380               34,769          
  Other liabilities     9,155               8,865               6,177          
  Minority interests     2,933               1,639               14          
  Stockholders' equity     24,194               26,406               23,024          
   
           
           
         
        Total liabilities and stockholders' equity   $ 323,389             $ 348,758             $ 326,233          
   
           
           
         
Net interest spread and net interest income         2.36   $ 8,177         2.13   $ 8,121         2.46   $ 8,218
             
           
           
Impact of noninterest-bearing sources         0.49               0.47               0.33      
Net interest margin         2.85               2.60               2.79      
Taxable-Equivalent Basis                                                
Net interest margin and net interest income on a taxable-equivalent basis(9)         2.86   $ 8,191         2.60   $ 8,129         2.79   $ 8,225

11



(1)
Average balances of assets and liabilities of acquired companies are calculated by dividing the stub period of the Company's ownership of those assets or liabilities by one year.
(2)
Nonaccrual assets and related income, if any, are included in their respective categories.
(3)
The average balance and yield are based on average amortized cost balances.
(4)
Interest income for loans held in portfolio includes amortization of net deferred loan origination costs of $391 million, $463 million, and $402 million for the years ended December 31, 2007, 2006 and 2005.
(5)
Capitalized interest recognized in earnings that resulted from negative amortization within the Option ARM portfolio totaled $1.42 billion, $1.07 billion, and $292 million for the years ended December 31, 2007, 2006 and 2005.
(6)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(7)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(8)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(9)
Includes taxable-equivalent adjustments primarily related to tax-exempt income on U.S. states and political subdivisions securities and loans related to the Company's community lending and investment activities. The federal statutory tax rate was 35% for the periods presented.

      The dollar amounts of interest income and interest expense fluctuate depending upon changes in interest rates and upon changes in the volume of 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 rates multiplied by the prior period's volume), and (iii) changes in rate/volume (changes in rate multiplied by the change in volume)

12


which were allocated in proportion to the percentage changes in average volume and average rate and included in the relevant column below were as follows:

 
  2007 vs. 2006
  2006 vs. 2005
 
 
  Increase/(Decrease)
Due to

   
  Increase/(Decrease)
Due to

   
 
 
  Total Change
  Total Change
 
 
  Volume
  Rate
  Volume
  Rate
 
 
  (in millions)

 
Interest Income                                      
Federal funds sold and securities purchased under agreements to resell   $ (66 ) $ 5   $ (61 ) $ 119   $ 52   $ 171  
Trading assets     (291 )   115     (176 )   42     95     137  
Available-for-sale securities:                                      
  Mortgage-backed securities     (104 )   17     (87 )   271     108     379  
  Investment securities     69     13     82     73     10     83  
Loans held for sale     (499 )   83     (416 )   (1,036 )   449     (587 )
Loans held in portfolio:                                      
  Loans secured by real estate:                                      
    Home loans(1)     (1,357 )   742     (615 )   526     1,000     1,526  
    Home equity loans and lines of credit(1)     299     65     364     279     676     955  
    Subprime mortgage channel(2)     (5 )   63     58     (22 )   83     61  
    Home construction(3)     1     7     8     (1 )   5     4  
    Multi-family     180     87     267     193     225     418  
    Other real estate     119     3     122     49     (9 )   40  
   
 
 
 
 
 
 
      Total loans secured by real estate     (763 )   967     204     1,024     1,980     3,004  
  Consumer:                                      
    Credit card     148     (58 )   90     745     (17 )   728  
    Other     (26 )   10     (16 )   (29 )   4     (25 )
  Commercial     2     22     24     (42 )   41     (1 )
   
 
 
 
 
 
 
      Total loans held in portfolio     (639 )   941     302     1,698     2,008     3,706  
Other     (44 )   (18 )   (62 )   37     61     98  
   
 
 
 
 
 
 
      Total interest income     (1,574 )   1,156     (418 )   1,204     2,783     3,987  
Interest Expense                                      
Deposits:                                      
  Interest-bearing checking deposits     (179 )   (72 )   (251 )   (222 )   276     54  
  Savings and money markets deposits     239     161     400     125     571     696  
  Time deposits     (73 )   271     198     864     921     1,785  
   
 
 
 
 
 
 
    Total deposits     (13 )   360     347     767     1,768     2,535  
Federal funds purchased and commercial paper     (224 )   17     (207 )   87     94     181  
Securities sold under agreements to repurchase     (368 )   30     (338 )   (4 )   262     258  
Advances from Federal Home Loan Banks     (1,021 )   156     (865 )   (471 )   922     451  
Other     520     69     589     342     317     659  
   
 
 
 
 
 
 
      Total interest expense     (1,106 )   632     (474 )   721     3,363     4,084  
   
 
 
 
 
 
 
Net interest income   $ (468 ) $ 524   $ 56   $ 483   $ (580 ) $ (97 )
   
 
 
 
 
 
 

(1)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(2)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(3)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

13


        Net interest income and the net interest margin, both expressed on a taxable-equivalent basis, totaled $8.19 billion and 2.86% in 2007, compared with $8.13 billion and 2.60% in 2006. The increase in the net interest margin was primarily due to increases in the yields of mortgage loan products tied to short-term interest rate indices and the sales of lower-yielding mortgage loans, and a favorable change in the mix between deposits and comparatively higher cost borrowed funds. Deposits funded 70% of the interest-earning asset base during 2007, compared with 65% in 2006. A decline in average interest earning assets in 2007 partially offset the expansion of the margin, as the Company sought to deemphasize balance sheet growth during a time in which the yield curve was relatively flat or slightly inverted.

        Noninterest income from continuing operations consisted of the following:

 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (in millions)

   
   
 
Revenue from sales and servicing of home mortgage loans   $ 944   $ 768   $ 2,017   23 % (62 )%
Revenue from sales and servicing of consumer loans     1,639     1,527     413   7   270  
Depositor and other retail banking fees     2,893     2,567     2,193   13   17  
Credit card fees     778     637     139   22   358  
Securities fees and commissions     260     215     189   21   13  
Insurance income     116     127     172   (8 ) (26 )
Loss on trading assets     (673 )   (154 )   (257 ) 336   (40 )
Loss on other available-for-sale securities     (319 )   (9 )   (84 )   (90 )
Other income     404     699     315   (42 ) 122  
   
 
 
         
  Total noninterest income   $ 6,042   $ 6,377   $ 5,097   (5 ) 25  
   
 
 
         

14


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

 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (in millions)

   
   
 
Revenue from sales and servicing of home mortgage loans:                            
  Sales activity:                            
    Gain from home mortgage loans and originated mortgage-backed securities(1)   $ 52   $ 626   $ 873   (92 )% (28 )%
    Revaluation gain from derivatives economically hedging loans held for sale     7     109     76   (93 ) 42  
   
 
 
         
      Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments     59     735     949   (92 ) (23 )
  Servicing activity:                            
    Home mortgage loan servicing revenue(2)     2,047     2,181     2,110   (6 ) 3  
    Change in MSR fair value due to payments on loans and other(3)     (1,363 )   (1,654 )     (18 )  
    Change in MSR fair value due to valuation inputs or assumptions(3)     (157 )   299          
    MSR valuation adjustments(4)             965      
    Amortization of MSR             (2,170 )    
    Revaluation gain (loss) from derivatives economically hedging MSR     358     (636 )   163      
    Adjustment to MSR fair value for MSR sale         (157 )        
   
 
 
         
    Home mortgage loan servicing revenue, net of MSR valuation changes and derivative risk management instruments     885     33     1,068     (97 )
   
 
 
         
      Total revenue from sales and servicing of home mortgage loans   $ 944   $ 768   $ 2,017   23   (62 )
   
 
 
         

(1)
Originated mortgage-backed securities represent available-for-sale securities retained on the balance sheet subsequent to the securitization of mortgage loans that were originated by the Company.
(2)
Includes contractually specified servicing fees (net of guarantee fees paid to housing government-sponsored enterprises, where applicable), late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors and that which is collected from borrowers upon payoff).
(3)
Line item descriptions reflect the impact of the adoption of Statement No. 156 on January 1, 2006. The retrospective application of this statement to prior periods is not permitted.
(4)
Net of fair value hedge ineffectiveness as well as any impairment/reversal recognized on MSR that resulted from the application of the lower of cost or fair value accounting methodology in 2005.

15


        The following table presents MSR valuation and the corresponding risk management derivative instruments and securities during the years ended December 31, 2007 and 2006:

 
  Year Ended December 31,
 
 
  2007
  2006
 
 
  (in millions)

 
MSR Valuation and Risk Management:              
  Change in MSR fair value due to valuation inputs or assumptions   $ (157 ) $ 299  
Gain (loss) on MSR risk management instruments:              
  Revaluation gain (loss) from derivatives     358     (636 )
  Revaluation gain (loss) from certain trading securities     4     (55 )
  Loss from certain available-for-sale securities         (1 )
   
 
 
    Total gain (loss) on MSR risk management instruments     362     (692 )
   
 
 
      Total changes in MSR valuation and risk management   $ 205   $ (393 )
   
 
 

        The following tables reconcile the gains (losses) on investment securities that are designated as MSR risk management instruments to loss on trading assets and loss on other available-for-sale securities that are reported within noninterest income during the years ended December 31, 2007 and 2006:

 
  Year Ended December 31,
 
 
  2007
  2006
 
 
  (in millions)

 
Gain (loss) on trading assets resulting from:              
  MSR risk management instruments   $ 4   $ (55 )
  Other     (677 )   (99 )
   
 
 
    Total loss on trading assets   $ (673 ) $ (154 )
   
 
 
 
 
  Year Ended December 31,
 
 
  2007
  2006
 
 
  (in millions)

 
Loss on other available-for-sale securities resulting from:              
  MSR risk management instruments   $   $ (1 )
  Other     (319 )   (8 )
   
 
 
    Total loss on other available-for-sale securities   $ (319 ) $ (9 )
   
 
 

        Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments was $59 million in 2007, compared with $735 million in the prior year. Secondary market conditions for subprime mortgage loans rapidly deteriorated during the first half of 2007 in response to the weakening housing market. As credit risk concerns from rising subprime mortgage borrower defaults increased, credit spreads widened to reflect secondary market demands for higher risk premiums on subprime mortgage loans, which lowered the value of the loans to be sold. Credit concerns spread across the secondary market in the second half of 2007 as mortgage delinquencies and loss severities across all single-family residential borrower classes accelerated. This led to a severe contraction in risk tolerances among secondary market participants and resulted in an illiquid market for nonconforming home loans. With the absence of liquidity for such loans, home loan sales volume totaled only $17.38 billion in the last half of 2007, a 69% decline from $56.58 billion for the same period in 2006. The Company transferred into its held for investment portfolio approximately

16



$15 billion of single-family residential loans in the third quarter of 2007, which were substantially comprised of nonconforming products that had initially been designated as held for sale prior to the rapid contraction in secondary market liquidity. A $139 million downward adjustment on the transferred loans was recorded based on the lower of cost or fair value, reflecting the wider secondary market credit spreads that accompanied the market disruption.

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

        In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets, which amends Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, permitting for the first time an entity to report classes of servicing assets at fair value at each reporting date and to record changes in fair value of such reported classes of servicing assets in earnings in the period in which the changes occur. The Company applied Statement No. 156 to its financial statements on January 1, 2006 and elected to measure its mortgage servicing assets at fair value. Upon electing the fair value method of accounting for its mortgage servicing assets, the Company discontinued the application of fair value hedge accounting. Accordingly, beginning in 2006, all derivatives held for MSR risk management are treated as economic hedges, with valuation changes recorded as revaluation gain (loss) from derivatives economically hedging MSR. Additionally, upon the change from the lower of cost or fair value accounting method to fair value accounting under Statement No. 156, the calculation of amortization and the assessment of impairment were discontinued and the MSR valuation allowance was written off against the recorded value of the MSR. Those measurements have been replaced by fair value adjustments that encompass market-driven valuation changes and the runoff in value that occurs as scheduled loan payments are made over time, which are each separately reported.

        Home mortgage loan servicing revenue decreased by $134 million for the year ended December 31, 2007, compared with 2006. The decrease was largely the result of the sale of $2.53 billion of mortgage servicing rights in July 2006. The decline was more than offset by a decrease in the rate of MSR fair value changes from loan payments of $291 million between the same years, as actual payment rates on the servicing portfolio decreased in 2007 due to significantly lower levels of refinancing activity.

        MSR valuation and risk management results were a gain of $205 million in 2007, compared with a loss of $393 million in 2006. Although mortgage interest rates at the end of 2007 were at similar levels to those that existed at the beginning of the year, more significant fluctuations occurred over the course of 2007, which led to a modest decrease in MSR value of $157 million for the year. The decrease in value occurred primarily during the second half of 2007, as mortgage rates generally declined during that period, resulting in higher expected prepayment speeds. However, the impact of lower interest rates on projected MSR prepayment speeds was mitigated by a smaller increase in expected prepayment rates, reflecting diminished opportunities for borrowers to refinance during a period when the housing market is weakening, underwriting standards across the mortgage banking industry have tightened and rates for nonconforming loan products are higher. The performance of the MSR risk management instruments was adversely affected by the flat-to-inverted slope of the yield curve in 2006, which had the effect of increasing hedging costs.

17


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

        Revenue from sales and servicing of consumer loans increased $112 million for the year ended December 31, 2007, compared with 2006. While revenue from sales increased between the two periods as a result of a 50% increase in credit card securitization volume, revenue from servicing declined in 2007, when compared with 2006. This decline in servicing revenue was a result of realization of higher than originally estimated interest and fees charged on securitized loans and lower than originally estimated credit losses.

        Depositor and other retail banking fees increased $326 million for the year ended December 31, 2007, compared with 2006, predominantly due to higher transaction fees and an increase in the number of noninterest-bearing checking accounts. The number of noninterest-bearing checking accounts at December 31, 2007 totaled approximately 11.0 million compared with approximately 9.6 million at December 31, 2006.

        Credit card fees increased $141 million for the year ended December 31, 2007, compared with 2006, reflecting growth in the average balance of the credit card portfolio.

        Securities fees and commissions increased $45 million for the year ended December 31, 2007, compared with 2006, due to an increase in the volume of mutual fund and annuity sales.

        Loss on trading assets increased $519 million for the year ended December 31, 2007, compared with 2006. Similar to the way in which capital market disruptions affected the Company's mortgage banking results, the severe downturn in the housing market and rising levels of credit card delinquencies contributed to less favorable economic assumptions used to measure the value of trading assets retained from mortgage loan and credit card securitizations.

        The Company recognizes impairment losses on available-for-sale securities through the income statement when it has concluded that a decrease in the fair value of a security is other than temporary. During the second half of 2007, the Company recognized charges totaling $375 million related to mortgage-backed securities where it determined that a decline in fair value below amortized cost represented an other-than-temporary condition.

        The decrease in other income of $295 million for the year ended December 31, 2007, compared with 2006, primarily resulted from losses related to equity method investments and revaluation losses on derivatives held for risk management purposes. In addition, included in 2006 was a $149 million litigation award from the partial settlement of the Company's claim against the U.S. Government with regard to the Home Savings supervisory goodwill lawsuit.

18


        Noninterest expense from continuing operations consisted of the following:

 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (in millions)

   
   
 
Compensation and benefits   $ 3,766   $ 3,937   $ 3,701   (4 )% 6 %
Occupancy and equipment     1,589     1,711     1,520   (7 ) 13  
Telecommunications and outsourced information services     530     554     449   (4 ) 23  
Depositor and other retail banking losses     262     229     226   14   2  
Advertising and promotion     445     443     315     41  
Professional fees     233     227     181   3   26  
Postage     417     471     293   (12 ) 61  
Foreclosed asset expense     309     117     75   164   56  
Goodwill impairment charge     1,775              
Other expense     1,274     1,118     860   14   30  
   
 
 
         
  Total noninterest expense   $ 10,600   $ 8,807   $ 7,620   20   16  
   
 
 
         

        Noninterest expense in 2007 includes the fourth quarter effects from a $1.78 billion pre-tax impairment loss related to all goodwill associated with the Home Loans business. With the fundamental shift in the mortgage market from credit disruptions and the expectation of a prolonged period of secondary mortgage market illiquidity, the Company also recorded charges of $143 million in the fourth quarter to resize its Home Loans business and corporate support functions in anticipation of continued declines in home mortgage industry loan originations, and to accelerate the direction of its mortgage banking operations to home lending conducted through retail banking stores and other retail distribution channels. The charges consist of $58 million in employee termination benefits, $42 million in lease termination and other decommissioning costs, and $43 million of fixed asset write-downs.

        The Company determined that the actions associated with the resizing of the Home Loans business represent restructuring activities. Accordingly, the resizing expenses described above included $98 million of restructuring charges that resulted from the discontinuation of subprime mortgage lending, the announced closure of WaMu Capital Corp., the wind-down of the Company's mortgage banker finance operations, and the closure of certain home loans production centers and back-office support functions. The restructuring charges are described further in Note 2 to the Consolidated Financial Statements – "Restructuring Activities."

        Compensation and benefits expense decreased $171 million, or 4%, from 2006, primarily due to lower home loan mortgage banking incentive compensation that resulted from the significant decline in home loan volume. The number of employees decreased from 49,824 employees at December 31, 2006 to 49,403 employees at December 31, 2007. Employee headcount was further reduced to 48,433 at January 31, 2008, reflecting the fourth quarter 2007 actions to resize the Company's Home Loans business and corporate support functions.

        The decrease in occupancy and equipment expense during 2007 was primarily due to charges in 2006 of approximately $185 million related to the Company's productivity and efficiency initiatives, partially offset by charges in 2007 to resize the Company's Home Loans business and corporate support functions.

        Depositor and other retail banking losses increased during 2007 predominantly due to an increase in the number of transaction accounts, resulting in an increase in loss levels for returned deposited items and overdrawn account losses.

19


        Postage expense decreased during 2007 due to a decline in courier expense related to improved efficiency in the cash distribution process in the Company's retail banking operations.

        The increase in foreclosed asset expense during 2007 was due to higher foreclosures reflecting the deterioration in the credit environment and further weakening in the housing market. The total number of foreclosed properties has increased while the values of those properties have generally declined.

        The increase in other expense from 2006 was partly due to charges of $88 million for Visa related litigation liabilities recognized during 2007. The Company recognized charges of $38 million in the third quarter of 2007 related to its share of the American Express settlement of a covered litigation matter and $50 million in the fourth quarter of 2007 to accrue for a contingent obligation for certain unresolved disputes involving Visa and its members.

        For 2007, a tax provision of $376 million was recorded, compared with a tax provision of $1.66 billion for 2006. The tax provision recorded for 2007 was significantly impacted by the pre-tax goodwill impairment charge of $1.78 billion, of which approximately $1.3 billion is not deductible for income tax purposes. The effective tax rate for the tax benefit recorded on the goodwill impairment charge was 9.83%. Excluding the goodwill impairment charge, the effective tax rate for 2007 would have been 26.41%, compared with 34.73% in 2006. The reduction in the effective tax rate for 2007 (excluding the goodwill impairment charge) is mostly due to reduced income from continuing operations before income taxes.

Review of Financial Condition

        Trading assets consisted of the following:

 
  December 31,
 
  2007
  2006
 
  (in millions)

Credit card retained interests   $ 1,838   $ 1,464
Mortgage-backed securities     854     2,880
U.S. Government and other debt securities     76     90
   
 
  Total trading assets   $ 2,768   $ 4,434
   
 

        The Company's trading assets are primarily comprised of financial instruments that are retained from securitization transactions. Credit card retained interests are mostly comprised of subordinated interests that consist of noninterest bearing beneficial interests. These retained interests are repaid after the related senior classes of securities, which are usually held by third party investors.

        Trading assets at December 31, 2007 decreased $1.67 billion from December 31, 2006 predominantly due to a $1.85 billion decline in securities held by WaMu Capital Corp. ("WCC"), an indirect subsidiary of the Company. During December 2007, the Company announced its intention to close WCC, its institutional broker-dealer business, as part of restructuring its Home Loans business.

20


        The following table presents trading assets, including mortgage-backed securities by asset type, by investment grade at December 31, 2007:

 
  AAA(1)
  AA
  A
  BBB
  Below Investment Grade
  Total
 
  (in millions)

Credit card retained interests   $   $ 34   $ 108   $ 284   $ 1,412   $ 1,838
Mortgage-backed securities:                                    
  Agency     53                     53
  Prime     310     5     32     39     23     409
  Alt-A     116     89     37     34     45     321
  Subprime                 2     20 (2)   22
  Commercial                     49     49
   
 
 
 
 
 
    Total mortgage-backed securities     479     94     69     75     137     854
U.S. Government and other debt securities     76                     76
   
 
 
 
 
 
      Total trading assets   $ 555   $ 128   $ 177   $ 359   $ 1,549   $ 2,768
   
 
 
 
 
 

(1)
Includes securities guaranteed by the U.S. Government or U.S. Government sponsored agencies, which are not rated.
(2)
Represents retained interest in subprime mortgage loan securitizations, including $5 million in residual interests.

        Available-for-sale securities consisted of the following:

 
  December 31,
 
  2007
  2006
 
  (in millions)

Available-for-sale securities, total amortized cost of $27,789 and $25,073:            
  Mortgage-backed securities   $ 19,249   $ 18,601
  Investment securities     8,291     6,377
   
 
    Total available-for-sale securities   $ 27,540   $ 24,978
   
 

        The Company holds available-for-sale securities primarily for interest rate risk management and liquidity enhancement purposes. Accordingly, the portfolio is comprised primarily of highly-rated debt securities.

21


        The fair value of available-for-sale mortgage-backed securities by asset type and investment grade at December 31, 2007 is presented in the following table:

 
  AAA(1)
  AA
  A
  BBB
  Below Investment Grade
  Total
 
  (in millions)

Mortgage-backed securities:                                    
  Agency   $ 7,192   $   $   $   $   $ 7,192
  Prime     3,801     540     161     73         4,575
  Alt-A     600     175     68     74     23     940
  Subprime     236     88     121     37     9     491
  Commercial     6,015     17         10     9     6,051
   
 
 
 
 
 
    Total mortgage-backed securities   $ 17,844   $ 820   $ 350   $ 194   $ 41   $ 19,249
   
 
 
 
 
 

(1)
Includes securities guaranteed by the U.S. Government or U.S. Government sponsored agencies, which are not rated.

        At December 31, 2007, available-for-sale investment securities were comprised primarily of U.S. Government-sponsored agency securities and securities issued by U.S. states and political subdivisions. Substantially all investment securities are investment grade.

        Refer to Note 5 to the Consolidated Financial Statements – "Available-for-Sale Securities" for additional information on securities, classified by security type.

Loans

        Total loans consisted of the following:

 
  December 31,
 
  2007
  2006
  2005
  2004
  2003
 
  (in millions)

Loans held for sale   $ 5,403   $ 44,970   $ 33,582   $ 42,743   $ 20,837
   
 
 
 
 
Loans held in portfolio:                              
  Loans secured by real estate:                              
    Home loans(1)   $ 110,387   $ 99,479   $ 114,144   $ 109,950   $ 100,043
    Home equity loans and lines of credit(1)     60,963     52,882     50,840     43,648     27,644
    Subprime mortgage channel(2):                              
      Home loans     16,092     18,725     21,146     19,184     12,973
      Home equity loans and lines of credit     2,525     2,042     11     2     3
    Home construction(3)     2,226     2,082     2,037     2,344     2,220
    Multi-family(4)     31,754     30,161     25,601     22,282     20,324
    Other real estate(5)     9,524     6,745     5,035     5,664     6,649
   
 
 
 
 
        Total loans secured by real estate     233,471     212,116     218,814     203,074     169,856
  Consumer:                              
    Credit card     8,831     10,861     8,043        
    Other     205     276     638     792     1,028
  Commercial     1,879     1,707     2,137     3,205     4,266
   
 
 
 
 
        Total loans held in portfolio(6)   $ 244,386   $ 224,960   $ 229,632   $ 207,071   $ 175,150
   
 
 
 
 

(1)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(2)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.

22


(3)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(4)
Includes multi-family construction balances of $967 million, $740 million, $632 million, $333 million and $325 million at December 31, 2007, 2006, 2005, 2004 and 2003.
(5)
Includes other commercial real estate construction balances of $812 million, $414 million, $208 million, $277 million and $382 million at December 31, 2007, 2006, 2005, 2004 and 2003.
(6)
Includes net unamortized deferred loan costs of $1.45 billion, $1.88 billion, $1.96 billion, $1.87 billion and $1.55 billion at December 31, 2007, 2006, 2005, 2004 and 2003.

        Due to the illiquid market, residential mortgage loans designated as held for sale at December 31, 2007 were largely limited to conforming loans eligible for purchase by the housing government-sponsored enterprises. The December 31, 2006 balance of loans held for sale included approximately $17.5 billion of medium-term adjustable-rate home loans which were transferred during the fourth quarter of 2006 from loans held in portfolio to loans held for sale. These loans were subsequently sold during the first quarter of 2007. In addition, as a result of the severe contraction in secondary market liquidity, the Company transferred approximately $17 billion of real estate loans to its loan portfolio during the third quarter of 2007, which represented substantially all of the Company's nonconforming loans that had been designated as held for sale prior to the market disruption.

        Total home loans held in portfolio consisted of the following:

 
  December 31,
 
  2007
  2006
 
  (in millions)

Home loans:            
  Short-term adjustable-rate loans(1):            
    Option ARMs(2)   $ 58,870   $ 63,557
    Other ARMs     9,551     6,791
   
 
      Total short-term adjustable-rate loans     68,421     70,348
  Medium-term adjustable-rate loans(3)     36,507     26,232
  Fixed-rate loans     5,459     2,899
   
 
      Home loans held in portfolio(4)     110,387     99,479
  Subprime mortgage channel     16,092     18,725
   
 
      Total home loans held in portfolio   $ 126,479   $ 118,204
   
 

(1)
Short-term adjustable-rate loans reprice within one year.
(2)
The total amount by which the unpaid principal balance of Option ARM loans exceeded their original principal amount was $1.73 billion and $888 million at December 31, 2007 and 2006.
(3)
Medium-term adjustable-rate loans reprice after one year.
(4)
Excludes home loans in the subprime mortgage channel.

        The home loans held in portfolio balance at December 31, 2007 increased $8.28 billion from December 31, 2006. The increase was due primarily to the transfer of approximately $15 billion of nonconforming home loans previously designated as loans held for sale prior to the market disruption experienced during the third quarter of 2007. Partially offsetting this increase was a decrease in Option ARM loans, reflecting the slowdown in the housing market and an interest rate environment in which loan products with longer repricing frequencies are priced more favorably than short-term adjustable-rate loans.

        The balance of home equity loans and lines of credit at December 31, 2007, excluding home equity loans and lines of credit in the subprime mortgage channel, increased 15% from December 31, 2006 primarily due to growth in lines of credit.

23


        Home, multi-family and other commercial real estate construction loans and commercial business loans by maturity date were as follows:

 
  December 31, 2007
 
  Due Within One Year
  After One But Within Five Years
  After
Five Years

  Total
 
  (in millions)

Home construction(1):                        
  Adjustable-rate   $ 1,021   $ 154   $ 217   $ 1,392
  Fixed-rate     108     3     723     834
Multi-family construction:                        
  Adjustable-rate     248     413     11     672
  Fixed-rate     148     31     116     295
Other commercial real estate construction:                        
  Adjustable-rate     313     476     1     790
  Fixed-rate             22     22
Commercial business:                        
  Adjustable-rate     1,320     101     148     1,569
  Fixed-rate     92     151     67     310
   
 
 
 
    Total   $ 3,250   $ 1,329   $ 1,305   $ 5,884
   
 
 
 

(1)
Includes $37 million of loans to builders and $2.19 billion of loans to the intended occupant of a single-family residence.

        Deposits consisted of the following:

 
  December 31,
 
  2007
  2006
 
  (in millions)

Retail deposits:            
  Checking deposits:            
    Noninterest bearing   $ 23,476   $ 22,838
    Interest bearing     25,713     32,723
   
 
      Total checking deposits     49,189     55,561
  Savings and money market deposits     44,987     41,943
  Time deposits     49,410     46,821
   
 
      Total retail deposits     143,586     144,325
Commercial business and other deposits     11,267     15,175
Brokered deposits:            
  Consumer     18,089     22,299
  Institutional     2,515     22,339
Custodial and escrow deposits     6,469     9,818
   
 
      Total deposits   $ 181,926   $ 213,956
   
 

        Interest-bearing retail checking deposits decreased as customers shifted from Platinum checking accounts to time deposits and savings and money market deposits as a result of higher interest rates offered for these products.

        Institutional brokered deposits decreased $19.82 billion or 89% from December 31, 2006, largely due to reduced funding needs as the Company reduced total assets approximately 10% during the first

24



half of 2007. During the second half of 2007, as a result of the illiquid capital markets, the Company retained nonconforming mortgage loan products in its portfolio. The increase in assets was funded with more readily available and lower cost funding sources such as advances from FHLBs. Advances from FHLBs increased from $44.30 billion at December 31, 2006 to $63.85 billion at December 31, 2007.

        Transaction accounts (checking, savings and money market deposits) comprised 66% of retail deposits at December 31, 2007 and 68% at December 31, 2006. These products generally have the benefit of lower interest costs, compared with time deposits, and represent the core customer relationship that is maintained within the retail banking franchise. Average total deposits funded 70% of average total interest-earning assets for the year ended December 31, 2007, compared with 65% for the year ended December 31, 2006.

Operating Segments

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

        The Company serves the needs of 19.8 million consumer households through its 2,257 retail banking stores, 233 lending stores and centers, 4,713 owned and branded ATMs, telephone call centers and online banking.

        The principal activities of the Retail Banking Group include: (1) offering a comprehensive line of deposit and other retail banking products and services to consumers and small businesses; (2) holding the substantial majority of the Company's held for investment portfolios of home loans, home equity loans and home equity lines of credit (but not the Company's held for investment portfolios of home loans, home equity loans and home equity lines of credit made to higher risk borrowers through the subprime mortgage channel); (3) originating home equity loans and lines of credit; and (4) providing investment advisory and brokerage services, sales of annuities and other financial services.

        Deposit products offered to consumers and small businesses include the Company's signature free checking and interest-bearing Platinum checking accounts, as well as other personal checking, savings, money market deposit and time deposit accounts. Many products are offered in retail banking stores and online. Financial consultants provide investment advisory and securities brokerage services to the public.

        On December 31, 2006, the Company sold its retail mutual fund management business, WM Advisors, Inc. The results of operations of WM Advisors for the years ended December 31, 2006 and 2005 are reported within the Retail Banking Group's results as discontinued operations and the gain on disposition of these discontinued operations, net of certain transaction expenses, is reported in the Corporate Support/Treasury and Other category.

        The Card Services Group manages the Company's credit card operations. The segment's principal activities include: (1) issuing credit cards; (2) either holding outstanding balances on credit cards in portfolio or securitizing and selling them; (3) servicing credit card accounts; and (4) providing other cardholder services. Credit card balances that are held in the Company's loan portfolio generate interest income from finance charges on outstanding card balances, and noninterest income from the

25



collection of fees associated with the credit card portfolio, such as performance fees (late, overlimit and returned check charges) and cash advance and balance transfer fees.

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

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

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

        The principal activities of the Home Loans Group include: (1) the origination, fulfillment and servicing of home loans; (2) the origination, fulfillment and servicing of home equity loans and lines of credit; (3) managing the Company's capital markets operations, which includes the buying and selling of all types of real estate secured loans in the secondary market; and (4) holding the Company's held for investment portfolios of home loans, home equity loans and home equity lines of credit made to higher risk borrowers through the subprime mortgage channel.

        During the fourth quarter of 2007, the Company announced that, in response to a fundamental shift in the home mortgage market due to credit dislocation and a prolonged period of reduced capital markets liquidity, it significantly changed the strategic focus of its Home Loans business to accelerate its alignment with the Company's retail banking operations. As part of these restructuring activities, the Company discontinued all remaining lending through its subprime mortgage channel, closed approximately 200 home loan locations, including 190 home loan centers and sales offices and nine home loans processing and call centers, eliminated approximately 2,600 positions in the Home Loans business, initiated the closure of WaMu Capital Corp., its institutional broker-dealer business, and began winding-down its mortgage banker finance warehouse lending operation.

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

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

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        The Company uses various management accounting methodologies, which are enhanced from time to time, to assign certain balance sheet and income statement items to the responsible operating segment. Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting. The management accounting process measures performance based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. Methodologies that are applied to the measurement of segment profitability include:

27


        Financial highlights by operating segments were as follows:

 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (dollars in millions)

   
   
 
Condensed income statement:                            
  Net interest income   $ 5,142   $ 5,201   $ 4,893   (1 )% 6 %
  Provision for loan losses     1,134     167     119   577   41  
  Noninterest income     3,254     2,914     2,575   12   13  
  Inter-segment revenue     48     58     42   (18 ) 39  
  Noninterest expense     4,567     4,364     4,177   5   4  
   
 
 
         
  Income from continuing operations before income taxes     2,743     3,642     3,214   (25 ) 13  
  Income taxes     869     1,392     1,216   (38 ) 14  
   
 
 
         
  Income from continuing operations     1,874     2,250     1,998   (17 ) 13  
  Income from discontinued operations         38     38      
   
 
 
         
    Net income   $ 1,874   $ 2,288   $ 2,036   (18 ) 12  
   
 
 
         
Performance and other data:                            
  Efficiency ratio     54.09 %   53.39 %   55.63 % 1   (4 )
  Average loans   $ 149,409   $ 177,401   $ 163,405   (16 ) 9  
  Average assets     159,184     187,735     173,631   (15 ) 8  
  Average deposits     144,233     140,344     136,893   3   3  
  Loan volume     18,926     20,354     32,953   (7 ) (38 )
  Employees at end of period     28,784     27,629     32,751   4   (16 )

        The decrease in net interest income in 2007 was primarily due to a decline in the average balances of home mortgage loans. This decline reflects the transfer of approximately $17.5 billion medium-term adjustable-rate portfolio home loans in the fourth quarter of 2006 to held for sale in the Home Loans Group. The decline in average loans was also driven by the decision to retain home loans originated in the second half of 2007 by the Home Loans Group within that segment's portfolio. The decrease in net interest income was partially offset by a $3.89 billion growth in average deposits.

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        The substantial increase in the provision for loan losses in 2007 was the result of increased delinquencies from the deteriorating housing market and the subsequent impact on losses in the portfolio.

        The increase in noninterest income in 2007 was substantially due to a 13% increase in depositor and other retail banking fees, reflecting the strong growth in the number of noninterest-bearing checking accounts and higher transaction fees. The number of noninterest-bearing retail checking accounts at December 31, 2007 totaled approximately 11.0 million, compared with approximately 9.6 million at December 31, 2006. Noninterest income for the year ended December 31, 2006 included a $21 million incentive payment received as part of the Company's migration of its debit card business to MasterCard.

        Noninterest expense increased primarily due to higher compensation and benefits expense and occupancy and equipment expense within the retail banking franchise. Compensation and benefits expense increased due to higher performance-based incentive compensation and a 4% increase in headcount related to the opening of 32 net new retail banking stores in 2007. Included in noninterest expense for 2007 was foreclosed asset expense of $60 million.

 
  Year Ended December 31,
   
  Percentage Change
 
 
  October 1, 2005 (Acquisition Date) through
December 31, 2005

 
 
  2007
  2006
  2007/2006
 
 
  (dollars in millions)

   
 
Condensed income statement:                        
  Net interest income   $ 2,659   $ 2,496   $ 642   7 %
  Provision for loan losses     2,113     1,647     454   28  
  Noninterest income     1,581     1,528     352   4  
  Noninterest expense     1,337     1,205     275   11  
   
 
 
     
  Income before income taxes     790     1,172     265   (33 )
  Income taxes     250     448     100   (44 )
   
 
 
     
    Net income   $ 540   $ 724   $ 165   (25 )
   
 
 
     

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 
  Efficiency ratio     31.53 %   29.96 %   27.63 % 5  
  Average loans   $ 25,066   $ 21,294   $ 4,908   18  
  Average assets     27,502     23,888     5,595   15  
  Employees at end of period     2,860     2,611     3,124   10  

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

        The increase in net interest income in 2007 was substantially due to higher average balances of managed credit card loans, which increased $3.77 billion from 2006. The increase was partially offset by lower yields, reflecting the decrease in the prime interest rate and a shift to retail accounts which have a narrower spread.

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        The increase in the provision for loan losses reflects the increase in balances of managed credit card loans and the softening of the economy resulting in increases in delinquencies and lower levels of anticipated recoveries.

        The increase in noninterest income during 2007 was substantially due to increased gain on securitizations due to a higher volume of securitizations and higher fee income. The increase was substantially offset by market valuation losses resulting from changes in performance assumptions and the disruption in the capital markets.

        Noninterest expense increased largely from charges of $88 million for Visa related litigation liabilities.

 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (dollars in millions)

   
   
 
Condensed income statement:                            
  Net interest income   $ 820   $ 719   $ 758   14 % (5 )%
  Provision for loan losses     24     (82 )   (26 )   218  
  Noninterest income     35     99     200   (65 ) (50 )
  Noninterest expense     282     259     243   9   7  
   
 
 
         
  Income before income taxes     549     641     741   (14 ) (14 )
  Income taxes     174     245     279   (29 ) (12 )
   
 
 
         
    Net income   $ 375   $ 396   $ 462   (5 ) (14 )
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Efficiency ratio     32.93 %   31.68 %   25.32 % 4   25  
  Average loans   $ 38,975   $ 33,230   $ 30,308   17   10  
  Average assets     41,296     35,565     33,351   16   7  
  Average deposits     12,722     10,364     7,796   23   33  
  Loan volume     16,873     12,854     11,231   31   14  
  Employees at end of period     1,406     1,416     1,325   (1 ) 7  

        The increase in net interest income in 2007 was primarily due to increased interest income on higher average balances of multi-family and non-residential real estate loans. Average loan balances reflect the acquisition of Commercial Capital Bancorp on October 1, 2006.

        The increase in the provision for loan losses during 2007 was primarily due to growth in loan balances. The provision in 2006 included a $60 million reduction in the allowance related to refinements in the Company's estimate of the allowance attributable to multi-family loans.

        A significant portion of the decrease in noninterest income in 2007 was due to losses on trading securities and lower gains on sale of multi-family and commercial loans, net of hedging and risk management instruments.

        Noninterest expense in 2007 increased primarily due to the addition of Commercial Capital Bancorp and a 31% increase in loan volume.

30


 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (dollars in millions)

   
   
 
Condensed income statement:                            
  Net interest income   $ 878   $ 1,165   $ 1,966   (25 )% (41 )%
  Provision for loan losses     985     189     110   421   71  
  Noninterest income     1,061     1,296     2,425   (18 ) (47 )
  Inter-segment expense     48     58     42   (18 ) 39  
  Noninterest expense     3,939     2,295     2,590   72   (11 )
   
 
 
         
  Income (loss) before income taxes     (3,033 )   (81 )   1,649      
  Income taxes     (573 )   (31 )   622      
   
 
 
         
    Net income (loss)   $ (2,460 ) $ (50 ) $ 1,027      
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Efficiency ratio     208.33 %   95.48 %   59.56 % 118   60  
  Average loans   $ 48,131   $ 47,586   $ 65,077   1   (27 )
  Average assets     64,695     72,772     87,422   (11 ) (17 )
  Average deposits     7,836     11,535     14,114   (32 ) (18 )
  Loan volume     115,241     171,569     216,308   (33 ) (21 )
  Employees at end of period     11,323     12,934     17,651   (12 ) (27 )

        The decrease in net interest income in 2007 was primarily due to the effect of transfer pricing on lower average balances of custodial deposits resulting from the $2.53 billion sale of mortgage servicing rights in 2006. Also contributing to the decrease was higher transfer pricing charges on subprime loans and higher balances of loans held for investment, which have a lower spread than loans held for sale. Average balances of loans held for investment increased during the second half of 2007, when deteriorating credit conditions caused significant contraction in secondary market liquidity for nonconforming loans, resulting in the Company's decision to transfer approximately $15 billion of such loans from held for sale and retain home loans originated by the Home Loans Group within the segment.

        The increase in the provision for loan losses reflects the downturn in the housing market resulting in increased delinquencies and higher credit costs and the impact of the retention of home loans originated by the Home Loans Group within the segment during the second half of 2007.

        The decrease in noninterest income in 2007 was primarily due to reduced gain on sale from an illiquid secondary market and decreased sales volume, including a reduced volume of loans sold to the Retail Banking Group, and an increase in trading losses on securities. Partially offsetting this decrease was increased income from MSR valuation and risk management activities and higher loan servicing income.

        The increase in noninterest expense in 2007 was predominately due to a $1.78 billion impairment loss recognized in the fourth quarter related to all of this segment's goodwill as a result of the fundamental shift in the mortgage market and the actions the Company is taking to resize its Home Loans business. The increase was partially offset by lower compensation and benefits expense resulting from a reduction in employee headcount. Included in noninterest expense for 2007 was foreclosed asset expense of $245 million.

31


 
  Year Ended December 31,
  Percentage Change
 
 
  2007
  2006
  2005
  2007/2006
  2006/2005
 
 
  (dollars in millions)

   
   
 
Condensed income statement:                            
  Net interest income (expense)   $ (86 ) $ (304 ) $ (105 ) (72 )% 190 %
  Provision for loan losses     51     (162 )   (82 )   98  
  Noninterest income (expense)     (137 )   303     (171 )    
  Noninterest expense     475     684     335   (31 ) 104  
  Minority interest expense     203     105       93    
   
 
 
         
  Loss from continuing operations before income taxes     (952 )   (628 )   (529 ) 52   19  
  Income taxes     (308 )   (296 )   (241 ) 4   23  
   
 
 
         
  Loss from continuing operations     (644 )   (332 )   (288 ) 94   15  
  Income from discontinued operations         406          
   
 
 
         
    Net income (loss)   $ (644 ) $ 74   $ (288 )    
   
 
 
         

Performance and other data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 
  Average loans   $ 1,403   $ 1,126   $ 931   25   21  
  Average assets     44,651     40,722     30,143   10   35  
  Average deposits     35,589     41,586     27,220   (14 ) 53  
  Loan volume     462     308     278   50   11  
  Employees at end of period     5,030     5,234     5,947   (4 ) (12 )

        The improvement in net interest income in 2007 was primarily due to lower interest expense on lower average balances of FHLB borrowings and wholesale deposits.

        The decrease in noninterest income was primarily due to $375 million of losses recognized in the second half of 2007 representing impairment on certain mortgage-backed securities where the reduction in fair value was deemed to be other than temporary. Noninterest income for the year ended December 31, 2006 included a litigation award of $149 million from the partial settlement of the Home Savings supervisory goodwill lawsuit.

        The decrease in noninterest expense in 2007 is primarily due to lower occupancy and equipment expense as a result of back office location consolidations in 2006 as well as lower compensation and benefits expense resulting from the Company's productivity and efficiency initiatives.

        Minority interest expense represents dividends on preferred securities that were issued during 2006 and 2007 by Washington Mutual Preferred Funding LLC ("WMPF LLC"), an indirect subsidiary of Washington Mutual Bank. For further detail, refer to Note 17 to the Consolidated Financial Statements – "Preferred Stock and Minority Interest."

        On December 31, 2006, the Company completed the sale of WM Advisors, Inc., its retail mutual fund management business. The activities of WM Advisors, Inc. were reported within the Retail Banking Group as discontinued operations. The gain from the sale is included in income from discontinued operations in the Corporate Support/Treasury and Other category.

Off-Balance Sheet Activities and Contractual Obligations

        The Company transforms loans into securities through a process known as securitization. When the Company securitizes loans, the loans are usually sold to a qualifying special-purpose entity ("QSPE"),

32


typically a trust. The QSPE, in turn, issues securities, commonly referred to as asset-backed securities, which are secured by future cash flows on the sold loans. The QSPE sells the securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses the proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These QSPEs are not consolidated within the financial statements since they satisfy the criteria established by Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. In general, these criteria require the QSPE to be legally isolated from the transferor (the Company), be limited to permitted activities, and have defined limits on the types of assets it can hold and the permitted sales, exchanges or distributions of its assets.

        When the Company sells or securitizes loans that it originated, it generally retains the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the sold or securitized assets. Retained interests in mortgage loan securitizations, excluding the rights to service such loans, were $1.71 billion at December 31, 2007, of which $1.56 billion are of investment grade quality. Retained interests in credit card securitizations were $1.84 billion at December 31, 2007, of which $426 million are of investment grade quality. Additional information concerning securitization transactions is included in Notes 7 and 8 to the Consolidated Financial Statements – "Securitizations" and "Mortgage Banking Activities."

        On December 6, 2007, the American Securitization Forum ("ASF"), working with various constituency groups as well as representatives of U.S. federal government agencies, issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the "ASF Framework") to enable residential mortgage loan servicers to streamline their loss avoidance and loan modification practices. In adopting the ASF Framework, the ASF commented that current subprime residential mortgage market conditions reflect a number of concerns that impact securitization transactions, subprime mortgage lending and the overall housing market: an increase in delinquency, default and foreclosure rates; an increase in real estate owned inventories; a decline in home prices; and a prevalence of loans with relatively low initial fixed interest rates that are entering their adjustable rate periods at significantly higher interest rate levels. The ASF Framework provides guidance for residential mortgage loan servicers to streamline subprime residential mortgage borrower evaluation procedures and to facilitate the use of foreclosure avoidance and loss prevention efforts to reduce the number of such borrowers who might default during 2008 because they cannot afford to make higher monthly loan payments after their loans reset to a higher, adjustable interest rate.

        The parameters of the ASF Framework were designed by the ASF to improve administrative efficiency while still maximizing cash flows to the QSPEs in which residential mortgage loans were transferred upon securitization by stratifying subprime borrowers into the following segments: borrowers that can refinance into readily available mortgage industry products ("Segment 1"); borrowers that have demonstrated the ability to pay their introductory rates, are unable to refinance, and are unable to afford their reset rates ("Segment 2"); and borrowers that require in-depth, case-by-case analysis due to loan histories that demonstrate difficulties in making timely, introductory rate payments ("Segment 3"). Consistent with its objectives, the ASF Framework was designed to fast-track loan modifications for Segment 2 borrowers, in which default is considered to be reasonably foreseeable. Under the ASF Framework, fast-track loan modifications would be available to Segment 2 borrowers with first-lien residential mortgage loans that: (1) have an initial fixed interest rate period of 36 months or less; (2) are included in securitized pools; (3) were originated between January 1, 2005 and July 31, 2007; and (4) have an initial interest rate reset date between January 1, 2008 and July 31, 2010. To be eligible for a fast-track loan modification under the ASF Framework, Segment 2 borrowers would also have to occupy the property as their primary residence and meet a specific FICO test, which is based on their current

33



FICO score, and the servicer must ascertain that the upcoming loan rate reset will result in an increase in the loan payment amount by more than 10%. If all of these criteria are satisfied, the servicer would be permitted to modify the Segment 2 borrower's loan interest rate by keeping it at the existing fixed interest rate, generally for five years following the upcoming reset period.

        On January 8, 2008, the Securities and Exchange Commission's (the "SEC") Office of the Chief Accountant (the "OCA") issued a letter (the "OCA Letter") addressing accounting issues that may be raised by the ASF Framework. Specifically, the OCA Letter expressed the view that if a subprime loan made to a Segment 2 borrower is modified in accordance with the ASF Framework and that loan could be legally modified, the OCA would not object to continued status of the transferee as a QSPE under Statement No. 140.

        As acknowledged in the OCA Letter, a uniform definition of a subprime mortgage loan does not exist within the mortgage banking industry. The Company has defined subprime residential mortgage loans by reference to the channel in which such loans were originated or purchased. Accordingly, the Company considers loans that were either originated under the Company's Long Beach Mortgage name or that were purchased from entities that are recognized as subprime lenders to comprise its population of subprime mortgage loans.

        As of December 31, 2007, the Company had not yet applied the loss mitigation approaches as outlined in the ASF Framework. The Company chose to adopt this framework during the first quarter of 2008 and does not expect that its application will impact the off-balance sheet status of the QSPEs that hold these subprime ARM loans.

        The following table presents, as of December 31, 2007, the Company's significant fixed and determinable contractual obligations, within the categories described below, by payment date or contractual maturity. These contractual obligations, except for the operating lease obligations and purchase obligations, are included in the Consolidated Statements of Financial Condition. The most significant purchase obligations are contracts related to services. The payment amounts represent those amounts contractually due to the recipient.

 
  Payments Due by Period (in millions)
 
  Total
  Due within One Year
  After One but within Three Years
  After Three but within Five Years
  More than Five Years
Contractual Obligations                              
Debt obligations   $ 106,944   $ 47,431   $ 25,645   $ 18,342   $ 15,526
Capital lease obligations     47     9     18     8     12
Operating lease obligations     2,074     415     664     410     585
Purchase obligations(1)     1,047     279     437     256     75
   
 
 
 
 
Total contractual obligations   $ 110,112   $ 48,134   $ 26,764   $ 19,016   $ 16,198
   
 
 
 
 


NOTE: At December 31, 2007, the liability recorded for uncertain tax positions, excluding associated interest and penalties, was approximately $500 million pursuant to FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"). This liability represents an estimate of tax positions that the Company has taken in its tax returns which may ultimately not be sustained upon examination by the tax authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, the estimated FIN 48 liability has been excluded from the contractual obligations table.
(1)
Purchase obligations are defined as an agreement to purchase goods or services that is enforceable and legally binding whereby the Company commits to a fixed or minimum purchase amount over a specified period of time. Estimated payments for contracts that may be terminated early without penalty are shown through the first termination date; all others are shown through the date of contract termination. Excluded from the table are purchase obligations expected to be settled in cash within 90 days of the end of the reporting period.

34


        The Company enters into derivative contracts under which the Company is required to either receive cash or pay cash to counterparties depending on changes in interest or foreign exchange rates. Derivative contracts are carried at fair value in the Consolidated Statements of Financial Condition with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of the contracts changes as a result of fluctuations in market interest rates. Further discussion of derivative instruments is included in Notes 1 and 23 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" and "Derivative Financial Instruments."

        The Company may incur liabilities under certain contractual agreements contingent upon the occurrence of certain events. A discussion of these contractual arrangements under which the Company may be held liable is included in Note 15 to the Consolidated Financial Statements – "Commitments, Guarantees and Contingencies." In addition, the Company has commitments and obligations under pension and other postretirement benefit plans as described in Note 22 to the Consolidated Financial Statements – "Employee Benefits Programs and Other Expense."

Risk Management

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

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

        The Board of Directors, assisted by the Audit and Finance Committees on certain delegated matters, oversees the monitoring and controlling of significant risk exposures, including the policies governing risk management. The Corporate Relations Committee of the Board of Directors oversees the Company's reputation and those elements of operational risk that impact the Company's reputation. Governance and oversight of credit, liquidity and market risks are provided by the Finance Committee of the Board of Directors. Governance and oversight of operational risk is provided by the Audit Committee of the Board of Directors.

        Management's governing risk committee is the Enterprise Risk Management Committee. This committee and its subcommittees include representation from the Company's lines of business and the Enterprise Risk Management function. Subcommittees of the Enterprise Risk Management Committee provide specialized risk governance and include the Credit Risk Management Committee, the Market Risk Committee and the Operational Risk Committee.

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

        Management is responsible for balancing risk and reward in determining and executing business strategies. Business lines, Enterprise Risk Management and Treasury divide the responsibilities of conducting measurement and monitoring of the Company's risk exposures. Risk exceptions, depending

35



on their type and significance, are elevated to management or Board committees responsible for oversight.

Credit Risk Management

        Credit risk is the risk of loss arising from adverse changes in a borrower's or counterparty's actual or perceived ability to meet its financial obligations under agreed-upon terms and exists primarily in lending, securities and derivative portfolios. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the contractual terms of the related documents, the credit characteristics of the borrower, the channel through which assets are acquired, the features of loan products or derivatives, the existence and strength of guarantor support and the availability, quality and adequacy of any underlying collateral. The degree of credit risk and level of credit losses is highly dependent on the economic environment that unfolds subsequent to originating or acquiring assets. The extent of asset diversification and concentrations also affect total credit risk. Credit risk is assessed through analyzing these and other factors.

        The Company's credit risk management process provides for management and accountability to be decentralized through our lines of business. The Chief Credit Officer's primary responsibilities include directing the activities of the Credit Risk Management Committee, overseeing portfolio performance and ensuring compliance with established credit policies, standards and limits, determining the reasonableness of the Company's allowance for loan losses, reviewing and approving large credit exposures, and delegating credit approval authorities. Each business segment has a chief risk officer who is primarily responsible for managing credit, market and operational risk within their business segment. Segment chief risk officers have both transaction approval authority and governance authority for the approval of products, programs and guidelines within established policies, standards and limits. The Chief Credit Officer reports directly to the Chief Enterprise Risk Officer. Segment chief risk officers have dual reporting responsibilities to the Chief Enterprise Risk Officer and to their respective segment President.

        The Credit Risk Management Committee is comprised of the Chief Credit Officer, business segment chief risk officers, and senior finance, treasury and portfolio management professionals. This Committee addresses a variety of matters including credit strategy and governance and is primarily responsible for approving new or amended credit standards and recommending new or amendments to significant credit policies to the Enterprise Risk Management Committee for approval by the Finance Committee of the Board of Directors.

        Following a prolonged period of growth, deteriorating conditions in the U.S. housing market that became evident in the first half of 2007 accelerated throughout the remainder of the year. The decline in home price appreciation rates in the first half of 2007 and absolute declines in home prices in the second half of 2007 has been particularly abrupt in California and Florida, where approximately 48% and 10% of the Company's single-family residential mortgage loans at December 31, 2007 are located. The significant and abrupt decline in secondary market liquidity for home loans which are not eligible for sale to housing government-sponsored enterprises ("nonconforming" loans) contributed to the decrease in the availability of housing credit. As many lenders have been forced out of business or have severely curtailed their operations and most remaining lenders have increased nonconforming mortgage interest rates and tightened underwriting standards, many borrowers, particularly subprime borrowers, borrowers in markets with declining housing prices and borrowers wanting nonconforming loans, have been unable either to refinance existing loans or sell their homes. Similarly, certain prospective home buyers have found it both harder to obtain credit and have found credit more expensive. These forces have combined to result in a supply of unsold homes in December 2007 of approximately 9.7 months, a 47% increase from December 2006, which in turn has contributed to a 7% decline in the national

36


median sales price for existing homes between those same periods. Housing market weakness was also evident in the change in the national volume of foreclosure filings which increased by 75% in 2007 from 2006.

        Faced with these unfavorable conditions, an increasing number of borrowers, including those with adjustable-rate mortgages that repriced upward at the expiration of their fixed rate periods, have defaulted on their loans thereby contributing to an increase in delinquency rates. Furthermore, the rate at which delinquent loans moved through delinquency stages towards foreclosure increased in the fourth quarter of 2007. This increase in late stage delinquencies is evident in the ratio of nonperforming assets to total assets which increased from 0.57% at the end of 2005 to 0.80% at the end of 2006 to 2.17% at December 31, 2007. Loss severities on foreclosed assets have also increased more than expected as lower collateral values on foreclosed properties have been insufficient to cover the recorded investment in the loan. Reflecting higher incurred losses inherent in the portfolio resulting primarily from these economic factors, the Company increased its allowance for loan losses, both in absolute terms and as a percentage of loans held in portfolio from $1.70 billion or 0.74% of loans held in portfolio at the end of 2005 to $2.57 billion or 1.05% of total loans held in portfolio at December 31, 2007.

        In a stressed housing market with increasing delinquencies and declining housing prices, such as currently exists, the adequacy of collateral securing a loan becomes an important factor in determining future loan performance as borrowers with more equity in their properties generally have a greater vested interest in keeping their loans current than borrowers with little to no equity in their properties. Generally speaking, homes purchased prior to the end of 2004 have benefited from more home price appreciation than homes purchased more recently. Unless a borrower has withdrawn substantial amounts of equity from the collateralized property, the credit performance of earlier vintage loans in the Company's residential loan portfolio is generally more favorable than loans originated or purchased more recently.

        In the event that the Company forecloses on a property, the extent to which the outstanding balance on a loan exceeds its collateral value (less cost to sell) will determine the severity of loss. Generally speaking, properties with higher current loan-to-value ratios would be expected to result in higher severity of loss on foreclosure than properties with lower current loan-to-value ratios. Both loan-to-value ratios at origination and estimated current loan-to-value ratios are key inputs in estimating the allowance for loan losses.

        Statistical estimation techniques used to estimate the allowance for loan losses in single family residential portfolios incorporate estimates of changes in housing prices using Office of Federal Housing Enterprise Oversight ("OFHEO") cumulative growth rates available at the time the assessments are conducted. The estimate of the allowance at December 31, 2007 incorporated OFHEO data as of September 30, 2007 as well as more current data evidencing conditions in the housing market, such as provided by the National Associations of Realtors, and internal estimates of future loss severity. On February 26, 2008, OFHEO published its estimate of changes in the housing price index as of December 31, 2007. Estimates of changes in the housing price index made by the Company in the fourth quarter of 2007 were determined to be in-line with those published by OFHEO. As indicated in the footnotes to the loan-to-value/vintage tables that follow, estimated current loan-to-value ratios reflected in the tables are estimated using OFHEO home price index data as of September 30, 2007.

37


        In foreclosure proceedings, lien position is also a critical determinant of severity of loss because when the Company holds a lien on a property that is subordinate to a first lien mortgage held by another lender, both the probability of loss and severity of loss risk are generally higher than when the Company holds both the first lien home loan and second lien home equity loan or line of credit. In the event of foreclosure, the probability of loss is generally higher because the first lien holder does not have to take into consideration any losses the second lien holder may sustain when deciding whether to foreclose on a property. The severity of loss risk is higher principally because a second lien holder who exercises its right to foreclose on a property must ensure the first lien holder's investment is repaid in full.

        The table below analyzes the composition of the unpaid principal balance ("UPB") of home loans held in portfolio at December 31, 2007:

 
  Year of Origination
 
Loan-to-Value Ratio at Origination

  Pre-2005
  2005
  2006
  2007
  Total UPB
  % of
Total

 
 
  (UPB in millions)
 
Home loans:                                    
  £50%   $ 3,827   $ 1,278   $ 845   $ 2,960   $ 8,910   8 %
  >50-60%     4,168     1,826     1,461     4,039     11,494   11  
  >60-70%     9,445     5,271     3,866     7,867     26,449   24  
  >70-80%     16,319     11,240     10,277     17,840     55,676   51  
  >80-90%     1,843     687     608     1,596     4,734   4  
  >90%     837     184     202     418     1,641   2  
   
 
 
 
 
 
 
  Home loans held in portfolio(1)(2)(3)(4)   $ 36,439   $ 20,486   $ 17,259   $ 34,720   $ 108,904   100 %
   
 
 
 
 
 
 
 
As a percentage of total UPB

 

 

33

%

 

19

%

 

16

%

 

32

%

 

100

%

 

 

Average loan-to-value ratio at origination

 

 

69

 

 

71

 

 

72

 

 

70

 

 

70

 

 

 
Average estimated current loan-to-value ratio(5)     46     66     75     71     62      

(1)
Excludes home loans in the subprime mortgage channel.
(2)
Excluded from the balances of home loans held in portfolio are $553 million of home loans that are insured by the Federal Housing Administration ("FHA") or guaranteed by the Department of Veterans Affairs ("VA"), of which $38 million have loan-to-value ratios of £80% and $515 million have loan-to-value ratios of >80%.
(3)
Included in the balance of home loans held in portfolio are the following interest-only home loans and their related loan-to-value ratios at origination: $28.64 billion (£80%), $997 million (>80-90%) and $253 million (>90%). The volume of interest-only loans amounted to $18.11 billion in 2007.
(4)
The volume of home loans with loan-to-value ratios at origination of >80% amounted to $8.40 billion in 2007.
(5)
The average estimated current loan-to-value ratio reflects the UPB outstanding at the balance sheet date, divided by the estimated current property value. Current property values are estimated using data from the September 30, 2007 Office of Federal Housing Enterprise Oversight ("OFHEO") home price index.

38


        The table below analyzes the composition of the unpaid principal balance ("UPB") of prime home equity loans and lines of credit held in portfolio at December 31, 2007:

 
  Year of Origination
 
Combined Loan-to-Value Ratio at Origination(1)

  Pre-2005
  2005
  2006
  2007
  Total UPB
  % of
Total

 
 
  (UPB in millions)
 
Prime home equity loans and lines of credit:                                    
  £50%   $ 2,896   $ 1,340   $ 1,515   $ 1,504   $ 7,255   12 %
  >50-60%     1,831     931     991     1,038     4,791   8  
  >60-70%     2,678     1,522     1,550     1,706     7,456   13  
  >70-80%     6,029     4,233     3,997     4,857     19,116   32  
  >80-90%     2,730     4,057     5,693     6,624     19,104   32  
  >90%     618     232     271     567     1,688   3  
   
 
 
 
 
 
 
  Prime home equity loans and lines of credit held in portfolio(2)(3)(4)(5)   $ 16,782   $ 12,315   $ 14,017   $ 16,296   $ 59,410   100 %
   
 
 
 
 
 
 
 
As a percentage of total UPB

 

 

28

%

 

21

%

 

24

%

 

27

%

 

100

%

 

 

Average combined loan-to-value ratio at origination(1)

 

 

68

 

 

74

 

 

75

 

 

76

 

 

73

 

 

 
Average estimated current combined loan-to-value ratio(1)(6)     49     65     73     76     65      

(1)
The combined loan-to-value ratio at origination measures the ratio of the original loan amount of the first lien product (typically a first lien mortgage loan) and the original loan amount of the second lien product (typically a second lien home equity loan or line of credit) to the appraised value of the underlying collateral at origination. Where the second lien product is a line of credit, the total commitment amount is used in calculating the combined loan-to-value ratio.
(2)
Excludes home equity loans in the subprime mortgage channel.
(3)
27% of prime home equity loans and lines of credit were in first lien position at December 31, 2007.
(4)
The Company has pool mortgage insurance that generally insulates it from the risk of default on certain prime home equity loans and lines of credit originated after March 2004 where the combined loan-to-value ratio at origination is greater than 90 percent. Contractual stop loss provisions limit the insurer's exposure to 10% of the outstanding loan balance for loans originated prior to December 31, 2006, and 8% for loans originated thereafter.
(5)
The volume of prime home equity loans and lines of credit with combined loan-to-value ratios at origination of >80% amounted to $10.10 billion in 2007.
(6)
The average estimated current combined loan-to-value ratio reflects the UPB outstanding or commitment amount (in the case of lines of credit) at the balance sheet date, divided by the estimated current property value. Current property values are estimated using data from the September 30, 2007 OFHEO home price index.

39


        The unpaid principal balance ("UPB") of prime home equity loans and lines of credit held in portfolio at December 31, 2007, as shown in the immediately preceding table, included the following home equity loans and lines of credit in junior lien position:

 
  Year of Origination
 
Combined Loan-to-Value Ratio at Origination(1)

  Pre-2005
  2005
  2006
  2007
  Total UPB
  % of
Total

 
 
  (UPB in millions)
 
Prime junior lien home equity loans and lines of credit:                                    
  £50%   $ 1,015   $ 654   $ 922   $ 729   $ 3,320   8 %
  >50-60%     905     642     832     685     3,064   7  
  >60-70%     1,533     1,158     1,365     1,148     5,204   12  
  >70-80%     3,798     3,381     3,573     3,349     14,101   32  
  >80-90%     2,303     3,694     5,461     5,181     16,639   38  
  >90%     338     100     212     496     1,146   3  
   
 
 
 
 
 
 
  Total prime junior lien home equity loans and lines of credit held in portfolio(2)(3)   $ 9,892   $ 9,629   $ 12,365   $ 11,588   $ 43,474   100 %
   
 
 
 
 
 
 
 
As a percentage of total UPB

 

 

23

%

 

22

%

 

28

%

 

27

%

 

100

%

 

 

Average combined loan-to-value ratio at origination(1)

 

 

73

 

 

76

 

 

77

 

 

78

 

 

76

 

 

 
Average estimated current combined loan-to-value ratio(1)(4)     54     68     75     78     69      

(1)
The combined loan-to-value ratio measures the ratio of the original loan amount of the first lien product (typically a first lien mortgage loan) and the original loan amount of the second lien product (typically a second lien home equity loan or line of credit) to the appraised value of the underlying collateral. Where the second lien product is a line of credit, the total commitment amount is used in calculating the combined loan-to-value ratio.
(2)
Excludes home equity loans in the subprime mortgage channel.
(3)
The Company has pool mortgage insurance that generally insulates it from the risk of default on certain prime home equity loans and lines of credit originated after March 2004 where the combined loan-to-value ratio at origination is greater than 90 percent. Contractual stop loss provisions limit the insurer's exposure to 10% of the outstanding loan balance for loans originated prior to December 31, 2006, and 8% for loans originated thereafter.
(4)
The average estimated current combined loan-to-value ratio reflects the UPB outstanding or commitment amount (in the case of lines of credit) at the balance sheet date, divided by the estimated current property value. Current property values are estimated using data from the September 30, 2007 OFHEO home price index.

        The Option ARM home loan product is an adjustable-rate mortgage loan that provides the borrower with the option each month to make a fully-amortizing, interest-only, or minimum payment. As described in greater detail below, the minimum payment is typically insufficient to cover interest accrued in the prior month and any unpaid interest is deferred and added to the principal balance of the loan. In the current housing market, the popularity of Option ARM loans has decreased and loan volumes have declined from $65.16 billion in 2005 to $42.59 billion in 2006 to $25.78 billion in 2007.

        The minimum payment on an Option ARM loan is based on the interest rate charged during the introductory period. This introductory rate has usually been significantly below the fully-indexed rate. The fully-indexed rate is calculated using an index rate plus a margin. Once the introductory period ends, the contractual interest rate charged on the loan increases to the fully-indexed rate and adjusts monthly to reflect movements in the index.

40


        If the borrower continues to make the minimum monthly payment after the introductory period ends, the payment may not be sufficient to cover interest accrued in the previous month. In this case, the loan will "negatively amortize" as unpaid interest is deferred and added to the principal balance of the loan. The minimum payment on an Option ARM loan is adjusted on each anniversary date of the loan but each increase or decrease is limited to a maximum of 7.5% of the minimum payment amount on such date until a "recasting event" occurs.

        A recasting event occurs every 60 months or sooner upon reaching a negative amortization cap. When a recasting event occurs, a new minimum monthly payment is calculated without regard to any limits on the increase or decrease in amount that would otherwise apply under the annual 7.5% payment cap. This new minimum monthly payment is calculated to be sufficient to fully repay the principal balance of the loan, including any theretofore deferred interest, over the remainder of the loan term using the fully-indexed rate then in effect. A recasting event occurs immediately whenever the unpaid principal balance reaches the negative amortization cap, which is expressed as a percent of the original loan balance. Prior to 2006, the negative amortization cap was 125% of the original loan balance (or 110% of the original loan balance for loans secured by property located in New York and loans purchased through the correspondent channel). For all Option ARM loans originated in 2006, the negative amortization cap was 110% of the original loan balance. For Option ARM loans originated in 2007, the negative amortization cap was raised to 115%, with the exception of loans secured by property located in New York and loans purchased through the correspondent channel where the negative amortization cap remains at 110%. Declines in mortgage rates to which Option ARM loans are indexed will generally delay the timeframe within which negatively amortizing Option ARM loans reach their negative amortization caps. Conversely, increases in mortgage rates to which Option ARM loans are indexed will generally accelerate the timeframe within which negatively amortizing Option ARM loans reach their negative amortization caps.

        In the first month that follows a recasting event, the minimum payment will equal the fully-amortizing payment. If in subsequent months the index rate decreases, the minimum payment may exceed the fully-amortizing payment. Conversely, if the index rate increases in subsequent months, negative amortization may resume. In this situation, the 7.5% annual payment cap will once again operate to limit the change in the minimum payment until another recasting event occurs.

        Assuming all Option ARM loans recast no earlier than five years after origination, as of December 31, 2007, 8% of the Company's Option ARM portfolio is scheduled to recast in 2008 and 13% is scheduled to recast in 2009.

41



        The table below analyzes the composition of the unpaid principal balance ("UPB") of Option ARM home loans held in portfolio at December 31, 2007:

 
  Year of Origination
 
Loan-to-Value Ratio at Origination

  Pre-2005
  2005
  2006
  2007
  Total UPB
  % of
Total

 
 
  (UPB in millions)
 
Home loan Option ARMs                                    
  £50%   $ 1,202   $ 719   $ 458   $ 753   $ 3,132   5 %
  >50-60%     1,439     1,076     883     1,344     4,742   8  
  >60-70%     4,327     3,525     2,835     3,333     14,020   24  
  >70-80%     8,521     7,429     8,421     8,519     32,890   57  
  >80-90%     1,017     495     504     939     2,955   5  
  >90%     288     92     152     125     657   1  
   
 
 
 
 
 
 
  Total home loan Option ARMs held in portfolio   $ 16,794   $ 13,336   $ 13,253   $ 15,013   $ 58,396   100 %
   
 
 
 
 
 
 
 
As a percentage of total UPB

 

 

29

%

 

23

%

 

23

%

 

25

%

 

100

%

 

 

Average loan-to-value ratio at origination

 

 

71

 

 

71

 

 

73

 

 

73

 

 

72

 

 

 
Average estimated current loan-to-value ratio(1)     48     69     77     74     66      

(1)
The average estimated current loan-to-value ratio reflects the UPB outstanding at the balance sheet date, divided by the estimated current property value. Current property values are estimated using data from the September 30, 2007 OFHEO home price index.

        Key statistics for Option ARM loans held in the Company's home loan portfolio are set forth in the following table:

 
  December 31,
 
 
  2007
  2006
  2005
 
 
  (dollars in millions)

 
Loan balance   $ 58,870   $ 63,557   $ 71,201  
Capitalized interest recognized in earnings that resulted from negative amortization     1,418     1,068     292  
Total amount by which the unpaid principal balance exceeded the original principal amount     1,731     888     160  
Balance of loans that experienced a net increase in negative amortization during the year     48,162     48,832     44,796  
Percentage of borrowers whose final loan payment of the year resulted in negative amortization:                    
  By number of loans     50 %   51 %   42 %
  By value of loans     69     68     56  

42


        The table below provides geographic distribution of the Company's home loan Option ARM portfolio at December 31, 2007:

 
  Portfolio
  Weighted Average
Estimated Current
Loan-to-Value Ratio

 
 
  (dollars in millions)
   
 
California   $ 28,956   49 % 66 %
Florida     7,605   13   66  
New York/New Jersey     5,333   9   62  
Washington/Oregon     2,186   3   62  
Illinois     1,506   3   67  
Texas     528   1   65  
Other     12,756   22   69  
   
 
     
  Total home loan Option ARMs held in portfolio   $ 58,870   100 % 66 %
   
 
     

        In the fourth quarter of 2007, the Company discontinued all lending in its subprime mortgage channel. This channel is comprised of loans originated under the Company's Long Beach Mortgage name or were purchased from lenders who were generally recognized as lending to subprime borrowers ("Subprime Lenders"). The Company did not originate or purchase loan products with negative amortization features through its subprime mortgage channel. The Company separately reports the performance of loans in its subprime mortgage channel as such loans generally experience higher delinquencies and net charge-offs than prime mortgage loans that possess comparable loan-to-value ratios and credit scores. To compensate for the increased credit risk of such loans, the Company generally charged such borrowers a higher rate of interest than borrowers in the prime channel. As of December 31, 2007, subprime mortgage channel loans held for investment totaled $18.62 billion, including $2.53 billion of home equity loans.

        Subprime mortgage channel loans are managed by a dedicated collections department with collectors experienced in subprime mortgage loan collections. Servicing activities for these loans emphasize direct contact with customers at early stages of delinquency based on a customer's risk profile, and the Company uses automated telephone dialing and call distribution systems to increase the effectiveness of collection calls. Customized payment plans and work-out plans may be used to return delinquent loans to current status. When delinquent loans become 120 days contractually past due, the loan foreclosure process typically begins. Loans are restructured on a selective basis, so as to minimize loss during the collections and foreclosure process.

43


        The unpaid principal balances ("UPB") of subprime mortgage channel loans held in portfolio at December 31, 2007 was as follows:

 
  Year of Origination
 
Loan-to-Value Ratio at Origination

  Pre-2005
  2005
  2006
  2007
  Total UPB
  % of
Total

 
 
  (UPB in millions)
 
Subprime mortgage channel:                                    
  £50%   $ 213   $ 111   $ 252   $ 61   $ 637   3 %
  >50-60%     259     150     229     87     725   4  
  >60-70%     533     341     504     209     1,587   9  
  >70-80%     1,704     2,527     2,382     838     7,451   40  
  >80-90%     1,827     1,246     2,054     660     5,787   31  
  >90%     34     134     1,912     247     2,327   13  
   
 
 
 
 
 
 
  Total subprime mortgage channel loans held in portfolio   $ 4,570   $ 4,509   $ 7,333   $ 2,102   $ 18,514   100 %
   
 
 
 
 
 
 
 
As a percentage of total UPB

 

 

25

%

 

24

%

 

40

%

 

11

%

 

100

%

 

 

Average loan-to-value ratio at origination(1)

 

 

77

 

 

79

 

 

83

 

 

80

 

 

80

 

 

 
Average estimated current loan-to-value ratio(2)     57     71     82     81     73      

(1)
Origination loan-to-value used for first liens and combined loan-to-value used for second liens.
(2)
The estimated current loan-to-value ratio reflects the UPB outstanding at the balance sheet date, divided by the estimated current property value. Current property values are estimated using data from the September 30, 2007 OFHEO home price index.

        Loans, excluding credit card loans, are generally placed on nonaccrual status upon reaching 90 days past due. Additionally, individual loans in non-homogeneous portfolios are placed on nonaccrual status prior to becoming 90 days past due when payment in full of principal or interest by the borrower is not expected. Restructured loans are reported as nonaccrual loans and interest received on such loans is accounted for using the cash method until such time as the Company determines that collectibility of principal and interest is reasonably assured, at which point the loan is returned to accrual status and reported as an accruing restructured loan. At December 31, 2007, restructured loans of $633 million were reported as nonaccrual loans in accordance with the Company's policy, accounting for 19 basis points of the 217 basis points of the nonperforming assets to total assets ratio.

44


        Nonaccrual loans and foreclosed assets ("nonperforming assets") consisted of the following:

 
  December 31,
 
 
  2007
  2006
  2005
  2004
  2003
 
 
  (dollars in millions)

 
Nonperforming assets:                                
  Nonaccrual loans(1)(2)(3):                                
    Loans secured by real estate:                                
      Home loans(4)   $ 2,302   $ 640   $ 565   $ 534   $ 736  
      Home equity loans and lines of credit(4)     835     231     87     66     47  
      Subprime mortgage channel(5)     2,721     1,283     873     682     597  
      Home construction(6)     56     27     10     28     35  
      Multi-family     131     46     25     12     19  
      Other real estate     53     51     70     162     153  
   
 
 
 
 
 
        Total nonaccrual loans secured by real estate     6,098     2,278     1,630     1,484     1,587  
    Consumer     1     1     8     9     8  
    Commercial     24     16     48     41     31  
   
 
 
 
 
 
        Total nonaccrual loans held in portfolio     6,123     2,295     1,686     1,534     1,626  
  Foreclosed assets(7)     979     480     276     261     311  
   
 
 
 
 
 
        Total nonperforming assets(8)   $ 7,102   $ 2,775   $ 1,962   $ 1,795   $ 1,937  
   
 
 
 
 
 
  Total nonperforming assets as a percentage of total assets     2.17 %   0.80 %   0.57 %   0.58 %   0.70 %

(1)
If interest on nonaccrual loans under the original terms had been recognized, such income is estimated to have been $246 million in 2007, $118 million in 2006, $79 million in 2005, $64 million in 2004 and $86 million in 2003.
(2)
Nonaccrual loans held for sale, which are excluded from the nonaccrual balances presented above, were $4 million, $185 million, $245 million, $76 million and $66 million at December 31, 2007, 2006, 2005, 2004 and 2003. Loans held for sale are accounted for at the lower of cost or fair value, with valuation changes included as adjustments to noninterest income.
(3)
Credit card loans are exempt under regulatory rules from being classified as nonaccrual because they are charged off when they are determined to be uncollectible, or by the end of the month in which the account becomes 180 days past due.
(4)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(5)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(6)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(7)
Foreclosed real estate securing Government National Mortgage Association ("GNMA") loans of $37 million, $99 million, $79 million, $79 million and $82 million at December 31, 2007, 2006, 2005, 2004 and 2003 have been excluded. These assets are fully collectible as the corresponding GNMA loans are insured by the Federal Housing Administration ("FHA") or guaranteed by the Department of Veterans Affairs ("VA").
(8)
Excludes accruing restructured loans of $251 million, $314 million, $296 million, $293 million and $249 million at December 31, 2007, 2006, 2005, 2004 and 2003.

45


        Loans held in portfolio (excluding the allowance for loan losses) and the nonaccrual component thereof, in each instance excluding credit card loans, by geographic concentration at December 31, 2007 were as follows:

 
  California
  New York/New Jersey
  Florida
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
Loans secured by real estate:                                      
  Home loans(1)   $ 53,299   $ 762   $ 11,528   $ 253   $ 11,027   $ 464  
  Home equity loans and lines of credit(1)     32,499     489     4,957     53     5,469     115  
  Subprime mortgage channel(2)     4,742     807     2,053     285     1,815     302  
  Home construction(3)     1,251     34     79     4     121     7  
  Multi-family     20,335     14     5,405     57     747     21  
  Other real estate     5,056     16     1,769     4     171     1  
   
 
 
 
 
 
 
    Total loans secured by real estate     117,182     2,122     25,791     656     19,350     910  
Consumer     87     1     18         13      
Commercial     514     6     229     4     200     3  
   
 
 
 
 
 
 
    Total loans and nonaccrual loans held in portfolio   $ 117,783   $ 2,129   $ 26,038   $ 660   $ 19,563   $ 913  
   
 
 
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     50 %   35 %   11 %   11 %   8 %   15 %

(1)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(2)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(3)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

 
  Washington/Oregon
  Texas
  Illinois
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
Loans secured by real estate:                                      
  Home loans(1)   $ 5,324   $ 50   $ 1,306   $ 30   $ 3,497   $ 95  
  Home equity loans and lines of credit(1)     6,359     31     3,271     15     1,338     21  
  Subprime mortgage channel(2)     718     61     1,130     116     869     147  
  Home construction(3)     320     4     26         36      
  Multi-family     1,588         483     11     744     7  
  Other real estate     697     2     673     19     50      
   
 
 
 
 
 
 
    Total loans secured by real estate     15,006     148     6,889     191     6,534     270  
Consumer     54         14         1      
Commercial     123     1     223     3     64     1  
   
 
 
 
 
 
 
    Total loans and nonaccrual loans held in portfolio   $ 15,183   $ 149   $ 7,126   $ 194   $ 6,599   $ 271  
   
 
 
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     7 %   2 %   3 %   3 %   3 %   4 %

46



(1)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(2)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(3)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

 
  Other(4)
  Total
 
 
  Portfolio
  Nonaccrual
  Portfolio
  Nonaccrual
 
 
  (dollars in millions)

 
Loans secured by real estate:                          
  Home loans(1)   $ 24,406   $ 648   $ 110,387   $ 2,302  
  Home equity loans and lines of credit(1)     7,070     111     60,963     835  
  Subprime mortgage channel(2)     7,290     1,003     18,617     2,721  
  Home construction(3)     393     7     2,226     56  
  Multi-family     2,452     21     31,754     131  
  Other real estate     1,108     11     9,524     53  
   
 
 
 
 
    Total loans secured by real estate     42,719     1,801     233,471     6,098  
Consumer     18         205     1  
Commercial     526     6     1,879     24  
   
 
 
 
 
    Total loans and nonaccrual loans held in portfolio   $ 43,263   $ 1,807   $ 235,555 (5) $ 6,123  
   
 
 
 
 
Loans and nonaccrual loans as a percentage of total loans and total nonaccrual loans     18 %   30 %   100 %   100 %

(1)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(2)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(3)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
(4)
Of this category, Colorado had the largest portfolio balance of approximately $4.03 billion and Massachusetts had the largest nonaccrual balance of $183 million.
(5)
Excludes credit card loans of $8.83 billion.

        The Company monitors delinquency rates for all loans held in portfolio. Increasing early stage delinquency rates (i.e., loans 30-89 days past due) are indicative of possible future credit problems when the Company has serious doubts as to the ability of such borrowers to cure the delinquency condition. Such loans have exhibited a greater propensity to migrate into nonaccrual status as cure rates on early-stage delinquencies deteriorated during the latter part of 2007. The delinquency rate for home loans and home equity loans and lines of credit that were more than 30 days past due but less than 90 days past due amounted to 1.43% and 2.02% at December 31, 2007 as compared to 0.68% and 0.89% at December 31, 2006.

        The Company offers a wide selection of credit cards to consumers and small businesses. Products offered include Washington Mutual-branded credit cards, as well as a variety of affinity and co-branded credit cards.

        Credit cards provide borrowers with revolving, generally unsecured lines of credit that are used to make purchases and obtain cash advances primarily through Visa and MasterCard credit card networks. Credit card loans typically have smaller balances, shorter lifecycles and experience higher delinquency and loss rates than secured real estate loans. To offset the higher risk of loss inherent in unsecured credit card loans, interest rates and fees are generally structured to generate higher yields than secured real estate loans.

47


        The Company selectively targets customers that are often underserved by large prime/superprime-oriented credit card issuers and who satisfy its underwriting criteria. The Company uses an automated underwriting process that includes an assessment of an applicant's credit profile and expected payment performance when reviewing credit card applications. The Company has been successful in selling credit cards to its existing retail customers.

        Account management efforts, seasoning, and economic conditions all affect overall credit quality. The Company monitors customers' risk profiles regularly to optimize loss exposure over time and reserves the right under its credit card account agreement to change or terminate at any time, subject to applicable notice requirements, any terms, conditions, services, or features of the agreement. In cases where the customer fails to comply with the account agreement or presents a higher credit risk, the Company may restrict further use of the card, close the account, increase the interest rate, and/or pursue collection efforts.

        Collection efforts are performed on accounts that are delinquent and for accounts that are current but over their credit limit. The Company uses a delinquency lifecycle strategy, in combination with behavior-driven approaches, consumer counseling, and consumer debt management programs, to manage delinquent accounts. Under the delinquency lifecycle strategy, the Company prioritizes collections to focus on delinquency status, with attention to customer events within each stage of delinquency.

        The allowance for loan losses represents management's estimate of incurred credit losses inherent in the Company's loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower's ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and unemployment levels have on a borrower's ability to repay adjustable-rate loans. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. The Company maintains a comprehensive governance structure and a certification and validation process that is designed to support, among other things, the appropriateness of the estimate of the allowance for loan losses. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods.

        The Company separately evaluates the impairment of the homogeneous and non-homogeneous loan portfolios. The homogeneous portfolio, comprising substantially all loans held in portfolio, is evaluated for collective impairment and consists predominantly of home loans, home equity loans and lines of credit, credit card loans and most commercial business, commercial real estate and multi-family loans. Certain home mortgage loans whose terms have been modified through debt restructurings and non-homogeneous loans are evaluated for individual impairment. In 2005, the Company defined non-homogeneous loans as commercial business, commercial real estate and multi-family loans with a current balance in excess of $1 million or loans with a current balance less than $1 million and highly risk rated. Beginning in 2006, reflecting (a) a shift in business practice towards originating and retaining in portfolio, multi-family loans whose performance could be modeled using a formulaic, statistical-based approach, and (b) the introduction of a new multi-family loan loss model that incorporated default-predictive variables that enabled the Company to make a more robust estimate of incurred losses on loans in this portfolio, the Company redefined non-homogeneous loans as certain commercial business, commercial real estate and multi-family loans with an unpaid principal balance in excess of $3 million.

        The Company accounts for the allowance for loan losses on its portfolio of homogeneous loans in accordance with FASB Statement No. 5, Accounting for Contingencies ("Statement No. 5"), recording an

48



allowance when (a) available information indicates that it is probable that a loss has been incurred and (b) the amount of the loss can be reasonably estimated. Generally, borrowers are impacted by events that result in loan default and eventual loss well in advance of the Company's knowledge of those events. Examples of such loss-causing events for home loans are borrower job loss, divorce and medical crisis. An example for commercial real estate loans would be the loss of a major tenant.

        The Company allocates a portion of the allowance to the homogeneous loan portfolios and estimates this allocated portion based on analyses of pools of loans with similar credit risk attributes. The Company also estimates an unallocated portion of the allowance that reflects management's assessment of various risk factors that are not fully captured by the statistical estimation techniques used to determine the allocated component of the allowance. However, both the allocated component and the portion that remains unallocated are available to absorb credit losses inherent in the homogeneous loan portfolio as of the balance sheet date.

        Statistical estimation techniques are used to determine the allocated allowance for homogeneous loans. Formulaic assessments of credit risk are primarily performed using the Loan Performance Risk Model. Statistical estimation techniques assess default and loss outcomes based on an evaluation of past performance of similar pools of loans in our portfolio, and other factors affecting default and loss factors, as well as industry historical loan loss data. Loss estimation techniques used in statistical models are supplemented by qualitative information to assist in estimating the allocated allowance. When housing prices are volatile, lags in data collection and reporting increase the likelihood of adjustments being made to the allowance. More current data evidencing conditions in the housing market are obtained from analyzing data from the National Association of Realtors on median sales and on housing inventory levels.

        Management routinely and regularly evaluates the accuracy of its statistical models and analyzes the performance of loans held in portfolio and makes improvements to those models as facts and circumstances warrant. In addition, the Company refines its estimates and assumptions used to calibrate particular models in response to new data and dynamic market conditions. As necessary and for the same reasons, the Company updates the relative weightings assigned to classes of inputs or factors considered in its particular models. The Company also considers whether the statistical models fully capture estimates of losses related to loans held in portfolio and to the extent adjustments are needed, they are incorporated into the allowance for loan losses.

        The Loan Performance Risk Model produces an estimate of the cumulative loss over the remaining terms of the loans by analyzing loan-level data, the key attributes of which are static collateral variables including property type, loan type, lien type, original balance, original loan-to-value ratio and documentation type; ARM-specific variables, such as ARM caps, floors and resets; dynamic variables, such as estimated current loan-to-value ratios and the age of the loan; borrower variables, such as original credit score and delinquency history; and market conditions, such as housing price appreciation or depreciation rates by metropolitan statistical area, and interest rates. Management then estimates the incurred portion of the cumulative loss when estimating its allowance for loan losses.

        The unallocated component of the allowance reflects management's evaluation of conditions that are not fully captured in determining the allocated allowance for homogenous loans. The weighting system used in estimating the appropriateness of the unallocated allowance reflects the relative significance of the following factors that are routinely and regularly reviewed: national and local economic trends and conditions (such as gross domestic product and unemployment trends); market conditions (such as changes in housing prices); industry and borrower concentrations within portfolio segments (including concentrations by metropolitan statistical area); recent loan portfolio performance (such as changes in the levels and trends in delinquencies and impaired loans); trends in loan growth (including the velocity of change in loan growth); changes in underwriting criteria; and the regulatory and public policy environment.

49


        In determining the allowance for loans evaluated for individual impairment and deemed to be impaired, the Company applies the provisions of FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan ("Statement No. 114"). Impairment of restructured home loans is measured by aggregating loans with common risk characteristics and calculating the present value of expected future cash flows using historical statistics such as average recovery period and average recovery amount, along with a composite effective interest rate. Impairment on non-homogeneous loans is measured principally using the fair value of the underlying collateral, since such loans are generally collateral dependent. In estimating the fair value of collateral, the Company evaluates various factors, such as occupancy and rental rates in the relevant real estate markets and their effect on the value of the collateral.

        When available information confirms that specific loans or portions thereof are uncollectible, those amounts are charged off against the allowance for loan losses. The existence of some or all of the following conditions will generally confirm that a loss has been incurred: the loan is significantly delinquent and the borrower has not demonstrated the ability to bring the loan current; the borrower has insufficient assets to repay the debt; or the fair value of the loan collateral is significantly below the current loan balance and there is little or no prospect for improvement. When home loans and home equity loans and lines of credit become 180 days past due, the portion of the loan balance in excess of the fair value of the underlying collateral (less estimated cost to sell) is charged off against the allowance for loan losses. Credit card loans are charged-off when they are determined to be uncollectible or by the end of the month in which the account becomes 180 days past due.

        Like all depository institutions with federal thrift charters, our subsidiary depository institutions continue to be subject to examination by their primary regulator, the OTS. The OTS examinations occur throughout the year and target various activities of our subsidiary depository institutions.

50


        Changes in the allowance for loan losses were as follows:

 
  Year Ended December 31,
 
 
  2007
  2006
  2005
  2004
  2003
 
 
  (dollars in millions)
 
Balance, beginning of year   $ 1,630   $ 1,695   $ 1,301   $ 1,250   $ 1,503  
Allowance transferred to loans held for sale     (550 )   (401 )   (270 )   (23 )   (3 )
Allowance acquired through business combinations         30     592          
Other     7                 17  
Provision for loan losses(1)     3,107     816     316     209     42  
   
 
 
 
 
 
      4,194     2,140     1,939     1,436     1,559  
Loans charged off:                                
  Loans secured by real estate:                                
    Home loans(2)     (214 )   (50 )   (38 )   (39 )   (65 )
    Home equity loans and lines of credit(2)     (437 )   (31 )   (30 )   (22 )   (14 )
    Subprime mortgage channel(3)     (566 )   (140 )   (50 )   (39 )   (39 )
    Home construction(4)         (8 )   (1 )   (1 )   (2 )
    Multi-family     (5 )       (1 )   (2 )   (5 )
    Other real estate     (2 )   (5 )   (8 )   (11 )   (97 )
   
 
 
 
 
 
      Total loans secured by real estate     (1,224 )   (234 )   (128 )   (114 )   (222 )
  Consumer:                                
    Credit card     (448 )   (322 )   (138 )        
    Other     (8 )   (19 )   (38 )   (53 )   (69 )
  Commercial     (76 )   (28 )   (34 )   (21 )   (79 )
   
 
 
 
 
 
      Total loans charged off     (1,756 )   (603 )   (338 )   (188 )   (370 )
Recoveries of loans previously charged off:                                
  Loans secured by real estate:                                
    Home loans(2)     6     1             10  
    Home equity loans and lines of credit(2)     13     8     9     4     1  
    Subprime mortgage channel(3)     16     6     3     3     3  
    Home construction(4)     1                  
    Multi-family         1     3     3     1  
    Other real estate     5     2     13     10     17  
   
 
 
 
 
 
      Total loans secured by real estate     41     18     28     20     32  
  Consumer:                                
    Credit card     75     53     40          
    Other     7     14     19     19     15  
  Commercial     10     8     7     14     14  
   
 
 
 
 
 
      Total recoveries of loans previously charged off     133     93     94     53     61  
   
 
 
 
 
 
        Net charge-offs     (1,623 )   (510 )   (244 )   (135 )   (309 )
   
 
 
 
 
 
Balance, end of year   $ 2,571   $ 1,630   $ 1,695   $ 1,301   $ 1,250  
   
 
 
 
 
 
Net charge-offs as a percentage of average loans held in portfolio     0.72 %   0.21 %   0.11 %   0.07 %   0.20 %
Allowance as a percentage of loans held in portfolio     1.05     0.72     0.74     0.63     0.71  

(1)
Includes a $202 million reversal of provision for loan losses recorded in the fourth quarter of 2003.
(2)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(3)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(4)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

51


        The allowance for loan losses increased slightly from $1.25 billion at December 31, 2003 to $1.30 billion at December 31, 2004 reflecting the growth in the loan portfolio. However, the allowance for loan losses as a percentage of loans held in portfolio declined from 0.71% at December 31, 2003 to 0.63% at December 31, 2004 reflecting the continuing strength of the U.S. housing market facilitated by a relatively benign credit environment throughout the year. The favorable credit climate, as well as the sales and runoff of higher risk portfolios in 2003, resulted in much lower net charge-offs in 2004.

        The allowance for loan losses increased $394 million from $1.30 billion at December 31, 2004 to $1.70 billion at December 31, 2005 largely reflecting the addition of the credit card portfolio of the former Providian Financial Corporation on October 1, 2005. Largely as a result of this addition, the allowance for loan losses expressed as a percentage of total loans held in portfolio increased from 0.63% at December 31, 2004 to 0.74% at December 31, 2005. Despite increases in short-term interest rates, the overall credit environment during 2005 was relatively stable, fostered by strong employment and real estate markets.

        The allowance for loan losses decreased $65 million from $1.70 billion at December 31, 2005 to $1.63 billion at December 31, 2006. The allowance for loans losses as a percentage of total loans held in portfolio, declined from 0.74% at December 31, 2005 to 0.72% at December 31, 2006, due to several factors. The credit profile of the Company's credit card portfolio improved due to the sale of higher risk credit card accounts and from a lower level of bankruptcy-related charge-offs. Delinquency rates on owned credit card loans declined from 3.08% at December 31, 2005 to 2.66% at December 31, 2006. Credit card delinquency rates are one of the key drivers of credit losses in the credit card portfolio and the Company correspondingly reduced the allowance related to credit card receivables. Additionally, the allowance for loan losses was reduced as a result of two primary changes in the assumptions and methodologies used to estimate the allowance attributable to multi-family loans. First, as part of its ongoing program of model improvement, the Company introduced a new model to estimate incurred losses on multi-family loans in 2006. The new model uses a formulaic statistical-based approach for determining loss factors based on relevant default-predictive variables such as loan-to-value and debt service coverage ratios, and geographic factors. The model that was replaced used the same underlying classes of inputs but categorized loans for collective review using the risk grade assigned to them for bank regulatory purposes, the categorization of which inherently involved management judgment. The Company expects this new methodology to result in a better estimate of incurred loss, with greater consistency across periods; it is also more consistent with risk assessment practices in the commercial lending industry. The Company also adopted three year loss confirmation periods for multi-family loans and loans originated or purchased through the subprime mortgage channel, in each case replacing the four year estimate of the loss confirmation period.

        The allowance for loan losses increased $941 million from $1.63 billion at December 31, 2006 to $2.57 billion at December 31, 2007 reflecting higher incurred losses inherent in the home loans portfolio, home equity loans and lines of credit portfolio, and in the subprime mortgage channel portfolio resulting primarily from deteriorating conditions in the U.S housing market during 2007. Accordingly the allowance for loan losses as a percentage of total loans held in portfolio increased from 0.72% at December 31, 2006 to 1.05% at December 31, 2007. Adverse trends in key housing market indicators, including growing inventories of unsold homes, rising foreclosure rates and a significant contraction in the availability of credit for nonconforming mortgage products were significant factors that resulted in the increase in the allowance. As a result of these factors, the Company increased its allowance for loan losses with the expectation that it would experience significantly higher credit costs throughout its single-family residential mortgage portfolio.

52


        An analysis of the allowance for loan losses was as follows:

 
  December 31,
 
 
  2007
  2006
  2005
 
 
  Allowance
for Loan
Losses

  Allocated
Allowance

of Loan
Category

  Loan
Category
as a %
of Total
Loans(1)

  Allowance
for Loan
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans(1)

  Allowance
for Loan
Losses

  Allocated
Allowance
as a %
of Loan
Category

  Loan
Category
as a %
of Total
Loans(1)

 
 
  (dollars in millions)

 
Allocated allowance:                                            
  Loans secured by real estate:                                            
    Home loans(2)   $ 322   0.29 % 45.17 % $ 202   0.20 % 44.22 % $ 222   0.19 % 49.71 %
    Home equity loans and lines of credit(2)     568   0.93   24.95     184   0.35   23.51     106   0.21   22.14  
    Subprime mortgage channel(3)     643   3.45   7.62     326   1.57   9.23     374   1.77   9.21  
    Home construction(4)     7   0.32   0.91     5   0.24   0.93     6   0.29   0.89  
    Multi-family     105   0.33   12.99     85   0.28   13.41     122   0.48   11.15  
    Other real estate     63   0.67   3.90     54   0.80   2.99     69   1.37   2.19  
   
     
 
     
 
     
 
      Total allocated allowance secured by real estate     1,708   0.73   95.54     856   0.40   94.29     899   0.41   95.29  
  Consumer:                                            
    Credit card     504   5.71   3.61     508   4.68   4.83     328   4.08   3.50  
    Other     6   2.90   0.08     7   2.32   0.12     27   4.25   0.28  
  Commercial     85   4.54   0.77     45   2.64   0.76     44   2.03   0.93  
   
     
 
     
 
     
 
      Total allocated allowance held in portfolio     2,303   0.94   100.00     1,416   0.63   100.00     1,298   0.57   100.00  
Unallocated allowance     268   0.11       214   0.09       397   0.17    
   
 
 
 
 
 
 
 
 
 
      Total allowance for loan losses   $ 2,571   1.05 % 100.00 % $ 1,630   0.72 % 100.00 % $ 1,695   0.74 % 100.00 %
   
 
 
 
 
 
 
 
 
 

(1)
Excludes loans held for sale.
(2)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(3)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(4)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

(This table is continued on the next page.)

53


        (Continued from the previous page.)

 
  December 31,
 
 
  2004
  2003
 
 
  Allowance for Loan Losses
  Allocated Allowance as a %
of Loan
Category

  Loan Category as a % of Total Loans(1)
  Allowance for Loan Losses
  Allocated Allowance as a %
of Loan
Category

  Loan Category as a % of Total Loans(1)
 
 
  (dollars in millions)

 
Allocated allowance:                              
  Loans secured by real estate:                              
    Home loans(2)   $ 214   0.19 % 53.10 % $ 321   0.32 % 57.12 %
    Home equity loans and lines of credit(2)     83   0.19   21.08     82   0.30   15.78  
    Subprime mortgage channel(3)     243   1.27   9.26     84   0.65   7.41  
    Home construction(4)     12   0.51   1.13     18   0.81   1.27  
    Multi-family     101   0.45   10.76     139   0.68   11.60  
    Other real estate     116   2.05   2.74     110   1.65   3.80  
   
     
 
     
 
      Total allocated allowance secured by real estate     769   0.38   98.07     754   0.44   96.98  
  Consumer:                              
    Credit card                  
    Other     36   4.55   0.38     49   4.77   0.59  
  Commercial     51   1.59   1.55     72   1.69   2.43  
   
     
 
     
 
      Total allocated allowance held in portfolio     856   0.41   100.00     875   0.50   100.00  
Unallocated allowance     445   0.22       375   0.21    
   
 
 
 
 
 
 
      Total allowance for loan losses   $ 1,301   0.63 % 100.00 % $ 1,250   0.71 % 100.00 %
   
 
 
 
 
 
 

(1)
Excludes loans held for sale.
(2)
Excludes home loans and home equity loans and lines of credit in the subprime mortgage channel.
(3)
Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio.
(4)
Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.

        As part of its ongoing program of model improvement, the Company introduced a new model to estimate incurred losses on multi-family loans in 2006. The new model uses a formulaic statistical-based approach for determining loss factors based on relevant default-predictive variables such as loan-to-value and debt service coverage ratios, and geographic factors. The model that was replaced used the same underlying classes of inputs but categorized loans for collective review using the risk grade assigned to them for bank regulatory purposes, the categorization of which inherently involved management judgment. The Company expects this new methodology to result in a better estimate of incurred loss, with greater consistency across periods; it is also more consistent with risk assessment practices in the commercial lending industry.

        The allocated allowance for loan losses for home loans decreased $20 million in 2006, while the allowance increased as a percentage of the total loan balance from 0.19% at the end of 2005 to 0.20% at the end of 2006. The $20 million decrease in the allowance for home loans is a small amount relative to the approximately $99 billion in the home loans portfolio at December 31, 2006. This decrease resulted from a combination of offsetting effects, including a $15 billion decline in home loans balances during 2006. In addition, the credit risk profile of the loans remaining in the home loans held in portfolio also changed as home prices in geographic areas of portfolio concentration (e.g., California) generally appreciated over the course of 2006. Partially offsetting these factors that reduced the allocated allowance was the impact from increased levels of delinquencies and nonperforming assets.

        The allocated allowance for loan losses for subprime mortgage channel loans decreased $48 million in 2006 primarily due to the change in the estimate of the loss confirmation period from four years to

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three years. The loss confirmation period represents the period between a loan default event occurring and the point at which the Company has knowledge of those events. Generally, borrowers are impacted by events that result in loan default and eventual loss well in advance of a lender's knowledge of those events. Examples of such loss-causing events for home loans are borrower job loss, divorce and medical crisis. The impact of changing the loss confirmation period was partially offset by an increase in the allowance for loan losses from improvements in the estimation of incurred losses associated with the Long Beach subprime portfolio with regard to loans with high loan-to-value ratios and loans in a junior lien position.

        The total amount of loans held in portfolio, excluding credit card loans, that were 90 days or more contractually past due and still accruing interest was $98 million, $97 million, $107 million, $85 million and $46 million at December 31, 2007, 2006, 2005, 2004 and 2003. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest. Managed credit card loans that were 90 days or more contractually past due and still accruing interest were $836 million, $586 million and $465 million at December 31, 2007, 2006 and 2005, including $174 million, $113 million and $87 million related to loans held in portfolio. The delinquency rate on managed credit card loans that were 30 days or more delinquent at December 31, 2007, 2006 and 2005 was 6.47%, 5.25% and 5.07%.

        Delinquent mortgages contained within GNMA servicing pools that were repurchased or were eligible to be repurchased by the Company are reported as loans held for sale. Substantially all of these loans are either guaranteed or insured by agencies of the federal government and therefore do not expose the Company to significant risk of credit loss. Due to the sale of substantially all of the Company's government loan servicing portfolio in July 2006, the balance of such loans declined considerably. The Company's held for sale portfolio contained zero, $37 million, $1.06 billion, $1.60 billion and $2.50 billion of such loans that were 90 days or more contractually past due and still accruing interest at December 31, 2007, 2006, 2005, 2004 and 2003.

        Derivative financial instruments 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. Credit risk related to derivative financial instruments is considered within the fair value measurement of the instrument. The Company manages the credit risk associated with its various derivative agreements through counterparty credit review, counterparty exposure limits and monitoring procedures. The Company obtains collateral from certain counterparties for amounts in excess of exposure limits and monitors all exposure and collateral requirements daily. The fair value of collateral received from a counterparty is continually monitored and the Company may request additional collateral from counterparties or return collateral pledged as deemed appropriate. The Company's agreements generally include master netting agreements whereby the counterparties are entitled to settle their positions "net." At December 31, 2007 and 2006, the gross positive fair value of the Company's derivative financial instruments was $2.04 billion and $618 million. The Company's master netting agreements at December 31, 2007 and 2006 reduced the exposure to this gross positive fair value by $331 million and $339 million. The Company's collateral against derivative financial instruments was $1.28 billion and $16 million at December 31, 2007 and 2006. Accordingly, the Company's net exposure to derivative counterparty credit risk at December 31, 2007 and 2006 was $435 million and $263 million.

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Liquidity Risk and Capital Management

        The objective of liquidity risk management is to ensure that the Company has the continuing ability to maintain cash flows that are adequate to fund operations and meet its other obligations on a timely and cost-effective basis in various market conditions. Changes in market conditions, the composition of its balance sheet and risk tolerance levels are among the factors that influence the Company's liquidity profile. The Company establishes liquidity guidelines for the Parent as well as for its banking subsidiaries.

        The Parent and its banking subsidiaries have separate liquidity risk management policies and contingent funding plans as each has different funding needs and requirements and sources of liquidity. The Company's banking subsidiaries also have regulatory capital requirements. The Company has policies that require current and forecasted liquidity positions to be monitored against pre-established limits and requires that contingency liquidity plans be maintained.

        For the Company's banking subsidiaries, liquidity is forecasted over short term (operational) and long term (strategic) horizons. Both approaches require that the Company's banking subsidiaries maintain minimum amounts of liquidity that exceed forecasted needs (excess liquidity). Whereas the focus for operational liquidity is to maintain sufficient excess liquidity to satisfy unanticipated funding requirements, strategic liquidity focuses on stress-testing liquidity risks and ensuring that sufficient excess liquidity is maintained under various scenarios to meet policy standards.

        The Parent's primary sources of liquidity are dividends from subsidiaries and funds raised in various capital markets. Dividends paid by the Parent's banking subsidiaries may fluctuate from time to time in order to ensure that both internal capital targets and various regulatory requirements related to capital adequacy are met. For more information on dividend limitations applicable to the Parent's banking subsidiaries, refer to "Business – Regulation and Supervision" and Note 20 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."

        In January 2006, the Parent filed an automatically effective registration statement under which an unlimited amount of debt securities, preferred stock and depositary shares were registered. The Parent's long-term and short-term indebtedness are rated A- and F2 by Fitch, BBB+ and A2 by Standard & Poor's, Baa2 and P2 by Moody's, and AL and R-1L by DBRS.

        The principal sources of liquidity for the Parent's banking subsidiaries are retail deposits, FHLB advances, repurchase agreements, federal funds purchased, the maturity and repayment of portfolio loans, securities held in the available-for-sale portfolio and loans designated as held for sale. Retail deposits continue to provide the Company with a significant source of stable funding while FHLB advances have increased in importance in the second half of 2007. The Company's continuing ability to retain its retail deposit base and to attract new deposits depends on various factors such as customer service satisfaction levels and the competitiveness of interest rates offered on deposit products. Washington Mutual Bank continues to have the necessary assets available to pledge as collateral for additional FHLB advances, repurchase agreements and other collateral-dependent sources of liquidity.

        FHLB borrowings have always been an important source of liquidity for the Company and remain so today. In response to the current global credit crisis, decreased investor risk tolerance levels and near-evaporation of liquidity in the secondary markets, the Parent's banking subsidiaries increased their borrowings from the Federal Home Loan Bank system in the second half of 2007. The increase in FHLB borrowings by $42.44 billion from June 30, 2007 or $19.56 billion from December 31, 2006 was

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facilitated by the $47.36 billion reduction in FHLB borrowings over the 18 months prior to June 30, 2007 as the Company diversified its wholesale funding sources and reduced the size of its balance sheet.

        For the year ended December 31, 2007, proceeds from the sale of loans originated and held for sale were approximately $78.93 billion. These proceeds were, in turn, used as the primary funding source for the origination and purchase, net of principal payments, of approximately $77.38 billion of loans held for sale during the same period.

        While recent market events have impacted the Company's liquidity planning, the Company remains comfortable with its ability to fund its mortgage banking operations. The Company's liquidity planning assumes that the only reliable sources of liquidity in the secondary mortgage market are Fannie Mae and Freddie Mac. While turbulence in the secondary mortgage market may change the type of liquidity the Company accesses, the amount of funding that is necessary to sustain the Company's mortgage banking operations does not typically affect overall liquidity levels.

        As part of its funding diversification strategy, Washington Mutual Bank launched a €20 billion covered bond program in September 2006. While €14 billion remains unissued under this program, no further issuances may occur until the Company's credit ratings assigned by Moody's are upgraded or the ratings-based restrictions are eliminated. Existing floating-rate U.S. dollar-denominated mortgage bonds were issued by Washington Mutual Bank and collateralize the outstanding Euro-denominated covered bonds. The covered bonds were issued by a statutory trust that is not consolidated by the Company. The mortgage bonds are secured principally by residential mortgage loans in Washington Mutual Bank's portfolio.

        Under the Global Bank Note Program, which was established in August 2003 and renewed in December 2005, Washington Mutual Bank may issue senior and subordinated notes in the United States and in international capital markets in a variety of currencies and structures. Washington Mutual Bank had $12.44 billion available under this program as of December 31, 2007.

        Senior unsecured long-term obligations of Washington Mutual Bank are rated A- by Fitch, A- by Standard & Poor's, Baa1 by Moody's and A by DBRS. Short-term obligations are rated F2 by Fitch, A2 by Standard & Poor's, P2 by Moody's and R-1L by DBRS.

        The Company monitors capital adequacy for both the Company (on a consolidated basis) and its regulated banking subsidiaries. Sufficient capital is maintained at both levels to provide for unexpected losses based on the risks inherent in the combination of businesses. The views of investors, credit rating agencies, lenders and regulators are considered in determining capital ratio targets.

        Capital is generated through the Company's business operations and through issuance of capital securities such as common stock and perpetual preferred stock, and the Company's capital management program promotes the efficient use of these resources. Capital is primarily used to fund organic growth, pay dividends and repurchase shares. On a consolidated basis, capital may also be raised through issuance of capital securities by various subsidiaries of the Company and its banking subsidiaries, in particular Washington Mutual Preferred Funding LLC ("WMPF LLC").

        During 2007, the Company issued approximately $1.5 billion of perpetual, non-cumulative preferred securities through its indirect subsidiary, WMPF LLC. While the high equity content characteristics of these securities have long been acknowledged by the OTS as qualifying elements in the composition of financial institutions' core capital structures, the rating agencies have only recently taken a similar view. Accordingly, such securities are included as equity components within the Company's tangible equity to total tangible assets ratio, estimated Tier 1 leverage ratio, and estimated total risk-based capital ratio.

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        Additionally, in the fourth quarter of 2007, the Company issued $3.0 billion of Series R Non-Cumulative Perpetual Convertible Preferred Stock for net proceeds of approximately $2.9 billion. Of the total net proceeds received from the sale of Series R Preferred Stock, $1.0 billion was contributed to the Company's banking subsidiary, Washington Mutual Bank, to enhance its capital position as it manages anticipated heightened credit losses. The remaining proceeds have been retained at the Company to enhance its liquidity profile and eliminate the need for dividend flows to support anticipated cash flows through the next two years.

        The Company's ability to generate capital internally through earnings was significantly impacted in 2007 by the deteriorating credit environment. With early indicators in 2008 suggesting that the housing market continues to deteriorate, the Company expects that it will continue to experience significantly higher credit costs throughout its single-family residential mortgage portfolios, which will in turn significantly impact the Company's ability to generate capital internally through earnings. Management has taken steps to mitigate the capital impact of the current earnings outlook by recommending that the Company's Board of Directors reduce the quarterly dividend payment to common stockholders to 15 cents per share from the prior level of 56 cents per share it paid in the fourth quarter. Management has incorporated this new reduced level of dividends into its capital and liquidity forecasts for 2008. Refer to Item 1A – Risk Factors for additional information regarding risks related to capital sufficiency.

        On January 15, 2008, the Company's Board of Directors declared a cash dividend of 15 cents per share on the Company's common stock, payable on February 15, 2008 to shareholders of record as of January 31, 2008. The Company's Board of Directors considers a variety of factors when determining the dividend on the Company's common stock, including overall capital levels, liquidity position and the Company's earnings. In addition, the Company will pay a dividend of 36 cents per depositary share of Series K Preferred Stock, and a dividend of $19.16 per share of Series R Preferred Stock on March 17, 2008 to shareholders of record on March 3, 2008.

        With certain limited exceptions, if the Company does not pay full quarterly dividends on any issued and outstanding class or series of its preferred stock for a particular dividend period, then the Company may not pay dividends on, or repurchase, redeem or make a liquidation payment with respect to its common stock or other junior securities during the next succeeding dividend period. Refer to Note 17 to the Consolidated Financial Statements – "Preferred Stock and Minority Interest" for additional information.

        As part of its capital management activities, from time to time the Company has repurchased shares to deploy excess capital. The Company adopted a new share repurchase program approved by the Board of Directors in 2006 (the "2006 Program"). Under the 2006 Program, the Company is authorized to repurchase up to 150 million shares of its common stock, as conditions warrant. There is no fixed termination date for the 2006 Program and purchases may be made in the open market, through block trades, accelerated share repurchase transactions, private transactions, or otherwise. Recently, the Company has focused on capital retention, and has not engaged in share repurchase activities since the third quarter of 2007. The total remaining common stock repurchase authority under the 2006 Program was 47.5 million shares as of December 31, 2007.

        When the Company engages in share repurchases, management evaluates the relative risks and benefits of repurchasing shares in the open market, with the attendant daily trading limits and other constraints of the SEC Rule 10b-18 safe harbor, as compared with an accelerated share repurchase ("ASR") transaction. In an ASR transaction, the Company repurchases a large block of stock at an initial specified price from a counterparty, typically a large broker-dealer, who has borrowed the shares. Upon final settlement of an ASR transaction, the initial specified price is adjusted to reflect actual prices at which the Company's shares traded over the period of time after the initial repurchase that is specified in the ASR agreement. Through this final settlement process, market risks and costs

58



associated with fluctuations in the Company's stock price during the subsequent time period may be transferred from the counterparty to the Company.

        ASR transactions immediately deploy the capital associated with share repurchases, making them economically more efficient than open market repurchases. Additionally, ASR transactions may be structured to include optionality or hedging arrangements that afford the Company the opportunity to mitigate price risk, and potentially mitigate the volatility of open market price fluctuations. While these benefits of an ASR transaction are significant considerations, open market repurchases are usually a more operationally efficient alternative when the Company chooses to deploy its excess capital in smaller amounts, particularly given the time required and the complexity associated with structuring an ASR transaction. In contrast, when the Company chooses to deploy its excess capital in larger amounts, an ASR transaction becomes more attractive and shares repurchased in an ASR transaction are removed upon the initiation of the repurchase when calculating earnings per share. Because ASR transactions involve more complex legal structures and counterparty risks than open market repurchases, the Company retains outside legal counsel to assist in structuring and documenting the transactions and applies its market risk and counterparty credit risk management standards. Additional information regarding these transactions is included in Note 16 to the Consolidated Financial Statements – "Common Stock."

        Refer to Item 5 – "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for additional information regarding share repurchase activities.

        The Parent's core capital consists primarily of common and preferred stock, retained earnings and, to a lesser degree, trust preferred securities. In recent years, the Company has remixed its core capital by replacing some of its common stock and trust preferred securities with perpetual non-cumulative preferred stock that reduced the cost of capital while preserving its core capital quality as shown below:

 
  At December 31,
 
  2007
  2006
  2005
 
  (in millions)

Capital Surplus-Common Stock   $ 2,630   $ 5,825   $ 8,176
Series K Preferred Stock     492     492    
Series R Preferred Stock     2,900        
WMPF LLC Preferred Securities     3,912     2,446    
Trust Preferred Securities     813     1,880     1,795

        OTS capital guidelines require that the dominant form of a savings association's equity (referred to as "core capital" under OTS guidelines, and equivalent to Tier 1 capital for other banking institutions) should be common voting shares and that savings associations should avoid undue reliance on preferred securities. Preferred securities issued by WMPF LLC (an indirect subsidiary of WMB) qualify as Tier 1 (core) capital at WMB. As a prudent safeguard, OTS limits the amount of WMB's Tier 1 (core) capital that may be comprised of preferred securities to an amount that cannot exceed 25% of its Tier 1 capital. At December 31, 2007, the aggregate amount of preferred securities issued by WMPF LLC totaled approximately $3.91 billion (net of expense) which represents 17.5% of its $22.4 billion Tier 1 (core) capital. In 2007, WMB also redeemed $170 million of preferred stock. WMBfsb's capital structure does not contain any preferred securities.

        The Parent is not required by the OTS to report its capital ratios, and as the Parent is not a bank holding company it is not required by the Federal Reserve Board to report its capital ratios. Nevertheless, capital ratios are integral to the Company's capital management process and the provision of such metrics facilitates peer comparisons with Federal Reserve Board-regulated bank holding companies. The ratio for the Company's tangible equity to total tangible assets, along with the

59



estimated ratios for Tier 1 capital to average total assets and total risk-based capital to total risk-weighted assets which exceed minimum regulatory guidelines, are presented below.

 
  At December 31,
 
 
  2007
  2006
 
 
  (dollars in millions)

 
Tangible equity   $ 21,387   $ 20,374  
Total tangible assets     320,749     337,050  
Tangible equity to total tangible assets     6.67 %   6.04 %
Tier 1 capital   $ 21,610   $ 21,789  
Average total assets     315,832     343,178  
Tier 1 leverage     6.84 %   6.35 %
Total risk-based capital   $ 31,128   $ 30,068  
Total risk-weighted assets     252,330     255,450  
Total risk-based capital to total risk-weighted assets     12.34 %   11.77 %

        The regulatory capital ratios of Washington Mutual Bank and Washington Mutual Bank fsb and minimum regulatory capital ratios to be categorized as well-capitalized are included in Note 20 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."

        The Company's broker-dealer subsidiaries are also subject to capital requirements. At December 31, 2007 and 2006, all of its broker-dealer subsidiaries were in compliance with their applicable capital requirements. During December 2007, the Company announced its intention to close WCC, its institutional broker-dealer business. In January 2008, substantially all the holdings of WCC were sold to various other subsidiaries of the Company in arms-length transactions.

Market Risk Management

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

        The Company's trading assets are primarily comprised of financial instruments that are retained from securitization transactions, or are purchased for MSR risk management purposes. The Company does not take significant short-term trading positions for the purpose of benefiting from price differences between financial instruments and markets.

        From time to time the Company issues debt denominated in foreign currencies. When such transactions occur, the Company uses derivatives to offset the associated foreign currency exchange risk.

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

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        The Company is exposed to different types of interest rate risks. These include lag, repricing, basis, prepayment, lifetime and periodic payment caps, and volatility risk.

        Lag risk results from timing differences between the repricing of adjustable-rate assets and liabilities. Repricing risk is caused by the mismatch in the maturities between assets and liabilities. For example, the Company's assets may reprice slower than its liabilities. The effect of this timing difference, or "lag," will generally be favorable during a period of declining interest rates and unfavorable during a period of rising interest rates. Lag/repricing risk can produce short-term volatility in net interest income during periods of interest rate movements, but the effect of this lag generally balances out over time.

        Basis risk occurs when assets and liabilities have similar repricing frequencies but are tied to different market interest rate indices. For example, adjustable-rate loans may reprice based on Treasury rates while borrowings may reprice based on LIBOR rates.

        Prepayment risk results from the ability of customers to pay off their loans prior to maturity. Generally, prepayments increase in falling interest rate environments and decrease in rising interest rate environments.

        Many of the Company's adjustable-rate home loan products contain lifetime interest rate caps, which prevent the interest rate on the loan from exceeding a contractually determined level. In periods of dramatically rising rates, those adjustable-rate loans that have reached their lifetime cap rate will no longer reprice upward. Periodic payment caps limit the amount that a borrower's scheduled payment on an adjustable-rate loan can increase when the interest rate is adjusted upward on the loan's periodic repricing date.

        Volatility risk is the potential change in the fair value of an option, or a fixed income instrument containing options (such as mortgages) from changes in the implied market level of future volatility ("implied volatility"). For the holder of an option contract, implied volatility is a key determinant of option value with higher volatility generally increasing option value and lower volatility generally decreasing option value.

        The Company manages potential changes in the fair value of MSR through a comprehensive risk management program. The intent is to mitigate the effects of changes in MSR fair value through the use of risk management instruments. Risk management instruments may include interest rate contracts, forward rate agreements, forward purchase commitments and available-for-sale and trading securities. The securities generally consist of fixed-rate debt securities, such as U.S. Government and agency obligations and mortgage-backed securities, including principal-only strips. The interest rate contracts typically consist of interest rate swaps, interest rate swaptions, interest rate futures and interest rate caps and floors. The Company may purchase or sell option contracts, depending on the portfolio risks

61


it seeks to manage. The Company also enters into forward commitments to purchase and sell mortgage-backed securities, which generally are comprised of fixed-rate mortgage-backed securities with 15 or 30 year maturities.

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

        The Company manages the MSR daily and adjusts the mix of instruments used to offset MSR fair value changes as interest rates and market conditions warrant. The objective is to maintain an efficient and fairly liquid mix as well as a diverse portfolio of risk management instruments with maturity ranges that correspond well to the anticipated behavior of the MSR. The Company also manages the size of the MSR asset, such as through the structuring of servicing agreements when loans are sold, and by periodically selling or purchasing servicing assets.

        In June 2007, the Company changed the model used to estimate the fair value of substantially all of its MSR from a static valuation model to an option-adjusted spread ("OAS") valuation model. The OAS model projects MSR cash flows over multiple interest rate scenarios, and discounts these cash flows using risk-adjusted discount rates. The significant assumptions used in the valuation of MSR include market interest rates, projected prepayment speeds, cost to service, ancillary income and option-adjusted spreads. Additionally, an independent broker estimate of the fair values of the mortgage servicing rights is obtained quarterly along with other market-based evidence. Management uses this information together with its OAS valuation methodology to estimate the fair value of the MSR.

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

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

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

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

        To analyze interest rate risk sensitivity, management projects net interest income under a variety of interest rate scenarios, assuming both parallel and non-parallel shifts in the yield curve. These scenarios illustrate net interest income sensitivity due to changes in the level of interest rates, the slope of the yield curve and the spread between Treasury and LIBOR/swap ("LIBOR") rates. Management also periodically projects the interest rate sensitivity of net income due to changes in the level of interest rates. Additionally, management projects the discounted value of assets and liabilities under different interest rate scenarios to assess their risk exposure over longer periods of time.

        The projection of the sensitivity of net income, net interest income and discounted cash flow analyses requires numerous assumptions. Prepayment speeds, decay rates (the estimated runoff of deposit accounts that do not have a stated maturity), future deposits and loan rates and loan and deposit volume and mix projections are among the most significant assumptions. Prepayments affect the size of the loan and mortgage-backed securities portfolios, which impacts net interest income. All deposit and loan portfolio assumptions, including loan prepayment speeds and deposit decay rates, require management's judgments of anticipated customer behavior in various interest rate environments. These assumptions are derived from internal and external analyses. The rates on new investment securities and borrowings are estimated based on market rates while the rates on deposits and loans are estimated based on the rates offered by the Company to retail customers.

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

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

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

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

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

        The table below indicates the sensitivity of net interest income as a result of hypothetical interest rate movements on market risk sensitive instruments. The base case assumptions used for this sensitivity analysis are similar to the Company's most recent net interest income projection for the respective twelve month periods as of the date the analysis was performed. The comparative results assume parallel shifts in the yield curve with interest rates rising 100 basis points and decreasing 100 basis points in even quarterly increments over the twelve month periods ending December 31, 2008 and December 31, 2007.

        Commencing with the analysis for the one year period beginning January 1, 2008, the interest rate scenarios will be derived from the year end forward yield curve. The comparative analysis is presented based on current coupon rates while the net interest income sensitivity based on the forward yield curve is presented separately. The revision to the interest rate scenario more closely aligns the analysis with market expectations. The base scenario for the current coupon rate analysis were the market rates as of December 31 held constant for the next twelve months. The base scenario for the implied forward rate analysis represents market expectations for interest rates for the next twelve months. The parallel scenarios represent the same absolute change in interest rates in both analyses.

        These analyses also incorporate assumptions about balance sheet dynamics such as loan and deposit growth and pricing, changes in funding mix and asset and liability repricing and maturity characteristics. The projected interest rate sensitivities of net interest income shown below may differ significantly from actual results, particularly with respect to non-parallel shifts in the yield curve or changes in the spreads between mortgage, Treasury and LIBOR rates, changes in loan volumes or loan and deposit pricing.

 
  Gradual Change in Rates
 
 
  -100 basis points
  +100 basis points
 
Current coupon rates          
Net interest income change for the one year period beginning:          
  January 1, 2008   3.13 % (2.67 )%
  January 1, 2007   3.80   (3.04 )
 
 
  Gradual Change in Rates
 
 
  -100 basis points
  +100 basis points
 
Implied forward rates          
Net interest income change for the one year period beginning:          
  January 1, 2008   2.78 % (2.74 )%

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        Treasury and LIBOR rates in the January 1, 2008 net interest income sensitivity analyses were lower than the rates at January 1, 2007 with Treasury rates declining significantly more than LIBOR rates. At January 1, 2008, two year interest rates were lower than three month and ten year interest rates on the Treasury and LIBOR curves. The January 1, 2007 curve was inverted with three month rates higher than ten year rates. The shape of the curves contributes to a continuing challenging interest rate environment for the Company.

        Net interest income sensitivity declined in the ±100 basis point environments in the January 1, 2008 analysis compared to the January 1, 2007 analysis. The main factors contributing to the reduction in sensitivity was the execution of term fixed-rate funding and interest rate contracts and changes in the projected balance sheet during the subsequent twelve month periods. The term funding and interest rate contracts were executed to offset the increased sensitivity resulting from the retention of medium-term adjustable-rate loans during the second half of 2007. A reduction in projected prepayments and loan volume resulted in decreased changes in average earning assets in all scenarios. The net result was a decreased change in net interest income in the ±100 basis point environments, as compared to the January 1, 2007 analysis.

        The net interest income sensitivity in the -100 basis point scenario in the implied forward rates analysis was slightly lower than in the current coupon rates analysis primarily due to enhanced net interest income in the base scenario. Net interest income increased in the base implied forward rates analysis as the projected interest rates were lower.

        Similar to the net interest income sensitivity analysis, management also periodically projects net income in a variety of interest rate scenarios assuming parallel shifts in the yield curve. The net income simulations project changes in MSR and related hedges, all of which are carried at fair value and whose values are sensitive to changes in interest rates. The analysis assumes no changes in credit provisions, gain on sale, non-interest income or non-interest expense except for the fair value changes in MSR and related hedges.

        In performing net income simulations, parallel shifts in the yield curve are assumed, with interest rates rising 100 basis points and decreasing 100 basis points in even quarterly increments over the twelve month periods ending December 31, 2008 and 2007. The interest rate scenarios are identical to the scenarios used for the net interest income comparison. The assumptions used in the base scenario are similar to the assumptions used in the Company's most current earnings forecast.

        For the twelve month period ending December 31, 2008, using current coupon rates, net income is projected to increase approximately $170 million in the -100 basis point simulation while it is projected to decrease approximately $110 million in the +100 basis point simulation. In comparison, net income was projected to increase approximately $70 million in the -100 basis point scenario and decrease approximately $100 million in the +100 basis point scenario for the twelve month period ended December 31, 2007. For the twelve month period ending December 31, 2008, using implied forward rates, net income is projected to increase approximately $160 million in the -100 basis point simulation while it is projected to decrease approximately $120 million in the +100 basis point simulation. The differences in the results between the implied forward curve rates and the current coupon rates analysis was due to slight variances in net interest income sensitivity offset by changes in the performance of MSR and related hedges.

        The projected increase in net income in the -100 basis point scenario for the twelve month period ending December 31, 2008 was mainly due to an improvement in other income (fair value changes in the MSR and related hedges) offset by less of an increase in net interest income. Net income in the +100 basis point environment was similar, as an improvement in other income was offset by less of a decrease in net interest income. This was mainly due to a reduction in projected MSR

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unpaid principal balances and changes in the shape of the yield curve resulting in changes to the projected hedging costs. The reduction in MSR unpaid principal balances was due to expected decreases in loan sales during the twelve month forecast resulting from changes in the secondary mortgage market.

        These net income and net interest income sensitivity analyses are limited in that they were performed at a particular point in time and do not reflect certain factors that would impact the Company's financial performance in a changing interest rate environment. Most significantly, the impact of changes in gain on sale from mortgage loans that result from changes in interest rates is not modeled in the simulation. The net income and net interest income analyses also assume no changes in credit spreads. In addition, the net income sensitivity analysis assumes no changes in credit provisions, noninterest income or noninterest expense in the different scenarios other than changes in the fair value of MSR and related hedges. Additional provisions may be required in a falling interest rate scenario while fewer provisions may be necessary in a rising rate scenario substantially changing the projected net income sensitivity estimates. The analyses assume management does not initiate additional strategic actions, such as increasing or decreasing term funding or selling assets, to offset the impact of projected changes in net interest income or net income in these scenarios.

        The analyses are also dependent on the reliability of various assumptions used, including prepayment forecasts and discount rates, and do not incorporate other factors that would impact the Company's overall financial performance in such scenarios. These analyses also assume that the projected MSR risk management strategy is effectively implemented and that mortgage and interest rate swap spreads are constant in all interest rate environments. These assumptions may not be realized. For example, changes in spreads between interest rate indices could result in significant changes in projected net income sensitivity. Projected net income may increase if market rates on interest rate swaps decrease by more than the decrease in mortgage rates, while the projected net income may decline if the rates on swaps increase by more than mortgage rates. Accordingly, the preceding sensitivity estimates should not be viewed as an earnings forecast.

Operational Risk Management

        Operational risk is the risk of loss resulting from human fallibility, inadequate or failed internal processes or systems, or from external events, including loss related to legal risk. Operational risk can occur in any activity, function, or unit of the Company.

        Primary responsibility for managing operational risk rests with the lines of business. Each line of business is responsible for identifying its operational risks and establishing and maintaining appropriate business-specific policies, internal control procedures and tools to quantify and monitor these risks. To help identify, assess and manage corporate-wide risks, the Company uses corporate support groups such as Legal, Compliance, Information Security, Continuity Assurance, Enterprise Spend Management and Finance. These groups assist the lines of business in the development and implementation of risk management practices specific to the needs of each business.

        The Operational Risk Management Policy, approved by the Audit Committee of the Board of Directors, establishes the Company's operational risk framework and defines the roles and responsibilities for the management of operational risk. The operational risk framework consists of a methodology for identifying, measuring, monitoring and controlling operational risk combined with a governance process that complements the Company's organizational structure and risk management philosophy. The Operational Risk Committee ensures consistent communication and oversight of significant operational risk issues across the Company and ensures sufficient resources are allocated to maintain business-specific operational risk controls, policies and practices consistent with and in support of the operational risk framework and corporate standards.

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        The Operational Risk Management function, part of Enterprise Risk Management, is responsible for maintaining the framework and works with the lines of business and corporate support functions to ensure consistent and effective policies, practices, controls and monitoring tools for assessing and managing operational risk across the Company. The objective of the framework is to provide an integrated risk management approach that emphasizes proactive management of operational risk using measures, tools and techniques that are risk-focused and consistently applied company-wide. Such tools include the collection of internal operational loss event data, relevant external operational loss event data, results from scenario analysis, and assessments of the Company's business environment and internal control factors. These elements are used to determine the Company's operational risk profile and are included in the measurement of operational risk capital.

Tax Uncertainties

        The Company accounts for unrecognized income tax benefits in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), which was adopted on January 1, 2007. FIN 48 requires that a tax benefit be recognized only if it is "more likely than not" that it will be realized, based solely on its technical merits, as of the reporting date. A tax position that meets the more-likely-than-not criterion shall be measured at the largest amount of benefit that is more than 50 percent likely of being realized upon settlement. As a result of the implementation of FIN 48, the Company recognized a $6 million increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to the January 1, 2007 balance of retained earnings.

        Prior to January 1, 2007, the Company accounted for income and other tax contingencies in accordance with FASB Statement No. 5, Accounting for Contingencies ("FAS 5"). The calculation of tax liabilities under FAS 5 involves judgment in estimating the impact of uncertainties in the application of complex tax laws. The Company continues to account for non-income tax contingencies in accordance with FAS 5.

Goodwill Litigation

        On August 9, 1989, the Financial Institutions Reform, Recovery and Enforcement Act was enact