Washington Mutual Q2 2007 Earnings Call Transcript

| About: WMIH Corp. (WMIH)
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Washington Mutual, Inc. (NYSE:WM)

Q2 2007 Earnings Call

July 18, 2007 5:00 pm ET

Executives

Alan Magleby - SVP, Investor Relations

Kerry Killinger - Chairman & CEO

Stephen Rotella - President & COO

Thomas Casey - CFO

Analysts

Bob Napoli - Piper Jaffray

Bruce Harting - Lehman Brothers

Brad Ball - Citigroup

Eric Wasserstrom - UBS

Chris Brendler - Stifel Nicolaus

Fred Cannon - KBW

George Sacco - J.P. Morgan

Bob Peck - Fremont Group

Moshe Orenbuch - Credit Suisse

Howard Shapiro - Fox-Pitt Kelton

Larry Batali - Moore Capital

Presentation

Operator

Good afternoon and welcome to WaMu's Second Quarter 2007 Earnings Conference Call. All participants are in a listen-only mode. After the presentation, we will conduct a question-and-answer session. Today's calling is being recorded for replay purposes. A replay will be available approximately one hour after the call has ended today.

The toll free phone number for today’s replay is 800-819-5743. This call is also being webcast live and will be archived for 30 days on the Company's website. Now I will turn the call over to Alan Magleby, Senior Vice President, Investor Relations to introduce today's conference call.

Alan Magleby

Good afternoon, and thank you for joining us today. I would like to welcome you to WaMu's second quarter 2007 earnings conference call. I want to remind you that our presentation today may contain forward-looking statements concerning our financial condition, results and expectations and that there are a number of factors that may cause actual results in the future to be different from our current expectations.

These factors include among other things, changes in general business and economic conditions, competitive pressures in the financial services industry, economic trends that negatively impact the real estate lending environment or legislative and regulatory changes that may impact our business.

For additional factors please see our press release and other documents filed with the SEC. With us today are Kerry Killinger, Chairman and CEO; Steve Rotella, President and Chief Operating Officer; and Tom Casey, Chief Financial Officer. At this time, I will turn the call over to Kerry. Kerry?

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Kerry Killinger

Well, good afternoon, everyone and thank you for joining us today, as we review our second quarter 2007 results. As Alan mentioned joining me today on the call is Tom Casey, our CFO, and our President, Steve Rotella will also be available to answer questions at the end of our remarks this afternoon.

Today we announced second quarter net income of $830 million, or $0.92 per share, up 16% from $767 million, or $0.79 per share in the second quarter of 2006. Earnings per share for the second quarter were also up 7% from $0.86 in the first quarter. I'm also pleased to announce that the Board once again increased the quarterly cash dividend for the 48th consecutive quarter by $0.01 to $0.56 per share.

Our overall performance this quarter, one again demonstrates the strength and momentum of our retail strategy which continues to fuel impressive organic growth and the benefits of our work to diversify the company. The ability to generate strong organic growth is I believe a hallmark of the most successful top tier performing companies.

Our commitment to innovation in products and services from our new WaMu Free Checking to WaMu Mortgage Plus to our efficient low cost commercial lending platform as well as our continued focus on delivering best-in-class service, helped drive several performance records for the second quarter. Our retail banking group hit another new record, opening over 406,000 net new checking accounts in the quarter.

In Card Services, we opened an impressive 928,000 new credit card accounts, also a record, and our Commercial Group turned in a record $4.3 billion in new loan originations, an increase of 18% over the prior quarter. We also saw improvement in the performance of our Home Loans Group, despite continued pressure from the challenging rate environment and ongoing weakness in the subprime mortgage market as well as continued erosion in the housing market.

Following on the heels of being recognized by BusinessWeek in its first ever ranking of the best 25 companies for customer service last February, where WaMu was the only bank to make that list, we were gratified to receive more recognition this quarter. In May following an extensive survey of U.S. consumers, WaMu was named by the reputation institute, as the bank with the best reputation in the U.S., and WaMu was the only bank included in its ranking at the top 50 best regarded companies in the country.

Then last month, WaMu was ranked number one in the Midwest and the West by J.D. Power and Associates into 2007 Retail Banking Satisfaction Study. All in all we delivered a solid performance last quarter in a difficult business environment. Our net interest margin was up 11 basis points in the quarter to 2.9%, reflecting the results of the portfolio repositioning we completed in the first quarter, as well as our ability to grow retail deposits while maintaining strong deposit pricing discipline.

The growth in our retail checking account base helped to drive depositor and other retail banking fees up 12% year-over-year. Increased credit costs, and the growth in credit card receivables held in portfolio lead to an increase in the loan-loss provision. The loss from our home loans business was reduced to $37 million, primarily from improved subprime gain on sale.

And finally, our continued focus on productivity and expense management helped us hold expenses essentially flat in the second quarter at $2.1 billion, and our expenses were down 4% from the prior year quarter.

In summary, we are pleased with how our business model is performing. We are tracking record numbers of new customers with our innovative products and then successfully cross-selling our customers products from across all our business lines. Great examples are sales of credit cards in our retail stores, which have increased from a run rate of 13 cards per store per month a year ago to 23 cards per store per month this past quarter.

Sales of prime home loans through our retail stores, the volume of which nearly doubled from last year's second quarter, and the sales of prime home equity loans through our home loans segment which now comprises a significantly larger portion of our total home equity production.

Now with that, let me comment just a little more in depth on the performance of each of our business units in the second quarter. I'll begin with our retail banking business. Our retail bank produced another strong quarter with net income of $558 million and record checking account growth.

While net income attributed to portfolio management improved modestly, an increase in credit cost, particularly in home equity lending, resulted in a higher provision for loan and lease losses, which reduced net income from the retail banking network.

An important fact to be aware of is the impact of the company's decision to limit asset growth on the retail bank. Average loans outstanding in the retail bank portfolio declined 18% over the past year. However, net interest income was down only 3%. This reflects solid deposit growth we achieved while maintaining strong deposit pricing discipline. The cost of retail deposits is now declined in each of the last three quarters, from 2.93% at the end of 2006 to 2.86% in the second quarter.

Meanwhile average deposits were up 5% year-over-year, and 1% from the prior quarter. As I already mentioned, we opened a record 406,000 net new checking accounts in the second quarter. An increase of 24% from the first quarter, and breaking the record set in the second quarter of last year. The results this quarter were particularly gratifying since the second quarter last year benefited from the first full quarter of our new WaMu Free Checking product.

Also net new households grew by 228,000 or 17% over the prior quarter. And home equity originations increased to $9.9 billion, surpassing last quarter's production by 19%. With the 1.2 million new accounts added to our retail checking account base in the last 12 months, depositor and other retail banking fees were up 12% year-over-year, or up 16% when the $21 million incentive payment from MasterCard is excluded from last year's second quarter fees.

Our efforts in small business continued to deliver good results. During the second quarter, we opened 69,000 net new small business checking accounts, up 19% from the first quarter and 26% from the second quarter of last year. Average small business deposits of $8.3 billion were up 20% year-over-year and contributed to overall retail deposit growth.

Average small business loans increased to $1.2 billion, a 74% increase from the prior year quarter. Wamu.com our online distribution channel continues to contribute significantly to our growth. In the second quarter we added 89,000 net new checking accounts twice the number opened in the second quarter of last year through this fast growing channel.

And according to a recent study published by wet metrics firm, comScore Networks, WaMu generated 35% of all new online checking accounts within our footprint markets, more than double that of our nearest competitor.

We also continued to open a significant number of savings, CD, and credit card accounts and other products online to meet the needs of our customers. We opened 11 new retail banking stores in the quarter and a total of 17 new stores year-to-date, and we expect to ramp-up our new store openings in the second half of the year.

We are currently targeting a total of around 100 at the low end of our projected openings of 100 to 125 for 2007, as we continue to exercise discipline around our new-store openings and take into account the strong growth in our online channel.

Our Card Services continued to deliver strong account and balance growth in the second quarter. During the quarter we added a record 928,000 new credit card accounts with strong performance across all channels. Credit card sales through our retail channel to WaMu customers accounted for about a third of overall sales.

At the end of the quarter managed receivables from WaMu customers totaled $3.3 billion or 13% of total receivables. Though, we feel we have significant opportunity within that customer base to grow. Now managed receivables of $25 billion at the end of the second quarter were up 18% year-over-year, and 6% from the prior quarter.

Net income of $141 million for the quarter was down from $256 million in the first quarter, reflecting the strong growth in receivables, the provisioning related to this growth, and lower income from securitizations. With managed receivables reaching $25 billion, up $1.4 billion from the prior quarter, that provision was approximately $125 million higher in the second quarter than in the first.

Credit quality remains strong in the quarter as we have seen in the past, we anticipate that both the delinquency and loss levels will increase as the economy slows, although the most important economic factor is unemployment which remains low at 4.5% nationally.

For the commercial group, net income of $113 million in the second quarter was up 35% from the second quarter of last year, and 20% from the first quarter, primarily due to an increase in non-interest income resulting from higher gain on sale from favorable hedging results. We do not expect similar strength in gain on sale in the third quarter.

Now as I mentioned, the commercial group delivered record loan originations of $4.3 billion in the second quarter, up 47% year-over-year and 18% on a linked-quarter basis, driven primarily by strong growth in multi-family and commercial real estate lending.

Average loans were relatively flat in the quarter, compared to the prior quarter but were up 23% from the same quarter last year, again, primarily due to continued growth in multi-family and non-residential assets, as well as our acquisition of commercial capital band core. Credit quality continued to be outstanding.

Turning now to the Home Loans business. I continue to be optimistic that the segment is on track to return to profitability by the end of the year. The second quarter net loss of $37 million was an improvement over the $113 million loss in the first quarter, and was due in large part to improve subprime results.

Subprime loss on sale of loans, and the decrease in the value of the subprime residual portfolio, totaled loss of $131 million in the second quarter or about half the $252 million in losses recognized in the first quarter.

Favorable MSR performance, the rollout of WaMu Mortgage Plus and our continued focus on growing originations through our retail and wholesale distribution network also contributed to the improvement in the segment's net income.

Our prime business continues to perform well and is profitable. Prime home loan volume was up a solid 7% for the quarter on a linked-quarter basis gaining ground from the seasonally low first quarter with most of the growth in fixed rate and hybrid ARM loans.

Gain on sale for this portion of the business remains strong reflecting solid sales volume of fixed and hybrid loans as well as better gain on sale rates. We continue to exercise caution, however, with regard to the subprime market and continue to take proactive steps to further reduce our exposure. We reduced our subprime volumes by 30% from the first quarter, and 70% from the second quarter of last year.

Now I'll have more comments on the housing market and subprime lending after Tom reviews the financials in more detail. Tom?

Thomas Casey

Thank you, Kerry. As Kerry said we are making good progress in all of our businesses. Including record customer growth rates in three of our four segments. We are also seeing the benefit of our efforts over the past 18 months to reduce our operating cost, improve service levels and proactively manage our asset liability mix and capital.

During the second quarter our return on assets equaled 1.05% up nicely from 88 basis points in last year's second quarter, and 95 basis points on a linked-quarter basis. We also improved our efficiency ratio in the quarter to 56.38% from 61.27% in last year's second quarter.

So now let's take a deeper look at the second quarter's financial performance. Halfway through 2007 our average assets are down 7% from 2006. The decline is primarily due to the asset repositioning initiated at the end of 2006 which resulting the sale of approximately $22 billion in low yielding assets.

Excluding the asset repositioning, assets have been relatively flat over the past 12 months. During this period, the yield curve has been mostly inverted and credit spreads have been very tight, and we have been very selective about new assets we add to our balance sheet.

The asset repositioning we did earlier in the year had a very favorable impact on our net interest margin contributing to an 11 basis point increase in the NIM to 2.9% in the second quarter. The short-term rates for the quarter remained pretty stable with three-month LIBOR remaining at 5.35%.

Though we continue to see some upward repricing of certain assets during the second quarter, the securitization of aged higher yielding credit card loans for the end of the first quarter resulted in yield on assets declining two basis points for the quarter. The NIM improvement for the quarter was driven by the liability side of the balance sheet.

Three things drove most of the 13 basis point decline in the cost of our liabilities during the second quarter. First, interest-bearing deposit costs were lowered five basis points, primarily due to significant reduction in the level of high cost brokered CDs.

Second, we lowered the average balance of high-rate federal home loan advances by $14 billion. As of the end of the quarter, we have reduced federal home advances by more than $22 billion since yearend.

And third, our non-interest bearing sources added four basis points, primarily driven by our continued success in Free Checking growth in the retail bank. During the second quarter, we saw the yield curve develop a positive slope as the long term rates increased. The five-year swap rate increased 59 basis points and the 10-year swap rate was up 61 basis points.

Adversely short-term rates remained unchanged and the forward curve projects that they will stay flat through the end of the year. A favorable impact of the increase in long-term rates was the lower than expected MSR hedging costs. MSR hedging cost were $21 million for the quarter compared to $124 million in the first quarter.

The improvement was driven in part by our long-planned conversion from a static valuation method to the option adjusted spread, or OAS valuation approach for MSR and in part by rising long-term interest rates which lowered mortgage prepayment fees during the second quarter.

The OAS methodology we adopted is consistent with the method used by most of our peers, and we believe it will improve the efficiency of our hedging strategy and lower the cost of our hedging in the MSR.

Now let me turn to credit. Market conditions are having a material impact on the performance of our home loan and home equity loan portfolios. We are experiencing rising MPAs and charge-offs due to the dramatic slowing in the home price appreciation in most parts of the country, and absolute declines in home values in some markets we serve.

We have and continue to monitor all of the markets we lend in and adjust our underwriting standards, based on changes in market conditions. During the first quarter, our non-performing assets were 1.29% of total assets at the quarter end, up from 1.02% of assets at the end of the first quarter.

The increase was primarily due to the higher non-accrual loans in our prime, subprime, and home equity portfolios. We also saw an increase in net charge-offs to $271 million in the second quarter, up from $183 million in the first quarter. The increase was primarily attributable to the subprime loan portfolio, where net charge-offs increased to $92 million from $39 million.

Home equity loans also saw an increase in net charge-offs to $52 million from $26 million. Both of these portfolios are seeing an increase in the severity of charge-offs, as housing values continue to soften across the country. Despite some challenging trends, overall home equity charge-offs remain within our expectations and we have mortgage, insurance and loans, where the CLTV is greater than 90%.

We expect the increasing trend of weaker home prices to continue in the second half of the year, and anticipate increasing loss of severity in both our subprime and home equity portfolios, which are most sensitive to falling home values. Despite the increase in non-accrual prime single-family mortgage loans, net charge-offs of those loans declined to $20 million in the quarter from $34 million in the first quarter.

While we anticipate that we will see higher MPAs across all of our home loan portfolios, we expect losses in the prime loans to be much lower due to the lower LTVs and high FICO profile of that prime portfolio.

At quarter end, our single-family residential prime portfolio had an estimated average current LTV of 56% and an average FICO score of 707. Our $29.3 billion multi-family loan portfolio continues to perform very well, with MPAs at a low of 24 basis points and no net charge-offs for the year.

We also continue to be pleased with the performance of our credit card portfolio, where 30-plus day delinquencies fell to 5.11% at quarter end from 5.15% at the end of the first quarter. And that quarter's managed credit losses remained in line with expectations at 6.49%.

In discussing credit quality, it's also important to look at the valuation of subprime residuals. During the second quarter, previously sold subprime loans underlining our residual interests continue to perform poorly. As a result, we recorded a $93 million downward adjustment in the subprime residual value, which is similar to the negative adjustment of $88 million in the first quarter. At quarter end the subprime residual balance was $79 million.

As we did last quarter, we have provided you with a comprehensive set of charts as an appendix to these remarks, which include additional credit statistics related to our loan portfolio.

The provision for loan losses of $372 million in the second quarter was up from $234 million in the first quarter, primarily due to an increase in provision for credit card loans. The 4% increase in balance sheet credit card receivables and an increase in the forecasted losses due to higher charge-offs and lower recoveries resulted in an increase in provision for credit cards to $229 million in the second quarter from $106 million in the first quarter, when on balance sheet prime receivables declined.

The increased provision for the second quarter also reflected the higher level of delinquencies and net charge-offs from our home loans portfolio that I just discussed. As we look forward, we expect those trends to continue and our provision level to increase. That expectation will be reflected in our earnings drivers that I am going to cover right now.

This update of our earnings drivers for 2007 reflects the current environment and our expectations for the remaining part of the year. First, average assets. Year-to-date average assets are down 7% or $25 billion from 2006. As I said, most of that decline was from our proactive asset repositioning to shed low-yielding assets.

Beyond that, we have also been extremely disciplined in adding assets during a period of very tight credit spreads and an inverted curve, and we think this discipline has positioned us well. With the transition to a slightly positive sloping yield curve in the second quarter, and some indication of wider credit spreads, we are cautiously optimistic about growing our balance sheet during the second half of the year.

But we remain cautions, and given our asset levels at the midpoint of the year, we now expect that average assets for all of 2007 will be between 5% and 7% lower than average assets of $349 million during 2006. We will remain disciplined in our asset management. If we are not able to find assets that meet our investment hurdles, we will instead deploy our capital through share repurchases.

We continue to be comfortable with our net interest margin guidance of 2.85% to 2.95%. We are pleased to be in the middle of our range with a NIM of 2.9% in the second quarter, as a result of our asset repositioning and deposit pricing discipline. However, with the forward curve no longer predicting any reduction in the short-term rates from this point, any NIM improvement will be more gradual as we continue to remix the balance sheet.

We are raising our guidance for credit provisioning, based on two factors. First is our expectation that credit costs will continue to increase as the housing market continues to slow, and we see further softening of housing values. Second is the strong growth of our credit card portfolio, which is above our forecasted growth, and requires a higher loan-loss provision.

Therefore, we are raising our forecasted credit provision by $200 million to $1.5 billion to $1.7 billion for the year. Given our year-to-date provision of $606 million, this forecasts an additional $900 million to $1.1 billion provision for the second half of the year. Our current guidance is based on our best thinking, regarding trends in loan delinquencies, foreclosures and housing evaluations at this time.

The retail bank has done a terrific job of adding a record number of net new checking accounts. That growth is reflected in the 14% increase in depositor and other retail banking fees over last year's first half. Given that performance and a continued strong customer growth, we are raising our guidance to 12% to 14%.

We are seeing benefits of our diversified business model coming through our non-interest income. Despite a very challenging interest rate environment, which has made asset growth difficult, we expect to continue to have increases in depositor and other retail banking fees and credit card non-interest income.

In this quarter we also had a significant decrease in our MSR risk management costs, which is included in non-interest income. Given these trends, we are increasing our non-interest income guidance by $200 million to $6.9 billion to $7.1 billion for the year.

Finally, on expenses, one of our business goals is to drive revenues at twice the pace of expenses. Better yet, we like to fund our growth through improved operating efficiency. We continue to do this by keeping our expenses essentially flat and we remained very comfortable with our full-year non-expense guidance range of $8.4 billion to $8.5 billion for the year.

I'll now turn it back over to Kerry for his closing comments.

Kerry Killinger

Thanks, Tom. I would now like to let you know about some important changes we are making in our subprime mortgage business.

You know it's been over two years since we first began talking to you about housing prices becoming inflated and the highs risk of a slowdown in housing with price declines in some parts of the country. As a result, we started to take actions to minimize our exposure, including tightening our underwriting, selling off the 2004 and 2005 subprime residuals, delaying our plans to grow our portfolio subprime loans and consciously decreasing our market share of new subprime originations. In fact, as I noted earlier, our volume is down 70% from a year ago.

Now, you may also recall that back in April we announced a $2 billion commitment to help our subprime customers who are current in their payments, but are feeling the effects of this challenging environment. Our goal is to help these customers stabilize their finances and avoid foreclosure. And I'm pleased to say that this program has been well received.

While today, we're taking another important step to adjust our subprime lending products and practices for new customers to reflect the current difficult conditions, especially softening housing prices. Effective immediately, we are implementing new industry-leading subprime mortgage leading standards.

First, we will no longer offer subprime stated income loans. In other words, we will only offer full income documentation subprime mortgage loans. Second, we will not offer subprime adjustable rate mortgage loans with initial fixed rate terms of less than 5 years, effectively eliminating the 228 and 327 products.

Third, we will require tax and insurance escrow accounts with all new subprime mortgage loans we originate. And fourth, we will offer industry-leading disclosures and enhanced outreach efforts, including preclosing contact by WaMu with the borrower, even when the borrower has been represented by a broker.

Now I want to emphasize, that we remain committed to providing subprime loans to credit-worthy borrowers, and that we believe these changes are the right thing to do for consumers to help them purchase and stay in their homes. It's also prudent for our business.

Finally, I wish to commend the efforts of our regulators to strengthen the mortgage industry, through their newly issued subprime lending guidance. We fully support this guidance and believe it's the step in the right direction. However, we also strongly believe that this type of guidance must apply to all subprime mortgage originators, if we are ever going to bring about a positive, meaningful change to this vital segment of the mortgage industry.

To this end, we urge our regulators and our elected official, to continue to work towards creating a level playing field among subprime originators. In doing so, we believe it will help bring much needed discipline and integrity, back to the subprime mortgage industry. I also want to challenge subprime mortgage investors, to require all mortgage originators to adopt similar standards that are disciplined and appropriate for this current market environment.

Now, before we take your questions, I like to invite you to join us in Seattle for our upcoming Annual Investor Day. We’ll be holding it on Thursday and Friday, September 13th and 14th. We will get started at 3:00 p.m. on the 13th and be finished by early afternoon on the 14th. Our focus this year will be on the strength and opportunity of our retail strategy. Then, of course, Tom will be giving you first look at our 2008 earnings guidance.

More details and instructions on how to register, will be available in the coming week. As you make your travel arrangements, remember we typically have very nice weather in September in the northwest, so you might want to consider staying over the weekend.

With that, Tom, Steve and I will be happy to take your questions.

Question-and-Answer Session

Operator

We will now begin the Q&A portion of today's call. In consideration of the number of participants who have joined us on today's call, we will accommodate one question per caller. We will get to as many questions as time permits. (Operator Instructions) Your first question comes from Bob Napoli of Piper Jaffray.

Bob Napoli - Piper Jaffray

Good afternoon. Thank you. I've asked this question before, it's a strategic question, on the mortgage banking business, the subprime business. And just wondered if there were any updated thoughts, broadly what your thoughts are, Kerry on. The importance of those businesses to WaMu, Washington Mutual on a long-term basis? Is that something that you need to be into? Or is it something that you feel is taking away the attention of the good the things going on elsewhere in the Company?

Kerry Killinger

Well, thanks, Bob. Appreciate the question. And, certainly we do feel good overall that the quarter was solid, and particularly strong growth in our retail distribution powerhouse. And that's really what’s driving the company right now.

I think in terms of your specific question regarding the mortgage banking business, we think that it's an integral part of our company, and isn't -- is a very important product line for our customers, and it can be an excellent business for us long-term.

I would say the evolution of the operation for us, will move ever increasingly towards the importance of being a source of originating loans for our portfolio. And so, both the prime and the subprime loans that can go to our portfolio is a very high priority.

I would also note that on channels of distribution, that our retail channel, I'll define that broadly as originating mortgages through our retail branches, and through our home loan centers, and through our call centers, is -- is perhaps the most powerful part of the distribution strategy that we have.

Yes, we'll continue to be involved in the wholesale business, but the real driving force of our company is really around, how to maximize these cross sales of products through this powerful distribution network, that we have put together.

So, in summary, I think the mortgage business gives us a very important product for our balance sheet. I think done correctly it can be profitable. Number three; it's really moving with an increasing emphasis around the retail distribution. And again, I think the folks in our home loans group are doing a good job of guiding that revised business strategy that we first implemented about a year ago towards the direction we wanted to go.

Bob Napoli - Piper Jaffray

Thank you.

Operator

Thank you. Your next question comes from Bruce Harting of Lehman Brothers.

Bruce Harting - Lehman Brothers

Yes, can you -- one of the competitors in the ARM lending space in California experienced pretty heavy prepays, and then looked like their prepay penalties -- they’ve anniversaried the one or two year time period. You didn't seem to have that problem at all. And, it seems like you were able to continue to maintain an orderly flow, even though your subprime is way down, that which you did originate. You seem like you are selling, or sort of orderly change in the residual.

So, can you comment on those? It seems like you’re -- it came through the quarter a lot better than some of the competition on that. And then, also on the continued G&A line, there was one specific, side of telecommunication. You seem to be able to keep grinding down the occupancy and equipment and telecom costs. And, how are you doing that? And is that part of the continued expense reduction? Thanks.

Kerry Killinger

Great, I think, this is Kerry again. I think I'll ask Steve to cover the G&A question, and some of the progress we are doing on the operating front, and then Tom can come back and talk about the ARMs.

Stephen Rotella

Yeah, Bruce on the expense side, we are pleased that we held expenses relatively flat in the quarter. And I'll just tell you in general, we have a process around the company to get each business, and each corporate area focused on productivity matrix and driving towards best in class.

In addition, we have focused the center, we are using tools like our OpEx program, which is sort of our version of Six Sigma. And a lot of focus on the utilization of our real estate across the country, both sharing real estate across businesses, are one of the key thrusts in the company, across enterprises to both cross-sell on the revenue side.

But on the expense side, also to share facilities and move focus to low-cost locations, which continues, domestically, San Antonio, and offshore in a number of our locations. And that trend has continued and increased in the second quarter, and we're also getting the benefit of all of the work we did last year.

Thomas Casey

And Bruce, on the prepay, we have not seen any significant change from first quarter second quarter on our prepayments. We are seeing a decline and optionize on our balance sheet, its down about $4.6 billion for the quarter. That's been a continued trend as the curve has been quite flat and consumers are moving into more hybrid and fixed rate products. So, no change really in the impact from prepayments.

Bruce Harting - Lehman Brothers

Okay. Thanks. I'll get back in line.

Operator

Thank you. Your next question comes from Brad Ball of Citigroup.

Brad Ball - Citigroup

Thanks. Yeah, I also have a two-part question. Tom, could you talk about your allowance and the adequacy of your reserves? It seems fairly significant increases in net charge-offs in home equity, up about 100% in subprime, up 2.5 times in the quarter. But you only increased the reserve by about $20 million.

And then the second question is more strategic, and that is, Kerry when you talk about cross selling in retail, is there any product that you don't have that you'd like to have or any area that you need to enhance? And would you consider doing that through acquisitions? What’s your acquisition strategy at this point in the cycle?

Kerry Killinger

Okay. This is Kerry. I'll cover the second one first. Certainly, we are very pleased with the results that we had with the Providian acquisition. I think it met or exceeded virtually every target that we set forth when we made that acquisition. And as you recall, part of the logic was to have an additional product line that we could sell through this powerful retail distribution system that we have now set up.

And that's really taken off, and we’ve seen that with a growth in receivables now to $3.3 billion from WaMu customers. We're seeing 1/3 of all Card Services new accounts coming from WaMu customers, and -- we’ve, again, seeing the number of cards sold on a per-store basis, grow pretty dramatically from a year ago. So that model really works well.

I would say as we look for acquisition opportunities, we would love to find something similar that gave us product extension that we could distribute through this powerful distribution capability.

Ideal situations are those that, again, have very strong operations, that they bring managements that are very capable of driving those businesses to us, and ones that certainly fit the customer demand profile that our customers might have.

So, I think this is something we are constantly looking for. It's as you know, it's very challenging to find opportunities that meet our stringent financial requirements, but if we can find them, we would certainly consider it.

Thomas Casey

And Brad, this is Tom. On the -- your comments, we are seeing increased charge-offs and delinquencies, as I mentioned in my prepared remarks. Keep in mind that the provision is a -- has been building for quite some time, we have been providing above charge-offs for the last five quarters.

This is not something that immediately is reflected. We are actually looking at this over quite some time so we have been building for this. We are trying to give some perspective that we expected to charge-offs to continue.

But keep in mind that our provision models and our reserving model taken into account all of this information. One other thing to keep in mind is that the balance sheet did not grow this quarter, in fact loans were down, which is also contributing to that provision level.

And then finally, I just point you to the allowance as a percentage of total assets in the health for investment portfolio it actually went up from 71 basis points to 73.

Brad Ball - Citigroup

Is that 73 about where you want to stay Tom?

Thomas Casey

I think it's going to be dependent upon where the environment is and how we see the housing market unfolding over the next few quarters. If the housing market was to continue to deteriorate further than what we're seeing that number may continue to go up.

Brad Ball - Citigroup

Okay. Thanks.

Thomas Casey

I think I tried to capture that expectation in our provision guidance. In our earnings driver, we raised that up $200 million from the quarter, and that's up from where I told you in the first quarter, so it's the second time we've increased that this quarter -- I mean this year.

Kerry Killinger

Brad, this is Kerry. I would just add, you might want to take a look at WM 1, which under the asset quality where we show for the last several quarters the provisioning as well as the charge-offs, and you can see that over the period that's shown there, that there has been a substantial provisioning in excess of charge-offs over the past five quarters.

And, again, I think it is important as you kind of compare all of these, not necessarily to look at just one quarter, but look at the overall trending that we have done in terms of increasing the provision at an appropriate level to the changes in the credit environment.

Brad Ball - Citigroup

Thanks.

Operator

Thank you. Your next question comes from Eric Wasserstrom with UBS.

Eric Wasserstrom - UBS

I guess this really follows on Brad's question, but I noticed now that your intangible equity is above 6% and typically that's proved to be an upper bound for you. So what are your thoughts now about capital utilization?

And particular with respect to the fact while -- I guess this is a related topic, but given that the difference between capital and reserves in many ways is an accounting fiction, and while you've provisioned ahead of your charge-offs your reserve actually I think grown that much in dollar terms, is there any relationship between those two in terms of keeping excess capital into a weaker credit environment?

Thomas Casey

No, I don't think there's a linkage there, Eric. I would say that we have had a long-standing practice of being disciplined about deploying our capital. We did buy back another $500 million of stock in the second quarter.

We will continue to evaluate deploying that in balance sheet growth, we expect a little more growth this quarter, it didn't come through, and so if we don't see opportunities to grow the balance sheet in the second half, you should expect us to continue to buy back our stock.

Eric Wasserstrom - UBS

All right. Thanks.

Operator

Thank you, your next question comes from Chris Brendler of Stifel Nicolaus.

Chris Brendler - Stifel Nicolaus

Hi, good evening. Can you -- one quick follow-up on the reserving question, and then a related question, the year -- I guess the charge-off issue is one thing, but what is striking me as alarming is the increase in MPAs and if I look year-over-year or even sequentially that reserve ratio doesn't come close to matching the increase in MPAs.

So I guess, where do you think, given what is happening on the non-performing asset side, where do you think you may need to build reserves to if housing continues to deteriorate? Can you give us a downside scenario there?

And then also, maybe can you comment on the strong trends you saw in the credit card portfolio? It seems a little counter intuitive to a lot of people's conventional thinking. Maybe if you could address any trends you're seeing beneath the surface in the credit card book on the credit side?

Thomas Casey

I think I have covered a few items on the MPAs already. We did see increases in MPAs in all of our real estate areas. The prime was up about 300 million, that's a very large portfolio, and we don't expect significant amount of charge-offs to come through. In fact, charge-offs for the quarter were down quarter-over-quarter. We do expect NPLs to continue to go up though in home equity and in subprime, and again, I'm trying to give you an indication that we do factor in this deterioration of these ratios into our provisioning and reserving guidance that we have given you.

The fact that we haven't been growing the balance sheet in some of these areas, some of these more recent vintages have performed quite poorly and so we feel pretty good about our portfolio, but they are go to escalate, we expect them to continue to increase, and we're trying to give you guidance in then and our earnings driver by increasing the provision by another $200 million.

Kerry Killinger

This is Kerry, I would just add on the second part of the question, the primary reason we're seeing increasing delinquencies in credit cost in prime, subprime, and home equity loans, I think it relates to the deceleration of housing price increases, and more recently, declines in certain markets, and certainly that is reflected, then, in our expected losses in the amount of provisioning that we're -- that we're putting forth. I think it’s relates to the credit card, the principal driver of losses in the credit card is employment, and people's jobs.

So with the unemployment rate relatively low at 4.5%, and with the economy in growth territory for the U.S., it's not surprising that credit card receivables would continue to perform very well. So there's quit a disconnect, I think, as to the primary factors causing delinquencies to rise in housing-related assets -- products versus the credit cards.

Chris Brendler - Stifel Nicolaus

Okay. One quick follow-up, if I could, just kind of quickly on the deteriorating MPAs relative to -- relatively stable or improving prime gain on sale margins?

Thomas Casey

Well, I think that the current gain on sale margins in the current quarter we are seeing improvement in that. I think there's a bit of a flight to quality, so the gain on sale in both fixed rate and hybrids is improving.

As far as how that relates to non-performing assets, there is a kind of disconnect between what we're seeing, a lot of these MPAs have been on the portfolio for one and two years, type of maturity before they get into this type of MPA situation, so there's really very little linkage. I think the gain on sale margins are reflecting what people's expectations are of losses in the future.

Chris Brendler - Stifel Nicolaus

Okay. Thank you.

Operator

Thank you. Your next question comes from Fred Cannon of KBW.

Fred Cannon - KBW

Thanks. Good afternoon. This question is really for Steve. We saw strong growth in the number of non-interest bearing checking accounts, and again, strong fee growth, but the balances of non-interest bearing actually dipped a bit, linked quarter. I was wondering if you could comment on that, and if you have any strategies to see if you could get the deposits as well as the fees to start growing?

Stephen Rotella

First of all, Fred, as you and I have talked in the past, we really look at growth in households and retail as our first indicator of success. I know you are going to issue your report card at some point after this. We feel really good about the growth in households, we feel really good about the growth in checking accounts, and obviously there's some timing in building those accounts as they open.

We had 404,000 new accounts in the second quarter, which is a record for us. And there is some development in those accounts as you move forward. So we feel very good about that, and obviously we also had an increase over all in non-interest bearing deposits our growth has been 1.3% since December.

1.3 billion, sorry, since December. Also, and Kerry talked about cross-sell, we use that account as the foundation for cross-selling in the future, and as you have seen the ratio of our cross-sell has gone up, and we think that bodes well for the rest of this year and into the future.

Fred Cannon - KBW

Thanks, Steve. There is any kind of guidance you can give us in terms of the when you see the number of accounts ramp-up, and how long it takes before they get to kind of a full deposit level?

Stephen Rotella

No, Fred, I don't think we would be able to talk about that.

Fred Cannon - KBW

Okay. Thank you.

Operator

Thank you. Your next question comes from George Sacco of J.P. Morgan.

George Sacco - J.P. Morgan

Hi. I actually want to go back to the reserves. Actually, I'm a little confused. I want to see if you can help me with something. It looks like your total provision was about $372 million. And if I look at your segment disclosure, it appears that the provision for the credit card portfolio on balance sheet was $229 million.

And that would imply that you only had about $143 million or so of additional provisions, and that compares to $180 million of net charge-offs excluding the credit card portfolio. I'm just wondering -- I guess, first, am I doing that math right? And just secondly, can you just explain how you can under reserve that way, given the trends in MPAs and charge-offs?

Thomas Casey

Sure. Your numbers are right, George, and I think that's the right math. We did have provisions below charge-offs, as Kerry, mentioned its first time we had that in actually six quarters. And just to refresh your memory, that we're trying to anticipate and project provisions well before we actually see the actual escalation like we're seeing now.

So these reserve models are capturing lots of different factors. The current delinquencies and MPAs, you must keep in mind that they go 30-day delinquency and 60-delinquency, we already are picking them up in our models, so that early stage delinquency information has already been picked up, and that's why you're seeing the reserves above charge-offs in the previous quarters.

So when you actually see the higher charge-off, what you are starting to see is just the evolution of that, maturity of that delinquency rate that we're putting into our models. And that's why we provisioned above charge-offs in the past, because the charge-off hadn't come yet, yet we anticipated it.

And so there's I think it's incorrect to be thinking that charge-offs and provisions should be linked. There's a lot more factors that come into play and it's built over a longer period of time, based on early indicators of loss as opposed to the ultimate charge-off, which is sometimes 180 days after we're seeing the early stage delinquency.

George Sacco - J.P. Morgan

And then just one quick follow-up on the gain on sale, you are saying that during the quarter you did see gain on sale margins is trending higher; is that correct?

Thomas Casey

On the prime side yes. The biggest driver for the quarter, however, was the gain on sale improvement from subprime.

George Sacco - J.P. Morgan

Subprime.

Thomas Casey

Which we obviously last quarter we have a significant write down in our loans held for sale, and this quarter we didn't experience that. And so, we had a large improvement in the gain on sale on subprime.

George Sacco - J.P. Morgan

Okay. Thanks.

Operator

Thank you. Your next question comes from Bob Peck of Fremont Group.

Bob Peck - Fremont Group

Hi, Kerry, I just wanted to ask, over time you've been very opportunistic in allocating capital in and out of the asset classes that are either very attractive or not attractive at all. And well, I understand you are tightening underwriting standards and why your subprime originations would be going down as they are.

I am just wondering if there's anything that you are looking to do or how actively possibilities are that you are considering of allocating capital to some areas of distress within the subprime area, if there are particular assets, or whether it's buying back residuals or looking at a myriad of options for taking advantage of some of the distress that other players seem to be in now?

Kerry Killinger

Well, thanks, Bob. Let me give you just a little bit of perspective around that question and my answer. From my point of view, I think too much money, and some would say just irrational money, did flood the mortgage market, particularly in the subprime area over the last two years.

And I think this caused underwriting standards to decline, credit spreads to narrow, volumes to surge, and now not unexpectedly delinquencies and losses to sore and this was a real concern of ours, and where we took a lot of defensive actions beginning about two years ago, like tightening underwriting, selling off our '04 and '05 residuals, delayed our plans to grow the subprime portfolio, so that capital allocation question you mentioned.

We cut our origination market shares, as I said they were down about 70% from the second quarter versus a year ago.

I think now what we're seeing is, some underwriting discipline starting to return, our credit spreads are widening, and marginal players are leaving the industry. And I do think this gives us an opportunity to gradually increase our loan portfolios, with much improved risk adjusted returns.

So I think -- I do think we're watching the subprime area very carefully. We think the industry has a lot more to go in terms of tightening underwriting to be appropriate for today's underwriting environment. That's why I mentioned the initiatives that we've taken to help lead the industry to what we think is much more prudent and appropriate underwriting standards at this point in the cycle.

And assuming we start to see credit quality improve because of these underwriting initiatives, and if we see credit spreads widened and good opportunities to take assets in our portfolio, we would like to start accelerating the growth of our balance sheet again.

So, on a broader basis beyond subprime, the last 12 months, we basically have reduced our balance sheet, we've used our capital predominantly for buying back stock, we've invested most of our marginal capital into growing our retail distribution system. As the environment changes, as credit spreads widen, as the yield curve starts to steepen a little more, I could see us getting much more aggressive in growing the balance sheet.

We'll just have to see what the environment brings over the next few quarters. But it's certainly looking like a better environment to grow the balance sheet in the past 12 months.

Bob Peck - Fremont Group

Great. Thanks, Kerry.

Operator

Thank you. Your next question comes from Moshe Orenbuch of Credit Suisse.

Moshe Orenbuch - Credit Suisse

Hi. Could you talk a little bit about the pipeline hedging game that was discussed? And there was mentioned somewhere of a change in methodology, was that the result of that gain, was that a result of a change in methodology?

Thomas Casey

No. There was no change in methodology. What we were saying is that the loans held for sale in the commercial business, we hedged a interest rate risk. And with interest rates moving up, we had a low-come on the loan, so we couldn't write the loan up, and we had the benefit in the hedge.

So you have got a situation where you just have a timing between second quarter and third quarter, as we were trying to…

Moshe Orenbuch - Credit Suisse

Okay. And what would the effect on the third quarter be then?

Thomas Casey

We're not sure exactly what the sales volumes is and what the spreads will be. But for this quarter it was approximately a $70 million benefit and that sits in other non-interest income. That's pre-tax.

Moshe Orenbuch - Credit Suisse

Thank you.

Operator

Thank you. Our next question comes from Howard Shapiro of Fox-Pitt Kelton.

Howard Shapiro - Fox-Pitt Kelton

Hi, two questions if I could. The first is, can you tell us how your option ARM portfolio in particular is performing relative to your expectations?

And the second question is following up on Fred's question earlier, the growth in deposit accounts and households is much stronger than I expected. Can you just give us some color around that? Are you just doing what you have always done, but doing it better? Are you doing something different than you've done in the past? Can you just give us some color?

Kerry Killinger

Let's let Steve handle the second question first.

Stephen Rotella

Yeah, I mean, we have a great retail franchise, and we have the best free checking product in the country, WaMu free checking, which we launched last year.

Third, we have a number of distribution channels for our customers to use, as Kerry mentioned early on. We had a record checking growth, 89,000 of those accounts came from online, our branch system. We have our phone system. So, it really is the power of the franchise and our people. Kerry mentioned earlier, we've won a number of awards around service, all of these things go into creating the kind of retail environment where customers want to come us to.

I would also mention, and I'd follow up on the question that Fred had earlier, a little more data, our average non-interest balances are actually up 3.5% year-on-year, and at the end of the quarter they were down somewhat, that's due to the timing of tax payments.

So, I would say, in answer to your question, it's a whole lot of thing starting from great people delivering great services with great products and we are out there attracting customers, and I think leading the industry in many ways and continue to focus on improving that franchise.

Howard Shapiro - Fox-Pitt Kelton

Great, and on the option ARMs?

Thomas Casey

On the option ARMs we really have not seen any differences other than the balance sheet run off I was telling you about. Assets are down about 4.6 billion in option ARMs, no change in credit, to speak of.

Even the amount above the original principal amount is starting to slow. It's only up 180 million this quarter. There's really, we feel very good about our option ARM portfolio and how it has performed. It's a very high FICO and low LTV portfolio.

I would point you to the back of the press release and see some of the statistics we break out on that portfolio.

Howard Shapiro - Fox-Pitt Kelton

Great. Thanks very much.

Operator

Thank you. Your last question today comes from Larry Batali (ph) of Moore Capital.

Larry Batali - Moore Capital

Hi. I'm glad I got it in. Yes. Let's see, I think Tom, you said something very interesting about loans that have been on the portfolio for one to two years before they are going non-performer, and I'm wondering if you can go into a little bit more detail about the profile of the loans? And why seasoned loans are going on to non-accrual status? Because I think for most of the loans that we see in the market it's the newly originated loans, especially the purchase loans that are causing those problems, and as loans season people get more comfortable with the credit quality, you're telling us that your portfolio is experiencing something different from that.

Thomas Casey

Yeah, Larry and I probably misspoke. What I was referring to is that, when we do our reserving methodology we're looking at multiple data points in order to come up with our provision, I was trying to indicate that it's not a point in time it's built up overtime. And so, what I was trying to refer to is that these loans that are been in our balance sheet for one or two years have a provision associated with them to the extent that they are going into a delinquency status.

Larry Batali - Moore Capital

Okay.

Thomas Casey

Just to clarify that for you. But having said that, to your point on translating into why the MPAs are going up, I think somewhat of, a couple of things, one, is with the significant decline in home price appreciation or at least declines in growth, that is putting some pressure on certain borrowers that are having difficulty refinancing or making their payments.

Larry Batali - Moore Capital

Okay. Can you give us some feel as to the severities -- the loss severities that you are experiencing in subprime and home equity?

Thomas Casey

I would say that the severity in home equity and subprime are up. I indicated that in my prepared remarks. As home price appreciation declines and in some areas, more so than others, we're seeing severity rates increase as you would expect.

Larry Batali - Moore Capital

Okay. Can you quantify them or would you contemplate quantifying them and disclosing that in the 10-Q?

Thomas Casey

I think it varies so significantly by individual MSA and individual type of loan, that it's quite hard to put a generalization around it. I think it's important to look at each individual loan and geography in order to kind of give you a perspective, and that's obviously quite challenging when you have got the number of loans we have.

Larry Batali - Moore Capital

Sure. And just two more things. Your loan modification program; what sort of take-up have you seen on that? And if somebody rewrites a loan from an 8 or 9% rate into a 3 or 4% rate, what are the financial implications for Washington Mutual, if something like that happens?

Thomas Casey

That's very different than a straight modification that we have been talking about. Our $2 billion program is getting off to a good start. It's very early. We're working with a number of borrowers. We're not doing the types of transactions you're referring to. These are current loans, and trying to get in front of a potential reset that can keep the borrower in the house.

Larry Batali - Moore Capital

Okay. And then finally, this is my last question, on July 10th, so it was last week, S&P put 612 classes of RMDS, backed by subprime Claron on negative watch. And one of issuers that they highlighted was Long Beach, and I'm wondering what the implications of their actions were or might be in the coming quarters for your company?

Thomas Casey

I think we've been talking about that really going back to the fourth quarter. What you're seeing in the downgrades, we reflected in the reduction in the valuation of residuals. We have already taken a lot of those residuals down to zero.

As I mentioned, the residuals on our balance sheet right now are 79 million. And the amount that we had on at the end of the first quarter of 105 is down to about 20. So you can see the value of the residuals is declining rapidly to reflect the performance of some of those trusts.

Larry Batali - Moore Capital

Do you own any of the lower rated credit pieces, the bonds?

Thomas Casey

We do not hold them, but we usually hold the residual, and that's been typically written down to mark-to-market.

Larry Batali - Moore Capital

So you don't hold any of the bonds in your deals?

Thomas Casey

To say that I can give you an authoritative, absolutely not, we may hold a small piece, but it's not material.

Larry Batali - Moore Capital

All right. Great. Thank you so much.

Alan Magleby

Kerry, you want to wrap it up?

Kerry Killinger

Thanks, Larry. Again, once again, thanks, everyone for the questions. Would remind you again, to, if at all possible, join us for Investor Day on September 13th and 14th. And finally, if you have follow-up questions, feel free to call our Investor Relationships Group. Thank you all.

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