Washington Mutual, Inc. Q3 2007 Earnings Call Transcript

| About: WMIH Corp. (WMIH)

Washington Mutual, Inc. (NYSE:WM)

Q3 2007 Earnings Call

October 17, 2007, 5:00 PM ET


Alan Magleby - Sr. VP, IR

Kerry K. Killinger - CEO

Thomas W. Casey - CFO and EVP

Stephen J. Rotella - President and COO


Paul Miller - Friedman Billings Ramsey & Co.

Chris Brendler - Stifel Nicolaus & Company Inc.

Eric Wasserstrom - UBS

Frederick Cannon - Keefe Bruyette & Woods Inc.

Jim Benson - Harris Associates

James Fotheringham - Goldman Sachs

David Hilder - Bear Stearns & Co.

Adam Yale - Red Cedar Capital

Gary Gordon - Portales Partners

Tom Mitchell - Miller Tabak


Good afternoon, and welcome to WaMu's Third Quarter 2007 Earnings Conference Call. All participants are in a listen-only mode. After the presentation we will conduct the question and answer session. Today’s call is being recorded for replay purposes. The replay will be available approximately one hour after the call has ended today. The toll-free number to access the replay is 800-584-7315. 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 call.

Alan Magleby - Senior Vice President, Investor Relations

Good afternoon, and thank you for joining us today. I would like to welcome you to one WaMu's third 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 and market 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, Financial Officer. At this time I will turn the call over to Kerry. Kerry?

Kerry K. Killinger - Chief Executive Officer

Well, good afternoon, everyone. And thank you for joining us today as we review the results of what was a very challenging third quarter.

As Alan mentioned, joining me today on the call is Tom Casey, our CFO, who will discuss our quarterly performance in more detail and update our 2007 earnings drivers. We will be discussing earnings drivers for 2008 at our Investor Day on November 7th. Our President, Steve Rotella, will also be available to answer questions at the end of our remarks this afternoon.

As we announced on October 5th, our results for the third quarter were significantly impacted by further weakening in the housing market and capital market disruptions. Our loan loss provision of $967 million for the quarter increased from $372 million in the prior quarter. In addition, our quarterly earnings were negatively impacted by valuation adjustments across several asset classes. And as a result, our third quarter net income of $210 million, or $0.23 per share, was down from $748 million, or $0.77 per share in the third quarter of 2006.

Yesterday, the Board of Directors declared a dividend of $0.56 per common share for the quarter. The Board of Directors considered a variety of financial factors, including the company's earnings, capital and liquidity position. These same factors and considerations are reviewed by the Board each quarter.

Before I go into detail regarding the performance of our business operations, I’ll make a few comments regarding the market environment we experienced during the most recent quarter. From time to time, financial markets go through periods of significant volatility and disruption, such as we recently experienced. It is during these periods that a company’s assets, capital and liquidity management capabilities are tested. I’m very pleased with how we’ve managed the company through this period of stress. Our retail deposit franchise remains strong, providing us with a stable and a reliable source of funding for our assets, and our management team has spent much of the last year diversifying our borrowing sources and proactively addressing the rapidly changing market conditions.

I also think it is important to understand that the impact on our earnings of the severe market conditions was twofold; one, transitional and the second, more long-lasting. First, as Tom will review in detail, was the impact of market illiquidity for mortgage and other financial instruments during the quarter. This impact resulted in market value losses in the quarter, most of which are not cash losses and generally are expected to be accreted back into income over the life of the related assets.

The second factor impacting earnings was an acceleration in the downturn in the housing markets. We first became concerned about a potential housing bubble in the summer of 2005 and began then preparing for a correction. As you can see from the housing price appreciation chart in our prepared remarks, the correction has been much more dramatic and rapid than the build-up. We now know that many markets, such as Florida and California, are experiencing price declines. But when you look at the situation two years ago, indications were that a correction in housing would likely be softened by continued good economic growth and employment, as well as historically low interest rates. While in the third quarter, the so called soft landing quickly transitioned to a severe downturn as conditions in the capital markets deteriorated and home prices fell.

We are proactively managing delinquencies in our home loans portfolio with a focus on keeping as many of our borrowers as possible in their homes. We have staffed up our loan servicing groups, and implemented several outreach programs especially for our subprime borrowers. As Tom will review with you later, the factor we expect to exert the greatest influence on the level of losses as we work through this period is home prices. We will continue to monitor them very closely.

Now, let’s look at the performance in each of our business units.

I’ll begin with our Retail Banking business which continues to drive strong net checking growth. During the third quarter the retail bank added over 310,000 net new checking accounts, bringing the year-to-date total to over 1 million and achieving in nine months our stated goal of adding more than one million net new accounts for the year. While customer growth and fee revenue growth continue on track, weakness in the housing and credit markets resulted in a $227 million increase in the Retail Bank’s loan loss provision for the quarter, depressing the segment’s net income for the quarter to $453 million, compared to $555 million in the third quarter of last year.

Our Retail Bank continues to drive solid household growth through all of its products, in stores and online, growing retail banking households 8% year over year and increasing the cross sell ratio to 7.13 from 6.55 in the third quarter of a year ago.

Our small business program continues to deliver good results, adding 69,000 net new checking accounts during the third quarter and increasing average deposits to $8.8 billion up 22% from the third quarter of 2006.

We continue to invest in growing our Retail Banking channel, opening 10 new retail stores during the quarter. However, we are also very focused on ensuring that each of our stores remains profitable and cost effective. As a result, during the third quarter we consolidated 33 stores, about half of which were acquired last year as part of the CCBI acquisition. Now in the fourth quarter, we expect to have net openings of about 50 stores.

Card Services continues to drive record account growth in the third quarter adding 945,000 new credit cards accounts, with solid account growth in all channels. The sale of retail accounts to WaMu customers continues to account for approximately one-third of all account growth year to date. Our period end managed receivables of $26.2 billion were up 5% from the second quarter and up 18% from the prior year.

Net income for the third quarter of $102 million was down from $141 million on a linked quarter basis, primarily due to a $65 million valuation adjustment in retained interests. This write-down was primarily driven by higher discount rates associated with the market disruption during the third quarter.

Credit continues to perform within our target for risk-adjusted returns. At 5.73% of period end managed receivables, the 30-plus day managed delinquency rate was up from 5.11% in the prior quarter reflecting, in part, seasonal trends. Net credit losses of 6.37% were down slightly from the second quarter, as the third quarter’s substantial growth in managed receivables more than offset an increase in charge-offs.

The Commercial Group continues to deliver good results, despite being impacted by capital market volatility in the third quarter. Net income of $54 million was down from $113 million in the prior quarter due to the decline in non-interest income. The $34 million loss in non-interest income was primarily due to a $21 million loss on sale of loans, net of hedging, which included an $8 million negative adjustment to the carrying value of $2 billion in loans moved from held-for-sale to the held-for-investment portfolio. This compares with second quarter non-interest income of $62 million, which included $63 million in gain on sale. And as we noted during last quarter’s earnings call, non-interest income in the second quarter reflected favorable hedging results. Now third quarter loan volume of $4.1 billion was down somewhat from the record volume of $4.3 billion in the second quarter, but remained very solid.

The capital market disruptions in the third quarter had the most significant impact on the performance of our Home Loans group. The segment incurred a net loss of $348 million in the third quarter compared to a $37 million loss in the second quarter. The Home Loans provision for loan losses increased by $222 million from the prior quarter, due to further weakness in the subprime portfolio and the movement of loans we would have held-for-sale under normal capital market conditions to the held-for-investment portfolio in this segment.

The decline in non-interest income for the third quarter reflected the company’s net loss on sale of $222 million compared to a second quarter net gain of $192 million on sale of mortgage loans. The third quarter loss included $139 million in negative adjustments to the carrying value related to the $15 billion of home loans moved to the investment portfolio as well as other home loan sales and risk management activities that were also impacted by the market disruption during the quarter. Partially offsetting these losses were stronger MSR valuation and risk management results of $222 million for the third quarter, compared to a loss of $21 million in the prior quarter.

Loan volume in this segment declined 26% to $26 billion for the third quarter. The decline was primarily due to a 35% reduction in refinancing volume as many borrowers held back refinancing plans as non-conforming loan rates increased. We also continued to deemphasize our subprime mortgage channel lending focus during the third quarter, resulting in an 80% decline in subprime volume on a linked quarter basis.

Now before turning it over to Tom, I want to comment on the OTS consent order referred to in our press release. We are fully committed to improving and strengthening the controls and processes in our Bank Secrecy Act program. As we said in the press release, the order does not impose any fines or restrictions on our business activities or growth initiatives.

I’ll now turn it over to Tom.

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Thank you, Kerry. Kerry gave you a good summary of the performance of our businesses during the quarter. We continue to drive good customer growth and deliver strong earnings from most of our businesses. However, our third quarter was greatly impacted by disruptions in the credit markets and further weakening in the housing market. I’m going to walk you through our results and provide you with details around how the market disruptions affected some of our asset valuations, as well as how the weakening housing market is affecting our business. I will also give you our current outlook on earnings drivers for 2007.

Let’s look first at the direct impact of the capital markets disruption on our Q3 results.

We have three significant asset classes that we mark to market or that we carry at the lower of cost or market, or LOCOM. They are, our warehouse of home, multi-family and commercial real estate loans held-for-sale; trading assets that we hold as part of our asset sale and securitization activities and our mortgage servicing rights. This quarter, we also recorded impairment in the value of some of our investment securities.

In the LOCOM category are our warehouse loans. As Kerry mentioned, we took downward adjustments of $147 million in the quarter related to $17 billion in held-for-sale single-family, multifamily and commercial real estate loans that were moved to our investment portfolio. $139 million of that $147 million loss resulted when we moved $15 billion in single-family home loans to held-for-investment. The loans included $7.7 billion of jumbo hybrid and fixed loans, $4.9 billion of Option ARMs, $1.1 billion of subprime loans and $1.3 billion of home equity and other loan types. Approximately 99% of these loans were performing when moved.

In addition to the $139 million loss on movement of home loans from the warehouse to the investment portfolio, the market disruption also impacted sales and risk management activities affecting other loans during the quarter, which together resulted in a total loss of $222 million, net of hedging and risk management. This compares to a net gain on sale of $192 million in the second quarter driving a $414 million swing in this component of our non-interest income.

In the first mark to market category, trading assets, we recorded a $153 million net loss. This included a $62 million reduction in the value of securities associated with our mortgage securitization programs, a $65 million reduction in the valuation of our credit card retained interests, and a $43 million reduction in the valuation of subprime residuals. At the end of September, our subprime residual book value was only $37 million and we are not currently creating any new subprime residuals.

The second mark to market category, mortgage servicing rights, moved sharply in the opposite direction. During the quarter, MSR valuation and risk management resulted in income of $222 million compared to a loss of $21 million in the second quarter. Improved MSR and hedging performance was significantly affected by the weakening housing market as projections for loan prepayments slowed considerably during the quarter.

Finally, as I mentioned, we evaluated our investment securities portfolio and recognized an impairment of $104 million for unrealized losses on some of our mortgage related holdings where we deemed the reduction in market value to be other than temporary. These securities were primarily investment grade mortgage-backed securities.

Next, let’s look at the impact of credit quality on our provision for loan losses. There has been a significant and abrupt change in the health of housing market since our second quarter earnings call. At that time, we noted significant slowing in the pace of home price appreciation in most parts of the country and absolute declines in some markets. Since August, the lack of secondary market liquidity for anything but agency conforming loans has resulted in sharply higher interest rates on all nonconforming prime loans, and subprime loans have become largely unavailable at any price. Many non-bank lenders have gone out of business or have severely curtailed their operations. This has increased the cost and decreased the availability of housing credit and contributed to the slowing of home sales. In combination, these factors are putting significant downward pressure on housing prices, especially in the high-cost markets and in markets where subprime loans were most prevalent. The national inventory of unsold homes has increased from 6.5 months in January to 10 months in August, its highest level in 25 years. Home builders are aggressively cutting new home prices, and many other indices are moving negatively. As a result, most markets in the country likely have experienced actual price declines.

This dramatic change in the housing and credit environment is changing consumer behavior in a manner that adversely impacted our third quarter credit results. Specifically, the combination of reduced liquidity for mortgages and the slowing housing market has accelerated delinquencies, as borrowers who are under payment pressure can no longer look to refinancing, home equity loans or quick sales as answers to their problems. Our nonperforming assets increased to 1.65% of assets at quarter end from 1.29% of assets at the end of the second quarter. As with the second quarter, subprime loans had the largest rate of nonperforming assets. However, during the third quarter we also saw an increase in prime home loan NPAs. The quarter's end NPAs included 16 basis points in restructured loans.

In contrast to our home loans portfolio, our credit card, multi-family and commercial real estate portfolios continued to perform well. The most significant external factor affecting the performance of our card portfolio is the level of unemployment, which remained relatively stable during the quarter. Our 30-plus day managed delinquencies increased to 5.73% from 5.11% in the prior quarter, while managed net credit losses declined to 6.37% from 6.49% on a linked quarter basis. We continue to proactively manage the credit quality of this portfolio.

Our $39 billion multi-family and commercial real estate loan portfolio continues to perform well, with non-performing assets of 43 basis points at the end of the third quarter and no net charge-offs for the year.

As a result of the significant changes in the housing market and the performance trends of our portfolio we increased the provision for loan losses to $967 million for the third quarter from $372 million in the second quarter. This brought our allowance for loan and lease losses to $1.9 billion at the end of the quarter, up 21% from the end of the second quarter. The higher level of provisioning reflects increases in delinquencies and charge-offs during the quarter, and the $22 billion increase in the quarter-end portfolio of loans held-for-investment.

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 portfolios. We also intend to go into more detail about our current credit outlook at our Investor Day on November 7th.

I’ll now shift over to review our balance sheet management. Over this past year, high levels of liquidity in the capital markets for mortgage assets and a flat yield curve have made it very difficult to add assets with acceptable risk-adjusted returns to our balance sheet. As a result, we reduced our total assets from $351 billion in June of 2006 to $312 billion in June of 2007. Instead of using our excess capital to grow the balance sheet, we returned it to our shareholders through share repurchases. During this time, we also proactively diversified our funding sources and added funding capacity by reducing our Federal Home Loan advances to $21 billion at June 30th 2007 from $55 billion a year ago. This put us in a much stronger position to withstand the market disruption of the third quarter.

In the third quarter, this funding flexibility allowed us to increase the loan portfolio by $22 billion, including the $17 billion of warehouse loans we moved to portfolio as I discussed earlier. We also more than doubled the level of our cash and cash equivalents to $11.4 billion to further strengthen our liquidity position during this period of extreme market volatility. The result was an increase in quarter-end assets of about 6% to $330 billion.

During the third quarter, home loan originations of $22.3 billion were down 28%, primarily due to lower home refinancing activity. Conforming originations totaled 43% of the quarter’s origination volume but increased to 51% for the month of September. Going forward, we see origination growth slowing but the quality of additions to the portfolio continuing to improve. We also anticipate the level of loan prepayments to decline as the housing market slows and therefore, expect to see less runoff of our existing loan portfolio.

Net interest income of $2 billion for the quarter was down $20 million on a linked quarter basis, as the one% increase in average interest-earning assets mostly offset a 4 basis point decline in the net interest margin. The slight decline in net interest margin in the quarter was the result of higher-cost wholesale borrowings funding the quarter’s asset growth, diminishing the relative contribution of our non-interest bearing deposits to our net interest margin.

Our primary short-term funding from the Federal Home Loan Bank and wholesale borrowings from other sources continue to be indexed to 3-month LIBOR. Although the Fed Funds rate was cut 50 basis points on September 18th, we have not seen the full benefit because the capital markets disruption has resulted in a significant widening in the spread between Fed Funds and 3-month LIBOR. Historically, 3-month LIBOR has tracked approximately 10 to 30 basis points above the Fed Funds rate but at quarter end this spread had widened to 52 basis points. We expect this difference to diminish as capital markets normalize, but until it does, our funding costs will remain somewhat higher.

As I mentioned previously, we have proactively managed our assets and diversified our funding and capital over the past 15 months. We ended the quarter with a tangible capital ratio of 5.61%, in excess of our target of 5.5%. As I mentioned previously we doubled our cash position during the quarter, which depressed our tangible capital ratio somewhat but it also pre-funded a portion of our anticipated fourth quarter asset growth.

With that, let’s transition to updating our 2007 earnings driver guidance. This update of our earnings drivers for 2007 reflects the current environment and our expectations for the remainder of the year. Through the first nine months of the year, average assets were down 7% from 2006. With only one quarter to go, we don’t expect the average to change much. In the fourth quarter, we expect to grow the balance sheet by about $5 billion bringing total assets up to about $335 billion. As we look out at the remainder of the year, the forward yield curve anticipates another 25 basis point cut in the Fed Funds rate by year end. While downward pressure on rates appears to be strong, the outlook changes daily as economic news becomes available. Any rate cut during the fourth quarter will primarily benefit 2008, assuming that LIBOR rates decline as well. With our net interest margin through the end of the third quarter at 2.85%, we expect to complete the year with a NIM at the lower end of our guidance range of 2.85% to 2.95%.

As we consider our credit provisioning outlook for the remainder of the year, let me just say that I have never seen housing credit conditions change so significantly over such a short period of time. Nor can I remember a period when there was less clarity about near-term housing and credit trends.

As I discussed in detail earlier, we have seen a sharp deterioration in the housing market since our second quarter earnings call and further acceleration of adverse trends in our portfolio since we updated our guidance last in September. The guidance I provide you today is based on our best thinking given the facts that are currently available. However, we expect the market will continue to change quickly.

The main drivers of our credit provision are the level of delinquencies and charge-offs in our portfolio, both of which rose sharply in the third quarter as home prices declined in many of our major markets. Based on our current view of the macro environment for housing and our own portfolio data, we expect delinquencies and charge-offs in our portfolio to increase further during the fourth quarter.

Considering the weakening housing market and adverse trends in the third quarter, our best estimate at this time is that charge-offs in our portfolio will increase between 20 and 40% in the fourth quarter and that our total 2007 provision will be between $2.7 and $2.9 billion.

The Retail Bank continues to have strong account growth, and with a 13% increase in depositor and other retail banking fees over the first nine months of last year, we continue to be comfortable with our guidance of 12 to 14%.

Non-interest income in the third quarter of $1.4 billion was down $379 million from the second quarter, primarily due to the market disruption in the quarter. While we don’t anticipate further deterioration in the capital markets, we also don’t believe there will be an immediate recovery of the secondary market for mortgages. Therefore, we expect the gain on sale in the fourth quarter to be modest. As a result, we are reducing our earnings guidance for non-interest income for the year by $500 million to $6.4 million to $6.5 billion.

Management remains focused on tight expense management and driving productivity and we have done a good job of that this past year. One by-product of the difficult credit period we are going through is higher foreclosure and problem loan expense. Despite this upward pressure, we expect our expenses for the year to remain in the guidance range of $8.4 to $8.5 billion.

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

Kerry K. Killinger - Chief Executive Officer

Thanks, Tom. In wrapping up our prepared remarks, let me offer the perspective of an 18 year CEO and a 35 year financial executive who has been through a lot of cycles. We are primarily impacted by interest rate, yield curve, housing and economic cycles. And cycles come and go. When cycles are in your favor, you need to plan for the inevitable downturn. And when they are against you, you need to work through them and prepare for the inevitable upturn. Today, the cycle that is working against us is a declining housing market. As Tom noted, current housing market conditions are very challenging. Housing inventories are rising, demand is falling and prices are declining in most markets. Delinquencies and foreclosures are rising. Now we expected a downturn from the cyclical highs of a couple of years ago, but as I said earlier, we are definitely experiencing an accelerating downturn at this time. However, I remind everyone that housing will continue to be vital to consumers and will recover at some point. It is not possible to predict the timing, but I expect us to work our way through this downturn and for market conditions to improve.

Now the cycle of rising short term interest rates and an inverted yield curve which negatively impacted us over the past few years appears to be improving. Most forecasters expect short-term interest rates to fall and the yield curve to steepen. However, the capital markets illiquidity we have experienced has added a new variable. My attitude on difficult cycles is that you may not like them, but you must deal with them. And the faster you deal with them, the better.

Now when difficult conditions hit, as owners of the company, we need to ask three key questions. Is management on top of the situation? Does the company have the financial strength to make it through the bottom of the cycle? And does the company have growth prospects once the cycle improves?

Well, on the first point, I believe this management team is strong, deep and is diligently addressing the challenges posed by this environment. Regarding our financial strength, we have appropriate capital and sources of liquidity to work our way through the cycle.

And regarding future growth prospects, we have a high growth retail banking powerhouse driving strong customer growth, increasing cross sales and double digit fee income growth. We have great opportunities to further increase our sales of credit cards, mortgage loans, securities and insurance products to our banking customers. And we are doing the right things to make our home loans operations profitable once the environment stabilizes. We have also vigorously attacked expenses, giving us excellent operating leverage.

And finally, we have good margin expansion potential if the interest rate environment were to return to more normal conditions. Now the Fed has reduced rates 50 basis points and appears ready to reduce rates further if economic conditions warrant. As Tom commented, our short-term funding is primarily LIBOR based which typically follows the Fed Funds rate. A return to a more normal yield curve and lower LIBOR rates would be quite beneficial to our net interest margin. Now while we are very attentive to the short term challenges, it is just as important to keep our focus on the long term value creation potential for the company. And we believe that value creation potential is excellent.

Now before we take questions, I want to invite you to join us in New York at the Sheraton New York Hotel and Towers on November 7th for the 2007 Investor Day Conference. At that time, we will provide you further detail on credit and our initial outlook for 2008.

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

Question and Answer


We will now begin the Q&A portion of today's call. In consideration of the number of people who have joined us on the call today, we will accommodate one question per caller. We will get to as many questions as time permits. [Operator Instructions].

Our first question comes from Paul Miller from FBR Capital Markets. Your line is open.

Paul Miller - Friedman Billings Ramsey & Co.

Yes, Kerry, I wanted to ask a question about your dividend policy because with the new guidance, and just on the back of the envelope, you are probably not going to make a dividend in the fourth quarter either; we know you didn’t make a dividend in the third quarter. And when housing pressures continue to come under pressure, I mean, nobody knows what's going to happen in '08 but I think everybody is predicting that credit also is going to continue to increase at least in the first half, maybe for the entire year of '08. Can you talk about your dividend policy, if you don’t start making your dividend policy, at what point do we start to see you back off it or maybe just take a temporary couple of quarters suspended until the environment returns where you are more profitable.

Kerry K. Killinger - Chief Executive Officer

Well, Paul, as I mentioned, the directors followed the same pattern this quarter that they've done each quarter in the past, and I suspect will continue into the future, and that’s to take a very careful look at the environment, take a look at our earnings. We certainly take a look at the forecast that we provide. We also look at the capital, the liquidity of the company. And we really bring all those factors together, and the board went through a thorough review of that and concluded that declaring a $0.56 dividend is appropriate, based on all those factors. It's inappropriate for me to speculate on what the board might do, into the future but I suspect that they will continue to take all those factors into consideration just as they did this quarter.

Paul Miller - Friedman Billings Ramsey & Co.

Is there any regulatory issues with… I mean, is there some point that you have to earn your dividend over a four quarter time period, or a two year time period, because I forget the rule?

Kerry K. Killinger - Chief Executive Officer

Yes, I think first of all the primary factor with our regulators is the maintaining appropriate levels of capital and of course, continuing to operate in a safe and sound manner. All of those indications are positive. From a regulatory capital standpoint we are in excellent shape. And again, I think as you think about dividends, again it's a whole combination of liquidity, the capital that we have, and as I implied there, relative to regulatory guidelines, we are in excellent shape as well as the earnings outlook for the Company.

Operator, next question.


The next question is from Chris Brendler with Stifel Nicholas. Your line is open.

Chris Brendler – Stifel Nicolaus & Company Inc.

Hi, thanks, good afternoon. I would like to drill a little more on credit, if you could. I understand your comment on the housing market and it's really something that we've been focused on for a while now but what do you think… where does this stop? I mean you are looking at 30% to 40% increases in the quarter, in NPAs, in your home loans, your HELOC and your subprime business. Can you give us any sense on, like on a vintage basis or a geographic basis, I would imagine if the 2006-2007 origination that are driving a lot of those increases in price, in the markets you mentioned California and Florida, that are also driving a lot of the weakness. Is there any way you can bracket for us where do you see these things peaking out and maybe accelerating a little bit, given the outlook that housing will continue to probably weaken a little bit into next year?

Unidentified Company Representative

Yes, we are, thanks Chris, and we are challenging the same thing trying to understand where the housing market will ultimately settle out. What we are indicating today is that we are not seeing signs of stabilization yet and so it's difficult to predict when that will peak out. Clearly some of the market indices that we point to, things like, unsold inventory for example, is continuing to increase, and if the supply and demand is still out of balance we are going to see continued housing decline. So it's very difficult for us to predict where this will ultimately settle out. And hopefully in the next few months we will have more information to start to communicate to you on where we are seeing it. But clearly the illiquidity and the housing slowdown is putting pressure on consumers and it is not isolated to any one particular area. There are a number of areas across the country that are seeing significant declines in home prices and that is resulting in higher levels of delinquencies and higher charge-offs.


Your next question is from Eric Wasserstrom with UBS.

Eric Wasserstrom – UBS

Thanks. Kerry, could you talk a little bit about what your priorities are for capital usage right now? Obviously you guys are pointing to a little bit of growth in the balance sheet in the fourth quarter and highlighted that the capital ratios are a little bit higher than where it would normally be, but were also in a situation where liquidity is a little more uncertain. Can you just refresh us on what your priority for uses are?

Kerry K. Killinger - Chief Executive Officer

Yes, thanks, Eric. Yes, first of all, the primary ways that we increase our capital is earnings, and periodically we have the opportunity to raise new capital and we have raised some new capital in the past year particularly in non common forms of a permanent capital. And I suspect over time we will continue with look for opportunities to grow that capital.

In terms of the use of capital, if I go over the past year to two years, the primary use of capital, first priority is the cash dividend, the second priority has been a very aggressive share repurchase and the areas that were kind of on the back burner were growing our balance sheet and significant capital deployment in acquisitions. I think at this time for utilization of capital, I would put at the top of the priority list, the cash dividend for our shareholders, and we will continue to view that highly. Second, is growth of our balance sheet. We think that there were excellent opportunities in the third quarter to increase the assets and very good risk adjusted return assets. I think we expect, as Tom indicated, the growth in the balance sheet in the fourth quarter to be at a slower pace than what we had in the third quarter. But nonetheless, we think that that is a good priority use for the capital.

I think share repurchase is something we will look from time to time on an opportunistic basis, but at this point growing the balance sheet and the cash dividend are a higher priority. And on the acquisition front we'll continue to look at acquisitions, but again I would expect that to be more of a secondary priority for use of capital at this time.

Eric Wasserstrom – UBS

Thanks very much, Kerry.


Your next question comes from Fred Cannon with KBW.

Frederick Cannon - Keefe Bruyette & Woods Inc.

Thanks, and good afternoon. Just wanted to ask you about your policy on foreclosed assets. I believe foreclosed assets are up over 100% in year over year, and clearly from the description that you talk about that’s an area that’s going to continue to increase, and I believe Tom mentioned in his comments that’s an area where expenses are going up. I was wondering if you could tell us what your policy is in terms when you take a foreclosed, Tom, and how aggressive you are on marking that to a point where you can get it sold, number one.

And number two, if you have any more color, Tom, on what is going on REO expenses and the non-interest expense line in the income statement?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Thanks, Fred. The foreclosed assets, we take the same approach that I'm sure most people do. We take our best mark at the time of foreclosure, and then to the extent we sell the property we market obviously the final sales price. We continually monitor low sales values throughout the foreclosure process to see if we need to take additional write downs through the income statement. And that is obviously an ongoing process.

For the quarter, just to give you an order of magnitude, foreclosed asset expense in the third quarter was about $82 million compared to about $56 million in the prior quarter. So you can see it started to increasing. We would expect that would out some additional pressure on our non-interest income area, as we continue to incur in these foreclosure process, we start to work through the charge-offs.

Frederick Cannon - Keefe Bruyette & Woods Inc.

Great, thanks. And, I guess, just a quick follow up, I mean, in my years of banking, there was a general rule that when you took back property your first loss is your best loss and it's best to move the property as quickly as you can. Is that the general approach or is Washington Mutual looking at holding properties for some extended period of time for fear of depressing market conditions further.

Kerry K. Killinger - Chief Executive Officer

Yes, this is Kerry, Fred, let me make one comment. The first priority, and we will comment around the turn times on the REO, the first priority for us is to try to keep that home auto foreclosure, if at all possible because keeping people in their homes in this kind of a market is the absolute first priority, and I thought I might have Steve Rotella mention just for a second all of the steps that we are taking to go out of our way to try to keep people in their homes and then maybe comment just a bit on the terms that we are doing in the REO front.

Stephen J. Rotella - President and Chief Operating Officer

Yes, Fred, as a guy who ran a servicing shop for a period of time, at times like this I would say the first thing that you want to concern yourself with is making you got a top tier organization managing this, and I can tell you unequivocally, we have a management team, technology, processes, and capabilities, and capacity to deal with this, and manage our way through it.

Secondly, WaMu has been taking a leadership position in trying to do as much as we can for our customers. You may remember the $2 billion borrower assistance program we kicked off for our subprime borrowers. We have been a leader in linking up with community groups around the country and constructing programs to reach out to consumers. We have gone and made sure for those customers who are having their rates reset that we as proactive as possible, particularly for borrowers in our portfolio in offering them arrangements. The most important thing is to get them to contact us, and in that regard we have really ramped up communications with a hundred numbers, we are actually sending DVDs out to certain consumers and I think uniquely for us, we have people on the ground in key states around the country who are meeting people eyeball to eyeball, because it is very important to have those discussions, and a whole series of other creative things.

So I can tell you looking at the stats around turn times around foreclosures and sale of REOs we are benchmarking ourselves and doing quite well, and those times have been fairly stable despite the volume increases.


Your next question comes from Jim Benson with Harris Associates.

Jim Benson – Harris Associates

Good afternoon, gentlemen.

Kerry K. Killinger - Chief Executive Officer

Hi, Jim.

Jim Benson – Harris Associates

A quick question for you on Page 9 of your prepared remarks. You've got a little table there on your credit quality metrics, which is similar to the one you've shown in the past. And the question I have is that I was not surprised to see, say in the 80% plus category in Home Loans, which is shown 11% here, in the previous period it was 8% and I would have thought in this environment there was a little bit of deterioration. But on the Home Equity part of the portfolio, you are showing 28% of the portfolio as an 80% higher LTV bucket. In the previous quarter it was 36%. So you had a fairly sizeable improvement in the higher risk bucket in the Home Equity portfolio. And I was wondering why that occurred.

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Jim, there is a lot of information here, that I have to go through to make sure I specifically understand your questions, you may want to follow up offline. But one of the things that is impacting these numbers is that we are seeing a very high degree of charge-offs and delinquencies in this portfolio, and that may be skewing some of the numbers as we take in the pretty sizeable charge-off. But I have to come back to you and specifically understand where you are looking and make sure I've got the right cut for you.

Jim Benson – Harris Associates



Your next question is from James Fotheringham of Goldman Sachs.

James Fotheringham – Goldman Sachs

Thank you. Kerry, you said that you expect home prices to exert the greatest influence on the level of losses, and I was just wondering if you could tell us what is your home price forecast that corresponds to your new provision guidance and how exactly have you been forecasting house prices? Thanks.

Kerry K. Killinger - Chief Executive Officer

Well, Jim, we do of course follow both the public information, both the Case-Shiller and the OFAO Index, and we also monitor what the futures markets are saying and what other forecasters are doing. I think when we try to look at making judgments about the loan loss or the level of potential charge-offs and the delinquency what's going to happen on charge offs, delinquencies, and ultimately to try and arrive at our loan loss provisioning, we really factor in a whole variety of those. We really don’t come up with a single HPA number out that we have benchmarked on that and released that publicly. But we look at a whole variety of factors is what I would say.

Without getting specific I would say that we generally expect housing prices to continue to deteriorate in most parts of the country for the immediate future. We have not, at this point in any of our projections put in a significant increase in prices in that foreseeable future.

James Fotheringham – Goldman Sachs

Thanks very much.

Kerry K. Killinger - Chief Executive Officer



Your next question is from Brad Ball with Citi.

Bradley Ball – Citigroup

Thanks. I have a follow up on the credit question. I wonder if you can comment on what you are seeing in terms of credit trends in the Card business. We're hearing from other Card issuers that fourth quarter net charge-offs should be up. People are talking about the normalizing of net charge-offs, maybe over the next 12 months. Are you seeing any of the mortgage credit issues breathing over into credit cards?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

I would say that we would agree with some of the comments from other credit card issuers. We are seeing credit losses go up, we see them going up in the next year maybe in the 20% area. It's starting to trend towards a normalized level of about maybe up in the 6% to 6.5% range to 7%. So I think that we are consistent with what you are seeing in the other parts of the credit card industry.

As far as the impacts of mortgages on credit cards we studied that quite dramatically, quite extensively and we don’t see anything dramatic that would point us to a contagion issue for say into our portfolio. Having said that, we are seeing certain customers that have multiple mortgages with a credit card, are starting to under perform but we still have a significant portion of that portfolio. But we are seeing that small piece start to deteriorate quite quickly, albeit, it is a very small piece of our portfolio.

Stephen J. Rotella - President and Chief Operating Officer

Yes, Brad, Steve Rotella. I just echo Tom's comments. I mean, first of all when we look at the expected losses in a portfolio like ours, you are talking about a number that is going to be in a 7% to 8% level. We are below that right now. Obviously part of that is the benefit of a higher receivables growth. But remember, about a third of that receivables growth is coming through what we think is outstanding cross-sell through our retail bank where we have a relationship, and those FICO scores actually skew a little bit higher. There is some stress in the portfolio, similar to other card companies, and we'd expect that to cost somewhat higher credit losses going forward, but again we'd expect that to be within our expected range of losses, going forward.

Bradley Ball – Citigroup

So just to clarify, Steve, Tom said, 6.5% to 7%, so that’s what you are looking at for '08; but you think normal is more like 7% or 8%?

Stephen J. Rotella - President and Chief Operating Officer

I think over the long term… remember that the credit card business is benefited from the change in bankruptcy laws in the past which made some of the numbers look particularly good. We are at about 6.37%, I think we ended up the quarter, so I am trying to give you a range of looking forward. But we would expect, as Tom said, going forward I think 20% some odd is probably a good estimate, in terms of the increase we would expect to see.

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Keep in mind, we're coming off some historical lows.


The next question comes from David Hilder with Bear Stearns.

David Hilder - Bear Stearns & Co.

Good afternoon, just a question about the tax rate. Could you provide any guidance on what it might be in the fourth quarter or for the full year? It looks again from sort of a rough estimate that your pretax earnings in the fourth quarter might be somewhat closer to what you had in the third and the second.

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Yes, that is a… the tax rate came in very low and that is a reflection of our lower effective tax rate we are expecting given our lower operating earnings. And so we would expect our effective tax rate probably down between 2 and 3 points from what you saw in the first half. So this is just a catch up impact of that reevaluation.

David Hilder - Bear Stearns & Co.

Sorry, then 2 or 3 points for the full year or for the second half?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

For the full year.

David Hilder - Bear Stearns & Co.

Okay, great.

Thomas W. Casey - Chief Financial Officer and Executive Vice President

What you are seeing is the impact of that all in one quarter

David Hilder - Bear Stearns & Co.

Okay, thanks very much.


The next question comes from Adam Yale with Red Cedar Capital.

Adam Yale - Red Cedar Capital

Good afternoon. As I am looking at the provisioning projection for 2007, if I do the math here , am I to understand that the credit provisioning is going to be over $1 billion in the first quarter of 2007?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Yes, I have given you guidance for the whole year, but if you look at two or three quarters, it would translate to $1.1 billion to $1.3 billion for the fourth quarter.

Adam Yale - Red Cedar Capital

Okay. And then, so why is it higher in the fourth quarter than the third quarter and have delinquencies and non-performing assets deteriorated more dramatically in the current quarter than they did in the third quarter?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

We are seeing continuing trends in the… although the provision for the third quarter took into account the results we saw as of the end of September, we are forecasting that there could be continued declines. We are still waiting for the facts to come in. But as I said in my prepared comments, there is probably going to be further declines. We just haven't see those or been able to measure them yet. But it is a potential that we wanted to make sure that you understood that if that continues that we would have to see higher provisions in the fourth quarter, and that’s what we are trying to do with our earnings guidance.


The next question comes from Gary Gordon with Portales Partners.

Gary Gordon - Portales Partners

Hi, thank you. So I have a follow-up question on the credit card. If housing does spill over more into the general economy, at least it would seem like a possibility, you talked about card losses going back to a normal rate. Are there any thoughts about tightening credit standards, changing credit standards in anyway, the credit card or commercial real estate or any of the non-full mortgage related assets?

Kerry K. Killinger - Chief Executive Officer

On the credit card front, we are currently tweaking our credit guidelines. And as Tom mentioned, we have been examining any impacts on the portfolio related to this mortgage downturn, housing downturn pretty aggressively. And we have made some changes and will continue to make changes going forward. We would also expect that to have somewhat of a moderating trend on our growth rate, going forward.

Gary Gordon - Portales Partners

Okay, anything on the commercial side at all?

Kerry K. Killinger - Chief Executive Officer

Our commercial credit, to date, has been exceptional. I think, we have no net credit losses so far this year. We did add a little bit of provision this quarter, but it was fairly insignificant within the context of the overall company and I don’t foresee any significant changes to that business at this point.

Gary Gordon - Portales Partners

Okay, thanks. I only have one more question on, and so I'd assume that commercial spreads widen out too. Does this give you an opportunity to generate more assets, commercial assets?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

This is Tom. We talked a lot about spreads widening in the single family area, they have not widened as much in the commercial area. So we see, we don’t see the opportunity as much as we do in the single family. Credit spreads in multi family loans is not widened as much and so we continue to be… continue to grow that balance, those volumes but not reaching full volumes in that class.


The next question comes from Chris Brendler with Stifel Nicolaus.

Chris Brendler - Stifel Nicolaus

Hi, one quick follow-up, if I could, please. The e discussion around the reserve in the provision expense, I am wondering, you are still looking at it, despite the provision this quarter, and it's hard to say what's going to happen next quarter with the provision and all the charge-offs. But you are still looking at a decline in the reserve as a percentage of the non-performers. I am wondering if you've changed at all your methodology for low rates and non-performers to charge-offs. I would imagine you've seen some deterioration there. And is that currently incorporated into any of your reserve policies or do you forecast or foresee making any adjustments to that policy given what's happening in the housing markets?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

So we have consistently applied our methodology for quite some time and so we factor in a lot of variables, as you can imagine, individual housing prices as well as our own delinquencies and charge-off statistics, as well a host of other variables. And so this is a pretty much bottoms-up loan by loan type of analysis that takes into account many, many variables. What we have tried to do is highlight some of bigger ones tat will drive that, which will be delinquencies and the level of charge-offs to give you some indication of where we think the fourth quarter will be. But as I said, it's just very challenging to be able to forecast this provision and reserve levels with any kind of certainty given the outlook on housing.

So I think we will continue to give you our best thinking, when we meet with you, and try to keep informed of what we see.

Chris Brendler - Stifel Nicolaus

One quick follow-up. Do you know what percentage of portfolio has been generated in 2006 or 2007

Thomas W. Casey - Chief Financial Officer and Executive Vice President

I do. I just don’t have it off the top of my head, and… I don’t have it off the top of my head. I would say that, keep in mind the only real assets we retained in 2007 were the transfers we brought in, in the third quarter. We were selling most of our production, notwithstanding multi-family, but the single family area, we were selling most of our production in first half. So while we had some, it's mostly through the transfers. But keep in mind we have been selling most of our option ARMs, about three-quarters of our options ARMs in '06, and even in '05. So, as Kerry mentioned, we've been pruning the balance sheet down from the highs of $351 billion down to $312 billion and that’s reflecting the sale and a lot of our originations through those years.


The next question comes from Nandu Narayanan with Trident. Your line is open.

Nandu Narayanan - Trident

Hi, my question really related to your policies for making allowances for loan losses. Because I am just looking at your non-performing assets, as a percentage of total assets and obviously it's steadily increasing for the last few quarters. And I guess, based on your numbers looks like about 1.65% of your total loans are non-performing. But at the same time your provisioning has actually not kept pace with the pace of growth and the non performing assets. So it looks like you're reserving only about 80 basis points. Why is that? Because based on what you have been saying earlier in the call, it looks like this is perhaps the worst housing market you've seen in 25 years. You're not projecting any improvement. So what is the logic that drives the fact that you're provisioning less and less and less, even as your non-performing assets keep on increasing?

Kerry K. Killinger - Chief Executive Officer

Yes, as far as our allowance goes, our allowance as a percent of our total loans in the portfolio has actually gone up from 73 basis points to 80. As I mentioned, we are seeing significant increases in non-performing assets and we factor in a number of things into that. Keep in mind that some loans have very low LTVs and so we don’t expect significant loss to occur. So, while the total NPAs may be going up, the loss may not be as great in some of those portfolios.

You may want to remember what I said in my prepared remarks that we also have about $500 million of assets that are restructured assets or modified, are also in there, that we expect those to outperform a typical NPA. And then finally, keep in mind when we move assets to our portfolio like we did in the third quarter, we took a very significant mark-to-market on that. And so, the ultimate loss on those, if you will, has already been taken or at least an estimate of it when we transferred it. And, so that doesn’t require an allowance, effectively went through the P&L at transfer.

So you have got a number of things in there. And what we are trying to do is give you our best thinking, and we keep track of it as best we can to try and make sure you understand what we are doing. But the provisioning and the reserving is a very, very rigorous process we go through and takes into account, a number of variables.


Our last question today comes from Tom Mitchell with Miller Tabak.

Tom Mitchell – Miller Tabak

I was very curious in light of the recent $100 billion fund being announced with Treasury Secretary Paulson apparently leading the way. You transferred $17 billion of loans from mark-to-market status to hold-until-indefinite status, and you took less than a 1% haircut on that on the transfer. People I talk to say that a papers that contain interest-only ARMs and papers that contain subprime loans has bids of $0.15 to $0.25 on the dollar to them. So I’m wondering what would your mark-to-market have been if you had not moved the $17 billion of loans?

Thomas W. Casey - Chief Financial Officer and Executive Vice President

Tom, one thing I want to make sure you know is that as Kerry mentioned, we actively manage our balance sheet throughout the quarter, not just at quarter end. When we saw liquidity start to dry up in the July timeframe we made a strategic decision to move those assets into the portfolio, at the end of July. A lot of the new liquidity that occurred wasn’t really until August and into September. So the mark-to-markets you're referring to are really reflecting the illiquidity marks that a number of distressed originators are having to go to the markets and sell their assets into.

This is one of the benefits that we think we have given our liquidity position. And so what we did is, took advantage of all of our flow [ph], of advance restructuring we did and portfolioed these loans quickly to avoid the illiquidity that we saw in the secondary market and made a decision to hold them to maturity in loan form rather than sell them into secondary market. And that’s why you see the mark being lower than you would have if it was down in September 30th.

Keep in mind these were, majority of these loans were high quality. 99% of them we are performing. And then we evaluated if we need any LLL on it, a reserve that is, when they transferred it into our portfolio. So that’s what happened.

Kerry K. Killinger - Chief Executive Officer

Okay. Again, thank you all for joining us on the call. I would remind everyone that again our Investor Day conference on November 7th in New York. Again, we'll, at that time have an update on credit, in a little more detail than what we were able to cover today and we'll try to make a few comments on our initial outlook for 2008 as well. So look forward to seeing you then. Thank you all very much.

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