Good afternoon and welcome to WAMU’s first quarter 2008 earnings conference call. (Operator Instructions) I will now turn the call over to Alan Magleby, Senior Vice President Investor Relations to introduce today’s call.
Good afternoon and thank you for joining us today. I would like to welcome you to WAMU’s first quarter 2008 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, 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 current press release and our other recent documents filed with the SEC.
With us today are Kerry Killinger, our Chairman and CEO, Steve Rotella, our President and Chief Operating Officer and Tom Casey, our Chief Financial Officer. At this time I will turn the call over to Kerry.
Kerry K. Killinger
Good afternoon everyone. Thank you for joining us today as we review the results for the first quarter. Joining me today on the call is Tom Casey, our CFO who will discuss our quarterly performance in more detail and give you an update on our 2008 earnings drivers. Our President Steven Rotella is also available to answer questions at the end of the remarks.
2008 is going to be a very challenging year for the company but I believe we’ll view this year as a turning point in our company’s history. Let me begin by giving you an update on today’s operating environment. Recent data continues to show a stagnant economy with weak and softening job markets and tepid consumer spending. The effects of the severe downturn in housing coupled with a weakening economy is raising credit costs across the board plus the secondary market for non-conforming mortgage loans remains basically shut down. This illiquidity as increased the severity in downturn in key housing markets and is adversely affecting overall credit performance. Since the beginning of the year home prices have been falling sharply in areas of our portfolio concentration, most importantly in California and Florida. Inventories of unsold homes in these markets and nationally have increased and the pace of sales is far below that of last year leaving these markets with an inventory overhang.
Our home loan and home equity portfolio loss frequency and loss severity have increased sharply due to the deterioration in housing markets. Prepayment rates have slowed sharply, delinquencies, charge offs and foreclosures are all rising because homeowners have few options if their situation changes and they are unable to make their monthly payments. Home prices will fall until demand and supply are balanced and it is a buyer’s market in most parts of the country right now and it will remain so until the inventory of homes returns to more normal levels. Our expectations are that home prices will fall nationally into 2009 and Tom will provide more details during his credit discussion. We saw a housing downturn coming, the board and management took major actions to prepare for the slowdown but it wasn’t enough. We raised new capital last fall but, it wasn’t enough. In short, the actual magnitude of the housing downturn and the unprecedented disruptions in the capital markets have overcome much of our preparations.
As the housing and capital markets continue to deteriorate in recent months we had to take another look at capital and in doing so we came to the conclusion that having additional capital as we work through this distressed environment made a lot of sense so our board of directors made increasing capital its highest priority. We examined a wide range of possible alternatives and concluded that the transaction we announced last week offered the most attractive opportunity to return value to our shareholders. This transaction does two important things: first, it brings us $7 billion in new capital which we believe to be more than enough to see us through the high point of our provisioning which we expect to peak in 2008; second, is the vote of confidence in our future from some sophisticated private equity investors including TPG Capital who conducted a thorough due diligence of our business.
As you may know TPG invests for the long haul and they are very active and constructive in helping companies to grow and prosper. I’m especially pleased to have TPG’s involvement because our company knows TPG’s founding partner David Bonderman very well. David served on the WaMu board from 1996 to 2002 during a period of very successful expansion. I am very pleased that along with this significant investment from TPG David will once again be joining our board of directors.
In other actions as Tom will discuss later, we’ve reduced our balance sheet in the first quarter through the run off of loans held in foreclosure and investment securities and have also lowered our full year outlook for asset growth. In addition, the board reduced the dividend on common stock to $0.01 per share. Weighed against the cost of capital our directors felt this was the appropriate course of action, that this will preserve approximately $490 million of capital annually. Last year we took steps to reduce the size of our home lending business and to align that business primarily in to our retail banking network. We are now further consolidating that business by closing all of our remaining freestanding home loan offices and exiting wholesale lending, our broker channel. We are still very much committed to home lending and will be investing in and growing our retail banking store and call center production capability. We are targeting $550 to $650 million in annual run rate cost savings which will come from home loans and corporate support areas. We have taken decisive steps to ensure our ability to withstand this period of unprecedented credit losses but it’s also important that we continue to invest in the core strengths in our business, our outstanding retail franchise, our award winning customer service and our unique and powerful brand. What this also means is that we can now turn our full energies to improving the company’s performance and restoring shareholder value.
Now, turning to first quarter results. During the first quarter we reported a net loss of $1.1 billion or $1.40 per diluted share. The loss was driven by the elevated level of provisioning. The provision for loan losses of $3.5 billion more than doubled from the prior quarter. The larger provision reflects an increase in delinquencies as the economy weakens as well as a higher level of losses as home prices declined sharply from the start of the year in many of our key markets. Even though net charge offs increased 83% over the prior quarter to $1.4 billion. The quarter’s provision was well in excess of net charge offs and brought the allowance for loan losses to $4.7 billion at March 31st up from $2.6 billion at the end of 2007. Tom will talk more about the provision during his remarks.
The current environment is perhaps the most difficult in the company’s 119-year history but it will turnaround at some point. Our job is to make sure that when this happens we have a franchise capable of adding significant shareholder value. In the first quarter the company generated $3.7 billion of revenue as net interest income continued to grow with the Fed easing short-term interest rates. Non-interest income is also growing as valuation losses from the market dislocation have lessened. As I said earlier we continue to invest in this company and we are doing so while keeping a strong hand on expenses. Our efficiency efforts are driving down costs which give us the ability to grow the franchise. This past quarter our efficiency ratio came in at 57.5%, a significant improvement compared with the prior two quarters. This Slide shows the company’s pre-provision pre-tax results remain strong at about $1.5 billion in the first quarter an increase of 3% from a year ago. This measure of the company’s performance demonstrates two important points: one, the company’s capacity together with its substantial capital cushion to absorb higher provisioning during this period of elevated credit costs; and two, the underlying ability the franchise has to drive earnings after these conditions abate.
The retail bank continues to perform well but growth has slowed with the weakness in the economy. Net interest income was down slightly from the fourth quarter due to the lag in the downward re-pricing of deposits as short term interest rates fell. Depositer and other retail banking fees totaled $704 million during the quarter down from the fourth quarter reflecting normal seasonality but were up 6% year-over-year. Non-interest expense was up slightly as we continue to invest in the retail-banking network. The provision for loan losses increased during the quarter as the deterioration in the home loan and home equity portfolios accelerated during the quarter. During the first quarter the retail bank added 256,000 net new checking accounts on pace towards reaching our goal of adding more than one million net new accounts this year. WaMu’s highly successful free checking account is the primary product for many consumers and provides a basis for cross sales and deepening customer relationships. Average retail deposits increased by $4 billion over the quarter reflecting both money market and CD growth. Deposit balances at the end of the quarter were up an impressive $8.1 billion to $151.7 billion and that growth was accomplished at a cost less than wholesale funding sources. In fact, we lowered overall deposit costs by nearly 30 basis points from the prior quarter.
Card services continues to generate solid revenue. Net interest income was up with lower funding costs. Non-interest income was also up from the prior quarter due to an $85 million benefit received from the company’s share of Visa’s IPO. Non-interest expense was down from the fourth quarter due to slower hiring and delays in marketing spending. I also want to point out that non-interest expense during the fourth quarter included a $50 million charge for Visa related litigation. $38 million of Visa related litigation accruals were recovered in the first quarter. During the quarter card services opened 666,000 new credit card accounts, 13,000 more than in the prior quarter. We continue to direct our growth effort to our core retail banking customers and have scaled back promotions on a national level to enhance the risk profile of the portfolio. WaMu’s retail bank customers accounted for 38% of total account production up from 35% a year ago. Total managed receivables decreased 3% during the quarter to $26.4 billion. This reduction is the result of actions we’re taking to reduce the company’s exposure to losses plus lower purchase volumes due to the softening economy and seasonal increase in payments. Net credit losses of 9.32% of average managed receivables were up from 6.9% in the fourth quarter. We expect the weakening job market to result in higher credit losses in the range of 9.5 to 10.5% for 2008. The increase in the provision reflects this worsening trend partially offset by the decline in ending managing receivables.
The commercial group again delivered a solid quarter, net interest of $196 million was down modestly from the prior quarter as the increase in loan yield was offset by lower non-interest bearing deposits. Non-interest income was slightly better compared with the prior quarter as a result of lower trading and hedging losses partially offset by lower sales volume. The provision for loan losses is still very low but did increase with an increase in delinquency plus portfolio growth as the company is holding more of its loan production in portfolio. Loan volume of $2.84 billion was down 41% from the prior quarter reflecting market illiquidity and our decision to limit balance sheet growth.
Operating results for our home loans group improved during the quarter with improved gain on sale and lower expenses. Despite an increase in foreclosure costs expenses were down 8% from the fourth quarter. During the fourth quarter we took actions to resize home loans business in response to a smaller mortgage market and reduce the number of employees to a little over 9,000 at March 31st from almost 12,000 at the end of 2007. As the mortgage market has yet to show any recovery the quarter’s provision was once again at an elevated level increasing subprime delinquencies along with higher loss severity rates drove the loan loss provision to $907 million from $511 million at the end of the prior quarter. During the quarter home loan volume totaled $13.77 billion down considerably from prior quarters with the decline in auction ARM, hybrid and home equity lending. Most of the quarter’s volume was for fixed rate loans as we placed more emphasis on originating GSE conforming loans and borrowers took advantage of lower interest rates.
I’ll now turn it over to Tom.
Thomas W. Casey
As Kerry discussed the first quarter has been a period of accelerating declines in home prices. I intend to spend the majority of my time talking about our credit profile and give you some insight in to our results and what we see going forward. I will also give you an update on our $7 billion capital raise and how it positions us to weather further decline in home prices. Before I dive into credit, I’ll first review a few key highlights of the quarter.
The first area I want to cover is how we’re managing the balance sheet. For the quarter total assets were down $8.2 billion or 3% reflecting run off and auction ARMs of $3 billion and $3.9 billion in available for sale securities. At the same time we experienced strong growth in our retail deposits which were up $8.1 billion or 6% for the quarter. Moving on to our net interest margin where we saw strong expansion. The NIM was up 19 basis points during the first quarter to 3.05% as the cost of liabilities declined 53 basis points compared to the yield on assets falling only 31 basis points. As we look forward we expect the margin will continue to expand during the year. The forward curve is indicating additional cuts in the Fed funds rate to about 1.75% by midyear. We expect this to drive an additional 15 to 20 basis points improvement in our NIM from lower funding costs.
As we look across our business we see positive trends in our non-interest income and operating expenses. Non-interest income for the quarter increased 15% from the fourth quarter. Revenue from sales and servicing of mortgage loans increased $53 million or 15% on a link quarter basis reflecting stronger gain on sale revenues partially offset by somewhat lower MSR valuation and risk management. The revenue from sales and servicing of consumer loans declined $127 million or 34% primarily due to the fact that we did no credit card securitizations during the quarter. And, deposits on the retail banking fees were up 6% from the first quarter a year ago with net checking account growth of $256,000.
The capital markets continued to be difficult during the first quarter. As a result we incurred $216 million of losses on our trading securities during the quarter compared to $267 million loss in the prior quarter. This quarter’s loss primarily related to the remaining assets of Washington Mutual Capital Corp which is being wound down in connection with our change in strategy for our home loans business. This portfolio totaled $283 million at quarter end and included $50 million in treasuries and $233 million in other securities which were valued at approximately 40% of face value.
As part of our balance sheet management strategy we sold $5.3 billion of fixed rate securities at a net gain of $85 million. Partially offsetting this gain were impairment losses of $67 million on other mortgage-backed securities which resulted in a net gain of $18 million for available-for-sale securities for the quarter. Non-interest expense for the first quarter totaled $2.2 billion which was about equal to our quarterly run rate in 2007. We are making significant progress on our cost reduction efforts. We reduced the number of employees by 7% during the quarter to end at 45,883. In comparison to the first quarter of 2007 compensation and employee benefits were down 9%, occupancy and equipment were down 5% and telecommunications and outsourced information expense were flat. Unfortunately this progress was masked by $116 million or approximately 300% increase in foreclosed asset expense. We expect foreclosure expenses to remain elevated until we work through this downturn in credit. We do however remain intently focused on reducing our expense levels. As part of our announcement to exit wholesale and retail mortgage we are targeting $550 to $650 million in annual run rate cost savings which will come from home loans and corporate support areas.
Now, let’s dig in to the credit story. There continues to be an excess in the supply of homes on the market and weak demand from prospective homebuyers. Nationally, there were about 4.5 million homes for sales at the end of February down from a peak last fall of about five million. Despite these declines there’s still a very large supply overhang and this excess supply is and will continue to depress home prices. In a more typical market we would expect about six months supply, about 3.5 million properties. In this slow pace of home sales we expect that this excess supply will persist for some time continuing to put pressure on home prices.
Traditional drivers of residential mortgage credit risks such as loan-to-value ratios and the FICO scores continue to be a powerful predictor of the default across all asset classes. The rapid and deep housing price declines have impacted both default probabilities as well as severity on loan losses. This connection of both the frequency and severity of losses to house price declines is no longer just a subprime phenomena; we are beginning to see stress in certain prime portfolios especially recent vintages of the 2006 and 2007 in California and Florida markets that have no benefitted from prior year’s house price appreciation. In addition to the unprecedented declines in house prices the other key contributor to elevated delinquencies and default is the lack of refinance opportunities for many of our borrowers. This credit cycle has seen prepayment rates at historical lows. Those borrowers once able to refinance out of trouble are increasingly stranded with few alternatives but to become further delinquent or ultimately default.
During the quarter non-performing assets increased $2.1 billion or 29% to $9.2 billion. The largest increase in NPAs in the quarter came from prime home loans which were up 50% as the dramatic correction in home prices hit prime borrowers. However, the growth in subprime NPAs slowed to 6% down from 15% in the prior quarter as the rate of growth in this portfolio is showing the first signs of moderating. We believe this reflects the seasoning of our subprime portfolio where NPAs were the first to accelerate last year. We also saw a decline in the rate of home equity NPAs which increased 32% down from a 57% growth rate in the fourth quarter. Recent delinquency and charge off performance in the prime portfolio is directly related to the current adverse environment including lower housing sales, declining property values and the typical liquidity conditions. Much of our prime portfolio is located in geographies where home priced declines have already been particularly pronounced such as in California and Florida while 50% of our loan portfolio was in California at quarter end only 36% of our non-accrual loans were. In contrast only 8% of our loans were in Florida but it accounted for 17% of our non-accruals.
Option ARMs represent roughly half of the prime balances but approximately 70% of our prime non-performing loans. Option ARMs tend to have higher expected losses in all environments. Losses tend to be driven by the same attributes: leverage and FICO that drive losses in other loan types, current evidence does not support the conclusion that negative amortization or payment shock from loan recast are contributing to the recent deterioration in the performance. Further, expected recast dates have been pushed further in to the future as a result of the decline in treasury yield which comprise the NPA index used for option ARMs. Although the bulk of our option ARMs are not expected to recast until 2009/2010 we are already working with option ARM borrowers in a variety ways such as expanding recast figures to avoid foreclosure. Included in our NPAs are $669 million of troubled debt restructurings resulting from our work with customers to keep them in their homes through work out plans or modifications. Approximately 54% or $363 million in non-accrual CDRs were current with revised loan terms at quarter end. We expect the level of work out plans or modifications to continue to rise in 2008 as we continue our proactive practice of working with borrowers to keep them in their homes.
Net charge offs in the first quarter of $1.4 billion were up 83% from the fourth quarter of last year. Consistent with prior quarters the majority of net charge offs came from our subprime and home equity portfolios. However, during the first quarter we also saw significant increase in the net charge offs from the prime home loan portfolio to $330 million from $101 million in the prior quarter. Approximately 60% of the quarter’s total residential net charge offs came from subprime and recent vintages of home equity and option ARMs with LTVs above 80%. Balances and thus losses are also concentrated in markets like California and Florida where the highest level of house price depreciation are being experienced. In January, we saw a sharp uptick in the severity of charge offs as the magnitude of the decline in home values became more apparent. In addition to writing down loans to net realizable value when they reached 180 days delinquent we are finding it increasingly necessary to remark loans that were more than 180 days delinquent with an incremental charge off. This impact continued throughout the quarter and as a result approximately 40% of the first quarter’s charge offs on subprime and prime loans or approximately $300 million in total were on loans that had been delinquent more than 180 days. This issue didn’t impact home equity loans to the same decree since the initial charge off on home equity loans is typically between 80 and 100% of the loan.
As before, we continue to build our allowance for loan losses through provisions that are well in excess of actual charge offs. The provision for loan losses of $3.5 billion in the first quarter was more than double the $1.5 billion provided in the prior quarter. The quarter ending allowance for the loan losses of $4.7 billion was up substantially from $2.6 billion at the end of 2007. The higher reserve reflects the increasing level of delinquencies, non-performing assets and charge offs as a result of the adverse and deteriorating environment. We expect our provision for loan losses to continue at well above the level of actual charge offs until the point where loan delinquencies and non-performing loans stabilizes. We are encouraged that our early stage delinquencies still are not rising as fast as NPAs. During the first quarter borrowers 30 to 89 days delinquent were up 12% compared to the 29% increase in NPAs. However, once a borrower is delinquent few are able to cure their loans through sale or refinancing and that is leading to the record number of foreclosures and charge offs.
While it is very difficult to predict credit costs and provisions by quarter we can provide estimates on the remaining charge offs we expect in the portfolio. That is how we are managing the balance sheet and sizing the appropriate level of capital needed to work our way through this elevated credit period. In creating an estimated range of the remaining losses, we employed a variety of techniques. This included using loan level models, considering losses generated through our previous stress events and then applying judgmental overrides that further increased the high end of the range. As a result of our work we believe the most likely range of remaining losses, that is the amount of balances that ultimately will be charged off in our residential portfolio is between $12 billion and $19 billion for our single-family residential portfolio of $187 billion. We expect those losses to be incurred through charge offs over the next three to four years. We have already provided for a portion of those losses through our loan loss provisioning.
At the end of the quarter approximately $4 billion of our $4.7 billion allowance for loan losses related to residential loans so the remaining losses not reserved for is in the approximate range of $8 billion to $15 billion. As part of our process we consider a range of possible environments where the key dimensions were the general economic conditions, Fed policy actions, the financial market conditions and loan prices. The low end of our range anticipates an economy which is in a borderline recession. It has significant further Fed cuts and continued liquidity difficulties. To get to the higher end of our range we would expect to see further deterioration in the environment with two or more of the following events to occur together: we enter in to a even deeper recession, home price declines are even more sever and more prolonged and I’ll give you our views on that in a second, there is no further helpful government intervention and there are additional market destructions impacting liquidity or consumer credit behavior. While the estimated range of remaining losses does not employ specific HBA paths our stress analysis implies significant further declines in home prices.
At year-end using the [inaudible] index on a portfolio weighted basis there has been a 10% decline nationally and a 13% California. The low end of our range implies an additional decline of approximately 13% nationally and 18% in California and the high end of our range implies more prolonged HBA declines of approximately 30% nationally and approximately 35% in California. Our estimated losses generally incorporates loss levels well beyond what’s happened historically. Let me illustrate this using option ARMs as an example. Losses on option ARMs from the more difficult California vintages from the late 80s and early 90s were around 3 to 4%. For the option ARMs we estimate remaining losses to be twice that level at a low of 6% to as much as 10%. The high end of the range can also be thought of in simple frequency and severity terms. One combination that could get you to a 10% loss is a 20% frequency times a 50% severity across our entire portfolio. To get to a 50% severity overall severities on second liens would need to be 100% and severities on first liens would need to be at least 40%. These severity levels are higher than either what we are seeing currently and are well in excess of any historical benchmarks. A 20% frequency is also beyond anything we have seen historically.
With that analysis of potential future losses let’s look at the strength of our capital position. We ended the quarter with tangible equity of $20.1 billion or 6.4% of tangible assets. The addition of our $7 billion capital range boosts our TE to TA ratio to 8.62% which exceeds our targeted ratio by nearly $10 billion or approximately $15 billion on a pre-tax basis. We’re also retaining capital by reducing the common dividend and will continue to strain asset growth and our normal pre-provision pre-tax earnings which totaled $1.5 billion in the quarter is a strong generator of capital. Effective capital management goes hand-in-hand with maintaining strong liquidity position. We have maintained a very strong liquidity position throughout this period of market stress and we further enhanced that position this last quarter. Retail deposits now comprise 53% of our funding up from 49% at year-end. We have a diversified wholesale funding strategy with staggered maturities and have approximately $50 billion in excess liquidity. Finally, we fund all of our business through our banking operations and do not rely on commercial paper. But, this issue of common stock completely as a holding company is very seldom.
Now, let’s move on to our earnings drivers. Given the uncertainty of the economy in the capital markets 2008 performance is difficult to predict however, the following update is our best estimate of the earnings drivers for 2008. Total assets of $320 billion were down 3% from $328 billion at year-end. We expect to remain conservative in our balance sheet management during this period of uncertainty. We expect our total asset level to be approximately $305 billion at the end of the year. Therefore, we now expect our average assets to be flat to down 5% compared to 2007. As I reviewed with your previously, given the forward yield curve projection of a Fed fund rate of 1.75% by midyear we expect our margin for the year to be between 3.15 and 3.25%. We feel confident in our overall estimate of cumulative home loan related losses and we continue to build loan loss reserves well ahead of actual charge offs. Based on what we know now we also believe provisions will peak in 2008. However, predicting the timing of losses is extremely difficult therefore, at this time we are going to refrain from providing actual credit provisioning guidance of the rest of the year.
Our retail banking business continues to be very successful and we are on track to open more than one million accounts again in 2008. However, we are seeing more conservative spending trends in our customers as the economy softens therefore we are scaling back our guidance for deposit and other retail banking fees slightly to 10 to 12%. Given our decision to exit the wholesale mortgage banking business the reduction in deposit and other retail banking fees, limited gain on the sale of securitization of credit cards and the expectation of continued illiquidity in the capital markets we’re lowering our guidance for non-interest income to $5.6 to $5.8 billion for the year. Lastly, is non-interest expense? We remain highly focused on tightly managing our operating expenses. While we expect long-term non-interest expense to be significantly lower we have some short-term expense pressure. First, we expect to incur approximately $200 million in charges related to our actions with the home loans and corporate support areas as well as other cost reduction areas. Second, we now expect foreclosure expenses to be significantly higher than our prior forecast. Therefore, we are adjusting our guidance on non-interest expense for the year to $8.4 to $8.6 billion.
I’ll now turn it back over to Kerry for his closing comments.
Kerry K. Killinger
We’re obviously not happy with our first quarter results and I want you to know that I am deeply committed to turning things around. The beginning of that turnaround was addressing our need for capital well in excess of our targets. With our $7 billion capital raise WaMu now has ample capital to weather the current challenges in the credit environment and to come out the other side in a strong position. As we move forward we will keep the following four priorities front and center: first, we must continue to manage capital and liquidity and we feel good about where we are at this point; second, we have to do everything we can to continue to manage credit prudently; third, we have to aggressively manage our expenses and streamline our business operations wherever possible; and finally, we have to maintain our focus and momentum in growing deposits. The management team and I are responsible for executing these strategies and we will be held accountable for returning the company to profitability.
On the topic of accountability I realize there’s been a lot of attention focused on our executive bonuses plan in the news media over the past month or so as well as in some analyst reports. The view has been expressed by some that our bonus plan will somehow shield management from credit losses in determining 2008 bonuses. I’d like to clear up any misconceptions about this. Our board has been absolutely committed to making credit one of the key components in determining bonuses for 2008. Their plan was to wait until the end of the year and to use a variety of factors to measure WaMu’s credit performance on a relative and absolute basis. However, with the benefit of shareholder input on this matter, our lead independent director Steve Frank and Jim Stever our chair of our human resources committee have advised me that they intend to recommend to the human resources committee that in amend the 2008 bonus plan to adopt specific credit related targets for which we will be held accountable. This action would make it abundantly clear that managing credit costs is a crucial priority for our management team in this challenging year. I strongly support this action and you can expect that specifics on this will be determined and communicated to all of you soon.
Having said this, I wish to emphasize in closing that our full energies remain focused on improving the company’s financial performance and in restoring shareholder value. Thank you and now we’ll open it up for your questions.
(Operator Instructions) Our first question comes from Chris Brendler of Stifel Nicolaus.
Christopher Brendler – Stifel Nicolaus & Company, Inc.
I may have missed it but can you talk at all about the credit performance of the credit card portfolio? Both the loss and the delinquency rates were much higher than I would have expected. What are you seeing in that portfolio? Is it just macro or are you also experiencing some of the geographic impact in that portfolio? Maybe also if you can break it up between retail, sort of branch originated WaMu customer performance as well as versus the national performance. Those card numbers just don’t look very encouraging.
Stephen J. Rotella
We are suggesting that the card net credit losses for the year will range between 9.5 and 10.5%. We feel comfortable with that range at this point. What I’d say about the geography first of all the card portfolio is fairly well diversified geographically. Unlike some of the comments you heard from Tom about our residential portfolio which has a heavy concentration in California and Florida, we are seeing some stress in certain parts of the country where there is a significant downturn in housing prices and higher mortgage delinquencies. We were seeing that starting late last year and in fact, we took a number of actions both on new loans coming in and on credit line increases and in fact, freezing them which is why our receivables are down in the first quarter. So, I think 9.5 to 10.5% is a good figure. Clearly, this portfolio like most credit card portfolios has a pretty strong correlation to unemployment so if we were to see the general economy slip in to a higher level of unemployment we might expect those losses to increase above that level.
Christopher Brendler – Stifel Nicolaus & Company, Inc.
Okay. A related question, as you mentioned freezing credit lines, are you doing any of that and do you plan to do more of it in your HELOC portfolio?
Stephen J. Rotella
Yeah. We have been active in a program of freezing open to buy on the home equities side. We have been working down from high risk to low risk accounts in our portfolio very aggressively with the letters out to customers informing them of that and we’d expect that to continue going forward.
Our next question comes from Howard Shapiro of Fox-Pitt.
Howard Shapiro – Fox-Pitt Kelton
Tom, your discussion of credit was very helpful but it was a little fast. I’m just wondering if you could just briefly tell us again the low end and the high end what your severity assumptions are and what your home price decline assumptions are. Then, if you could just tell us what the severity you’re seeing right now in California and Florida is, that would be helpful.
Thomas W. Casey
Obviously, this will be reported so you’ll be able to read it yourself but let me give you some stats. As I mentioned, we’ve given quite a bit of thinking around how to look at this and cumulative losses is clearly the right way for us to be thinking about it. What I said in my comments is that – and this is kind of a top down approach but in our high end of our range we’re assuming that we’re going to see severities of about 40% in all first liens and approximately 100% on all second liens. Then, the mathematic I gave you was if you assume a frequency of about 20% based on the weighting of our portfolio that would result in about a 10% remaining loss on our portfolio. So, that’s the mathematics that I took you through. With regard to severities we’re nowhere near those levels currently. I don’t have specifics in front of me on individual MSAs but it total first lien prime loans for example are in the mid 20s and second liens are in the about 80s so clearly lower than the high end of our range currently.
Our next question comes from Eric Wasserstrom of UBS.
Eric Wasserstrom – UBS
Actually, if I could just follow up on Chris’ question, Steve the 9.5 to 10.5% guidance can you specify what employment situation that relates to because it would seem that we’re at a very benign level of unemployment currently but to see a 300 basis point move in the charge off rate is pretty inconsistent with the very moderate decree of unemployment that we’ve seen.
Stephen J. Rotella
First of all one thing that I would ask you to keep in mind and I’m sure you know this, on a credit card portfolio there’s also a denominator effect going on here. When you look at net credit losses on a go forward basis portfolios growing obviously have the benefit of that. In this case our portfolio, our managed receivables were actually down somewhat so part of the increase is due to that. We are assuming an unemployment rate in thinking about the 9.5 to 10.5% of about 6%.
Thomas W. Casey
Eric, I would add just one more thing, keep in mind that the retained interest, the fact that you’re looking at this on a managed basis [inaudible] but when you look at it on a GAAP basis those retained interests have already been marked. We took about $159 million mark in the fourth quarter as the discount rates were increased significantly. We also took another $72 million in the first quarter so while you’re seeing the net credit losses going up the impact is already being factored in the finances.
Eric Wasserstrom – UBS
And your remaining IO is how big?
Thomas W. Casey
Total retained interest is about $1.8 billion total.
Our next question comes from Moshe Orenbuch of Credit Suisse.
Moshe Orenbuch – Credit Suisse
Kind of following up on the earlier question on credit quality, you mentioned what the severity rates were, you also mentioned that a good portion of the charge offs are coming from loans that had been in NPA and just marking them down a second time. Could you talk about how much o of your NPAs are actually getting disposed of and when you’re actually seeing kind of a market based severity rather than just what you’re kind of estimating?
Thomas W. Casey
The way our process works is we take an initial charge off at 180 days past due per our regulations and then once the loan goes in to REO we take a second charge off. In fact, up to 90 days after being in REO we still have a charge off that goes back through the provisions. Anything subsequent to that will go through as a charge to our foreclosed asset expense in the NIE line. So, what I was referring to is that given the severity of home price decline that came through late in 07 and then the first part of 08 we found ourselves having to remark those portfolios further than we had at 180 days past due.
Moshe Orenbuch – Credit Suisse
Right. The first part of the question was how much of the NPAs as of the beginning of the year were you able to get rid of from sales or other kinds of needs during the quarter?
Thomas W. Casey
Well, we’re turning assets in the pipeline at about 20% a month.
Moshe Orenbuch – Credit Suisse
20% of the beginning balance a month?
Thomas W. Casey
Stephen J. Rotella
And that’s on the REO. We are not selling any of the NPAs.
Our next question comes from Brad Ball of Citi.
Bradley Ball – Citigroup
I wonder if you can give us a little more color around your confidence that provisioning will peak during 2008. Does that statement; does that jive with the high end of the cumulative loss range or the low end that you gave us? Then, one question for Kerry, I understand that at today’s shareholder meeting it was decided that the chairman and CEO positions would be separated. Can you give us a sense as to the timing for that and which of those duties will you assume? Either the CEO or the chairman jobs?
Kerry K. Killinger
Well, first on that there was talk on that issue, still a preliminary vote and we’ll get the final results in before long but that is simply an advisory vote and the board of directors will take that in to consideration and look at that in due course. But again, that is not a mandatory immediate movement or anything; it was just an advisory vote on the subject.
Thomas W. Casey
On the provision side we feel that the severity that we’re seeing are going to result in higher levels of provisioning in 08. We think that even on the low end of the range, at $12 billion keep in mind that we’ve already had $4 billion up in the allowance. That would say that if we were to see some form of fiscal stimulation or [inaudible] that would bring us in at that lower end of the range we still think that 08 would be the most significant levels of provisions. When you get to the higher end of the range again, that’s going to be dependent on where the economy looks like at the end of the year but it is our anticipation that the way the [inaudible] level is building that we think provisions will be amongst the highest in 08 and then slowly coming down in 09. That’s the way we’re looking at it right now. Then ultimately, charge offs will come in probably over the next probably three to four years.
Our next question comes from Analyst Inaudible.
You specifically mentioned that the negative equity is not a good predictor and I was wondering has that been played out in your practice. Or, how did you come to that conclusion particularly given that it seems that there are people that are suggesting that is the new way to look at a predictor of foreclosure or delinquency.
Thomas W. Casey
We think it’s an important part. I didn’t make any specific comments about what we were referring to but what we have seen, just to expand on your question, we have seen that consumers that do roll over 100% LTV are still more than likely to continue to pay. We are seeing some increase in delinquencies there but they’re down in the ranges of more like 15%, 20% as opposed to what I think the people are assuming it’s much, much higher than that. So, folks that have greater than 100% LTVs we do see higher levels of delinquencies but it’s nearing greater than 50% or anything like that it’s still 15 to 20%.
Our next question comes from Paul Miller of FBR Capital Markets.
Paul Miller – Friedman, Billings, Ramsey & Co.
Tom, you mentioned that you had 30 to 89 days was only up 12% in the quarter. Can you give us what it was in the fourth quarter, what the growth rate was?
Thomas W. Casey
I don’t have that off the top of my head Paul, I’ll have to follow up with you off line to get that. The delinquencies on the front end of the [inaudible] has not really changed that dramatically so it would probably be very similar to the levels we’re seeing here. We’re continuing to articulate that clearly the late phase delinquencies that we’re seeing included in the stuff that we prepared for this call the one area that I’d say has increased is the option ARM, the early stage delinquencies are up and we wanted to make sure that everyone was aware of that. But, the rest of the portfolio really has not changed that much on that 30 to 89 day level.
Our next question comes from Fred Cannon of KBW.
Frederick Cannon – Keefe, Bruyette & Woods
This might be for Steve but I noticed that you guys have pretty much shut off the option ARM production. I think it was only like $231 million down from $4 billion in the previous quarter and $8 billion a year ago. So that’s a specific question, is that in fact the case that you essentially shut that off? And, related to that just kind of a reflection on a go forward basis it seems like you shut down a lot of the asset generate capability of Washington Mutual and kind of how strategically how you’re thinking about that on a go forward basis since you’ve essentially seemed to have loss or shut down a lot of your asset generation capabilities? Thanks.
Stephen J. Rotella
Fred, first on the option ARM we’ve not shut it down. What’s happening right now is a combination of consumer preference and underwriting shifts in the marketplace. Consumers right now are clearly choosing, when they can get a loan, 15 and 30 year fixed and hybrid products and that’s the predominate portion of application volume and closing volume for us. I think as Tom mentioned in his comments about 90% of our application flow is GSE saleable. So, we do have the option ARM on our menu and for certain customers it’s the appropriate product but at the current time between underwriting and the marketplace it is not a hot seller by all means. Secondly, in terms of strategy let me first of all talk a little bit about what we’re trying to do here again in home loans. We’ve been successful in growing our bank loan consultant channel up to about 1,000 loan consultants. We believe we have plenty of room to add more of them and as we move forward continue to have a much stronger linkage to the retail banking strategy of the company which we think is appropriate and those bank loan consultants will be able to get mortgages and home equity loans and also help us cross sell bank products as we go forward.
Secondly, we have a very strong capable call center capabilities as well as web capability that we’ll be working on as we move forward. So, for us at this point we think sizing the business appropriately in that manner is the right thing particularly when you consider that the market in and of itself is smaller, the GSEs are becoming more dominant. We think they’ll be heavier regulations and the product set is a very heavily commoditized product so even the product we could generate today, most of it while there is a reasonable spread on hybrid jumbo ARMs is not the kind of product we think we want to build our balance sheet on and again, we need to diversify the company going forward. So, we do have capabilities in our multifamily business, we obviously have some capability with cars, we will selectively put mortgages on the balance sheet. Going forward as we go through this transition with the balance sheet becoming smaller there are other asset classes we can be thinking about adding to the company. Also, I just mentioned again, this is part of a longer-term strategy we’ve had to size the business properly and I know Fred you’re aware of the MSR sale we did in the past and closing our correspondent business. So, we view this as a next stage in that evolution of the business.
Our next question comes from Jay Winthrop of KBW.
Jay Winthrop – Keefe, Bruyette & Woods
I see that you cut the common stock dividend to a penny and I was wondering if there was any specific reason for maintaining some dividend. And in connection with that is there any relation to the deferrable and non-cumulative preferred and hybrid payments that must be paid as long as the common stock dividend is paid?
Kerry K. Killinger
I think the directors choose to reduce the dividend to one penny a quarter primarily to preserve and strengthen our capital even further. Given where we are at this point in the cycle I think that they made a judgment that having a nominal dividend was better than not having a dividend because some of our shareholders in order to invest in the company need to have a dividend payment and so that’s why they took it to a low level. We think that’s appropriate for the time being. We do feel that with the strength of our new capital raise along with the balance sheet management and now the reduction of this cash dividend that we should have a very strong capital position to deal with virtually any credit cycle and certainly should be able to work right through even that stress scenario that Tom was laying out a little bit earlier in case that happens to take place. We think that our capital position is very strong now and obviously we look forward to a time when the provisioning starts to come back down and we can get the earnings power back up to a much more acceptable level and I would certainly like to see that cash dividend on the common have more flexibility at some point in the future.
Thomas W. Casey
In the press release we do say that the Series S and Series T are also getting a $0.01 dividend so those are, if you will, the common stock equivalent that [inaudible]
Our next question comes from Dustin Brumbaugh of Ragen Mackenzie.
Dustin Brumbaugh – Ragen Mackenzie
My question is on just deposit growth, you named it as one of your 4Q priorities and I’m just wondering if you could talk a little bit about strategy on that going forward and how pricing plays in to that strategy.
Thomas W. Casey
Well, I think as we’ve talked about in the past growing our deposits is critical to maintain our liquidity. Overall, retail deposits on an average basis were up $4 billion, on a period over period up about $8 billion, commercial was down about $2 billion so we are seeing some mix in our deposit base but we’re seeing good strong growth in demand in the money market and timed deposits in most of our markets. We’ve been quite disciplined in changing our goals of our store managers and the entire retail bank is focused on generating deposits in this environment. Steve, do you maybe want to touch on that?
Stephen J. Rotella
I’d add a couple of other things, our increase in deposits is coming from three places and I’ll do them in the order of size right now. Our Internet bank which is doing quite well has over $5.5 billion of deposits and growing. By the way just ranked number one by comScore in satisfaction and in share of checking and deposits online which is terrific. Secondly, our small business practice which we really established over the last year or so and is beginning to mature is up in the market and bringing in deposits. I believe we’re over $9.2 billion in deposits at the end of the quarter. And third, as Tom mentioned, in our retail franchise we’ve placed more emphasis on gathering core deposits this year through goal alignment, training and a number of other actions and we think it’s starting to pay off. Obviously, it’s a very competitive environment out there and we continue to feel that we’ve got opportunities to grow deposits going forward and given the cost of wholesale funding we think that’s a darn good thing.
Our next question comes from Howard Shapiro from Fox-Pitt.
Howard Shapiro – Fox-Pitt Kelton
Just a follow up on credit and I’m referring to the transition roll rates in your credit appendix on page 13. You’re I guess going from three payments delinquent to non-accrual appears to have flattened out and I’m just wondering if that’s because of the large increase in inventory and the difficulty in I guess getting it out in to the market and processing it or is there something else going on?
Thomas W. Casey
I think what we’ve indicated in my comments is that we are starting to see particularly in the subprime, starting to see some form of reflection. It’s a little early to be that hopeful but we are seeing signs of a reduction in the size of the non-performing assets and what you’re seeing in that three payments past due and going in to non-accruals is really the bucket I was referring to. You can see that the other portfolios are having similar levels but I guess it’s just a little too early to say that we’re seeing a reflection in all of the products. We’re really saying mostly in subprime.
Stephen J. Rotella
Let me come in behind Tom on that, I’d also remind you that in the case of subprime that’s the asset class that started going in to troubled status first. And secondly, for us, we started reducing our participation in subprime earlier than most players so we’ve got a portfolio that’s got a little bit more age around it if you will so it’s not unexpected to see it mature a little bit faster and start to flatten out. Again, not to declaring victory but those two things have a lot to do with this. And, in general in the marketplace what’s going on again is some liquidity issue for the most part. Customers cannot get out of a delinquent status once they go past a couple of payments past due and that’s a significant issue. When liquidity starts coming back to the market we should start seeing that ease somewhat.
Our next question comes from Gary Gordon of [Inaudible].
Gary Gordon – [Inaudible]
I’d like to discuss the recent capital raise a little. Putting a couple of things together your capital ratio gain in the first quarter was actually materially larger than a year ago. Two, you’re talking about shrinking assets. Three and you may want to correct me on this, even in the higher end of your NPA range gets you roughly sort of breakeven earnings for the next couple of years and obviously the recent capital raise is fairly dilutive. I was wondering about the size of the raise, the $7 billion, is that extra there for even if we could get potentially past the high end of your range? Or, you would like to be in a position to grow the balance sheet actively? Or, regulators would like a higher level of capital? How are you thinking about that? How did you think about the $7 billion?
Kerry K. Killinger
I think there were a number of factors that came in to consideration and I think one is there is clearly an uncertainty out in the marketplace with the residential real estate markets and we have seen again, HBA declines that were certainly much greater in recent months than people would have forecast a number of months ago. So, I think there was a certain amount of conservatives that says with that uncertainty let’s bet sure we have a very strong capital position. I think secondly, again as we looked at all our capital ratios we felt that this was an important time to increase the tangible common equity ratio that we would have in the company so that’s why we did a common and common equivalent form of capital raising through here. I think third is that [inaudible] element about we want to be cautious about going through the downturn and then there’s a bit on the other side that is saying that we want to be very well positioned when things improve so that we have capital that could facilitate opportunities that become available. We will always have the opportunity for share repurchase in that improved period but by having the capital in place we’d also have the alternative of expanding our balance sheet, of potential acquisitions on an opportunistic way. Our board just tried to weigh all of the risks and rewards and concluded that having a very strong level of capital on balance was the smart thing to do.
Our final question comes from Tom Marsico of Marsico Capital.
Tom Marsico – Marsico Capital
Just continuing along with the capital raise, can you discuss any sort of management issues between the new partners at TPG and Washington Mutual? How the new board member will react with management on different issues?
Kerry K. Killinger
Again, I think as I mentioned as a company we’re very familiar with David Bonderman. He served on our board from 96 through 2002. In fact, we’ve already had a couple of meetings with David and people in his organization. David was appointed to our board of directors this afternoon so he will be a board member. As part of the agreement we also agreed that there will be a board observer in addition that [inaudible] specific group could have for our board and so we look forward to that as well. Just on a periodic basis we certainly in the due diligence process we went through a very thorough review of all of our business plans and opportunities that we saw for creating shareholder value over the next several years and I think they are very much in agreement with those core plans that we laid out for you and they are really around the themes of first going through some changes in our home loans group and significant cost savings which we’re working on now and then investing heavily in the core retail banking business and growing that as much as we can. I think we all view that as the most important part of our franchise that we want to keep growing. I think that they completed their due diligence and became comfortable that they could see the range of credit losses in our portfolios and I think Tom reviewed the range of our estimates on that and that seems to be consistent with how they believe things are. I really expect that we’ll be working with them with a very strong board member, with David. We expect to periodically produce strategic plans and initiatives with both not only David but his lead people at TPG and again, I think we’ll have a very strong partnership.
Thank you. That concludes the Q&A portion of today’s call. I will now turn the call over to Mr. Killinger for closing remarks.
Kerry K. Killinger
Again, thank you all very much for joining the call. We look forward to talking to you next quarter and be sure to follow up with any other questions to investor relations. Thank you.
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