Washington Mutual, Inc. Q2 2008 Earnings Call Transcript

Jul.23.08 | About: WMIH Corp. (WMIH)

Washington Mutual, Inc. (NYSE:WM)

Q2 2008 Earnings Call

July 22, 2008 5:00 pm ET

Executives

Alan Magleby - Senior Vice President of Investor Relations

Kerry K. Killinger - Chief Executive Officer & Director

Stephen J. Rotella - President, Chief Operating Officer & Interim President - Retail Banking

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

John McMurray - Executive Vice President & Chief Enterprise Risk Officer

Analysts

Howard Shapiro - Fox-Pitt Kelton Cochran LLC

Moshe A. Orenbuch – Credit Suisse

Bruce Harting – Lehman Brothers

Gary Gordon – Portales Partners

Chris Brendler – Stifel Nicolaus & Company, Inc.

Frederick Cannon - Keefe Bruyette & Woods, Inc.

[Shawn McGee – Morgan Stanley]

[Louise Pitt – Goldman Sachs]

[David Knudsen – Legal & General]

Bradley Ball – Citigroup

Paul Miller, Jr. – FBR Capital Markets

Operator

Welcome to WaMu’s second quarter 2008 earnings conference call. (Operator Instructions) I will now turn the call over to Alan Magleby, Senior Vice President of Investor Relations, to introduce today’s call.

Alan Magleby

I would like to welcome you to WaMu’s second quarter 2008 earnings conference call. I want to remind you that our presentation 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 other recent documents filed with the SEC.

With us today are Kerry Killinger our Chief Executive Officer, Steve Rotella our President and Chief Operating Officer, Tom Casey our Chief Financial Officer, and John McMurray our Chief Enterprise Risk Officer.

At this time I will turn the call over to Kerry.

Kerry K. Killinger

Good afternoon everyone and thank you for joining us today as we review our results for the second quarter. Joining me today on the call is Tom Casey our Chief Financial Officer and John McMurray our Chief Enterprise Risk Officer who oversees corporate credit. I know that credit is on everyone’s mind so John will provide you with additional disclosure around our credit position as well as some of the actions we’re taking to manage our credit exposure. Tom will discuss our quarterly performance in much more detail and give you an update on our 2008 earnings drivers. Our President Steve Rotella will also be available to answer your questions at the end of the presentation today.

I want to begin my remarks today by emphasizing to all of you that in the face of the unprecedented housing and mortgage market conditions we’re experiencing, we are continuing to execute on a comprehensive plan designed to ensure that we have strong capital and liquidity, an appropriately sized expense base, and a growing profitable retail franchise. I also want to call your attention to some key take-aways that everyone should draw from today’s discussion.

First, the quarterly increase in the provision we announced today reflected the impacts of the very difficult conditions in the housing market. In response to these adverse trends we changed our provisioning assumption which had the affect of accelerating provisions into the quarter. John and Tom will discuss our approach to the provision in more detail in a few minutes. The key take-away here is that we expect total remaining cumm losses in our residential portfolio to be toward the upper end of the range we disclosed in April. And just to remind you, the top end of the range was $19 billion.

We also continue to expect 2008 to be the peak year for provisioning. When we completed the $7.2 billion capital raise back in mid-April we said that our pro forma capital position should enable us to withstand a high end credit scenario. Based on what we have seen through the second quarter, we continue to believe this to be the case. In addition you will hear later from John and Tom that our capital planning included not just estimated losses on our residential portfolio but costs for all other asset classes.

Second, it’s important to note that our capital position remains significantly in excess of our 5.5% targeted level. The after tangible equity to tangible asset ratio at the end of the second quarter increased to 7.79% from 6.4% at the end of the first quarter. This is $7 billion above our targeted level. From a regulatory capital perspective our Tier 1 risk-based ratio remained strong at 8.44% which is 244 basis points above well capitalized. In addition we continue to focus on maintaining strong levels of liquidity. We ended the second quarter with over $40 billion of readily available liquidity.

Third, we continue to build reserves well in excess of net charge offs. During the quarter we provided for losses at 2.7 times net charge offs of $2.17 billion bringing our loan loss reserves to $8.5 billion at the end of the second quarter. The reserves we now have available to address possible charge offs are up substantially. As a percentage of loans in our portfolio the reserve has more than tripled from year-end 2007 and our coverage ratio of reserves to nonperformers has more than doubled over the same timeframe.

Fourth, we also continued to aggressively manage our expenses with the implementation of a series of cost-saving initiatives during the quarter. As a result we now expect to achieve $1 billion in annualized cost savings which will contribute to pretax pre-provision earnings going forward.

The fifth and final point I want to emphasize is that our core businesses continued to drive strong pretax pre-provision earnings. On a normalized basis we would expect those earnings to be approximately $6 billion annually. In our retail business we saw a significant increase in depositor fee income during the quarter, up 9% to $767 million from the first quarter and we opened approximately 250,000 net new checking accounts. This brings our net new checking account growth for the year to about 500,000. The key take-away here is that our core retail franchise remains strong, we continue to attract retail customers at a healthy pace, and our employees continue to deliver what customers value and want.

Before John digs into the credit discussion, let me provide a closer look at the four key strategies we are deploying to return WaMu to profitability as soon as possible. First, we will maintain sufficient capital and adequate liquidity. As I commented before, we believe our current capital position will be sufficient to weather a high end credit scenario. Our second key strategy is to tightly manage our credit portfolio. John will cover this in detail, but for example we took decisive steps to reduce our unfunded home equity lines of credit by $17.7 billion since the beginning of the year and our total amount of restructured loans included in nonperforming assets more than doubled to $1.4 billion. This is a reflection of our commitment to helping customers who are having problems with their house payment avoid foreclosure. We also continued to tighten underwriting and card services, eliminated the wholesale origination channel of home loans, closed 160 retail home loan centers and eliminated negatively amortizing products including the option ARM from our product line.

Healthy markets continue to be under great pressure but as John will review we are seeing some leveling in early stage delinquencies for home equity and subprime loans however, prime residential early delinquencies are still rising. Our delinquencies will be highly correlated with the unemployment and the economy but are also showing signs of stabilization. As you will see, card losses are elevated and we expect them to be approximately 10.5% for the year while multifamily and commercial real estate delinquencies appear to be maintaining their good performance.

Our third strategy is to continue to strengthen our core retail franchise. As I mentioned earlier, we continued to see significant increases in net new checking accounts generated through our stores and online banking channels during the quarter and a sizeable increase in depositor fee income. In addition, we’re focusing our mortgage originations through our retail stores. And, our fourth strategy is to improve the efficiency and productivity of our organization. Earlier this year we announced a series of initiatives in the home loans unit which we estimated would reduce annualized operating expenses by $550 to $650 million. As Tom will review, we expect these initiatives to result in restructuring costs of approximately $450 million this year but annualized run rates savings now should be about $1 billion.

With that, I’d like to now give you a brief overview of our second quarter results. We reported a net loss of $3.3 billion, driven by a $5.9 billion provision for loan losses. This increased our loan loss reserves by 79% from the first quarter. Despite our quarterly loss, we ended the second quarter with a tangible equities to tangible asset ratio of 7.79% up from 6.4% in the first quarter. Now, I’ll turn it over to John McMurray.

John McMurray

As you are all aware, the operating environment continues to be very difficult. Home prices continue to decline and the secondary market for non-conforming loans remains illiquid while the economy appears to be getting weaker. In the 10-City composite index compiled by Case-Shiller, home prices were down an additional 6.7% in the most recent three months of data bring home price depreciation to 19% down since the approximate peak of the market in July of 2006. Weighting this data to reflect WaMu’s residential portfolio yields a decline of 22%. It’s important to remember that the housing bubble built up over a period of many years and its going to take some time to recover.

This afternoon I’m going to update you on the current performance of our loans and also provide some new information on some of our portfolios. We have posted on our website supplemental materials with additional information that you may find useful. First, let’s look at the overall trends of our portfolio. We significantly reduced our production in new mortgages and tightened our underwriting standards across our loan portfolio products and are allowing certain types of loans to decline with loan amortization and payoffs. As part of these actions, we will no longer be originating option ARMs.

Year-to-date, single family residential loans are down $8.5 billion or 4% with most of that decrease coming from the option ARM portfolio. Offsetting a portion of this decline was an increase of $3.7 billion in other loans as we continue to further diversify our portfolio away from single family mortgages and home equity loans. Specifically, multifamily loans were up 4% as we continue to be comfortable with these loans which has a second quarter annualized net charge off rate of only four basis points.

Although our total managed credit card portfolio actually declined by 3% in the first half of the year, our on balance sheet credit card receivables were up 20% as the securitization market remained illiquid. Early stage delinquencies are demonstrating mixed trends. We have seen a migration of credit problems through various loan types. First to deteriorate were subprime loans in late 2006 and 2007. Then, in the second half of last year, home equity delinquencies began to rise. In 2008, option ARMs are the product type experiencing the fastest rise in delinquencies. We expect other prime loans which are mostly five and seven year hybrids to follow option ARMs closely in this timing but don’t anticipate they will experience the same level of delinquencies. The poor performance we’re seeing in option ARMs tend to be concentrated in those markets experiencing the greatest degree of home price depreciation. At this point in time increases in option ARM delinquencies are not being driven by loan recast issues.

We did see signs of moderation in delinquencies of some other products. Subprime loan delinquencies are down slightly over the last six months and we believe that this portfolio may be starting to burn out. Home equity delinquencies declined slightly in the quarter to 1.48% from 1.66% at the end of the first quarter. It’s premature to isolate specific causes or to know whether this will continue. Some have speculated that it reflects pay downs from the federal economic stimulus program reflected in higher personal savings rates in recent months, or perhaps conservatism by consumers but we will watch this trend closely. We’re observing a directional change in the rate of growth for non-performing loans. The rate of increase of non-performing loans and delinquencies was increasing through the end of 2007. However, during the first and second quarter of 2008, we have seen the pace of increase slow. Granted, this is due in part to the large size of these numbers, but this quarter we are seeing some slowing in the pace of growth. As with decline in home values, the pace of change has to slow before it can flatten or change direction.

In the second quarter early delinquencies were up 4% after growing 12% in the first quarter and 30% in the fourth quarter of last year. Non-performing assets increased 22% after an approximate 30% increase in the prior two quarters. Non-performing assets increased $2 billion in the second quarter to $11.2 billion. Nearly 40% of that increase was due to the more than doubling of restructured loans that are classified at TDRs or troubled debt restructurings, to $1.4 billion from $669 million. Importantly, at quarter end, approximately $1 billion or 71% of these loans were current with their revised loan terms. If a TDR remains current for six consecutive months the loan will move back to an accrual status. We remain very committed to working with our borrowers when it is possible. It is the right thing to do and should minimize the bank’s loan losses in the long run.

Excluding restructured loans, non-performing assets increased 15% or about half the rate of increase in the first quarter. Foreclosed assets were up 11% compared to a 39% increase in the first quarter. Charge offs have increased significantly as tighter underwriting makes it difficult for troubled homeowners to refinance and the slow pace of home sales and declining house prices make it difficult to sell homes. Despite significant actions being taken by the company to modify existing loans, we expect credit losses to continue to remain elevated until home prices begin to stabilize. On this Slide, you will see that both charge offs and provisions have moved higher reflecting this less favorable environment. In total, net charge offs increased to $2.2 billion from $1.4 billion in the first quarter. The quarter’s provision of $5.9 billion was the third consecutive quarter were provisions were at least double net charge offs.

Approximately one third of the quarter’s provisions related to significant changes in key assumptions the company used to estimate incurred losses in its loan portfolio in response to the increasingly adverse credit trends. Specifically, the company shorten the historical time period used to evaluate default frequencies for its [inaudible] to a one year period reflecting the evolving risk profile of the loan portfolio and adjusted severity assumptions for all single family mortgages to reflect the continuing decline in home prices. For any specific population of loans, loan loss provisions must equal charge offs. Provisioning therefore cannot continue at this ration indefinitely

During the second quarter, net charge offs of subprime and recent vintage home equity loans continued to increase and we saw a significant increase in net charge offs from our option ARM portfolio to $523 million up from $254 million in the prior quarter. Beyond our residential portfolio we expect the net credit loss rate for our managed card portfolio to be in the 10.5% range for the full year due to the weak economy and expectations of the further increases in unemployment. And, we expect credit losses for our multifamily portfolio to remain modest during 2008. Year-to-date, we have provided $9.4 billion for loan losses in comparison with net charge offs of $3.5 billion, increasing the reserve to $8.5 billion at June 30th. This growth and the level of reserve combined with our efforts to reduce the size of the loan portfolio is driving much stronger coverage ratio.

As a percentage of loans held in portfolio, the reserve now stands at 3.53% up from 1.05% at the end of 2007. The coverage ratio of the reserve to non-performing loans of 87% is more than double the 42% at the end of last year. Keep in mind that many of our non-performing loans are first liens where substantial recoveries are expected. While our option ARMs are clearly facing performance challenges that are shared across the industry we believe our portfolio may be better positioned to face many of these challenges. As you will see shortly, our option ARMs generally appear to be performing better than the more than $250 billion of loans underlying ABS MBS securities. I’d therefore like to provide you with a little more perspective on some of the drivers of performance and the risk profile of these loans and discuss what these may mean for our portfolio.

Option ARMS feature a low minimum payment which allows the borrower to obtain more leverage in their home over time. We have typically required meaningful borrower equity when originating these loans. More than 81% of our current option ARM borrowers have put down at least 20% at origination and only 6.5% have put down 10% or less. Looking across the industry, many other originators appear to be less well positioned in this respect with a greater prevalence of low down payment loans. This has been especially true for many of the securitizations in the ABS MBS market and is likely an important factor in explaining the relatively adverse performance of these loans to date.

One of the reasons for this is because option ARMs were particularly popular in many of the housing markets that are today experiencing some of the faster rates of house price declines. As a consequence, loss of borrower equity has tended to be especially pronounced for this product. While a significant portion of our option ARM portfolio is in California, you can see that much of that portfolio is concentrated in coastal markets. These differences are important drivers of performance. MSAs in the southeastern US such as those in Florida and Georgia and MSAs in the inland empire and central valley of California have recently experienced some of the worse housing market conditions and price declines in the country. While these MSAs make up only 20% of our option ARM exposure, they have contributed 39% of our total option ARM delinquency growth for the year.

This is significantly more than other groups of areas including the coastal areas of California which make up roughly 85% of our California exposure, yet have contributed much less to our delinquency growth. There are a number of additional points to make about the prospects for this portfolio. First, these remain primarily loans to prime borrowers who all else being equal are more likely to repay their debt. The majority of our option ARM borrowers have a current FICO score of about 700. Second, recast risk is distributed over the next five years with a majority of the scheduled recast to occur between 2010 and 2012. Moreover, for our portfolio loans, we have the flexibility to extend recast dates beyond that period if we feel it is prudent to do so. Third, WaMu is aggressively modifying option ARM loans to mitigate foreclosures and losses and we will maintain that flexibility going forward. Finally, the pattern we discussed earlier of slowing rates of delinquency growth for the total portfolio can also be observed for option ARMs.

On a quarter-over-quarter basis, option ARM total delinquencies grew by 22% down from 37% and 58% from the prior two quarters respectively. You can see from this panel of charts that our option ARMs have lower delinquencies in each of the four vintages than the comparison from the loan performance database. A couple of important notes are that in addition to the $6 billion in 2004 vintage option ARMs, we have another $8.8 billion originated in 2003 or earlier that are performing at or better than the 2004 vintage. The 2005 and 2006 vintages are at risk for elevated losses due to home price declines because those loans were made close to the peak of the market. Note that the portion of our HFI loans in this comparison populations for 2005 and 2006 is down from 2004. The proportions are approximately 32%, 15% and 9% for 2004, 2005 and 2006 respectively.

In the first half of 2007, we sold many of our originations but added loans in the second half of the year when the mortgage markets froze up. As a result of this market seizure, 2007 is somewhat of a mix match with essentially all of the MBS ABS loans originated in the first half of the year and our portfolio more heavily weighted to the second half. It’s still early in the cycle for that vintage but we’re tracking more closely with other loans in the loan performance data base. As I mentioned earlier, recasts are not presently a key factor driving option ARM performance. Nevertheless, selectively extending recast periods is one of the tools that we will use as more scheduled recast occur over the next five years. We will generally have more flexibility with borrowers in our HFI portfolio on workouts and modifications compared to loans in securitized pools. Across all loans we will actively work with our borrowers to restructure loans where and when its appropriate.

Turning to our home equity portfolio, we have reduced our unfunded home equity loan exposure by 30% since the beginning of the year. At the end of June, our total commitments were down to $41 billion and of this amount only a little over half had any lines drawn against them. As you can see, the line reductions were largely based on loan level estimates of current combined loan-to-value ratios. Lines were reduced most significantly in the higher LTV categories, yet there reductions across combined loan-to-value ratios because we also looked at credit quality of these borrowers as well.

So, what does this all come down to as we look at our remaining loss estimates? First, although we now believe we are in our higher end of our original range of estimates, the upper range of the remaining loss estimate for our March 31, 2008 single family residential portfolio remains at $19 billion. Second, we want you to understand that we considered all credit costs, not just the single family, subprime and home equity accumulative losses covered by the $19 billion estimate when we made our financial forecast and did so when we raised capital in April. We included loss estimates on multifamily, credit card and unfunded home equity which equal about $760 million on an annualized basis for the first half of this year. We also considered foreclosed asset expenses which using the first half of 2008 would annualize out at about $744 million. Tom will discuss this a bit more in his comments on capital.

We have grown our allowance to $8.5 billion and added provisions at 2.7 times charge offs in the first half of this year. With that in mind, we continue to expect charge offs in our residential portfolio to occur over the next several years but continue to believe that 2008 will be the peak year for loan loss provisioning. The environment is unprecedented and of course, we can’t foresee the future when it comes to economic conditions or how governments, institutions or consumers will respond to these conditions. But, this is our best thinking at this time.

Before I pass it over to Tom, I want to make a distinction between how losses are recognized in mortgage securitizations versus the financials of the portfolio lender. This is important because there are a lot of comparisons of loss estimates using securitizations as a proxy for portfolio loans. While the ultimate loss on a loan-by-loan basis is comparable, the accounting and timing is much different. In a mortgage securitization, pass through losses include foregone interest, losses on the sale of REO plus expenses. For a portfolio lender, these credit losses are spread across the income statement. We obviously have credit losses that run through the provision and the reserve which is the $19 billion expectation we shared with you previously for our March 31, 2008 residential portfolio. Foregone interest is a separate line item and appears as a reduction in net interest income. Furthermore, some expenses and losses on the sale of REO are booked as foreclosed asset expense and are part of our non-interest expenses. Finally, unlike securities losses, a portfolio lender provides for losses when they are incurred and takes a charge off when the loan is 180 days delinquent and/or when the property is foreclosed.

Depending on the circumstances, such as coupon, liquidation timeframes and other factors, we estimate that foregone interest and foreclosed asset expense can represent up to one quarter of the total cumulative loss. So, while we are experiencing the full loss through our income statement, the cumulative loss estimate we recognize through our provision represents approximately three quarters of a comparable loss on a securitization basis.

That concludes my remarks. Let me now turn the call over to Tom.

Thomas W. Casey

As Kerry and John discussed, the second quarter was a period of continued home price declines and turmoil in the financial markets. Given John’s analysis of our credit profile, I’ll focus on how we are managing through this difficult environment. Specifically, the actions we are taken to reduce the size of our balance sheet, to free up capital, maintain strong liquidity and reduce our operating costs. I’ll also provide you with our outlook for the rest of 2008.

Our tangible equity to tangible asset ratio improved during the quarter to 7.79% from 6.4% despite the loss for the quarter. We ended the quarter with total assets of just under $310 billion, down $10 billion from the prior quarter and down $18 billion or 6% from the start of the year. We have exited significant channels of mortgage production and tightened our credit standards. Therefore, we are adding very few assets to the balance sheet as we allow a significant portion of the residential loan portfolio to run down. One area of loan growth is card receivables. Although total managed receivables are flat, we are bringing back loans on to the balance sheet as securitization funding costs have increased significantly and we can fund them more cheaply on our balance sheet.

We expect the balance sheet to decline throughout 2008. Right now we are forecasting total assets between $285 and $295 billion by year end. It’s important to remember that for each $10 billion in asset reduction, that frees up approximately $550 million in capital so the asset shrinkage since the start of the year has already freed up approximately $1 billion in capital. We continue to see increases in our NIM in 2008. The NIM was up 17 basis points in the second quarter after improving 19 basis points in the first quarter. This higher level of NIM offsets the decline in balance sheet and increase in non-accrual balances.

During the second quarter, MPAs compressed the NIM by approximately 30 basis points. Despite the MPA impact, the stronger NIM drove a $121 million increase in net interest income from Q1. The NIM improvement was driven by lower borrowing costs from the full benefit of 325 basis point Fed Fund rate cuts in the last year and a reduction in high cost federal home loan bank advances. Three month LIBOR is down by nearly 260 basis points in the year which has helped reduce our average cost of retail deposits by 59 basis points to 2.23% in the second quarter from 2.82% in the fourth quarter of last year. We are also managing the maturities of our wholesale funding to reduce the overall interest rate sensitivity should rates rise.

Deposit and other retail banking fees continue to be stronger growing 9% during the second quarter coming off a seasonably low first quarter and were up 6% year-over-year. However, two major issues negatively affected non-interest income for the quarter: revenue from home loans; and losses on security. Revenue from the sale and servicing of home mortgage loans showed a loss of $109 million compared to a gain of $411 million in the first quarter. This decline in part reflects our decision to exit the wholesale channel, close our retail home loan centers and resize our home loans business. Therefore, a gain on sale was significantly impacted by lower saleable mortgage production. Also impacting the quarter was $171 million provision for repurchase reserves up from $56 million in the first quarter due primarily to an increase in repurchase requests for prime loans.

In addition, MSR revenue declined as the favorable MSR evaluation adjustment recognized in the first quarter for slowing prepays did not have the same impact in the second quarter. However, we are seeing slowing prepayments in July so we will watch that trend carefully and may see valuation adjustments in Q3. Revenues and fees from consumer loans declined 22% to $336 million from $429 million in the first quarter due to the decline in the performance of our securitized portfolio primarily resulting from higher credit losses.

During the second quarter we also saw further widening of credit spreads impacting valuations in our mark-to-market portfolio. The net loss on securities of $607 million in the second quarter compared to $185 in the first quarter includes net losses on trading and available for sale securities as well as a gain on early extinguishment of borrowings. Losses on trading assets increased $89 million a linked quarter basis primarily due to lower asset values and higher discount rates on credit card retained interest. The second quarter net loss of $402 million on available for sale securities was due to other than temporary impairments on mortgage backed securities resulting from the deteriorating credit spreads during the second quarter. Approximately 70% of these loans were on securities rated BBB or below investment grade and the majority of that loss has been recognized in earnings.

Although it’s impossible to forecast the future, it’s unlikely that this level of valuation losses will continue given the current profile of our available for sale MBS profile. As you can see on the slide the quality of the AFS MBS portfolio continues to be very high. At quarter end 96% of the portfolio was rated AAA, only 1% was below A and only 5% of the portfolio was comprised of subprime or all day loans. Hard book value is 89% of par while securities below AAA carried a 36% below par value. Most of this decline in values has already been reflected in our earnings.

The continued focus on reducing our operating costs is one of the ways we will offset elevated credit costs as well as improve our overall efficiency. Non-interest expense included foreclosed asset expense and restructuring expenses have trended lower over the past year due to expense reduction actions we took in the past. In the first quarter we announced targeted savings related to the further consolidation of our home loans business of approximately $550 million. Today we announced additional initiatives of approximately $450 million in our corporate support and other businesses for total expected annualized savings of approximately $1 billion. We expect the full benefit of these actions to be realized in 2009. As part of these efforts we expect restructuring and resizing expenses of approximately $450 million in 2008 of which approximately $180 million relates to home loans initiatives and $270 million from our corporate support and other businesses.

We have continue to maintain our liquidity position in this challenging environment with half of our funding coming from consumer and small business retail deposits, our remaining is well diversified between Federal Home Bank advances, non-retail deposits and other borrowings. At quarter end we had readily available liquidity of more than $40 billion and during the quarter we reduced our Federal Home Bank advances by $5.6 billion to a total of $58 billion.

At this point, I’ll provide you our best thinking on our earnings drivers for the year. The total assets at quarter end of $310 billion were down $18 billion from $328 billion at the end of last year reflecting the proactive management actions I’ve discussed. The only portfolios growing are multi-family and credit cards. As I mentioned earlier we are bringing some card receivables back on the books due to rising costs of securitization. Nevertheless we expect the balance sheet to continue to decline to approximately $285 billion to $295 billion by year end. This translates into a full year decline in average assets of about 5% from $323 billion last year.

One development we are watching closely that could change our balance sheet outlook is the potential accounting guidance change for loan securitizations. While the timing of credit cards coming back on the balance sheet is unclear we are considering the implications as part of our long term capital planning. After the strong NIM expansion in the first half of the year we expect our NIM to expand at a slower pace during the second half. While we may see some pressure in the second half of the year from rising rates and increased non-performing loans we are maintaining our full year guidance of a net interest margin at 3.15% to 3.25% which compares with a 3.14% margin for the first half of the year.

As John reviewed with you we continue to believe that 2008 will be the peak of our provisioning for this cycle. We are building substantial reserves ahead of charge offs. With our allowance for losses now at $8.5 billion we don’t believe that the high multiple of charge offs we’ve been seeing will be necessary in the future. I’ll give you more detail on how we are looking at credit and capital in a minute. Our depositor and other retail banking fees continue to demonstrate strong growth. However the weaker economy is having an impact on consumer spending and this is translating into some softening in retail banking fees. As a result we are reducing our guidance for depositor and other retail banking fees to 7% to 10% growth over last year.

Non-interest income in 2008 has been negatively impacted by the credit markets and mortgage related trends. Year-to-date non-interest income totaled $2.1 billion. We expect gain on sale of home loans to be lower due to the reduced scale of our home loans operations but that lower revenue will be offset by lower operating expenses as the effects of our resizing efforts take hold. Mark-to-market valuations are difficult to predict but we feel that the quarter’s losses were unusually high and the amount of lower rated securities on our books continues to decline. Considering all these factors and our outlook for the operating environment we are reducing our non-interest income guidance to approximately $5 billion for the year.

As I said we are taking significant steps to reduce the run rate of our operating expenses and we have increased our total savings to $1 billion when compared to 2007’s run rate. We expect a partial benefit in 2008 and a full benefit of these efforts to be realized in 2009. There are a few pieces that make up non-interest expense and we have provided you with the details on them. First, we expect operating expenses to come in around $7.7 billion to $7.9 billion in 2008. This reflects approximately $500 million of savings in 2008 from 2007’s expense levels. While it’s early to be talking about 2009 the $1 billion in costs savings bring our quarterly operating expense levels to approximately $1.85 billion in 2009.

With the increase in the level of REO we now expect foreclosed asset expense to increase to approximately $1 billion for the year and because of the increase in our expense initiatives we’re now expecting our restructuring and resizing costs to increase from $200 million to approximately $500 million. Therefore our guidance for non-interest expense for the full year is between $9.2 billion and $9.4 billion.

Before I turn it back over to Kerry, I want to give you an update on our capital levels and provide some information that supports our view that we don’t believe we need additional capital. In the quarter the tangible equity to tangible asset ratio increased to 7.79% from 6.4% in the prior quarter after incorporating the loss in the quarter. This reflects the significant capital raise as well as our ongoing actions to reduce the balance sheet. Additionally our bank level capital remains strong with a tier-one ridge based regulatory capital ratio of 8.44%. All our other ratios were also comfortably above the well capitalized level. As you can see on this slide, we had approximately $7 billion in capital above our targeted TE to TA ratio which equates to about $11 billion in pre-tax capacity to cover potential credit losses.

There seems to be a great deal of speculation around whether WaMu will need to raise capital and we answer that by walking you through the details of how we expect to manage through this difficult credit environment. First, we currently have substantial capital plus loan loss reserves sufficient to handle the upper end of our current loss expectations. Second, our ongoing pre-tax, pre-provision income and balance sheet reductions will provide additional cushion for future credit losses.

Let’s go through some details. As you can see on this slide, and from what John covered, we expect the total remaining cumulative losses in our residential mortgage portfolios to be towards the upper end of our range the top of which was $19 billion. In the second quarter we took net charge offs on this portfolio of about $2 billion reducing the estimated remaining loss to approximately $17 billion. The right hand of the slide reflects our quarter end loan loss reserves of $8.5 billion and as I just showed you, our current capital in excess of our targeted capital ratios equates to $11 billion on a pre-tax basis. So even at the upper end of the expected range for residential losses we are more than covered with today’s capital and loan loss reserves.

Looking at the lower left portion of the page, we have also included additional credit losses. As you heard from John, these include losses on credit card, multi-family lending and unfunded home equity commitments as well as foreclosed asset expense. As John illustrated the annualized run rate of these costs was approximately $1.5 billion for the first half of 2008. As you can see on the right hand box offsetting these costs are other sources of future capital. First, we continue to generate approximately $6 billion of pre-tax, pre-provision operating income per year and that is consistent with what we saw in 2006 and 2007. Additionally we expect that the balance sheet will continue to decline in 2008 as we reduce our exposure to single-family residential loans. This will free up additional capacity of approximately $1.7 billion.

Given our current strong capital, existing reserve for loan losses, ongoing operating earnings and planned balance sheet shrinkage, we are in a strong position to work our way through this difficult credit cycle without the need for additional capital.

With that, I’ll pass it back to Kerry for his closing comments.

Kerry K. Killinger

Before we open up the phone lines to your questions, I want to make just a few closing comments. Let me begin by saying that at times like this, it’s important that we remain focused on the steps we are taking to work our through this situation. If we do, we will emerge from this period a stronger, healthier and importantly profitable company. I’m very proud of how hard our thousands of WaMu employees are working to do exactly that and I believe we are taking the right steps. We are executing aggressively but prudently on our plan to sustain capital, manage credit tightly, cut costs, improve efficiency and productivity and support the sustained growth of our core retail franchise.

Finally I want to reiterate once again the key takeaways for this quarter. We expect our remaining cumm losses in our residential mortgage portfolios to be at the upper end of the range we disclosed in April and we see credit provisions peaking in 2008. We have $7 billion of capital above our targeted levels and we’re well capitalized by regulatory standards. We ended the quarter with over $40 billion of readily available liquidity, we have $8.5 billion in reserves to cover loan losses a tripling from year end 2007 and our people continue to deliver great products and services to our customers, so our core businesses are demonstrating good revenue generating capacity and we continue to win new households and new checking accounts at a solid pace.

In summary we are working hard and we are making headway and I am confident in the future of the company.

With that, now let’s turn to your questions.

Question-And-Answer Session

Operator

Operator Instructions) Your first question comes from Howard Shapiro - Fox-Pitt Kelton Cochran LLC.

Howard Shapiro - Fox-Pitt Kelton Cochran LLC

In terms of your guidance for the upper end of $19 billion and the change in your reserve methodology a part of which had to do with higher severities on losses that you’re seeing, can you just remind us now what your assumptions are about cumulative frequency and severity and have those changed dramatically and what that implies in terms of peak to trough hump price declines?

John McMurray

Let’s cover the severity portion or just the simple equation first, to get to $19 billion one of the ways that we talked about getting there was a frequency on the remaining pool of 20% and then a weighted average severity of 40%, and just as a quick reminder, that severity was comprised of two components. There was a second lien component of 100% severity on the second liens and then a 50% severity on the, we weighed average to 40% using 100% on the second liens. So the 20 times the 50 gets us to the $19 billion. Where we’re running right now on severity is 30% on second liens and we’re approaching 100% on first liens. We expect the severity on first liens to move up through time but we also expect the percentage of second liens to decline so it’s partially going to offset that effect. Briefly that’s how we got to the $19 billion and we’re not quite there yet in terms of severity or frequencies but we still have a way to go in this cycle.

In terms of our outlook on housing prices we expect the worst rate of decline to be reached sometime during the middle part of this year, and again I remind you that’s a rate of decline and not the actual trough in house prices, and then we expect house prices to continue to decline all the way through 2009 and into 2010. For our portfolio on a Case-Shiller basis that would probably weight out to around 30%.

Operator

Your next question comes from Moshe A. Orenbuch – Credit Suisse.

Moshe A. Orenbuch – Credit Suisse

When you’re talking about the delinquencies stabilizing one of the things I don’t you included was the actual charge offs because the charge offs have gone up over the last year by $1.8 billion and if you look at it over the last two quarters and you had $1.6 billion increase in NPAs two quarters ago, $2.1 billion in the last couple of quarters but the charge offs have gone from $600 million to $2 billion so that’s $2.2 billion in the December quarter, $3.2 billion in the fourth quarter if you add them up, but $4.1 billion in this quarter. Are you actually seeing an inflow of problem assets and what progress can you make actually getting rid of problem assets?

John McMurray

The sequence that we’re seeing subprime was the first to surge and we’re starting to see early indications of that perhaps slowing, home equity was the second sub-portfolio to surge within residential and then most recently in the primary it’s been particularly in the option ARM area. What we’ve seen recently there is a continued acceleration. With respect to charge offs an important consideration there those consist of two key components. The first component is the initial charge off that typically occurs at 180 days. There are some cases where that may occur earlier than 180 days and then subsequent to 180 days we’re going to re-evaluate those NPLs or in the case of an REO in the first 90 days, re-evaluate that for additional charge off. So a significant portion of the charge off activity that you’ve seen for us in the last couple quarters is not the initial charge off but re-evaluations of loans moving through the foreclosure process.

Thomas W. Casey

John, the other thing that we’re seeing is that the late stage delinquencies, consumers that are getting down two payments are having less and less capability to refinance or to sell their home and so those are going to 180 days. What John was referring to was this early stage delinquencies, those are actually improving. We’re hopeful that the charge off rate does start to flatten out.

Operator

Your next question comes from Bruce Harting – Lehman Brothers.

Bruce Harting – Lehman Brothers

When you say the provisions should peak this year, can you make any comment about the sequential from 2Q to 3Q to 4Q? Is that implying that 2Q will also be a peak?

Thomas W. Casey

We’ve stopped giving specific quarterly provision guidance, it’s obviously challenging. What I said in my prepared remarks is that we’ve been running the last three quarters at a multiple of charge offs of about 2.5 times. We don’t think that is a level that we would expect going forward. It’s premature to say specifically what the rest of the year provision will be but we are trying, obviously you’re seeing a significant growth in the reserve up to $8.5 billion through June but it’s going to be dependent on the environment and what we see and we’ll have to watch it closely but clearly this has been a significant increase in the total reserve build now at $8.5 billion of reserves on $2.2 billion of charges offs, that’s a very healthy level of reserves at this point with a very, very good coverage ratio.

Operator

Your next question comes from Gary Gordon – Portales Partners.

Gary Gordon – Portales Partners

Switching to the credit card business, there’s been regulations to adjust allowable charges on the credit card companies, what change in revenues might we expect for ‘09 over ‘08 because of that?

Stephen J. Rotella

I think you’re referring to the UDAB proposals that are out for comment right now and we are like the rest of the industry following those suggestions in Washington, making comments on them and we’ll have to wait until they’re finalized. So we’re not going to project any changes in our go forward revenues at this point. We’ll update you when we know more.

Operator

Your next question comes from Chris Brendler – Stifel Nicolaus & Company, Inc.

Chris Brendler – Stifel Nicolaus & Company, Inc.

Another question on the card business, can you comment at all on the health of the Old Providian Gateway Trust? It looks to me that there’s danger of trapping cash, the yield has come down quite a bit, too. I don’t know if you have any ability to manage the yield up in that portfolio and is there anything in your liquidity plans for that trust hitting early amortization?

Thomas W. Casey

We’re constantly watching that obviously, the trust has been impacted by the same level of net credit losses that we shared with you for the quarter, they were at about 10.8. Right now we’re forecasting about 10.5 for the year. We’re obviously watching the performance of the trust closely and factor that into our liquidity and capital ratios on a forecasted basis and we’ll continue to watch that and continue to keep you informed of any changes with the trust.

Operator

Your next question comes from Frederick Cannon - Keefe Bruyette & Woods, Inc.

Frederick Cannon - Keefe Bruyette & Woods, Inc.

On the capital, in terms of the 7.79% tangible equity to assets that you report I think in the footnote it says it excludes net gains on available for sale securities, does that include the negative $400 million of other than temporary charge or exclude that? Secondly, your capital ratios at the subsidiary thrift didn’t increase the way the holding company once did and I was wondering if you’re planning to downstream some of the cash from the capital raised to the thrift to increase those?

Thomas W. Casey

The answer to your first question is the $400 million is in one through earnings so that is already in retained earnings and therefore is already in that ratio. The other than temporary impairment number goes through the P&L whereas the other mark-to-markets that go through OCI, other comprehensive income, are the ones you’re referring to and so that’s about $800 million in equity that’s added back.

On your second question with regard to down streaming capital to the bank we continue to monitor that, we did move some down to the bank level as part of the equity raised and continue to evaluate that and probably will move some additional capital down to the bank this quarter. We’re obviously also maintaining good liquidity at the holding company through 2010 to 2011.

Operator

Your next question comes from [Shawn McGee – Morgan Stanley].

[Shawn McGee – Morgan Stanley]

We’re assuming that all option ARMs are in neg am and if that is correct, what percentage are going to hit their neg am peak this year?

John McMurray

First off, I’m not sure that they’re all in neg am so in a typical month you may have on the order of three quarters of those negatively amortizing and what you would see if we look at, there’s a chart in the deck that we published that’ll show you the calendar recast that we anticipate, I believe that’s on Slide 15. In the third quarter and the fourth quarter of 2008 most of those are calendar recasts and we don’t anticipate many of those loans hitting a neg am cap. With that said, we do analyses to try to evaluate what might hit a neg am cap and so, just very briefly, the drivers are the interest rate environment and the particular loan index. So keep in mind many of our loans are indexed to the MTA, borrower behavior, so how often they choose the minimum payment each time through time and then prepayments both voluntary and involuntarily. A loan that prepays is obviously not going to recast and then modifications.

If we assume that every borrower makes only the minimum payment every month, that nor borrower prepays either voluntarily or involuntarily that there are no modifications, we could see an additional $3 to $4 billion of recasts brought forward into 2009 and 2010 with all those assumptions and that might be somewhat higher still if we get on the bad interest rate path. Keep in mind that a fair amount of those that would be brought forward into ‘09 and ‘10 would be from New York where there’s 110% neg am cap. Two points there, the neg am cap is lower so the recasts aren’t quite as large and then the home price situation in New York is not as dire as what we see in Florida and California. Just a quick box on those recasts.

Operator

Your next question comes from [Louise Pitt – Goldman Sachs].

[Louise Pitt – Goldman Sachs]

Moodys had put your ratings under review for downgrade since the earnings release came out this afternoon and obviously the holding company is now at B double A three so there is a risk that that goes to non-investor grade. Do you have any comment on that or are you focused on maintaining investment grade ratings going forward?

Stephen J. Rotella

We’ve obviously just seen that news as well and obviously we’re keeping a good level of liquidity as I mentioned. We’re keeping liquidity at the holding company through 2011 and we’re working very closely with the rating indices on that. We’ll have to wait and see what their final outcome is. Obviously we’ll work closely with them, but right now we don’t have any need to go the capital markets for any issuance of debt and so the impact of this is quite low for us right now. We’re shrinking the balance sheet and our access of the Federal Home Loan Bank and other types of borrowings we don’t see much impact.

Operator

Your next question comes from [David Knudsen – Legal & General].

[David Knudsen – Legal & General]

Have you discussed with the rating agencies or have you done internal calculations as to the incremental collateral posting that would be required if a downgrade is forthcoming?

Stephen J. Rotella

In our liquidity planning we always look at the amount of collateral available. In the calculation we gave you of available liquidity that takes into account the appropriate haircuts we see with the Federal and Loan Bank and other collateral arrangements so that we don’t see a significant change in this time. Obviously we’ll work through that as it becomes to light but we’ve been working through that for the last two quarters.

Operator

Your next question comes from Bradley Ball - Citigroup.

Bradley Ball - Citigroup

Point of clarification on one of the prior questions, did you say that your cumulative loss expectation on the option ARM portfolio was 19% or did you say that that was 10%? I think you said 20% frequency and 50% severity and then before I get off, could you repeat again what your what your total cumulative loss estimates are for the total roughly $190 billion of single-family mortgages? I think you said 20% frequency and 40% severity which would imply an 8% cumulative loss rate.

John McMurray

Let me go through that again because I wasn’t clear at all previously. To get to the $19 billion it’s a 20% frequency times a 50% severity gets you to a 10% loss rate times the $190 billion that gets you to the $19 billion. If we separate out option ARMs in particular I think our original expectation back when we raised capital was a loss rate of 10.7%. Out of all those sub-portfolios in the residential area that’s the one that we’re watching most closely and where we think the most stresses are present.

Operator

Your next question comes from Paul Miller, Jr. – FBR Capital Markets.

Paul Miller, Jr. – FBR Capital Markets

John, can you tell us a little bit about your home equity lines and your non-performing assets, the $1.5 billion and what cure rate? You talked about severity on those loans being at 100% so I’m just wondering why do you carry a non-performing asset of those loans and what type of cure rate does those things have after 90 days past due?

John McMurray

Couple questions in there, first of all with respect to charge offs that’s a loan-by-loan evaluation that’s done and on the second what we are seeing is severity rates drifting to 100%. The other thing that we’re seeing in this by the way is of cross-residential loan types is once a loan becomes one payment past due the transition to the next successive delinquency status has been increasing. In other words it’s not as easy for borrowers to either sell their home or refinance and so that’s been one of the key drivers of both NPLs and net charge offs.

Operator

Your next question comes from Howard Shapiro - Fox-Pitt Kelton Cochran LLC.

Howard Shapiro - Fox-Pitt Kelton Cochran LLC

Kerry it may be a little premature but it seems to me you’ve decisively moved ahead on credit costs and the trajectory the provision is going to go down over the course of the year. As you look at beyond this credit problem into 2009 and beyond, can you tell us what you see Washington Mutual being? Your balances are going down obviously, you have less of a focus on residential mortgage. What are going to be the drivers of income going forward as we leave this credit cycle?

Kerry K. Killinger

Let me first frame things. We have put together I think a very aggressive plan to return the company to profitability and that is our first priority and that plan very simply is maintain appropriate capital and liquidity, which we’ve talked about and the capital raised was a very important part of that last April and as we’ve commented here, we think that we sufficient capital now to see us through the cycle and including assumptions of a stressed real estate market. The second part of that plan was to go after our cost base so we’re working on basically a $1 billion run rate improvement in that cost structure. The third was to aggressively attack credit costs both in terms of going after reducing some of the credit risk like we’re doing on the home equity lines of credit, adjusting our credit card underwriting and our other underwriting of other products as well and eliminating some products from our arsenal like the option ARMs.

Also as part of that is to get the reserving in an appropriate and strong position. Clearly this quarter we have increased those reserves very materially and I think we’re on a good track on that front. The fourth part of our strategy was really put our focus on the core retail business including all the different products that we can sell through that retail franchise and to put emphasis through retail stores. I’d say the priority for the next several quarters is execute very crisply on that plan and all those four key elements and that’s the driving force of the company. I think when we look to the long term we will return to profitability when the credit costs start coming down and from a timing standpoint loan loss provisions are made well in excess of charge offs so there will be a time when we won’t have to have this level of provisioning as we indicated we think this is the peak year and then we’ll get better or reduced provision levels clearly next year.

There’s still that underlying profitability of the company before provisioning of about $6 billion pre-tax. We expect that to come through and then for our provisioning rates to come down materially, that’s what will allow the company to return to profitability in conjunction with what I mentioned on the other strategy initiatives. Now if you look to the long run, and again I don’t want to spend too much time right now because we are so focused on returning the company to profitability in all those measures but certainly on the long term basis this will be a consumer bank driven company, the core retail franchise will be the center of what we’re doing, we’ll continue to work on finding ways to sell more and more products to that core retail customer base and we’ll continue our efforts to diversify our balance sheet so that it has a lower percent in residential assets over time.

We have I think a very clear plan for the next period of time that we see to get us back to the level of profitability that we should have and then longer term, it will be more around continued products through our system and better diversification.

Operator

Your next question comes from Gary Gordon – Portales Partners.

Gary Gordon – Portales Partners

You were describing a big jump in your TDR, troubled debt restructurings, can you characterize that increase? How much was loans that were performing loans that were modified versus loans that were non-performing about to become non-performing that you modified?

Thomas W. Casey

I don’t have that specific level of detail in front of me. Our total NPR and PDRs jumped up about 100% rather to about $1.4 billion. It is obviously a very archaic but important accounting regime that we go through to evaluate what the TDRs are but we’re working very, very closely. I think John mentioned that 71% of them are current and we will evaluate the back on to rule status.

Operator

Your last question today comes from Louise Pitt – Goldman Sachs.

Louise Pitt – Goldman Sachs

This is a follow up to my earlier question, I just want to ask about the operating company ratings given that if they fall to high yield there’s clearly going to be a significant secondary market impact on that and as a result is there going to be an impact on the dividend given that it’s already at $0.01 per share if you go below investment grade?

Stephen J. Rotella

The $0.01 per share is that WMI, that’s included in my forecast I gave you on liquidity and there is no need for advances coming from the bank to meet that liquidity profile through 2011. We feel that the holding company from a liquidity standpoint is not [inaudible] bank and feel that we don’t any specific change in our dividend policy.

Kerry K. Killinger

Thank you all very much for joining us today. Again we look forward to talking to you next quarter’s conference call. If you have any follow up questions with Investor Relations please give them a call. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!