Washington
Mutual, Inc.
Prepared
Remarks for Third Quarter 2007 Earnings Conference Call
October 17,
2007
Please
see the Cautionary Statements at the end of this document
 |
Remarks
of Kerry Killinger
Chairman
and CEO
|
Good
afternoon, everyone. Thank you for joining us today as we review the results
of
what was a very challenging third quarter.
As
Alan
mentioned, joining me today on the call is Tom Casey, our CFO, who will
discuss
our quarterly performance in more detail and update our 2007 earnings
drivers. We will be discussing earnings drivers for 2008 at our
Investor Day on November 7th. Our President, Steve Rotella, will also
be available to answer questions at the end of our remarks this
afternoon.
Third
Quarter 2007 Earnings
As
we
announced on October 5th, our results for the third quarter were significantly
impacted by further weakening in the housing market and capital market
disruptions. Our loan loss provision of $967 million for the quarter increased
from $372 million in the prior quarter. In addition, our quarterly earnings
were
negatively impacted by valuation adjustments across several asset classes.
And
as a result, our third quarter net income of $210 million, or 23 cents
per
share, was down from $748 million, or 77 cents per share in the third quarter
of
2006.
Yesterday,
the Board of Directors declared a dividend of $0.56 per common share for
the
quarter. The Board of Directors considered a variety of financial factors,
including the company's earnings, capital and liquidity position. These
same
factors and considerations are reviewed by the Board each quarter.
Before
I
go into detail regarding the performance of our business operations, I’ll make a
few comments regarding the market environment we experienced during the
most
recent quarter. From time to time, financial markets go through periods
of
significant volatility and disruption, such as we recently experienced.
It is
during these periods that a company’s asset, capital and liquidity management
capabilities are tested. I’m very pleased with how we’ve managed the company
through this period of stress. Our retail deposit franchise remains strong,
providing us with a stable and reliable source of funding for our assets,
and
our management team has spent much of the last year diversifying our borrowing
sources and proactively addressing the rapidly changing market
conditions.
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Prepared Remarks - October 17, 2007 |
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I
also
think it is important to understand that the impact on our earnings of
the
severe market conditions was two-fold, one transitional and the second
more
long-lasting. First, as Tom will review in detail, was the impact of market
illiquidity for mortgage and other financial instruments during the quarter.
This impact resulted in market value losses in the quarter, most of which
are
not cash losses and generally are expected to be accreted back into income
over
the life of the related assets.
The
second
factor impacting earnings was an acceleration in the downturn in the housing
markets. We first became concerned about a potential housing bubble
in the summer of 2005 and began then preparing for a correction. As
you can see from the housing price appreciation chart in our prepared remarks,
the correction has been much more dramatic and rapid than the build-up.
We now
know that many markets, such as Florida and California, are experiencing
price
declines. When we looked at the situation two years ago, indications were
that a
correction in housing would likely be softened by continued good economic
growth
and employment, as well as historically low interest rates. In the third
quarter, the so called “soft landing” quickly transitioned to a severe downturn
as conditions in the capital markets deteriorated and home prices
fell.
We
are
proactively managing delinquencies in our home loans portfolio with a focus
on
keeping as many of our borrowers as possible in their homes. We have staffed
up
our loan servicing groups and implemented several outreach programs especially
for our subprime borrowers. As Tom will review with you later, the factor
we
expect to exert the greatest influence on the level of losses as we work
through
this period is home prices. We will continue to monitor them very
closely.
Now,
let’s
look at the performance in each of our business units.
Retail
Banking
I’ll
begin
with our Retail Banking business which continues to drive strong net checking
growth. During the third quarter the retail bank added over 310,000 net
new
checking accounts, bringing the year-to-date total to over 1.0 million
and
achieving in nine months our stated goal of adding more than one million
net new
accounts for the year.
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Prepared Remarks - October 17, 2007 |
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While
customer growth and fee revenue growth continue on track, weakness in
the
housing and credit markets resulted in a $227 million increase in the
Retail
Bank’s loan loss provision for the quarter, depressing the segment’s net income
for the quarter to $453 million, compared to $555 million in the third
quarter
of last year.
Our
Retail
Bank continues to drive solid household growth through all of its products,
in
stores and online, growing retail banking households 8 percent year over
year
and increasing the cross sell ratio to 7.13 from 6.55 in the third quarter
of a
year ago.
Our
small
business program continues to deliver good results, adding 69,000 net
new
checking accounts during the third quarter and increasing average deposits
to
$8.8 billion up 22 percent from the third quarter of 2006.
We
continue to invest in growing our Retail Banking channel, opening 10
new retail
stores during the quarter. However, we are also very focused on ensuring
that
each of our stores remains profitable and cost effective. As a result,
during
the third quarter we consolidated 33 stores, about half of which were
acquired
last year as part of the CCBI acquisition. In the fourth quarter, we
expect to
have net openings of about 50 stores.
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Card
Services
Card
Services continues to drive record account growth in the third quarter
adding
945,000 new credit cards accounts, with solid account growth in all
channels.
The sale of retail accounts to WaMu customers continues to account
for
approximately one-third of all account growth year to date. Period-end
managed
receivables of $26.2 billion were up 5 percent from the second quarter
and up 18
percent from the prior year.
Net
income
for the third quarter of $102 million was down from $141 million
on a linked
quarter basis, primarily due to a $65 million valuation adjustment
in retained
interests. This writedown was primarily driven by higher discount
rates
associated with the market disruption during the third quarter.
Credit
continues to perform within our target for risk-adjusted returns.
At 5.73
percent of period-end managed receivables, the 30-plus day managed
delinquency
rate was up from 5.11 percent in the prior quarter reflecting, in
part, seasonal
trends. Net credit losses of 6.37 percent were down slightly from
the second
quarter, as the third quarter’s substantial growth in managed receivables more
than offset an increase in charge-offs.
Commercial
Group
The
Commercial Group continues to deliver good results, despite being
impacted by
capital market volatility in the third quarter. Net income of $54
million was
down from $113 million in the prior quarter due to the decline in
noninterest
income.
The
$34
million loss in noninterest income was primarily due to a $21 million
loss on
sale of loans, net of hedging, which included an $8 million negative
adjustment
to the carrying value of $2 billion in loans moved from held for
sale to the
held for investment portfolio. This compares with second quarter
noninterest
income of $62 million, which included $63 million in gain on sale.
And as we
noted during last quarter’s earnings call, noninterest income in the second
quarter reflected favorable hedging results.
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Third
quarter loan volume of $4.1 billion was down somewhat from the record
volume of
$4.3 billion in the second quarter, but remained very solid.
Home
Loans
The
capital market disruptions in the third quarter had the most significant
impact
on the performance of our Home Loans group. The segment incurred
a net loss of
$348 million in the third quarter compared to a $37 million loss
in the second
quarter.
The
Home
Loans provision for loan losses increased by $222 million from the
prior
quarter, due to further weakness in the subprime portfolio and the
movement of
loans we would hold for sale under normal capital market conditions
to the held
for investment portfolio in this segment.
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The
decline in noninterest income for the third quarter reflected the
company’s net
loss on sale of $222 million compared to a second quarter net gain
of $192
million on sale of mortgage loans. The third quarter loss included
$139 million
in negative adjustments to the carrying value related to the $15
billion of home
loans moved to the investment portfolio as well as other home loan
sales and
risk management activities that were also impacted by the market
disruption
during the quarter.
Partially
offsetting these losses were stronger MSR valuation and risk management
results
of $222 million for the third quarter, compared to a loss of $21
million in the
prior quarter.
Loan
volume in this segment declined 26 percent to $26 billion for the
third quarter.
The decline was primarily due to a 35 percent reduction in refinancing
volume as
many borrowers held back refinancing plans as nonconforming loan
rates
increased. We also continued to deemphasize our subprime mortgage
channel
lending focus during the third quarter, resulting in an 80 percent
decline in
subprime volume on a linked quarter basis.
Before
turning it over to Tom, I want to comment on the OTS consent order
referred to
in our press release. We are fully committed to improving and strengthening
the
controls and processes in our Bank Secrecy Act program. As we said
in the press
release, the order does not impose any fines or restrictions on
our business
activities or growth initiatives.
I’ll
now
turn it over to Tom.
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Prepared Remarks - October 17, 2007 |
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|
 |
Remarks
of Tom Casey
Executive
Vice President and CFO
|
Thank
you,
Kerry.
Kerry
gave
you a good summary of the performance of our businesses during
the quarter. We
continue to drive good customer growth and deliver strong earnings
from most of
our businesses. However, our third quarter was greatly impacted
by disruptions
in the credit markets and further weakening in the housing
market. I’m going to
walk you through our results and provide you with details around
how the market
disruption affected some of our asset valuations, as well as
how the weakening
housing market is affecting our business. I will also give
you our current
outlook on earnings drivers for 2007.
Market
disruptions
Let’s
look
first at the direct impact of the capital market disruption
on our Q3 results.
We have three significant asset classes that we mark to market
or that we carry
at the lower of cost or market, or “LOCOM.” They are: our warehouse of home,
multi-family and commercial real estate loans held for sale;
trading assets that
we hold as part of our asset sale and securitization activities
and our mortgage
servicing rights. This quarter, we also recorded impairment
in the value of some
of our investment securities.
In
the
LOCOM category are our warehouse loans. As Kerry mentioned,
we took downward
adjustments of $147 million in the quarter related to $17 billion
in held for
sale single-family, multi-family and commercial real estate
loans that were
moved to our investment portfolio.
$139
million of that $147 million loss resulted when we moved $15
billion in
single-family home loans to held for investment. The loans
included $7.7 billion
of jumbo hybrid and fixed-rate loans, $4.9 billion of Option
ARMs, $1.1 billion
of subprime loans and $1.3 billion of home equity and other
loan types.
Approximately 99 percent of these loans were performing when
moved.
In
addition to the $139 million loss on movement of home loans
from the warehouse
to the investment portfolio, the market disruption also impacted
sales and risk
management activities affecting other loans during the quarter,
which together
resulted in a total loss of $222 million, net of hedging and
risk management.
This compares to a net gain on sale of $192 million in the
second quarter
driving a $414 million swing in this component of our noninterest
income.
In
the
first mark to market category—trading assets—we recorded a $153 million net
loss. This included a $62 million reduction in the value on
securities
associated with our mortgage securitization programs, a $65
million reduction in
the valuation of our credit card retained interests, and a
$43 million reduction
in the valuation of subprime residuals. At the end of September,
our subprime
residual book value was only $37 million and we are not currently
creating any
new subprime residuals.
The
second
mark to market category—mortgage servicing rights—moved sharply in the opposite
direction. During the quarter, MSR valuation and risk management
resulted in
income of $222 million compared to a loss of $21 million in
the second quarter.
The improved MSR and hedging performance was significantly
affected by the
weakening housing market as projections for loan prepayments
slowed considerably
during the quarter.
Finally,
as I mentioned, we evaluated our investment securities portfolio
and recognized
an impairment of $104 million for unrealized losses on some
of our mortgage
related holdings where we deemed the reduction in market value
to be “other than
temporary.” These securities were primarily investment grade mortgage-backed
securities.
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Credit
Quality and Provision for Loan
Losses
Next
let’s
look at the impact of credit quality on our provision for loan
losses.
There
has
been a significant and abrupt change in the health of the housing
market since
our second quarter earnings call. At that time, we noted significant
slowing in
the pace of home price appreciation in most parts of the country
and absolute
declines in some markets. Since August, the lack of secondary
market liquidity
for anything but agency conforming loans has resulted in sharply
higher interest
rates on all nonconforming prime loans, and subprime loans
have become largely
unavailable at any price. Many non-bank lenders have gone out
of business or
have severely curtailed their operations. This has increased
the cost and
decreased the availability of housing credit and contributed
to the slowing of
home sales. In combination, these factors are putting significant
downward pressure on housing prices, especially in high-cost
markets and in
markets where subprime loans were most prevalent. The national
inventory of
unsold homes has increased from 6.5 months in January to 10
months in August,
its highest level in 25 years. Home builders are aggressively
cutting new home
prices, and many other indices are moving negatively. As a
result, most markets
in the country likely have experienced actual price declines.
This
dramatic change in the housing and credit environment is changing
consumer
behavior in a manner that adversely impacted our third quarter
credit results.
Specifically, the combination of reduced liquidity for mortgages
and the slowing
housing market has accelerated delinquencies, as borrowers
who are under payment
pressure can no longer look to refinancing, home equity loans
or quick sales as
answers to their problems.
Our
nonperforming assets increased to 1.65 percent of assets at
quarter end from
1.29 percent of assets at the end of the second quarter. As
with the second
quarter, subprime loans had the largest rate of nonperforming
assets. However,
during the third quarter we also saw an increase in prime home
loan NPAs. The
quarter end NPAs included 16 basis points in restructured loans.
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In
contrast to our home loans portfolio, our credit card, multi-family
and
commercial real estate portfolios continue to perform well.
The most significant
external factor affecting the performance of our card portfolio
is the level of
unemployment, which remained relatively stable during the
quarter. Our 30-plus
day managed delinquencies increased to 5.73 percent from
5.11 percent in the
prior quarter, while the managed net credit losses declined
to 6.37 percent from
6.49 percent on a linked quarter basis. We continue to proactively
manage the
credit quality of this portfolio.
Our
$39
billion multi-family and commercial real estate loan portfolio
continues to
perform well, with non-performing assets of 43 basis points
at the end of the
third quarter and no net charge-offs for the year.
As
a
result of the significant changes in the housing market and
the performance
trends of our portfolio we increased the provision for loan
losses to $967
million for the third quarter from $372 million in the second
quarter. This
brought our allowance for loan and lease losses to $1.9 billion
at quarter end,
up 21 percent from the end of the second quarter. The higher
level of
provisioning reflects increases in delinquencies and charge-offs
during the
quarter, and the $22 billion increase in the quarter-end
portfolio of loans held
for investment.
As
we did
last quarter, we have provided you with a comprehensive set
of charts as an
appendix to these remarks which include additional credit
statistics related to
our loan portfolios. We also intend to go into more detail
about our current
credit outlook at our investor day on November 7th
Asset
Growth
I’ll
now
shift over to review our balance sheet management. Over this
past year, high
levels of liquidity in the capital markets for mortgage assets
and a flat yield
curve have made it very difficult to add assets with acceptable
risk-adjusted
returns to our balance sheet. As a result, we reduced our
total assets from $351
billion in June of 2006 to $312 billion in June of 2007.
Instead of using our
excess capital to grow the balance sheet, we returned it
to our shareholders
through share repurchases. During this time, we also proactively
diversified our
funding sources and added funding capacity by reducing our
FHLB advances to $21
billion at June 30th 2007 from $55 billion a year earlier.
This put us in a much
stronger position to withstand the market disruption of the
third
quarter.
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In
the
third quarter, this funding flexibility allowed us to increase
the loan
portfolio by $22 billion, including the $17 billion of
warehouse loans we moved
to portfolio as I discussed earlier. We also more than
doubled the level of our
cash and cash equivalents to $11.4 billion to further strengthen
our liquidity
position during this period of extreme market volatility.
The result was an
increase in quarter-end assets of about 6 percent to $330
billion.
During
the
third quarter, home loan originations of $22.3 billion
were down 28 percent,
primarily due to lower home refinancing activity. Conforming
originations
totaled 43 percent of the quarter’s origination volume but increased to 51
percent for the month of September. Going forward, we see
origination growth
slowing but the quality of additions to the portfolio continuing
to improve. We
also anticipate the level of loan prepayments to decline
as the housing market
slows and, therefore, expect to see less runoff of our
existing loan
portfolio.
Yield
Curve and Net Interest Margin
Net
interest income of $2.0 billion for the quarter was down
$20 million on a linked
quarter basis, as the one percent increase in average interest-earning
assets
mostly offset a 4 basis point decline in the net interest
margin. The slight
decline in net interest margin in the quarter was the result
of higher-cost
wholesale borrowings funding the quarter’s asset growth, diminishing the
relative contribution of our noninterest bearing deposits
to our net interest
margin.
Our
primary short-term funding from the FHLB and wholesale
borrowings from other
sources continue to be indexed to 3-month LIBOR. Although
the Fed Funds rate was
cut 50 basis points on September 18th,
we have not seen
the full benefit because the capital markets disruption
has resulted in a
significant widening in the spread between Fed Funds and
3-month LIBOR.
Historically, 3-month LIBOR has tracked approximately 10
to 30 basis points
above the Fed Funds rate but at quarter end this spread
had widened to 52 basis
points. We expect this difference to diminish as capital
markets normalize, but
until it does our funding costs will remain somewhat higher.
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Capital
and Liquidity
As
I
mentioned previously, we have proactively managed our
assets and diversified our
funding and capital over the past 15 months. We ended the quarter
with a tangible capital ratio of 5.61 percent, in excess
of our target of 5.50
percent. As I mentioned previously we doubled our cash
position during the
quarter, which depressed our tangible capital ratio somewhat
but it also
pre-funded a portion of our anticipated fourth quarter
asset
growth.
With
that,
let’s transition to updating our 2007 earnings driver guidance.
Earnings
Driver Guidance
This
update of our earnings drivers for 2007 reflects the
current environment and our
expectations for the remainder of the year.
|
2007
Earnings Driver Guidance
|
||
|
Driver
|
July
2007 Guidance
|
October
2007 Guidance
|
|
1)
Average assets
|
5%
–
7% decline
|
|
|
2)
Net interest margin
|
2.85%
- 2.95%
|
|
|
3)
Credit provisioning
|
$1.5
– $1.7 billion
|
$2.7
– 2.9 billion
|
|
4)
Depositor and other retail banking fees
|
12%
– 14% growth
|
|
|
5)
Noninterest income
|
$6.9
– $7.1 billion
|
$6.4
- $6.5 billion
|
|
6)
Noninterest expense
|
$8.4
- $8.5 billion
|
|
Average
Assets
Through
the first nine months of the year, average assets were
down 7 percent from 2006.
With only one quarter to go, we don’t expect the average to change much. In the
fourth quarter, we expect to grow the balance sheet by
about $5 billion bringing
total assets up to about $335 billion.
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Net
Interest Margin
As
we look
out at the remainder of the year, the forward yield
curve anticipates another 25
basis point cut in the Fed Funds rate by year end.
While downward pressure on
rates appears to be strong, the outlook changes daily
as economic news becomes
available. Any rate cut during the fourth quarter will
primarily benefit 2008,
assuming that LIBOR rates decline as well.
With
our
net interest margin through the end of the third quarter
at 2.85 percent, we
expect to complete the year with a NIM at the lower
end of our guidance range of
2.85 percent to 2.95 percent.
Credit
Provision
As
we
consider our credit provisioning outlook for the remainder
of the year, let me
just say that I have never seen housing credit conditions
change so
significantly over such a short period of time. Nor
can I remember a period when
there was less clarity about near-term housing and
credit trends.
As
I
discussed in detail earlier, we have seen a sharp deterioration
in the housing
market since our second quarter earnings call and a
further acceleration of
adverse trends in our portfolio since we updated our
guidance last in September.
The guidance I provide you today is based on our best
thinking given the facts
that are currently available. However, we expect the
market will continue to
change quickly.
The
main
drivers of our credit provision are the level of delinquencies
and charge-offs
in our portfolio, both of which rose sharply in the
third quarter as home prices
declined in many of our major markets. Based on our
current view of the macro
environment for housing and our own portfolio data,
we expect delinquencies and
charge-offs in our portfolio to increase further during
the fourth
quarter.
Considering
the weakening housing market and adverse trends in
the third quarter, our best
estimate at this time is that charge-offs in our portfolio
will increase between
20 and 40 percent in the fourth quarter and that our
total 2007 provision will
be between $2.7 and $2.9 billion.
Depositor
and other retail banking fees
The
Retail
Bank continues to have strong account growth, and with
a 13 percent increase in
depositor and other retail banking fees over the first
nine months of last year,
we continue to be comfortable with our guidance to
12 to 14
percent.
Noninterest
Income
Noninterest
income in the third quarter of $1.4 billion was down
$379 million from the
second quarter, primarily due to the market disruption
in the quarter. While
we don’t anticipate further
deterioration in the capital markets, we also don’t believe there will be an
immediate recovery of the secondary market for mortgages.
Therefore, we expect
the gain on sale in the fourth quarter to be modest.
As a result, we are
reducing our earnings guidance for noninterest income
for the year by $500
million to $6.4 to $6.5 billion.
Noninterest
Expense
Management
remains focused on tight expense management and driving
productivity and we have
done a good job of that this past year. One by-product
of the difficult credit
period we are going through is higher foreclosure and
problem loan expense.
Despite this upward pressure, we expect our expenses
for the year to remain in
the guidance range of $8.4 to $8.5 billion.
I’ll
now
turn it back over to Kerry for his closing comments.
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Remarks
of Kerry Killinger
Chairman
and CEO (continued)
|
Thanks,
Tom.
In
wrapping up our prepared comments, let me offer the
perspective of an 18-year
CEO and a 35-year financial executive who has been
through a lot of
cycles.
We
are
primarily impacted by interest rate, yield curve,
housing and economic cycles.
Cycles come and go. When cycles are in your favor,
you need to plan for the
inevitable downturn. And when they are against you,
you need to work through
them and prepare for the inevitable upturn.
Today,
the
cycle that is working against us is a declining housing
market. As Tom noted,
current housing market conditions are very challenging.
Housing inventories are
rising, demand is falling and prices are declining
in most markets.
Delinquencies and foreclosures are rising. We expected
a downturn from the
cyclical highs of a couple of years ago, but as I
said earlier, we are
definitely experiencing an accelerating downturn
at this time. However, I remind
everyone that housing will continue to be vital to
consumers and will recover at
some point. It is not possible to predict the timing,
but I expect us to work
our way through this downturn and for market conditions
to improve.
The
cycle
of rising short term interest rates and an inverted
yield curve which negatively
impacted us over the past few years appears to be
improving. Most forecasters
expect short-term interest rates to fall and the
yield curve to steepen.
However, the capital markets illiquidity we have
experience4d has added a new
variable.
My
attitude on difficult cycles is that you may not
like them, but you must deal
with them. And the faster you deal with them, the
better. When difficult
conditions hit, as owners of the company, we need
to ask three key questions: Is
management on top of the situation? Does the company
have the financial strength
to make it through the bottom of the cycle? Does
the company have growth
prospects once the cycle improves?
On
the
first point, I believe this management team is strong,
deep and is diligently
addressing the challenges posed by this environment.
Regarding
our financial strength, we have appropriate capital
and sources of liquidity to
work our way through the cycle.
And
regarding future growth prospects, we have a high
growth retail banking
powerhouse driving strong customer growth, increasing
cross sales and double
digit fee income growth. We have great opportunities
to further increase our
sales of credit cards, mortgage loans, securities
and insurance products to our
banking customers. And we are doing the right things
to make our home loans
operations profitable once the environment stabilizes.
We
have
also vigorously attacked expenses, giving us excellent
operating
leverage.
And
finally, we have good margin expansion potential
if the interest rate
environment were to return to more normal conditions.
The Fed has reduced rates
50 basis points and appears ready to reduce rates
further if economic conditions
warrant it. As Tom commented, our short-term funding
is primarily LIBOR based
which typically follows the Fed Funds rate. A return
to a more normal yield
curve and lower LIBOR rates would be quite beneficial
to our net interest
margin.
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Prepared Remarks - October 17, 2007 |
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So
while
we are very attentive to the short term challenges,
it is just as important to
keep our focus on the long term value creation
potential for the company. And we
believe that value creation potential is excellent.
Before
we
take questions, I want to invite you to join us
in New York at the Sheraton New
York Hotel and Towers on November 7th for our 2007
Investor Day Conference. At
that time, we will provide you further detail on
credit and our initial outlook
for 2008.
With
that,
Tom, Steve and I would be happy to take your questions.
