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Point of View: WaMu Rebalances Home Loan Portfolio

This viewpoint is an excerpt from Washington Mutual chairman and CEO Kerry Killinger's remarks to investors following the company's release of third quarter earnings.

Our earnings included net after-tax charges of $31 million, or $0.03 per share, associated with the sale of $2.5 billion in mortgage servicing rights that we talked about on our last call. This quarter's earnings were also reduced by after-tax charges of $33 million, or $0.04 per share, related to the company's ongoing productivity and efficiency initiatives.

As I said on last quarter's call and again at our Investor Day in September, we fully anticipated that the MSR sale, the sale of our retail mutual fund management company and our productivity and efficiency initiatives would produce unevenness in our quarterly earnings during the remainder of 2006, and we've seen that impact in the earnings we announced. Nevertheless, when taken together, we continue to expect that these actions will be accretive to earnings in 2007.

In the third quarter, we continued to feel the effects of the difficult interest rate environment throughout our operations. Because the Fed increased rates throughout the second quarter, fed funds averaged 35 basis points higher in the third quarter than in the second quarter, despite the Fed's pause in August. In addition, the yield curve became inverted during the third quarter. Both of these conditions contributed to further compression in our net interest margin during the third quarter.

Looking forward, as a point of reference, during the last cycle of Fed tightening, our net interest margin didn't bottom out until the first quarter after the last Fed increase. Therefore, assuming we've seen the last of the Fed increases, we expect that our net interest margin has bottomed out for this cycle and will begin to recover in the fourth quarter.

Despite the challenging environment impacting the mortgage banking industry, we feel good about the proactive steps we have taken. Our portfolio remains in very good shape and nonperforming assets remain very low. The housing market is clearly weakening, with the pace of housing price appreciation slowing in most regions of the country. We are also experiencing somewhat higher delinquencies and loan losses. However, we began preparing for this possibility quite some time ago and took defensive actions to strengthen our portfolio. So we believe we are well prepared to weather the more difficult credit environment.

In the meantime, we continued to aggressively attack the cost structure in our home loans business during the quarter and reduced non-interest expense by 21% over the same period a year ago. This was achieved through key productivity and efficiency initiatives. Technology and off-shoring initiatives currently underway are expected to result in further expense reductions in future quarters.

For the third quarter, home loans reported a net loss of $33 million vs. net income of $302 million in the prior year and $31 million on a linked-quarter basis.

Home loan volume declined by 11% on a linked quarter basis and 32% from the third quarter of last year, commensurate with higher interest rates and the general slowing of the housing market. We are seeing the effects of our strategy to shift toward higher margin products. This is reflected in the mix of originations during the quarter. Fixed-rate originations declined from 39% of home loan volume in the third quarter of last year to 26% in the most recent quarter. Option ARMs continued to comprise approximately 30% of volume, similar to the same quarter a year ago, but hybrid ARMs were much more popular, growing from only 29% last year to 44% of volume in the third quarter.

Both our gain on sale and MSR hedging costs are being negatively impacted by the difficult interest rate environment and competitive pressures.

We've taken a number of specific actions, both strategic and tactical, to position the home loans business for focused growth. We're continuing our efforts to produce greater volumes of higher margin loans and an efficient operating platform.

Finally, we've established a clear strategic direction by which we will drive our actions over the next few years.

The quality of our option ARM portfolio remains strong. At the end of the third quarter, the current estimated loan-to-value ratio of our option ARM portfolio was 57%, with an average FICO of 707. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com

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