Case 1:09-cv-01656-RMC Document 54 Filed 11/22/10 Page 1 of 2
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
DEUTSCHE BANK NATIONAL TRUST COMPANY,
Plaintiff,
v.
Case No. 09-CV-1656-RMC FEDERAL DEPOSIT INSURANCE
CORPORATION (as receiver of Hon. Rosemary M. Collyer WASHINGTON MUTUAL BANK); JPMORGAN CHASE BANK, National Association; and WASHINGTON MUTUAL MORTGAGE SECURITIES CORPORATION,
Defendants.
FDIC RECEIVER’S MOTION TO DISMISS
Defendant Federal Deposit Insurance Corporation, in its capacity as Receiver for
Washington Mutual Bank (“FDIC Receiver”), by its undersigned counsel, hereby moves this
Court, pursuant to Rules 12(b)(1) and 12(b)(6) of the Federal Rules of Civil Procedure, for an order dismissing with prejudice all claims asserted against FDIC Receiver in the above-captioned action.
Support for this motion is set forth in the accompanying Memorandum of Points and
Authorities in Support of FDIC Receiver’s Motion to Dismiss, and in the Declaration of Jason S.
Cohen and the exhibits thereto. A proposed order is attached hereto. Case 1:09-cv-01656-RMC Document 54 Filed 11/22/10 Page 2 of 2
Dated: November 22, 2010 Respectfully submitted,
Of Counsel: /s/ William R. Stein William R. Stein, D.C. Bar No. 304048 Kathryn R. Norcross, D.C. Bar No. 398120 Scott H. Christensen, D.C. Bar No. 476439 Senior Counsel, Commercial Litigation Unit Jason S. Cohen, D.C. Bar No. 501834 Anne M. Devens HUGHES HUBBARD & REED LLP Counsel, Commercial Litigation Unit 1775 I Street, N.W., Suite 600 Kaye A. Allison Washington, D.C. 20006-2401 Counsel, Commercial Litigation Unit Telephone: (202) 721-4600 FEDERAL DEPOSIT INSURANCE Facsimile: (202) 721-4646 CORPORATION Email: [email protected] 3501 Fairfax Drive, Room VS-D-7062 Email: [email protected] Arlington, Virginia 22226 Email: [email protected] Telephone: (703) 562-2204 Facsimile: (703) 562-2475 Attorneys for Federal Deposit Insurance Email: [email protected] Corporation in its capacity as Receiver for Email: [email protected] Washington Mutual Bank Email: [email protected]
2
Case 1:09-cv-01656-RMC Document 54-1 Filed 11/22/10 Page 1 of 51
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
DEUTSCHE BANK NATIONAL TRUST COMPANY,
Plaintiff,
v.
Case No. 09-CV-1656-RMC FEDERAL DEPOSIT INSURANCE CORPORATION (as receiver of Hon. Rosemary M. Collyer WASHINGTON MUTUAL BANK); JPMORGAN CHASE BANK, National Association; and WASHINGTON MUTUAL MORTGAGE SECURITIES CORPORATION,
Defendants.
MEMORANDUM OF POINTS AND AUTHORITIES IN SUPPORT OF FDIC RECEIVER’S MOTION TO DISMISS
Of Counsel: William R. Stein (D.C. Bar No. 304048) Scott H. Christensen (D.C. Bar No. 476439) Kathryn R. Norcross (D.C. Bar No. 398120) Jason S. Cohen (D.C. Bar No. 501834) Senior Counsel, Commercial Litigation Unit HUGHES HUBBARD & REED LLP Anne M. Devens 1775 I Street, N.W. Counsel, Commercial Litigation Unit Washington, D.C. 20006-2401 Kaye A. Allison Telephone: (202) 721-4600 Counsel, Commercial Litigation Unit Facsimile: (202) 721-4646 FEDERAL DEPOSIT INSURANCE Email: [email protected] CORPORATION Email: [email protected] 3501 Fairfax Drive, Room VS-D-7062 Email: [email protected] Arlington, Virginia 22226 Telephone: (703) 562-2204 Attorneys for Federal Deposit Insurance Facsimile: (703) 562-2475 Corporation in its capacity as Receiver for Email: [email protected] Washington Mutual Bank Email: [email protected] Email: [email protected]
November 22, 2010
Case 1:09-cv-01656-RMC Document 54-1 Filed 11/22/10 Page 2 of 51
TABLE OF CONTENTS
Page
Table of Authorities ...... iii
INTRODUCTION ...... 1
BACKGROUND AND SUMMARY OF ALLEGATIONS ...... 4
A. The WaMu Receivership And The P&A Agreement ...... 6
B. WaMu’s Mortgage-Backed Securities Business ...... 10
1. The Securitization Process ...... 10
2. The Trusts and the Governing Agreements ...... 12
C. WaMu’s Disclosure Of Liabilities And Obligations Under The Governing Agreements ...... 16
D. JPMC’s Acknowledgment Of Liabilities And Obligations Under The Governing Agreements ...... 19
E. DBNTC’s Amended Complaint ...... 22
ARGUMENT ...... 23
I. FDIC RECEIVER HAS NO LIABILITY TO DBNTC UNDER THE GOVERNING AGREEMENTS...... 23
A. The P&A Agreement Transferred The Governing Agreements And All Of WaMu’s Rights, Obligations, And Liabilities Thereunder To JPMC...... 24
1. The Governing Agreements are Assets that transferred to JPMC under Section 3.1 of the P&A Agreement...... 25
2. All of WaMu’s obligations and liabilities under the Governing Agreements transferred to JPMC under Section 2.1 of the P&A Agreement...... 29
B. The Transfer Of The Governing Agreements To JPMC Extinguished FDIC Receiver’s Potential Liability...... 38
II. CLAIMS AGAINST FDIC RECEIVER BASED ON ALLEGED POST- RECEIVERSHIP BREACHES SHOULD BE DISMISSED...... 40
A. DBNTC Failed To Exhaust The Administrative Claims Process With Respect To Its Claims Of Post-Receivership Breach...... 40
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TABLE OF CONTENTS (continued) Page
B. The Amended Complaint Fails to State A Claim Of Post-Receivership Breach Against FDIC Receiver...... 42
CONCLUSION ...... 45
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TABLE OF AUTHORITIES
Page(s) CASES
Acevedo v. First Union Nat’l Bank, 357 F.3d 1244 (11th Cir. 2004) ...... 39
Aljaf Assocs. Ltd. P’ship v. FDIC, 879 F. Supp. 515 (E.D. Pa. 1995)...... 42
Ameren Servs. Co. v. FERC, 330 F.3d 494 (D.C. Cir. 2003) ...... 24
Bank of N.Y. v. FDIC, 453 F. Supp. 2d 82 (D.D.C. 2006) ...... 26
Beal Bank, SSB v. Pittorino, 177 F.3d 65 (1st Cir. 1999) ...... 30
Brady Dev. Co., Inc. v. RTC, 14 F.3d 998 (4th Cir. 1994) ...... 40
Brown Leasing Co. v. FDIC, 833 F. Supp. 672 (N.D. Ill. 1993) ...... 42
In re Chicago, Milwaukee, St. Paul, & Pac. R. Co., 789 F.2d 1281 (7th Cir. 1986)...... 38
Coleman v. FDIC, 826 F. Supp. 31 (D. Mass. 1993) ...... 42
Conseil Alain Aboudaram, S.A. v. de Groote, 460 F.3d 46 (D.C. Cir. 2006) ...... 24
Courtney v. Halleran, 485 F.3d 942 (7th Cir. 2007) ...... 39
E.I. du Pont de Nemours & Co. v. FDIC, 32 F.3d 592 (D.C. Cir. 1994)...... 30
FDIC v. Condit, 861 F.2d 853 (5th Cir. 1988) ...... 39
FDIC v. Great Am. Ins. Co., 607 F.3d 288 (2d Cir. 2010) ...... 30
Flynn v. Dick Corp., 481 F.3d 824 (D.C. Cir. 2007) ...... 33
Flynn v. So. Seamless Floors, Inc., 460 F. Supp. 2d 46 (D.D.C. 2006) ...... 34
Forest Mktg. v. State Dept. Natural Res., 104 P.3d 40 (Wash. Ct. App. 2005) ...... 35
Freeman v. FDIC, 56 F.3d 1394 (D.C. Cir. 1995) ...... 40, 41
Goodman v. Challenger Int’l, Ltd., No. 94-1262, 1995 WL 402510 (E.D. Pa. July 5, 1995) ...... 38
Hatco Corp. v. W.R. Grace & Co., 59 F.3d 400 (3d Cir. 1995) ...... 38
Henderson v. Bank of New England, 986 F.2d 319 (9th Cir. 1993) ...... 41
Hennessy v. FDIC, 58 F.3d 908 (3d Cir. 1995) ...... 39
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Home Capital Collateral, Inc. v. FDIC, 96 F.3d 760 (5th Cir. 1996) ...... 41
India Breweries, Inc. v. Miller Brewing Co., 612 F. 3d 651 (7th Cir. 2010) ...... 30
Langley v. FDIC, 484 U.S. 86 (1987) ...... 30
Lone Star Fund V (U.S.), L.P. v. Barclays Bank PLC, 594 F.3d 383 (5th Cir. 2010) ...... 26
In re MBIA, Inc. Sec. Litig., 700 F. Supp. 2d 566 (S.D.N.Y. 2010) ...... 5
McCarthy v. FDIC, 348 F.3d 1075 (9th Cir. 2003) ...... 41
McGlothlin v. RTC, 913 F. Supp. 15 (D.D.C. 1996) ...... 42
Mintz v. FDIC, ___ F. Supp. 2d ____, No. 09-1894, 2010 WL 3064373 (D.D.C. Aug. 6, 2010) ...... 5
Paylor v. Winter, 600 F. Supp. 2d 117 (D.D.C. 2009) ...... 4
Payne v. Sec. Sav. & Loan Ass’n, F.A., 924 F.2d 109 (7th Cir. 1991) ...... 39
Pfeiffer v. Duncan, 659 F. Supp. 2d 160 (D.D.C. 2009)...... 33
Rothman v. Gregor, 220 F.3d 81 (2d Cir. 2000)...... 5
Segar v. Mukasey, 508 F.3d 16 (D.C. Cir. 2007) ...... 24, 33
Simon v. FDIC, 48 F.3d 53 (1st Cir. 1995) ...... 41
SR Int’l Bus. Ins. Co. v. World Trade Ctr. Props., 467 F.3d 107 (2d Cir. 2006) ...... 35
Staehr v. Hartford Fin. Servs. Group, 547 F.3d 406 (2d Cir. 2008) ...... 5
Tri-State Hotels, Inc. v. FDIC, 79 F.3d 707 (8th Cir. 1996)...... 44
United States v. First N. Dakota Nat’l Bank, 137 F.3d 1077 (8th Cir. 1998)...... 38
United States v. Sunoco, Inc., 637 F. Supp. 2d 282 (E.D. Pa. 2009) ...... 38
Village of Oakwood v. State Bank and Trust Co., 539 F.3d 373 (6th Cir. 2008) ...... 41
Wilson Court Ltd. P’ship v. Tony Maroni’s, Inc, 952 P.2d 590 (Wa. 1998) ...... 35
STATUTES AND RULES
12 U.S.C. § 1821 ...... passim
12 U.S.C. § 1823 ...... 6, 30
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Fed. R. Civ. P. 12(b)(1)...... 42
Fed. R. Civ. P. 12(b)(6)...... 3, 4, 40, 44
Financial Institutions Reform Recovery and Enforcement Act of 1989, Pub. L. No. 101-73 ...... 22, 38, 40, 41
LEGISLATIVE AND ADMINISTRATIVE MATERIALS
H.R. Conf. Rep. No. 103-213, 1993 U.S.C.C.A.N. 1088 (Aug. 4, 1993)...... 44
TREATISES AND PERIODICAL MATERIALS
RESTATEMENT (SECOND) OF CONTRACTS § 202(1), CMT. C (1993) ...... 35
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Defendant Federal Deposit Insurance Corporation in its capacity as Receiver for
Washington Mutual Bank (“FDIC Receiver”) submits this memorandum in support of its motion to dismiss the First Amended Complaint (the “Amended Complaint”).
INTRODUCTION
Plaintiff Deutsche Bank National Trust Company (“DBNTC”) asserts claims for
monetary damages and declaratory relief against FDIC Receiver and, in the alternative,
Defendant JPMorgan Chase Bank, N.A. (“JPMC”) as purported successors-in-interest to
Washington Mutual Bank (“WaMu”). DBNTC’s claims arise from alleged breaches by WaMu
of contractual obligations reflected in the “Governing Agreements” of 127 separate trusts created
for the securitization of residential mortgage loans between 1992 and 2007. Am. Compl. ¶¶ 2-3.
As Trustee for these 99 “Primary Trusts” and 28 “Secondary Trusts” (which DBNTC refers to
collectively as “the Trusts”), DBNTC seeks damages of more than $10 billion on behalf of the
Trusts and investors in securities issued by the Trusts. See id. ¶¶ 3, 5-6, 85.
DBNTC’s claims against FDIC Receiver should be dismissed in their entirety, because
FDIC Receiver transferred all of WaMu’s liabilities and obligations under the Governing
Agreements to JPMC. Under the Purchase and Assumption (“P&A”) Agreement1 that JPMC and FDIC Receiver entered into when the Office of Thrift Supervision (“OTS”) closed WaMu on
September 25, 2008, JPMC acquired WaMu’s ongoing banking operations in a “whole bank” transaction, “purchas[ing] substantially all of the assets and assum[ing] all deposit and
substantially all other liabilities” of WaMu, for a purchase price of $1.9 billion. P&A Agreement
1. The P&A Agreement is Exhibit 2 to the Amended Complaint. The P&A Agreement is maintained in the publicly-available files of the FDIC and can be accessed at http://www.fdic.gov/about/freedom/Washington_Mutual_P_and_A.pdf.
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at 1, Art. VI. JPMC expressly agreed to “pay, perform, and discharge” all liabilities reflected on
WaMu’s books and records as of September 25, 2008, including specifically “all mortgage servicing rights and obligations.” Id. § 2.1. JPMC purchased “all” the assets of WaMu, including specifically “all the mortgage servicing rights and obligations,” id. § 3.1, and “all rights of [WaMu] to provide mortgage servicing for others . . . and related contracts,” id.
Schedule 3.2. Further, the assets were purchased subject to “all liabilities” affecting those assets,
as provided in Section 2.1. Without question, JPMC succeeded to all of WaMu’s interests, rights, obligations, and liabilities under the Governing Agreements, which, according to
DBNTC, are for each Trust an integrated set of agreements governing the transfer of loans into the Trust, the securitization of the loans in the Trust, the servicing of the loans, and the rights and obligations of all the parties to the transaction.
As a result of the P&A Agreement, JPMC acquired from FDIC Receiver assets with a net fair value of nearly $12 billion, including WaMu’s nationwide mortgage banking operations and its valuable mortgage servicing rights. Despite its extraordinary gain and continuing profits,
JPMC now seeks to walk away from the associated obligations and liabilities, by denying the plain meaning of the P&A Agreement and asserting that FDIC Receiver should bear the cost of
WaMu’s liabilities and obligations under the Governing Agreements. Yet as DBNTC alleges, these liabilities and obligations – such as the obligation to repurchase “defective” mortgage loans and to indemnify the Trusts for certain expenses – are express provisions in the Governing
Agreements, which “constituted official books and records of [WaMu] at the time of [its] closing on September 25, 2008.” Am. Compl. ¶ 42(e); see also id. ¶¶ 40, 43. As illustrated by WaMu’s public filings in 2007 and 2008, WaMu disclosed its liabilities and obligations under the
Governing Agreements long before OTS had closed, and JPMC had acquired, WaMu. In fact, in
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its own public filings following the WaMu transaction, JPMC acknowledged its assumption of
WaMu’s liabilities and obligations under the Governing Agreements.
Now, JPMC is attempting to rewrite history. The unambiguous terms of the P&A
Agreement, which the Court may construe as a matter of law, demonstrate that any and all of
WaMu’s rights, obligations, and liabilities under the Governing Agreements were transferred to and assumed by JPMC. Accordingly, FDIC Receiver can have no liability to DBNTC for any obligation owed under the Governing Agreements, whether arising before or after WaMu’s closure, and all claims against FDIC Receiver should be dismissed under Rule 12(b)(6).
DBNTC also appears to allege that either JPMC or FDIC Receiver, as successor to
WaMu, committed post-receivership breaches of servicing or repurchase obligations under the
Governing Agreements. Any claims against FDIC Receiver based on post-receivership breaches should be dismissed for two additional reasons.2 First, this Court lacks subject matter
jurisdiction to consider such claims because DBNTC did not include in its administrative Proof
of Claim to FDIC Receiver any claim or allegation based on post-receivership breaches by FDIC
Receiver or anyone else, but instead limited its claims to alleged pre-receivership breaches by
WaMu. See 12 U.S.C. § 1821(d)(13)(D). Second, the post-receivership breach claims against
FDIC Receiver should be dismissed under Rule 12(b)(6), because the Amended Complaint does
not establish a basis for those claims against FDIC Receiver. As to post-receivership servicing
obligations, the P&A Agreement unambiguously provides that JPMC would assume “all
2. In its Amended Complaint, DBNTC refers to WaMu, JPMC, and FDIC Receiver indiscriminately under the blanket term “WaMu.” Am. Compl. ¶ 13. By conflating WaMu, JPMC and FDIC Receiver in this fashion, DBNTC adds unnecessary confusion to the Court’s task, particularly when DBNTC ascribes post-receivership actions to “WaMu.” See infra Section II.
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mortgage servicing rights and obligations” and that FDIC Receiver would transfer all loan and mortgage files to JPMC; accordingly, FDIC Receiver indisputably had no post-receivership obligations to service loans in any Trust or provide DBNTC with access to loan files, and could not possibly have breached obligations it did not have. As to post-receivership repurchase obligations, DBNTC acknowledges that it has not provided FDIC Receiver with the required notice and opportunity to cure with respect to any specific mortgage loan in any Trust pools, which is DBNTC’s sole remedy under the Governing Agreements; accordingly, even if FDIC
Receiver had retained any repurchase obligations under those Agreements (which it did not), those obligations have never been triggered and thus could not have been breached.
BACKGROUND AND SUMMARY OF ALLEGATIONS3
Before its closure, WaMu was the nation’s largest savings and loan association. Its
business was heavily focused on residential mortgage lending. During the years preceding the
current financial crisis, WaMu, along with a number of other mortgage lenders, began using a
variety of high-risk mortgage products that enabled it to increase revenue and market share.4
Borrowers’ ability to repay or refinance these mortgages often depended upon home prices continuing to increase. WaMu also was a major participant in the residential mortgage-backed
3. In evaluating a motion under Rule 12(b)(6), the Court may consider “facts alleged in the complaint, any documents attached to or incorporated in the complaint, matters of which the court may take judicial notice, and matters of judicial record.” Paylor v. Winter, 600 F. Supp. 2d 117, 123 (D.D.C. 2009). The documents cited herein in support of FDIC Receiver’s motion to dismiss are attached as exhibits to the Declaration of Jason S. Cohen, received on November 22, 2010, and submitted herewith. When citing these materials, the notation “Ex. ___” refers to the corresponding exhibit attached to Mr. Cohen’s Declaration.
4. Dan Margolies, US Senate Panel: High-Risk Loans Brought Down WaMu, REUTERS, Apr. 12, 2010, available at http://www.reuters.com/article/idUSN1220708420100412.
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securitization market.5 Securitization of the loans it originated was an important source of liquidity for WaMu.6
When home prices began to plateau and fall, and when the credit markets began to lose
their appetite for mortgage-backed securities, WaMu’s business model could not withstand the
resulting stresses. In 2008, WaMu was having increasingly large mortgage loan losses. It
suffered three straight quarters of losses totaling $6.1 billion, and was encountering increasingly
difficult market conditions.7 On September 15, 2008, an outflow of deposits began that reached
$16.7 billion in only eight business days.8 As a result, on September 25, 2008, OTS closed
WaMu, finding the bank to have “insufficient liquidity to meet its obligations” and thus to be in
an “unsafe and unsound condition to conduct business.”9 OTS appointed FDIC as Receiver on
the same day. See Am. Compl. ¶ 10; OTS Order 2008-36.
FDIC Receiver was thus called upon to help resolve the problems with one of the
nation’s most troubled mortgage lenders at the low point of the financial crisis – only ten days
5. See, e.g., Ex. 1, Washington Mutual, Inc. (“WMI”) 2007 Form 10-K (2/29/08) at 132-133. The Court “may take judicial notice of ‘documents required by law to be, and that have been, filed with the SEC.’” In re MBIA, Inc. Sec. Litig., 700 F. Supp. 2d 566, 574 n.5 (S.D.N.Y. 2010) (quoting Rothman v. Gregor, 220 F.3d 81, 88 (2d Cir. 2000)); accord, e.g., Staehr v. Hartford Fin. Servs. Group, 547 F.3d 406, 425 (2d Cir. 2008); Mintz v. FDIC, ___ F. Supp. 2d ____, No. 09-1894, 2010 WL 3064373, at *2 n.2 (D.D.C. Aug. 6, 2010). References to WMI filings are relevant because WaMu was wholly-owned by WMI, a publicly traded bank holding company. See Ex. 1, WMI 2007 Form 10-K (2/29/08) at 2. 6. See, e.g., Ex. 1, WMI 2007 Form 10-K (2/29/08) at 87. 7. Office of Thrift Supervision, “OTS Fact Sheet on Washington Mutual Bank,” 3 (Sept. 25, 2008) (available at http://www.ots.treas.gov/_files/730021.pdf). 8. Id. 9. Office of Thrift Supervision, Press Release, “Washington Mutual Acquired by JPMorgan Chase” (No. OTS 08-046) (Sept. 25, 2008).
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after Lehman Brothers filed for bankruptcy protection. Since the beginning of 2008, 314 banks have been closed and placed in FDIC receiverships,10 but WaMu’s closure remains the largest bank failure in United States history.11 In order to resolve the failed bank quickly at the least
cost to the FDIC’s Deposit Insurance Fund during a period of great financial stress, FDIC
Receiver conducted a competitive bidding process and, immediately upon being appointed
Receiver, sold WaMu’s banking operations – “substantially all” assets and “all deposits and
substantially all other” liabilities – to JPMC. FDIC Receiver thus was able to resolve WaMu
without disruption for depositors and other bank customers, without cost to the Deposit
Insurance Fund, and without posing additional systemic risk to the U.S. financial system.
A. The WaMu Receivership And The P&A Agreement
Upon its appointment, FDIC Receiver succeeded to all the rights, titles, powers,
privileges, and operations of WaMu with respect to the bank, its assets, and its valid obligations.
12 U.S.C. § 1821(d)(2). The powers and duties of FDIC Receiver include the ability to “transfer
any asset or liability of the institution in default . . . without any approval, assignment, or consent
with respect to such transfer,” id. § 1821(d)(2)(G)(i)(II), and to otherwise act in “the best
interests of the [failed] depository institution, its depositors, or the [FDIC],” id. § 1821(d)(2)(J).
FDIC Receiver has a statutory duty to resolve a failed financial institution in the manner least
costly to the Deposit Insurance Fund with respect to “the total amount of the expenditures . . .
and obligations incurred by the [FDIC] (including any immediate and long-term obligation of the
10. See Failed Bank List, available at http://www.fdic.gov/bank/individual/failed/banklist.html.
11. Elinor Complay and Jonathan Stempel, WaMu Is Largest U.S. Bank Failure, REUTERS, Sept. 26, 2008, available at http://www.reuters.com/article/idUSTRE48P08920080926.
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[FDIC] and any direct or contingent liability for future payment by the [FDIC]).” 12 U.S.C.
§ 1823(c)(4)(A)(ii).
Immediately following FDIC Receiver’s appointment on September 25, 2008, FDIC
Receiver accepted JPMC’s bid to “purchase substantially all of the assets and assume all deposit and substantially all other liabilities of [WaMu]” in a P&A Agreement designed to transfer the
“whole bank.” P&A Agreement at 1; id. §§ 2.1, 3.1; see id. at 20. As a result of this transaction,
JPMC acquired the ongoing banking operations of WaMu, which “consisted of a retail bank network of 2,244 branches, a nationwide credit card lending business, a multi-family and commercial real estate lending business, and nationwide mortgage banking activities,” specifically including WaMu’s valuable mortgage servicing rights with respect to hundreds of billions of dollars of residential mortgage loans.12 Ex. 9, JPMC 2009 Form 10-K (2/24/10) at 58;
see, e.g., Ex. 7, JPMC Form 8-K (1/15/09), Ex. 99.1 Earnings Release at 6 (“Total third-party mortgage loans serviced [in 2008] were $1.2 trillion, an increase of $557.9 billion, or 91%, predominantly due to the Washington Mutual transaction.”); Am. Compl. ¶¶ 38-39. According
to JPMC, “the Washington Mutual transaction . . . contributed to increases in net interest income,
lending- and deposit-related fees, and mortgage fees and related income.” Ex. 9, JPMC 2009
Form 10-K (2/24/10) at 45.
In exchange for WaMu’s ongoing banking operations – i.e., for “purchas[ing]
substantially all the assets and assum[ing] all deposit and substantially all other liabilities of
WaMu” – JPMC paid $1.9 billion in cash. P&A Agreement, Art. VII; see Am. Compl. ¶ 86.
12. See Ex. 9, JPMC 2009 Form 10-K (2/24/10) at 58 (“The [WaMu] transaction expanded [JPMC’s] U.S. consumer branch network in California, Florida, Washington, Georgia, Nevada and Oregon and created the nation’s third-largest branch network.”).
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According to JPMC, however, the fair value of the net assets it acquired from FDIC Receiver in
the WaMu transaction (i.e., WaMu’s assets net of its liabilities) was $11.99 billion at the time of
sale. See Ex. 9, JPMC 2009 Form 10-K (2/24/10) at 144.13 Thus, by JPMC’s own reckoning, the total fair value of the assets and liabilities it assumed under the P&A Agreement, even after
“[a]djustments to reflect liabilities assumed at fair value,” was more than six times greater than
JPMC’s $1.9 billion purchase price.14 Id. The projected future cash flow for WaMu’s mortgage servicing rights alone was valued as an asset worth $5.87 billion on JPMC’s balance sheets immediately after the purchase. Id.
Section 3.1 of the P&A Agreement provided that JPMC “purchases from the Receiver,
and the Receiver hereby sells, assigns, transfers, conveys, and delivers to [JPMC], all right, title,
and interest of the Receiver in and to all of the assets” of WaMu, “whether or not reflected in the
books of [WaMu] as of Bank Closing,” and “subject to all liabilities . . . affecting such Assets to
the extent provided in Section 2.1.”15 Section 2.1 of the P&A Agreement, which governs
JPMC’s assumption of WaMu’s liabilities, provided that:
13. Such a transaction, in which the acquisition-date fair value of the net assets acquired exceeds the purchase price, is literally considered a “bargain purchase” by GAAP standards. See FASB Statement (“SFAS”) No. 141R (Business Combinations) at iv-v (Fin. Accounting Standards Bd. 2007). 14. Concluding that “[t]he fair value of the net assets of Washington Mutual’s banking operations exceeded the $1.9 billion purchase price,” by over $10 billion, JPMC ultimately recorded a $2 billion “extraordinary gain” in 2008 and 2009. Ex. 9, JPMC 2009 Form 10-K (2/24/10) at 143-44; see Ex. 8, JPMC 2008 Form 10-K (3/2/09) at 123-24. 15. The P&A Agreement also stated that “[t]he conveyance of all assets” purchased by JPMC “shall be made . . . without any warranties whatsoever with respect to such assets, express or implied, with respect to . . . freedom from liens or encumbrances (in whole or in part), or any other matters.” P&A Agreement § 3.3.
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Subject to Sections 2.5 and 4.8, [JPMC] expressly assumes at Book Value . . . and agrees to pay, perform, and discharge all of the liabilities of [WaMu] which are reflected on the Books and Records of [WaMu] as of Bank Closing, . . . except as listed on the attached Schedule 2.1, and as otherwise provided in this Agreement.
(Emphasis added.)16
Schedule 3.2 specifically identified the “rights of [WaMu] to provide mortgage servicing
for others . . . and related contracts” as assets purchased by JPMC. P&A Agreement at 36. The
P&A Agreement also provided that “notwithstanding Section 4.8,” JPMC specifically “assumes”
(under Section 2.1) and “purchases” (under Section 3.1) “all mortgage servicing rights and
obligations of [WaMu].” Id. §§ 2.1, 3.1. Thus, while JPMC generally had the right under
Section 4.8 of the P&A Agreement to elect not to assume existing agreements “which provide
for the rendering of services by or to [WaMu],” JPMC could not reject any agreements providing
for WaMu’s mortgage servicing rights and obligations.17 Id. § 4.8. Consistent with JPMC’s irrevocable purchase and assumption of WaMu’s mortgage servicing activities, the P&A
Agreement required FDIC Receiver to deliver to JPMC “as soon as practicable” all “[l]oan and collateral records and Credit Files and other documents,” title records “pertaining to … real
16. As DBNTC alleges, “[t]he list [in Schedule 2.1] of liabilities not assumed by JPMC pursuant to the [P&A Agreement] does not include or reference any liabilities or obligations arising under the Governing [Agreements].” Am. Compl. ¶ 87; see P&A Agreement at 34. Section 2.5, which is entitled “Borrower Claims,” excludes from the scope of liabilities assumed by JPMC “any liability associated with borrower claims for payment of or liability to any borrower,” and thus is not relevant. 17. Section 4.8 permitted JPMC to elect not to assume existing service agreements if JPMC provided written notice of its decision with respect to “each such agreement” within 120 days of WaMu’s closing. P&A Agreement § 4.8. Section 4.8 provided that JPMC “shall be deemed to have assumed agreements for which no notification is timely given.” Id.
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estate mortgages,” and other “Records pertaining to the Assets” purchased by JPMC.18 Id. § 6.1.
B. WaMu’s Mortgage-Backed Securities Business
Prior to WaMu’s closure, the sale and servicing of securitized mortgage loans through
large-scale, multi-billion dollar financial transactions was a central aspect of WaMu’s residential
mortgage banking operations. See Ex. 1, Washington Mutual, Inc. (“WMI”) 2007 Form 10-K
(2/29/08) at 133 (reflecting $113.5 billion and $82.6 billion in proceeds from new residential
mortgage loan securitizations in 2006 and 2007, respectively).
1. The Securitization Process
The securitization transactions at issue involve the creation and sale of securities backed
by underlying pools of thousands of residential mortgage loans, typically held in trusts formed
for that purpose.19 See Am. Compl. ¶¶ 25-30; see also Ex. 2, WMI Form 10-Q (8/11/08) at 60
(describing securitization process). Broadly speaking, the securitization process occurs as
18. “Records” is defined in the P&A Agreement as “any document, microfiche, microfilm and computer records . . . of [WaMu] generated or maintained by [WaMu] that is owned by or in the possession of the Receiver at Bank Closing.” P&A Agreement at 6; see also id. at 4 (defining “Credit File”), 5 (defining “Loan”). 19. FDIC Receiver assumes (as it must) only for purposes of this motion the specific factual allegations contained in the Amended Complaint, but does not necessarily concede their accuracy, particularly the allegations relating to the scope and extent of breaches of the Governing Agreements and the amount of damages caused by any alleged breaches. If this case proceeds, DBNTC will, of course, be required to prove each and every breach for which it seeks to recover, and for each such breach, that it caused a material loss to the relevant Trust. DBNTC also must establish, for each Trust, that it has standing to assert the breach claims and that each Defendant is contractually liable under the agreement allegedly breached. For example, Governing Agreements provided as exhibits to the Amended Complaint indicate on their face that any breach claims with respect to forty-two of the Primary Trusts (see Am. Compl. Ex. 1-A, Trust Nos. 46 through 87) can only be asserted against Washington Mutual Mortgage Securities Corp. (“WMMSC”), a co-defendant in this action and a wholly-owned subsidiary of JPMC. See Ex. 8, JPMC 2008 Form 10-K (3/2/09) at 245 (Ex. 21.1 – List of Subsidiaries of JPMorgan Chase & Co.); Am. Compl. ¶ 9.
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follows: The entity sponsoring the securitization (the “seller”) – typically a bank or bank subsidiary – originates or acquires a pool of mortgage loans and sells those loans to an intermediate entity (the “depositor”), which in turn places the pooled loans into a trust as collateral for mortgage-backed securities.20 See Am. Compl. ¶ 28(a); Ex. 3, WaMu 2007 Form
10-K (3/21/08) at 76-77. The trust then issues different classes of securities, each of which entitles investors to specific interests in periodic disbursements from the cash flows available to the trust from borrower payments of principal, interest, and fees made over the life of the underlying mortgages. See Am. Compl. ¶¶ 28(c); Ex. 1, WMI 2007 Form 10-K (2/29/08) at 48.
A trustee ensures the proper distribution of trust funds to investors in accordance with the terms of the trust agreements. See Am. Compl. ¶ 28(b).
The sponsoring entity often retains the right to service the pooled loans after they have
been sold, because those rights are a valuable source of revenue that can be worth billions of
dollars annually. See Ex. 1, WMI 2007 Form 10-K (2/29/08) at 48, 133; Am. Compl. ¶ 28(d).
The servicer acts as “the day-to-day administrator of the mortgage loan assets held by the trust,”
responsible for “collecting payments due from the borrowers [and] remitting those payments to
the trust for ultimate payment to the investors.” Am. Compl. ¶ 28(d). In exchange, the servicer
“receives servicing fees equal to a percentage of the outstanding principal balance of mortgage
loans . . . being serviced.” Ex. 3, WaMu 2007 Form 10-K (3/21/08) at 91. In 2006 and 2007, the
20. The depositor is typically a wholly-owned subsidiary of the sponsoring entity or its holding company. See, e.g., Am. Compl. Ex. 1-A (identifying WaMu as both seller and depositor for 95 of 99 Primary Trusts); Ex. 1, WMI 2007 Form 10-K (2/29/08), Ex. 21 (listing depositor entities Long Beach Securities Corporation, WaMu Asset Acceptance Corporation, and Washington Mutual Mortgage Securities Corporation, inter alia, among WMI subsidiaries).
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mortgage servicing rights retained by WaMu in connection with its sale of securitized mortgage loans generated revenue streams of $2.1 billion and $1.9 billion, respectively. See id. These mortgage servicing rights are so lucrative that the expected future cash flow from such rights is often recorded as an asset on the bank’s income statements because “the expected future cash flows from servicing are projected to be more than adequate compensation for such services.”
Ex. 1, WMI 2007 Form 10-K (2/29/08) at 116.21
Along with mortgage servicing rights, the sponsoring entity typically retains certain
residual or other continuing interests in the securitized loans. See Ex. 3, WaMu 2007 Form 10-K
(3/21/08) at 76-77. Such retained interests commonly include “the right to cash flows remaining
after the investors in the securitization trusts have received their contractual payments.” Id. at 91; see Am. Compl. ¶ 26.
2. The Trusts and the Governing Agreements
DBNTC purports to assert breach claims with respect to 127 separate Trusts created
between 1992 and 2007, for which DBNTC allegedly served in the capacity of Trustee or
Indenture Trustee, and for which WaMu (or subsidiaries, affiliates, or predecessors-in-interest of
WaMu) allegedly served as seller, depositor, and servicer. Am. Compl. ¶¶ 3, 28; see also id., Ex.
1 (listing 99 “Primary Trusts” and 28 “Secondary Trusts”). According to DBNTC, the original outstanding balance of the 99 “Primary Trusts” was approximately $165 billion, while the
21. According to the Notes to Consolidated Financial Statements in WMI’s 2007 annual report, “[a]dequate compensation is where the benefits of servicing would fairly compensate a substitute servicer should one be required, including a profit margin that would be demanded in the market place.” Ex. 1, WMI 2007 Form 10-K (2/29/08) at 116. As of December 31, 2007, WaMu’s financial statements reflected $6.3 billion in recorded assets for the projected “excess” cash flow of the bank’s mortgage servicing rights. Id. at 104.
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outstanding principal balance of the Primary Trusts at the time of WaMu’s closure on September
25, 2008 was approximately $45 billion. Id. ¶ 4. DBNTC alleges that the 28 “Secondary Trusts” are trusts through which WaMu “issued mortgage-backed or derivative securities whose performance is dependent, in whole or in part, on the performance of the Primary Trusts or of other residential mortgage-backed securities issued by [WaMu].” Id. ¶ 3.
Each Trust is governed by a complex web of interrelated transaction documents (the
“Governing Agreements”), each set of which comprises hundreds of pages of executory contracts memorializing the rights, interests, liabilities, and continuing obligations of the contracting parties in exhaustive detail. See Am. Compl. ¶¶ 29-33. Among other things, the
Governing Agreements set forth the terms by which mortgage loans are to be contributed to the
Trusts, securitized, insured, and serviced; how the resulting securities are to be sold to investors; and how cash flows from payments of principal, interest and fees on the loans are to be allocated and distributed. See id. ¶ 29. As DBNTC alleges, the Governing Agreements for each Trust represent a unitary and “integrated set of contractual undertakings . . . that involve obligations that are ongoing, mutual, and interrelated.” Id. ¶¶ 31-33. As DBNTC also alleges – consistent with the importance of the Governing Agreements to WaMu’s mortgage banking business and with the amount of money at risk – the Governing Agreements “constituted official books and records of [WaMu] at the time of [WaMu’s] closing on September 25, 2008,” maintained in the bank’s formal files and “executed on behalf of WaMu by individuals duly authorized by the applicable WaMu entity’s Board of Directors.” See id. ¶¶ 42(c), (e).
According to DBNTC, while the “related ancillary documents and agreements” may vary from Trust to Trust, each set of Governing Agreements generally includes a Mortgage Loan
Purchase Agreement (“MLPA”), which governs the transfer of the mortgage loans from the
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sponsoring entity (the “seller”) to the depositor, and a Pooling and Servicing Agreement
(“PSA”), which governs the administration of the Trust, the transfer of the loans into the Trust,
the securitization process, the servicing of the underlying mortgage loans, and the management
of the Trust cash flow. See id. ¶¶ 29-30. DBNTC alleges that all of “WaMu’s” liabilities and
obligations under the Governing Agreements that DBNTC seeks to enforce are contained within
these MLPAs and PSAs. Id. ¶¶ 30, 47, 52, 57, 62, 64; see also id., Ex. 7 (purporting to identify
the contractual provisions giving rise to WaMu’s obligations with respect to each Primary
Trust).22 DBNTC also alleges that the MLPAs and PSAs also contain provisions describing
WaMu’s continuing rights and interests in the Trusts as seller, depositor, and servicer. See, e.g.,
Am. Compl. Ex. 4, WaMu Series 2007-HE1 Trust (Issue ID No. WA07H1), MLPA § 3; id., PSA
§§ 2.01, 3.01, 6.01 et seq. More specifically, DBNTC alleges WaMu undertook certain continuing obligations under the Governing Agreements (see Am. Compl. ¶ 43) that have been breached and continue to be breached:
a. Repurchase and Indemnification Obligations
According to DBNTC, the Governing Agreements contain a number of representations and warranties made by WaMu in connection with its securitization activities regarding, inter alia, “the underwriting of the mortgage loans, the loan to value ratios for the mortgage loans, and
22. DBNTC uses the term “WaMu” indiscriminately in its Amended Complaint, although in fact (as the charts and exhibits to the Amended Complaint show), the sponsoring entity, seller, depositor, and servicer for many of the Trusts were entities other than Washington Mutual Bank. If this case proceeds against FDIC Receiver, DBNTC will be required to prove not simply that these entities were affiliates or subsidiaries of Washington Mutual Bank, but that Washington Mutual Bank was legally obligated for the other entities’ liabilities as of September 25, 2008. For ease of reference, we will continue to use the term “WaMu” throughout this memorandum, subject to the issue noted in this footnote.
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compliance of the loans with local, state and federal laws.” Am. Compl. ¶ 45. DBNTC alleges that WaMu breached representations and warranties regarding the loans. Id. ¶ 93. DBNTC asserts that the Governing Agreements impose upon WaMu: (1) the obligation to cure, repurchase, or substitute any mortgage loans with respect to which any material breach of such representations and warranties or other material defect exists, within a specified period of days following discovery or written notice (“Repurchase Obligations”), id. ¶ 53; and (2) the duty to indemnify the Trustee for certain losses or expenses resulting from WaMu’s breach of its representations, warranties, and obligations under the Governing Agreements (“Indemnification
Obligations”), id. ¶ 60. DBNTC acknowledges that, under the Governing Agreements, “the sole remedy” available to the Trustee or the Trust investors for any such breach or defect is to invoke the Repurchase Obligations. Id. ¶¶ 54-55; see, e.g., Am. Compl. Ex. 4, WaMu Series 2007-HE1
Trust (Issue ID No. WA07H1), PSA § 2.03(a).
b. Notice Obligations
DBNTC alleges that the Governing Agreements impose upon WaMu, in its capacities as
Seller and Servicer, the duty “to give prompt written notice to the Trustee and other parties upon discovery” of any material breach of its representations and warranties with respect to the underlying mortgage loans (“Notice Obligations”). Am. Compl. ¶ 49. DBNTC acknowledges that, as Trustee, it has a reciprocal obligation under the Governing Agreements to provide prompt written notice to WaMu, as the Seller, regarding material breaches or defects in the underlying mortgage loans. See id. ¶¶ 50-51. The “sole remedy” provisions of the Governing
Agreements uniformly require that, upon discovery or receipt of notice from the Trustee, WaMu must be given the opportunity to cure the alleged breach or defect, or to substitute or repurchase the affected loans, within a specific period of time – typically 60 to 90 days – before DBNTC as
Trustee is entitled to enforce the Repurchase Obligations. See, e.g., Am. Compl. Ex. 4, WaMu
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Series 2007-HE1 Trust (Issue ID No. WA07H1), PSA § 2.03(a); id., GSAMP Series 2005-S2
Trust (Issue ID No. GS05X2), PSA § 2.08. DBNTC concedes that it has not “provid[ed] WaMu with notice of a breach with respect to, and demand[ed] cure, substitution or repurchase of, specific mortgage loans included in the Trusts.” Am. Compl. ¶ 99.
c. Servicing Obligations and Access Rights
DBNTC alleges that the Governing Agreements impose upon WaMu, solely in its capacity as Servicer, the duty to “service and administer the mortgage loans in the Trusts on behalf of the Trustee,” in accordance with the terms of each specific Governing Agreement
(“Servicing Obligations”). Am. Compl. ¶ 63. Among these alleged Servicing Obligations is the duty to provide the Trustee, upon request, with access to “all records maintained by WaMu in respect of WaMu’s rights and obligations under the Governing [Agreements], including information about the mortgage loans and the mortgage loan files” (“Access Rights”).23 Id. ¶ 58.
DBNTC also alleges that “WaMu as the Seller, Depositor and/or Servicer has exclusive
possession of the loan origination and servicing records,” id. ¶ 48, and “has denied the Trustee
access to the loan-level books and records[] and information concerning the mortgage loans in
the Trusts,” id. ¶ 81.
C. WaMu’s Disclosure Of Liabilities And Obligations Under The Governing Agreements
Public disclosures made by WaMu and its holding company, Washington Mutual Inc.
(“WMI”), in 2007 and 2008 repeatedly made it clear that the Governing Agreements imposed
23. According to DBNTC, “[s]uch documents and other information includes origination and underwriting files, servicing records, borrower statements both recorded on tape and transcribed into servicing notes, borrower statements made during the origination of the loan, payment histories, and borrower correspondence.” Am. Compl. ¶ 44.
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liabilities and continuing obligations on WaMu as the seller and servicer of securitized loans.
See, e.g., Ex. 2, WMI Form 10-Q (8/11/08) at 10-11.24 For example, in the “Commitments,
Guarantees and Contingencies” section of the Notes to Consolidated Financial Statements in
WaMu’s 2007 annual report, WaMu stated:
In the ordinary course of business, the Bank sells loans to third parties and . . . [may] be required to repurchase sold loans when representations and warranties made by the Bank in connection with those sales are breached. . . . [I]f the breach had a material adverse effect on the value of the loan, the Bank will be required to either repurchase the loan or indemnify the investor for losses sustained. In addition, the Bank is a party to . . . agreements that contain general indemnification provisions, primarily in connection with agreements to sell and service loans or other assets or the sales of mortgage servicing rights. These provisions typically require the Bank to make payments to the purchasers or other third parties to indemnify them against losses they may incur due to actions taken by the Bank prior to entering into the agreement or due to a breach of representations, warranties, and covenants made in connection with the agreement.
Ex. 3, WaMu 2007 Form 10-K (3/21/08) at 107. Elsewhere in this same document, WaMu stated that “[i]n the event of a breach of the representations and warranties . . . the Bank bears the risk of any loss on the loans.” Id. at 77 (emphasis added); see also, e.g., Ex. 1, WMI 2007
Form 10-K (2/29/08) at 117, 152.
WaMu established reserves on its balance sheets based on estimates of its probable
“exposure to the potential repurchase or indemnification liabilities,” but cautioned that the
24. WaMu’s separate financial statements are presented within the Consolidated Financial Statements and other information provided in WMI’s SEC filings. See Ex. 1, WMI 2007 Form 10-K (2/29/08) at 16 (Overview); Ex. 2, WMI Form 10-Q (8/11/08) at 6 (Basis of Presentation). WaMu’s separate filings of periodic reports with the Office of Thrift Supervision – e.g., Ex. 3, WaMu 2007 Form 10-K (3/21/08) – reflect the same information and are cited as appropriate throughout.
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estimated reserves were subject to adjustment and did not represent the maximum risk exposure
“[t]hroughout the life of these repurchase or indemnification liabilities.” Ex. 3, WaMu 2007
Form 10-K (3/21/08) at 15-16; see also, e.g., Ex. 2, WMI Form 10-Q (8/11/08) at 10-11; Ex. 1,
WMI 2007 Form 10-K (2/29/08) at 22. In March 2008, WaMu offered a candid assessment of its continuing exposure to repurchase liability under the Governing Agreements based on the principal outstanding balance of securitized loans:
The Bank’s liquidity could also be adversely affected by unanticipated demands on its cash, such as having to repurchase securitized loans if it were found to have violated representations and warranties contained in the securitization agreements. In such event, the Bank generally would be required to repurchase these loans or indemnify the investor for losses sustained. Since in most instances the repurchased loans would be in default, it is unlikely that the Bank would be able to resell these loans in the secondary market. If the Bank were required to repurchase a substantial amount of these loans, its liquidity and capital would be adversely affected as the amount of nonperforming assets on its balance sheet would increase.
Ex. 3, WaMu 2007 Form 10-K (3/21/08) at 50 (emphasis added). The extent to which WaMu’s
Repurchase and Indemnification Obligations mature into current cash demands is driven primarily by the performance of the underlying loans in providing cash flow to the Trust, because WaMu is required to repurchase defective loans only “if the breach had a material adverse effect on the value of the loan.” Id. at 107; see also id. at 25 (“The degree of credit risk and level of credit losses is highly dependent on the economic environment that unfolds subsequent to originating or acquiring assets.”); Ex. 1, WMI 2007 Form 10-K (2/29/08) at 133
(recording $1.8 billion in repurchased mortgage loans in 2006 and $431 million in repurchased mortgage loans in 2007).
Indeed, WaMu’s filings in the months prior to its closing demonstrated WaMu’s increasing risk of exposure to liabilities arising from its Repurchase and Indemnification
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Obligations, as “[h]igher delinquencies drove increased repurchase requests from investors resulting in an increase in the provision for repurchase reserves.” Ex. 2, WMI Form 10-Q
(8/11/08) at 58; see, e.g., Ex. 1, WMI 2007 Form 10-K (2/29/08) at 85 (noting “significant increases in loan delinquencies and credit losses”); Ex. 5, WMI Form 8-K (7/22/08), Ex. 99.1
(Press Release) at 6 (noting “an increase in repurchase demands”); Ex. 4, WaMu Form 10-Q
(8/14/08) at 21-22 (noting “sharply higher delinquency rates” and “an increase in the volume of investor requests to repurchase loans the Bank had previously sold”).
D. JPMC’s Acknowledgment Of Liabilities And Obligations Under The Governing Agreements
Notwithstanding the plain terms of the P&A Agreement and the many benefits that JPMC has received from the acquisition of WaMu’s assets, JPMC has denied assuming any of WaMu’s liabilities under the Governing Agreements.25 See Am. Compl. ¶ 91 (“JPMC further contends
that ‘all other liabilities of [WaMu], including the DBNTC liabilities, remain with [FDIC
Receiver].’”) (quoting 8/25/10 letter from JPMC counsel to DBNTC counsel) (emphasis in
original). JPMC’s public statements both before and after the WaMu transaction, however, belie
this denial, and instead evince a clear awareness that those liabilities were reflected on WaMu’s
books and records prior to its closure and transferred to JPMC along with all of WaMu’s rights,
interests, and obligations under the Governing Agreements.
In connection with its own loan securitization activities, JPMC has consistently
demonstrated its familiarity with the liabilities and obligations assumed by seller and servicer
25. According to DBNTC, JPMC has taken the position that the P&A Agreement transferred liabilities reflected on WaMu’s pre-closure books and records “only if and to the extent they had a ‘Book Value.’” Am. Compl. ¶ 90 (emphasis in original). As we demonstrate below, this is incorrect.
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banks in residential mortgage loan securitizations, including the seller’s repurchase and indemnification obligations. See Ex. 6, JPMC 2007 Form 10-K (2/29/08) at 172 (acknowledging that “the maximum amount of future payments the [bank] would be required to make under such repurchase and/or indemnification provisions would be equal to the current amount of assets held” in the trust).26
JPMC’s public filings after the P&A Agreement make repeated reference to its
assumption of WaMu’s rights and responsibilities under the Governing Agreements. When
discussing its accounting for the WaMu transaction in its 2008 Form 10-K, for example, JPMC
noted that the liabilities it had assumed include WaMu’s “executory contracts and other
commitments.” Ex. 8, JPMC 2008 Form 10-K (3/2/09) at 124. Elsewhere in that Form 10-K, in presenting data about its residential mortgage securitization activities, JPMC included the principal balances of the loans in securitizations sponsored by WaMu in a table displaying “the total unpaid principal amount of assets held in JPMorgan Chase-sponsored securitization entities
. . . to which the Firm has continuing involvement” such as ongoing repurchase or indemnification obligations. Id. at 168 (emphasis added) (defining “continuing involvement”); see also id. at 169 (noting that the overview of securitized assets held in QSPEs as of December
31, 2008 “[i]ncludes securitization-related QSPEs sponsored by . . . Washington Mutual”), 171-
172 (JPMC’s securitization activities “include securitizations sponsored by . . . Washington
Mutual”). Thus, JPMC expressly acknowledged that it had stepped into WaMu’s shoes with
26. See also, e.g., Ex. 9, JPMC 2009 Form 10-K (2/24/10) at 233 (stating that the seller bank’s maximum liability “for breaches under [its] representations and warranties . . . [is] equal to the unpaid principal balance of such loans held by purchasers . . . that are deemed to have defects”).
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respect to WaMu-sponsored securitizations. Indeed, in the “Risk Factors” section of a December
2009 prospectus supplement, JPMC forthrightly discussed its potential exposure resulting from
its assumption of WaMu’s repurchase and indemnification obligations. Under the heading
“Defective and repurchased loans may harm our business and financial condition,” JPMC stated:
In connection with the sale and securitization of loans (whether with or without recourse), the originator is generally required to make a variety of customary representations and warranties regarding both the originator and the loans being sold or securitized. We and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, have made such representations and warranties in connection with the sale and securitization of loans (whether with or without recourse), and we will continue to do so as part of our normal Consumer Lending business. Our obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and relate to, among other things, compliance with laws and regulations; underwriting standards; the accuracy of information in the loan documents and loan file; and the characteristics and enforceability of the loan. . . . Accordingly, such repurchase and/or indemnity obligations arising in connection with the sale and securitization of loans (whether with or without recourse) by us and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, could materially increase our costs and lower our profitability, and could materially and adversely impact our results of operations and financial condition.
Ex. 11, 424B7 Prospectus Supplement (12/8/09) at S-7 (emphases added); see also, e.g., Ex. 9,
JPMC 2009 Form 10-K (2/24/10) at 58 (stating that the positive “impact of the Washington
Mutual transaction” on its 2009 net revenue was “partially offset by $1.6 billion in estimated
losses related to the repurchase of previously sold loans”). These disclosures make clear that
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JPMC understood what the P&A Agreement unambiguously provides: that WaMu’s rights, interests, obligations, and liabilities under the Governing Agreements transferred to JPMC.27
E. DBNTC’s Amended Complaint
DBNTC initially submitted some of the claims asserted in the Amended Complaint to
FDIC Receiver through its administrative process, as required by the Financial Institutions
Reform Recovery and Enforcement Act of 1989 (“FIRREA”), Pub. L. No. 101-73. See Am.
Compl. ¶ 14; Proof of Claim (Am. Compl. Ex. 3); 12 U.S.C. § 1821(d)(13)(D). In its Proof of
Claim, DBNTC asserted only that WaMu had breached its contractual obligations; DBNTC did not assert any separate claim or make any allegation that FDIC Receiver itself had assumed
WaMu’s obligations under the Governing Agreements, had breached those Agreements post-
receivership, or otherwise had engaged in wrongful post-receivership conduct regarding these
Agreements. DBNTC’s Proof of Claim was deemed disallowed by operation of law on June 28,
2009 (180 days after it was submitted). Pursuant to 12 U.S.C. § 1821(d)(6)(A), DBNTC
commenced this action on August 26, 2009. Am. Compl. ¶ 19. On September 8, 2010, DBNTC
filed its Amended Complaint and added JPMC as a defendant.
In Count I (Breach of Contract), DBNTC alleges that FDIC Receiver or JPMC, or both, is
or are liable, as WaMu’s successor-in-interest, for alleged breaches of WaMu’s
(1) Representations and Warranties as seller, depositor, and servicer, Am. Compl. ¶ 93;
(2) Notice, Repurchase and Indemnification Obligations as seller, depositor, and servicer, id.;
and (3) obligations as servicer with respect to DBNTC’s Access Rights, id. ¶ 98. DBNTC also
27. Since being named in this lawsuit, JPMC has tried to walk away from its previous acknowledgements, to the point of publicly disclaiming responsibility for WaMu’s repurchase obligations. See Ex. 10, JPMC Form 10-Q (11/9/10) at 58.
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alleges that FDIC Receiver or JPMC continues to breach WaMu’s Servicer Obligations with
respect to DBNTC’s Access Rights, which has “made it impossible for the Trustee . . . to enforce
WaMu’s Repurchase Obligations, including the enforcement mechanism of providing WaMu
with notice of a breach with respect to . . . specific mortgage loans included in the Trusts.” Id.
¶ 99; see also id. ¶ 82. Without access to this information, DBNTC alleges that it “is unable to specifically identify particular mortgage loans that breached particular Representations and
Warranties or for which the Notice and/or Repurchase Obligations have been triggered and breached.” Id. ¶ 81; see id. ¶¶ 44, 98. DBNTC estimates that the Trusts have incurred losses due to the alleged breaches “rang[ing] from approximately $6 billion to $10 billion, with such losses continuing to accrue.” Am. Compl. ¶ 85. DBNTC contends, without specifying any basis for such a claim, that “[t]he Trust’s and the Trustee’s claims against the FDIC for breaches of these assumed contracts are entitled at least to administrative expense priority in the [WaMu] receivership estate.” Id. ¶ 97. In other words, DBNTC seeks to be paid ahead of any depositor claims and any other creditors of WaMu.
In Count II (Declaratory Judgment), DBNTC seeks a determination as to whether, and to what extent, WaMu’s liabilities for alleged breaches of the Governing Agreements and ongoing obligations under those Agreements were transferred by FDIC Receiver and assumed by JPMC pursuant to the P&A Agreement. See Am. Compl. ¶¶ 103-106.
ARGUMENT
I. FDIC RECEIVER HAS NO LIABILITY TO DBNTC UNDER THE GOVERNING AGREEMENTS.
DBNTC’s claims arise from WaMu’s alleged pre-closure breach of representations, warranties and obligations under the Governing Agreements, and from alleged post-closure continuing breaches by WaMu’s successor-in-interest. Under the plain terms of the P&A
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Agreement, the Governing Agreements and any of WaMu’s rights, interests, liabilities, and obligations thereunder were transferred to JPMC on September 25, 2008. That transfer extinguished any liability of FDIC Receiver for the claims asserted by DBNTC. This Court can make these determinations as a matter of law, based on the unambiguous language of the P&A
Agreement. See, e.g., Conseil Alain Aboudaram, S.A. v. de Groote, 460 F.3d 46, 50 (D.C. Cir.
2006) (“[W]here the language and the inferences to be drawn from it are unambiguous, a district court may construe a contract as a matter of law and grant judgment accordingly.”); see also
Ameren Servs. Co. v. FERC, 330 F.3d 494, 499 (D.C. Cir. 2003) (“[Courts] determine the plain meaning of a contract from the language used by the parties to express their agreement.”). “[A] contract provision is not ambiguous merely because the parties later disagree on its meaning.”
Segar v. Mukasey, 508 F.3d 16, 22 (D.C. Cir. 2007).28 Indisputable, judicially-noticeable facts
reflected on the public record confirm and support the plain meaning construction of the P&A
Agreement.
A. The P&A Agreement Transferred The Governing Agreements And All Of WaMu’s Rights, Obligations, And Liabilities Thereunder To JPMC.
The Governing Agreements, and any and all of WaMu’s attendant interests, rights,
obligations, and liabilities thereunder transferred to JPMC under the P&A Agreement as part of
JPMC’s acquisition of WaMu’s mortgage banking operations. Section 3.1 of the P&A
Agreement transferred to JPMC “all right, title, and interest” in and to all of WaMu’s assets,
28. The P&A Agreement provides “this agreement and the rights and obligations hereunder shall be governed by and construed in accordance with the federal law of the United States of America, and in the absence of controlling federal law, in accordance with the laws of the state in which the main office of the failed bank is located.” P&A Agreement § 13.4.
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“subject to all liabilities . . . affecting such Assets to the extent provided in Section 2.1.” P&A
Agreement § 3.1. Under Section 2.1, JPMC “agree[d] to pay, perform, and discharge all of the liabilities of [WaMu] which are reflected on the Books and Records of [WaMu] as of Bank
Closing, . . . except as listed on the attached Schedule 2.1 and as otherwise provided in this
Agreement.”29 Id. § 2.1. These provisions effect the transfer to JPMC of the Governing
Agreements in their entirety, inclusive of all of WaMu’s obligations and liabilities thereunder.
1. The Governing Agreements are Assets that transferred to JPMC under Section 3.1 of the P&A Agreement.
The P&A Agreement unambiguously treats the Governing Agreements as Assets that transferred to JPMC under Section 3.1 and its related provisions. The P&A Agreement states that JPMC “specifically assume[d]” (under Section 2.1) and “specifically purchase[d]” (under
Section 3.1) “all mortgage servicing rights and obligations of [WaMu].” P&A Agreement
§§ 2.1, 3.1. Schedule 3.2, which lists the notional purchase price of certain types of assets, identifies as assets transferred to JPMC the “rights of [WaMu] to provide mortgage servicing. . . and related contracts.” Id. at 36 (emphasis added). Because “[t]he mortgage servicing rights and obligations of WaMu with respect to the Trusts arose under the Governing [Agreements],”
Am. Compl. ¶ 40, the Governing Agreements are among the “related contracts” referred to in
Schedule 3.2 and transferred to WaMu under Section 3.1 of the P&A Agreement.
The Governing Agreements for each Trust comprise several complex, integrated
agreements containing various valuable rights and interests bundled together with certain
29. The list of “Certain Liabilities Not Assumed” in Schedule 2.1 “does not include or reference any liabilities or obligations arising under the Governing [Agreements].” Am. Compl. ¶ 87; see P&A Agreement at 34 (Schedule 2.1).
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attendant and ongoing duties, obligations, and liabilities. See Am. Compl. ¶¶ 31-33. Such interrelated securitization agreements “formed part of a single transaction and were designed to effectuate the same purpose.” Bank of N.Y. v. FDIC, 453 F. Supp. 2d 82, 99-100 (D.D.C. 2006).
As DBNTC alleges, the Governing Agreements here are “executory contracts that involve obligations that are ongoing mutual, and interrelated,” Am. Compl. ¶ 33, and these obligations – as well as WaMu’s other rights, interests, and duties reflected therein – are part of “an integrated set of contractual undertakings,” id. ¶ 31. See Lone Star Fund V (U.S.), L.P. v. Barclays Bank
PLC, 594 F.3d 383, 388 (5th Cir. 2010) (“[T]he representations are isolated portions of complex contractual documents that must be read in their entirety to be given effect.”).
WaMu’s rights and interests under the Governing Agreements include the valuable mortgage servicing rights, as well as residual interests in the underlying Trust assets. See, e.g.,
Ex. 3, WaMu 2007 Form 10-K (3/21/08) at 77 (describing WaMu’s “retained interests in the securitized assets”), 91 (“Generally, [WaMu] . . . receives the right to cash flows remaining after the investors in the securitization trusts have received their contractual payments.”).30 Along with these rights and interests, WaMu expressly took on a number of related and continuing
obligations under the Governing Agreements with respect to the cash flow of the Trusts, such as
the duty to monitor the Trust assets and notify the Trustee of material breaches of its
representations and warranties or defects in the underlying loans (the Notice Obligations), and
the duty to remedy such material breaches or defects, upon discovery or notice, by curing,
30. See also, e.g., Am. Compl., Ex. 4, WaMu 2007-HE1 MLPA § 3 (“In consideration for the Mortgage Loans to be purchased hereunder, the Purchaser shall . . . deliver to the Seller . . . the Class C Certificates, the Class P Certificates, the Class R Certificates, the Class R-CX Certificates, and the Class R-PX Certificates (the ‘Retained Certificates’).”); id., WaMu 2007-HE1 PSA § 10.01 (identifying such certificates as “residual interests”).
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substituting, or repurchasing the affected loans and indemnifying losses to the Trust (the
Repurchase and Indemnification Obligations). See Am. Compl. ¶¶ 49-55, 60-61; see also, e.g.,
Ex. 3, WaMu 2007 Form 10-K (3/21/08) at 107. DBNTC alleges that, as to many of the loan- related representations and warranties, the breach takes place at the time the loan is sold into the
Trust.31 As of that time, therefore, to the extent WaMu had made and breached a loan-related representation or warranty, WaMu had a contingent liability under its express Repurchase and
Indemnification Obligation; whether and when the contingent liability would mature into a current payment demand would depend on whether the loan goes into default, whether the breach or defect was material, whether the breach or defect actually caused the loss, whether notice is given, and whether the breach or defect cannot be cured. The Repurchase and
Indemnification Obligations, therefore, include the duty to make good on these contingent liabilities arising from existing breaches and default, if and when they mature.
These rights and related executory obligations are all part of the “related contracts”
referred to in Schedule 3.2. Schedule 3.2 makes clear that the Governing Agreements, as
“related contracts” to WaMu’s mortgage servicing rights, were among WaMu’s assets and, as
such, were transferred to JPMC under Section 3.1. Thus, the Governing Agreements under
which WaMu had ongoing rights and obligations, including obligations that had not yet given
rise to specific recorded liabilities at the time of WaMu’s closure, were also transferred to JPMC
31. See, e.g., Am. Compl. ¶¶ 46(b) (“Each Mortgage Loan at origination complied in all material respects with applicable local, state and federal laws.”), (j) (“The Loan-to-Value Ratio for each Mortgage Loan was no greater than 100% at the time of origination.”), (m) (“The Seller did not select the Mortgage Loans with the intent to adversely affect the interests of the Purchaser.”) (quoting Long Beach Mortgage Loan Trust Series 2006-2 (Issue ID No. LB0602), MLPA § 6).
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under Section 3.1. In fact, JPMC has acknowledged as much: in its 2008 Form 10-K, for example, JPMC noted that, under the P&A Agreement, it had assumed WaMu’s “executory contracts and other commitments.” Ex. 8, JPMC 2008 Form 10-K (3/2/09) at 124.
Other aspects of the P&A Agreement make it clear that the Governing Agreements in
their entirety transferred to JPMC. Section 4.8 of the P&A Agreement provides a mechanism for
JPMC to elect not to assume individual “agreements existing as of Bank Closing which provide for the rendering of services by or to the Failed Bank,” by giving written notice to the FDIC within 120 days of WaMu’s closure. (Emphasis added.) As noted above, Sections 2.1 and 3.1 provide that “[n]otwithstanding Section 4.8,” JPMC “specifically assume[d]” and “specifically purchase[d]” “all mortgage servicing rights and obligations” of WaMu, thereby exempting these rights and obligations from Section 4.8. Because Section 4.8 applies to “agreements,” this carve- out in Sections 2.1 and 3.1 necessarily reflects JPMC’s irrevocable assumption of the entire agreements containing “all the mortgage servicing rights and obligations” – i.e., the Governing
Agreements, including all the rights and obligations thereunder.
Those obligations include the ongoing Service Obligations and Access Obligations upon which DBNTC bases its breach claims against WaMu as servicer – and which undeniably transferred to JPMC. For each Trust, however, those same Governing Agreements also contain the Repurchase and Indemnification Obligations and Notice Obligations on which DBNTC bases its breach claims against WaMu as seller and depositor. See Am. Compl. ¶ 43. DBNTC alleges
WaMu’s Repurchase and Indemnification Obligations and Notice Obligations with respect to each Trust are contained within the same agreement – the Pooling and Servicing Agreement
(“PSA”) – as WaMu’s mortgage servicing rights and obligations for that Trust. See id. ¶¶ 50
(Notice Obligation), 54-55 (Repurchase Obligation), 59-60 (Indemnification Obligation and
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Access Obligation), 63 (Servicing Obligation); see also id., Ex. 7 (identifying the contractual provisions giving rise to WaMu’s obligations with respect to each Primary Trust). By expressly excluding “all mortgage servicing rights and obligations” from the scope of Section 4.8, the P&A
Agreement ensured that the “agreements” containing these rights and obligations – i.e., the
Governing Agreements – would be transferred in their entirety to JPMC.
2. All of WaMu’s obligations and liabilities under the Governing Agreements transferred to JPMC under Section 2.1 of the P&A Agreement.
The transfer to JPMC of WaMu’s obligations and liabilities under the Governing
Agreements also was effected by Section 2.1, which provides that JPMC “expressly assumes at
Book Value (subject to adjustment pursuant to Article VIII) and agrees to pay, perform, and discharge, all of the liabilities of [WaMu] which are reflected on the Books and Records of
[WaMu] as of Bank Closing.” P&A Agreement § 2.1 (emphasis added). The only limitation on
JPMC’s assumption of WaMu’s liabilities is that the liability be “reflected” on WaMu’s “Books and Records” as of September 25, 2008. While the term “Records” is defined broadly in the
P&A Agreement to include all of WaMu’s paper and electronic files, the terms “Books” is not defined. See id. at 6 (defining “Records”). Whatever the outside limits of these terms, however, they include the operative agreements for the large-scale financial transactions at the heart of
WaMu’s business, involving hundreds of billions of dollars in mortgage loan securitizations.
The Governing Agreements – and WaMu’s obligations and liabilities thereunder – unquestionably were reflected in WaMu’s pre-closure Books and Records.
DBNTC alleges that the Governing Agreements were executed, in writing, “on behalf of
WaMu by individuals duly authorized by the applicable WaMu entity’s Board of Directors,” and have been maintained continuously in the bank’s formal files “since the time of execution.” Am.
Compl. ¶¶ 42(a)-(d). DBNTC further alleges that the Governing Agreements “constituted
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official books and records of [WaMu] at the time of [WaMu’s] closing on September 25, 2008.”
Id. ¶ 42(e). Indeed, common sense dictates that these are the kinds of major agreements that, as a matter of policy and practice, were carefully maintained by the bank in its formal files. See, e.g.,
India Breweries, Inc. v. Miller Brewing Co., 612 F. 3d 651, 658 (7th Cir. 2010) (“Common sense is as much a part of contract interpretation as is the dictionary or arsenal of canons.”). If the allegations in Paragraph 42 of the Amended Complaint are not true, the Governing Agreements would be unenforceable against FDIC Receiver as a matter of law. These allegations track the statutory requirements of 12 U.S.C. § 1823(e), which are intended to ensure that the purported preexisting obligations of a failed bank are sufficiently memorialized in the bank’s pre-closure records before claims arising from those obligations can be enforced against the FDIC as receiver. See 12 U.S.C. §§ 1821(d)(9)(A), 1823(e); Beal Bank, SSB v. Pittorino, 177 F.3d 65, 68
(1st Cir. 1999) (claims arising from agreements that are “not properly recorded in the records of the bank” are unenforceable against FDIC Receiver).
The purpose of Section 1823(e) is to limit the enforceable obligations of FDIC Receiver to those liabilities and obligations of the failed bank the existence of which was readily discernable by bank examiners prior to the bank’s closure. See Langley v. FDIC, 484 U.S. 86,
91 (1987); E.I. du Pont de Nemours & Co. v. FDIC, 32 F.3d 592, 600 (D.C. Cir. 1994) (“The key question is whether [the case concerns] . . . ‘matters that would generally be reflected in the records of ordinary banking transactions.’”) (citation omitted). This prevents counterparties and creditors from alleging the existence of unrecorded agreements imposing obligations upon FDIC
Receiver as the failed bank’s successor-in-interest, since FDIC Receiver lacks the institutional history of the bank yet is expected to honor all of its valid obligations. See FDIC v. Great Am.
Ins. Co., 607 F.3d 288, 293 (2d Cir. 2010). Whatever the outer contours of the term “Books and
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Records” for purposes of Section 2.1, any obligation or liability that is reflected on the face of an agreement that meets the criteria of Section 1823(e) necessarily is “reflected on the Books and
Records of the Failed Bank as of Bank Closing,” and thus included within the scope of
Section 2.1. Here, DBNTC alleges that the Repurchase and Indemnification Obligations, and the
other contractual obligations upon which DBNTC premises its claims, are clearly stated on the
face of the Governing Agreements. See Am. Compl. ¶¶ 50, 54-55, 59-60, 63 (providing examples of specific provisions); id. Ex. 7 (identifying provisions in each of the Governing
Agreements).32
JPMC asserts, however, that it did not assume any of WaMu’s liabilities under the
Governing Agreements. See Am. Compl. ¶¶ 90-91. JPMC’s argument is premised entirely on three words in Section 2.1 – “at Book Value” – and the definition of “Book Value” in the P&A
Agreement as “the dollar amount . . . stated on the Accounting Records of the Failed Bank.”33
JPMC argues that it assumed only liabilities for which there was a specific line item with a stated
dollar amount on WaMu’s accounting ledgers, which WaMu’s liabilities under the Governing
Agreements purportedly lack. See id. ¶ 91. JPMC’s position is not consistent with the
contractual language, common sense, or JPMC’s own public filings.
Section 2.1 does not by its terms limit the Liabilities Assumed to those with a stated
dollar amount on WaMu’s Accounting Records – i.e., its “general ledger, subsidiary ledgers, and
32. This does not mean, of course, that DBNTC can prove that WaMu or its successor-interest is liable for the breaches and damages that it claims, or even that DBNTC can establish a basis for asserting a claim against WaMu or its successor-interest with respect to each and every Trust. 33. See P&A Agreement at 2 (defining “Accounting Records” as the “general ledger, subsidiary ledgers, and any schedules supporting the general ledger balance”), 3 (defining “Book Value”).
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supporting schedules” – as of September 25, 2008. See Am. Compl. ¶¶ 90-91. Nor does
Section 2.1 provide that JPMC assumes “all liabilities reflected on WaMu’s Accounting
Records,” which is what JPMC’s interpretation amounts to. Rather, Section 2.1 expressly and
unambiguously states that JPMC “assumes at Book Value . . . and agrees to pay, perform, and
discharge, all of the liabilities of [WaMu] which are reflected on the Books and Records of
[WaMu] as of Bank Closing.” P&A Agreement § 2.1 (emphasis added). “Books and Records” necessarily means something other – and broader – than “Accounting Records.”
In fact, the reference to Book Value in the liability assumption provision of Section 2.1 is
a parallel to the references to Book Value and Market Value in Section 3.2 and Schedule 3.2,
which address the “price” of the specific assets transferred under Section 3.1. Of course, JPMC
did not pay specific prices for specific assets. As indicated in Article VII of the P&A
Agreement, JPMC bid and paid a lump sum of approximately $1.9 billion “for the Assets purchased and Liabilities Assumed.” Thus, the Book Value and Market Value “prices” of the specific “assets” as reflected in Section 3.2 and Schedule 3.2 were notional prices, useful in allocating the Bank Closing date purchase price among the acquired assets as required by GAAP purchase accounting (e.g., for basis purposes).34 Likewise, the Book Value reference for the
assumption of liabilities had a similar purpose – JPMC assumed the liabilities “at Book Value”
for accounting purposes as of the Bank Closing Date. Compare P&A Agreement § 2.1 (“assume
at Book Value”) with id. § 3.2 (“purchases at Book Value”). Nothing in that phrase or the rest of
34. See Ex. 8, JPMC 2008 Form 10-K (3/2/09) at 123-24; SFAS No. 141 (Business Combinations) ¶¶ 35-41 (Fin. Accounting Standards Bd. 2001).
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Section 2.1 suggests that these three words were intended to define or limit the scope of the
Liabilities Assumed by JPMC.35
Moreover, JPMC’s construction of the phrase “assumes at Book Value” gives no
meaning to the portion of Section 2.1 in which JPMC expressly agrees to “pay, perform, and
discharge all of the liabilities” reflected on WaMu’s pre-closure Books and Records, because
“pay, perform, and discharge” is not limited by Book Value. P&A Agreement § 2.1. To
interpret Section 2.1 to mean that liabilities are transferred to JPMC “only if and to the extent
they had a Book Value,” Am. Compl. ¶ 90 (emphasis in original), would allow the phrase
“assumes at Book Value” to nullify the remainder of Section 2.1, and “it is a cardinal principle of
contract construction that a document should be read to give effect to all its provisions and to
render them consistent with each other.” Segar, 508 F.3d at 22. Contractual provisions should
be interpreted to avoid rendering any provision meaningless. See, e.g., Flynn v. Dick Corp., 481
F.3d 824, 831 (D.C. Cir. 2007).
There is no reasonable basis to interpret the word “liabilities” narrowly to mean only
those liabilities that have become sufficiently concrete to warrant recording as specific line item
amounts on WaMu’s financial accounting records. The word “liabilities” as used in Section 2.1
is not a defined term in the P&A Agreement, and it therefore should be interpreted consistent
with its ordinary meaning.36 See, e.g., Pfeiffer v. Duncan, 659 F. Supp. 2d 160, 165 (D.D.C.
35. Likewise, nothing in the language of Section 2.1 suggests that any assumed liability is capped or limited by its Book Value. Section 2.1 does not provide that JPMC “will pay, perform and discharge liabilities only to the extent of their Book Value,” or that JPMC “assumes liabilities up to the amount of their Book Value.” 36. While the P&A Agreement does define “Liabilities Assumed,” that definition states only that the term “has the meaning provided in Section 2.1” P&A Agreement at 5.
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2009) (“The starting point for [contractual] interpretation is the plain language of the contract and the ordinary meaning of its terms – unless the parties mutually intended and agreed to an alternative meaning.”); Flynn v. So. Seamless Floors, Inc., 460 F. Supp. 2d 46, 54 (D.D.C. 2006)
(citing cases). In common legal usage, the term “liabilities” is not limited to items with recordable value for accounting purposes. The use of the words “perform” and “discharge” in Section 2.1 confirms that “liabilities” was intended in this more inclusive sense, since these words connote continuing obligations like those memorialized in unitary and integrated executory contracts like the Governing Agreements, as well as contingent and unmatured liabilities arising under such obligations. Indeed, it is particularly appropriate to construe the term “liability” in this way in a
“whole bank” P&A Agreement intended to convey the failed bank’s ongoing operations to an acquiring bank that “desires to purchase substantially all of the assets and assume all deposit and substantially all other liabilities of the Failed Bank.” P&A Agreement at 1.
Section 2.5 provides additional confirmation that the term “liabilities” in Section 2.1 has a broader meaning than JPMC pretends. Section 2.5 excludes “Borrower Claims” from the scope of Liabilities Assumed. The section provides that JPMC does not assume
any liability associated with borrower claims for payment of or liability to any borrower for monetary relief, or that provide for any other form of relief to any borrower, whether or not such liability is reduced to judgment, liquidated or unliquidated, fixed or contingent, matured or unmatured, disputed or undisputed . . . whether asserted affirmatively or defensively. . . .
(Emphasis added). If JPMC had assumed only liabilities with stated dollar Book Values on
WaMu’s accounting ledgers, the italicized language would be entirely unnecessary, since many unliquidated, contingent, unmatured and disputed claims are not so recorded.
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Contracts should be interpreted, where possible, in accordance with standards of commercial reasonableness and in accordance with the parties’ apparent principal purpose.37
Here, the purpose of the P&A Agreement was to transfer to JPMC “substantially all of the assets and all the deposit and substantially all other liabilities of [WaMu]” so that JPMC could succeed to and carry on WaMu’s ongoing banking operations. P&A Agreement at 1; see Ex. 8, JPMC
2008 Form 10-K (3/2/09) at 124, 168-72. In entering into this deal, JPMC paid $1.9 billion in cash, but reaped a huge benefit, as described above. See supra pp. 7-8. Yet on the liability side of the ledger, JPMC says it can walk away, leaving FDIC Receiver with the obligation to pay any liabilities incurred under the Governing Agreements. The plain text of the P&A Agreement belies this result.
JPMC cannot feign ignorance about WaMu’s obligations under the Governing
Agreements or the liabilities to which the obligations could give rise. As a sophisticated actor in
the mortgage banking field, JPMC was familiar with the obligations and potential liabilities
arising from representations and warranties made in connection with residential mortgage loan
securitizations, including repurchase and indemnification obligations. JPMC made similar
representations and warranties as a matter of course in connection with its own securitization
activities. See, e.g., Ex. 6, JPMC 2007 Form 10-K (2/29/08) at 172 (“[T]he Firm provides
37. See, e.g., SR Int’l Bus. Ins. Co. v. World Trade Ctr. Props., 467 F.3d 107, 125 (2d Cir. 2006); Wilson Court Ltd. P’ship v. Tony Maroni’s, Inc, 952 P.2d 590, 597 (Wa. 1998) (“Where two commercial entities sign a commercial agreement, we will give such an agreement a commercially reasonable construction.”); Forest Mktg. v. State Dept. Natural Res., 104 P.3d 40 (Wash. Ct. App. 2005) (“We adopt the contract interpretation that best reflects the parties’ reasonable expectations.”); RESTATEMENT (SECOND) OF CONTRACTS § 202(1), cmt. c (1993) (“If such a purpose is disclosed further interpretation is guided by it. Even language which is otherwise explicit may be read with a modification needed to make it consistent with such a purpose.”).
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representations and warranties that certain securitized loans meet specific requirements . . . [and] may be required to repurchase the loans and/or indemnify the purchaser of the loans against losses due to any breaches of such representations or warranties.”); supra pp. 19-22.
Likewise, WaMu’s public disclosures made quite clear the nature and scope of JPMC’s
assumed liabilities with respect to WaMu’s Repurchase and Indemnification Obligations. For
example, WaMu plainly disclosed that “[i]n the event of a breach of the representations and
warranties . . . the Bank bears the risk of any loss on the loans.” Ex. 3, WaMu 2007 Form 10-K
(3/21/08) at 77 (emphasis added). WaMu cautioned that its estimates for necessary loss reserves
for obligations arising from securitized mortgage loans were subject to continual revision
“[t]hroughout the life of these repurchase or indemnification liabilities.” Id. at 15; see also Ex. 1,
WMI 2007 Form 10-K (2/29/08) at 22. WaMu also discussed the impact of increasing
delinquencies and credit loss on its Repurchase and Indemnification Obligations, and warned
that its “liquidity could also be adversely affected by unanticipated demands on its cash, such as
having to repurchase securitized loans if it were found to have violated representations and
warranties contained in the securitization agreements.” Ex. 3, WaMu 2007 Form 10-K (3/21/08)
at 50; see also Ex. 2, WMI Form 10-Q (8/11/08) at 58 (“Higher delinquencies drove increased
repurchase requests from investors resulting in an increase in the provision for repurchase
reserves.”). In short, while all the Governing Agreements were contained in WaMu’s records,
the very obligations and liabilities at issue here were publicly disclosed in WaMu’s books and
records at the time of the P&A Agreement.38 See supra pp. 17-19.39
38. Moreover, it was no secret that WaMu itself faced sharply increasing liabilities arising from its Trust-related repurchase obligations. WaMu’s public filings amply detail its “potential
(Footnote continued on next page)
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In fact, as noted above (p. 21), in December 2009, JPMC warned investors that WaMu had made “representations and warranties in connection with the sale and securitization of loans,” but that JPMC’s “obligations with respect to these representations and warranties are generally outstanding for the life of the loan,” and that “[a]ccordingly, such repurchase and/or indemnity obligations arising in connection with the sale and securitization of loans (whether with or without recourse) by . . . [WaMu] . . . could materially increase [JPMC’s] costs and lower
[JPMC’s] profitability, and could materially and adversely impact [JPMC’s] results of operations and financial condition.” Ex. 11, 424B7 Prospectus Supplement (12/8/09) at S-7. Clearly,
JPMC – which appears to have been referring to WaMu’s liabilities under the Repurchase and
Indemnification Obligations – understood what the P&A Agreement unambiguously provides.
Accordingly, the Court should determine, as a matter of law, that under the P&A
Agreement JPMC is solely liable to DBNTC for all of WaMu’s liabilities as of September 25,
2008, for all liabilities arising after that date, and for all continuing obligations, under the
Governing Agreements.
(Footnote continued from previous page)
exposure to repurchase or indemnification liabilities” and warn of the prospect of increased delinquencies and defaults leading to greater losses to the trusts. Ex. 3, WaMu 2007 Form 10-K (3/21/08) at 15-16, 50; Ex. 1, WMI 2007 Form 10-K (2/29/08) at 85; Ex. 2, WMI Form 10-Q (8/11/08) at 58. According to DBNTC, JPMC “conducted a due diligence review of WMB, including a review of WMB’s loan taped and data and discussions with WMB employees,” before entering into the P&A Agreement. Am. Compl. ¶ 12. 39. JPMC itself expressly acknowledged both before and after the WaMu transaction that “[g]enerally, the maximum amount of future payments [JPMC] would be required to make for breaches under these representations and warranties would be equal to the current amount of assets held” as outstanding principal in the securitization Trusts. Ex. 8, JPMC 2008 Form 10-K (3/2/09) at 209; see also, e.g., Ex. 6, JPMC 2007 Form 10-K (2/29/08) at 172.
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B. The Transfer Of The Governing Agreements To JPMC Extinguished FDIC Receiver’s Potential Liability.
In entering into the P&A Agreement, FDIC Receiver was exercising its statutory power under FIRREA to “transfer” WaMu’s assets and liabilities (including the Governing Agreements and WaMu’s rights and obligations thereunder) to JPMC. See 12 U.S.C. § 1821(d)(2)(G)(i)(II).
In the P&A Agreement, FDIC Receiver exercised its transfer power fully, and did not retain any aspect of the liabilities assumed by JPMC. Nothing in the statute or the P&A Agreement even hints that FDIC Receiver remained obligated for the transferred liabilities, including for any liabilities under the Governing Agreements.
FDIC Receiver’s exercise of the transfer provision in this case is consistent with the general principle that when an entity purchases the assets of an ongoing business and expressly or impliedly assumes the related liabilities, the acquiring entity succeeds to the pre-sale debts and obligations of the business, thereby extinguishing the liability of the seller. See, e.g., United
States v. First N. Dakota Nat’l Bank, 137 F.3d 1077, 1080 (8th Cir. 1998); Hatco Corp. v. W.R.
Grace & Co., 59 F.3d 400, 406 (3d Cir. 1995); In re Chicago, Milwaukee, St. Paul, & Pac. R.
Co., 789 F.2d 1281, 1282-83 (7th Cir. 1986); United States v. Sunoco, Inc., 637 F. Supp. 2d 282,
288 (E.D. Pa. 2009); Goodman v. Challenger Int’l, Ltd., No. 94-1262, 1995 WL 402510, at *3-4
(E.D. Pa. July 5, 1995) (“[W]here the purchaser expressly or impliedly assumes the seller’s liabilities . . . courts have determined that the transferor is no longer responsible for the transferred liability, including the conducting of litigation over that liability.”) (citing cases).
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A liability is held by either FDIC Receiver or the assuming institution, not both, and
FDIC Receiver’s liability ends when the transferee’s liability begins.40 See, e.g., Acevedo v.
First Union Nat’l Bank, 357 F.3d 1244, 1248 (11th Cir. 2004) (rejecting argument that P&A agreement provision “shift[ed] the liability” for a particular asset “back to the FDIC”); Hennessy v. FDIC, 58 F.3d 908, 913 (3d Cir. 1995) (describing liabilities retained by FDIC Receiver after signing P&A agreement as only “the liabilities not assumed by [the assuming institution]”);
FDIC v. Condit, 861 F.2d 853, 855 (5th Cir. 1988) (concluding that FDIC Receiver “maintained no direct interest in [transferred assets] after the purchase and assumption transaction was consummated”). That principle follows from the substantial discretion that Section
1821(d)(2)(G)(i)(II) grants FDIC Receiver to determine “which assets and liabilities of a failed thrift should be sold and transferred, and which it should keep.” Payne v. Sec. Sav. & Loan
Ass’n, F.A., 924 F.2d 109, 111 (7th Cir. 1991).
Here, JPMC purchased substantially all of WaMu’s assets in a “whole bank” transaction, including its ongoing banking operations and “nationwide mortgage banking activities.” Ex. 9,
JPMC 2009 Form 10-K (2/24/10) at 58; see P&A Agreement at 1. In connection with that purchase, FDIC Receiver transferred to JPMC, and JPMC expressly agreed to “assume” and to
“pay, perform and discharge,” substantially all of WaMu’s liabilities – which, as discussed, included WaMu’s liabilities and obligations under the Governing Agreements. P&A Agreement
§ 2.1. Under its statutory transfer power, FDIC Receiver was thereby relieved of its liability for
40. Indeed, some provisions of the P&A Agreement would make little sense if JPMC and FDIC Receiver had concurrent liability. For instance, Section 12.1 of the Agreement provides that FDIC Receiver will not indemnify JPMC for any “claims based on, related to, or arising from any . . . liability assumed by the Assuming Bank.” P&A Agreement § 12.1(b)(14). Concurrent liability would essentially render this provision a nullity.
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these obligations, and only JPMC remains liable. Consequently, the Amended Complaint should be dismissed against FDIC Receiver.
II. CLAIMS AGAINST FDIC RECEIVER BASED ON ALLEGED POST-RECEIVERSHIP BREACHES SHOULD BE DISMISSED.
DBNTC asserts claims against FDIC Receiver or JPMC for alleged post-receivership
breaches of the Governing Agreements. See Am. Compl. ¶¶ 95-98. DBNTC also contends that its breach claims are entitled to priority as administrative expenses of FDIC Receiver under 12
U.S.C. § 1821(d)(11)(A). Id. ¶ 97. These claims should be dismissed under Rule 12(b)(6) for the
reasons stated in Section I, and under Rules 12(b)(1) and 12(b)(6) for the additional reasons set
forth below.
A. DBNTC Failed To Exhaust The Administrative Claims Process With Respect To Its Claims Of Post-Receivership Breach.
Before DBNTC may proceed with any action alleging liability against FDIC Receiver,
FIRREA requires that DBNTC exhaust the administrative claims procedures prescribed by that statute. See, e.g., Freeman v. FDIC, 56 F.3d 1394, 1401 (D.C. Cir. 1995); Brady Dev. Co., Inc.
v. RTC, 14 F.3d 998, 1005-06 (4th Cir. 1994). FIRREA provides:
Except as otherwise provided in this subsection, no court shall have jurisdiction over —
(i) any claim or action for payment from, or any action seeking a determination of rights with respect to, the assets of any depository institution for which the [FDIC] has been appointed receiver, including assets which the [FDIC] may acquire from itself as such receiver; or
(ii) any claim relating to any act or omission of such institution or the [FDIC] as receiver.
12 U.S.C. § 1821(d)(13)(D). Subsection (d) elsewhere provides for an administrative claims process before the FDIC. Id. § 1821(d)(3) & (5). Courts have uniformly interpreted these provisions as depriving courts of jurisdiction over claims seeking payment from the assets of a
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failed depository institution or from its receiver unless the claimant has exhausted the administrative claims process. See, e.g., Freeman, 56 F.3d at 1400 (Section 1821(d)(13)(D)
“acts as a jurisdictional bar to claims or actions [against FDIC Receiver] by parties who have not exhausted their § 1821(d) administrative remedies.”) (citing cases).41
The requirement that DBNTC exhaust the administrative claims process applies equally
to any claims against FDIC Receiver that may have arisen after WaMu closed. See 12 U.S.C.
§ 1821(d)(13)(D)(ii); Village of Oakwood v. State Bank and Trust Co., 539 F.3d 373, 387 (6th
Cir. 2008) (“The overwhelming majority of courts to address the issue have concluded that the
administrative process applies to post-receivership claims.”); McCarthy v. FDIC, 348 F.3d 1075,
1081 (9th Cir. 2003) (“Therefore, we join the majority of courts in holding that claimants . . . who challenge conduct by the FDIC as receiver[] must exhaust administrative remedies before seeking judicial review.”); Home Capital Collateral, Inc. v. FDIC, 96 F.3d 760, 763-64 (5th Cir.
1996) (“We agree . . . that all claims subject to the jurisdictional bar of § 1821(d)(13)(D), including both claims against the receiver and against the assets of the failed financial institution, and both pre-receivership and post-receivership claims, must comply with the [administrative claims review procedure].”).
DBNTC’s claims against FDIC Receiver for post-receivership breach and administrative priority, however, are nowhere to be found in its Proof of Claim filed with FDIC Receiver. See
41. See also, e.g., Henderson v. Bank of New England, 986 F.2d 319, 320-21 (9th Cir. 1993) (“Section 1821(d)(13)(D) strips all courts of jurisdiction over claims made outside the administrative procedures of section 1821 . . . . [and] bars judicial review of any non- exhausted claim, monetary or nonmonetary, which is susceptible of resolution through the claims process.”); Simon v. FDIC, 48 F.3d 53, 56 (1st Cir. 1995) (“Failure to comply with the [FIRREA-mandated administrative claims review process] deprives the courts of subject matter jurisdiction over any claim to assets of the failed financial institution.”).
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Am. Compl. Ex. 3. DBNTC’s Proof of Claim does not include any claim for wrongful actions or omissions by FDIC Receiver – or, indeed, by any other party – after the failure of WaMu on
September 25, 2008; rather, the Proof of Claim is limited to pre-receivership actions or omissions by WaMu. Consequently, this Court lacks jurisdiction to hear those claims, and they
should be dismissed. See e.g., McGlothlin v. RTC, 913 F. Supp. 15, 19 (D.D.C. 1996)
(dismissing claims not admitted in administrative claims process); Aljaf Assocs. Ltd. P’ship v.
FDIC, 879 F. Supp. 515, 518 (E.D. Pa. 1995) (same); Brown Leasing Co. v. FDIC, 833 F. Supp.
672, 675-76 (N.D. Ill. 1993) (same); Coleman v. FDIC, 826 F. Supp. 31, 32 (D. Mass. 1993)
(same).
B. The Amended Complaint Fails to State A Claim Of Post- Receivership Breach Against FDIC Receiver.
Although the Amended Complaint is not entirely clear – largely due to DBNTC’s use of
the term “WaMu” to refer indiscriminately to WaMu, JPMC, and FDIC Receiver – it appears
that DBNTC is alleging that either FDIC Receiver or JPMC, as successor-in-interest to WaMu,
breached provisions of the Governing Agreements by action or inaction after WaMu was closed,
and rights and obligations under the Governing Agreements transferred, on September 25, 2008.
See Am. Compl. ¶ 95-98. The face of the Amended Complaint makes clear, however, that FDIC
Receiver could not possibly have breached these Agreements post-receivership.
First, DBNTC alleges that “WaMu” – presumably FDIC Receiver or JPMC –
“discovered and/or had notice of WaMu’s breaches of the Representations and Warranties” and
thus breached post-receivership WaMu’s Notice Obligation “in their capacity or capacities as
successor Servicer for WaMu.” Am. Compl. ¶ 95. Under the P&A Agreement, however, JPMC
specifically purchased and assumed all of WaMu’s “mortgage servicing rights and obligations”
immediately upon WaMu’s closure. See P&A Agreement §§ 2.1, 3.1. By the clear terms of the
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P&A Agreement, therefore, FDIC Receiver never retained any servicing rights and obligations, and thus could not have any duty to act as “successor Servicer for WaMu.” Accordingly, FDIC
Receiver had no post-receivership Notice Obligations “as successor Servicer for WaMu”; and could not possibly have breached an obligation it did not have.
Second, DBNTC asserts claims arising from the alleged post-receivership breach of
DBNTC’s Access Rights to WaMu’s loan files. See, e.g., Am. Compl. ¶¶ 82, 98. But DBNTC’s alleged Access Rights arise only under the Governing Agreements’ servicing obligations, see id.
¶ 58, and (as explained above) only JPMC took over WaMu’s mortgage servicing obligation.
Moreover, Section 6.1 of the P&A Agreement makes clear that upon WaMu’s closure, FDIC
Receiver was required to transfer to JPMC “all Records pertaining to . . . Loan and collateral records and Credit Files” and to “deeds, mortgages, abstracts, surveys, and other instruments or records of title pertaining to real estate or real estate mortgages.” P&A Agreement § 6.1. 42
Thus, the P&A Agreement demonstrates that JPMC, and not FDIC Receiver, possesses both the
records that DBNTC seeks and, under the Governing Agreements, the obligation as servicer to
provide access to the records.43 As a result, FDIC Receiver cannot possibly be liable for the post-receivership breach of WaMu’s Access Rights.
Third, DBNTC alleges that FDIC Receiver is liable for post-receivership breaches of
Repurchase Obligations under the Governing Agreements. Am. Compl. ¶¶ 96, 97. As discussed in Section I, because all the liabilities and obligations under the Governing Agreements have
42. See P&A Agreement at 4 (defining “Credit Files”), 5 (defining “Loans”). 43. According to DBNTC, “[s]uch documents and other information include origination and underwriting files, servicing records, borrower statements both recorded on tape and transcribed into servicing notes, borrower statements made during the origination of the loan, payment histories, and borrower correspondence.” Am. Compl. ¶ 44.
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transferred to JPMC under the unambiguous terms of the P&A Agreement, FDIC Receiver can have no liability to DBNTC for these Obligations. Moreover, the Amended Complaint does not allege that DBNTC has ever provided FDIC Receiver with the notice of defect or breach, and the opportunity to correct, required by the Governing Agreements with respect to any specific mortgage loan in the Trust pools. See id. ¶ 99; supra pp. 15-16. Indeed, DBNTC admits that it has not yet “determine[d] whether Repurchase Obligations exist with respect to particular mortgage loans in the Trusts,” id. ¶ 98, let alone “confirm[ed] whether a particular mortgage in the Trusts is in breach of any of the Representations and Warranties,” id. ¶ 44. Thus, FDIC
Receiver cannot be liable for any post-receivership breaches – or indeed, any pre-receivership breaches – of any Repurchase Obligations.
Finally, DBNTC has articulated no basis upon which it could claim administrative expense priority. DBNTC certainly cannot seek administrative priority for claims arising from acts of the failed bank prior to its closure. See, e.g., Tri-State Hotels, Inc. v. FDIC, 79 F.3d 707,
713 (8th Cir. 1996) (plaintiff could not characterize its claim as arising after the appointment of
FDIC as receiver when “the genesis of its claim is the prereceivership misconduct by the failed bank[]”); H.R. Conf. Rep. No. 103-213, 1993 U.S.C.C.A.N. 1088, 1125 (Aug. 4, 1993) (limiting
“administrative expenses of the receiver” under 12 U.S.C. § 1821(d)(11)(A) to “ordinary and necessary expenses of the [failed] institution . . . , but only those that the receiver determines are necessary to maintain services and facilities to effect an orderly resolution of the institution”).
Thus, at a minimum the Court should strike the demand for administrative claim priority.
In sum, the Amended Complaint fails to state a claim against FDIC Receiver for any post-receivership breaches, and any claims against FDIC Receiver arising from alleged post- receivership breaches should be dismissed on the merits under Rule 12(b)(6).
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CONCLUSION
For the foregoing reasons, the complaint against FDIC Receiver should be dismissed in
its entirety.
Dated: November 22, 2010 Respectfully submitted,
Of Counsel: /s/ William R. Stein William R. Stein, D.C. Bar No. 304048 Kathryn R. Norcross, D.C. Bar No. 398120 Scott H. Christensen, D.C. Bar No. 476439 Senior Counsel, Commercial Litigation Unit Jason S. Cohen, D.C. Bar No. 501834 Anne M. Devens HUGHES HUBBARD & REED LLP Counsel, Commercial Litigation Unit 1775 I Street, N.W. Kaye A. Allison Washington, D.C. 20006-2401 Counsel, Commercial Litigation Unit Telephone: (202) 721-4600 FEDERAL DEPOSIT INSURANCE Facsimile: (202) 721-4646 CORPORATION Email: [email protected] 3501 Fairfax Drive, Room VS-D-7062 Email: [email protected] Arlington, Virginia 22226 Email: [email protected] Telephone: (703) 562-2204 Facsimile: (703) 562-2475 Attorneys for Federal Deposit Insurance Email: [email protected] Corporation in its capacity as Receiver for Email: [email protected] Washington Mutual Bank Email: [email protected]
61221878_5 - 45 - Case 1:09-cv-01656-RMC Document 54-2 Filed 11/22/10 Page 1 of 2
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
DEUTSCHE BANK NATIONAL TRUST COMPANY,
Plaintiff,
v.
Case No. 09-CV-1656-RMC FEDERAL DEPOSIT INSURANCE
CORPORATION (as receiver of Hon. Rosemary M. Collyer WASHINGTON MUTUAL BANK); JPMORGAN CHASE BANK, National Association; and WASHINGTON MUTUAL MORTGAGE SECURITIES CORPORATION,
Defendants.
[PROPOSED] ORDER
The Motion to Dismiss filed by Defendant Federal Deposit Insurance Corporation in its
capacity as Receiver for Washington Mutual Bank (“FDIC Receiver”), and papers filed in
support thereof and in opposition thereto, having been reviewed by this Court, and this Court
being fully advised in the premises,
IT IS HEREBY ORDERED that FDIC Receiver’s Motion to Dismiss is
GRANTED; and
IT IS FURTHER ORDERED that the claims asserted against FDIC Receiver are
dismissed with prejudice.
SO ORDERED.
Dated: ______HON. ROSEMARY M. COLLYER Case 1:09-cv-01656-RMC Document 54-2 Filed 11/22/10 Page 2 of 2 2
UNITED STATES DISTRICT JUDGE Case 1:09-cv-01656-RMC Document 54-3 Filed 11/22/10 Page 1 of 3
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
DEUTSCHE BANK NATIONAL TRUST COMPANY,
Plaintiff,
v.
Case No. 09-CV-1656-RMC FEDERAL DEPOSIT INSURANCE
CORPORATION (as receiver of Hon. Rosemary M. Collyer WASHINGTON MUTUAL BANK); JPMORGAN CHASE BANK, National Association; and WASHINGTON MUTUAL MORTGAGE SECURITIES CORPORATION,
Defendants.
DECLARATION OF JASON S. COHEN IN SUPPORT OF DEFENDANT FDIC RECEIVER’S MOTION TO DISMISS
I, Jason S. Cohen, declare as follows:
1. I am an attorney admitted to practice before this Court. I am an associate of the
firm Hughes Hubbard & Reed LLP, attorneys of record for Defendant Federal Deposit Insurance
Corporation (“FDIC”), in its capacity as Receiver for Washington Mutual Bank (“FDIC
Receiver”).
2. Attached as Exhibit 1 are excerpts from a true and correct copy of the Form 10-K
Annual Report for Washington Mutual, Inc. (“WMI”) for the fiscal year ended December 31,
2007, filed with the SEC by WMI on February 29, 2008, and publicly available at http://www.sec.gov/Archives/edgar/data/933136/000104746908002083/a2182890z10-k.htm. Case 1:09-cv-01656-RMC Document 54-3 Filed 11/22/10 Page 2 of 3
3. Attached as Exhibit 2 are excerpts from a true and correct copy of the Form 10-Q
Quarterly Report for WMI for the fiscal quarter ended June 30, 2008, filed with the SEC by
WMI on August 11, 2008, and publicly available at http://www.sec.gov/Archives/edgar/data/
933136/000104746908009146/a2187197z10-q.htm.
4. Attached as Exhibit 3 are are excerpts from a true and correct copy of the Form
10-K Annual Report for Washington Mutual Bank (“WaMu”) for the fiscal year ended
December 31, 2007, filed with the Office of Thrift Supervision (“OTS”) by WaMu on March 21,
2008.
5. Attached as Exhibit 4 are excerpts from a true and correct copy of the Form 10-Q
Quarterly Report for WaMu for the fiscal quarter ended June 30, 2008, filed with the OTS by
WaMu on August 14, 2008.
6. Attached as Exhibit 5 is a true and correct copy of the Form 8-K Report and
accompanying Exhibit 99.1 (Press Release) filed with the SEC by WMI on July 22, 2008, and publicly available at http://www.sec.gov/Archives/edgar/data/933136/
000115752308005716/a5735438.htm.
7. Attached as Exhibit 6 are excerpts from a true and correct copy of the Form 10-K
Annual Report for JPMorgan Chase & Co. (“JPMC”) for the fiscal year ended December 31,
2007, filed with the SEC by JPMC on February 29, 2008, and publicly available at http://www.sec.gov/Archives/edgar/data/19617/000119312508043536/d10k.htm.
8. Attached as Exhibit 7 is a true and correct copy of the Form 8-K Report and accompanying Exhibit 99.1 (Earnings Release) filed with the SEC by JPMC on January 15,
2009, and publicly available at http://www.sec.gov/Archives/edgar/data/19617/
000095012309000686/y74000e8vk.htm
2
Case 1:09-cv-01656-RMC Document 54-3 Filed 11/22/10 Page 3 of 3
9. Attached as Exhibit 8 are excerpts from a true and correct copy of the Form 10-K
Annual Report for JPMC for the fiscal year ended December 31, 2008, filed with the SEC by
JPMC on March 2, 2009, and publicly available at http://www.sec.gov/Archives/edgar/data/
19617/000095012309003840/y74757e10vk.htm.
10. Attached as Exhibit 9 are excerpts from a true and correct copy of the Form 10-K
Annual Report for JPMC for the fiscal year ended December 31, 2009, filed with the SEC by
WMI on February 24, 2010, and publicly available at http://www.sec.gov/Archives/edgar/data/
19617/000095012310016029/e82150e10vk.htm.
11. Attached as Exhibit 10 are excerpts from a true and correct copy of the Form
10-Q Quarterly Report for the fiscal quarter ended September 30, 2010, filed with the SEC by
JPMC on November 9, 2010, and publicly available at http://www.sec.gov/Archives/edgar/data/
19617/000095012310102689/y86142e10vq.htm.
12. Attached as Exhibit 11 are excerpts from a true and correct copy of the Rule
424(b)(7) Preliminary Prospectus Supplement filed by JPMC with the SEC on December 8,
2009, and publicly available at http://www.sec.gov/Archives/edgar/data/19617/
000119312509249391/d424b7.htm.
I declare under the penalty of perjury that the foregoing is true and correct, and that this declaration was executed in Washington, D.C., on November 22, 2010.
______/s/______Jason S. Cohen D.C. Bar No. 501834
3
Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 1 of 35
EXHIBIT 1
Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 2 of 35 10-K 1 a2182890z10-k.htm 10-K QuickLinks -- Click here to rapidly navigate through this document
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2007
Commission File Number 1-14667 WASHINGTON MUTUAL, INC. (Exact name of registrant as specified in its charter)
Washington 91-1653725 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number)
1301 Second Avenue, Seattle, Washington 98101 (Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (206) 461-2000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Common Stock New York Stock Exchange Depositary Shares each representing a 1/40,000th interest in a share of Series K Perpetual Preferred Non-Cumulative Floating Rate Stock New York Stock Exchange 7.75% Series R Non-Cumulative Perpetual Convertible Preferred Stock New York Stock Exchange
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Litigation Tracking Warrants™ NASDAQ
Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes ý No o.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No ý.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 3 of 35 contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10- K or any amendment to this Form 10-K. ý.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ý Accelerated filer o Non-accelerated filer o Smaller reporting company o (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý.
The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2007, based on the closing sale price as reported on the New York Stock Exchange:
Common Stock – $36,953,361,076(1) (1) Does not include any value attributable to 6,000,000 shares held in escrow.
The number of shares outstanding of the issuer's classes of common stock as of January 31, 2008:
Common Stock – 882,557,330(2) (2) Includes 6,000,000 shares held in escrow.
Documents Incorporated by Reference
Portions of the definitive proxy statement for the Annual Meeting of Shareholders to be held April 15, 2008, are incorporated by reference into Part III.
WASHINGTON MUTUAL, INC. 2007 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
Page
PART I 1 Item 1. Business 1 General 1 Available Information 1 Employees 1 Environmental Regulation 2 Regulation and Supervision 2 Executive Officers of the Registrant 7 Item 1A. Risk Factors 13 Item 1B. Unresolved Staff Comments(1) – Item 2 Properties 9 Item 3. Legal Proceedings 10 Item 4. Submission of Matters to a Vote of Security Holders 13 PART II 14 Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 14 Item 6. Selected Financial Data 24 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Controls and Procedures 16 Overview 16 Critical Accounting Estimates 19 Recently Issued Accounting Standards Not Yet Adopted 23 Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 4 of 35 Five-Year Summary of Selected Financial Data 24 Ratios and Other Supplemental Data 25 Earnings Performance from Continuing Operations 26 Review of Financial Condition 35 Operating Segments 40 Off-Balance Sheet Activities and Contractual Obligations 47 Risk Management 50 Credit Risk Management 51 Liquidity Risk and Capital Management 68 Market Risk Management 73 Operational Risk Management 79 Tax Uncertainties 79 Goodwill Litigation 80 Factors That May Affect Future Results 84 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 73 Item 8. Financial Statements and Supplementary Data 93 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 93 Item 9A. Controls and Procedures 16 Item 9B. Other Information 93 PART III 94 Item 10. Directors and Executive Officers of the Registrant 94 Item 11. Executive Compensation 94 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 94 Item 13. Certain Relationships and Related Transactions 94 Item 14. Principal Accountant Fees and Services 94 PART IV 95 Item 15. Exhibits, Financial Statement Schedules 95
(1) None.
i
PART I
BUSINESS
General
With a history dating back to 1889, Washington Mutual, Inc. (together with its subsidiaries, "Washington Mutual," the "Company," "we," "us," or "our") is a consumer and small business banking company with operations in major U.S. markets. Based on its consolidated assets at December 31, 2007 the Company was the seventh largest among all U.S.-based bank and thrift holding companies.
Since the early 1990s, the Company has expanded its retail banking and lending operations organically and through a series of acquisitions of retail banking institutions and mortgage companies. On October 1, 2005, the Company acquired Providian Financial Corporation, a credit card lender, thereby entering the credit card lending business.
The Company's earnings are primarily driven by lending to consumers and small businesses and by deposit taking activities which generate net interest income, and by activities that generate noninterest income, including the sale and servicing of loans and the provision of fee-based services to its customers.
The Company currently has four operating segments for management reporting purposes: the Retail Banking Group, which operates a retail bank network of 2,257 stores in California, Florida, Texas, New York, Washington, Illinois, Oregon, New Jersey, Georgia, Arizona, Colorado, Nevada, Utah, Idaho and Connecticut; the Card Services Group, which operates a nationwide credit card lending business; the Commercial Group, which conducts a multi-family and commercial real estate lending business in selected markets; and the Home Loans Group, which engages in nationwide single-family residential real estate lending, servicing and capital markets activities. Financial information and descriptions of these operating segments are provided in the Management's Discussion and Analysis section of this Annual Report on Form 10-K.
Available Information Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 5 of 35 activities since the third quarter of 2007. (2) Effective July 18, 2006, the Company adopted a share repurchase program approved by the Board of Directors (the "2006 Program"). Under the 2006 Program, the Company was authorized to repurchase up to 150 million shares of its common stock as conditions warrant and had repurchased 102,545,978 shares under this program as of December 31, 2007.
15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Controls and Procedures
Disclosure Controls and Procedures
The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or furnishes under the Securities Exchange Act of 1934.
Management reviews and evaluates the design and effectiveness of the Company's disclosure controls and procedures on an ongoing basis, which may result in the discovery of deficiencies, and improves its controls and procedures over time, correcting any deficiencies, as needed, that may have been discovered.
Changes in Internal Control Over Financial Reporting
Management reviews and evaluates the design and effectiveness of the Company's internal control over financial reporting on an ongoing basis, which may result in the discovery of deficiencies, some of which may be significant. Management changes its internal control over financial reporting as needed to maintain its effectiveness, correcting any deficiencies, as needed, in order to ensure the continued effectiveness of the Company's internal control over financial reporting. There have not been any changes in the Company's internal control over financial reporting during the fourth quarter of 2007 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. For management's assessment of the Company's internal control over financial reporting, refer to Management's Report on Internal Control Over Financial Reporting on page 98.
Overview
Washington Mutual, through its subsidiaries, is one of the nation's leading consumer and small business banks. At December 31, 2007, Washington Mutual and its subsidiaries had assets of $328 billion. The Company has a history dating back to 1889 and its subsidiary banks currently operate nearly 2,500 consumer and small business banking stores throughout the nation. When we refer to "the Company," "we," "our" and "us" in this Annual Report on Form 10-K, we mean Washington Mutual, Inc. and subsidiaries. When we refer to "the Parent," we mean Washington Mutual, Inc.
The Company's sources of revenue are net interest income and noninterest income. Net interest income is generated by interest received from loans, investment securities and other interest-earning assets, less rates paid on deposits and borrowings. The primary sources of noninterest income are revenue from loan sales and servicing and fees from financial services provided to customers. A summary of the Company's key financial results are presented below:
The Company recorded a net loss for 2007 of $67 million, or $0.12 per diluted share, compared with net income of $3.56 billion, or $3.64 per diluted share, in 2006. The decline was primarily the result of significant credit deterioration in the Company's single-family residential mortgage loan portfolio and significant disruptions in the capital markets, including a sudden and severe contraction in secondary mortgage market liquidity for nonconforming residential loan products. These conditions also contributed to the impairment of all goodwill associated with the Company's Home Loans business near the end of 2007.
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Reflecting the significant credit deterioration, the Company recorded a provision for loan losses of $3.11 billion in 2007, an increase of Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 6 of 35 $2.29 billion from 2006 and about twice the level of 2007 net charge-offs, which totaled $1.62 billion. Adverse trends in key housing market indicators, including growing inventories of unsold homes, rising foreclosure rates and a significant contraction in the availability of credit for nonconforming mortgage products continued to deteriorate throughout 2007 and exerted significant downward pressure on home prices, particularly in areas of the country in which the Company's lending activities have been concentrated. Nationwide sales volume of existing homes in December 2007 was 22% lower than in December 2006, leading to a supply of unsold homes of approximately 9.7 months, a 47% increase from December 2006, while the national median sales price for existing homes declined by 7% between those same periods. Housing market weakness was also evident from the change in the national volume of foreclosure filings, which increased by 75% in 2007 compared with 2006. With the downturn in the housing market, single-family residential mortgage delinquency levels have increased substantially and loss severity rates have grown significantly. These conditions are reflected in the Company's nonperforming assets to total assets ratio, which increased from 0.80% at December 31, 2006 to 2.17% at December 31, 2007. Net mortgage loan charge-offs as a percentage of the average balance of the real estate loan portfolio increased from 0.09% in 2006 to 0.55% in 2007, and on an annualized basis, from 0.14% in the fourth quarter of 2006 to 1.08% in the fourth quarter of 2007, reflecting the accelerating pace of deterioration in the credit quality of the mortgage loan portfolio. The increase in loss severity rates was particularly evident in the subprime mortgage channel and home equity loans and lines of credit portfolios. With early indicators in 2008 suggesting that the housing market is continuing to deteriorate, the Company expects that it will experience significantly higher credit costs throughout its single-family residential mortgage portfolios.
Net credit card charge-offs as a percentage of the average balance of the credit card portfolio were 3.08% in 2006 and 3.69% in 2007, reflecting a gradual downturn in credit quality as the U.S. economy softened. The national unemployment rate, which held steady in a range of 4.4% to 4.7% for most of 2007, increased to 4.9% in January 2008, while average net job growth for the three months ending January 31, 2008 was 42,000, compared with 121,000 for the three months ending January 31, 2007. The Company expects net credit card charge-off rates will continue to rise if the economy is pressured further by higher unemployment levels and sluggish job growth.
Noninterest income was $6.04 billion in 2007, compared with $6.38 billion in 2006. Deteriorating credit conditions also caused significant disruptions in the secondary mortgage market, which adversely affected the Company's noninterest income results. Gain from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments, totaled $59 million in 2007, compared with $735 million in 2006. Credit quality concerns created uncertainty in the market for subprime mortgage products during the first half of 2007. Those concerns intensified during the second half of the year and spread into the broader secondary market, resulting in a severe contraction of secondary market liquidity as investors avoided purchasing all mortgage products backed by nonconforming loan collateral. Because of this disruption, the Company transferred approximately $17 billion of real estate loans to its loan portfolio in the third quarter of 2007, representing substantially all of the Company's nonconforming loans that had been designated as held for sale. Illiquid secondary market conditions also affected the valuations of the Company's trading assets, which are primarily comprised of interests retained from mortgage loan and credit card securitizations. Widening credit spreads on these retained interests were primarily responsible for the loss on trading assets of $673 million in 2007, compared with a loss of $154 million in 2006. The Company also recognized other-than-temporary impairment losses of $375 million in the available-for-sale securities portfolio during the second half of 2007 on certain mortgage-backed securities.
Partially offsetting the losses in noninterest income were gains from mortgage servicing rights ("MSR") valuation and risk management of $205 million in 2007, compared with a loss of $393 million in 2006, as gains from the Company's MSR risk management instruments outpaced the decline in MSR
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fair value. While lower mortgage interest rates during the latter part of 2007 increased expected loan prepayment speeds, their effect on the MSR value was softened by the weakening housing market and the severe contraction in home mortgage credit availability, both of which significantly reduced home loan refinancing volume.
Noninterest expense totaled $10.60 billion in 2007, compared with $8.81 billion in 2006. The unprecedented challenges in the mortgage and credit markets during 2007 also had a significant effect on the Company's noninterest expense results. Noninterest expense in 2007 includes the fourth quarter effects from a $1.78 billion pre-tax impairment loss related to all goodwill associated with the Home Loans business. This non-cash charge did not affect the Company's tangible equity or regulatory capital ratios, or its liquidity position. With the fundamental shift in the mortgage market from credit disruptions and the expectation of a prolonged period of secondary mortgage market illiquidity, the Company took actions in the fourth quarter of 2007 to resize its home loans business in anticipation of continued declines in loan volume within the home mortgage industry, and to accelerate the direction of the home loans business to mortgage lending conducted through the Company's retail banking stores and other retail distribution channels. Among the actions taken by the Company were:
• Discontinuing all remaining lending through the subprime mortgage channel;
• Initiating the closure of WaMu Capital Corp., the Company's institutional broker-dealer business; Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 7 of 35 • Winding-down the Company's mortgage banker finance warehouse lending operations;
• Eliminating approximately 2,600 positions in the Home Loans business and approximately 550 corporate and other support positions; and
• Closing various home loan centers, sales offices, and home loan processing and call centers.
The Company recorded $143 million of additional noninterest expense in the fourth quarter of 2007 as a result of these actions, which are expected to generate approximately $500 million of expense savings during 2008.
Net interest income on a taxable-equivalent basis was $8.19 billion in 2007, compared with $8.13 billion in 2006. The increase was due to the expansion of the net interest margin, which increased, on a taxable-equivalent basis, from 2.60% in 2006 to 2.86% in 2007. The increase in the margin was primarily due to increases in the yields of mortgage loan products tied to short-term interest rate indices and the sales of lower- yielding mortgage loans. With the increasing deterioration in the housing market and the general softening of the economy, the Federal Reserve reduced the target Federal Funds rate by 100 basis points during the second half of 2007, and lowered this benchmark rate by another 125 basis points in January 2008, bringing the target rate down to 3.00%. As the Company's wholesale borrowing rates are usually correlated with interest rate policy changes made by the Federal Reserve and reprice to current market levels faster than most of the Company's interest-earning assets, the actions taken by the Fed are expected to further expand the margin in 2008.
To bolster its capital levels and liquidity position, the Company issued a total of $3.9 billion of Tier 1 capital in the fourth quarter of 2007, comprised of $2.9 billion, net, of noncumulative, perpetual convertible preferred stock issued by the Parent and $1 billion of noncumulative, perpetual preferred shares issued by Washington Mutual Preferred Funding LLC, an indirect subsidiary of Washington Mutual Bank. Additionally, commencing in the first quarter of 2008, the Company reduced its quarterly cash dividend rate on the Company's common stock to 15 cents per share. At December 31, 2007, the Company's estimated total risk-based capital to total risk-weighted assets ratio was 12.34% and its estimated Tier 1 capital to average total assets ratio was 6.84%, exceeding the minimum regulatory guidelines of 8% and 4%, respectively, while the Company's tangible equity to total tangible assets ratio was 6.67%, well above its established target of 5.50%.
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Critical Accounting Estimates
The preparation of financial statements in accordance with the accounting principles generally accepted in the United States of America ("GAAP") requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the financial statements. Various elements of the Company's accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain inherent uncertainties. It is possible that, in some instances, different estimates and assumptions could reasonably have been made and used by management, instead of those the Company applied, which might have produced different results that could have had a material effect on the financial statements.
The Company has identified four accounting estimates that, due to the judgments and assumptions inherent in those estimates, and the potential sensitivity of its financial statements to those judgments and assumptions, are critical to an understanding of its financial statements. These estimates are: the fair value of certain financial instruments and other assets; the allowance for loan losses and contingent credit risk liabilities; other-than-temporary impairment losses on available-for-sale securities; and the determination of whether a derivative qualifies for hedge accounting.
Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Company's Board of Directors. The Company believes that the judgments, estimates and assumptions used in the preparation of its financial statements are appropriate given the facts and circumstances as of December 31, 2007. The nature of these judgments, estimates and assumptions are described in greater detail in subsequent sections of Management's Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."
The discussion below presents information about the nature of the Company's critical accounting estimates:
Fair Value of Certain Financial Instruments and Other Assets
A portion of the Company's assets are carried at fair value, including: mortgage servicing rights, trading assets including certain retained interests from securitization activities, available-for-sale securities and derivatives. In addition, loans held for sale are recorded at the lower of cost or fair value. Changes in fair value of those instruments that qualify as hedged items under fair value hedge accounting are recognized in earnings Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 8 of 35 and offset the changes in fair value of derivatives used as hedge accounting instruments.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Generally, for assets that are reported at fair value, the Company uses quoted market prices or internal valuation models to estimate their fair value. These models incorporate inputs such as forward yield curves, loan prepayment assumptions, market volatilities and pricing spreads utilizing market-based inputs where readily available. The degree of management judgment involved in estimating the fair value of a financial instrument or other asset is dependent upon the availability of quoted market prices or observable market value inputs. For financial instruments that are actively traded in the marketplace or whose values are based on readily available market value data, little judgment is necessary when estimating the instrument's fair value. When observable market prices and data are not readily available, significant management judgment often is necessary to estimate fair value. In those cases, different assumptions could result in significant changes in valuation.
During the latter half of 2007, deteriorating credit conditions caused significant disruptions in the secondary mortgage market. Credit quality concerns prompted market participants to avoid purchasing
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mortgage investment products backed by nonconforming loan collateral. As market activity slowed, the availability of observable market prices was reduced. Accordingly, there was less market data available for use by management in the judgments applied to key valuation inputs.
The following financial instruments and other assets require the Company's most complex judgments and assumptions when estimating fair value:
Mortgage Servicing Rights and Certain Other Retained Interests in Securitizations
In June 2007, the Company implemented a model that is based on an option-adjusted spread ("OAS") valuation methodology to estimate the fair value of substantially all of its MSR asset. The model projects cash flows over multiple interest rate scenarios and discounts these cash flows using risk-adjusted discount rates. Additionally, an independent broker estimate of the fair values of the mortgage servicing rights is obtained quarterly along with other market-based evidence. Management uses this information together with its OAS valuation methodology to estimate the fair value of the MSR. Models used to value MSR assets, including those employing an OAS valuation methodology, are highly sensitive to changes in certain assumptions. Different expected prepayment speeds, in particular, can result in substantial changes in the estimated fair value of MSR. If actual prepayment experience differs materially from the expected prepayment speeds used in the Company's model, this difference may result in a material change in MSR fair value.
Changes in MSR value are reported in the Consolidated Statements of Income under the noninterest income caption "Revenue from sales and servicing of home mortgage loans." Additional discussion regarding the estimation of MSR fair value, including limitations to the MSR fair value measurement process, are described in the subsequent section of Management's Discussion and Analysis – "Earnings Performance from Continuing Operations." Key economic assumptions and the sensitivity of MSR fair value to immediate changes in those assumptions are described in Note 8 to the Consolidated Financial Statements – "Mortgage Banking Activities."
For other retained interests in securitization activities (such as interest-only strips and residual interests in mortgage and credit card securitizations), the discounted cash flow model used in estimating fair value utilizes projections of expected cash flows that are greatly influenced by expected prepayment speeds and, in some cases, expected net credit losses or finance charges related to the securitized assets. Key economic assumptions and the sensitivity of retained interests fair value to immediate changes in those assumptions are described in Note 7 to the Consolidated Financial Statements – "Securitizations." Changes in those and other assumptions used could have a significant effect on the valuation of these retained interests. Changes in the value of other retained interests in securitization activities are reported in the Consolidated Statements of Income under the noninterest income caption "Loss on trading assets" and in the Consolidated Statements of Financial Condition as "Trading assets."
Loans held for sale
The fair value of loans designated as held-for-sale is generally based on observable market prices of securities that have loan collateral or interests in loans that are similar to the held-for-sale loans or whole loan sale prices if formally committed. If market prices are not readily available, fair value is based on a discounted cash flow model, which considers expected prepayment factors and the degree of credit risk associated with the loans and the estimated effects of changes in market interest rates relative to the loans' interest rates. When the estimated fair value of loans held for sale is lower than their cost, including adjustments to cost if the loans were in a fair value hedge relationship under Financial Accounting Standards Board ("FASB") Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended ("Statement No. 133"), a valuation adjustment that accounts for this difference is reported in the Consolidated Statements of Income as a Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 9 of 35 component
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within the noninterest income caption "Revenue from sales and servicing of home mortgage loans" for home loans. Valuation adjustments for consumer loans held for sale are recorded under the noninterest income caption "Revenue from sales and servicing of consumer loans." Valuation adjustments for multi-family and commercial real estate loans held for sale are recorded under the noninterest income caption "Other income."
Fair Value of Reporting Units and Goodwill Impairment
Under FASB Statement No. 142, Goodwill and Other Intangible Assets, goodwill must be allocated to reporting units and tested for impairment. The Company tests goodwill for impairment at least annually or more frequently if events or circumstances, such as adverse changes in the business, indicate that there may be justification for conducting an interim test. Impairment testing is performed at the reporting unit level (which is the same level as the Company's four major operating segments identified in Note 26 to the Consolidated Financial Statements – "Operating Segments"). The first part of the test is a comparison, at the reporting unit level, of the fair value of each reporting unit to its carrying value, including goodwill. If the fair value is less than the carrying value, then the second part of the test is needed to measure the amount of potential goodwill impairment. The implied fair value of the reporting unit goodwill is calculated and compared with the actual carrying value of goodwill recorded within the reporting unit. If the carrying value of reporting unit goodwill exceeds the implied fair value of that goodwill, then the Company would recognize an impairment loss for the amount of the difference, which would be recorded as a charge against net income.
The fair value of the reporting units are determined primarily using discounted cash flow models based on each reporting unit's internal forecasts. In addition, analysis using market-based trading and transaction multiples, where available, is used to assess the reasonableness of the valuations derived from the discounted cash flow models.
For additional information regarding the carrying values of goodwill by operating segment, see Note 9 to the Consolidated Financial Statements – "Goodwill and Other Intangible Assets."
Allowance for Loan Losses and Contingent Credit Risk Liabilities
Allowance for Loan Losses
The allowance for loan losses represents management's estimate of incurred credit losses inherent in the Company's loan portfolio as of the balance sheet date. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods.
The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower's ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and unemployment levels have on a borrower's ability to repay adjustable-rate loans.
The Company allocates a portion of the allowance to the homogeneous loan portfolios and estimates this allocated portion using statistical estimation techniques. Loss estimation techniques used in statistical models are supplemented by qualitative information to assist in estimating the allocated allowance. When housing prices are volatile, lags in data collection and reporting increase the likelihood of adjustments being made to the allowance.
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The Company also estimates an unallocated portion of the allowance that reflects management's assessment of various risk factors that are not fully captured by the statistical estimation techniques used to determine the allocated component of the allowance. The following factors are routinely and regularly reviewed in estimating the appropriateness of the unallocated allowance: national and local economic trends and conditions (such as gross domestic product and unemployment trends); market conditions (such as changes in housing prices); industry and borrower concentrations within portfolio segments (including concentrations by metropolitan statistical area); recent loan portfolio performance (such as changes in the levels and trends in delinquencies and impaired loans); trends in loan growth (including the velocity of change in loan growth); changes in underwriting criteria; and the regulatory and public policy environment.
The allowance for loan losses is reported in the Consolidated Statements of Financial Condition and the provision for loan losses is reported Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 10 of 35 in the Consolidated Statements of Income.
The estimates and judgments are described in further detail in the subsequent section of Management's Discussion and Analysis—"Credit Risk Management" and in Note 1 to the Consolidated Financial Statements—"Summary of Significant Accounting Policies."
Contingent Credit Risk Liabilities
In the ordinary course of business, the Company sells loans to third parties and in certain circumstances, such as in the event of early or first payment default, retains credit risk exposure on those loans. The Company may also be required to repurchase sold loans when representations and warranties made by the Company in connection with those sales are breached. Under certain circumstances, such as when a loan sold to an investor and serviced by the Company fails to perform according to its contractual terms within the six months after its origination or upon written request of the investor, the Company will review the loan file to determine whether or not errors may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a violation of a representation or warranty made to the investor in connection with the Company's sale of the loan, then the Company will be required to either repurchase the loan or indemnify the investor for losses sustained if the violation had a material adverse effect on the value of the loan.
Reserves are established for the Company's exposure to the potential repurchase or indemnification liabilities described above as such liabilities are initially recorded at fair value. Throughout the life of these repurchase or indemnification liabilities, the Company may learn of additional information that can affect the assessment of loss probability or the estimation of the amounts involved. Changes in these assessments can lead to significant changes in the recorded reserves. Repurchase and indemnification liabilities are recorded within other liabilities in the Consolidated Statements of Financial Condition, and losses are recorded in the Consolidated Statements of Income under the noninterest income caption "Revenue from sales and servicing of home mortgage loans."
Impairment of Securities
The Company monitors securities in its available-for-sale investment portfolio for impairment. Impairment may result from credit deterioration of the issuer, from changes in market rates relative to the interest rate of the instrument, or from changes in prepayment speeds. The Company considers many factors in determining whether the impairment is other than temporary, including but not limited to adverse changes in expected cash flows, the length of time the security has had a fair value less than the cost basis, the severity of the unrealized loss, the Company's intent and ability to hold the security for a period of time sufficient for a recovery in value and issuer-specific factors such as the issuer's financial condition, external credit ratings and general market conditions. The determination of
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other-than-temporary impairment is a subjective process, requiring the use of judgments and assumptions in interpreting relevant market data. Other-than-temporary valuation losses on available-for-sale securities are reported in the Consolidated Statements of Income under the noninterest income caption "Loss on other available-for-sale securities." For additional information regarding the amortized cost, unrealized gains, unrealized losses, and fair value of securities, see Note 5 to the Consolidated Financial Statements – "Available-for-Sale Securities."
Derivatives and Hedging Activities
The Company enters into derivative contracts to manage the various risks associated with certain assets, liabilities, or probable forecasted transactions. When the Company enters into derivative contracts, the derivative instrument is designated as: (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (a "fair value" hedge); (2) a hedge of the variability in expected future cash flows associated with an existing recognized asset or liability or a probable forecasted transaction (a "cash flow" hedge); or (3) held for other risk management purposes ("risk management derivatives").
All derivatives, whether designated in hedging relationships or not, are recorded at fair value as either assets or liabilities in the Consolidated Statements of Financial Condition. Changes in fair value of derivatives that are not in hedge accounting relationships (as in (3) above) are recorded in the Consolidated Statements of Income in the period in which the change in value occurs. Changes in the fair value of derivatives that are designated as cash flow hedges (as in (2) above), to the extent such hedges are deemed highly effective, are recorded as a separate component of accumulated other comprehensive income and reclassified into earnings when the earnings effect of the hedged cash flows is recognized. Changes in the fair value of derivatives in qualifying fair value hedge accounting relationships (as in (1) above) are recorded each period in earnings along with the change in fair value of the hedged item attributable to the risk being hedged.
The determination of whether a derivative qualifies for hedge accounting requires complex judgments about the application of Statement No. 133. Additionally, this Statement requires contemporaneous documentation of the Company's hedge relationships. Such documentation includes the nature of the risk being hedged, the identification of the hedged item, or the group of hedged items that share the risk exposure that is Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 11 of 35
Corporate Support/Treasury and Other
Year Ended December 31, Percentage Change
2007 2006 2005 2007/2006 2006/2005
(dollars in millions)
Condensed income statement: Net interest income (expense) $ (86) $ (304) $ (105) (72)% 190% Provision for loan losses 51 (162) (82) – 98 Noninterest income (expense) (137) 303 (171) – – Noninterest expense 475 684 335 (31) 104 Minority interest expense 203 105 – 93 –
Loss from continuing operations before income taxes (952) (628) (529) 52 19 Income taxes (308) (296) (241) 4 23
Loss from continuing operations (644) (332) (288) 94 15 Income from discontinued operations – 406 – – –
Net income (loss) $ (644) $ 74 $ (288) – –
Performance and other data: Average loans $ 1,403 $ 1,126 $ 931 25 21 Average assets 44,651 40,722 30,143 10 35 Average deposits 35,589 41,586 27,220 (14) 53 Loan volume 462 308 278 50 11 Employees at end of period 5,030 5,234 5,947 (4) (12)
The improvement in net interest income in 2007 was primarily due to lower interest expense on lower average balances of FHLB borrowings and wholesale deposits.
The decrease in noninterest income was primarily due to $375 million of losses recognized in the second half of 2007 representing impairment on certain mortgage-backed securities where the reduction in fair value was deemed to be other than temporary. Noninterest income for the year ended December 31, 2006 included a litigation award of $149 million from the partial settlement of the Home Savings supervisory goodwill lawsuit.
The decrease in noninterest expense in 2007 is primarily due to lower occupancy and equipment expense as a result of back office location consolidations in 2006 as well as lower compensation and benefits expense resulting from the Company's productivity and efficiency initiatives.
Minority interest expense represents dividends on preferred securities that were issued during 2006 and 2007 by Washington Mutual Preferred Funding LLC ("WMPF LLC"), an indirect subsidiary of Washington Mutual Bank. For further detail, refer to Note 17 to the Consolidated Financial Statements – "Preferred Stock and Minority Interest."
On December 31, 2006, the Company completed the sale of WM Advisors, Inc., its retail mutual fund management business. The activities of WM Advisors, Inc. were reported within the Retail Banking Group as discontinued operations. The gain from the sale is included in income from discontinued operations in the Corporate Support/Treasury and Other category.
Off-Balance Sheet Activities and Contractual Obligations
Asset Securitization
The Company transforms loans into securities through a process known as securitization. When the Company securitizes loans, the loans are usually sold to a qualifying special-purpose entity ("QSPE"), Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 12 of 35 47
typically a trust. The QSPE, in turn, issues securities, commonly referred to as asset-backed securities, which are secured by future cash flows on the sold loans. The QSPE sells the securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses the proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These QSPEs are not consolidated within the financial statements since they satisfy the criteria established by Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. In general, these criteria require the QSPE to be legally isolated from the transferor (the Company), be limited to permitted activities, and have defined limits on the types of assets it can hold and the permitted sales, exchanges or distributions of its assets.
When the Company sells or securitizes loans that it originated, it generally retains the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the sold or securitized assets. Retained interests in mortgage loan securitizations, excluding the rights to service such loans, were $1.71 billion at December 31, 2007, of which $1.56 billion are of investment grade quality. Retained interests in credit card securitizations were $1.84 billion at December 31, 2007, of which $426 million are of investment grade quality. Additional information concerning securitization transactions is included in Notes 7 and 8 to the Consolidated Financial Statements – "Securitizations" and "Mortgage Banking Activities."
American Securitization Forum Framework
On December 6, 2007, the American Securitization Forum ("ASF"), working with various constituency groups as well as representatives of U.S. federal government agencies, issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the "ASF Framework") to enable residential mortgage loan servicers to streamline their loss avoidance and loan modification practices. In adopting the ASF Framework, the ASF commented that current subprime residential mortgage market conditions reflect a number of concerns that impact securitization transactions, subprime mortgage lending and the overall housing market: an increase in delinquency, default and foreclosure rates; an increase in real estate owned inventories; a decline in home prices; and a prevalence of loans with relatively low initial fixed interest rates that are entering their adjustable rate periods at significantly higher interest rate levels. The ASF Framework provides guidance for residential mortgage loan servicers to streamline subprime residential mortgage borrower evaluation procedures and to facilitate the use of foreclosure avoidance and loss prevention efforts to reduce the number of such borrowers who might default during 2008 because they cannot afford to make higher monthly loan payments after their loans reset to a higher, adjustable interest rate.
The parameters of the ASF Framework were designed by the ASF to improve administrative efficiency while still maximizing cash flows to the QSPEs in which residential mortgage loans were transferred upon securitization by stratifying subprime borrowers into the following segments: borrowers that can refinance into readily available mortgage industry products ("Segment 1"); borrowers that have demonstrated the ability to pay their introductory rates, are unable to refinance, and are unable to afford their reset rates ("Segment 2"); and borrowers that require in-depth, case- by-case analysis due to loan histories that demonstrate difficulties in making timely, introductory rate payments ("Segment 3"). Consistent with its objectives, the ASF Framework was designed to fast-track loan modifications for Segment 2 borrowers, in which default is considered to be reasonably foreseeable. Under the ASF Framework, fast-track loan modifications would be available to Segment 2 borrowers with first-lien residential mortgage loans that: (1) have an initial fixed interest rate period of 36 months or less; (2) are included in securitized pools; (3) were originated between January 1, 2005 and July 31, 2007; and (4) have an initial interest rate reset date between January 1, 2008 and July 31, 2010. To be eligible for a fast-track loan modification under the ASF Framework, Segment 2 borrowers would also have to occupy the property as their primary residence and meet a specific FICO test, which is based on their current
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FICO score, and the servicer must ascertain that the upcoming loan rate reset will result in an increase in the loan payment amount by more than 10%. If all of these criteria are satisfied, the servicer would be permitted to modify the Segment 2 borrower's loan interest rate by keeping it at the existing fixed interest rate, generally for five years following the upcoming reset period.
On January 8, 2008, the Securities and Exchange Commission's (the "SEC") Office of the Chief Accountant (the "OCA") issued a letter (the "OCA Letter") addressing accounting issues that may be raised by the ASF Framework. Specifically, the OCA Letter expressed the view that if a subprime loan made to a Segment 2 borrower is modified in accordance with the ASF Framework and that loan could be legally modified, the OCA would not object to continued status of the transferee as a QSPE under Statement No. 140.
As acknowledged in the OCA Letter, a uniform definition of a subprime mortgage loan does not exist within the mortgage banking industry. The Company has defined subprime residential mortgage loans by reference to the channel in which such loans were originated or purchased. Accordingly, the Company considers loans that were either originated under the Company's Long Beach Mortgage name or that were purchased Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 13 of 35 and lower spreads on loans. The increase in provision for loan losses during 2006 was primarily due to growth in the portfolio of purchased home equity loans
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and higher levels of delinquencies in the subprime mortgage channel. The decrease in noninterest income was substantially due to a less favorable MSR hedging environment in 2006 compared with 2005. Additionally, the gain from mortgage loans was lower due to the slowdown in the housing market and a decline in the secondary market performance of loans sold through the subprime mortgage channel. The decrease in noninterest expense was primarily due to a significant decline in employee headcount, as a result of the Company's efficiency initiatives.
Corporate Support/Treasury and Other
The increase in net interest expense from 2005 to 2006 was due to increasing short-term interest rates which drove higher interest expense on FHLB borrowings, and a significant increase in the average balance of brokered certificates of deposit. The increase in noninterest income was primarily due to a litigation award of $149 million from the partial settlement of the Home Savings supervisory goodwill lawsuit, a gain of $74 million related to the transfer from held for investment to held for sale of $17.79 billion of medium-term adjustable-rate home loans and the associated derivatives executed to hedge that transaction and a $52 million increase in the cash surrender value of the Company's bank-owned life insurance. The increase in noninterest expense was predominantly due to charges of $315 million associated with the Company's productivity and efficiency initiatives and a charge of $67 million associated with the sale in 2006 of a significant portion of the Company's MSR. On December 31, 2006, the Company recognized a gain of $415 million, net of tax, upon completion of the sale of WM Advisors, Inc.
Factors That May Affect Future Results
The Company's Form 10-K and other documents that it files with the Securities and Exchange Commission contain forward-looking statements. In addition, the Company's senior management may make forward-looking statements orally to analysts, investors, the media and others. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may."
Forward-looking statements provide management's current expectations or predictions of future conditions, events or results. They may include projections of the Company's revenues, income, earnings per share, capital expenditures, dividends, capital structure or other financial items, descriptions of management's plans or objectives for future operations, products or services, or descriptions of assumptions underlying or relating to the foregoing. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. These statements speak only as of the date made and management does not undertake to update them to reflect changes or events that occur after that date except as required by federal securities laws.
There are a number of significant factors which could cause actual conditions, events or results to differ materially from those described in the forward-looking statements, many of which are beyond management's control or its ability to accurately forecast or predict. Factors that might cause our future performance to vary from that described in our forward-looking statements include market, credit, operational, regulatory, strategic, liquidity, capital and economic factors as discussed in "Management's Discussion and Analysis" and in other periodic reports filed with the SEC. In addition, other factors besides those listed below or discussed in reports filed with the SEC could adversely affect our results
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and this list is not a complete set of all potential risks or uncertainties. Significant among the factors are the following:
Economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in a deterioration in credit quality of the Company's loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on the Company's business.
Washington Mutual is one of the nation's largest lenders, and deterioration in the credit quality of the Company's loan portfolios can have a negative impact on earnings resulting from increased provisioning for loan losses and from increased nonaccrual loans, which could cause a decrease in interest-earning assets. Credit risk incorporates the risk of loss due to adverse changes in a borrower's ability to meet its financial obligations on agreed upon terms. The overall credit quality of the Company's loan portfolios is particularly impacted by the strength of the U.S. economy and local economies in which the Company conducts its lending operations as well as trends in residential housing prices. The Company continually monitors changes in the economy, particularly unemployment rates and housing prices, because these factors can impact the ability of Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 14 of 35 the Company's borrowers to repay their loans.
During 2007, the housing market in the United States (particularly in California and Florida, where properties securing approximately 48% and 10% of the Company's outstanding single-family residential mortgage loans are located) began to experience significant adverse trends, including accelerating price depreciation in some markets and rising delinquency and default rates. These conditions led to significant increases in loan delinquencies and credit losses in the Company's mortgage portfolios and higher provisioning for loan losses which has adversely affected the Company's earnings. The Company expects that housing prices will experience significant further deterioration in 2008 with further adverse effects on its operating results, business and financial condition. Furthermore, the Company expects that the onset of a recession either in the United States as a whole or in specific regions of the country, or the occurrence of a major natural or other disaster in the United States, would significantly increase the level of delinquencies and credit losses. Increases in credit costs would reduce the Company's earnings and adversely affect its capital position and financial condition.
The Company makes various assumptions and judgments about the collectibility of its loan portfolios when estimating the allowance for loan losses, which represents management's estimate of incurred credit losses inherent in the loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower's ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and employment conditions have on a borrower's ability to repay adjustable-rate loans. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. The Company collects information on the performance of loans in its portfolios and routinely uses this information to recalibrate the formulaic models used in estimating the allowance for loan losses. Subsequent evaluations of the loan portfolio may reveal that estimated levels of loss severity used in estimating the allowance for loan losses differed significantly from actual experience, and in such circumstances the Company may have to record an increased provision for loan losses in subsequent periods thereby reducing earnings in those periods.
Until recently, the Company originated and purchased from third-party lenders loans to higher risk borrowers through its subprime mortgage channel. Borrowers in the subprime mortgage channel tend to have greater vulnerability to changes in economic and housing market factors, such as increases in unemployment, a slowdown in housing price appreciation or declines in housing prices, than do other borrowers. Additionally, the tightening of underwriting standards throughout the mortgage industry have significantly reduced the eligibility of borrowers to obtain credit, or to find credit on affordable terms. The performance of this loan portfolio in recent quarters has been, and in the future will likely
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continue to be, negatively impacted by a variety of factors, including changes in the economic factors noted above, which negatively impact borrowers.
The Company's access to market-based liquidity sources may be negatively impacted if market conditions persist or if further ratings downgrades occur. Funding costs may increase from current levels, and gain on sale may be reduced, leading to reduced earnings.
While the Company actively manages its liquidity risk and maintains liquidity at least sufficient to cover all maturing debt obligations or other forecasted funding requirements over the next twelve months (see "Liquidity Risk and Capital Management"), the Company's liquidity may be affected by an inability to access the capital markets or by unforeseen demands on cash. This situation may arise due to circumstances beyond the Company's control, and is subject to the Company's and its subsidiaries' credit ratings as assigned by various nationally recognized statistical rating organizations ("NRSROs"). During 2007, disruptions in the capital markets substantially limited the ability of mortgage originators, including Washington Mutual, to sell mortgage loans to the capital markets through whole loan sales or securitization. As a result, the Company experienced a general loss of liquidity in most secondary markets for both its loan and asset-backed securities holdings, and this condition has persisted to the present time. The Company cannot forecast if or when either specific secondary markets or broader market liquidity conditions will see improvement from current stresses, although it is the Company's expectation that the existing turmoil in secondary loan and asset-backed securities markets may continue to affect its performance, described below, throughout 2008.
As a result of these conditions, secondary loan sales are currently limited primarily to sales of conforming loans to government-sponsored enterprises ("GSEs"), and the Company cannot predict when secondary markets for nonconforming loans, credit card receivables, and other loan assets will reopen. As such, the Company has in recent periods retained for its own account substantially all of the loans and receivables the Company has originated or purchased, other than conforming mortgage loans. The Company will generally be unable to recognize gains on sale, and may be required to establish reserves for loans that remain on its balance sheet, which may reduce earnings. In addition, the Company has taken steps to reduce or eliminate its origination of assets for which limited secondary market liquidity exists.
While the Company remains comfortable with its ability to fund mortgage loans (see "Liquidity Risk and Capital Management"), the Company's ability to sell conforming loans is dependent on its relationships with the GSEs. The Company presently sells a substantial portion of its conforming residential originations to the GSEs, primarily Freddie Mac. The ability of the GSEs to continue to purchase loans at current Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 15 of 35 volume levels is dependent in part on their own capital positions and the levels of defaults in the portfolios underlying the mortgage-backed securities issued by the GSEs. The Company's liquidity and earnings could be adversely affected if the GSEs were unwilling to purchase the Company's residential loan products.
The Company has generally securitized a large portion of its credit card portfolio, which provided additional liquidity for the Company. Due to disruptions in the secondary market for credit card receivables, the Company is presently not able to securitize credit card receivables on terms it considers acceptable. As a result, the Company's liquidity will be adversely affected until the credit card securitization market normalizes. Additionally, the Company will be required to provide additional loss reserves for the credit card receivables that it retains in its portfolio, which will adversely affect earnings.
Current market conditions have also limited the Company's liquidity sources to secured funding outlets such as the Federal Home Loan Banks and repurchase agreements, and to FDIC-insured deposits originated through either brokers or through its branch network. Other sources of funding, such as medium-term notes, uninsured institutional deposits, and certain escrow balances have largely been closed to the Company. Many of these sources are ratings-sensitive, and due to recent negative
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ratings actions, the Company does not expect these sources to return as reliable sources of funding even if general market liquidity conditions improve until the Company's ratings improve. For example, institutional depositors generally require issuers to have the highest short-term ratings from at least one of the major rating agencies; however, as a result of recent actions, the Company and its banking subsidiaries are now generally in the second-highest short-term rating category.
The Company's rating profile remains "investment grade" as defined by NRSROs. No assurance can be given, however, that the Company will be able to retain an "investment grade" rating. The loss of investment grade ratings would likely result in further reductions in the sources of liquidity available to the Company; may result in increased collateral or margining requirements under derivative and repurchase agreements with counterparties, which could increase the Company's funding costs and further reduce its earnings and liquidity; and could adversely affect the Company's ability to conduct its normal business operations, in ways that could be material.
The Company's liquidity could also be adversely affected by unanticipated demands on its cash, such as having to repurchase securitized loans if it were found to have violated representations and warranties contained in the securitization agreements. In such event, the Company generally would be required to repurchase these loans or indemnify the investor for losses sustained. Since in most instances the repurchased loans would be in default, it is unlikely that the Company would be able to resell these loans in the secondary market. If the Company were required to repurchase a substantial amount of these loans, its liquidity and capital would be adversely affected as the amount of nonperforming assets on its balance sheet would increase.
If the Company has significant additional losses, it may need to raise additional capital, which could have a dilutive effect on existing shareholders, and it may affect its ability to pay dividends on its common and preferred stock.
The Company's primary subsidiary, Washington Mutual Bank, must maintain certain minimum capital ratios in order to remain a "well- capitalized" institution for regulatory purposes. While the Company believes it has sufficient capital for its operations (see "Liquidity Risk and Capital Management"), if the Bank is unable to meet its minimum capital ratios, the Company or the Bank would be forced to raise additional capital. No assurance can be given that sufficient additional capital would be available nor as to the terms on which capital would be available. If sufficient capital were not available, the Company would consider a variety of alternatives, including the sale of assets. Under such forced sale conditions, the Company may not be able to realize fair value for the assets sold. Other alternatives would include changing the Company's business practices or entering into equity transactions. Even if capital is available, the terms and pricing of such securities could be dilutive to existing shareholders and cause the price of the Company's outstanding securities to decline.
The Company depends on dividends, distributions and other payments from its banking and nonbanking subsidiaries to fund dividend payments on common and preferred stock and to fund all payments on its other obligations, including debt obligations. If the earnings of the Company's subsidiaries are not sufficient to make dividend payments to the Company while maintaining adequate capital levels, the Company may not be able to make dividend payments to its common or preferred shareholders.
Changes in interest rates may adversely affect the Company's business, including net interest income and earnings.
Like other financial institutions, Washington Mutual and its banking subsidiaries raise funds for the Company's business by, among other things, borrowing money in the capital markets and from the Federal Home Loan Bank system and accepting deposits from depositors, which the Company uses to make loans to customers and invest in debt securities and other interest-earning assets. The Company earns interest on these loans and assets and pays interest on the money it borrows and on the deposits it accepts from depositors. Changes in interest rates, including Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 16 of 35 changes in the relationship between
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short-term rates and long-term rates, may have negative effects on the Company's net interest income and therefore its earnings. Changes in interest rates and responses by the Company's competitors to those changes may affect the rate of customer prepayments for mortgages and other term loans and may affect the balances customers carry on their credit cards. These changes can reduce the overall yield on the Company's assets. Changes in interest rates and responses by the Company's competitors to these changes may also affect customer decisions to maintain balances in the deposit accounts they have with the Company. These changes may require us to replace withdrawn balances with higher-cost alternative sources of funding.
In addition, changes in interest rates may affect the Company's mortgage banking business in complex and significant ways. For example, changes in interest rates can affect gain from mortgage loans and loan servicing fees, which are the principal components of revenue from sales and servicing of home mortgage loans. When mortgage rates decline, the fair value of the mortgage servicing rights ("MSR") asset generally declines and gain from mortgage loans tends to increase, to the extent the Company is able to sell or securitize mortgage loans in the secondary market. When mortgage rates rise, the Company generally expects loan volumes and payoffs in its servicing portfolio to decrease. As a result, the fair value of its MSR asset generally increases and gain from mortgage loans decreases. In recent periods, however, declines in general interest rates have resulted in slower increases in prepayment rates than in prior periods of declining interest rates, due in part to the reduced liquidity and tightened underwriting standards in the mortgage market making refinancing by borrowers more difficult.
As part of the Company's overall risk management activities, the Company seeks to mitigate changes in the fair value of its MSR asset by purchasing and selling financial instruments, entering into interest rate contracts and forward commitments to purchase or sell mortgage-backed securities and adjusting the mix and amount of such financial instruments or contracts to take into account the effects of different interest rate environments. The MSR asset and the mix of financial instruments used to mitigate changes in its fair value are not perfectly correlated. This imperfect correlation creates the potential for excess MSR risk management gains or losses during any period. Management must exercise judgment in selecting the amount, type and mix of financial instruments and contracts to mitigate changes in the fair value of the Company's MSR. The Company cannot assure that the amount, type and mix of financial instruments and contracts it selects will fully offset significant changes in the fair value of the MSR, and the Company's actions could negatively impact its earnings. The Company's reliance on these risk management instruments may be impacted by periods of illiquidity in the secondary markets, which could negatively impact the performance of the MSR risk management instruments. For further discussion of how interest rate risk, basis risk, volatility risk and prepayment risk are managed, see "Market Risk Management."
Certain of the Company's loan products have features that may result in increased credit risk.
The Company has significant portfolios of home equity loans, which are secured by a first or second lien on the borrower's property. When the Company holds a second lien on a property which is subordinate to a first lien mortgage held by another lender, both the probability of default and severity of loss risk is generally higher than when the Company holds both the first and second lien positions. Home equity loans and lines of credit with combined loan-to-value ratios of greater than 80 percent also expose the Company to greater credit risk than home loans with loan-to- value ratios of 80 percent or less at origination. This greater credit risk arises because, in general, both default risk and the severity of loss risk are higher when borrowers have less equity in their homes.
The Company originates Option ARM loans under which borrowers have the option of making minimum payments based on an interest rate that is lower than the fully-indexed rate. Borrowers who continue to make minimum payments will generally experience negative amortization as unpaid interest is capitalized and added to the principal amount of the loan. The minimum payment resets to a fully-amortizing payment at the earlier of five years from origination or when the amount of negative
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amortization reaches specified levels. The risk that Option ARM borrowers will be unable to make increased loan payments as a result of the minimum payment on the loan adjusting upward to a fully- amortizing payment is a key risk associated with the Option ARM product.
The Company originates interest-only loans that it either securitizes or holds in its portfolio. Borrowers with interest-only loans are initially required to make payments that are sufficient to cover accrued interest. After a predetermined period (generally five years), the payments are reset to allow the loan to fully amortize over its remaining life. Borrowers with interest-only loans are particularly affected by declining housing prices because there is no amortization of principal on the loans. Such economic trends could cause the credit performance of interest-only loans to deteriorate more rapidly than other types of loans with a negative impact on the Company's results. For further discussion of credit risk, see "Credit Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 17 of 35 Risk Management."
Consistent with mortgage industry underwriting practices, loans underwritten with limited documentation of income, net worth or credit history are widely represented within the Company's single-family residential loan products. In particular, such practices are frequently applied to the origination of Option ARM products. Accordingly, approximately 75% of the Company's Option ARM portfolio was originated using a limited documentation standard. As limited documentation loans have a higher risk of default than loans with full documentation, a continued downturn in economic conditions or a further decrease in housing prices could result in higher default rates in the Company's loan portfolio.
The Company uses estimates in determining the fair value of certain of our assets, which estimates may prove to be imprecise and result in significant changes in valuation.
A portion of the Company's assets are carried on the balance sheet at fair value, including: the Company's trading assets including certain retained interests from securitization activities, available-for-sale securities, derivatives and MSR. Generally, for assets that are reported at fair value, the Company uses quoted market prices or internal valuation models that utilize observable market data inputs to estimate their fair value. In certain cases, observable market prices and data may not be readily available or their availability may be diminished due to market conditions. The Company uses financial models to value certain of these assets. These models are complex and use asset specific collateral data and market inputs for interest rates. Although the Company has processes and procedures in place governing internal valuation models and their testing and calibration, the Company cannot assure that it can properly manage the complexity of its models and valuations to ensure, among other things, that the models are properly calibrated, the assumptions are reasonable, the mathematical relationships used in the model are predictive and remain so over time, and the data and structure of the assets and hedges being modeled are properly input. Such assumptions are complex as the Company must make judgments about the effect of matters that are inherently uncertain. Different assumptions could result in significant changes in valuation, which in turn could affect earnings or result in significant changes in the dollar amount of assets reported on the balance sheet.
The Company is subject to risks related to credit card operations, and this may adversely affect its credit card portfolio and its ability to continue growing the credit card business.
Credit card lending brings with it certain risks and uncertainties. These include the composition and risk profile of the Company's credit card portfolio and the Company's ability to continue growing the credit card business. Credit cards typically have smaller balances, shorter lifecycles and experience higher delinquency and charge-off rates than real estate secured loans. Delinquencies and credit losses in the consumer finance industry generally increase during economic downturns or recessions. Likewise, consumer demand may decline during an economic downturn or recession. Account management efforts, seasoning and economic conditions, including unemployment rates and housing prices, affect the overall credit quality of the Company's credit card portfolio. The success of the credit card business also depends, in part, on the success of the Company's product development, product rollout efforts
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and marketing initiatives, including the rollout of credit card products to the Company's existing retail and mortgage loan customers, and the Company's ability to continue to successfully target creditworthy customers.
Recent disputes involving the Visa and MasterCard networks, including their membership standards and pricing structures, could also result in changes that would be adverse to the credit card business. Changes in interest rates can also negatively affect the credit card business, including costs associated with funding the credit card portfolio, as described above under "Changes in interest rates may adversely affect the Company's business, including net interest income and earnings."
The Company is subject to operational risk, which may result in incurring financial and reputational losses.
The Company is exposed to many types of operational risk, including the risk of fraud by employees or outsiders, the risk of operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. Given the Company's high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully corrected. The Company's dependence upon automated systems to record and process transactions may further increase the risk that technical system flaws or employee tampering with or manipulation of those systems will result in losses that are difficult to detect.
The Company may be subject to disruptions of its systems, arising from events that are wholly or partially beyond the Company's control (including, for example, computer viruses or electrical or telecommunications outages), which may give rise to losses in service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as we are) and to the risk that the Company's (or the Company's vendors') business continuity and data security systems prove to be inadequate. The Company relies on offshoring of services to vendors in foreign countries for certain functions and this creates the risk of incurring losses arising from unfavorable political, Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 18 of 35 economic and legal developments in those countries.
The Company also faces the risk that the design of its controls and procedures may prove to be inadequate or are circumvented, thereby causing delays in detection of errors or inaccuracies in data and information. Although the Company maintains a system of controls designed to keep operational risk at appropriate levels, it is possible that any lapses in the effective operations of controls and procedures could materially affect earnings or harm the Company's reputation. In an organization as large and complex as Washington Mutual, lapses or deficiencies in internal control over financial reporting could be material to the Company.
In addition, the Company is heavily dependent on the strength and capability of its technology systems which it uses both to interface with its customers and to manage internal financial and other systems. The Company's ability to run its business in compliance with applicable laws and regulations is dependent on these infrastructures.
The Company depends on the expertise of key personnel and faces competition for talent. The Company's success depends, in large part, on its ability to hire and retain key people. If the Company is unable to retain these people and to attract talented people, or if key people fail to perform properly, the Company's business may suffer. For further discussion of operational risks, see "Operational Risk Management."
The Company's failure to comply with laws and regulations could have adverse effects on the Company's operations and profitability.
The Company operates in a regulated industry and is subject to a wide array of laws and regulations that apply to almost every element of its business, including banking, mortgage, securities, consumer lending and deposit laws and regulations. Failure to comply with these laws and regulations
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could result in financial and operational penalties, including fines, restrictions on otherwise permissible activities and receivership. In addition, establishing systems and processes to achieve compliance with these laws and regulations may increase its costs and/or limit its ability to pursue certain business opportunities.
Effective October 17, 2007, Washington Mutual Bank consented to the issuance by the Office of Thrift Supervision ("OTS") of a cease and desist order requiring Washington Mutual Bank to comply with the Bank Secrecy Act ("BSA") and related BSA regulations and regulations governing suspicious activity reporting. Although no fines or restrictions on Washington Mutual Bank's activities have been imposed by the OTS, failure by the Company to comply with the terms of this order or other applicable laws and regulations could have a material adverse effect on the Company's business, financial condition or operating results through the imposition of additional sanctions.
The volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. Substantial legal liability or significant regulatory action against the Company and its subsidiaries could adversely affect the Company's financial results or cause reputational harm to the Company, which in turn could seriously harm its business prospects. For further discussion of pending legal actions that may affect the Company, see "Legal Proceedings."
Changes in the regulation of financial services companies, housing government-sponsored enterprises and credit card lenders could adversely affect the Company.
The banking and financial services industries, in general, are heavily regulated. Proposals for legislation further regulating the banking and financial services industry are continually being introduced in the United States Congress and in state legislatures. The agencies regulating the financial services industry also periodically adopt changes to their regulations.
Proposals that are now receiving a great deal of attention and could significantly impact the Company's business include changes to consumer protection initiatives relating to bank overdraft practices, security of customer information, marketing practices, nontraditional mortgage loan products including Option ARM loans and interest-only products, credit card lending practices, fees charged to merchants for credit and debit card transactions and mortgage lending and servicing practices. For instance, the Federal Reserve Board has proposed amendments to Regulation Z, which implements the Truth in Lending Act and the Home Ownership Equity Protection Act, to require new disclosures and restrict certain lending practices with regard to mortgage lending. The Federal Reserve Board has also proposed amendments to Regulation Z that would require changes to the format, timing, and content of credit card disclosures. Legislation calling for increased regulation of mortgage and credit card lending is also receiving serious consideration in Congress and in the state legislatures. In 2007, the U.S. House of Representatives passed legislation that would impose new responsibilities on mortgage lenders and restrict certain mortgage lending and servicing practices.
Policymakers are also considering a number of initiatives to assist borrowers who are having difficulty repaying their home loans. On December 5, 2007, President Bush proposed a plan for a five year moratorium on interest rate resets for certain subprime mortgages held by Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 19 of 35 qualifying borrowers. Other public officials and private groups have proposed similar plans. The U.S. House of Representatives Judiciary Committee has reported out legislation that would allow judges to modify the terms of certain mortgages in Chapter 13 bankruptcies. On February 13, 2008, President Bush signed the Economic Stimulus Act of 2008 into law. Among other things, the legislation will raise the Federal Housing Administration ("FHA") loan limit to 125 percent of the area median house price (as determined by the Secretary of Housing and Urban Development) up to a maximum of $729,750 for loans approved by December 31, 2008, and will increase the Fannie Mae and Freddie Mac conforming loan limit to the same amount for loans originated between July 1, 2007 through December 31, 2008.
In addition, there continues to be a focus on reform of the regulatory oversight of the housing government-sponsored enterprises including the Federal Home Loan Bank system. The Company is
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unable to predict whether any of these proposals will be implemented or in what form and what effect any such proposal could have on its business or operating results.
It is possible that one or more legislative proposals may be adopted or regulatory changes may be made that would have an adverse effect on the Company's business. For further discussion of the regulation of financial services, see "Regulation and Supervision" and Note 20 to the Consolidated Financial Statements – "Regulatory Capital Requirements and Dividend Restrictions."
The Company's business and earnings are highly sensitive to general business, economic and market conditions, and continued deterioration in these conditions may adversely affect its business and earnings.
The Company's business and earnings are highly sensitive to general business and economic conditions. These conditions include the strength of the U.S. economy and the local economies in which the Company conducts business, in particular the strength of national and local job markets, the level of interest rates, the slope of the yield curve, the level of inflation, the value of the U.S. dollar as compared to foreign currencies and fluctuations in the level or the volatility in debt, equity and housing markets. Changes in these conditions may adversely affect the Company's business and earnings. For example, when short-term interest rates rise, there is a lag period until adjustable-rate mortgages reprice. As a result, the Company may experience compression of its net interest margin with a commensurate adverse effect on earnings. Likewise, the Company's earnings could also be adversely affected when a flat or inverted yield curve develops, as this may inhibit its ability to grow its adjustable-rate mortgage portfolio and may also cause margin compression. A prolonged economic downturn could increase the number of customers who become delinquent or default on their loans. A rising interest rate environment could increase the negative amortization of Option ARM loans, which may eventually result in increased delinquencies and defaults. Rising interest rates could also decrease customer demand for loans.
The Company's business and earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies. The Company is particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. Federal Reserve policies directly and indirectly influence the yield on the Company's interest-earning assets and the cost of its interest- bearing liabilities. Changes in those policies are beyond the Company's control and are difficult to predict.
The Company may face damage to its professional reputation and business as a result of allegations and negative public opinion as well as pending and threatened litigation.
Reputational risk, meaning the risk to earnings and capital from negative public opinion, is inherent in Washington Mutual's business. Negative public opinion can result from the actual or perceived manner in which the Company conducts its business activities, which include its sales and trading practices, its loan origination and servicing activities, its retail banking and credit card operations, its management of actual or potential conflicts of interest and ethical issues and its protection of confidential customer information. Negative public opinion can adversely affect the Company's ability to keep and attract customers. The Company cannot assure that it will be successful in avoiding damage to its business from reputational risk.
The Company is subject to significant competition from banking and nonbanking companies.
The Company operates in a highly competitive environment and expects competition to continue as financial services companies combine to produce larger companies that are able to offer a wide array of financial products and services at competitive prices with attractive terms. In addition, customer convenience and service capabilities, such as product lines offered and the accessibility of services, are significant competitive factors.
92 Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 20 of 35 The Company's most direct competition for loans comes from commercial banks, other savings institutions, investment banking firms, national mortgage companies and other credit card lenders. The Company's most direct competition for deposits comes from commercial banks, other savings institutions and credit unions doing business in the Company's markets. As with all banking organizations, the Company also experiences competition from nonbanking sources, including mutual funds, corporate and government debt securities and other investment alternatives offered within and outside of the Company's primary markets. In addition, technological advances and the growth of e-commerce have made it possible for non-depository institutions to offer products and services that were traditionally offered only by banks. Many of these competitors have fewer regulatory constraints and some have lower cost structures.
In addition, the Company competes on the basis of transaction execution, innovation and technology. The Company's industry is subject to rapid and significant technological changes. In order to compete in the Company's industry, Washington Mutual must continue to invest in technologies across all of its businesses, including transaction processing, data management, customer interactions and communications and risk management and compliance systems. The Company expects that new technologies will continue to emerge, and these new services and technologies could be superior to or render the Company's technologies obsolete. The Company's future success will depend in part on its ability to continue to develop and adapt to technological changes and evolving industry standards. If the Company is not able to invest successfully in and compete at the leading edge of technological advances across all of its businesses, its revenues and profitability could suffer.
Each of the factors discussed in the preceding paragraphs can significantly impact the Company's businesses, operations, activities, condition and results in significant ways that are not described in the foregoing discussion and which are beyond the Company's ability to anticipate or control, and could cause actual results to differ materially from the outcomes described in the forward-looking statements.
Financial Statements and Supplementary Data
For financial statements, see Index to Consolidated Financial Statements on page 97.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Other Information
None.
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PART III
Items 10, 11, 13 and 14 are incorporated by reference from the Company's definitive proxy statement issued in conjunction with the Company's Annual Meeting of Shareholders to be held April 15, 2008. Certain information regarding the Company's executive officers is set forth in "Business – Executive Officers of the Registrant."
In response to Item 12, the information set forth in the Company's definitive proxy statement relating to the ownership of common stock by the Company's directors, executive officers and principal stockholders under the headings "Security Ownership of Directors and Executive Officers" and "Principal Holders of Common Stock" is incorporated herein by reference. Equity compensation plans information is disclosed below.
Equity Compensation Plans Information
The following table sets forth information regarding the Common Stock that may be issued upon the exercise of options, warrants and other rights granted to employees, directors or consultants under all of the Company's existing equity compensation plans, as of December 31, 2007.
(a) (b) (c)
Number of securities remaining available for Number of securities to be Weighted-average exercise issuance under equity issued upon exercise of price of outstanding options, compensation plans outstanding options, warrants and rights (in (excluding securities Plan Category warrants and rights dollars) reflected in column (a))
Equity compensation plans approved by security holders 37,855,494 $ 38.84 70,753,568(2)(3)(4) Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 21 of 35 Equity compensation plans not approved by security holders 1,587,753(1) 36.53(1) 5,016,996(5)
Total 39,443,247 38.75 75,770,564
(1) Represents WAMU Shares Stock Option Plans grants approved by the Company's Board of Directors. Does not include stock options that were assumed in connection with the Company's acquisition of certain companies. The assumed options are for the purchase of 4,227,286 shares of Common Stock and have a weighted-average exercise price of $69.43 per share. In the event that any assumed option is not exercised, no further option to purchase shares of Common Stock will be issued in place of such unexercised option. (2) Includes 1,202,461 shares of Common Stock remaining available for purchase under the Company's Amended and Restated 2002 Employee Stock Purchase Plan and 68,017,037 shares of Common Stock remaining available for issuance under the 2003 Equity Incentive Plan ("2003 EIP"). (3) The 2003 EIP provides that each of the Company's nonemployee directors may receive stock grants or awards at the recommendation of the Governance Committee. See Note 21 to the Consolidated Financial Statements – "Stock-Based Compensation Plans and Shareholder Rights Plan." (4) Under the Company's 2003 EIP, the Company may grant restricted stock or stock units, including performance shares. See Note 21 to the Consolidated Financial Statements – "Stock-Based Compensation Plans and Shareholder Rights Plan." (5) Includes shares of Common Stock cancelled and available for issuance under the WAMU Shares Stock Option Plans.
Non-Shareholder Approved Plans
WAMU Shares Stock Option Plans
From time to time, the Board of Directors approves grants of nonqualified stock options to certain groups of employees. The grants are made pursuant to a series of plans, collectively known as "WAMU Shares." The aggregate number of shares authorized by the Board of Directors for grants under the WAMU Shares plans was 14,511,900. On October 16, 2002, the Board amended the 1999 WAMU Shares and the 2001 WAMU Shares plans to allow grants to a broader group of employees, including management, so that some of the authorized but unissued options could be
94
granted to eligible employees as part of the annual grant in December 2002. Generally, eligible full-time and part-time employees on the award dates were granted options to purchase shares of Washington Mutual common stock. The exercise price for all grants is the fair value of Washington Mutual's common stock on the grant date, and all options vest one to three years after that date and expire five to ten years from the grant date.
PART IV
Exhibits, Financial Statement Schedules
(a) (1) Financial Statements
See Index to Consolidated Financial Statements on page 97.
(2) Financial Statement Schedules
All financial statement schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or the Notes thereto.
(b) Exhibits:
The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed in the Index of Exhibits to this Annual Report on Form 10-K (pages E-1 through E-4).
95
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on February 29, 2008. Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 22 of 35 WASHINGTON MUTUAL, INC.
/s/ KERRY K. KILLINGER
Kerry K. Killinger Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated on February 29, 2008.
/s/ KERRY K. KILLINGER /s/ THOMAS W. CASEY
Kerry K. Killinger Thomas W. Casey Chairman and Chief Executive Officer; Executive Vice President and Chief Financial Officer (Principal Director (Principal Executive Officer) Financial Officer)
/s/ ANNE V. FARRELL /s/ MELISSA J. BALLENGER
Anne V. Farrell Melissa J. Ballenger Director Senior Vice President and Controller (Principal Accounting Officer)
/s/ STEPHEN E. FRANK /s/ REGINA MONTOYA
Stephen E. Frank Regina Montoya Director Director
/s/ THOMAS C. LEPPERT /s/ MARY E. PUGH
Thomas C. Leppert Mary E. Pugh Director Director
/s/ CHARLES LILLIS /s/ WILLIAM G. REED, JR.
Charles Lillis William G. Reed, Jr. Director Director
/s/ PHILLIP D. MATTHEWS /s/ ORIN C. SMITH
Phillip D. Matthews Orin C. Smith Director Director
/s/ MICHAEL K. MURPHY /s/ JAMES H. STEVER
Michael K. Murphy James H. Stever Director Director
/s/ MARGARET OSMER MCQUADE
Margaret Osmer McQuade Director
96
Financial Statement and Supplementary Data
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 23 of 35 See Notes to Consolidated Financial Statements.
103
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31,
2007 2006
(dollars in millions)
Assets Cash and cash equivalents $ 9,560 $ 6,948 Federal funds sold and securities purchased under agreements to resell 1,877 3,743 Trading assets (including securities pledged of $388 and $1,868) 2,768 4,434 Available-for-sale securities, total amortized cost of $27,789 and $25,073: Mortgage-backed securities (including securities pledged of $1,221 and $3,864) 19,249 18,601 Investment securities (including securities pledged of $3,078 and $3,481) 8,291 6,377
Total available-for-sale securities 27,540 24,978 Loans held for sale 5,403 44,970 Loans held in portfolio 244,386 224,960 Allowance for loan losses (2,571) (1,630)
Loans held in portfolio, net 241,815 223,330 Investment in Federal Home Loan Banks 3,351 2,705 Mortgage servicing rights 6,278 6,193 Goodwill 7,287 9,050 Other assets 22,034 19,937
Total assets $ 327,913 $ 346,288
Liabilities Deposits: Noninterest-bearing deposits $ 30,389 $ 33,386 Interest-bearing deposits 151,537 180,570
Total deposits 181,926 213,956 Federal funds purchased and commercial paper 2,003 4,778 Securities sold under agreements to repurchase 4,148 11,953 Advances from Federal Home Loan Banks 63,852 44,297 Other borrowings 38,958 32,852 Other liabilities 8,523 9,035 Minority interests 3,919 2,448
Total liabilities 303,329 319,319 Stockholders' Equity Preferred stock 3,392 492 Common stock, no par value: 1,600,000,000 shares authorized, 869,036,088 and 944,478,961 shares issued and outstanding – – Capital surplus – common stock 2,630 5,825 Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 24 of 35 Accumulated other comprehensive loss (359) (287) Retained earnings 18,921 20,939
Total stockholders' equity 24,584 26,969
Total liabilities and stockholders' equity $ 327,913 $ 346,288
See Notes to Consolidated Financial Statements.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
Number of Accumulated Other Common Preferred Capital Surplus-Common Comprehensive Retained Shares Stock Stock Income (Loss) Earnings Total
(in millions)
BALANCE, December 31, 2004 874.3 $ – $ 3,350 $ (76) $ 17,615 $ 20,889 Comprehensive income: Net income – 2005 – – – – 3,432 3,432 Other comprehensive income (loss), net of tax: Net unrealized loss from securities arising during the year, net of reclassification adjustments – – – (198) – (198) Net unrealized gain from cash flow hedging instruments – – – 40 – 40 Minimum pension liability adjustment – – – (1) – (1)
Total comprehensive income 3,273 Cash dividends declared on common stock – – – – (1,709) (1,709) Common stock repurchased and retired (23.8) – (921) – – (921) Common stock issued for acquisition 127.0 – 5,030 – – 5,030 Fair value of Providian stock options – – 140 – – 140 Common stock issued 16.4 – 577 – – 577
BALANCE, December 31, 2005 993.9 – 8,176 (235) 19,338 27,279 Cumulative effect from the adoption of Statement No. 156, net of income taxes – – – 6 29 35
Adjusted balance 993.9 – 8,176 (229) 19,367 27,314 Comprehensive income: Net income – 2006 – – – – 3,558 3,558 Other comprehensive income (loss), net of tax: Net unrealized gain from securities arising during the year, net of reclassification adjustments – – – 17 – 17 Net unrealized gain from cash flow hedging instruments – – – 83 – 83 Minimum pension liability adjustment – – – (1) – (1)
Total comprehensive income 3,657 Cumulative effect from the adoption of Statement No. 158, net of income taxes – – – (157) – (157) Cash dividends declared on common stock – – – – (1,978) (1,978) Cash dividends declared on preferred stock – – – – (8) (8) Common stock repurchased and retired (67.4) – (3,039) – – (3,039) Common stock issued 18.0 – 688 – – 688 Preferred stock, Series K, issued – 492 – – – 492
BALANCE, December 31, 2006 944.5 492 5,825 (287) 20,939 26,969 Cumulative effect from the adoption of FASB Interpretation No. 48 – – – – (6) (6) Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 25 of 35
Adjusted balance 944.5 492 5,825 (287) 20,933 26,963 Comprehensive income: Net loss – 2007 – – – – (67) (67) Other comprehensive income (loss), net of tax: Net unrealized loss from securities arising during the year, net of reclassification adjustments – – – (100) – (100) Net unrealized gain from cash flow hedging instruments – – – 43 – 43 Amortization and deferral of gains, losses and prior service costs from defined benefit plans – – – (15) – (15)
Total comprehensive loss (139) Cash dividends declared on common stock – – – – (1,929) (1,929) Cash dividends declared on preferred stock – – – – (31) (31) Cash dividends returned(1) – – – – 15 15 Common stock repurchased and retired (82.1) – (3,497) – – (3,497) Common stock issued 6.6 – 302 – – 302 Preferred stock, Series R, issued – 2,900 – – – 2,900
BALANCE, December 31, 2007 869.0 $ 3,392 $ 2,630 $ (359) $ 18,921 $ 24,584
(1) Represents accumulated dividends on shares returned from escrow.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31,
2007 2006 2005
(in millions)
Cash Flows from Operating Activities Net income (loss) $ (67) $ 3,558 $ 3,432 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Provision for loan losses 3,107 816 316 Gain from home mortgage loans (52) (622) (807) Gain from credit card loans (533) (279) (103) Loss on available-for-sale securities 319 5 41 Gain on disposition of discontinued operations, net of tax – (415) – Depreciation and amortization 504 827 2,656 Goodwill impairment charge 1,775 – – Change in fair value of MSR 1,536 1,364 – Provision for mortgage servicing rights reversal – – (943) Stock dividends from Federal Home Loan Banks (89) (164) (146) Capitalized interest income from option adjustable-rate mortgages (1,418) (1,068) (292) Origination and purchases of loans held for sale, net of principal payments (77,381) (125,204) (165,424) Proceeds from sales of loans originated and held for sale 78,930 122,977 166,997 Net decrease (increase) in trading assets 2,761 7,226 (3,227) Increase in other assets (1,281) (2,821) (4,160) (Decrease) increase in other liabilities (414) 1,069 3,449
Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 26 of 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
correlations between the hedging instruments and hedged items are assessed at inception of the hedge and on an ongoing basis, which includes determining whether the hedging derivative is expected to be highly effective in offsetting changes in fair value or cash flows of the hedged items attributable to the risk being hedged.
We discontinue hedge accounting when (1) we determine that the derivative is no longer expected to be highly effective in offsetting changes in the fair value or cash flows of the designated hedged item; (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is de- designated from the hedge relationship; or (4) it is no longer probable that a hedged forecasted transaction will occur by the end of the originally specified time period.
If we determine that the derivative no longer qualifies as a fair value or cash flow hedge and therefore hedge accounting is discontinued, the derivative (if retained) will continue to be recorded on the balance sheet at its fair value with changes in fair value included in current earnings. For a discontinued fair value hedge, the previously hedged item is no longer adjusted for changes in fair value.
When we discontinue hedge accounting because it is not probable that a forecasted transaction will occur, the derivative will continue to be recorded on the balance sheet at its fair value with changes in fair value included in current earnings, and the gains and losses in accumulated other comprehensive income will be recognized immediately in earnings. When we discontinue hedge accounting because the hedging instrument is sold, terminated or de-designated as a hedge, the amount reported in accumulated other comprehensive income through the date of sale, termination or de-designation will continue to be reported in accumulated other comprehensive income until the forecasted transaction affects earnings.
We occasionally enter into contracts that contain an embedded derivative instrument. At inception of the contract, we determine whether the embedded derivative instrument is required to be accounted for separately from its host contract. As of December 31, 2007, 2006 and 2005, our embedded derivatives were considered clearly and closely related to their host contracts and therefore were not required to be separately accounted for from their host contracts.
We enter into commitments to originate loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). We also enter into commitments to purchase mortgage loans (purchase commitments). Both rate lock and purchase commitments on mortgage loans that are intended to be sold are derivatives. In addition, purchase commitments for mortgage loans that will be held for investment purposes are also derivatives. Those derivatives are recorded at fair value in other assets or other liabilities in the Consolidated Statements of Financial Condition, with changes in fair value recorded in revenue from sales and servicing of home mortgage loans in the Consolidated Statements of Income. The amount of the expected servicing rights is not included when determining the fair value of interest rate lock commitments that are derivatives. However, for derivative loan commitments issued or modified on or after January 1, 2008, the amount of expected servicing rights will be included when determining their fair value, in accordance with Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings ("SAB 109"). Both rate lock and purchase commitments expose us to interest rate risk. We economically hedge that risk by using various types of derivative contracts. The changes in fair value of these contracts are reported in revenue from sales and servicing of home mortgage loans.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Transfers and Servicing of Financial Assets
We sell home loans, credit card loans, multi-family loans and commercial mortgage loans in either whole loan or securitized form. FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ("Statement No. 140"), provides specific criteria for determining whether legal and effective control over the transferred assets has been surrendered. To the extent the sale requirements are met, the transferred assets are removed from our balance sheet, placed in an off-balance sheet qualifying special purpose entity ("QSPE"), as applicable, and any gain or loss on sale is recognized through noninterest income.
QSPEs must meet a series of requirements at the inception of the transaction and on an ongoing basis. These requirements are designed to ensure that the activities of the entity are essentially predetermined at the inception of the QSPE, as specified in the legal documents which created it, and that the Company cannot exercise control over the QSPE and the assets therein. In its fiduciary duty as servicer of assets in the QSPEs, the Company is permitted to modify certain loans that are neither delinquent or in default so long as such actions are significantly limited and Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 27 of 35 compliant with the legal documents that established the QSPE, default is reasonably foreseeable and the modification would meet the conditions that constitute a TDR in accordance with GAAP.
When we sell or securitize mortgage loans, we generally retain the right to service the loans. We record a mortgage servicing right ("MSR") when the expected future cash flows from servicing are projected to be more than adequate compensation for such services. Adequate compensation is where the benefits of servicing would fairly compensate a substitute servicer should one be required, including a profit margin that would be demanded in the marketplace. The projected cash flows that exceed this adequate compensation level are recorded as an MSR asset. We have determined the contractual servicing fee for credit card loans represents adequate compensation and therefore no servicing asset or liability in connection with the securitization of these loans is recognized.
Effective January 1, 2006, we early adopted FASB Statement No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140 ("Statement No. 156"). Statement No. 156 requires that servicing rights resulting from the sale or securitization of loans be initially recognized at fair value at the date of transfer, and permits a class-by-class election between fair value and the lower of amortized cost or fair value for subsequent measurement of MSR classes. Upon adoption, we recognized all MSR assets at fair value, and have elected to subsequently account for all MSR assets at fair value, which is the preferable measurement attribute under Statement No. 156. We have one MSR servicing class, as determined by the availability of market inputs used to measure the fair value of mortgage servicing assets and the treatment of the MSR as one aggregate pool for risk management purposes.
When we securitize loans, in addition to recording an MSR, we may also retain senior, subordinated, residual and other interests, all of which are considered retained interests in the securitized assets. These retained interests may provide limited credit enhancement to the investors and, absent the violation of representations and warranties, generally represent our maximum risk exposure associated with these transactions. These retained interests are initially recorded by allocating the previously recorded cost of the loans transferred between the interests sold and interests retained based on their relative fair values at the date of transfer. At the time of securitization, these retained interests are designated as or treated like trading or available-for-sale securities.
116
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
While we generally sell loans without credit recourse, either in the form of securities or whole loans, we generally make certain representations and warranties to the buyer of those assets, which can include early or first payment default protection. In the event of a breach of such representations and warranties, we may be required to either repurchase the subject loans or indemnify the investor or insurer. During the warranty period, we bear the risk of any loss on the loans. These representation and warranty obligations are recorded at fair value on the balance sheet at the date of transfer.
On December 6, 2007 the American Securitization Forum ("ASF") issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the "ASF Framework") to enable residential mortgage loan servicers to streamline their loss avoidance and loan modification practices.
The parameters of the ASF Framework were designed by the ASF to improve administrative efficiency while maximizing cash flows to the QSPEs to which residential mortgage loans were transferred upon securitization by identifying the following subprime borrower segment categories: borrowers that can refinance into readily available mortgage industry products ("Segment 1"); borrowers that have demonstrated the ability to pay their introductory rates, are unable to refinance, and are unable to afford their reset rates ("Segment 2"); and borrowers that require in-depth, case-by-case analysis due to loan histories that demonstrated difficulties in making timely, introductory rate payments ("Segment 3"). Consistent with its objectives, the ASF Framework was designed to fast-track loan modifications for Segment 2 borrowers, in which default is considered to be reasonably foreseeable. Under the ASF Framework, fast-track loan modifications would be available to Segment 2 borrowers with first-lien residential mortgage loans that: (1) have an initial fixed interest rate period of 36 months or less; (2) are included in securitized pools; (3) were originated between January 1, 2005 and July 31, 2007; and (4) have an initial interest rate reset date between January 1, 2008 and July 31, 2010. To be eligible for a fast-track loan modification under the ASF Framework, Segment 2 borrowers would also have to occupy the property as their primary residence and meet a specific FICO test which is based on their current FICO score, and the servicer must ascertain that the upcoming loan rate reset will result in an increase in the loan payment amount by more than 10%.
On January 8, 2008, the Securities and Exchange Commission's (the "SEC") Office of the Chief Accountant (the "OCA") issued a letter (the "OCA Letter") addressing accounting issues that may be raised by the ASF Framework. Specifically, the OCA Letter expressed the view that if a subprime loan made to a Segment 2 borrower is modified in accordance with the ASF Framework and that loan could be legally modified, the OCA does not object to continued status of the transferee as a QSPE under Statement No. 140. As of December 31, 2007, the Company had not yet applied the loss mitigation approaches outlined in the ASF Framework. Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 28 of 35 (3) Represents mortgage loans purchased from recognized subprime lenders and mortgage loans originated under the Long Beach Mortgage name and held in the investment portfolio. (4) Represents loans to builders for the purpose of financing the acquisition, development and construction of single-family residences for sale and construction loans made directly to the intended occupant of a single-family residence.
The total amount of loans held in portfolio, excluding credit card loans, that were 90 days or more contractually past due and still accruing interest was $98 million and $97 million at December 31, 2007 and 2006. The majority of these loans are either VA- or FHA-insured with little or no risk of loss of principal or interest. Credit card loans held in portfolio that were 90 days or more contractually past due and still accruing interest were $174 million and $113 million at December 31, 2007 and 2006.
Delinquent mortgages contained within GNMA servicing pools that were repurchased or were eligible to be repurchased by the Company are reported as loans held for sale. Substantially all of these loans are either guaranteed or insured by agencies of the federal government and therefore do not expose the Company to significant risk of credit loss. Due to the sale of substantially all of the Company's government loan servicing portfolio in July 2006, the balance of such loans declined considerably. The Company's held for sale portfolio contained zero and $37 million of such loans that were 90 days or more contractually past due and still accruing interest at December 31, 2007 and 2006.
The total amount of nonaccrual loans held in portfolio at December 31, 2007 and 2006 was $6.12 billion and $2.29 billion. The total amount of nonaccrual loans held for sale at December 31, 2007 and 2006 was $4 million and $185 million.
Note 7: Securitizations
Securitization of Assets
During 2007 and 2006, the Company sold loans and retained servicing responsibilities as well as senior and subordinated interests from securitization transactions. The Company receives servicing fees equal to a percentage of the outstanding principal balance of mortgage loans and credit card loans being serviced. Generally, the Company also receives the right to cash flows remaining after the investors in the securitization trusts have received their contractual payments. The allocated carrying values of mortgage loans securitized and sold during the years ended December 31, 2007 and 2006 were $82.58 billion and $110.08 billion, which included loans sold with recourse of $6 million and $959 million during the same periods. The allocated carrying values of credit card loans securitized and sold were $10.65 billion and $7.11 billion during the years ended December 31, 2007 and 2006.
The Company realized pretax gains of $484 million and $1 billion on mortgage loan securitizations during 2007 and 2006. Pretax gains realized on credit card securitizations were $533 million and $279 million during 2007 and 2006.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The table below summarizes certain cash flows received from and paid to securitization trusts, except as footnoted below:
Year Ended December 31,
2007 2006
Mortgages Credit Cards Mortgages Credit Cards
(in millions)
Proceeds from new securitization sales $ 82,655 $ 9,275 $ 113,453 $ 6,314 Proceeds from collections reinvested in new receivables – 13,731 – 11,912 Principal and interest received on interests that continue to be held by the transferor 648 1,194 360 1,415 Servicing fees received(1) 1,980 400 2,066 346 Loan repurchases(1)(2) (431) – (1,848) –
(1) Amounts include cash received/paid related to all transfers of loans, including securitizations accounted for as sales, interests that continue to be held by the transferor and whole loan sales. Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 29 of 35 (2) During 2007 and 2006, loan repurchases include zero and $378 million related to GNMA early buy out repurchases.
Key economic assumptions used in measuring the initial value of interests that continue to be held by the transferor (excluding MSR) resulting from securitizations completed during the years ended December 31, 2007 and 2006, and accounted for as sales at the date of securitization, were as follows (rates are per annum and are weighted based on the principal amounts securitized):
Mortgage Loans
Home
Subprime Mortgage Other Real Fixed-Rate Adjustable- Rate Channel Estate(1) Credit Card Loans
Year Ended December 31, 2007 Payment rate(2) 9.03% 14.43% 29.48% 24.41% 8.82% Anticipated net charge-offs –% –% 4.53% –% 9.00% Expected weighted-average life (in years) 4.8 7.4 5.0 14.0 0.5 Discount rate 9.79% 8.55% 22.20% 11.90% 5.63-26.33% Year Ended December 31, 2006 Payment rate(2) 13.28% 19.56% 34.06% 10.00% 9.06% Anticipated net charge-offs –% –% 4.64% –% 9.60% Expected weighted-average life (in years) 5.9 6.3 4.8 14.5 0.5 Discount rate 5.71% 5.35% 20.20% 10.84% 6.58-15.00%
(1) Includes multi-family and commercial real estate loans. (2) Represents the expected lifetime average payment rate, which is based on the constant annualized prepayment rate for mortgage related loans and represents the average monthly expected principal payment rate for credit card related loans.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
At December 31, 2007, key economic assumptions and the sensitivity of the current fair value of interests that continue to be held by the transferor (excluding MSR) to immediate changes in those assumptions were as follows:
Mortgage Loans
Home
Subprime Mortgage Other Real Fixed-Rate Adjustable- Rate Channel Estate(1) Credit Card Loans
(dollars in millions)
Fair value of interests that continue to be held by the transferor $ 127 $ 887 $ 20 $ 679 $ 1,838 Expected weighted-average life (in years) 7.8 4.7 5.1 4.1 0.5 Payment rate(2) 5.67% 14.88% 23.43% 0.69% 8.60% Impact on fair value of 10% adverse change $ – $ (6) $ – $ (1) $ (25) Impact on fair value of 25% adverse change (1) (13) – (2) (56) Charge-off rate 1.98% 0.68% 22.95% –% 9.49% Impact on fair value of 10% adverse change $ – $ – $ (2) $ – $ (70) Impact on fair value of 25% adverse change – – (3) – (173) Discount rate 9.62% 13.14% 22.47% 6.18% 5.93-26.33% Impact on fair value of 25% adverse change $ (23) $ (128) $ (1) $ (36) $ (83) Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 30 of 35 Impact on fair value of 50% adverse change (44) (202) (1) (62) (160)
(1) Includes multi-family and commercial real estate loans. (2) Represents the expected lifetime average based on the constant prepayment rate for mortgage related loans and represents the average monthly expected principal payment rate for credit card related loans.
These sensitivities are hypothetical and should be used with caution. As the table above demonstrates, the Company's methodology for estimating the fair value of interests that continue to be held by the transferor is highly sensitive to changes in assumptions. For example, the Company's determination of fair value uses anticipated net charge-offs. Actual charge-off experience may differ and any difference may have a material effect on the fair value of interests that continue to be held by the transferor. Changes in fair value resulting from changes in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the interests that continue to be held by the transferor is calculated without changing any other assumptions; in reality, changes in one factor may be associated with changes in another, which may magnify or counteract the sensitivities. Thus, any measurement of the fair value of interests that continue to be held by the transferor is limited by the conditions existing and assumptions made as of a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time.
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The table below presents information about delinquencies, net charge-offs and components of reported and securitized financial assets at December 31, 2007 and 2006:
Net Charge-offs Total Loans Loans on Nonaccrual Status(1)
December 31, Year Ended December 31,
2007 2006 2007 2006 2007 2006
(in millions)
Home mortgage loans $ 225,756 $ 219,227 $ 12,329 $ 3,062 $ 1,378 $ 300 Other loans secured by real estate 113,824 103,825 1,075 365 866 44 Credit card loans 27,240 23,509 – – 1,636 1,235 Other loans 2,084 1,996 25 17 64 29
Total loans managed(2) 368,904 348,557 $ 13,429 $ 3,444 $ 3,944 $ 1,608
Less: Loans sold, including securitizations 112,968 73,004 Loans securitized(3) 6,147 5,623 Loans held for sale 5,403 44,970
Total loans held in portfolio $ 244,386 $ 224,960
(1) Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies" for further discussion of loans on nonaccrual status. (2) Represents both loans in the Consolidated Statements of Financial Condition and loans that have been securitized, but excludes loans for which the Company's only continuing involvement is servicing of the assets. (3) Represents the interests retained by the Company which are included as an adjustment in this table as they have been recognized separately in the Consolidated Statements of Financial Condition.
135 Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 31 of 35 The IRS is currently examining the Company's federal income tax returns for the years 2004 and 2005. As of December 31, 2007, no issue has been raised that will result in a significant impact on the Company's Consolidated Financial Statements.
The Company is currently attempting to settle a deficiency asserted by the UK Inland Revenue. The issue relates to the taxes due on the 2002 sale of credit card operations by a subsidiary of the former Providian Financial Corporation. It is reasonably possible that this issue will be settled within the next twelve months. The range of the possible settlement is estimated to be $21 million to $32 million.
From 1981 through 1985, H.F. Ahmanson & Co. ("Ahmanson"), which was acquired by the Company in 1998, acquired thrift institutions in six states through Federal Savings and Loan Insurance Corporation assisted transactions. In addition to acquiring the assets and operations of these thrift institutions, Ahmanson also acquired (1) the rights to establish branches in the states where the acquired thrifts operated ("Branching Rights") and/or (2) favorable regulatory treatment of goodwill recorded as a result of these acquisitions ("Goodwill Rights").
Ahmanson abandoned the Branching Rights it acquired in several of those states in years prior to 1999. The Company (as successor to Ahmanson) believes it is entitled to tax deductions at the time the branches were sold and the Branching Rights abandoned. In addition, the Company believes it is entitled to tax deductions relating to the amortization or loss of Goodwill Rights due in part to a 1989 change in law. The Company filed several refund claims with the IRS with respect to such deductions that the IRS has denied. The Company filed an action in the U.S. District Court for the Western District of Washington in October 2006 asserting its rights to refunds for the abandonment of Branching Rights in one state and for the amortization or loss of Goodwill Rights with respect to one acquisition. The trial date for this case has been set to occur in September 2008. The amount of refund claimed in this case is approximately $16 million of tax.
In addition to the claims being tried in the action cited above, as of December 31, 2007, the Company has claims and potential claims with the IRS relating to Branching Rights and Goodwill Rights totaling $534 million.
No benefit has been recognized in the Company's Consolidated Financial Statements with respect to the tax deductions for Branching Rights or Goodwill Rights. The previous amounts, whether filed or yet to be filed, are included in the total unrecognized tax benefits as of December 31, 2007.
Note 15: Commitments, Guarantees and Contingencies
Commitments
Commitments to extend credit are agreements to lend to customers in accordance with predetermined amounts and other contractual provisions. These commitments may be for specific periods or may contain clauses permitting termination or reduction of the commitment by the Company and may require the payment of a fee by the customer. The total amounts of unused commitments do
151
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) not necessarily represent future credit exposure or cash requirements, in that commitments often expire without being drawn upon.
Unfunded commitments to extend credit consisted of the following:
December 31,
2007 2006
(in millions)
Residential real estate $ 68,071 $ 69,675 Commercial 6,109 5,512 Credit card 47,524 40,169 Other 890 892
Total unfunded commitments $ 122,594 $ 116,248
Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 32 of 35 The Company reserved $47 million and $27 million as of December 31, 2007 and 2006 to cover its loss exposure to unfunded commitments.
Guarantees
In the ordinary course of business, the Company sells loans to third parties and in certain circumstances retains credit risk exposure on those loans and may be required to repurchase them. The Company may also be required to repurchase sold loans when representations and warranties made by the Company in connection with those sales are breached. Under certain circumstances, such as when a loan sold to an investor and serviced by the Company fails to perform according to its contractual terms within the six months after its origination or upon written request of the investor, the Company will review the loan file to determine whether or not errors may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a breach of a representation or warranty made to the investor in connection with the Company's sale of the loan, then if the breach had a material adverse effect on the value of the loan, the Company will be required to either repurchase the loan or indemnify the investor for losses sustained. In addition, the Company is a party to and from time to time enters into agreements that contain general indemnification provisions, primarily in connection with agreements to sell and service loans or other assets or the sales of mortgage servicing rights. These provisions typically require the Company to make payments to the purchasers or other third parties to indemnify them against losses they may incur due to actions taken by the Company prior to entering into the agreement or due to a breach of representations, warranties, and covenants made in connection with the agreement or possible changes in or interpretations of tax law. The Company has recorded reserves of $268 million and $220 million as of December 31, 2007 and 2006, to cover its estimated exposure related to all of the aforementioned loss contingencies.
In order to meet the needs of its customers, the Company issues direct-pay, standby and other letters of credit. Letters of credit are conditional commitments issued by the Company generally to guarantee the performance of a customer to a third party in borrowing arrangements, such as commercial paper issuances, bond financing, construction and similar transactions. Collateral may be required to support letters of credit in accordance with management's evaluation of the credit worthiness of each customer. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. At December 31, 2007 and 2006, outstanding letters of credit issued by Washington Mutual totaled $374 million and $409 million, which included $32 million and $39 million in participations sold to other institutions.
152
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
At December 31, 2007, the Company is the guarantor of eight separate issues of trust preferred securities. The Company has issued subordinated debentures to wholly-owned special purpose trusts. Each trust has issued preferred securities. The sole assets of each trust are the subordinated debentures issued by the Company. The Company guarantees the accumulated and unpaid distributions of each trust to the extent the Company provided funding to the trust per the Company's obligations under the subordinated debentures. The maximum potential amount of future payments the Company could be required to make under these guarantees are the expected principal and interest each trust is obligated to remit under the issuance of trust preferred securities, which totaled $1.23 billion and $2.31 billion as of December 31, 2007 and 2006. No liability has been recorded because the fair value of such guarantees is de minimis.
In connection with the sale of its retail mutual fund management business, WM Advisors, Inc., the Company provided a guarantee under which it is committed to make certain payments to the purchaser in each of the four years following the closing of the sale on December 31, 2006 in the event that certain fee revenue targets are not met. The fee revenue targets are based on the Company's sales of mutual funds and other financial products that are managed by the purchaser. The Company's maximum potential future payments total $30 million per year for each of the four years following the sale. At the end of the four-year period, the Company can recover all or a portion of the payments made under the guarantee if the aforementioned fee revenues during the four-year period meet or exceed certain targets. The estimated fair value of the guarantee was recorded at December 31, 2006. The carrying amount of the guarantee is being amortized ratably over the four-year period and at each reporting date the Company evaluates the recognition of a loss contingency. The loss contingency is measured as the probable and reasonably estimable amount, if any, that exceeds the amortized value of the remaining guarantee. Based on the evaluation performed at December 31, 2007, no loss contingency was recognized.
The Company is a member of the Visa USA network. Pursuant to the Visa USA bylaws, the Company is obligated to indemnify Visa, Inc. for potential losses arising from certain Visa litigation. The Company's indemnification obligation is limited to its proportionate equity interest in Visa USA. On November 7, 2007, Visa announced the settlement of its litigation involving American Express, and accordingly, the Company recognized a charge of $38 million for its share of the settlement in the third quarter of 2007. On October 3, 2007, the Visa organization completed a series of restructuring transactions to combine its affiliated operating companies, including Visa USA, under a single holding company, Visa, Inc. in contemplation of its planned initial public offering. In conjunction with the restructuring, changes were also made to the bylaws of Visa USA, Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 33 of 35 EX-21 14 a2182890zex-21.htm EXHIBIT 21 EXHIBIT 21
WASHINGTON MUTUAL, INC. DIRECT AND INDIRECT SUBSIDIARIES
Company Name Jurisdiction of Formation 110 East 42nd Operating Company, Inc. Delaware
620-622 Pellhamdale Avenue Owners Corporation New York
Accord Realty Management Corporation New York
ACD2 California
ACD3 California
ACD4 California
Ahmanson Developments, Inc. California
Ahmanson GGC LLC California
Ahmanson Insurance, Inc. California
Ahmanson Land Company California
Ahmanson Marketing, Inc. California
Ahmanson Obligation Company California
Ahmanson Residential 2 California
Ahmanson Residential Development California
Bryant Financial Corporation California
California Reconveyance Company California
CCB Capital Trust IV Delaware
CCB Capital Trust IX Delaware
CCB Capital Trust V Delaware
CCB Capital Trust VI Delaware
CCB Capital Trust VII Delaware
CCB Capital Trust VIII Delaware
Clayton Blackbear, Inc. New York
Commercial Loan Partners L.P. Nevada
CRP Properties, Inc. California
Dime Capital Partners, Inc. New Jersey
Dime Commercial Corp. New York
Dime CRE, Inc. New York
Dime Mortgage of New Jersey, Inc. New York
ECP Properties, Inc. Texas
The E-F Battery Accord Corporation New York
F.C. LTD. New York
FA California Aircraft Holding Corporation California
FA Out-of-State Holdings, Inc. California
Flower Street Corporation California
Great Western FS Corporation Virgin Islands
Great Western Service Corporation Two California
H.F. Ahmanson & Company Nevada
H.S. Loan Corporation California
Harmony Agency, Inc. New York
HCP Properties Holdings, Inc. Delaware
HCP Properties, Inc. California
HFC Capital Trust I Delaware
HHP Investment, LLC Delaware
HMP Properties, Inc. Utah
Home Crest Insurance Services, Inc. California
HS Loan Partners LLC California
Irvine Corporate Center, Inc. California
Ladue Service Corporation Missouri
Long Beach Securities Corp. Delaware
Marion Insurance Company, Inc. Vermont
Marion Street, Inc. Washington
Mid Country Inc. New York
Murphy Favre Housing Managers, Inc. Washington
Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 34 of 35 Murphy Favre Properties, Inc. Washington
Company Name Jurisdiction of Formation NAMCO Securities Corp. Delaware
Nickel Purchasing Company, Inc. New York
Norstar Mortgage Corp. New York
North Properties, Inc. New Jersey
Pacific Centre Associates LLC California
Pacoima Investment Fund LLC Delaware
PCA Asset Holdings LLC California
Pike Street Holdings, Inc. Delaware
Plainview Inn, Inc. New York
Providian Bancorp Services California
Providian Leasing Corporation Delaware
Providian Mauritius Investments LTD Mauritius
Providian Services Corporation Delaware
Providian Services LLC Delaware
Providian Technology Services Private Limited India
Reverse Exchange Corporation California
Rivergrade Investment Corp. California
Riverpoint Associates California
Robena Feedstock LLC Delaware
Robena LLC Delaware
Savings of America, Inc. California
Seafair Securities Holdings Corp. Delaware
Second and Union LLC Delaware
Seneca Funding (UK) Limited United Kingdom
Seneca Funding LLC Delaware
Seneca Funding Management LLC Delaware
Seneca Funding Trust Delaware
Seneca Holdings, Inc. California
Seneca Newco LLC Delaware
Seneca Street, Inc. Washington
Sivage Financial Services LLC Delaware
Snohomish Asset Holdings LLC Nevada
SoundBay Leasing LLC Delaware
Stockton Plaza, Incorporated Florida
Strand Capital LLC Delaware
Sutter Bay Associates LLC California
Sutter Bay Corporation California
Thackeray Funding Corp. Delaware
Thackeray Funding Partners Delaware
Thackeray Holdings Corp. Washington
University Street, Inc. Washington
WaMu 1031 Exchange California
WaMu Asset Acceptance Corp. Delaware
WaMu Capital Corp. Washington
WaMu Insurance Services, Inc. California
WaMu Investments, Inc. Washington
Washington Mutual Asset Securities Corp. Delaware
Washington Mutual Bank Federal
Washington Mutual Bank fsb Federal
Washington Mutual Brokerage Holdings, Inc. California
Washington Mutual Capital Trust 2001 Washington
Washington Mutual Community Development, Inc. California
Washington Mutual Finance Group LLC Delaware
Washington Mutual Life Insurance Company of California, a Stock Insurer California
Case 1:09-cv-01656-RMC Document 54-4 Filed 11/22/10 Page 35 of 35 Washington Mutual Mortgage Securities Corp. Delaware
Company Name Jurisdiction of Formation Washington Mutual Preferred Funding LLC Delaware
Washington Mutual Trade Service Limited Hong Kong
Washington Mutual-Seattle Art Museum Project Owners Association Washington
Western Service Co. Oregon
WM Aircraft Holdings LLC Delaware
WM Asset Holdings Corp. Delaware
WM Citation Holdings, LLC Delaware
WM Enterprises & Holdings, Inc. Washington
WM Funds Disbursements, Inc. Nevada
WM Marion Holdings LLC Delaware
WM Mortgage Reinsurance Company, Inc. Hawaii
WM Specialty Mortgage LLC Delaware
WM Winslow Funding LLC Delaware
WMB St. Helens LLC Washington
WMBFA Insurance Agency, Inc. California
WMFS Insurance Services, Inc. California
WMGW Delaware Holdings LLC Delaware
WMHFA Delaware Holdings LLC Delaware
WMI Investment Corp. Delaware
WMI Rainier LLC Washington
WMICC Delaware Holdings LLC Delaware
WMRP Delaware Holdings LLC Delaware
Yellowstone Venture, Inc. New York
Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 1 of 18
EXHIBIT 2
Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 2 of 18 10-Q 1 a2187197z10-q.htm FORM 10-Q QuickLinks -- Click here to rapidly navigate through this document
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008
Commission File Number 1-14667
WASHINGTON MUTUAL, INC. (Exact name of registrant as specified in its charter)
Washington 91-1653725 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number)
1301 Second Avenue, Seattle, Washington 98101 (Address of principal executive offices) (Zip Code)
(206) 461-2000 (Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ý Accelerated filer o Non-accelerated filer o Smaller reporting company o. (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
The number of shares outstanding of the issuer's classes of common stock as of July 31, 2008:
Common Stock — 1,705,359,302(1)
(1)Includes 6,000,000 shares held in escrow.
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2008 Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 3 of 18 TABLE OF CONTENTS
Page PART I – Financial Information 1 Item 1. Financial Statements 1 Consolidated Statements of Income (Unaudited) – Three and Six Months Ended June 30, 2008 and 2007 1 Consolidated Statements of Financial Condition (Unaudited) – June 30, 2008 and December 31, 2007 2 Consolidated Statements of Stockholders' Equity and Comprehensive Income (Unaudited) – Six Months Ended June 30, 2008 and 2007 3 Consolidated Statements of Cash Flows (Unaudited) – Six Months Ended June 30, 2008 and 2007 4 Notes to Consolidated Financial Statements (Unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 31 Risk Factors 31 Controls and Procedures 32 Critical Accounting Estimates 33 Overview 35 Recently Issued Accounting Standards Not Yet Adopted 37 Summary Financial Data 38 Earnings Performance 39 Review of Financial Condition 48 Operating Segments 54 Off-Balance Sheet Activities 60 Risk Management 62 Credit Risk Management 63 Liquidity Risk and Capital Management 76 Market Risk Management 80 Operational Risk Management 85 Goodwill Litigation 86 Item 3. Quantitative and Qualitative Disclosures About Market Risk 80 Item 4. Controls and Procedures 32
PART II – Other Information 88 Item 1. Legal Proceedings 88 Item 1A. Risk Factors 31 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 93 Item 4. Submission of Matters to a Vote of Security Holders 94 Item 6. Exhibits 95
i
Part I – FINANCIAL INFORMATION
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
Three Months Ended Six Months Ended June 30, June 30, 2008 2007 2008 2007 (in millions, except per share amounts) Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 4 of 18 Interest Income Loans held for sale $ 52 $ 421 $ 138 $ 984 Loans held in portfolio 3,604 3,786 7,559 7,686 Available-for-sale securities 335 351 691 682 Trading assets 117 108 233 221 Other interest and dividend income 94 82 171 183
Total interest income 4,202 4,748 8,792 9,756 Interest Expense Deposits 1,115 1,723 2,443 3,495 Borrowings 791 991 1,878 2,146
Total interest expense 1,906 2,714 4,321 5,641
Net interest income 2,296 2,034 4,471 4,115 Provision for loan losses 5,913 372 9,423 606
Net interest income (expense) after provision for loan losses (3,617) 1,662 (4,952) 3,509 Noninterest Income Revenue from sales and servicing of home mortgage loans (109) 300 302 425 Revenue from sales and servicing of consumer loans 159 403 407 846 Depositor and other retail banking fees 767 720 1,470 1,385 Credit card fees 177 183 358 355 Securities fees and commissions 64 70 122 131 Insurance income 32 29 63 58 Loss on trading assets (305) (145) (521) (253) Gain (loss) on other available-for-sale securities (402) 7 (384) 41 Gain (loss) on extinguishment of borrowings 100 (14) 113 (7) Other income 78 205 199 318
Total noninterest income 561 1,758 2,129 3,299 Noninterest Expense Compensation and benefits 939 977 1,853 1,979 Occupancy and equipment 460 354 818 731 Telecommunications and outsourced information services 123 132 253 261 Depositor and other retail banking losses 61 58 124 119 Advertising and promotion 103 113 208 211 Professional fees 57 55 96 93 Foreclosed asset expense 217 56 372 95 Other expense 443 393 831 755
Total noninterest expense 2,403 2,138 4,555 4,244 Minority interest expense 75 42 151 85
Income (loss) before income taxes (5,534) 1,240 (7,529) 2,479 Income taxes (2,206) 410 (3,063) 865
Net Income (Loss) $ (3,328) $ 830 $ (4,466) $ 1,614
Net Income (Loss) Applicable to Common Stockholders $ (6,689) $ 822 $ (7,892) $ 1,599
Earnings Per Common Share: Basic $ (6.58) $ 0.95 $ (8.43) $ 1.83 Diluted (6.58) 0.92 (8.43) 1.78 Dividends declared per common share 0.01 0.55 0.16 1.09 Basic weighted average number of common shares outstanding (in thousands) 1,016,081 868,968 936,502 871,876 Diluted weighted average number of common shares outstanding (in thousands) 1,016,081 893,090 936,502 896,304
See Notes to Consolidated Financial Statements.
1
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 5 of 18 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(UNAUDITED)
June 30, December 31, 2008 2007 (dollars in millions) Assets Cash and cash equivalents $ 7,235 $ 9,560 Federal funds sold and securities purchased under agreements to resell 2,750 1,877 Trading assets (including securities pledged of zero and $388) 2,308 2,768 Available-for-sale securities, total amortized cost of $25,756 and $27,789: Mortgage-backed securities (including securities pledged of $121 and $1,221) 18,241 19,249 Investment securities (including securities pledged of $112 and $3,078) 6,134 8,291
Total available-for-sale securities 24,375 27,540 Loans held for sale 1,877 5,403 Loans held in portfolio 239,627 244,386 Allowance for loan losses (8,456) (2,571)
Loans held in portfolio, net 231,171 241,815 Investment in Federal Home Loan Banks 3,498 3,351 Mortgage servicing rights 6,175 6,278 Goodwill 7,284 7,287 Other assets 23,058 22,034
Total assets $ 309,731 $327,913
Liabilities Deposits: Noninterest-bearing deposits $ 31,112 $ 30,389 Interest-bearing deposits 150,811 151,537
Total deposits 181,923 181,926 Federal funds purchased and commercial paper 75 2,003 Securities sold under agreements to repurchase 214 4,148 Advances from Federal Home Loan Banks 58,363 63,852 Other borrowings 30,590 38,958 Other liabilities 8,566 8,523 Minority interests 3,914 3,919
Total liabilities 283,645 303,329 Stockholders' Equity Preferred stock 3,392 3,392 Common stock, no par value: 3,000,000,000 shares authorized, 1,705,343,797 and 869,036,088 shares issued and outstanding – – Capital surplus – common stock 12,916 2,630 Accumulated other comprehensive loss (1,079) (359) Retained earnings 10,857 18,921
Total stockholders' equity 26,086 24,584
Total liabilities and stockholders' equity $ 309,731 $327,913
See Notes to Consolidated Financial Statements.
2 Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 6 of 18 Aspects of Endorsement Split-Dollar Life Insurance Arrangements ("Issue No. 06-4") and EITF Issue No. 06-10, Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements ("Issue No. 06-10"). The cumulative effect, net of income taxes, on the Consolidated Statements of Stockholders' Equity and Comprehensive Income upon the adoption of Statement No. 157, Issue No. 06-4 and Issue No. 06-10 was $1 million, $(35) million and $(2) million.
Recently Issued Accounting Standards Not Yet Adopted
In March 2008, the FASB issued Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities–an amendment of FASB Statement No. 133 ("Statement No. 161"). Statement No. 161 amends and requires enhanced qualitative, quantitative and credit risk disclosures about an entity's derivative and hedging activities, but does not change the scope or accounting principles of Statement No. 133. Statement No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. Because Statement No. 161 impacts the Company's disclosure and not its accounting treatment for derivative financial instruments and related hedged items, the Company's adoption of Statement No. 161 will not impact the Consolidated Statement of Income and the Consolidated Statement of Financial Condition.
In April 2008, the FASB issued FASB Staff Position ("FSP") FAS 142-3, Determination of the Useful Life of Intangible Assets ("FSP FAS 142-3"), which amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of a recognized intangible asset under FASB Statement No. 142, Goodwill and Other Intangible Assets. FSP FAS 142-3 is effective for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited. The Company is currently evaluating the effect FSP FAS 142-3 will have on the Consolidated Financial Statements.
In May 2008, the FASB issued Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles ("Statement No. 162"). Statement No. 162 is intended to improve financial reporting by
6
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with GAAP for nongovernmental entities. This statement is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board Auditing amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company is currently evaluating the effect, if any, that Statement No. 162 will have on the Consolidated Financial Statements.
In May 2008, the FASB issued Statement No. 163, Accounting for Financial Guarantee Insurance Contracts – an interpretation of FASB Statement No. 60 ("Statement No. 163"). Statement No. 163 requires an insurance enterprise that issues financial guarantee insurance contracts to initially recognize the premiums received (or premiums expected to be received) for issuing the contracts as unearned premium revenue and to recognize that premium revenue over the period of the contract and in proportion to the amount of insurance protection provided. Statement No. 163 also requires recognition of a claim liability before an event of default if there is evidence that credit deterioration of the guaranteed obligation has occurred. This statement is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008, except for some disclosures about the insurance enterprise's risk-management activities and claim liabilities. Statement No. 163 requires that disclosures about the risk-management activities of the insurance enterprise and its claim liabilities be effective for the first period (including interim periods) beginning after its issuance. The Company is currently evaluating the effect, if any, that Statement No. 163 will have on the Consolidated Financial Statements.
In May 2008, the FASB issued FSP Accounting Principles Board ("APB") 14-1, Accounting for Convertible Debt Instruments That May be Settled in Cash Upon Conversion (Including Partial Cash Settlement) ("FSP APB 14-1"). FSP APB 14-1 addresses the accounting for convertible debt securities that, upon conversion, may be settled by the issuer fully or partially in cash (i.e., if the investor elects to convert, the issuer has the right to pay some or all of the conversion value in cash rather than to settle the conversion value fully in shares). Such guidance is effective for fiscal years and interim periods beginning after December 15, 2008. It requires retrospective application to instruments that are within the scope of this guidance and were outstanding during any period presented in the financial statements. The Company is currently evaluating the effect that FSP APB 14-1 will have on the Consolidated Financial Statements. Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 7 of 18 8
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)
Note 3: Mortgage Banking Activities
Revenue from sales and servicing of home mortgage loans, including the effects of derivative risk management instruments, consisted of the following:
Three Months Ended Six Months Ended June 30, June 30, 2008 2007 2008 2007 (in millions) Revenue from sales and servicing of home mortgage loans: Sales activity: Gain (loss) from home mortgage loans and originated mortgage-backed securities(1) $ (162) $ 66 $ (19) $ 214 Revaluation gain (loss) from derivatives economically hedging loans held for sale 11 126 (9) 72
Gain (loss) from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments (151) 192 (28) 286 Servicing activity: Home mortgage loan servicing revenue(2) 438 526 908 1,041 Change in MSR fair value due to payments on loans and other (301) (401) (531) (757) Change in MSR fair value due to valuation inputs or assumptions 542 530 42 434 Revaluation loss from derivatives economically hedging MSR (637) (547) (89) (579)
Home mortgage loan servicing revenue, net of MSR valuation changes and derivative risk management instruments 42 108 330 139
Total revenue from sales and servicing of home mortgage loans $ (109) $ 300 $ 302 $ 425
(1) Originated mortgage-backed securities represent available-for-sale securities retained on the balance sheet subsequent to the securitization of mortgage loans that were originated by the Company. (2) Includes contractually specified servicing fees (net of guarantee fees paid to housing government-sponsored enterprises, where applicable), late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors and that which is collected from borrowers upon payoff).
9
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
Changes in the balance of mortgage servicing rights ("MSR") were as follows:
Three Months Ended Six Months Ended June 30, June 30, 2008 2007 2008 2007 (in millions) Fair value, beginning of period $ 5,726 $ 6,507 $6,278 $6,193 Home loans: Additions 205 592 386 1,351 Change in MSR fair value due to payments on loans and other (301) (401) (531) (757) Change in MSR fair value due to valuation inputs or assumptions 542 530 42 434 Sale of MSR – – (1) – Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 8 of 18 Net change in commercial real estate MSR(1) 3 3 1 10
Fair value, end of period $ 6,175 $ 7,231 $6,175 $7,231
Unrealized gain still held(2) $ 544 $ N/A $ 42 $ N/A
(1) Changes in commercial real estate MSR fair value are included in other income on the Consolidated Statements of Income. (2) Pursuant to the disclosure requirements of Statement No. 157 that was adopted by the Company on January 1, 2008, this represents the amount of gains for the period included in earnings attributable to the change in unrealized gains relating to MSR still held at June 30, 2008.
Changes in the portfolio of mortgage loans serviced for others were as follows:
Three Months Ended June 30, Six Months Ended June 30, 2008 2007 2008 2007 (in millions) Balance, beginning of period $ 449,126 $ 467,782 $ 456,484 $ 444,696 Home loans: Additions 9,828 29,949 19,690 74,500 Sale of servicing – – (109) – Loan payments and other (17,534) (24,213) (34,711) (46,682) Net change in commercial real estate loans 181 1,349 247 2,353
Balance, end of period $ 441,601 $ 474,867 $ 441,601 $ 474,867
Note 4: Guarantees
In the ordinary course of business, the Company sells loans to third parties and in certain circumstances retains credit risk exposure on those loans and may be required to repurchase them. The Company may also be required to repurchase sold loans when representations and warranties made by the Company in connection with those sales are breached. Under certain circumstances, such as when a loan sold to an investor and serviced by the Company fails to perform according to its contractual terms within the six months after its origination or upon written request of the investor, the Company will review the loan file to determine whether or not errors may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a breach
10
WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
of a representation or warranty made to the investor in connection with the Company's sale of the loan, then if the breach had a material adverse effect on the value of the loan, the Company will be required to either repurchase the loan or indemnify the investor for losses sustained. Reserves established to repurchase loans or indemnify investors are recorded as a reduction to revenue from sales and servicing of home loans on the Consolidated Statements of Income.
In addition, the Company is a party to and from time to time enters into agreements that contain general indemnification provisions, primarily in connection with agreements to sell and service loans or other assets or the sales of mortgage servicing rights. These provisions typically require the Company to make payments to the purchasers or other third parties to indemnify them against losses they may incur due to actions taken by the Company prior to entering into the agreement or due to a breach of representations, warranties and covenants made in connection with the agreement or possible changes in or interpretations of tax law.
The Company has recorded reserves of $375 million and $268 million as of June 30, 2008 and December 31, 2007, to cover its estimated exposure related to all of the aforementioned loss contingencies.
From time to time, the Company and its subsidiaries enter into agreements in connection with the issuance of debt or equity securities which contain standard representations, warranties and indemnifications to third parties against damages, losses and expenses arising from those transactions. The extent of the Company's obligation under these agreements depends on the occurrence of future events that cannot be determined. Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 9 of 18 Accordingly, the Company's potential future liability under these agreements cannot be estimated and it has therefore not accrued for these potential future liabilities.
Note 5: Covered Bond Program
In September 2006, WMB launched a €20 billion Covered Bond Program ("the Program") intended to diversify its investor base, lengthen the maturity profile of its liabilities and provide an additional source of stable funding. Under the Program, the Company may, from time to time, issue floating rate US dollar-denominated mortgage bonds secured principally by its portfolio of residential mortgage loans to a statutory trust not affiliated with the Company, which in turn will issue Euro-denominated covered bonds secured by the mortgage bonds.
At June 30, 2008 and December 31, 2007, €6.00 billion in principal amount of Euro-denominated covered bonds with an average interest rate of 4.08% and $7.78 billion in principal amount of mortgage bonds, which are included in other borrowings on the Consolidated Statements of Financial Condition, have been issued and are outstanding. Mortgage bonds are floating rate instruments with the applicable interest rate payable on mortgage bonds tied to short-term interest rates. Euro-denominated covered bonds (and related mortgage bonds) issued on September 26, 2006, mature on each of September 27, 2011 and September 27, 2016, respectively; additional Euro-denominated covered bonds (and related mortgage bonds) issued on May 18, 2007, mature on May 19, 2014.
At June 30, 2008, rating agencies required 13.4% over-collateralization with respect to assets comprising the cover pool. Over- collateralization requirements may change from time to time based on rating agency requirements, market conditions and composition of the cover pool.
To be included in the cover pool, mortgage loans must satisfy eligibility criteria which are as follows: (a) no mortgage bond issuer event of default would occur as a result of including the mortgage loan in the cover pool; (b) current ratings on covered bonds would not be adversely affected as a result
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WASHINGTON MUTUAL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(UNAUDITED)
of including the mortgage loan in the cover pool; (c) the mortgage loan does not have an outstanding principal balance greater than $3,000,000; and (d) the mortgage loan is approved for inclusion in the cover pool by the rating agencies. The foregoing eligibility criteria may change from time to time subject to approval by the rating agencies. The Company may add and remove mortgage loans from the cover pool that collateralizes mortgage bonds.
At June 30, 2008, outstanding Euro-denominated covered bonds were rated AAA by each of Standard & Poor's and Fitch, and A2 by Moody's. Euro-denominated covered bonds were on "negative watch" by Moody's and Fitch. Mortgage bonds are not rated. Under current program covenants, due to the recent downgrades of Washington Mutual Bank's long-term rating by Moody's and Standard & Poor's, the Program may not issue additional covered bond series.
There are no material contingent liabilities, guarantees, or reimbursement programs entered into between the Company, its affiliates and the issuing trusts established under the Program. The Company is obligated to reimburse the issuing trusts for certain fees and expenses (primarily rating agency fees and trustee service fees) associated with the issuance of covered bonds as such fees and expenses become due; however, these are not material.
The statutory trusts formed in connection with the Program are not qualifying special purpose entities ("QSPEs") that meet all the conditions for non-consolidation in FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ("Statement No. 140"). The statutory trusts are special purpose entities ("SPEs") (which also meet the definition of variable interest entities), for purposes of FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities ("FIN46(R)"), but do not qualify for consolidation in the Company's financial statements. Specifically, under the Program documentation, the Company's interests in the statutory trusts do not cause the Company to absorb the majority of expected losses or entitle it to receive the majority of residual returns, if any, upon the liquidation of the statutory trusts. The statutory trusts' variable interests, including the covered bonds they issued, and the swap and the guaranteed investment contracts into which they entered, collectively absorb the majority of expected losses. Finally, the Company does not control the exercise of Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 10 of 18 and derivative contracts traded in over-the-counter markets, such as interest rate swaps, forwards and options, and foreign currency swaps.
Level 3 assets are comprised of the Company's mortgage servicing rights ("MSR"), substantially all trading assets, mortgage loan commitments that are accounted for as derivatives, and certain available-for-sale securities in which market-based information to estimate fair value was not available. The Company's Level 3 assets totaled $9.89 billion at June 30, 2008 and represented approximately 28% of total assets measured at fair value on a recurring basis and approximately 3% of the Company's total assets.
See Note 9 to the Consolidated Financial Statements – "Fair Value" for a further description of the valuation methodologies used for assets and liabilities measured at fair value.
Fair Value of Reporting Units and Goodwill Impairment
Under FASB Statement No. 142, Goodwill and Other Intangible Assets, goodwill must be allocated to reporting units and tested for impairment. The Company tests goodwill for impairment at least annually or more frequently if events or circumstances, such as adverse changes in the business, indicate that there may be justification for conducting an interim test. Impairment testing is performed at the reporting unit level, which is the same level as the Company's four operating segments identified in Note 10 to the Consolidated Financial Statements – "Operating Segments." The Company's goodwill totaled $7.28 billion as of June 30, 2008, and is recorded in three of its operating segments: the Retail Banking Group, the Card Services Group and the Commercial Group. The first part of the test is a comparison, at the reporting unit level, of the fair value of each reporting unit to its carrying value, including goodwill. If the fair value is less than the carrying value, then the second part of the test is needed to measure the amount of potential goodwill impairment. The implied fair value of the reporting unit goodwill is calculated and compared with the actual carrying value of goodwill recorded
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within the reporting unit. If the carrying value of reporting unit goodwill exceeds the implied fair value of that goodwill, then the Company would recognize an impairment loss for the amount of the difference, which would be recorded as a charge against net income.
The estimation of fair value for each reporting unit is determined primarily through a discounted cash flow approach that considers the market environment and the Company's expectations about future conditions. Estimated fair value computed under this approach contemplates cash flow projections based on the internal business forecasts for each reporting unit, and appropriate discount rates. Estimation of fair value involves significant management judgment about future conditions that are inherently uncertain, including the results of operations and the extent and timing of credit losses. In addition, analysis using market-based trading and transaction multiples, where available, is used to assess the reasonableness of the valuations derived from the discounted cash flow models.
In the second quarter, the Company considered the continuing adverse conditions within the market environment and the Company's best estimates regarding future conditions including credit losses, and concluded that there was no goodwill impairment within its reporting units with recorded goodwill as of June 30, 2008. A continuing period of market disruption, the Company's diminished trading value and market capitalization, or further market deterioration are factors the Company will continue to consider in future evaluations of recorded goodwill for impairment, including particularly its annual evaluation to be conducted in the third quarter of 2008 and subsequent evaluations.
For additional information regarding the carrying values of goodwill by operating segment, see Note 9 to the Consolidated Financial Statements – "Goodwill and Other Intangible Assets" in the Company's 2007 Annual Report on Form 10-K/A.
Overview
The Company recorded a net loss in the second quarter of 2008 of $3.33 billion, compared with net income of $830 million in the second quarter of 2007, primarily due to the Company's significant increase in loan reserves by $3.74 billion to $8.46 billion. Diluted loss per share was $6.58 for the quarter ended June 30, 2008. Diluted loss per share in the second quarter was negatively impacted by a one-time, non-cash adjustment of $(3.24) per share related to the conversion in June 2008 of Series S and Series T convertible preferred stock issued in April 2008 in connection with the Company's $7.2 billion capital raise. This non-cash adjustment had no effect on the Company's capital ratios or the net loss recorded in the second quarter, but had the effect of reducing retained earnings by $3.29 billion and increasing capital surplus-common stock by a corresponding amount. Excluding this one-time adjustment, diluted loss per share in the second quarter was $3.34 per share, compared with diluted earnings per share of $0.92 in the second quarter of 2007. The conversion option in the Series S and Series T Preferred Stock created a beneficial conversion feature as defined within generally accepted accounting principles and is described in further detail in Note 7 to the Consolidated Financial Statements — "Earnings Per Common Share."
The Company recorded a provision for loan losses of $5.91 billion in the second quarter of 2008, an increase of $5.54 billion from the second quarter of 2007 and significantly higher than second quarter 2008 net charge-offs, which totaled $2.17 billion. Net charge-offs in the second Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 11 of 18 quarter of 2007 were $271 million. Adverse trends in key credit risk indicators, including high inventory levels of unsold homes, rising foreclosure rates, the significant contraction in the availability of credit for nonconforming mortgage products and negative job growth trends exerted severe pressure on the performance of the single-family residential ("SFR") loan portfolio, particularly loans in geographic areas in which the Company's lending activities have been concentrated in recent years. Nationwide sales volume of existing homes in June 2008 was 15% lower than June 2007, leading to a supply of unsold homes of approximately 11.1 months, a 22% increase from June 2007, while the national median sales price for existing homes fell by 6% between those periods. Since July 2006, average home
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prices declined 19%, as measured by the S&P Case-Shiller 10-City Composite Home Price Index, or 22% when this index is weighted to reflect the geographic distribution of the Company's SFR portfolio. Foreclosure filings were also up significantly, increasing by 121% from the second quarter of 2007 to the second quarter of 2008.
The deteriorating housing market conditions resulted in sharply higher delinquency rates and restructurings of troubled loans, as the Company has intensified its efforts to work with borrowers to keep them in their homes whenever it can do so. The ratio of nonperforming assets to total assets rose to 3.62% at June 30, 2008, compared with 1.29% at June 30, 2007. Restructured nonaccrual loans accounted for 0.46% of the nonperforming assets to total assets ratio at June 30, 2008, compared with 0.05% of the ratio at June 30, 2007. Cure rates on early stage delinquencies, representing loans that are up to three payments past due, have also deteriorated, as declining home values and the reduced availability of credit throughout the mortgage market have created conditions in which many borrowers cannot refinance their mortgage or sell their home at a price that is sufficient to repay their mortgage.
Deteriorating trends in delinquency rates began migrating across the different types of loans in the Company's SFR portfolio starting in 2007. Rising levels of delinquencies initially occurred within the subprime mortgage channel during the first half of 2007, followed by the appearance of higher delinquencies in home equity loans and lines of credit during the second half of 2007. During the first half of 2008, Option ARMs have been the product type exhibiting the greatest increase in delinquency rates. The increases in Option ARM delinquencies are generally concentrated in geographic markets that have experienced the most significant levels of housing price depreciation, particularly in the inland regions of California and the Southeastern section of the country. While Option ARM loans that have experienced negative amortization are subject to payment recasting events, the presence of this feature has not been a significant contributor to the increase in delinquency rates, as the majority of recasts are not contractually scheduled to occur until 2010 and later years.
In addition to higher delinquency levels within its SFR loan portfolio, the Company also began experiencing deteriorating trends in loan loss severities starting in 2007, which continued to increase in the second quarter of 2008, reflecting the steep decline in home prices. Annualized net SFR charge-offs as a percentage of the average balance of the SFR portfolio increased from 0.39% in the second quarter of 2007 to 4.21% in the second quarter of 2008.
In response to these deteriorating trends in housing market conditions, delinquencies and loss severities, the Company has continued in 2008 to update its loan loss provisioning assumptions for its SFR portfolio, changing key assumptions used to evaluate default frequencies and loss severities, to reflect these trends. These updated assumptions accounted for approximately one-third of the provision recorded in the second quarter of 2008 and approximately $1.2 billion of the provision recorded in the first quarter of 2008. Refer to Credit Risk Management – "Allowance for Loan Losses" section for further discussion of these changes and a general discussion of the Allowance for Loan Losses.
The Company also experienced declines in the credit performance of its credit card portfolio during the first half of 2008, reflecting a softening U.S. economy and increased national unemployment, the macroeconomic factors that generally have the greatest impact on consumer spending and credit card performance. Annualized net credit card charge-offs as a percentage of the average balance of the credit card portfolio were 6.51% in the second quarter of 2008 and 3.63% in the second quarter of 2007. The national unemployment rate increased to 5.5% in June 2008 from 4.6% in June 2007, while the U.S. economy lost approximately 191,000 net jobs during the second quarter of 2008, compared with net job growth of 315,000 in the second quarter of 2007.
With the elevated levels of loan loss provisioning and charge-offs in its loan portfolios, the Company took steps to bolster its capital and liquidity positions during the second quarter. In April 2008, the Company issued approximately $7.2 billion of equity, comprised of common stock; perpetual, non-cumulative convertible preferred stock that was subsequently converted into common shares on
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June 30, 2008 after receiving approval of the conversion from the Company's shareholders; and warrants. The Company took further steps to enhance its capital position by reducing both its quarterly common stock dividend to $0.01 per share, and the size of its balance sheet by Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 12 of 18 $18 billion since the beginning of 2008. The Company expects that 2008 will be the peak year for loan loss provisioning.
At June 30, 2008, the Company's Tier 1 capital to average total assets ratio was 7.76%, and its total risk-based capital to total risk-weighted assets ratio was 13.93%, exceeding the regulatory guidelines for well-capitalized institutions, and the tangible equity to total tangible assets ratio was 7.79%, above the Company's established target of 5.50%.
Net interest income was $2.30 billion in the second quarter of 2008, compared with $2.03 billion in the second quarter of 2007. The increase was due to the expansion of the net interest margin, which increased, on a taxable-equivalent basis, from 2.91% in the second quarter of 2007 to 3.22% in the second quarter of 2008. As the Company's short-term wholesale borrowing costs reprice to current market rates faster than most of its interest-earning assets, the margin was aided by lower short-term interest rates, reflecting the actions taken by the Federal Reserve to stimulate the economy in light of the deteriorating housing market and higher unemployment rates. Since June 30, 2007, the target Federal Funds rate declined from 5.25% to 2.00%.
Noninterest income totaled $561 million in the second quarter of 2008, compared with $1.76 billion in the same quarter of 2007. Results from the sales and servicing of home mortgage loans declined from net revenue of $300 million in the second quarter of 2007 to net expense of $109 million in the second quarter of 2008. Continuing illiquidity in the secondary market for nonconforming loans, along with the Company's decisions to discontinue all lending through the subprime mortgage channel in the fourth quarter of 2007 and the wholesale mortgage channel in April 2008 led to significantly lower mortgage production activity. Additionally, the provision for loan repurchases rose significantly, primarily reflecting an increase in the volume of investor requests to repurchase loans the Company had previously sold. Revenue from the sales and servicing of consumer loans declined from $403 million in the second quarter of 2007 to $159 million in the second quarter of 2008 as the absence of securitization sales activity from the continued illiquid secondary market for unsecured loan products decreased the amount of gain on sale and higher net credit losses on securitized loans lowered excess servicing income. The Company also recorded a $407 million loss through earnings from the write-down of certain mortgage-backed securities within the available-for-sale securities portfolio, reflecting credit deterioration in which the declines in value were determined to represent an other-than-temporary impairment condition.
Noninterest expense totaled $2.40 billion in the second quarter of 2008, compared with $2.14 billion in the second quarter of 2007. With high volumes of delinquent loans migrating to foreclosure status and the steep declines in home prices, foreclosed asset expense increased from $56 million in the second quarter of 2007 to $217 million in the second quarter of 2008. Foreclosure expenses are expected to remain elevated until housing market conditions stabilize. In addition to the actions taken in the fourth quarter of 2007 to resize the home loans business and corporate and other functions, the Company initiated additional measures in the second quarter of 2008 to significantly reduce expenses, primarily within the home loans business and corporate support functions. The Company expects to incur approximately $450 million of restructuring and resizing costs related to these measures, of which $207 million were recorded in the second quarter, and anticipates that annualized expense savings of approximately $1 billion will be realized upon the completion of these initiatives.
Recently Issued Accounting Standards Not Yet Adopted
Refer to Note 1 to the Consolidated Financial Statements – "Summary of Significant Accounting Policies."
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Summary Financial Data
Three Months Ended Six Months Ended June 30, June 30, 2008 2007 2008 2007 (dollars in millions, except per share amounts) Profitability Net interest income $ 2,296 $ 2,034 $ 4,471 $ 4,115 Net interest margin on a taxable-equivalent basis(1) 3.22% 2.91% 3.14% 2.85% Noninterest income $ 561 $ 1,758 $ 2,129 $ 3,299 Noninterest expense 2,403 2,138 4,555 4,244 Net income (loss) (3,328) 830 (4,466) 1,614 Basic earnings per common share $ (6.58) $ 0.95 $ (8.43) $ 1.83 Diluted earnings per common share: Diluted earnings per common share (6.58) 0.92 (8.43) 1.78 Less: Effect of conversion feature(2) (3.24) – (3.51) –
Diluted earnings per common share excluding effect of conversion feature (3.34) 0.92 (4.92) 1.78 Basic weighted average number of common shares outstanding (in thousands) 1,016,081 868,968 936,502 871,876 Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 13 of 18 Total revenue from sales and servicing of home mortgage loans $(109) $ 300 – $ 302 $ 425 (29)
(1) Originated mortgage-backed securities represent available-for-sale securities retained on the balance sheet subsequent to the securitization of mortgage loans that were originated by the Company. (2) Includes contractually specified servicing fees (net of guarantee fees paid to housing government-sponsored enterprises, where applicable), late charges and loan pool expenses (the shortfall of the scheduled interest required to be remitted to investors and that which is collected from borrowers upon payoff).
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The following table presents MSR valuation and the corresponding risk management derivative instruments and securities during the three and six months ended June 30, 2008 and 2007:
Three Months Six Months Ended Ended June 30, June 30, 2008 2007 2008 2007 (in millions) MSR Valuation and Risk Management: Change in MSR fair value due to valuation inputs or assumptions $ 542 $ 530 $ 42 $ 434 Loss on MSR risk management instruments: Revaluation loss from derivatives economically hedging MSR (637) (547) (89) (579) Revaluation loss from certain trading securities (2) (4) (2) –
Total loss on MSR risk management instruments (639) (551) (91) (579)
Total changes in MSR valuation and risk management $ (97) $ (21) $(49) $(145)
The following table reconciles the loss on investment securities that are designated as MSR risk management instruments to loss on trading assets that are reported within noninterest income during the three and six months ended June 30, 2008 and 2007:
Three Months Six Months Ended Ended June 30, June 30, 2008 2007 2008 2007 (in millions) Loss on trading assets resulting from: MSR risk management instruments $ (2) $ (4) $ (2) $ – Other (303) (141) (519) (253)
Total loss on trading assets $(305) $(145) $(521) $(253)
The fair value changes in home mortgage loans held for sale and the offsetting changes in the derivative instruments used as fair value hedges are recorded within gain from home mortgage loans when hedge accounting treatment is achieved. Home mortgage loans held for sale where hedge accounting treatment is not achieved are recorded at the lower of cost or fair value. This accounting method requires declines in the fair value of these loans, to the extent such value is below their cost basis, to be immediately recognized within gain from home mortgage loans, but any increases in the value of these loans that exceed their original cost basis may not be recorded until the loans are sold. However, all changes in the value of derivative instruments that are used to manage the interest rate risk of these loans must be recognized in earnings as those changes occur.
Loss from home mortgage loans and originated mortgage-backed securities, net of hedging and risk management instruments, was $151 million in the second quarter of 2008 compared with a gain of $192 million in the same period of 2007, and a loss of $28 million for the six months ended June 30, 2008, compared with a gain of $286 million for the same period in 2007. The decreases for the three and six months ended June 30, 2008 reflected significantly lower sales and production volume as the Company discontinued all lending through the subprime mortgage channel in the fourth quarter of 2007 and the wholesale mortgage channel in April 2008 and retained more loans in its portfolio in response to the severe contraction in the secondary mortgage markets for substantially all loans not eligible for purchase by the housing government-sponsored enterprises. Also contributing to the decline in performance was an increase in the provision for loan repurchases to $171 million and $227 million for the three and six months ended June 30, 2008 compared with $11 million and $34 million for the
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same periods in 2007, due primarily to an increase in repurchase demands for prime home mortgage loans previously sold. Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 14 of 18 The value of the MSR asset, which is estimated using an OAS valuation methodology classified as Level 3 in the fair value hierarchy, is subject to prepayment risk. Future expected net cash flows from servicing a loan in the servicing portfolio will not be realized if the loan pays off earlier than expected. Moreover, since most loans within the servicing portfolio do not impose prepayment fees for early payoff, a corresponding economic benefit will not be received if the loan pays off earlier than expected. The fair value of the MSR is estimated from the present value of the future net cash flows the Company expects to receive from the servicing portfolio. Accordingly, prepayment risk subjects the MSR to potential declines in fair value. Due to this risk, the realization of future expected net cash flows may differ significantly from period end fair value of the MSR asset.
Home mortgage loan servicing revenue, net of loan payments, increased by $12 million and $93 million for the three and six months ended June 30, 2008, compared with the same periods in 2007. The increase in net servicing revenue between the comparative six month periods was attributable to a slowdown in mortgage prepayments, reflecting diminished opportunities for borrowers to refinance during a period when the housing market is weakening, underwriting standards across the mortgage banking industry have tightened and rates for nonconforming loan products have increased above levels experienced prior to the illiquid secondary market conditions.
MSR valuation and risk management resulted in a loss of $97 million in the second quarter of 2008, compared with a loss of $21 million in the second quarter of 2007 as the decline in the value of MSR risk management instruments more than offset the increase in MSR valuation. Loss from MSR valuation and risk management was $49 million for the six months ended June 30, 2008, compared with $145 million for the same period in 2007. The performance of the MSR risk management instruments was adversely affected by the flat-to-inverted slope of the yield curve during the first quarter of 2007, which had the effect of increasing hedging costs during that period.
All Other Noninterest Income Analysis
Revenue from sales and servicing of consumer loans decreased $244 million for the three months ended June 30, 2008, compared with the same period in 2007, predominantly due to a decline in the performance of the securitized credit card loan portfolio primarily resulting from higher credit costs and a $104 million decrease in gain from securitizations as the Company did not enter into credit card securitization sales during the second quarter of 2008. For the six months ended June 30, 2008, revenue from sales and servicing of consumer loans decreased $439 million compared with the same period in 2007, primarily due to the absence of new credit card securitization sales in the first half of 2008 due to the challenging capital markets environment. This led to a decrease of $259 million in gain from securitizations for the six months ended June 30, 2008, compared with the same period in 2007.
The increase in depositor and other retail banking fees was largely due to higher transaction fees and an increase in the number of noninterest- bearing checking accounts. The number of noninterest-bearing retail checking accounts at June 30, 2008 totaled approximately 11.6 million compared with approximately 10.4 million at June 30, 2007.
Loss on trading assets increased $160 million for the three months ended June 30, 2008, compared with the same period in 2007, primarily due to a decline in the value of retained interests from credit card securitizations reflecting unfavorable market conditions. The increase in loss on trading assets for the first half of 2008, compared with the same period in 2007, was a result of downward adjustments to the fair value of trading assets backed by Alt-A loans and the decrease in the value of retained interests from credit card securitizations.
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The Company recognized impairment losses of $407 million and $474 million for the three and six months ended June 30, 2008 on certain mortgage-backed securities where the Company determined that the decline in the fair value of the securities below their amortized cost represented an other-than-temporary condition. Partially offsetting the impairment losses for the six months ended June 30, 2008 was a realized net gain on sale of available-for-sale securities of $90 million driven by higher sales volume.
During the second quarter of 2008, the Company retired approximately $1.11 billion of Washington Mutual's senior and subordinated debt reflecting the reduction in the Company's funding requirements resulting from the reduction of the balance sheet in the first half of 2008. These senior and subordinated debts were retired at a discounted value resulting in a gain on extinguishment of borrowings of $99 million in the second quarter of 2008.
The decrease in other income of $127 million and $119 million for the three and six months ended June 30, 2008, compared with the same periods in 2007, primarily resulted from revaluation losses on derivatives held for interest-rate risk management purposes, and a $55 million downward adjustment on the price protection feature related to the capital issuance in April 2008. See Note 6 to the Consolidated Financial Statements – "Equity Issuance" for the details of the price protection feature.
Noninterest Expense Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 15 of 18 primarily due to reduced gain on sale resulting from the absence of securitization sale activity in 2008 and higher market valuation losses on retained interests. Also contributing to the decrease was lower excess servicing, which was partially offset by the recognition of an $85 million pretax gain from the redemption of a portion of the Company's shares associated with the Visa initial public offering in March 2008 and an increase in fee income.
The decrease in noninterest expense during the six months ended June 30, 2008, compared with the same period in 2007, was significantly due to a $38 million partial recovery of the Visa-related litigation expense recorded during the second half of 2007 and lower marketing expenses. These were partially offset by higher compensation costs related to an increase in the number of employees.
Commercial Group
Three Months Ended Six Months Ended June 30, Percentage June 30, Percentage 2008 2007 Change 2008 2007 Change (dollars in millions) Condensed income statement: Net interest income $ 203 $ 208 (3)%$ 400 $ 420 (5)% Provision for loan losses 17 2 607 47 (7) – Noninterest income 5 63 (93) (3) 78 – Noninterest expense 63 74 (15) 131 148 (12)
Income before income taxes 128 195 (35) 219 357 (39) Income taxes 41 73 (44) 70 134 (48)
Net income $ 87 $ 122 (29) $ 149 $ 223 (33)
Performance and other data: Efficiency ratio 30.34% 27.42% 11 33.07% 29.89% 11 Average loans $41,891 $38,789 8 $41,413 $38,715 7 Average assets 43,875 41,184 7 43,439 41,094 6 Average deposits 6,632 15,294 (57) 7,053 13,671 (48) Loan volume 3,768 4,348 (13) 6,603 8,018 (18) Employees at end of period 1,342 1,508 (11) 1,342 1,508 (11)
The decrease in net interest income for the three and six months ended June 30, 2008, compared with the same periods in 2007, was substantially due to lower funds transfer credits on lower average balances of deposits attributable to the winding-down of the mortgage banker finance warehouse lending operations in the fourth quarter of 2007. Largely offsetting this decrease was higher net interest income from $3.10 billion growth in the average balance of loans in the second quarter of 2008 compared with the same period in 2007, predominantly in multi- family and non-residential loans.
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The increase in the provision for loan losses was due to higher reserve requirements reflecting higher unemployment rates in portfolio concentration areas, increased delinquencies and higher loan balances. Net charge-offs have remained relatively low at $7 million in the first half of 2008.
The decrease in noninterest income was predominantly due to lower gain on sale resulting from reduced sales volume of multi-family and commercial loans in 2008.
Noninterest expense declined during the three and six months ended June 30, 2008, compared with the same periods in 2007, substantially due to the decision to scale back presence in non-core markets resulting in a decrease in employee compensation and benefits expense due to the reduction in the number of employees and a decrease in occupancy expense.
Home Loans Group
Three Months Ended Six Months Ended June 30, Percentage June 30, Percentage 2008 2007 Change 2008 2007 Change (dollars in millions) Condensed income statement: Net interest income $ 240 $ 211 13% $ 490 $ 455 8% Provision for loan losses 1,637 101 – 2,544 150 – Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 16 of 18 Noninterest income (97) 389 – 221 550 (60) Inter-segment expense 2 16 (86) 6 34 (83) Noninterest expense 484 547 (12) 983 1,069 (8)
Loss before income taxes (1,980) (64) – (2,822) (248) – Income taxes (635) (24) – (904) (93) 871
Net loss $ (1,345) $ (40) – $ (1,918) $ (155) –
Performance and other data: Efficiency ratio 344.70% 93.71% 268 139.26% 110.07% 27 Average loans $54,880 $43,312 27 $55,275 $48,255 15 Average assets 65,074 60,342 8 65,958 65,831 – Average deposits 5,202 8,372 (38) 5,335 8,436 (37) Loan volume 8,462 35,938 (76) 22,236 69,718 (68) Employees at end of period 7,338 13,150 (44) 7,338 13,150 (44)
The increase in net interest income during the second quarter of 2008, compared with the second quarter of 2007, was primarily due to the increase of $14.28 billion in average balances of prime home mortgage loans. Beginning in July 2007, the Home Loans Group began retaining these home mortgage loans within its portfolio. Also contributing to the increase were lower funds transfer pricing charges on the MSR asset. These increases were substantially offset by lower net interest income resulting from a decline in average balances of custodial and escrow deposits.
The provision for loan losses increased in response to higher levels of delinquencies and loss severity rates as a result of deteriorating housing market conditions. Due to declining home values and reduced availability of credit throughout the mortgage market, borrowers who become delinquent are less likely to be able to cure their loans through sale or refinancing, resulting in increased foreclosures and charge-offs.
The decrease in noninterest income for the second quarter of 2008, compared with the same period in 2007, was largely due to reduced gain on sale resulting from higher provision for loan repurchases and lower volumes in the mortgage origination pipeline, as well as lower inter- segment sales. Higher delinquencies drove increased repurchase requests from investors resulting in an increase in the provision for repurchase reserves.
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The decrease in noninterest income for the six months ended June 30, 2008, compared with the same period in 2007, was significantly driven by reduced gain on sale due to higher repurchase reserves and lower volumes. Also contributing to the decrease were increased losses from trading securities stemming from credit downgrades and widening spreads. These decreases were partially offset by the write-down of trading assets retained from subprime mortgage securitizations that occurred in the first half of 2007.
The decrease in noninterest expense for the three and six months ended June 30, 2008, compared with the same periods in 2007, was primarily due to a reduction in the number of employees and locations, resulting from the initiatives to resize the home loans business. This decrease was largely offset by higher foreclosed asset expense as a result of the downturn in the housing market and increased number of foreclosures. Foreclosed asset expense totaled $149 million and $267 million for the three and six months ended June 30, 2008, compared with $47 million and $80 million for the same periods in 2007.
Corporate Support/Treasury and Other
Three Months Ended June 30, Percentage Six Months Ended June 30, Percentage 2008 2007 Change 2008 2007 Change (dollars in millions) Condensed income statement: Net interest income (expense) $ 254 $ (4) –% $ 386 $ (26) –% Provision for loan losses 55 (51) – 173 (25) – Noninterest income (327) 60 – (241) 154 – Noninterest expense 327 80 312 431 191 126 Minority interest expense 75 42 78 151 85 77
Loss before income taxes (530) (15) – (610) (123) 396 Income taxes (247) (37) 573 (316) (106) 199
Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 17 of 18 Net income (loss) $ (283) $ 22 – $ (294) $ (17) –
Performance and other data: Average loans $ 1,648 $ 1,367 21 $ 1,602 $ 1,356 18 Average assets 47,151 41,789 13 46,338 41,335 12 Average deposits 23,267 37,847 (39) 23,947 42,002 (43) Loan volume 84 72 17 226 179 26 Employees at end of period 3,721 3,981 (7) 3,721 3,981 (7)
The increase in net interest income was primarily due to improved spreads on lower cost borrowings. Also contributing to the increase was higher yields and lower funds transfer charges on available-for-sale securities.
The decline in noninterest income was primarily due to a $407 million other-than-temporary impairment in the Company's available-for-sale securities portfolio during the three months ended June 30, 2008. Also contributing to the decline was a $55 million downward adjustment on the price protection feature derivative related to the capital issuance in April 2008. Partially offsetting the decrease were gains resulting from the early retirement of $1.11 billion of Washington Mutual's senior and subordinated debts.
The increase in noninterest expense was primarily due to $204 million in charges related to the Company's second quarter 2008 restructuring efforts.
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Off-Balance Sheet Activities
The Company transforms loans into securities through a process known as securitization. When the Company securitizes loans, the loans are usually sold to a qualifying special-purpose entity ("QSPE"), typically a trust. The QSPE, in turn, issues securities, commonly referred to as asset- backed securities, which are secured by future cash flows on the sold loans. The QSPE sells the securities to investors, which entitle the investors to receive specified cash flows during the term of the security. The QSPE uses the proceeds from the sale of these securities to pay the Company for the loans sold to the QSPE. These QSPEs are not consolidated within the financial statements since they satisfy the criteria established by Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. In general, these criteria require the QSPE to be legally isolated from the transferor (the Company), be limited to permitted activities, and have defined limits on the types of assets it can hold and the permitted sales, exchanges or distributions of its assets.
When the Company sells or securitizes loans that it originated, it generally retains the right to service the loans and may retain senior, subordinated, residual, and other interests, all of which are considered retained interests in the sold or securitized assets. Retained interests in mortgage loan securitizations, excluding the rights to service such loans, were $1.23 billion at June 30, 2008, of which $1.13 billion are of investment-grade quality. Retained interests in credit card securitizations were $1.56 billion at June 30, 2008, of which $421 million are of investment-grade quality. Additional information concerning the pretax gains, cash flows, servicing fees, principal and interest received on and valuation of retained interests and loan repurchases, in each case, arising from the Company's securitization activities is included in Note 7 to the Consolidated Financial Statements – "Securitizations" in the Company's 2007 Annual Report on Form 10-K/A. Additional information concerning the revenue and expenses from the sales and servicing of home mortgage loans, including the effects of derivative risk management instruments is included in Note 8 to the Consolidated Financial Statements – "Mortgage Banking Activities" in the Company's 2007 Annual Report on Form 10- K/A.
American Securitization Forum Framework
In December 2007, the American Securitization Forum ("ASF"), working with various constituency groups as well as representatives of U.S. Federal government agencies, issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the "ASF Framework"). On January 8, 2008, the Securities and Exchange Commission's (the "SEC") Office of the Chief Accountant (the "OCA") issued a letter (the "OCA Letter") addressing accounting issues that may be raised by the ASF Framework. The OCA Letter expressed the view that if a subprime ARM loan made to a Segment 2 borrower, as described below, is modified in accordance with the ASF Framework and that loan could be legally modified, the OCA would not object to continued status of the transferee as a QSPE under Statement No. 140.
The parameters of the ASF Framework were designed by the ASF to improve administrative efficiency while still maximizing cash flows to the QSPEs in which residential mortgage loans were transferred upon securitization by stratifying subprime borrowers into the following segments: borrowers that can refinance into readily available mortgage industry products ("Segment 1"); borrowers that have demonstrated the ability to pay their introductory rates, are unable to refinance and are unable to afford their reset rates ("Segment 2"); and borrowers that require in-depth, case- Case 1:09-cv-01656-RMC Document 54-5 Filed 11/22/10 Page 18 of 18 1. Amendment to the Company's Amended and Restated Articles of Incorporation to 735,441,135 25,007,544 10,478,751 increase the number of authorized shares of common stock from 1,600,000,000 to 3,000,000,000
For Against Abstain 2. Authorization for Conversion of Series S and Series T Contingent Convertible 737,547,392 22,584,827 10,795,211 Perpetual Non-Cumulative Preferred Stock into common stock and exercise of warrants to purchase common stock
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Item 6. Exhibits
(a) Exhibits
See Index of Exhibits on page 97.
95
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 11, 2008.
WASHINGTON MUTUAL, INC.
By: /s/ THOMAS W. CASEY
Thomas W. Casey Executive Vice President and Chief Financial Officer
By: /s/ MELISSA J. BALLENGER
Melissa J. Ballenger Senior Vice President and Controller (Principal Accounting Officer)
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WASHINGTON MUTUAL, INC. INDEX OF EXHIBITS
Exhibit No. 3.1 Amended and Restated Articles of Incorporation of the Company, as amended (Filed herewith).
3.2 Restated Bylaws of the Company (Filed herewith).
4.1 The Company will furnish upon request copies of all instruments defining the rights of holders of long-term debt instruments of the Company and its consolidated subsidiaries.
4.2 Form of Warrant to purchase common stock of the Company issued to certain investors under the Investment Agreement dated as of Case 1:09-cv-01656-RMC Document 54-6 Filed 11/22/10 Page 1 of 26
EXHIBIT 3
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OFFICE OF THRIFT SUPERVISION Washington, D.C. 20552
FORM 10-K ______
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR FISCAL YEAR ENDED DECEMBER 31, 2007
OTS Docket Number 08551 WASHINGTON MUTUAL BANK (Exact name of registrant as specified in its charter) ______
Federal Charter 68-0172274 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification Number)
1301 Second Avenue, Seattle, WA 98101 (Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: (206) 461-2000 ______
Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes No 7. Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes No 7. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes 7 No . Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 7. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer Accelerated filer Non-accelerated filer 7 Smaller reporting company . (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No 7. The aggregate market value of voting stock held by nonaffiliates of the registrant as of June 30, 2007: None The number of shares outstanding of the issuer’s classes of common stock as of February 29, 2008: Common Stock — 331,386 Documents Incorporated by Reference: None Note: Registrant meets the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and is therefore filing this Form with the reduced disclosure format.
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WASHINGTON MUTUAL BANK 2006 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
Page PART I...... 1 Item 1. Business...... 1 General...... 1 Sources of Funds...... 3 Available Information...... 3 Employees...... 3 Environmental Regulation ...... 4 Regulation and Supervision ...... 4 Item 1A. Risk Factors ...... 9 Item 1B. Unresolved SEC Staff Comments(1) ...... – Item 2. Properties...... 8 Item 3. Legal Proceedings...... 8 PART II ...... 9 Item 5. Market for Washington Mutual Bank’s Common Equity and Related Stockholder Matters...... 9 Item 7. Management’s Discussion and Analysis of Results of Operations...... 10 Controls and Procedures ...... 10 Overview...... 10 Critical Accounting Estimates ...... 12 Recently Issued Accounting Standards Not Yet Adopted...... 16 Earnings Performance...... 17 Risk Management ...... 24 Credit Risk Management ...... 25 Liquidity Risk and Capital Management ...... 37 Market Risk Management...... 39 Operational Risk Management...... 45 Goodwill Litigation...... 45 Factors that May Affect Future Results ...... 47 Item 7A. Quantitative and Qualitative Disclosures about Market Risk ...... 39 Item 8. Financial Statements...... 56 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ...... 56 Item 9A. Controls and Procedures ...... 10 Item 9B. Other Information ...... 56 PART III...... 56 Item 14. Principal Accountant Fees and Services ...... 56 PART IV...... 57 Item 15. Exhibits, Financial Statement Schedules ...... 57 ______(1) None.
Note: Items 4, 6, 10, 11, 12 and 13 are not included, as per conditions met by the Registrant set forth in General Instruction I (1)(a) and (b) of Form 10-K.
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PART I
BUSINESS General Washington Mutual Bank (together with its subsidiaries, “WMB” or the “Bank”) is a federally chartered savings association committed to serving consumers and small businesses. The Bank accepts deposits from the general public, originates, purchases, services and sells home loans, makes credit card, home equity, multi-family and other commercial real estate loans, and to a lesser extent, engages in certain commercial banking activities such as providing credit facilities and cash management and deposit services. The Bank also markets annuities and other insurance products and offers securities brokerage services. The Bank is a direct, wholly-owned subsidiary of Washington Mutual, Inc. (“Washington Mutual” or the “Company”). In the past six years, the Bank’s assets have grown primarily through business combinations. On January 4, 2002, Washington Mutual completed its acquisition of New York-based Dime Bancorp, Inc. The Dime Savings Bank of New York, FSB, a federally chartered savings bank and principal subsidiary of Dime Bancorp was merged into WMB. In two transactions during 2002, WMB purchased HomeSide Lending, Inc., the U.S. mortgage unit of National Australia Bank Limited. On October 1, 2005, Washington Mutual acquired Providian Financial Corporation, a credit card lender, thereby entering the credit card lending business. Concurrently, Providian National Bank (“Providian”), a national banking association and principal subsidiary of Providian Financial Corporation, was merged into WMB. On October 1, 2006 Washington Mutual completed its acquisition of Commercial Capital Bancorp, Inc. (“CCB”), a multi-family and small commercial real estate lending institution located in Southern California, and Commercial Capital Bank, FSB, a federally chartered saving bank and principal subsidiary of CCB, was merged into WMB. On January 1, 2005, the former Washington Mutual Bank, a subsidiary of Washington Mutual, merged into Washington Mutual Bank, FA and ceased to exist; subsequently, Washington Mutual Bank, FA changed its name to WMB. The subsidiary companies of the former Washington Mutual Bank were transferred at the same time and became subsidiaries of WMB. On July 1, 2005, WaMu Capital Corporation, another subsidiary of Washington Mutual, became a subsidiary of WMB. On March 1, 2006, Long Beach Mortgage, an originator of loans to subprime borrowers and another subsidiary of Washington Mutual, became a subsidiary of WMB. On November 1, 2007, New American Capital, Inc. (“NACI”), which had been a direct subsidiary of Washington Mutual and the parent company of WMB, merged into an interim subsidiary of WMB. Immediately thereafter, the interim subsidiary of WMB distributed all of its assets to WMB and as a result, NACI ceased to exist as a separate corporation and WMB became a direct subsidiary of Washington Mutual. Residential Lending The Bank’s principal residential lending activities are comprised of originating and servicing home loans, buying and selling home loans in the secondary market, managing the home loan portfolio and originating home equity loans and lines of credit. The Bank’s products are offered to customers through multiple distribution channels including 2,257 retail banking stores, 158 retail home loan stores, 24 wholesale home loan centers, telephone call centers and online banking. The Bank’s home loan products include: • Fixed-rate home loans;
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• Adjustable-rate home loans or “ARMs” (where the interest rate may be adjusted as frequently as every month); • Hybrid home loans (where the interest rate is fixed for a predetermined time period, typically 3 to 5 years, and then converts to an ARM that reprices monthly or annually, depending on the product); and • Option ARM loans (where borrowers have the option of making a minimum payment that can result in unpaid interest being deferred and added to the principal balance of the loan.) Home loans are either originated or purchased, and are either held in portfolio or sold to institutional investors in the secondary market, including the housing government-sponsored enterprises – such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). The decision to retain or sell home loans, with the retention of servicing, is dependent upon the existence of liquidity in the secondary market, and involves the analysis and comparison of expected interest income and the interest rate and credit risks inherent with holding loans in portfolio, with the expected servicing fees, the size of the gain or loss that would be realized if the loans were sold and the expected expense of managing the risk related to any retained mortgage servicing rights. All loans, whether originated or purchased, are subject to the same nondiscriminatory underwriting standards. When originating home loans, the Bank follows established lending policies and procedures that require consideration of an applicant’s credit profile relative to the size and characteristics of the loan. Mortgage servicing involves the administration and collection of home loan payments. When loans are sold into the secondary market, the Bank generally retains the right to service those loans and hence retains the customer relationship. The Bank intends to use these customer relationships to cross-sell additional products and services. During the fourth quarter of 2007, Washington Mutual announced that, in response to a fundamental shift in the home mortgage market due to credit dislocation and a prolonged period of reduced capital markets liquidity, it significantly changed the strategic focus of its Home Loans business to accelerate its alignment with the Bank’s retail banking operations. As part of these restructuring activities, the Bank discontinued all remaining lending through its subprime mortgage channel, closed approximately 200 home loan locations, including 190 home loan centers and sales offices and nine home loans processing and call centers, eliminated approximately 2,600 positions in the Home Loans business, initiated the closure of WaMu Capital Corp., its institutional broker-dealer business, and began winding-down its mortgage banker finance warehouse lending operation. Multi-family Lending The Bank provides financing to developers and investors for multi-family dwellings and, to a lessor extent, other commercial properties. The multi-family lending program is comprised of three key activities: originating and managing loans retained in the loan portfolio, servicing all originated loans, whether they are retained or sold, and providing ancillary banking services to enhance customer retention. Retail Banking The Bank offers a comprehensive line of deposit and other retail banking products and services to consumers and small businesses. Deposit products offered by the Bank in all of its stores include its signature free checking and interest-bearing Platinum checking accounts, as well as other personal checking, savings, money market deposit and time deposit accounts.
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Consumer Lending The Bank’s primary consumer lending activities include originating and servicing credit card loans. Credit card operations target customers by leveraging the Bank’s retail banking distribution network and through direct mail solicitations, augmented by online and telemarketing activities and other marketing programs including affinity programs. In addition to credit cards, the Bank also markets a variety of other products to its customer base. Sources of Funds Deposits The Bank offers various consumer and business deposit products, including checking accounts, savings accounts, money market deposit accounts and time deposits. Custodial/escrow deposits related to the Bank’s loan servicing activities are a component of time deposits. The Bank offers interest-bearing and noninterest-bearing checking accounts. The Bank assesses monthly service charges on interest-bearing checking accounts, unless the depositor maintains a minimum balance. The Bank assesses no monthly fees on the vast majority of its noninterest-bearing checking accounts. Checking accounts, savings accounts and money market deposit accounts generally have the benefit of lower interest costs, compared with time deposit accounts. Even though checking, savings and money market deposits are more liquid, the Bank considers them to be the key relationship with its customers. Borrowings The Bank’s wholesale borrowings predominantly take the form of repurchase agreements and advances from the Federal Home Loan Banks (“FHLBs”) of San Francisco and Seattle. The exact mix of these two types of wholesale borrowings at any given time is dependent upon the market pricing and availability of the individual borrowing sources. The Bank actively engages in repurchase agreements with authorized broker-dealers and major customers. This activity involves selling debt securities under agreements to repurchase them at a future date. The Bank is a member of the FHLB of San Francisco and the FHLB of Seattle, and maintains a credit line that is a percentage of its total regulatory assets. Each institution obtaining FHLB advances is required to enter into a written agreement with the lending FHLB under which the borrowing institution is primarily and unconditionally obligated to repay such advances and all other amounts owed to the lending FHLB. All advances must be fully secured by eligible collateral. Eligible collateral includes all stock owned in the FHLB, deposits with the FHLB, and certain mortgages or deeds of trust and securities of the U.S. Government and its agencies. Available Information Washington Mutual has implemented a Code of Ethics applicable to senior financial officers of the Bank and a Code of Conduct applicable to all Bank officers, employees and directors. The Code of Ethics provides fundamental ethical principles to which Bank senior financial officers are expected to adhere. The Code of Conduct operates as a tool to help Bank officers, employees and directors understand and adhere to the high ethical standards required for employment by, or association with, the Bank. Both the Code of Ethics and the Code of Conduct are available on Washington Mutual’s website at www.wamu.com/ir. Employees At December 31, 2007, WMB had 49,351 employees compared with 49,541 employees at December 31, 2006, and 60,567 employees at December 31, 2005. During 2006, the number of employees decreased due to the implementation of various productivity, efficiency and outsourcing initiatives. The
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Bank believes that it has been successful in attracting quality employees and that employee relations are good. On December 10, 2007, Washington Mutual announced in a current report on Form 8-K that it was eliminating approximately 3,200 positions, largely due to the announced restructuring of the Home Loans business. The majority of these employees were terminated during the first quarter of 2008. Environmental Regulation The Bank’s business and properties are subject to federal and state laws and regulations governing environmental matters, including the regulation of hazardous substances and waste. For example, under the Federal Comprehensive Environmental Response, Compensation, and Liability Act and similar state laws, owners and operators of contaminated properties may be liable for the costs of cleaning up hazardous substances without regard to whether such persons actually caused the contamination. Such laws may affect the Bank both as an owner or former owner of properties used in or held for its business, and as a secured lender on property that is found to contain hazardous substances or waste. The Bank’s general policy is to obtain an environmental assessment prior to foreclosing on commercial property. The Bank may elect not to foreclose on properties that contain such hazardous substances or waste, thereby limiting, and in some instances precluding, the disposition of such properties. Regulation and Supervision The following discussion describes elements of the extensive regulatory framework applicable to savings and loan holding companies as well as federal savings associations. This regulatory framework is primarily intended for the protection of depositors, the federal deposit insurance fund and the banking system as a whole rather than for the protection of shareholders and creditors. To the extent that this section describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Those statutes and regulations, as well as related policies, are subject to change by U.S. Congress, state legislatures and federal and state regulators. Changes in statutes, regulations or regulatory policies, including interpretation or implementation thereof, could have a material effect on the Bank’s business. General WMB is a federal savings association and is subject to regulation and examination by the Office of Thrift Supervision (the “OTS”), its primary federal regulator, as well as the Federal Deposit Insurance Corporation (“FDIC”). Deposits at the Bank are insured by the FDIC. If an insured institution fails, claims for administrative expenses of the receiver and for deposits in U.S. branches (including claims of the FDIC as subrogee of the failed institution) have priority over the claims of general unsecured creditors. In addition, the FDIC has authority to require the Bank to reimburse the FDIC for losses it incurs in connection with the failure of a commonly controlled bank or savings association or with an FDIC provision of assistance granted to a commonly controlled bank or savings association that is in danger of failure. Since WMB and Washington Mutual Bank fsb (“WMBfsb”) are owned by Washington Mutual, Inc., they are commonly controlled institutions. Payment of Dividends Federal laws limit the amount of dividends or other capital distributions that a federal savings association, such as the Bank, can pay. In addition, the Bank must file an application for approval or notice with the OTS at least 30 days before it may pay dividends to its parent company. Refer to Note 20 to the Consolidated Financial Statements – “Regulatory Capital Requirements and Dividend Restrictions” for a more detailed description of the limits on the dividends the Bank can pay. Capital Adequacy WMB and its banking subsidiary, WMBfsb, are subject to OTS capital requirements. Federal law and OTS regulations have established four ratios for measuring an institution’s capital adequacy: A
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risk liabilities; other-than-temporary impairment losses on available-for-sale securities; and the determination of whether a derivative qualifies for hedge accounting. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Bank’s Board of Directors. The Bank believes that the judgments, estimates and assumptions used in the preparation of its financial statements are appropriate given the facts and circumstances as of December 31, 2007. The nature of these judgments, estimates and assumptions are described in greater detail in subsequent sections of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies.” The discussion below presents information about the nature of the Bank’s critical accounting estimates: Fair Value of Certain Financial Instruments and Other Assets A portion of the Bank’s assets are carried at fair value, including: mortgage servicing rights, trading assets including certain retained interests from securitization activities, available-for-sale securities and derivatives. In addition, loans held for sale are recorded at the lower of cost or fair value. Changes in fair value of those instruments that qualify as hedged items under fair value hedge accounting are recognized in earnings and offset the changes in fair value of derivatives used as hedge accounting instruments. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Generally, for assets that are reported at fair value, the Bank uses quoted market prices or internal valuation models to estimate their fair value. These models incorporate inputs such as forward yield curves, loan prepayment assumptions, market volatilities and pricing spreads utilizing market-based inputs where readily available. The degree of management judgment involved in estimating the fair value of a financial instrument or other asset is dependent upon the availability of quoted market prices or observable market value inputs. For financial instruments that are actively traded in the marketplace or whose values are based on readily available market value data, little judgment is necessary when estimating the instrument’s fair value. When observable market prices and data are not readily available, significant management judgment often is necessary to estimate fair value. In those cases, different assumptions could result in significant changes in valuation. During the latter half of 2007, deteriorating credit conditions caused significant disruptions in the secondary mortgage market. Credit quality concerns prompted market participants to avoid purchasing mortgage investment products backed by nonconforming loan collateral. As market activity slowed, the availability of observable market prices was reduced. Accordingly, there was less market data available for use by management in the judgments applied to key valuation inputs. The following financial instruments and other assets require the Bank’s most complex judgments and assumptions when estimating fair value: Mortgage Servicing Rights and Certain Other Retained Interests in Securitizations In June 2007, the Bank implemented a model that is based on an option-adjusted spread (“OAS”) valuation methodology to estimate the fair value of substantially all of its MSR asset. The model projects cash flows over multiple interest rate scenarios and discounts these cash flows using risk-adjusted discount rates. Additionally, an independent broker estimate of the fair values of the mortgage servicing rights is obtained quarterly along with other market-based evidence. Management uses this information together with its OAS valuation methodology to estimate the fair value of the MSR. Models used to value MSR assets, including those employing an OAS valuation methodology, are highly sensitive to changes in certain assumptions. Different expected prepayment speeds, in particular, can result in substantial changes in the estimated fair value of MSR. If actual prepayment experience differs materially from the expected prepayment speeds used in the Bank’s model, this difference may result in a material change in MSR fair value.
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Changes in MSR value are reported in the Consolidated Statements of Income under the noninterest income caption “Revenue from sales and servicing of home mortgage loans.” Additional discussion regarding the estimation of MSR fair value, including limitations to the MSR fair value measurement process, are described in the subsequent section of Management’s Discussion and Analysis – “Earnings Performance.” Key economic assumptions and the sensitivity of MSR fair value to immediate changes in those assumptions are described in Note 9 to the Consolidated Financial Statements – “Mortgage Banking Activities.” For other retained interests in securitization activities (such as interest-only strips and residual interests in mortgage and credit card securitizations), the discounted cash flow model used in estimating fair value utilizes projections of expected cash flows that are greatly influenced by expected prepayment speeds and, in some cases, expected net credit losses or finance charges related to the securitized assets. Key economic assumptions and the sensitivity of retained interests fair value to immediate changes in those assumptions are described in Note 8 to the Consolidated Financial Statements – “Securitizations.” Changes in those and other assumptions used could have a significant effect on the valuation of these retained interests. Changes in the value of other retained interests in securitization activities are reported in the Consolidated Statements of Income under the noninterest income caption “Loss on trading assets” and in the Consolidated Statements of Financial Condition as “Trading assets.” Loans held for sale The fair value of loans designated as held-for-sale is generally based on observable market prices of securities that have loan collateral or interests in loans that are similar to the held-for-sale loans or whole loan sale prices if formally committed. If market prices are not readily available, fair value is based on a discounted cash flow model, which considers expected prepayment factors and the degree of credit risk associated with the loans and the estimated effects of changes in market interest rates relative to the loans’ interest rates. When the estimated fair value of loans held for sale is lower than their cost, including adjustments to cost if the loans were in a fair value hedge relationship under Financial Accounting Standards Board (“FASB”) Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (“Statement No. 133”), a valuation adjustment that accounts for this difference is reported in the Consolidated Statements of Income as a component within the noninterest income caption “Revenue from sales and servicing of home mortgage loans” for home loans. Valuation adjustments for consumer loans held for sale are recorded under the noninterest income caption “Revenue from sales and servicing of consumer loans.” Valuation adjustments for multi-family and commercial real estate loans held for sale are recorded under the noninterest income caption “Other income.” Fair Value of Reporting Units and Goodwill Impairment Under FASB Statement No. 142, Goodwill and Other Intangible Assets, goodwill must be allocated to reporting units and tested for impairment. Goodwill is tested for impairment at least annually or more frequently if events or circumstances, such as adverse changes in the business, indicate that there may be justification for conducting an interim test. Impairment testing is performed by Washington Mutual at the reporting unit level. The first part of the test is a comparison, at the reporting unit level, of the fair value of each reporting unit to its carrying value, including goodwill. If the fair value is less than the carrying value, then the second part of the test is needed to measure the amount of potential goodwill impairment. The implied fair value of the reporting unit goodwill is calculated and compared with the actual carrying value of goodwill recorded within the reporting unit. If the carrying value of reporting unit goodwill exceeds the implied fair value of that goodwill, then an impairment loss would be recognized for the amount of the difference, which would be recorded as a charge against net income. The fair value of the reporting units are determined primarily using discounted cash flow models based on each reporting unit’s internal forecasts. In addition, analysis using market-based trading and transaction multiples, where available, is used to assess the reasonableness of the valuations derived from the discounted cash flow models. For additional information regarding the carrying value of goodwill, see Note 10 to the Consolidated Financial Statements – “Goodwill and Other Intangible Assets.”
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Allowance for Loan Losses and Contingent Credit Risk Liabilities Allowance for Loan Losses The allowance for loan losses represents management’s estimate of incurred credit losses inherent in the Bank’s loan portfolio as of the balance sheet date. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. Subsequent evaluations of the loan portfolio, in light of the factors then prevailing, may result in significant changes in the allowance for loan losses in future periods. The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower’s ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and unemployment levels have on a borrower’s ability to repay adjustable-rate loans. The Bank allocates a portion of the allowance to the homogeneous loan portfolios and estimates this allocated portion using statistical estimation techniques. Loss estimation techniques used in statistical models are supplemented by qualitative information to assist in estimating the allocated allowance. When housing prices are volatile, lags in data collection and reporting increase the likelihood of adjustments being made to the allowance. The Bank also estimates an unallocated portion of the allowance that reflects management’s assessment of various risk factors that are not fully captured by the statistical estimation techniques used to determine the allocated component of the allowance. The following factors are routinely and regularly reviewed in estimating the appropriateness of the unallocated allowance: national and local economic trends and conditions (such as gross domestic product and unemployment trends); market conditions (such as changes in housing prices); industry and borrower concentrations within portfolio segments (including concentrations by metropolitan statistical area); recent loan portfolio performance (such as changes in the levels and trends in delinquencies and impaired loans); trends in loan growth (including the velocity of change in loan growth); changes in underwriting criteria; and the regulatory and public policy environment. The allowance for loan losses is reported in the Consolidated Statements of Financial Condition and the provision for loan losses is reported in the Consolidated Statements of Income. The estimates and judgments are described in further detail in the subsequent section of Management’s Discussion and Analysis – “Credit Risk Management” and in Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies.” Contingent Credit Risk Liabilities In the ordinary course of business, the Bank sells loans to third parties and in certain circumstances, such as in the event of early or first payment default, retains credit risk exposure on those loans. The Bank may also be required to repurchase sold loans when representations and warranties made by the Bank in connection with those sales are breached. Under certain circumstances, such as when a loan sold to an investor and serviced by the Bank fails to perform according to its contractual terms within the six months after its origination or upon written request of the investor, the Bank will review the loan file to determine whether or not errors may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a violation of a representation or warranty made to the investor in connection with the Bank’s sale of the loan, then the Bank will be required to either repurchase the loan or indemnify the investor for losses sustained if the violation had a material adverse effect on the value of the loan. Reserves are established for the Bank’s exposure to the potential repurchase or indemnification liabilities described above and such liabilities are initially recorded at fair value. Throughout the life of these repurchase or indemnification liabilities, the Bank may learn of additional information that can affect the assessment of loss probability or the estimation of the amounts involved. Changes in these assessments can lead to significant changes in the recorded reserves. Repurchase and indemnification
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liabilities are recorded within other liabilities in the Consolidated Statements of Financial Condition, and losses are recorded in the Consolidated Statements of Income under the noninterest income caption “Revenue from sales and servicing of home mortgage loans.” Impairment of Securities The Bank monitors securities in its available-for-sale investment portfolio for impairment. Impairment may result from credit deterioration of the issuer, from changes in market rates relative to the interest rate of the instrument, or from changes in prepayment speeds. The Bank considers many factors in determining whether the impairment is other than temporary, including but not limited to adverse changes in expected cash flows, the length of time the security has had a fair value less than the cost basis, the severity of the unrealized loss, the Bank’s intent and ability to hold the security for a period of time sufficient for a recovery in value and issuer-specific factors such as the issuer’s financial condition, external credit ratings and general market conditions. The determination of other-than-temporary impairment is a subjective process, requiring the use of judgments and assumptions in interpreting relevant market data. Other-than-temporary valuation losses on available-for-sale securities are reported in the Consolidated Statements of Income under the noninterest income caption “Loss on other available- for-sale securities.” For additional information regarding the amortized cost, unrealized gains, unrealized losses, and fair value of securities, see Note 6 to the Consolidated Financial Statements – “Available-for- Sale Securities.” Derivatives and Hedging Activities The Bank enters into derivative contracts to manage the various risks associated with certain assets, liabilities, or probable forecasted transactions. When the Bank enters into derivative contracts, the derivative instrument is designated as: (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (a “fair value” hedge); (2) a hedge of the variability in expected future cash flows associated with an existing recognized asset or liability or a probable forecasted transaction (a “cash flow” hedge); or (3) held for other risk management purposes (“risk management derivatives”). All derivatives, whether designated in hedging relationships or not, are recorded at fair value as either assets or liabilities in the Consolidated Statements of Financial Condition. Changes in fair value of derivatives that are not in hedge accounting relationships (as in (3) above) are recorded in the Consolidated Statements of Income in the period in which the change in value occurs. Changes in the fair value of derivatives that are designated as cash flow hedges (as in (2) above), to the extent such hedges are deemed highly effective, are recorded as a separate component of accumulated other comprehensive income and reclassified into earnings when the earnings effect of the hedged cash flows is recognized. Changes in the fair value of derivatives in qualifying fair value hedge accounting relationships (as in (1) above) are recorded each period in earnings along with the change in fair value of the hedged item attributable to the risk being hedged. The determination of whether a derivative qualifies for hedge accounting requires complex judgments about the application of Statement No. 133. Additionally, this Statement requires contemporaneous documentation of the Bank’s hedge relationships. Such documentation includes the nature of the risk being hedged, the identification of the hedged item, or the group of hedged items that share the risk exposure that is designated as being hedged, the selection of the instrument that will be used to hedge the identified risk, and the method used to assess the effectiveness of the hedge relationship. The assessment of hedge effectiveness requires calculations that utilize standard statistical methods of correlation that must support the determination that the hedging relationship is expected to be highly effective, during the period that the hedge is designated, in achieving offsetting changes in fair value or cash flows attributable to the hedged risk. If the Bank’s assessment of effectiveness is not considered to be adequate to achieve hedge accounting treatment, the derivative is treated as a free- standing risk management instrument. Recently Issued Accounting Standards Not Yet Adopted Refer to Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies.”
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besides those listed below could adversely affect our results and this list is not a complete set of all potential risks or uncertainties. Significant among the factors are the following: Economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in a deterioration in credit quality of the Bank’s loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on the Bank’s business. Washington Mutual is one of the nation’s largest lenders, and deterioration in the credit quality of the Bank’s loan portfolios can have a negative impact on earnings resulting from increased provisioning for loan losses and from increased nonaccrual loans, which could cause a decrease in interest-earning assets. Credit risk incorporates the risk of loss due to adverse changes in a borrower’s ability to meet its financial obligations on agreed upon terms. The overall credit quality of the Bank’s loan portfolios is particularly impacted by the strength of the U.S. economy and local economies in which the Bank conducts its lending operations as well as trends in residential housing prices. The Bank continually monitors changes in the economy, particularly unemployment rates and housing prices, because these factors can impact the ability of the Bank’s borrowers to repay their loans. During 2007, the housing market in the United States (particularly in California and Florida, where properties securing approximately 48% and 10% of the Bank’s outstanding single-family residential mortgage loans are located) began to experience significant adverse trends, including accelerating price depreciation in some markets and rising delinquency and default rates. These conditions led to significant increases in loan delinquencies and credit losses in the Bank’s mortgage portfolios and higher provisioning for loan losses which has adversely affected the Bank’s earnings. The Bank expects that housing prices will experience significant further deterioration in 2008 and that a recession could occur in either the United States as a whole or in a specific region. These conditions, or a major natural or other disaster, could have a materially adverse impact on the Bank's operating results, business and financial condition and in turn, could significantly increase the level of delinquencies and credit losses. Increases in credit costs would reduce the Bank’s earnings and adversely affect its capital position and financial condition. The Bank makes various assumptions and judgments about the collectibility of its loan portfolios when estimating the allowance for loan losses, which represents management’s estimate of incurred credit losses inherent in the loan portfolio as of the balance sheet date. The estimate of the allowance is based on a variety of factors, including past loan loss experience, the current credit profile of borrowers, adverse situations that have occurred that may affect a borrower’s ability to meet his financial obligations, the estimated value of underlying collateral, general economic conditions, and the impact that changes in interest rates and employment conditions have on a borrower’s ability to repay adjustable-rate loans. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. The Bank collects information on the performance of loans in its portfolios and routinely uses this information to recalibrate the formulaic models used in estimating the allowance for loan losses. Subsequent evaluations of the loan portfolio may reveal that estimated levels of loss severity used in estimating the allowance for loan losses differed significantly from actual experience, and in such instances the Bank may have to record an increased provision for loan losses in subsequent periods thereby reducing earnings in those periods. Until recently, the Bank originated and purchased from third-party lenders loans to higher risk borrowers through its subprime mortgage channel. Borrowers in the subprime mortgage channel tend to have greater vulnerability to changes in economic and housing market factors, such as increases in unemployment, a slowdown in housing price appreciation or declines in housing prices, than do other borrowers. Additionally, the tightening of underwriting standards throughout the mortgage industry have significantly reduced the eligibility of borrowers to obtain credit, or to find credit on affordable terms. The performance of this loan portfolio in recent quarters has been, and in the future will likely continue to be, negatively impacted by a variety of factors, including changes in the economic factors noted above, which negatively impact borrowers.
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The Bank’s access to market-based liquidity sources may be negatively impacted if market conditions persist or if further ratings downgrades occur. Funding costs may increase from current levels, and gain on sale may be reduced, leading to reduced earnings. While the Bank actively manages its liquidity risk and maintains liquidity at least sufficient to cover all maturing debt obligations or other forecasted funding requirements over the next twelve months (see “Liquidity Risk and Capital Management”), the Bank's liquidity may be affected by an inability to access the capital markets or by unforeseen demands on cash. This situation may arise due to circumstances beyond the Bank's control, and is subject to the Bank's credit ratings as assigned by various nationally recognized statistical rating organizations (“NRSROs”). During 2007, disruptions in the capital markets substantially limited the ability of mortgage originators, including Washington Mutual, to sell mortgage loans to the capital markets through whole loan sales or securitization. As a result, the Bank experienced a general loss of liquidity in most secondary markets for both its loan and asset-backed securities holdings, and this condition has persisted to the present time. The Bank cannot forecast if or when either specific secondary markets or broader market liquidity conditions will see improvement from current stresses, although it is the Bank's expectation that the existing turmoil in secondary loan and asset-backed securities markets may continue to affect its performance, described below, throughout 2008. As a result of these conditions, secondary loan sales are currently limited primarily to sales of conforming loans to government-sponsored enterprises (“GSEs”), and the Bank cannot predict when secondary markets for nonconforming loans, credit card receivables, and other loan assets will reopen. As such, the Bank has in recent periods retained for its own account substantially all of the loans and receivables the Bank has originated or purchased, other than conforming mortgage loans. The Bank will generally be unable to recognize gains on sale, and may be required to establish reserves for loans that remain on its balance sheet, which may reduce earnings. In addition, the Bank has taken steps to reduce or eliminate its origination of assets for which limited secondary market liquidity exists. While the Bank remains comfortable with its ability to fund mortgage loans (see “Liquidity Risk and Capital Management”), the Bank’s ability to sell conforming loans is dependent on its relationships with the GSEs. The Bank presently sells a substantial portion of its conforming residential originations to the GSEs, primarily Freddie Mac. The ability of the GSEs to continue to purchase loans at current volume levels is dependent in part on their own capital positions and the levels of defaults in the portfolios underlying the mortgage-backed securities issued by the GSEs. The Bank’s liquidity and earnings could be adversely affected if the GSEs were unwilling to purchase the Bank’s residential loan products. The Bank has generally securitized a large portion of its credit card portfolio, which provided additional liquidity for the Bank. Due to disruptions in the secondary market for credit card receivables, the Bank is presently not able to securitize credit card receivables on terms it considers acceptable. As a result, the Bank’s liquidity will be adversely affected until the credit card securitization market normalizes. Additionally, the Bank will be required to provide additional loss reserves for the credit card receivables that it retains in its portfolio, which will adversely affect earnings. Current market conditions have also limited the Bank's liquidity sources to secured funding outlets such as the Federal Home Loan Banks and repurchase agreements, and to FDIC-insured deposits originated through either brokers or through its branch network. Other sources of funding, such as medium-term notes, uninsured institutional deposits, and certain escrow balances have largely been closed to the Bank. Many of these sources are ratings-sensitive, and due to recent negative ratings actions, the Bank does not expect these sources to return as reliable sources of funding even if general market liquidity conditions improve until the Bank’s ratings improve. For example, institutional depositors generally require issuers to have the highest short-term ratings from at least one of the major rating agencies; however, as a result of recent actions, the Bank is now generally in the second-highest short-term rating category.
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The Bank's rating profile remains "investment grade" as defined by NRSROs. No assurance can be given, however, that the Bank will be able to retain an “investment grade” rating. The loss of investment grade ratings would likely result in further reductions in the sources of liquidity available to the Bank; may result in increased collateral or margining requirements under derivative and repurchase agreements with counterparties, which could increase the Bank’s funding costs and further reduce its earnings and liquidity; and could adversely affect the Bank’s ability to conduct its normal business operations, in ways that could be material. The Bank’s liquidity could also be adversely affected by unanticipated demands on its cash, such as having to repurchase securitized loans if it were found to have violated representations and warranties contained in the securitization agreements. In such event, the Bank generally would be required to repurchase these loans or indemnify the investor for losses sustained. Since in most instances the repurchased loans would be in default, it is unlikely that the Bank would be able to resell these loans in the secondary market. If the Bank were required to repurchase a substantial amount of these loans, its liquidity and capital would be adversely affected as the amount of nonperforming assets on its balance sheet would increase. If the Bank has significant additional losses, it may need to raise additional capital. Washington Mutual Bank must maintain certain minimum capital ratios in order to remain a “well- capitalized” institution for regulatory purposes. While the Bank believes it has sufficient capital for its operations (see “Liquidity Risk and Capital Management”), if the Bank is unable to meet its minimum capital ratios, Washington Mutual or the Bank would be forced to raise additional capital. No assurance can be given that sufficient additional capital would be available nor as to the terms on which capital would be available. If sufficient capital were not available, the Bank would consider a variety of alternatives, including the sale of assets. Under such forced sale conditions, the Bank may not be able to realize fair value for the assets sold. Other alternatives would include changing the Bank’s business practices. Changes in interest rates may adversely affect the Bank’s business, including net interest income and earnings. Like other financial institutions, Washington Mutual Bank raises funds for the Bank’s business by, among other things, borrowing money in the capital markets and from the Federal Home Loan Bank system and accepting deposits from depositors, which the Bank uses to make loans to customers and invest in debt securities and other interest-earning assets. The Bank earns interest on these loans and assets and pays interest on the money it borrows and on the deposits it accepts from depositors. Changes in interest rates, including changes in the relationship between short-term rates and long-term rates, may have negative effects on the Bank’s net interest income and therefore its earnings. Changes in interest rates and responses by the Bank’s competitors to those changes may affect the rate of customer prepayments for mortgages and other term loans and may affect the balances customers carry on their credit cards. These changes can reduce the overall yield on the Bank’s assets. Changes in interest rates and responses by the Bank’s competitors to these changes may also affect customer decisions to maintain balances in the deposit accounts they have with the Bank. These changes may require us to replace withdrawn balances with higher-cost alternative sources of funding. In addition, changes in interest rates may affect the Bank’s mortgage banking business in complex and significant ways. For example, changes in interest rates can affect gain from mortgage loans and loan servicing fees, which are the principal components of revenue from sales and servicing of home mortgage loans. When mortgage rates decline, the fair value of the mortgage servicing rights (“MSR”) asset generally declines and gain from mortgage loans tends to increase, to the extent the Bank is able to sell or securitize mortgage loans in the secondary market. When mortgage rates rise, the Bank generally expects loan volumes and payoffs in its servicing portfolio to decrease. As a result, the fair value of its MSR asset generally increases and gain from mortgage loans decreases. In recent periods, however, declines in
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general interest rates have resulted in slower increases in prepayment rates than in prior periods of declining interest rates, due in part to the reduced liquidity and tightened underwriting standards in the mortgage market making refinancing by borrowers more difficult. As part of the Bank’s overall risk management activities, the Bank seeks to mitigate changes in the fair value of its MSR asset by purchasing and selling financial instruments, entering into interest rate contracts and forward commitments to purchase or sell mortgage-backed securities and adjusting the mix and amount of such financial instruments or contracts to take into account the effects of different interest rate environments. The MSR asset and the mix of financial instruments used to mitigate changes in its fair value are not perfectly correlated. This imperfect correlation creates the potential for excess MSR risk management gains or losses during any period. Management must exercise judgment in selecting the amount, type and mix of financial instruments and contracts to mitigate changes in the fair value of the Bank’s MSR. The Bank cannot assure that the amount, type and mix of financial instruments and contracts it selects will fully offset significant changes in the fair value of the MSR, and the Bank’s actions could negatively impact its earnings. The Bank’s reliance on these risk management instruments may be impacted by periods of illiquidity in the secondary markets, which could negatively impact the performance of the MSR risk management instruments. For further discussion of how interest rate risk, basis risk, volatility risk and prepayment risk are managed, see “Market Risk Management.” Certain of the Bank’s loan products have features that may result in increased credit risk. The Bank has significant portfolios of home equity loans, which are secured by a first or second lien on the borrower’s property. When the Bank holds a second lien on a property which is subordinate to a first lien mortgage held by another lender, both the probability of default and severity of loss risk is generally higher than when the Bank holds both the first and second lien positions. Home equity loans and lines of credit with combined loan-to-value ratios of greater than 80 percent also expose the Bank to greater credit risk than home loans with loan-to-value ratios of 80 percent or less at origination. This greater credit risk arises because, in general, both default risk and the severity of loss risk are higher when borrowers have less equity in their homes. The Bank originates Option ARM loans under which borrowers have the option of making minimum payments based on an interest rate that is lower than the fully-indexed rate. Borrowers who continue to make minimum payments will generally experience negative amortization as unpaid interest is capitalized and added to the principal amount of the loan. The minimum payment resets to a fully-amortizing payment at the earlier of five years from origination or when the amount of negative amortization reaches specified levels. The risk that Option ARM borrowers will be unable to make increased loan payments as a result of the minimum payment on the loan adjusting upward to a fully-amortizing payment is a key risk associated with the Option ARM product. The Bank originates interest-only loans that it either securitizes or holds in its portfolio. Borrowers with interest-only loans are initially required to make payments that are sufficient to cover accrued interest. After a predetermined period (generally five years), the payments are reset to allow the loan to fully amortize over its remaining life. Borrowers with interest-only loans are particularly affected by declining housing prices because there is no amortization of principal on the loans. Such economic trends could cause the credit performance of interest-only loans to deteriorate more rapidly than other types of loans with a negative impact on the Bank’s results. For further discussion of credit risk, see “Credit Risk Management.” Consistent with mortgage industry underwriting practices, loans underwritten with limited documentation of income, net worth or credit history are widely represented within the Bank’s single- family residential loan products. In particular, such practices are frequently applied to the origination of Option ARM products. Accordingly, approximately 75% of the Bank’s Option ARM portfolio was originated using a limited documentation standard. As limited documentation loans have a higher risk of
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default than loans with full documentation, a continued downturn in economic conditions or a further decrease in housing prices could result in higher default rates in the Bank’s loan portfolio. The Bank uses estimates in determining the fair value of certain of our assets, which estimates may prove to be imprecise and result in significant changes in valuation. A portion of the Bank’s assets are carried on the balance sheet at fair value, including: the Bank’s trading assets including certain retained interests from securitization activities, available-for-sale securities, derivatives and MSR. Generally, for assets that are reported at fair value, the Bank uses quoted market prices or internal valuation models that utilize observable market data inputs to estimate their fair value. In certain cases, observable market prices and data may not be readily available or their availability may be diminished due to market conditions. The Bank uses financial models to value certain of these assets. These models are complex and use asset specific collateral data and market inputs for interest rates. Although the Bank has processes and procedures in place governing internal valuation models and their testing and calibration, the Bank cannot assure that it can properly manage the complexity of its models and valuations to ensure, among other things, that the models are properly calibrated, the assumptions are reasonable, the mathematical relationships used in the model are predictive and remain so over time, and the data and structure of the assets and hedges being modeled are properly input. Such assumptions are complex as the Bank must make judgments about the effect of matters that are inherently uncertain. Different assumptions could result in significant changes in valuation, which in turn could affect earnings or result in significant changes in the dollar amount of assets reported on the balance sheet. The Bank is subject to risks related to credit card operations, and this may adversely affect its credit card portfolio and its ability to continue growing the credit card business. Credit card lending brings with it certain risks and uncertainties. These include the composition and risk profile of the Bank’s credit card portfolio and the Bank’s ability to continue growing the credit card business. Credit cards typically have smaller balances, shorter lifecycles and experience higher delinquency and charge-off rates than real estate secured loans. Delinquencies and credit losses in the consumer finance industry generally increase during economic downturns or recessions. Likewise, consumer demand may decline during an economic downturn or recession. Account management efforts, seasoning and economic conditions, including unemployment rates and housing prices, affect the overall credit quality of the Bank’s credit card portfolio. The success of the credit card business also depends, in part, on the success of the Bank’s product development, product rollout efforts and marketing initiatives, including the rollout of credit card products to the Bank’s existing retail and mortgage loan customers, and the Bank’s ability to continue to successfully target creditworthy customers. Recent disputes involving the Visa and MasterCard networks, including their membership standards and pricing structures, could also result in changes that would be adverse to the credit card business. Changes in interest rates can also negatively affect the credit card business, including costs associated with funding the credit card portfolio, as described above under “Changes in interest rates may adversely affect the Bank’s business, including net interest income and earnings.” The Bank is subject to operational risk, which may result in incurring financial and reputational losses. The Bank is exposed to many types of operational risk, including the risk of fraud by employees or outsiders, the risk of operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. Given the Bank’s high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully corrected. The Bank’s dependence upon automated systems to record and process transactions may further increase the risk that technical system flaws or employee tampering with or manipulation of those systems will result in losses that are difficult to detect.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Bank has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 21, 2008.
WASHINGTON MUTUAL BANK
/s/ KERRY K. KILLINGER Kerry K. Killinger Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Bank and in the capacities indicated on March 21, 2008.
/s/ KERRY K. KILLINGER /s/ THOMAS W. CASEY Kerry K. Killinger Thomas W. Casey Chairman and Chief Executive Officer; Executive Vice President and Chief Financial Director (Principal Executive Officer) Officer (Principal Financial Officer)
/s/ ANNE V. FARRELL /s/ MELISSA J. BALLENGER Anne V. Farrell Melissa J. Ballenger Director Senior Vice President and Controller (Principal Accounting Officer)
/s/ STEPHEN E. FRANK /s/ REGINA MONTOYA Stephen E. Frank Regina Montoya Director Director
/s/ THOMAS C. LEPPERT /s/ MARY E. PUGH Thomas C. Leppert Mary E. Pugh Director Director
/s/ CHARLES LILLIS /s/ WILLIAM G. REED, JR. Charles Lillis William G. Reed, Jr. Director Director
/s/ PHILLIP D. MATTHEWS /s/ ORIN C. SMITH Phillip D. Matthews Orin C. Smith Director Director
/s/ MICHAEL K. MURPHY /s/ JAMES H. STEVER Michael K. Murphy James H. Stever Director Director
/s/ MARGARET OSMER MCQUADE Margaret Osmer McQuade Director
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When the Bank discontinues hedge accounting because it is not probable that a forecasted transaction will occur, the derivative will continue to be recorded on the balance sheet at its fair value with changes in fair value included in current earnings, and the gains and losses in accumulated other comprehensive income will be recognized immediately in earnings. When the Bank discontinues hedge accounting because the hedging instrument is sold, terminated or de-designated as a hedge, the amount reported in accumulated other comprehensive income through the date of sale, termination or de- designation will continue to be reported in accumulated other comprehensive income until the forecasted transaction affects earnings. The Bank occasionally enters into contracts that contain an embedded derivative instrument. At inception of the contract, the Bank determines whether the embedded derivative instrument is required to be accounted for separately from its host contract. As of December 31, 2007, 2006 and 2005, the Bank’s embedded derivatives were considered clearly and closely related to their host contracts and therefore were not required to be separately accounted for from their host contracts. The Bank enters into commitments to originate loans whereby the interest rate on the loan is set prior to funding (rate lock commitments). The Bank also enters into commitments to purchase mortgage loans (purchase commitments). Both rate lock and purchase commitments on mortgage loans that are intended to be sold are derivatives. In addition, purchase commitments for mortgage loans that will be held for investment purposes are also derivatives. Those derivatives are recorded at fair value in other assets or other liabilities in the Consolidated Statements of Financial Condition, with changes in fair value recorded in revenue from sales and servicing of home mortgage loans in the Consolidated Statements of Income. The amount of the expected servicing rights is not included when determining the fair value of interest rate lock commitments that are derivatives. However, for derivative loan commitments issued or modified on or after January 1, 2008, the amount of expected servicing rights will be included when determining their fair value, in accordance with Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (“SAB 109”). Both rate lock and purchase commitments expose us to interest rate risk. The Bank economically hedges that risk by using various types of derivative contracts. The changes in fair value of these contracts are reported in revenue from sales and servicing of home mortgage loans. Transfers and Servicing of Financial Assets The Bank sells home loans, credit card loans, multi-family loans and commercial mortgage loans in either whole loan or securitized form. FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“Statement No. 140”), provides specific criteria for determining whether legal and effective control over the transferred assets has been surrendered. To the extent the sale requirements are met, the transferred assets are removed from the Bank’s balance sheet, placed in an off-balance sheet qualifying special purpose entity (“QSPE”), as applicable, and any gain or loss on sale is recognized through noninterest income. QSPEs must meet a series of requirements at the inception of the transaction and on an ongoing basis. These requirements are designed to ensure that the activities of the entity are essentially predetermined at the inception of the QSPE, as specified in the legal documents which created it, and that the Bank cannot exercise control over the QSPE and the assets therein. In its fiduciary duty as servicer of assets in the QSPEs, the Bank is permitted to modify certain loans that are neither delinquent or in default so long as such actions are significantly limited and compliant with the legal documents that established the QSPE, default is reasonably foreseeable and the modification would meet the conditions that constitute a TDR in accordance with GAAP. When the Bank sells or securitizes mortgage loans, it generally retains the right to service the loans. The Bank records a mortgage servicing right (“MSR”) when the expected future cash flows from servicing are projected to be more than adequate compensation for such services. Adequate compensation is where the benefits of servicing would fairly compensate a substitute servicer should one be required, including a profit margin that would be demanded in the marketplace. The projected cash flows that exceed this adequate compensation level are recorded as an MSR asset. The Bank has
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determined the contractual servicing fee for credit card loans represents adequate compensation and therefore no servicing asset or liability in connection with the securitization of these loans is recognized. Effective January 1, 2006, the Bank early adopted FASB Statement No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140 (“Statement No. 156”). Statement No. 156 requires that servicing rights resulting from the sale or securitization of loans be initially recognized at fair value at the date of transfer, and permits a class-by-class election between fair value and the lower of amortized cost or fair value for subsequent measurement of MSR classes. Upon adoption, the Bank recognized all MSR assets at fair value, and elected to subsequently account for all MSR assets at fair value, which is the preferable measurement attribute under Statement No. 156. The Bank has one MSR servicing class, as determined by the availability of market inputs used to measure the fair value of mortgage servicing assets and the treatment of the MSR as one aggregate pool for risk management purposes. When the Bank securitizes loans, in addition to recording an MSR, the Bank may also retain senior, subordinated, residual and other interests, all of which are considered retained interests in the securitized assets. These retained interests may provide limited credit enhancement to the investors and, absent the violation of representations and warranties, generally represent the Bank’s maximum risk exposure associated with these transactions. These retained interests are initially recorded by allocating the previously recorded cost of the loans transferred between the interests sold and interests retained based on their relative fair values at the date of transfer. At the time of securitization, these retained interests are designated as or treated like trading or available-for-sale securities. While the Bank generally sells loans without credit recourse, either in the form of securities or whole loans, it generally makes certain representations and warranties to the buyer of those assets, which can include early or first payment default protection. In the event of a breach of such representations and warranties, the Bank may be required to either repurchase the subject loans or indemnify the investor or insurer. During the warranty period, the Bank bears the risk of any loss on the loans. These representation and warranty obligations are recorded at fair value on the balance sheet at the date of transfer. On December 6, 2007 the American Securitization Forum (“ASF”) issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the “ASF Framework”) to enable residential mortgage loan servicers to streamline their loss avoidance and loan modification practices. The parameters of the ASF Framework were designed by the ASF to improve administrative efficiency while maximizing cash flows to the QSPEs to which residential mortgage loans were transferred upon securitization by identifying the following subprime borrower segment categories: borrowers that can refinance into readily available mortgage industry products (“Segment 1”); borrowers that have demonstrated the ability to pay their introductory rates, are unable to refinance, and are unable to afford their reset rates (“Segment 2”); and borrowers that require in-depth, case-by-case analysis due to loan histories that demonstrated difficulties in making timely, introductory rate payments (“Segment 3”). Consistent with its objectives, the ASF Framework was designed to fast-track loan modifications for Segment 2 borrowers, in which default is considered to be reasonably foreseeable. Under the ASF Framework, fast-track loan modifications would be available to Segment 2 borrowers with first-lien residential mortgage loans that: (1) have an initial fixed interest rate period of 36 months or less; (2) are included in securitized pools; (3) were originated between January 1, 2005 and July 31, 2007; and (4) have an initial interest rate reset date between January 1, 2008 and July 31, 2010. To be eligible for a fast-track loan modification under the ASF Framework, Segment 2 borrowers would also have to occupy the property as their primary residence and meet a specific FICO test which is based on their current FICO score, and the servicer must ascertain that the upcoming loan rate reset will result in an increase in the loan payment amount by more than 10%.
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On January 8, 2008, the Securities and Exchange Commission’s (the “SEC”) Office of the Chief Accountant (the “OCA”) issued a letter (the “OCA Letter”) addressing accounting issues that may be raised by the ASF Framework. Specifically, the OCA Letter expressed the view that if a subprime loan made to a Segment 2 borrower is modified in accordance with the ASF Framework and that loan could be legally modified, the OCA does not object to continued status of the transferee as a QSPE under Statement No. 140. As of December 31, 2007, the Bank had not yet applied the loss mitigation approaches outlined in the ASF Framework. Costs associated with exit or disposal activities From time to time, the Bank may incur costs associated with employee termination or relocation benefits, the closure or relocation of facilities, and the termination of contracts. The Bank provides separation benefits to involuntarily terminated employees under a normal ongoing severance plan. Involuntary termination costs are recognized when they are probable and can be reasonably estimated. The Bank recognizes the liability for employee relocation costs in the period in which they are incurred. The Bank recognizes and measures the fair value of the liability for contract termination costs or fees when it terminates the contract in accordance with the contract terms. For operating lease rentals, the Bank records a liability when it ceases to use the leased property or equipment. The fair value of the liability at the cease-use date is determined based on the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for property leases. The Bank also reviews owned buildings, leasehold improvements and equipment for impairment. When the Bank’s review results in a change in the estimated useful life of an asset, it prospectively recognizes the change as an adjustment to depreciation expense. Premises and Equipment Building, leasehold improvements and equipment are carried at amortized cost. Buildings and equipment are depreciated over their estimated useful lives using the straight-line method. The estimated useful life of newly constructed buildings is 40 years. The lives of improvements to existing buildings are based on the remaining life of the original building. The estimated useful life for equipment is 3-10 years. Leasehold improvements are amortized over the shorter of their useful lives or lease terms considering options to extend that are reasonably assured. The Bank reviews owned buildings, leasehold improvements and equipment for impairment whenever events or changes in circumstances in the business activities related to these assets indicate that such activities may not generate enough income to recover the asset’s carrying value. Impairment is measured as the amount by which an asset’s carrying value exceeds its fair value. When the Bank’s review results in a change in the estimated useful life of an asset, it prospectively recognizes the change as an adjustment to depreciation expense. Goodwill and Other Intangible Assets Goodwill represents the excess of the purchase price over the fair value of tangible and specifically identifiable intangible net assets acquired in business combinations. Other intangible assets include purchased credit card relationships, core deposit and other finite-life intangible assets; these assets are amortized over their estimated useful lives ranging from 2-10 years. Goodwill is not amortized, but instead is tested for impairment at least annually in the third quarter, and more frequently if certain circumstances indicate that impairment may have occurred. Impairment testing is also performed periodically on amortizable intangible assets. Other intangible assets are classified as other assets in the Consolidated Statements of Financial Condition. Securities Sold Under Agreements to Repurchase Certain securities that are sold in exchange for cash are subject to an obligation to repurchase the same or similar securities (“repurchase agreements”). Under these arrangements, the Bank transfers the securities but still retains effective control through an agreement that both entitles and obligates us to repurchase them. As a result, repurchase agreements are accounted for as collateralized financing
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arrangements. The repurchase obligations are reflected as a liability in the Consolidated Statements of Financial Condition while the securities remain in the respective asset accounts. Guarantees The Bank makes guarantees in the normal course of business in connection with its sales of certain loans and certain securitized financial assets, issuance of standby letters of credit and relationship as a member of Visa Inc., among other transactions. The Bank accounts for these guarantees in accordance with either Statement No. 5 or, when appropriate, FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”). FIN 45 generally requires the use of fair value for the initial measurement of guarantees, but does not prescribe a subsequent measurement method. For subsequent measurement of guarantees for which the performance obligation declines over time, the Bank generally amortizes the carrying amount of the guarantee ratably over the period that the guarantee applies and at each reporting date the Bank evaluates the recognition of a loss contingency under Statement No. 5. The loss contingency is measured as the probable and reasonably estimable amount, if any, that exceeds the amortized value of the remaining guarantee. Preferred Stock The Bank issues preferred stock as part of its capital structure. Preferred stock ranks senior to common shares with respect to the dividend and has preference in the event of liquidation. Preferred stock is reported in stockholders’ equity unless it is mandatorily redeemable or it embodies an unconditional obligation that the Bank must or may settle in shares and whose monetary value at inception is based solely or predominantly on any of the following: (1) a fixed amount known at inception, (2) variations in something other than the fair value of the Bank’s equity shares, or (3) variations inversely related to changes in the fair value of the Bank’s equity shares as prescribed in FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Dividends declared on preferred stock are accounted for as a reduction in the retained earnings. Features embedded in the terms of preferred stock with derivative characteristics such as options to convert into the Bank’s common shares are evaluated under Statement No. 133. Features that qualify as derivatives but are indexed to the Bank’s equity shares are not accounted for separately. In addition, the Bank evaluates the terms of the conversion to determine if such an option is in-the-money to the preferred stockholder at the commitment date or becomes beneficial if certain future events occur (“beneficial conversion”) as prescribed in EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios and EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments. If a beneficial conversion feature is present in convertible preferred stock, it is recognized as a return to the preferred stockholder and an increase in additional paid- in capital. If a contingent beneficial conversion feature is present in convertible preferred stock, the Bank does not recognize the intrinsic value of it until the triggering events for such beneficial conversion occur. Stock-Based Compensation Effective January 1, 2003 and in accordance with the transitional guidance of FASB Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure (“Statement No. 148”), the Bank elected to prospectively apply the fair value method of accounting for stock-based awards granted after December 31, 2002. Effective January 1, 2006, the Bank adopted FASB Statement No. 123R, Share-Based Payment (“Statement No. 123R”), using the modified prospective application transition method. Since the Bank had already adopted Statement No. 148 and substantially all stock-based awards granted prior to its adoption were fully vested at December 31, 2005, Statement No. 123R did not have a significant effect on the Consolidated Statements of Income or the Consolidated Statements of Financial Condition. Prior to the Bank’s adoption of Statement No. 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows in the Consolidated Statements of Cash Flows. Statement No. 123R requires excess tax benefits to be reported as a financing cash inflow rather than as a reduction of taxes paid.
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are either guaranteed or insured by agencies of the federal government and therefore do not expose the Bank to significant risk of credit loss. Due to the sale of substantially all of the Bank’s government loan servicing portfolio in July 2006, the balance of such loans declined considerably. The Bank’s held for sale portfolio contained zero and $37 million of such loans that were 90 days or more contractually past due and still accruing interest at December 31, 2007 and 2006. The total amount of nonaccrual loans held in portfolio at December 31, 2007 and 2006 was $6.12 billion and $2.29 billion. The total amount of nonaccrual loans held for sale at December 31, 2007 and 2006 was $4 million and $185 million. Note 8: Securitizations Securitization of Assets During 2007 and 2006, the Bank sold loans and retained servicing responsibilities as well as senior and subordinated interests from securitization transactions. The Bank receives servicing fees equal to a percentage of the outstanding principal balance of mortgage loans and credit card loans being serviced. Generally, the Bank also receives the right to cash flows remaining after the investors in the securitization trusts have received their contractual payments. The allocated carrying values of mortgage loans securitized and sold during the years ended December 31, 2007 and 2006 were $82.58 billion and $110.08 billion, which included loans sold with recourse of $6 million and $959 million during the same periods. The allocated carrying values of credit card loans securitized and sold were $10.65 billion and $7.11 billion during the years ended December 31, 2007 and 2006. The Bank realized pretax gains of $484 million and $1 billion on mortgage loan securitizations during 2007 and 2006. Pretax gains realized on credit card securitizations were $533 million and $279 million during 2007 and 2006. The table below summarizes certain cash flows received from and paid to securitization trusts, except as footnoted below: Year Ended December 31, 2007 2006 Credit Credit Mortgages Cards Mortgages Cards (in millions) Proceeds from new securitization sales...... $ 82,655 $ 9,275 $ 113,453 $ 6,314 Proceeds from collections reinvested in new receivables ...... – 13,731 – 11,912 Principal and interest received on interests that continue to be held by the transferor...... 648 1,194 360 1,323 Servicing fees received(1) ...... 1,980 400 2,066 346 Loan repurchases(1)(2)...... (431) – (1,848) – ______(1) Amounts include cash received/paid related to all transfers of loans, including securitizations accounted for as sales, interests that continue to be held by the transferor and whole loan sales. (2) During 2007 and 2006, loan repurchases include zero and $378 million related to GNMA early buy out repurchases.
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Key economic assumptions used in measuring the initial value of interests that continue to be held by the transferor (excluding MSR) resulting from securitizations completed during the years ended December 31, 2007 and 2006, and accounted for as sales at the date of securitization, were as follows (rates are per annum and are weighted based on the principal amounts securitized): Mortgage Loans Home Subprime Adjustable- Mortgage Other Real Credit Card Fixed-Rate Rate Channel Estate(1) Loans Year Ended December 31, 2007 Payment rate(2) ...... 9.03% 14.43% 29.48% 24.41% 8.82% Anticipated net charge-offs ...... – % – % 4.53% – % 9.00% Expected weighted-average life (in years) .... 4.8 7.4 5.0 14.0 0.5 Discount rate ...... 9.79% 8.55% 22.20% 11.90% 5.63-26.33% Year Ended December 31, 2006 Payment rate(2) ...... 13.28% 19.56% 34.06% 10.00% 9.06% Anticipated net charge-offs ...... – % – % 4.64% – % 9.60% Expected weighted-average life (in years) .... 5.9 6.3 4.8 14.5 0.5 Discount rate ...... 5.71% 5.35% 20.20% 10.84% 6.58-15.00% ______(1) Includes multi-family and commercial real estate loans. (2) Represents the expected lifetime average payment rate, which is based on the constant annualized prepayment rate for mortgage related loans and represents the average monthly expected principal payment rate for credit card related loans. At December 31, 2007, key economic assumptions and the sensitivity of the current fair value of interests that continue to be held by the transferor (excluding MSR) to immediate changes in those assumptions were as follows: Mortgage Loans Home Subprime Adjustable- Mortgage Other Real Credit Card Fixed-Rate Rate Channel Estate(1) Loans (dollars in millions)
Fair value of interests that continue to be held by the transferor ...... $ 127 $ 887 $ 20 $ 679 $ 1,838 Expected weighted-average life (in years)...... 7.8 4.7 5.1 4.1 0.5 Payment rate(2) ...... 5.67% 14.88% 23.43% 0.69% 8.60% Impact on fair value of 10% adverse change ...... $ – $ (6) $ – $ (1) $ (25) Impact on fair value of 25% adverse change ...... (1) (13) – (2) (56) Charge-off rate...... 1.98% 0.68% 22.95% –% 9.49% Impact on fair value of 10% adverse change...... $ – $ – $ (2) $ – $ (70) Impact on fair value of 25% adverse change...... – – (3) – (173) Discount rate...... 9.62% 13.14 % 22.47% 6.18% 5.93-26.33% Impact on fair value of 25% adverse change...... $ (23) $ (128) $ (1) $ (36) $ (83) Impact on fair value of 50% adverse change...... (44) (202) (1) (62) (160) ______(1) Includes multi-family and commercial real estate loans. (2) Represents the expected lifetime average based on the constant prepayment rate for mortgage related loans and represents the average monthly expected principal payment rate for credit card related loans. These sensitivities are hypothetical and should be used with caution. As the table above demonstrates, the Bank’s methodology for estimating the fair value of interests that continue to be held
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by the transferor is highly sensitive to changes in assumptions. For example, the Bank’s determination of fair value uses anticipated net charge-offs. Actual charge-off experience may differ and any difference may have a material effect on the fair value of interests that continue to be held by the transferor. Changes in fair value resulting from changes in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the interests that continue to be held by the transferor is calculated without changing any other assumptions; in reality, changes in one factor may be associated with changes in another, which may magnify or counteract the sensitivities. Thus, any measurement of the fair value of interests that continue to be held by the transferor is limited by the conditions existing and assumptions made as of a particular point in time. Those assumptions may not be appropriate if they are applied to a different point in time. The table below presents information about delinquencies, net charge-offs and components of reported and securitized financial assets at December 31, 2007 and 2006: Loans on Total Loans Nonaccrual Status(1) Net Charge-offs December 31, Year Ended December 31, 2007 2006 2007 2006 2007 2006 (in millions) Home mortgage loans ...... $ 225,733 $ 219,207 $ 12,326 $ 3,059 $ 1,378 $ 300 Other loans secured by real estate...... 113,817 103,817 1,074 365 866 44 Credit card loans ...... 27,240 23,509 – – 1,636 1,235 Other loans...... 2,084 1,995 25 17 64 29 Total loans managed(2) ...... 368,874 348,528 $ 13,425 $ 3,441 $ 3,944 $ 1,608 Less: Loans sold, including securitizations ..... 112,968 73,004 Loans securitized(3) ...... 6,147 5,623 Loans held for sale...... 5,403 44,969 Total loans held in portfolio ...... $ 244,356 $ 224,932 ______(1) Refer to Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies” for further discussion of loans on nonaccrual status. (2) Represents both loans in the Consolidated Statements of Financial Condition and loans that have been securitized, but excludes loans for which the Bank’s only continuing involvement is servicing of the assets. (3) Represents the interests retained by the Bank which are included as an adjustment in this table as they have been recognized separately in the Consolidated Statements of Financial Condition.
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Division for review. During 2006 all asserted deficiencies were resolved in principle, and their resolution did not materially affect the Bank’s 2006 Consolidated Financial Statements. The remaining issue involved a claim for refund with respect to certain tax sharing payments to the FDIC. In 2007, the Bank reached an agreement in principle with the IRS Appeals Division on a settlement of this issue for 1998- 2005. Such agreement is subject to administrative review within the IRS as well as review by the Joint Committee on Taxation. Should the settlement be approved, the Bank will recognize a reduction in income tax expense of approximately $33 million. During 2007, the IRS completed the examination of the Bank’s federal income tax returns for 2001 through 2003. The Bank entered into a partial agreement with the IRS on several aspects of the examination resulting in an expected refund of tax in the amount of $1.65 billion. In February of 2008, the Joint Committee on Taxation approved the refund. In addition, selected issues have been raised by the IRS which will be referred to the IRS Appeals Division for review. The Bank does not anticipate that the resolution of these issues will result in a significant impact on the Bank’s Consolidated Financial Statements. The IRS is currently examining the Bank’s federal income tax returns for the years 2004 and 2005. As of December 31, 2007, no issue has been raised that will result in a significant impact on the Bank’s Consolidated Financial Statements. From 1981 through 1985, H.F. Ahmanson & Co. (“Ahmanson”), which was acquired by the Bank in 1998, acquired thrift institutions in six states through Federal Savings and Loan Insurance Corporation assisted transactions. In addition to acquiring the assets and operations of these thrift institutions, Ahmanson also acquired (1) the rights to establish branches in the states where the acquired thrifts operated (“Branching Rights”) and/or (2) favorable regulatory treatment of goodwill recorded as a result of these acquisitions (“Goodwill Rights”). Ahmanson abandoned the Branching Rights it acquired in several of those states in years prior to 1999. The Bank (as successor to Ahmanson) believes it is entitled to tax deductions at the time the branches were sold and the Branching Rights abandoned. In addition, the Bank believes it is entitled to tax deductions relating to the amortization or loss of Goodwill Rights due in part to a 1989 change in law. The Bank filed several refund claims with the IRS with respect to such deductions that the IRS has denied. The Bank filed an action in the U.S. District Court for the Western District of Washington in October 2006 asserting its rights to refunds for the abandonment of Branching Rights in one state and for the amortization or loss of Goodwill Rights with respect to one acquisition. The trial date for this case has been set to occur in September 2008. The amount of refund claimed in this case is approximately $16 million of tax. In addition to the claims being tried in the action cited above, as of December 31, 2007, the Bank has claims and potential claims with the IRS relating to Branching Rights and Goodwill Rights totaling $534 million. No benefit has been recognized in the Bank’s Consolidated Financial Statements with respect to the tax deductions for Branching Rights or Goodwill Rights. Note 16: Commitments, Guarantees and Contingencies Commitments Commitments to extend credit are agreements to lend to customers in accordance with predetermined amounts and other contractual provisions. These commitments may be for specific periods or may contain clauses permitting termination or reduction of the commitment by the Bank and may require the payment of a fee by the customer. The total amounts of unused commitments do not necessarily represent future credit exposure or cash requirements, in that commitments often expire without being drawn upon.
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Unfunded commitments to extend credit consisted of the following: December 31, 2007 2006 (in millions) Residential real estate ...... $ 68,071 $ 69,675 Commercial...... 6,109 5,512 Credit card ...... 47,524 40,169 Other ...... 890 892 Total unfunded commitments ...... $ 122,594 $ 116,248 The Bank reserved $47 million and $27 million as of December 31, 2007 and 2006 to cover its loss exposure to unfunded commitments. Guarantees In the ordinary course of business, the Bank sells loans to third parties and in certain circumstances retains credit risk exposure on those loans and may be required to repurchase them. The Bank may also be required to repurchase sold loans when representations and warranties made by the Bank in connection with those sales are breached. Under certain circumstances, such as when a loan sold to an investor and serviced by the Bank fails to perform according to its contractual terms within the six months after its origination or upon written request of the investor, the Bank will review the loan file to determine whether or not errors may have been made in the process of originating the loan. If errors are discovered and it is determined that such errors constitute a breach of a representation or warranty made to the investor in connection with the Bank’s sale of the loan, then if the breach had a material adverse effect on the value of the loan, the Bank will be required to either repurchase the loan or indemnify the investor for losses sustained. In addition, the Bank is a party to and from time to time enters into agreements that contain general indemnification provisions, primarily in connection with agreements to sell and service loans or other assets or the sales of mortgage servicing rights. These provisions typically require the Bank to make payments to the purchasers or other third parties to indemnify them against losses they may incur due to actions taken by the Bank prior to entering into the agreement or due to a breach of representations, warranties, and covenants made in connection with the agreement or possible changes in or interpretations of tax law. The Bank has recorded reserves of $268 million and $220 million as of December 31, 2007 and 2006, to cover its estimated exposure related to all of the aforementioned loss contingencies. In order to meet the needs of its customers, the Bank issues direct-pay, standby and other letters of credit. Letters of credit are conditional commitments issued by the Bank generally to guarantee the performance of a customer to a third party in borrowing arrangements, such as commercial paper issuances, bond financing, construction and similar transactions. Collateral may be required to support letters of credit in accordance with management’s evaluation of the credit worthiness of each customer. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. At December 31, 2007 and 2006, outstanding letters of credit issued by the Bank totaled $374 million and $409 million, which included $32 million and $39 million in participations sold to other institutions. At December 31, 2007, the Bank is the guarantor of seven separate issues of trust preferred securities. The Bank has issued subordinated debentures to wholly-owned special purpose trusts. Each trust has issued preferred securities. The sole assets of each trust are the subordinated debentures issued by the Bank. The Bank guarantees the accumulated and unpaid distributions of each trust to the extent the Bank provided funding to the trust per the Bank’s obligations under the subordinated debentures. The maximum potential amount of future payments the Bank could be required to make under these guarantees are the expected principal and interest each trust is obligated to remit under the issuance of trust preferred securities, which totaled $67 million and $544 million as of December 31, 2007 and 2006. No liability has been recorded because the fair value of such guarantees is de minimis.
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EXHIBIT 4
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OFFICE OF THRIFT SUPERVISION WASHINGTON, D.C. 20552 ______
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008
OTS Docket Number 08551 ______
WASHINGTON MUTUAL BANK (Exact name of registrant as specified in its charter)
Federal Charter 68-0172274 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number)
1301 Second Avenue, Seattle, WA 98101 (Address of principal executive offices) (Zip Code)
(206) 461-2000 (Registrant’s telephone number, including area code) ______Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non- accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer Accelerated filer Non-accelerated filer Smaller reporting company (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No The number of shares outstanding of the issuer's classes of common stock as of July 31, 2008:
Common Stock – 331,386
Note: Registrant meets the conditions set forth in General Instructions (H)(1)(a) and (b) of Form 10-Q and is therefore filing this form with reduced disclosure format.
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In the second quarter, the Company considered the continuing adverse conditions within the market environment and the Company’s best estimates regarding future conditions including credit losses, and concluded that there was no goodwill impairment within its reporting units with recorded goodwill as of June 30, 2008. A continuing period of market disruption, Washington Mutual’s diminished trading value and market capitalization, or further market deterioration are factors the Company will continue to consider in future evaluations of recorded goodwill for impairment, including particularly its annual evaluation to be conducted in the third quarter of 2008 and subsequent evaluations. Overview The Bank recorded a net loss in the second quarter of 2008 of $3.19 billion, compared with net income of $935 million in the second quarter of 2007, primarily due to the Bank’s significant increase in loan reserves by $3.74 billion to $8.46 billion. The Bank recorded a provision for loan losses of $5.91 billion in the second quarter of 2008, an increase of $5.54 billion from the second quarter of 2007 and significantly higher than second quarter 2008 net charge-offs, which totaled $2.17 billion. Net charge-offs in the second quarter of 2007 were $271 million. Adverse trends in key credit risk indicators, including high inventory levels of unsold homes, rising foreclosure rates, the significant contraction in the availability of credit for nonconforming mortgage products and negative job growth trends exerted severe pressure on the performance of the single-family residential (“SFR”) loan portfolio, particularly loans in geographic areas in which the Bank’s lending activities have been concentrated in recent years. Nationwide sales volume of existing homes in June 2008 was 15% lower than June 2007, leading to a supply of unsold homes of approximately 11.1 months, a 22% increase from June 2007, while the national median sales price for existing homes fell by 6% between those periods. Since July 2006, average home prices declined 19%, as measured by the S&P Case-Shiller 10-City Composite Home Price Index, or 22% when this index is weighted to reflect the geographic distribution of the Bank’s SFR portfolio. Foreclosure filings were also up significantly, increasing by 121% from the second quarter of 2007 to the second quarter of 2008. The deteriorating housing market conditions resulted in sharply higher delinquency rates and restructurings of troubled loans, as the Bank has intensified its efforts to work with borrowers to keep them in their homes whenever it can do so. The ratio of nonperforming assets to total assets rose to 3.65% at June 30, 2008, compared with 1.29% at June 30, 2007. Restructured nonaccrual loans accounted for 0.47% of the nonperforming assets to total assets ratio at June 30, 2008, compared with 0.05% of the ratio at June 30, 2007. Cure rates on early stage delinquencies, representing loans that are up to three payments past due, have also deteriorated, as declining home values and the reduced availability of credit throughout the mortgage market have created conditions in which many borrowers cannot refinance their mortgage or sell their home at a price that is sufficient to repay their mortgage. Deteriorating trends in delinquency rates began migrating across the different types of loans in the Bank’s SFR portfolio starting in 2007. Rising levels of delinquencies initially occurred within the subprime mortgage channel during the first half of 2007, followed by the appearance of higher delinquencies in home equity loans and lines of credit during the second half of 2007. During the first half of 2008, Option ARMs have been the product type exhibiting the greatest increase in delinquency rates. The increases in Option ARM delinquencies are generally concentrated in geographic markets that have experienced the most significant levels of housing price depreciation, particularly in the inland regions of California and the Southeastern section of the country. While Option ARM loans that have experienced negative amortization are subject to payment recasting events, the presence of this feature has not been a significant contributor to the increase in delinquency rates, as the majority of recasts are not contractually scheduled to occur until 2010 and later years.
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In addition to higher delinquency levels within its SFR loan portfolio, the Bank also began experiencing deteriorating trends in loan loss severities starting in 2007, which continued to increase in the second quarter of 2008, reflecting the steep decline in home prices. Annualized net SFR charge-offs as a percentage of the average balance of the SFR portfolio increased from 0.39% in the second quarter of 2007 to 4.21% in the second quarter of 2008. In response to these deteriorating trends in housing market conditions, delinquencies and loss severities, the Bank has continued in 2008 to update its loan loss provisioning assumptions for its SFR portfolio, changing key assumptions used to evaluate default frequencies and loss severities, to reflect these trends. These updated assumptions accounted for approximately one-third of the provision recorded in the second quarter of 2008 and approximately $1.2 billion of the provision recorded in the first quarter of 2008. Refer to Credit Risk Management – “Allowance for Loan Losses” section for further discussion of these changes and a general discussion of the Allowance for Loan Losses. The Bank also experienced declines in the credit performance of its credit card portfolio during the first half of 2008, reflecting a softening U.S. economy and increased national unemployment, the macroeconomic factors that generally have the greatest impact on consumer spending and credit card performance. Annualized net credit card charge-offs as a percentage of the average balance of the credit card portfolio were 6.51% in the second quarter of 2008 and 3.63% in the second quarter of 2007. The national unemployment rate increased to 5.5% in June 2008 from 4.6% in June 2007, while the U.S. economy lost approximately 191,000 net jobs during the second quarter of 2008, compared with net job growth of 315,000 in the second quarter of 2007. With the elevated levels of loan loss provisioning and charge-offs in its loan portfolios, Washington Mutual took steps to bolster its capital and liquidity positions during the second quarter. In April 2008, Washington Mutual issued approximately $7.2 billion of equity, comprised of common stock; perpetual, non-cumulative convertible preferred stock that was subsequently converted into common shares on June 30, 2008; and warrants, of which $3.0 billion was contributed to the Bank during the second quarter of 2008 and an additional $2.0 billion was contributed following the end of the second quarter. The Bank also reduced the size of its balance sheet by $19 billion since the beginning of 2008. The Bank expects that 2008 will be the peak year for loan loss provisioning. At June 30, 2008, the Bank’s Tier 1 capital to adjusted total assets ratio was 7.07%, and its total risk-based capital to total risk-weighted assets ratio was 12.44%, exceeding the regulatory guidelines for well-capitalized institutions, and the tangible equity to total tangible assets ratio was 7.02%, above the Bank’s established target of 5.50%. Net interest income was $2.35 billion in the second quarter of 2008, compared with $2.16 billion in the second quarter of 2007. The increase was due to the expansion of the net interest margin, which increased, on a taxable-equivalent basis, from 3.09% in the second quarter of 2007 to 3.31% in the second quarter of 2008. As the Bank’s short-term wholesale borrowing costs reprice to current market rates faster than most of its interest-earning assets, the margin was aided by lower short-term interest rates, reflecting the actions taken by the Federal Reserve to stimulate the economy in light of the deteriorating housing market and higher unemployment rates. Since June 30, 2007, the target Federal Funds rate declined from 5.25% to 2.00%. Noninterest income totaled $718 million in the second quarter of 2008, compared with $1.76 billion in the same quarter of 2007. Results from the sales and servicing of home mortgage loans declined from net revenue of $300 million in the second quarter of 2007 to net expense of $109 million in the second quarter of 2008. Continuing illiquidity in the secondary market for nonconforming loans, along with the Bank’s decisions to discontinue all lending through the subprime mortgage channel in the fourth quarter of 2007 and the wholesale mortgage channel in April 2008 led to significantly lower mortgage production activity. Additionally, the provision for loan repurchases rose significantly, primarily reflecting an increase in the volume of investor requests to repurchase loans the Bank had previously sold. Revenue from the sales and servicing of consumer
22 Case 1:09-cv-01656-RMC Document 54-7 Filed 11/22/10 Page 5 of 6
loans declined from $403 million in the second quarter of 2007 to $159 million in the second quarter of 2008 as the absence of securitization sales activity from the continued illiquid secondary market for unsecured loan products decreased the amount of gain on sale and higher net credit losses on securitized loans lowered excess servicing income. The Bank also recorded a $407 million loss through earnings from the write-down of certain mortgage backed securities within the available-for- sale securities portfolio, reflecting credit deterioration in which the declines in value were determined to represent an other-than-temporary impairment condition. Noninterest expense totaled $2.37 billion in the second quarter of 2008, compared with $2.10 billion in the second quarter of 2007. With high volumes of delinquent loans migrating to foreclosure status and the steep declines in home prices, foreclosed asset expense increased from $56 million in the second quarter of 2007 to $217 million in the second quarter of 2008. Foreclosure expenses are expected to remain elevated until housing market conditions stabilize. In addition to the actions taken in the fourth quarter of 2007 to resize the home loans business and corporate and other functions, the Bank initiated additional measures in the second quarter of 2008 to significantly reduce expenses, primarily within the home loans business and corporate support functions. The Bank expects to incur approximately $450 million of restructuring and resizing costs related to these measures, of which $207 million were recorded in the second quarter, and anticipates that annualized expense savings of approximately $1 billion will be realized upon the completion of these initiatives. Recently Issued Accounting Standards Not Yet Adopted Refer to Note 1 to the Consolidated Financial Statements – “Summary of Significant Accounting Policies.”
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Bank has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on August 14, 2008.
WASHINGTON MUTUAL BANK
By: /s/ THOMAS W. CASEY Thomas W. Casey Executive Vice President and Chief Financial Officer
By: /s/ MELISSA J. BALLENGER Melissa J. Ballenger Senior Vice President and Controller (Principal Accounting Officer)
59 Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 1 of 9
EXHIBIT 5
Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 2 of 9 8-K 1 a5735438.htm WASHINGTON MUTUAL, INC. 8-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 8-K
CURRENT REPORT Pursuant to Section 13 OR 15(d) of The Securities Exchange Act of 1934
Date of Report: July 22, 2008 Washington Mutual, Inc. (Exact name of registrant as specified in its charter)
Washington 1-14667 91-1653725 (State or other jurisdiction (Commission (IRS Employer of incorporation) File Number) Identification No.)
1301 Second Avenue, Seattle, Washington 98101 (Address of principal executive offices) (Zip Code)
(206) 461-2000 (Registrant’s telephone number, including area code)
Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions (see General Instruction A.2. below):
[ ] Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)
[ ] Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)
[ ] Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))
[ ] Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))
Item 2.02 Results of Operations and Financial Condition
On July 22, 2008, Washington Mutual, Inc. issued a press release and held a conference call regarding its results of operations and financial condition for the quarter ended June 30, 2008. The text of the press release is included as Exhibit 99.1 to this report, the financial supplement to the press release is included as Exhibit 99.2 to this report and the credit risk management slides supplement for the conference call is included as Exhibit 99.3 to this report. The information included in the press release text, financial supplement and credit risk management slides supplement for the conference call is considered to be “furnished” under the Securities Exchange Act of 1934. The Company will include final financial statements and additional analyses for the quarter ended June 30, 2008, as part of its Form 10-Q covering that period.
Item 9.01 Financial Statements and Exhibits
(d) The following exhibits are being furnished herewith:
Exhibit Exhibit Description No. 99.1 Press release text of Washington Mutual, Inc. dated July 22, 2008. 99.2 Financial supplement of Washington Mutual, Inc. 99.3 Credit risk management slides supplement for Washington Mutual, Inc. conference call held on July 22, 2008.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized.
Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 3 of 9
WASHINGTON MUTUAL, INC.
Dated: July 22, 2008 By: /s/ Thomas W. Casey Thomas W. Casey Executive Vice President and Chief Financial Officer of Washington Mutual, Inc.
Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 4 of 9 EX-99.1 2 a5735438ex99_1.htm EXHIBIT 99.1 Exhibit 99.1
Washington Mutual, Inc. (NYSE: WM) July 22, 2008
WaMu Reports Significant Build-Up of Reserves Contributing to Second Quarter Net Loss of $3.3 billion
Company Increases Capital Levels
Company Expects to Reduce Expenses by $1 billion
WaMu today announced a second quarter 2008 net loss of $3.33 billion as it significantly increased its loan loss reserves by $3.74 billion to $8.46 billion. The quarter’s loss compares with the first quarter net loss of $1.14 billion and net income of $830 million during the second quarter of 2007. The quarter’s financial results reflect an elevated level of provisioning due in large part to changes in the company’s provisioning assumptions in response to continued declines in housing prices nationwide. These changes had the effect of accelerating provisions into the quarter. The quarter’s provision was $5.9 billion compared with $2.2 billion of net charge-offs. The company now expects the remaining cumulative losses in its residential mortgage portfolios to be toward the upper end of the range it disclosed in April, and continues to expect 2008 to be the peak year for provisioning.
The company’s tangible equity to total tangible assets capital ratio increased during the second quarter to 7.79 percent from 6.40 percent in the first quarter, resulting in approximately $7 billion of capital in excess of its targeted 5.50 percent level. The increase reflects the effects of the $7.2 billion capital raise, the reduction of the company’s balance sheet by $10 billion and the loss for the quarter. The company also maintained strong levels of liquidity during the quarter, with over $40 billion of readily available liquidity at quarter end.
“In the face of unprecedented housing and mortgage market conditions, 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 strong, profitable retail franchise,” said WaMu Chief Executive Officer Kerry Killinger. “Our recent $7.2 billion capital raise, combined with the other proactive steps we have taken this quarter to strengthen our banking franchise and further expense reductions, continue to move us toward achieving these goals.”
Killinger also said that the company now expects to realize annualized cost savings of approximately $1 billion which will contribute to improved pretax, pre-provision earnings. “We remain confident that we have sufficient capital to successfully manage our way through this challenging period,” Killinger added.
The company reported a second quarter diluted loss per share of $6.58, which included a previously disclosed one-time earnings per share reduction in the amount of $3.24 related to the company’s capital issuance in April. Excluding this one-time reduction, the company’s second quarter loss per common share was $3.34. This non-cash reduction in earnings per share, which resulted in a reclassification within stockholders’ equity, had no effect on the company’s capital ratios or the net loss recorded in the second quarter.
SECOND QUARTER FINANCIAL SUMMARY AND HIGHLIGHTS
Selected Financial Summary Three Months Ended ($ in millions, except per share data) Jun. 30, 2008 Mar. 31, 2008 Dec. 31, 2007 Sept. 30, 2007 Jun. 30, 2007 Income Statement Net interest income $ 2,296 $ 2,175 $ 2,047 $ 2,014 $ 2,034 Provision for loan losses 5,913 3,511 1,534 967 372 Noninterest income 561 1,569 1,365 1,379 1,758 Foreclosed asset expense 217 155 133 82 56 Goodwill impairment charge - - 1,775 - - All other noninterest expense 2,186 1,997 2,258 2,109 2,082 Minority interest expense 75 75 65 53 42 Income (loss) before income taxes (5,534) (1,994) (2,353) 182 1,240 Income taxes (2,206) (856) (486) (4) 410 Net income (loss) $ (3,328) $ (1,138) $ (1,867) $ 186 $ 830
Diluted earnings per common share $ (6.58) $ (1.40) $ (2.19) $ 0.20 $ 0.92 Less : effect of conversion feature (3.24) - - - - Diluted earnings per common share excluding effect of conversion feature $ (3.34) $ (1.40) $ (2.19) $ 0.20 $ 0.92
Balance Sheet Total assets, end of period $ 309,731 $ 319,668 $ 327,913 $ 330,110 $ 312,219 Average total assets 314,882 319,928 325,276 320,475 316,004 Average interest-earning assets 285,503 285,265 287,988 283,263 279,836 Average total deposits 184,610 184,304 185,636 198,649 206,765
Profitability Ratios Return on average common equity (69.25)% (23.27)% (32.64)% 3.03% 13.74% Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 5 of 9 Net interest margin 3.22 3.05 2.86 2.86 2.91 Efficiency ratio 84.11 57.49 122.13 64.55 56.38 Nonperforming assets/total assets 3.62 2.87 2.17 1.65 1.29 Allowance for loan losses/ nonperforming loans 87.26 60.25 41.99 41.27 47.63 Tangible equity/total tangible assets 7.79 6.40 6.67 5.60 6.07
? Capital ratios improve. The tangible equity to total tangible assets ratio at June 30 was 7.79 percent compared with 6.40 percent as of Mar. 31, reflecting the April capital raise of $7.2 billion and despite significant provisioning to cover credit costs. Also contributing to the improved capital ratios this quarter was a decrease in total assets of approximately $10 billion, which freed up approximately $550 million in capital. Additional asset reductions are expected as the company continues to prudently manage the size of its balance sheet.
? Net interest margin up 17 basis points to 3.22 percent. The quarter’s increase in net interest income to $2.30 billion was driven by the 17 basis point expansion in the net interest margin. The margin improved as decreases in rates paid on interest bearing liabilities outpaced the decline in asset yields, while generally lower cost retail deposits grew as a percentage of funding. This expansion occurred despite an increase in nonperforming loans from the first quarter.
? Company builds reserves to $8.46 billion. During the second quarter, the company increased the provision for loan losses to $5.91 billion from $3.51 billion in the first quarter. The company expects remaining cumulative losses in its residential mortgage portfolios to be at the upper end of the range of losses it disclosed at the time of its capital raise in April, and for 2008 to be the peak year for provisioning.
The increase in provision for loan losses reflected the further decline in house prices which increased expected loss severities, increased delinquencies, reduced availability of credit, and the weakening economy. Total net charge-offs in the loan portfolio rose to $2.17 billion from $1.37 billion in the prior quarter. Nonperforming assets grew to 3.62 percent of total assets at June 30 from 2.87 percent at the end of the first quarter. At the same time, early stage delinquencies for the subprime and home equity portfolios showed early signs of stabilization in the quarter.
2
Approximately one third of the second quarter provision for loan losses 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 shortened the historical time period used to evaluate default frequencies for its prime mortgage portfolio from a three-year period to a one-year period to reflect the evolving risk profile of the loan portfolio and adjusted its severity assumptions for all single family mortgages to reflect the continuing decline in home prices.
Year to date, the company has provided $9.42 billion for loan losses in comparison with net charge-offs of $3.54 billion, increasing the reserve to $8.46 billion at June 30. As a percentage of loans held in portfolio, the reserve stands at 3.53 percent, up from 1.05 percent at the end of 2007. In addition, the company’s coverage ratio of the reserve to nonperforming loans was 87.26 percent, more than double the 41.99 percent at the end of last year.
? Decline in noninterest income reflects further market stress and restructuring of home loans business. Despite the 9 percent quarter over quarter increase in depositor and other retail banking fees, noninterest income of $561 million in the second quarter was down from $1.6 billion in the prior quarter. During the second quarter, the company recognized other than temporary impairment losses of $407 million in the company’s available-for-sale securities portfolio, compared with $67 million in the prior quarter. Net trading losses of $305 million were up from net losses of $216 million in the first quarter primarily due to a reduction in the value of retained interests from credit card securitizations reflecting market conditions.
The decrease in revenue from the sales and servicing of home mortgage loans reflects lower volumes in the mortgage origination pipeline due to the company’s exit from wholesale lending and closing of its home loan centers. Also impacting the quarter was a $171 million provision for repurchase reserves, up from a provision of $56 million in the first quarter. Mortgage servicing revenue was down $247 million primarily due to declines in the value of MSR risk management instruments that more than offset the increase in the MSR fair value.
? Company expands expense initiatives targeting $1 billion in savings. Noninterest expense of $2.40 billion in the quarter included $207 million in restructuring and resizing costs related to Home Loans activities as well as other corporate initiatives and foreclosed asset expense of $217 million, up from $155 million in the first quarter.
During the quarter, the company implemented a series of additional initiatives designed to significantly reduce expense levels going forward. These initiatives included the previously announced wholesale and home loans center closures and other savings across functions that primarily supported home loans activities that have been discontinued. These actions will result in total annualized cost savings of approximately $1 billion, while incurring restructuring and resizing costs of approximately $450 million, of which $207 million were recorded in the second quarter.
? Net loss per share includes one-time adjustment. The company reported a second quarter diluted net loss per share of $6.58, which included a one-time earnings per share non-cash reduction in the amount of $3.24 per common share. The reduction was recorded as a result of the June conversion of the preferred stock issued in connection with the company’s capital transaction in April. This non-cash adjustment, which had no effect on the company’s capital ratios or the net loss recorded in the second quarter, reduced retained earnings by $3.29 billion, with a corresponding increase to capital surplus-common stock. Excluding this one-time reduction, the company’s second quarter diluted net loss per common share was $3.34.
3
SECOND QUARTER SEGMENT RESULTS
Retail Banking Group
Selected Segment Information Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 6 of 9 Three Months Ended ($ in millions, except accounts and households) Jun. 30, 2008 Mar. 31, 2008 Dec. 31, 2007 Sept. 30, 2007 Jun. 30, 2007 Net interest income $ 1,210 $ 1,203 $ 1,262 $ 1,306 $ 1,291 Provision for loan losses 3,823 2,300 663 318 91 Noninterest income 842 775 850 833 820 Inter-segment revenue 7 9 5 9 16 Noninterest expense 1,232 1,221 1,212 1,149 1,131 Income (loss) before income taxes (2,996) (1,534) 242 681 905 Income taxes (959) (491) (39) 225 340 Net income (loss) $ (2,037) $ (1,043) $ 281 $ 456 $ 565
Average loans $ 138,671 $ 142,720 $ 145,486 $ 147,357 $ 149,716 Average retail deposits 149,509 146,734 142,733 144,921 145,252 Net change in number of retail checking accounts 254,957 256,069 74,493 310,360 406,243 Net change in retail households 94,000 154,000 37,000 161,000 228,000
? Revenue growth driven by increase in depositor fee income, expenses held steady. Net interest income was up slightly from the first quarter as the drop in the overall cost of deposits outpaced the decline in variable rate loan yields. Noninterest income, comprised primarily of depositor and other retail banking fees, was up 9 percent quarter over quarter. Depositor fees totaled $767 million in the second quarter, up 9 percent from the seasonally slow first quarter. The company continues to have strong checking account growth adding 254,957 net new accounts in the quarter.
? Quarterly results adversely impacted by higher loan loss provisioning. The quarter’s net loss reflected the increase in the provision for loan losses due in large part to changes in the company’s provisioning assumptions in response to continued declines in housing prices nationwide.
? Average retail deposits up 2 percent. Average retail deposits of $149.51 billion were up $2.78 billion during the quarter reflecting the growth in money market accounts. Retail deposit balances at the end of the quarter were down $3.40 billion to $148.25 billion reflecting the reduction in higher cost promotional certificates of deposit during the quarter. The average cost of retail deposits during the quarter was 2.23 percent, down from 2.65 percent in the prior quarter.
Card Services Group (managed basis)
Selected Segment Information Three Months Ended ($ in millions) Jun. 30, 2008 Mar. 31, 2008 Dec. 31, 2007 Sept. 30, 2007 Jun. 30, 2007 Net interest income $ 769 $ 765 $ 694 $ 674 $ 649 Provision for loan losses 911 626 591 611 523 Noninterest income 187 418 315 400 393 Inter-segment expense 5 5 - - - Noninterest expense 297 260 338 364 306 Income (loss) before income taxes (257) 292 80 99 213 Income taxes (82) 93 (12) 33 80 Net income (loss) $ (175) $ 199 $ 92 $ 66 $ 133
Average managed receivables $ 26,314 $ 26,889 $ 26,665 $ 25,718 $ 24,234 Period end managed receivables 26,430 26,378 27,239 26,227 24,987 30+ day managed delinquency rate 7.05% 6.89% 6.47% 5.73% 5.11% Managed net credit losses 10.84 9.32 6.90 6.37 6.49
4
? Revenue down primarily due to higher credit costs and valuation adjustments. Net interest income was flat with the prior quarter as lower funding costs were offset by a lower balance of average receivables and declines in interest rates charged on card receivables. Noninterest income was down from the prior quarter reflecting reduced value of retained interests due to market conditions. In addition, noninterest income during the first quarter included an $85 million benefit received from the company’s share of VISA’s IPO.
Noninterest expense was flat with the prior quarter, excluding the $38 million partial recovery of VISA litigation expense recorded in that quarter.
? Provision up but delinquencies stabilizing. The increase in the provision to $911 million from $626 million reflected higher managed net credit losses and an increase in reported receivables as maturing securitizations resulted in on-balance sheet funding of new originations. Managed net credit losses of 10.84 percent reflected the increase in contractual and bankruptcy losses in the face of a weaker economy. Reflecting the previous actions taken to reduce the company’s loss exposure, the 30+ day managed delinquency rate of 7.05 percent was up slightly from the prior quarter.
? Total managed receivables flat with prior quarter. Total managed receivables at quarter end remained level at $26.43 billion. During the quarter, Card Services opened 755,301 new credit card accounts, up from 666,407 in the prior quarter. Approximately 35 percent of the new accounts came through the retail channel as the company continued to leverage its retail network.
Commercial Group
Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 7 of 9 Selected Segment Information Three Months Ended ($ in millions) Jun. 30, 2008 Mar. 31, 2008 Dec. 31, 2007 Sept. 30, 2007 Jun. 30, 2007 Net interest income $ 203 $ 196 $ 200 $ 200 $ 208 Provision for loan losses 17 29 19 12 2 Noninterest income 5 (8) (10) (34) 63 Noninterest expense 63 68 66 67 74 Income before income taxes 128 91 105 87 195 Income taxes 41 29 11 28 73 Net income $ 87 $ 62 $ 94 $ 59 $ 122
Loan volume $ 3,768 $ 2,835 $ 4,800 $ 4,054 $ 4,348 Average loans 41,891 40,934 40,129 38,333 38,789
? Net income up $25 million to $87 million. Net interest income of $203 million was up modestly from the prior quarter due to loan growth and improved net interest margin. Noninterest income was up slightly from the first quarter as a result of lower trading asset write-downs and higher gain on sale driven by an increase in volume.
The low level of noninterest expense continued to reflect ongoing expense efficiencies.
? Provision down, strong credit trends continue. The provision for loan losses was down for the quarter with a corresponding decline in net charge-offs. Charge-offs during the quarter remained low at an annualized rate of only 2 basis points reflecting the portfolio’s conservative underwriting, low loan-to-value ratios, and small balance lending.
? Loan volume and balances up. Loan volume of $3.77 billion was up 33 percent from the prior quarter and average loans of $41.89 billion were up 2 percent as the company continued to invest in this business.
5
Home Loans Group
Selected Segment Information Three Months Ended ($ in millions) Jun. 30, 2008 Mar. 31, 2008 Dec. 31, 2007 Sept. 30, 2007 Jun. 30, 2007 Net interest income $ 240 $ 250 $ 229 $ 191 $ 211 Provision for loan losses 1,637 907 511 323 101 Noninterest income (97) 319 329 183 389 Inter-segment expense 2 4 5 9 16 Noninterest expense* 484 499 2,319 554 547 Income (loss) before income taxes (1,980) (841) (2,277) (512) (64) Income taxes (635) (269) (312) (169) (24) Net (loss) $ (1,345) $ (572) $ (1,965) $ (343) $ (40)
Loan volume $ 8,462 $ 13,774 $ 19,089 $ 26,434 $ 35,938 Average loans 54,880 55,672 52,278 43,737 43,312
*Includes $1.78 billion goodwill charge in fourth quarter 2007.
? Results reflect reduced mortgage market participation. Net interest income fell slightly from the prior quarter reflecting a higher level of nonaccruals and a decline in loan balances on lower production.
Noninterest income was down from the first quarter due to the decline in gain on sale from lower loan commitment volume and the increase in the provision for repurchase reserves reflecting an increase in repurchase demands related to prime home mortgage loans. The repurchase reserve totaled $283 million at the end of the quarter, up from $178 million at Mar. 31. The quarterly gain on sale variance was also impacted by $68 million in additional gains in the first quarter from sales of loans locked prior to the adoption of new accounting pronouncements impacting gain on sale recognition.
Noninterest income also reflected mortgage servicing revenue down $247 million, primarily due to declines in the value of MSR risk management instruments that more than offset the increase in MSR fair value.
? Expense declines reflect consolidation of Home Loans business. Despite the increase in foreclosed asset expense to $149 million from $118 million, noninterest expense of $484 million in the second quarter was down 3 percent from the first quarter with the further consolidation of the home loans business. The number of employees was reduced to 7,338 at the end of the second quarter from 9,135 at the end of the first quarter.
? Credit costs remain elevated. The increase in the provision to $1.64 billion from $907 million in the first quarter was driven by an acceleration in delinquencies and charge-offs, while subprime delinquencies showed signs of stabilization during the quarter. Total charge-offs rose to $807 million, up $341 million from the prior quarter.
? Production volume reduced as a result of management’s actions. Home loans segment volume of $8.46 billion was down 39 percent from first quarter levels reflecting the company’s decision to exit wholesale lending and close all remaining home loan centers.
Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 8 of 9
6
COMPANY UPDATES
? On July 22, WaMu announced that the Human Resources Committee of the Board of Directors determined that, in light of the company’s 2008 financial performance to date, including the impact of mortgage-related loan loss provisions and foreclosed asset expense, the company’s Chief Executive Officer, President and Chief Operating Officer and Chief Financial Officer will not receive annual incentive payments under the company's 2008 Leadership Bonus Plan.
? On July 15, WaMu’s Board of Directors declared a cash dividend of $0.01 per share on the company’s common stock. Dividends on the common stock are payable on Aug. 15, 2008 to shareholders of record as of Jul. 31, 2008. In addition to declaring a dividend on the company’s common stock, the company will pay a dividend of $0.2528 per depository share of Series K Preferred Stock to be payable on Sept. 15, 2008 to holders of record on Sept. 1, 2008, a dividend of $19.8056 per share of Series R Preferred Stock to be payable on Sept. 15, 2008 to holders of record on Sept. 1, 2008.
? On Jun. 27, WaMu announced that a search had been initiated to replace James Corcoran, President of the Retail Bank who left WaMu to pursue other career opportunities.
? On Jun. 24, WaMu shareholders approved an amendment to increase the number of authorized common stock from 1,600,000,000 to 3,000,000,000, the conversion of the Series S and Series T Perpetual Contingent Convertible Non-Voting Preferred Stock into common stock and the ability of the warrants to be exercised to purchase common stock. On Jun. 30, the Series S and Series T preferred stock was converted into common stock.
? On Jun. 4, WaMu announced that Michael S. Solender had been named the company’s Executive Vice President and Chief Legal Officer. Solender reports to Kerry Killinger, WaMu’s CEO, and is a member of the company’s Executive Committee.
? On Jun. 2, WaMu announced that effective Jul. 1, independent director Stephen E. Frank would assume the role of independent Board Chair while Kerry Killinger would continue to lead the company as Chief Executive Officer and serve as a director.
? On Jun. 2, WaMu announced that under its new majority voting standard, in uncontested director elections, nominees must receive a majority of votes cast to be re- elected.
? On Apr. 29, WaMu announced that it named John P. McMurray as the company’s Chief Enterprise Risk Officer.
ABOUT WAMU
WaMu, through its subsidiaries, is one of the nation’s leading consumer and small business banks. At Jun. 30, 2008, WaMu and its subsidiaries had assets of $309.73 billion. The company has a history dating back to 1889 and its subsidiary banks currently operate approximately 2,300 consumer and small business banking stores throughout the nation. WaMu’s financial reports and news releases are available at www.wamu.com/ir.
WEBCAST INFORMATION
A conference call to discuss the company’s financial results will be held on Tuesday, Jul. 22, 2008, at 5:00 p.m. ET and will be hosted by Kerry Killinger, Chief Executive Officer, Tom Casey, Executive Vice President and Chief Financial Officer and John McMurray, Executive Vice president and Chief Enterprise Risk Officer. The conference call is available by telephone or on the Internet. The dial-in number for the live conference call is 888-324-6919. Participants calling from outside the United States may dial 312- 470-7289. The passcode “WaMu” is required to access the call. Via the Internet, the conference call is available on the Investor Relations portion of the company’s web site at www.wamu.com/ir. A recording of the conference call will be available from approximately 7:00 p.m. ET on Tuesday, Jul. 22, 2008 through 11:59 p.m. on Friday, Aug. 1, 2008. The recorded message will be available at 888-568-0151. Callers from outside the United States may dial 203-369-3462.
7
FORWARD LOOKING STATEMENTS
This presentation contains forward-looking statements, which are not historical facts and pertain to future operating results. These forward-looking statements are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this document that are not historical facts. When used in this presentation, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or words of similar meaning, or future or conditional verbs, such as “will,” “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the results discussed in these forward-looking statements for the reasons, among others, discussed under the heading “Factors That May Affect Future Results” in Washington Mutual’s 2007 Annual Report on Form 10-K, as amended, and Quarterly Report on Form 10-Q for the quarter ended March 31, 2008 which include: ? Economic conditions that negatively affect housing prices and the job market that have resulted, and may continue to result, in deterioration in credit quality of the company's loan portfolio. ? Access to market-based liquidity sources that may be negatively impacted if market conditions persist or if further ratings downgrades occur and could lead to increased funding costs and reduced gain on sale. ? The need to raise additional capital due to significant additional losses which could have a dilutive effect on existing shareholders and could affect the ability to pay dividends. ? Changes in interest rates. ? Features of certain of the company’s loan products that may result in increased credit risk. ? Estimates used by the company to determine the fair value of certain of our assets that may prove to be imprecise and result in significant changes in valuation. Case 1:09-cv-01656-RMC Document 54-8 Filed 11/22/10 Page 9 of 9 ? Risks related to the company’s credit card operations that could adversely affect the credit card portfolio and our ability to continue growing the credit card business. ? Operational risk which may result in incurring financial and reputational losses. ? Failure to comply with laws and regulations. ? Changes in the regulation of financial services companies, housing government-sponsored enterprises, mortgage originators and servicers, and credit card lenders. ? General business, economic and market conditions and continued deterioration in these conditions. ? Damage to the company’s professional reputation and business as a result of allegations and negative public opinion as well as pending and threatened litigation. ? Significant competition from banking and nonbanking companies. There are other factors not described in our 2007 Form 10-K, as amended, and Form 10-Q for the quarter ended March 31, 2008 which are beyond the company’s ability to anticipate or control that could cause results to differ.
####
Media Contact Investor Relations Contact Derek Aney Alan Magleby 206-500-6094 (Seattle) 206-500-4148 (Seattle) 212-326-6075 (New York) 212-702-6955 (New York) [email protected] [email protected]
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Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 2 of 8 10-K 1 d10k.htm FORM 10-K
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K
Annual report pursuant to section 13 or 15(d) of The Securities Exchange Act of 1934 For the fiscal year ended Commission file December 31, 2007 number 1-5805 JPMorgan Chase & Co. (Exact name of registrant as specified in its charter) Delaware 13-2624428 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.)
270 Park Avenue, New York, NY 10017 (Address of principal executive offices) (Zip code)
Registrant’s telephone number, including area code: (212) 270-6000 Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Common stock JPMorgan Market Participation Notes on the S&P 500® Index due 6 1/8% subordinated notes due 2008 March 12, 2008 6.75% subordinated notes due 2008 Capped Quarterly Observation Notes Linked to S&P 500® Index due 6.50% subordinated notes due 2009 September 22, 2008 Guarantee of 7.00% Capital Securities, Series J, of J.P. Morgan Capped Quarterly Observation Notes Linked to S&P 500® Index due Chase Capital X October 30, 2008 Guarantee of 5 7/8% Capital Securities, Series K, of J.P. Morgan Chase Capped Quarterly Observation Notes Linked to S&P 500® Index due Capital XI January 21, 2009 Guarantee of 6.25% Capital Securities, Series L, of J.P. Morgan JPMorgan Market Participation Notes on the S&P 500® Index due Chase Capital XII March 31, 2009 Guarantee of 6.20% Capital Securities, Series N, of JPMorgan Capped Quarterly Observation Notes Linked to S&P 500® Index due Chase Capital XIV July 7, 2009 Guarantee of 6.35% Capital Securities, Series P, of JPMorgan Capped Quarterly Observation Notes Linked to S&P 500® Index due Chase Capital XVI September 21, 2009
Guarantee of 6.625% Capital Securities, Series S, of JPMorgan Consumer Price Indexed Securities due January 15, 2010 Chase Capital XIX Principal Protected Notes Linked to S&P 500® Index due Guarantee of 6.875% Capital Securities, Series X, of JPMorgan September 30, 2010 Chase Capital XXIV
Guarantee of 7.20% Preferred Securities of BANK ONE Capital VI
The JPMorgan Market Participation Notes, Capped Quarterly Observation Notes, Consumer Price Indexed Securities and Principal Protected Notes are listed on the American Stock Exchange; all other securities named above are listed on the New York Stock Exchange.
Securities registered pursuant to Section 12(g) of the Act: none
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. x Yes ¨ No
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes x No
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 3 of 8 further discussion of MSR risk management activities, see Note 18 on pages 154–156 of this Annual Report. All amounts have been included in earnings consistent with the classification of the hedged item, primarily Net interest income for Long-term debt and AFS securities; Mortgage fees and related income for MSRs, Other income for warehouse loans; and Principal transactions for gold inventory. The Firm did not recognize any gains or losses during 2007, 2006 or 2005 on firm commitments that no longer qualify as fair value hedges. JPMorgan Chase also enters into derivative contracts to hedge exposure to variability in cash flows from floating-rate financial instruments and forecasted transactions, primarily the rollover of short-term assets and liabilities, and foreign currency– denominated revenue and expense. Interest rate swaps, futures and forward contracts are the most common instruments used to reduce the impact of interest rate and foreign exchange rate changes on future earnings. All amounts affecting earnings have been recognized consistent with the classification of the hedged item, primarily Net interest income.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JPMorgan Chase & Co.
Note 31 – Off–balance sheet lending- To provide for the risk of loss inherent in wholesale-related related financial instruments and contracts, an allowance for credit losses on lending-related guarantees commitments is maintained. See Note 15 on pages 138–139 of this Annual Report for further discussion of the allowance JPMorgan Chase utilizes lending-related financial instruments for credit losses on lending-related commitments. (e.g., commitments and guarantees) to meet the financing needs of its customers. The contractual amount of these The following table summarizes the contractual amounts of financial instruments represents the maximum possible credit off–balance sheet lending-related financial instruments and risk should the counterparty draw down the commitment or the guarantees and the related allowance for credit losses on Firm fulfill its obligation under the guarantee, and the lending-related commitments at December 31, 2007 and 2006. counterparty subsequently fail to perform according to the terms of the contract. Most of these commitments and guarantees expire without a default occurring or without being drawn. As a result, the total contractual amount of these instruments is not, in the Firm’s view, representative of its actual future credit exposure or funding requirements. Further, certain commitments, primarily related to consumer financings, are cancelable, upon notice, at the option of the Firm.
Off–balance sheet lending-related financial instruments and guarantees
Allowance for Contractual amount lending-related commitments December 31, (in millions) 2007 2006 2007 2006 Lending-related Consumer(a) $ 815,936 $ 747,535 $ 15 $ 25 Wholesale: Other unfunded commitments to extend credit (b)(c)(d)(e) 250,954 229,204 571 305 Asset purchase agreements(f) 90,105 67,529 9 6 Standby letters of credit and financial guarantees(c)(g)(h) 100,222 89,132 254 187 Other letters of credit(c) 5,371 5,559 1 1 Total wholesale 446,652 391,424 835 499 Total lending-related $ 1,262,588 $ 1,138,959 $ 850 $ 524 Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 4 of 8 Other guarantees Securities lending guarantees(i) $ 385,758 $ 318,095 NA NA Derivatives qualifying as guarantees(j) 85,262 71,531 NA NA
(a) Includes credit card and home equity lending-related commitments of $714.8 billion and $74.2 billion, respectively, at December 31, 2007; and $657.1 billion and $69.6 billion, respectively, at December 31, 2006. These amounts for credit card and home equity lending–related commitments represent the total available credit for these products. The Firm has not experienced, and does not anticipate, that all available lines of credit for these products will be utilized at the same time. The Firm can reduce or cancel these lines of credit by providing the borrower prior notice or, in some cases, without notice as permitted by law. (b) Includes unused advised lines of credit totaling $38.4 billion and $39.0 billion at December 31, 2007 and 2006, respectively, which are not legally binding. In regulatory filings with the Federal Reserve Board, unused advised lines are not reportable. (c) Represents contractual amount net of risk participations totaling $28.3 billion and $32.8 billion at December 31, 2007 and 2006, respectively. (d) Excludes unfunded commitments for private third-party equity investments of $881 million and $589 million at December 31, 2007 and 2006, respectively. Also excludes unfunded commitments for other equity investments of $903 million and $943 million at December 31, 2007 and 2006, respectively. (e) Included in Other unfunded commitments to extend credit are commitments to investment and noninvestment grade counterparties in connection with leveraged acquisitions of $8.2 billion at December 31, 2007. (f) Largely represents asset purchase agreements to the Firm’s administered multi-seller, asset-backed commercial paper conduits. It also includes $1.1 billion and $1.4 billion of asset purchase agreements to other third-party entities at December 31, 2007 and 2006, respectively. (g) JPMorgan Chase held collateral relating to $15.8 billion and $13.5 billion of these arrangements at December 31, 2007 and 2006, respectively. (h) Included unused commitments to issue standby letters of credit of $50.7 billion and $45.7 billion at December 31, 2007 and 2006, respectively. (i) Collateral held by the Firm in support of securities lending indemnification agreements was $390.5 billion and $317.9 billion at December 31, 2007 and 2006, respectively. (j) Represents notional amounts of derivatives qualifying as guarantees.
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Other unfunded commitments to extend credit Asset purchase agreements Unfunded commitments to extend credit are agreements to The majority of the Firm’s unfunded commitments are not lend only when a customer has complied with predetermined guarantees as defined in FIN 45, except for certain asset conditions, and they generally expire on fixed dates. purchase agreements that are principally used as a Included in Other unfunded commitments to extend credit are mechanism to provide liquidity to SPEs, primarily multi-seller commitments to investment and noninvestment grade conduits, as described in Note 17 on pages 146–154 of this borrowers in connection with leveraged acquisitions. These Annual Report. The conduit’s administrative agent can require commitments are dependent on whether the acquisition by the the liquidity provider to perform under their asset purchase borrower is successful, tend to be short-term in nature and, in agreement with the conduit at any time. These agreements most cases, are subject to certain conditions based on the may cause the Firm to purchase an asset from the SPE at an borrower’s financial condition or other factors. Additionally, the amount above the asset’s then fair value, in effect providing a Firm often syndicates portions of the initial position to other guarantee of the initial value of the reference asset as of the investors, depending on market conditions. These date of the agreement. In most instances, third-party credit commitments generally contain flexible pricing features to enhancements of the SPE mitigate the Firm’s potential losses adjust for changing market conditions prior to closing. on these agreements. Alternatively, the borrower may turn to the capital markets for Standby letters of credit and financial guarantees required funding instead of drawing on the commitment Standby letters of credit and financial guarantees are provided by the Firm, and the commitment may expire unused. conditional lending commitments issued by JPMorgan Chase As such, these commitments are not necessarily indicative of to guarantee the performance of a customer to a third party the Firm’s actual risk and the total commitment amount may under certain arrangements, such as commercial paper not reflect actual future cash flow requirements. The amount of facilities, bond financings, acquisition financings, trade and these commitments at December 31, 2007, was $8.2 billion. similar transactions. Approximately 50% of these arrangements For further information, see Note 4 and Note 5 on pages 111– mature within three years. The Firm typically has recourse to 118 and 119–121, respectively, of this Annual Report. recover from the customer any amounts paid under these FIN 45 guarantees guarantees; in addition, the Firm may hold cash or other highly FIN 45 establishes accounting and disclosure requirements for liquid collateral to support these guarantees. guarantees, requiring that a guarantor recognize, at the Securities lending indemnification inception of a guarantee, a liability in an amount equal to the Through the Firm’s securities lending program, customers’ fair value of the obligation undertaken in issuing the securities, via custodial and non-custodial arrangements, may guarantee. FIN 45 defines a guarantee as a contract that be lent to third parties. As part of this program, the Firm issues contingently requires the guarantor to pay a guaranteed party, securities lending indemnification agreements to the lender based upon: (a) changes in an underlying asset, liability or which protects it principally against the failure of the third-party equity security of the guaranteed party; or (b) a third party’s borrower to return the lent securities. To support these failure to perform under a specified agreement. The Firm indemnification agreements, the Firm obtains cash or other considers the following off–balance sheet lending highly liquid collateral with a market value exceeding 100% of arrangements to be guarantees under FIN 45: certain asset the value of the securities on loan from the borrower. Collateral purchase agreements, standby letters of credit and financial is marked to market daily to help assure that collateralization is guarantees, securities lending indemnifications, certain adequate. Additional collateral is called from the borrower if a Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 5 of 8 indemnification agreements included within third-party shortfall exists or released to the borrower in the event of contractual arrangements and certain derivative contracts. overcollateralization. If an indemnifiable default by a borrower These guarantees are described in further detail below. occurs, the Firm would expect to use the collateral held to The fair value at inception of the obligation undertaken when purchase replacement securities in the market or to credit the issuing the guarantees and commitments that qualify under lending customer with the cash equivalent thereof. FIN 45 is typically equal to the net present value of the future Also, as part of this program, the Firm invests cash collateral amount of premium receivable under the contract. The Firm received from the borrower in accordance with approved has recorded this amount in Other Liabilities with an offsetting guidelines. On an exception basis the Firm may indemnify the entry recorded in Other Assets. As cash is received under the lender against this investment risk when certain types of contract, it is applied to the premium receivable recorded in investments are made. Other Assets, and the fair value of the liability recorded at Based upon historical experience, management believes that inception is amortized into income as Lending & deposit- these risks of loss are remote. related fees over the life of the guarantee contract. The amount of the liability related to FIN 45 guarantees recorded at December 31, 2007 and 2006, excluding the allowance for credit losses on lending-related commitments and derivative contracts discussed below, was approximately $335 million and $297 million, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JPMorgan Chase & Co.
Indemnification agreements – general Credit card charge-backs In connection with issuing securities to investors, the Firm may The Firm is a partner with one of the leading companies in enter into contractual arrangements with third parties that may electronic payment services in a joint venture operating under require the Firm to make a payment to them in the event of a the name of Chase Paymentech Solutions, LLC (the “joint change in tax law or an adverse interpretation of tax law. In venture”). The joint venture was formed in October 2005, as a certain cases, the contract also may include a termination result of an agreement by the Firm and First Data Corporation, clause, which would allow the Firm to settle the contract at its its joint venture partner, to integrate the companies’ jointly fair value; thus, such a clause would not require the Firm to owned Chase Merchant Services and Paymentech merchant make a payment under the indemnification agreement. Even businesses. The joint venture provides merchant processing without the termination clause, management does not expect services in the United States and Canada. Under the rules of such indemnification agreements to have a material adverse Visa USA, Inc., and Mastercard International, JPMorgan effect on the consolidated financial condition of JPMorgan Chase Bank, N.A., is liable primarily for the amount of each Chase. See below for more information regarding the Firm’s processed credit card sales transaction that is the subject of a loan securitization activities. The Firm may also enter into dispute between a cardmember and a merchant. The joint indemnification clauses in connection with the licensing of venture is contractually liable to JPMorgan Chase Bank, N.A., software to clients (“software licensees”) or when it sells a for these disputed transactions. If a dispute is resolved in the business or assets to a third party (“third-party purchasers”), cardmember’s favor, the joint venture will (through the pursuant to which it indemnifies software licensees for claims cardmember’s issuing bank) credit or refund the amount to the of liability or damage that may occur subsequent to the cardmember and will charge back the transaction to the licensing of the software, or third-party purchasers for losses merchant. If the joint venture is unable to collect the amount they may incur due to actions taken by the Firm prior to the from the merchant, the joint venture will bear the loss for the sale of the business or assets. It is difficult to estimate the amount credited or refunded to the cardmember. The joint Firm’s maximum exposure under these indemnification venture mitigates this risk by withholding future settlements, arrangements, since this would require an assessment of retaining cash reserve accounts or by obtaining other security. future changes in tax law and future claims that may be made However, in the unlikely event that: (1) a merchant ceases against the Firm that have not yet occurred. However, based operations and is unable to deliver products, services or a upon historical experience, management expects the risk of refund; (2) the joint venture does not have sufficient collateral loss to be remote. from the merchant to provide customer refunds; and (3) the Securitization-related indemnifications joint venture does not have sufficient financial resources to As part of the Firm’s loan securitization activities, as described provide customer refunds, JPMorgan Chase Bank, N.A., would in Note 16 on pages 139–145 of this Annual Report, the Firm be liable for the amount of the transaction, although it would Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 6 of 8 provides representations and warranties that certain securitized have a contractual right to recover from its joint venture partner loans meet specific requirements. The Firm may be required to an amount proportionate to such partner’s equity interest in the repurchase the loans and/or indemnify the purchaser of the joint venture. For the year ended December 31, 2007, the joint loans against losses due to any breaches of such venture incurred aggregate credit losses of $10 million on representations or warranties. Generally, the maximum amount $719.1 billion of aggregate volume processed. At of future payments the Firm would be required to make under December 31, 2007, the joint venture held $779 million of such repurchase and/or indemnification provisions would be collateral. For the year ended December 31, 2006, the joint equal to the current amount of assets held by such venture incurred aggregate credit losses of $9 million on securitization-related SPEs as of December 31, 2007, plus, in $660.6 billion of aggregate volume processed. At certain circumstances, accrued and unpaid interest on such December 31, 2006, the joint venture held $893 million of loans and certain expense. The potential loss due to such collateral. The Firm believes that, based upon historical repurchase and/or indemnity is mitigated by the due diligence experience and the collateral held by the joint venture, the fair the Firm performs before the sale to ensure that the assets value of the Firm’s chargeback-related obligations would not comply with the requirements set forth in the representations be different materially from the credit loss allowance recorded and warranties. Historically, losses incurred on such by the joint venture; therefore, the Firm has not recorded any repurchases and/or indemnifications have been insignificant, allowance for losses in excess of the allowance recorded by and therefore management expects the risk of material loss to the joint venture. be remote.
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Exchange, clearinghouse and credit card Derivative guarantees association guarantees In addition to the contracts described above, there are certain The Firm is a member of several securities and futures derivative contracts to which the Firm is a counterparty that exchanges and clearinghouses, both in the United States and meet the characteristics of a guarantee under FIN 45. These other countries. Membership in some of these organizations derivatives are recorded on the Consolidated balance sheets requires the Firm to pay a pro rata share of the losses incurred at fair value. These contracts include written put options that by the organization as a result of the default of another require the Firm to purchase assets from the option holder at a member. Such obligations vary with different organizations. specified price by a specified date in the future, as well as These obligations may be limited to members who dealt with derivatives that effectively guarantee the return on a the defaulting member or to the amount (or a multiple of the counterparty’s reference portfolio of assets. The total notional amount) of the Firm’s contribution to a members’ guaranty value of the derivatives that the Firm deems to be guarantees fund, or, in a few cases, the obligation may be unlimited. It is was $85.3 billion and $71.5 billion at December 31, 2007 and difficult to estimate the Firm’s maximum exposure under these 2006, respectively. The Firm reduces exposures to these membership agreements, since this would require an contracts by entering into offsetting transactions or by entering assessment of future claims that may be made against the into contracts that hedge the market risk related to these Firm that have not yet occurred. However, based upon contracts. The fair value related to these contracts was a historical experience, management expects the risk of loss to derivative receivable of $213 million and $230 million, and a be remote. derivative payable of $2.5 billion and $987 million at The Firm is an equity member of VISA Inc. During October December 31, 2007 and 2006, respectively. 2007, certain VISA related entities completed a series of Finally, certain written put options and credit derivatives permit restructuring transactions to combine their operations, cash settlement and do not require the option holder or the including VISA USA, under one holding company, VISA Inc. buyer of credit protection to own the reference asset. The Firm Upon the restructuring, the Firm’s membership interest in VISA does not consider these contracts to be guarantees under FIN USA was converted into an equity interest in VISA Inc. VISA 45. Inc. intends to issue and sell shares via an initial public offering and to use a portion of the proceeds from the offering to Note 32 – Credit risk concentrations redeem a portion of the Firm’s equity interest in Visa Inc. Concentrations of credit risk arise when a number of Prior to the restructuring, VISA USA’s by-laws obligated the customers are engaged in similar business activities or Firm upon demand by VISA to indemnify VISA for, among activities in the same geographic region, or when they have other things, litigation obligations of Visa. The accounting for similar economic features that would cause their ability to meet that guarantee was not subject to fair value accounting under contractual obligations to be similarly affected by changes in FIN 45 because the guarantee was in effect prior to the economic conditions. effective date of FIN 45. Upon the restructuring event, the JPMorgan Chase regularly monitors various segments of its Firm’s obligation to indemnify Visa was limited to certain credit portfolio to assess potential concentration risks and to Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 7 of 8 one day and three months. Commercial paper generally is have maturities of one year or less. At December 31, 2007, issued in amounts not less than $100,000 and with maturities JPMorgan Chase had no lines of credit for general corporate of 270 days or less. purposes.
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Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.
JPMorgan Chase & Co. (Registrant)
By: /s/ JAMES DIMON (James Dimon Chairman and Chief Executive Officer)
Date: February 29, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the date indicated. JPMorgan Chase does not exercise the power of attorney to sign on behalf of any Director.
Capacity Date
/s/ JAMES DIMON Director, Chairman and Chief Executive Officer (Principal (James Dimon) Executive Officer)
/s/ CRANDALL C. BOWLES Director (Crandall C. Bowles) February 29, 2008
/s/ STEPHEN B. BURKE Director (Stephen B. Burke)
/s/ DAVID M. COTE Director (David M. Cote)
/s/ JAMES S. CROWN Director (James S. Crown)
/s/ ELLEN V. FUTTER Director (Ellen V. Futter)
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Capacity Date
/s/ WILLIAM H. GRAY, III Director (William H. Gray, III) Case 1:09-cv-01656-RMC Document 54-9 Filed 11/22/10 Page 8 of 8
/s/ LABAN P. JACKSON, JR. Director (Laban P. Jackson, Jr.)
/s/ ROBERT I. LIPP Director (Robert I. Lipp)
/s/ DAVID C. NOVAK Director February 29, 2008 (David C. Novak)
/s/ LEE R. RAYMOND Director (Lee R. Raymond)
/s/ WILLIAM C. WELDON Director (William C. Weldon)
/s/ MICHAEL J. CAVANAGH Executive Vice President (Michael J. Cavanagh) and Chief Financial Officer (Principal Financial Officer)
/s/ LOUIS RAUCHENBERGER Managing Director and Controller (Louis Rauchenberger) (Principal Accounting Officer)
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EXHIBIT 7
Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 2 of 17 8-K 1 y74000e8vk.htm FORM 8-K
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 8-K
CURRENT REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Date of Report (date of earliest event reported): January 15, 2009 JPMORGAN CHASE & CO. (Exact name of registrant as specified in its charter)
Delaware 1-5805 13-2624428 (State or Other Jurisdiction of (Commission File Number) (IRS Employer Incorporation) Identification No.)
270 Park Avenue, New York, NY 10017 (Address of Principal Executive Offices) (Zip Code)
Registrant’s telephone number, including area code: (212) 270-6000 Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions (see General Instruction A.2. below): o Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425) o Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12) o Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b)) o Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))
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Item 2.02 Results of Operations and Financial Condition Item 9.01 Financial Statements and Exhibits SIGNATURE EXHIBIT INDEX EX-12.1: COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES EX-12.2: COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND PREFERRED STOCK DIVIDEND REQUIREMENTS EX-99.1: EARNINGS RELEASE EX-99.2: EARNINGS RELEASE FINANCIAL SUPPLEMENT Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 3 of 17
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Item 2.02 Results of Operations and Financial Condition On January 15, 2009, JPMorgan Chase & Co. (“JPMorgan Chase” or the “Firm”) reported 2008 fourth quarter net income of $702 million, or $0.07 per share, compared with net income of $3.0 billion, or $0.86 per share, for the fourth quarter of 2007. A copy of the 2008 fourth quarter earnings release is attached hereto as Exhibit 99.1, and a copy of the earnings release financial supplement is attached hereto as Exhibit 99.2. Each of the Exhibits provided with this Form 8-K shall be deemed to be “filed” for purposes of the Securities Exchange Act of 1934, as amended. This current report on Form 8-K (including the Exhibits hereto) contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found in the Firm’s Quarterly Reports on Form 10-Q for the quarters ended September 30, 2008, June 30, 2008, and March 31, 2008, and its Annual Report on Form 10-K for the year ended December 31, 2007, each of which has been filed with the Securities and Exchange Commission and is available on JPMorgan Chase’s website (www.jpmorganchase.com) and on the Securities and Exchange Commission’s website (www.sec.gov). JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.
Item 9.01 Financial Statements and Exhibits (d) Exhibits
Exhibit Number Description of Exhibit 12.1 JPMorgan Chase & Co. Computation of Ratio of Earnings to Fixed Charges
12.2 JPMorgan Chase & Co. Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividend Requirements
99.1 JPMorgan Chase & Co. Earnings Release — Fourth Quarter 2008 Results
99.2 JPMorgan Chase & Co. Earnings Release Financial Supplement — Fourth Quarter 2008
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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
JPMORGAN CHASE & CO.
(Registrant)
By: /s/ Louis Rauchenberger
Louis Rauchenberger
Managing Director and Controller [Principal Accounting Officer]
Dated: January 15, 2009 Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 4 of 17 3
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EXHIBIT INDEX
Exhibit Number Description of Exhibit 12.1 JPMorgan Chase & Co. Computation of Ratio of Earnings to Fixed Charges
12.2 JPMorgan Chase & Co. Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividend Requirements
99.1 JPMorgan Chase & Co. Earnings Release — Fourth Quarter 2008 Results
99.2 JPMorgan Chase & Co. Earnings Release Financial Supplement — Fourth Quarter 2008
4 Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 5 of 17 EX-99.1 4 y74000exv99w1.htm EX-99.1: EARNINGS RELEASE
Exhibit 99.1
JPMorgan Chase & Co. 270 Park Avenue, New York, NY 10017-2070 NYSE symbol: JPM www.jpmorganchase.com
News release: IMMEDIATE RELEASE
JPMORGAN CHASE REPORTS FULL-YEAR 2008 NET INCOME OF $5.6 BILLION, OR $1.37 PER SHARE, ON REVENUE OF $67.3 BILLION; FOURTH-QUARTER 2008 NET INCOME OF $702 MILLION, OR $0.07 PER SHARE • Reported the following significant items in the fourth quarter:
- $4.1 billion (pretax) increase to loan loss reserves, resulting in coverage ratios of 4.24%1 for consumer businesses and 2.64% for wholesale businesses
- $2.9 billion (pretax) net markdowns due to leveraged lending exposures and mortgage- related positions in the Investment Bank
- $1.1 billion (aftertax) benefit from merger-related items
- $854 million (aftertax) benefit from MSR risk management results
- $680 million (aftertax) private equity write-downs
- $627 million (aftertax) gain due to dissolution of Paymentech joint venture • Maintained strong balance sheet, with Tier 1 capital of $136.2 billion, or 10.8% (estimated), at year- end
• Grew the franchise in 2008, as demonstrated by the following accomplishments2: - More than one million new checking accounts opened in Retail Financial Services
- Double-digit growth in loans and liability balances in Commercial Banking and in liability balances in Treasury & Securities Services
- #1 rankings for Global Investment Banking Fees and Global Debt, Equity & Equity-related volumes for the fourth quarter and full-year 20082 • Continued to focus on safe and sound lending activities, and launched significant enhancements to mortgage modification programs: - Extended more than $100 billion in new credit during the fourth quarter to consumers, corporations, small businesses, municipalities, and non-profits during the fourth quarter alone (including more than five million card, home equity, mortgage, auto and education loans)
- Announced plan to help 400,000 U.S. homeowners avoid foreclosure over the next two years through loan modifications New York, January 15, 2009 – JPMorgan Chase & Co. (NYSE: JPM) today reported fourth-quarter 2008 net income of $702 million, compared with net income of $3.0 billion in the fourth quarter of 2007. Earnings per share were $0.07, compared with $0.86 in the fourth quarter of 2007. For the full year 2008, net income was $5.6 billion, or $1.37 per share, down 64% from $15.4 billion, or $4.38 per share, in 2007.
1 Excluding purchased credit impaired loans.
2 Excluding impact of Washington Mutual.
3 Source: Dealogic for fees and Thomson Reuters for volumes.
Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 6 of 17 Investor Contact: Julia Bates (212) 270-7325 Media Contact: Joe Evangelisti (212) 270-7438
J.P. Morgan Chase & Co. News Release Jamie Dimon, Chairman and Chief Executive Officer, commented: “Our fourth-quarter financial results were very disappointing, driven by a loss in Investment Banking largely attributable to continued markdowns on leveraged loans and mortgage trading positions, as well as weak trading results. We also faced higher credit costs associated with continued deterioration across our loan portfolios, including a $4.1 billion addition to loan loss reserves. However, we continued to see underlying growth in many business areas. The integration of our recently-acquired Washington Mutual franchise has progressed well, and we continued to grow in Treasury & Securities Services and Commercial Banking. We also opened millions of new checking and credit card accounts, experienced net inflows in assets under management, and gained Investment Banking market share in all major fee categories.” As of December 31, 2008, the firm reported a Tier 1 capital ratio of 10.8% (estimated). During the year, the firm increased its total allowance for loan losses to $23.2 billion, resulting in a firmwide coverage ratio of 3.16%4. Dimon commented, “While the diversified nature of our franchise and strong capital position have enabled us to weather the recessionary environment so far, we added $13.9 billion to our allowance for loan losses in 2008 to keep this important component of our fortress balance sheet firmly intact.” Looking ahead to 2009, Dimon continued: “If the economic environment deteriorates further, which is a distinct possibility, it is reasonable to expect additional negative impact on our market-related businesses, continued higher loan losses and increases to our credit reserves.” “We are doing our part to help stabilize the financial markets and hasten recovery. We assumed risk and expended resources to assimilate Bear Stearns and Washington Mutual. We continued to lend in a safe and sound manner – extending more than $100 billion in new credit in the fourth quarter alone to consumers, businesses, municipalities, and non-profit organizations. We also prevented more than 300,0005 foreclosures, and we plan to help more than 300,000 more families keep their homes through mortgage modifications over the next two years. In addition, we currently have billions invested in renewable energy projects, including wind farms and solar facilities, to provide green energy for the current and future generations.” Dimon added: “JPMorgan Chase’s management team is working diligently to manage through this very difficult business climate, and to position the franchise to benefit when the economy eventually recovers. No matter how difficult the environment may get, we at JPMorgan Chase remain fully committed to delivering for our clients, supporting our franchise, and doing all we can to help restore broad-based economic growth and prosperity.” In the discussion below of the business segments and of JPMorgan Chase as a firm, information is presented on a managed basis. Managed basis starts with GAAP results and includes the following adjustments: for Card Services and the firm as a whole, the impact of credit card securitizations is excluded, and for each line of business and the firm as a whole, net revenue is shown on a tax-equivalent basis. For more information about managed basis, as well as other non- GAAP financial measures used by management to evaluate the performance of each line of business, see Notes 1 and 2 (page 13). Commencing this quarter: (1) RFS has been resegmented into two reporting segments; and (2) prime mortgage balances originated in RFS but previously reported in Corporate/Private Equity are now being reported in RFS. In addition, end-of- period third quarter balance sheet amounts related to assets acquired and liabilities assumed from Washington Mutual Bank have been reclassified into the
4 Excluding purchased credit impaired loans.
5 From early 2007 through the 4th quarter of 2008.
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J.P. Morgan Chase & Co. Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 7 of 17 News Release appropriate business segment for the 2008 third quarter. For further information, see JPMorgan Chase’s Earning Release Financial Supplement filed by the Firm today. The following discussion compares the fourth quarter of 2008 with the fourth quarter of 2007 unless otherwise noted.
INVESTMENT BANK (IB)
Results for IB 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $ (302) $ 4,035 $ 3,172 $ (4,337) NM $ (3,474) NM Provision for Credit Losses 765 234 200 531 227 565 283 Noninterest Expense 2,741 3,816 3,011 (1,075) (28%) (270) (9%)
Net Income/(Loss) $ (2,364) $ 882 $ 124 $ (3,246) NM $ (2,488) NM
Discussion of Results: Net loss was $2.4 billion, a decrease of $2.5 billion from the prior year. The weaker results reflected a decrease in net revenue and a higher provision for credit losses, partially offset by lower noninterest expense. Net revenue was negative $302 million, a decrease of $3.5 billion from the prior year. Investment banking fees were $1.4 billion, down 17% from the prior year. Advisory fees were $579 million, down 10% from the prior year, reflecting decreased levels of activity, partially offset by improved market share. Debt underwriting fees were $464 million, down 1% from the prior year. Equity underwriting fees were $330 million, down 39% from the prior year. Fixed Income Markets revenue was negative $1.7 billion, compared with $615 million in the prior year. The decrease was driven by $1.8 billion of net markdowns on leveraged lending funded and unfunded commitments; $1.1 billion of net markdowns on mortgage-related exposures; weak trading results in credit- related products; and losses of $367 million from the tightening of the firm’s credit spread on certain structured liabilities. These results were largely offset by record performance in rates and currencies and strong performance in commodities and emerging markets. Equity Markets revenue was negative $94 million, down by $672 million from the prior year, reflecting weak trading results and losses of $354 million from the tightening of the firm’s credit spread on certain structured liabilities, partially offset by strong client revenue across products, including prime services. Credit Portfolio revenue was $90 million, down $232 million from the prior year. The provision for credit losses was $765 million, compared with $200 million in the prior year, predominantly reflecting a higher allowance driven by a weakening credit environment. Net charge-offs were $87 million, compared with net recoveries of $9 million in the prior year. The allowance for loan losses to average loans retained was 4.71% for the current quarter, an increase from 1.93% in the prior year. Average loans retained were $73.1 billion, an increase of $4.2 billion, or 6%, from the prior year. Average fair-value and held-for- sale loans were $16.4 billion, down $8.6 billion, or 34%, from the prior year. Noninterest expense was $2.7 billion, down 9% from the prior year, reflecting lower performance-based compensation expense, largely offset by additional expenses relating to the Bear Stearns merger.
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J.P. Morgan Chase & Co. News Release Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § Ranked #1 in Global Debt, Equity and Equity-related; #1 in Global Equity and Equity-related; #2 in Global Long-Term Debt; #1 in Global Syndicated Loans; and #2 in Global Announced M&A, based on volume, for the year ended December 31, 2008, according to Thomson Reuters. § Ranked #1 in Global Investment Banking Fees for the year ended December 31, 2008, according to Dealogic.
§ Return on Equity was negative 28% on $33.0 billion of average allocated capital. Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 8 of 17 RETAIL FINANCIAL SERVICES (RFS)
Results for RFS 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $8,684 $4,963 $4,796 $3,721 75% $3,888 81% Provision for Credit Losses 3,576 2,056 1,063 1,520 74 2,513 236 Noninterest Expense 4,046 2,779 2,541 1,267 46 1,505 59
Net Income $ 624 $ 64 $ 731 $ 560 NM $ (107) (15%)
Discussion of Results: Net income was $624 million, a decrease of $107 million, or 15%, from the prior year, as a significant increase in the provision for credit losses was predominantly offset by positive MSR risk management results and the positive impact of the Washington Mutual transaction. Net revenue was $8.7 billion, an increase of $3.9 billion, or 81%, from the prior year. Net interest income was $4.7 billion, up $2.0 billion, or 75%, benefiting from the Washington Mutual transaction, wider deposit and loan spreads, and higher loan and deposit balances. Noninterest revenue was $4.0 billion, up $1.9 billion, or 88%, as positive MSR risk management results and the impact of the Washington Mutual transaction were offset partially by a decline in mortgage production revenue. The provision for credit losses was $3.6 billion, an increase of $2.5 billion from the prior year, as housing price declines continued to result in significant increases in estimated losses, particularly for high loan-to-value home equity and mortgage loans. The provision includes $1.6 billion in addition to the allowance for loan losses for the heritage Chase home equity and mortgage portfolios. Home equity net charge-offs were $770 million (2.15% net charge-off rate; 2.67% excluding purchased credit impaired loans), compared with $248 million (1.05% net charge-off rate) in the prior year. Subprime mortgage net charge-offs were $319 million (5.64% net charge-off rate; 8.08% excluding purchased credit impaired loans), compared with $71 million (2.08% net charge-off rate) in the prior year. Prime mortgage net charge-offs were $195 million (0.89% net charge-off rate; 1.20% excluding purchased credit impaired loans), compared with $17 million (0.22% net charge-off rate) in the prior year. The provision for credit losses was also affected by an increase in estimated losses for the auto and business banking loan portfolios. Noninterest expense was $4.0 billion, an increase of $1.5 billion, or 59%, from the prior year, reflecting the impact of the Washington Mutual transaction, higher mortgage reinsurance losses, and increased servicing expense. Retail Banking, which includes the results of all consumer banking and business banking activities, reported net income of $1.0 billion, up $479 million, or 85%, from the prior year. Net
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J.P. Morgan Chase & Co. News Release revenue was $4.5 billion, up to $2.0 billion, or 78%, reflecting the impact of the Washington Mutual transaction, wider deposit spreads, higher deposit-related fees, and higher deposit balances. The provision for credit losses was $268 million, compared with $50 million in the prior year, reflecting an increase in the allowance for loan losses for Business Banking loans due to higher estimated losses on the portfolio. Noninterest expense was $2.5 billion, up $965 million, or 62%, from the prior year, due to the Washington Mutual transaction. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § Checking accounts totaled 24.5 million, including 12.6 million attributable to the Washington Mutual transaction, an increase of 13.7 million, or 126%.
§ Average total deposits grew to $339.8 billion, including $126.3 billion attributable to the Washington Mutual transaction, an increase of $131.4 billion, or 63%.
§ Deposit margin increased to 2.94% from 2.67%.
§ Average business banking loans were $18.2 billion and originations were $0.8 billion.
§ Number of branches grew to 5,474, including 2,237 attributable to the Washington Mutual transaction, up 2,322 overall.
§ Branch sales of credit cards increased by 56%.
§ Branch sales of investment products decreased by 4%. Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 9 of 17
§ Overhead ratio (excluding amortization of core deposit intangibles) decreased to 54% from 57%. Consumer Lending, which includes the results of all consumer loan origination, servicing, and portfolio management activities, reported a net loss of $416 million, compared with net income of $170 million in the prior year. Net revenue was $4.2 billion, up $1.9 billion, or 85%, driven by higher mortgage fees and related income, the Washington Mutual transaction, wider loan spreads and higher loan balances. The increase in mortgage fees and related income was driven by higher net mortgage servicing revenue, partially offset by lower mortgage production revenue. Mortgage production revenue of $62 million was down $103 million, reflecting markdowns of the mortgage warehouse and an increase in reserves related to the repurchase of previously-sold loans. Net mortgage servicing revenue (which includes loan servicing revenue, MSR risk management results and other changes in fair value) was $1.9 billion, an increase of $1.2 billion, or 163%, from the prior year. Loan servicing revenue was $1.4 billion, an increase of $741 million on growth of 91% in third-party loans serviced. MSR risk management results were positive $1.4 billion, compared with positive $491 million in the prior year. Other changes in fair value of the MSR asset were negative $843 million, compared with negative $393 million in the prior year. The provision for credit losses was $3.3 billion, compared with $1.0 billion in the prior year. The provision reflected weakness in the home equity and mortgage portfolios (see Retail Financial Services discussion of the provision for credit losses above for further detail). Noninterest expense was $1.5 billion, up $540 million, or 55%, from the prior year, reflecting the impact of the Washington Mutual transaction, higher mortgage reinsurance losses and higher servicing expense due to increased delinquencies and defaults.
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J.P. Morgan Chase & Co. News Release Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § Average mortgage loans were $150.0 billion, up $105.5 billion, or 237%, due to the Washington Mutual transaction. Mortgage loan originations were $28.1 billion, down 30% from the prior year and down 25% from the prior quarter.
§ Total third-party mortgage loans serviced were $1.2 trillion, an increase of $557.9 billion, or 91%, predominantly due to the Washington Mutual transaction.
§ Average home equity loans were $142.8 billion, up $48.8 billion, or 52%, due to the Washington Mutual transaction. Home equity originations were $1.7 billion, down $8.1 billion, or 83%.
§ Average auto loans were $42.9 billion, up 3%. Auto loan originations were $2.8 billion, down 50%, reflecting industry-wide weakness in auto sales.
CARD SERVICES (CS)(a)
Results for CS 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $ 4,908 $ 3,887 $ 3,971 $ 1,021 26% $ 937 24% Provision for Credit Losses 3,966 2,229 1,788 1,737 78 2,178 122 Noninterest Expense 1,489 1,194 1,223 295 25 266 22
Net Income/(Loss) $ (371) $ 292 $ 609 $ (663) (227)% $ (980) (161)%
(a) Presented on a managed basis; see Note 1 (page 13) for further explanation of managed basis. Discussion of Results: Net loss was $371 million, a decline of $980 million from the prior year. The decrease was driven by a higher provision for credit losses, partially offset by higher net revenue. End-of-period managed loans were $190.3 billion, an increase of $33.3 billion, or 21%, from the prior year and up $3.8 billion, or Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 10 of 17 2%, from the prior quarter. Average managed loans were $187.3 billion, an increase of $35.6 billion, or 23%, from the prior year and up $29.7 billion, or 19%, from the prior quarter. The increase from the prior year in both end-of-period and average managed loans was predominantly due to the impact of the Washington Mutual transaction. Excluding Washington Mutual, end-of-period and average managed loans were $162.1 billion and $159.6 billion, respectively. Managed net revenue was $4.9 billion, an increase of $937 million, or 24%, from the prior year. Net interest income was $4.3 billion, up $1.2 billion, or 38%, from the prior year, driven by the impact of the Washington Mutual transaction, higher average managed loan balances, and wider loan spreads. These benefits were offset partially by the effect of higher revenue reversals associated with higher charge-offs. Noninterest revenue was $590 million, a decrease of $244 million, or 29%, from the prior year, driven by lower securitization income as well as increased rewards expense and higher volume-driven payments to partners, partially offset by the impact of the Washington Mutual transaction. The managed provision for credit losses was $4.0 billion, an increase of $2.2 billion, or 122%, from the prior year, due to an increase of $1.1 billion in the allowance for loan losses and a higher level of charge-offs. The managed net charge-off rate for the quarter was 5.56%, up from 3.89% in the prior year and 5.00% in the prior quarter. The 30-day managed delinquency rate was 4.97%, up from 3.48% in the prior year and 3.91% in the prior quarter. Excluding Washington Mutual, the managed net charge-off rate for the fourth quarter was 5.29% and the 30-day delinquency rate was 4.36%.
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J.P. Morgan Chase & Co. News Release Noninterest expense was $1.5 billion, an increase of $266 million, or 22%, from the prior year, due to the impact of the Washington Mutual transaction. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § Return on equity was negative 10%, down from positive 17% in the prior year.
§ Pretax income to average managed loans (ROO) was negative 1.16%, compared with positive 2.51% in the prior year and positive 1.17% in the prior quarter.
§ Net interest income as a percentage of average managed loans was 9.17%, up from 8.20% in the prior year and 8.18% in the prior quarter. Excluding Washington Mutual, the ratio was 8.18%.
§ Net accounts of 4.3 million were opened during the quarter. Excluding Washington Mutual, net accounts opened were 3.8 million.
§ Charge volume was $96.0 billion, an increase of $0.5 billion, or 1%, from the prior year. Excluding Washington Mutual, charge volume was $88.2 billion.
§ Merchant processing volume was $135.1 billion and total transactions were 4.9 billion.
§ The termination of Chase Paymentech Solutions, a global payments and merchant-acquiring joint venture between JPMorgan Chase and First Data Corporation, was completed on November 1, 2008. JPMorgan Chase retained approximately 51% of the business under the Chase Paymentech name.
COMMERCIAL BANKING (CB)
Results for CB 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $ 1,479 $ 1,125 $ 1,084 $ 354 31% $ 395 36% Provision for Credit Losses 190 126 105 64 51 85 81 Noninterest Expense 499 486 504 13 3 (5) (1)
Net Income $ 480 $ 312 $ 288 $ 168 54% $ 192 67%
Discussion of Results: Net income was a record $480 million, an increase of $192 million, or 67%, from the prior year, driven by higher net revenue including the impact of the Washington Mutual transaction, offset partially by higher provision for credit losses. Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 11 of 17 Net revenue was $1.5 billion, an increase of $395 million, or 36%, from the prior year. Net interest income was $1.1 billion, up $345 million, or 46%, from the prior year, driven by the Washington Mutual transaction, double-digit growth in liability and loan balances, and a shift to higher spread liability products, partially offset by spread compression in the liability and loan portfolios. Noninterest revenue was $376 million, an increase of $50 million, or 15%, from the prior year, reflecting higher deposit and lending- related fees, partially offset by lower other income. Revenue from Middle Market Banking was $796 million, an increase of $101 million, or 15%, from the prior year. Revenue from Commercial Term Lending, a new client segment encompassing multi-family and commercial mortgage loans, was $243 million. Revenue from Mid-Corporate Banking was $243 million, an increase of $4 million, or 2%. Revenue from Real Estate Banking was $131 million, an increase of $29 million, or 28%, due to the impact of the Washington Mutual transaction.
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J.P. Morgan Chase & Co. News Release The provision for credit losses was $190 million, an increase of $85 million, or 81%, compared with the prior year. The current- quarter provision reflects a weakening credit environment. The allowance for loan losses to average loans retained was 2.41% for the current quarter, down from 2.66% in the prior year and up from 2.32% in the prior quarter, reflecting the changed mix of the loan portfolio as a result of the Washington Mutual transaction. Nonperforming loans were $1.0 billion, up $880 million from the prior year and up $182 million from the prior quarter, reflecting the impact of the Washington Mutual transaction and the effect across all business segments of a weakening credit environment. Net charge-offs were $118 million (0.40% net charge-off rate), compared with $33 million (0.21% net charge-off rate) in the prior year and $40 million (0.22% net charge-off rate) in the prior quarter. Noninterest expense was $499 million, a decrease of $5 million, or 1%, from the prior year, due to lower performance-based compensation expense, largely offset by the impact of the Washington Mutual transaction. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § Overhead ratio was 34%, an improvement from 46%.
§ Gross investment banking revenue (which is shared with the Investment Bank) was $241 million.
§ Average loan balances were $117.7 billion, up $52.1 billion, or 80%, from the prior year and up $45.4 billion, or 63%, from the prior quarter.
§ Average liability balances were $114.1 billion, up $17.4 billion, or 18%, from the prior year and up $14.7 billion, or 15%, from the prior quarter.
TREASURY & SECURITIES SERVICES (TSS)
Results for TSS 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $ 2,249 $ 1,953 $ 1,930 $ 296 15% $ 319 17% Provision for Credit Losses 45 18 4 27 150 41 NM Noninterest Expense 1,339 1,339 1,222 — — 117 10
Net Income $ 533 $ 406 $ 422 $ 127 31% $ 111 26%
Discussion of Results: Net income was a record $533 million, an increase of $111 million, or 26%, from the prior year, driven by higher net revenue, partially offset by higher noninterest expense. Net revenue was a record $2.2 billion, an increase of $319 million, or 17%, from the prior year. Worldwide Securities Services net revenue was a record $1.3 billion, an increase of $150 million, or 14%, from the prior year. The growth was driven by higher liability balances, reflecting increased client deposit activity resulting from recent market conditions, and wider spreads in foreign exchange. These benefits were offset partially by the effects of market depreciation and lower securities lending balances. Treasury Services net revenue was a record $1.0 billion, an increase of $169 million, or 21%, reflecting higher liability balances and higher trade revenue. Liability balance revenue growth reflects increased client deposit activity, resulting from recent market conditions and Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 12 of 17 organic growth, partially offset by spread compression. Trade revenue benefited from higher volumes and wider loan spreads. TSS firmwide net revenue, which includes Treasury Services net revenue recorded in other lines of business, grew to $3.1 billion, an increase of $454 million, or 17%. Treasury Services firmwide net revenue grew to $1.8 billion, an increase of $304 million, or 20%.
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J.P. Morgan Chase & Co. News Release The provision for credit losses was $45 million, an increase of $41 million from prior year, reflecting a weakening credit environment. Noninterest expense was $1.3 billion, an increase of $117 million, or 10%, from the prior year, reflecting higher expense related to business and volume growth as well as continued investment in new product platforms. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted)
§ TSS pretax margin(2) was 37%, up from 29% in the prior quarter and 35% in the prior year.
§ Average liability balances were $336.3 billion, up 34%.
§ Assets under custody were $13.2 trillion, down 17%.
§ Key new client relationships/services added in the fourth quarter: - Chosen by ICE Clear Europe to provide a comprehensive solution combining multi-currency payments, cash investment and global custody capabilities; ICE Clear Europe provides clearing services for all ICE Futures Europe contracts and all cleared OTC contracts transacted in ICE’s global OTC markets.
- Appointed by Roche Holding Ltd as the successor depositary bank for Roche’s ADR program, one of the top-10 ADR programs in Europe and among the most actively traded.
- Expanded relationship with the U.S. Postal Service to include cash and check depository processing services.
- Selected by Augustus Asset Managers Limited to provide Fund Administration and Middle Office services to the majority of its managed hedge funds.
ASSET MANAGEMENT (AM)
Results for AM 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $ 1,658 $ 1,961 $ 2,389 $ (303) (15)% $(731) (31)% Provision for Credit Losses 32 20 (1) 12 60 33 NM Noninterest Expense 1,213 1,362 1,559 (149) (11) (346) (22)
Net Income $ 255 $ 351 $ 527 $ (96) (27)% $(272) (52)%
Discussion of Results: Net income was $255 million, a decline of $272 million, or 52%, from the prior year, due to lower net revenue offset partially by lower noninterest expense. Net revenue was $1.7 billion, a decrease of $731 million, or 31%, from the prior year. Noninterest revenue was $1.2 billion, a decline of $868 million, or 42%, due to the effect of lower markets, including the impact of lower market valuations of seed capital investments and lower performance fees; these effects were offset partially by the benefit of the Bear Stearns merger. Net interest income was $466 million, up $137 million, or 42%, from the prior year, predominantly due to wider deposit spreads and higher deposit and loan balances. Private Bank revenue declined 3% to $630 million, as the effects of lower markets and lower performance fees were predominantly offset by increased deposit and loan balances. Private
9 Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 13 of 17
J.P. Morgan Chase & Co. News Release Wealth Management revenue declined 4% to $330 million due to lower assets under management. Institutional revenue declined 57% to $327 million due to lower performance fees and lower market valuations of principal investments, partially offset by net liquidity inflows. Retail revenue decreased by 59% to $265 million due to the effect of lower markets, including the impact of lower market valuations of seed capital investments and net equity outflows. Bear Stearns Brokerage contributed $106 million to revenue. Assets under supervision were $1.5 trillion, a decrease of $76 billion, or 5%, from the prior year. Assets under management were $1.1 trillion, down $60 billion, or 5%, from the prior year. The decrease was due to the effect of lower markets and non-liquidity outflows, predominantly offset by liquidity product inflows across all segments and the addition of Bear Stearns assets under management. Custody, brokerage, administration and deposit balances were $363 billion, down $16 billion due to the effect of lower markets on brokerage and custody balances, offset by the addition of Bear Stearns Brokerage. The provision for credit losses was $32 million, compared with negative $1 million in the prior year, reflecting a weakening credit environment. Noninterest expense of $1.2 billion decreased $346 million, or 22%, from the prior year due to lower performance-based compensation, partially offset by the effect of the Bear Stearns merger. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted)
§ Pretax margin(2) was 25%, down from 35%.
§ Assets under management were $1.1 trillion, down $60 billion, or 5%, included: — Growth of $213 billion, or 53%, in liquidity products; and
— The addition of $15 billion from the Bear Stearns merger. § Assets under management net inflows were $61 billion for the fourth quarter of 2008. Net inflows were $151 billion for the 12-month period ended December 31, 2008.
§ Assets under management ranked in the top two quartiles for investment performance were 76% over five years, 65% over three years and 54% over one year.
§ Customer assets in 4 and 5 Star–rated funds were 42%.
§ Average loans of $36.9 billion were up $4.2 billion, or 13%.
§ Average deposits of $76.9 billion were up $12.3 billion, or 19%.
10
J.P. Morgan Chase & Co. News Release CORPORATE/PRIVATE EQUITY
Results for Corporate/Private 3Q08 4Q07 Equity ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $ 432 $(1,836) $ 933 $ 2,268 NM $(501) (54)% Provision for Credit Losses (33) 1,977 2 (2,010) NM (35) NM Noninterest Expense (72) 161 660 (233) NM (732) NM Extraordinary Gain 1,325 581 — 744 128 1,325 NM
Net Income/(Loss) $ 1,545 $(1,780) $ 270 $ 3,325 NM $ 1,275 472
Discussion of Results: Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 14 of 17 Net income for Corporate/Private Equity was $1.5 billion, compared with net income of $270 million in the prior year. This segment includes the results of Private Equity and Corporate business segments, as well as merger-related items. Net loss for Private Equity was $682 million, compared with net income of $356 million in the prior year. Net revenue was negative $1.1 billion, a decrease of $1.8 billion, reflecting Private Equity write-downs of $1.1 billion, compared with gains of $712 million in the prior year. Noninterest expense was negative $40 million, a decrease of $173 million from the prior year, reflecting lower compensation expense. Net income for Corporate was $1.2 billion, compared with a net loss of $72 million in the prior year, and included an after-tax gain of $627 million on the dissolution of the Chase Paymentech joint venture. Net after-tax merger-related items included a $1.3 billion extraordinary gain, net costs of $60 million related to the Washington Mutual transaction, and net costs of $201 million related to the Bear Stearns merger. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § The Private Equity portfolio totaled $6.9 billion, compared with $7.2 billion in the prior year and $7.5 billion in the prior quarter. The portfolio represented 5.8% of total stockholders’ equity less goodwill, down from 9.2% in the prior year and 7.5% in the prior quarter.
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J.P. Morgan Chase & Co. News Release
JPMORGAN CHASE (JPM)(a)
Results for JPM(a) 3Q08 4Q07 ($ millions) 4Q08 3Q08 4Q07 $ O/(U) O/(U) % $ O/(U) O/(U) % Net Revenue $19,108 $16,088 $18,275 $ 3,020 19% $ 833 5% Provision for Credit Losses 8,541 6,660 3,161 1,881 28 5,380 170 Noninterest Expense 11,255 11,137 10,720 118 1 535 5 Extraordinary Gain 1,325 581 — 744 128 1,325 NM
Net Income $ 702 $ 527 $ 2,971 $ 175 33% $ (2,269) (76)%
(a) Presented on a managed basis; see Note 1 (page 13) for further explanation of managed basis. Net revenue on a U.S. GAAP basis was $17,226 million, $14,737 million, and $17,384 million for the fourth quarter of 2008, third quarter of 2008 and fourth quarter of 2007, respectively. Discussion of Results: Net income was $702 million, a decrease of $2.3 billion, or 76%, from the prior year. The decline in earnings was driven by a higher provision for credit losses and increased noninterest expense. Managed net revenue was $19.1 billion, an increase of $833 million, or 5%, from the prior year. Noninterest revenue was $3.2 billion, down $6.2 billion, or 66%, due to lower principal transactions revenue, which reflected net markdowns on leveraged lending funded and unfunded commitments and mortgage-related exposures, and Private Equity write-downs. Partially offsetting these declines were the gain on the dissolution of the Chase Paymentech joint venture and positive MSR risk management results. Net interest income was $15.9 billion, up $7.1 billion, or 80%, due to the impact of the Washington Mutual transaction, higher trading-related net interest income, higher liability and loan balances, and wider loan and deposit spreads. The managed provision for credit losses was $8.5 billion, up $5.4 billion, or 170%, from the prior year. The total consumer- managed provision for credit losses was $7.4 billion, compared with $2.9 billion in the prior year, reflecting increases in the allowance for credit losses related to home equity, mortgage and credit card loans, as well as higher net charge-offs. Consumer- managed net charge-offs were $4.3 billion, compared with $2.0 billion in the prior year, resulting in managed net charge-off rates of 3.61% and 2.22%, respectively. The wholesale provision for credit losses was $1.1 billion, compared with $308 million in the prior year, due to an increase in the allowance for credit losses reflecting the effect of a weakening credit environment. Wholesale net charge-offs were $217 million, compared with net charge-offs of $25 million, resulting in net charge-off rates of 0.33% and 0.05%, respectively. The firm had total nonperforming assets of $12.7 billion at December 31, 2008, up from the prior-year level of Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 15 of 17 $3.9 billion. Noninterest expense was $11.3 billion, up $535 million, or 5%, from the prior year. The increase was driven by the impact of the Washington Mutual transaction and additional operating costs relating to the Bear Stearns merger, partially offset by lower compensation expense. Key Metrics and Business Updates: (All comparisons to the prior-year quarter except as noted) § Tier 1 capital ratio was 10.8% at December 31, 2008 (estimated), 8.9% at September 30, 2008, and 8.4% at December 31, 2007. § Headcount was 224,961 at December 31, 2008, which includes 41,398 from the acquisition of Washington Mutual’s banking operations. The remaining 183,563, which includes headcount from the Bear Stearns merger, reflects an increase of 2,896 from December 31, 2007.
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J.P. Morgan Chase & Co. News Release
Notes: 1. In addition to analyzing the firm’s results on a reported basis, management analyzes the firm’s results and the results of the lines of business on a managed basis, which is a non-GAAP financial measure. The firm’s definition of managed basis starts with the reported U.S. GAAP results and includes the following adjustments: First, for Card Services and the firm, managed basis excludes the impact of credit card securitizations on total net revenue, the provision for credit losses, net charge-offs and loan receivables. The presentation of Card Services results on a managed basis assumes that credit card loans that have been securitized and sold in accordance with SFAS 140 still remain on the balance sheet and that the earnings on the securitized loans are classified in the same manner as the earnings on retained loans recorded on the balance sheet. JPMorgan Chase uses the concept of managed basis to evaluate the credit performance and overall financial performance of the entire managed credit card portfolio. Operations are funded and decisions are made about allocating resources, such as employees and capital, based upon managed financial information. In addition, the same underwriting standards and ongoing risk monitoring are used for both loans on the balance sheet and securitized loans. Although securitizations result in the sale of credit card receivables to a trust, JPMorgan Chase retains the ongoing customer relationships, as the customers may continue to use their credit cards; accordingly, the customer’s credit performance will affect both the securitized loans and the loans retained on the balance sheet. JPMorgan Chase believes managed-basis information is useful to investors, enabling them to understand both the credit risks associated with the loans reported on the balance sheet and the firm’s retained interests in securitized loans. Second, managed revenue (noninterest revenue and net interest income) for each of the segments and the firm is presented on a tax-equivalent basis. Accordingly, revenue from tax-exempt securities and investments that receive tax credits is presented in the managed results on a basis comparable to taxable securities and investments. This methodology allows management to assess the comparability of revenue arising from both taxable and tax-exempt sources. The corresponding income tax impact related to these items is recorded within income tax expense. See page 8 of JPMorgan Chase’s Earnings Release Financial Supplement (fourth quarter of 2008) for a reconciliation of JPMorgan Chase’s income statement from a reported basis to a managed basis. 2. Pretax margin represents income before income tax expense divided by total net revenue, which is, in management’s view, a comprehensive measure of pretax performance derived by measuring earnings after all costs are taken into consideration. It is, therefore, another basis that management uses to evaluate the performance of TSS and AM against the performance of competitors.
13
J.P. Morgan Chase & Co. News Release JPMorgan Chase & Co. (NYSE: JPM) is a leading global financial services firm with assets of $2.2 trillion and operations in more than 60 countries. The firm is a leader in investment banking, financial services for consumers, small business and commercial Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 16 of 17 banking, financial transaction processing, asset management, and private equity. A component of the Dow Jones Industrial Average, JPMorgan Chase & Co. serves millions of consumers in the United States and many of the world’s most prominent corporate, institutional and government clients under its J.P. Morgan, Chase, and WaMu brands. Information about JPMorgan Chase & Co. is available at www.jpmorganchase.com. JPMorgan Chase will host a conference call today at 7:45 a.m. (Eastern Time) to review fourth-quarter financial results. The general public can access the call by dialing (866) 541-2724 or (877) 368-8360 in the U.S. and Canada; (706) 902-3714 for International participants. The live audio webcast and presentation slides will be available at the firm’s website www.jpmorganchase.com under Investor Relations, Investor Presentations. A replay of the conference call will be available beginning at approximately 11:00 a.m. on Thursday, January 15, through midnight, Friday, January 30, by telephone at (800) 642-1687 (U.S. and Canada) or (706) 634-7246 (International). The replay will also be available via webcast on www.jpmorganchase.com under Investor Relations, Investor Presentations. Additional detailed financial, statistical and business-related information is included in a financial supplement. The earnings release and the financial supplement are available at: www.jpmorganchase.com. This earnings release contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found in JPMorgan Chase’s Quarterly Reports on Form 10-Q for the quarters ended September 30, 2008, June 30, 2008 and March 31, 2008, and its Annual Report on Form 10-K for the year ended December 31, 2007, each of which has been filed with the Securities and Exchange Commission and is available on JPMorgan Chase’s website (www.jpmorganchase.com), and on the Securities and Exchange Commission’s website. JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.
14
JPMORGAN CHASE & CO. CONSOLIDATED FINANCIAL HIGHLIGHTS (in millions, except per share, ratio and headcount data)
QUARTERLY TRENDS FULL YEAR 4Q08 Change 2008 Change 4Q08 3Q08 4Q07 3Q08 4Q07 2008 2007 2007 SELECTED INCOME STATEMENT DATA Total net revenue $ 17,226 $ 14,737 $ 17,384 17% (1)% $ 67,252 $ 71,372 (6)% Provision for credit losses (a) 7,313 5,787 2,542 26 188 20,979 6,864 206 Total noninterest expense 11,255 11,137 10,720 1 5 43,500 41,703 4
Income (loss) before extraordinary gain (623) (54) 2,971 NM NM 3,699 15,365 (76) Extraordinary gain (b) 1,325 581 — 128 NM 1,906 — NM Net income 702 527 2,971 33 (76) 5,605 15,365 (64)
PER COMMON SHARE: Basic Earnings Income (loss) before extraordinary gain (0.28) (0.06) 0.88 (367) NM 0.86 4.51 (81) Net income 0.07 0.11 0.88 (36) (92) 1.41 4.51 (69)
Diluted Earnings Income (loss) before extraordinary gain (0.28) (0.06) 0.86 (367) NM 0.84 4.38 (81) Net income 0.07 0.11 0.86 (36) (92) 1.37 4.38 (69)
Cash dividends declared 0.38 0.38 0.38 — — 1.52 1.48 3 Book value 36.15 36.95 36.59 (2) (1) 36.15 36.59 (1) Closing share price 31.53 46.70 43.65 (32) (28) 31.53 43.65 (28) Market capitalization 117,695 174,048 146,986 (32) (20) 117,695 146,986 (20)
COMMON SHARES OUTSTANDING: Weighted-average diluted shares outstanding 3,737.5(h) 3,444.6(h) 3,471.8 9 8 3,604.9 3,507.6 3 Common shares outstanding at period-end (c) 3,732.8 3,726.9 3,367.4 — 11 3,732.8 3,367.4 11
FINANCIAL RATIOS: (d) Income (loss) before extraordinary gain: Return on common equity (“ROE”) (3)% (1)% 10% 2% 13% Return on equity-goodwill (“ROE-GW”) (e) (5) (1) 15 4 21 Return on assets (“ROA”) (0.11) (0.01) 0.77 0.21 1.06 Net income: ROE 1 1 10 4 13 ROE-GW (e) 1 2 15 6 21 ROA 0.13 0.12 0.77 0.31 1.06 Case 1:09-cv-01656-RMC Document 54-10 Filed 11/22/10 Page 17 of 17
CAPITAL RATIOS: Tier 1 capital ratio 10.8(i) 8.9 8.4 Total capital ratio 14.7(i) 12.6 12.6
SELECTED BALANCE SHEET DATA (Period-end) Total assets $ 2,175,052 $ 2,251,469 $ 1,562,147 (3) 39 $ 2,175,052 $ 1,562,147 39 Wholesale loans 262,044 288,445 213,076 (9) 23 262,044 213,076 23 Consumer loans 482,854 472,936 306,298 2 58 482,854 306,298 58 Deposits 1,009,277 969,783 740,728 4 36 1,009,277 740,728 36 Common stockholders’ equity 134,945 137,691 123,221 (2) 10 134,945 123,221 10
Headcount (f) 224,961 228,452 180,667 (2) 25 224,961 180,667 25
LINE OF BUSINESS NET INCOME (LOSS) Investment Bank $ (2,364) $ 882 $ 124 NM NM $ (1,175) $ 3,139 NM Retail Financial Services 624 64 731 NM (15) 880 2,925 (70) Card Services (371) 292 609 NM NM 780 2,919 (73) Commercial Banking 480 312 288 54 67 1,439 1,134 27 Treasury & Securities Services 533 406 422 31 26 1,767 1,397 26 Asset Management 255 351 527 (27) (52) 1,357 1,966 (31) Corporate/Private Equity (g) 1,545 (1,780) 270 NM 472 557 1,885 (70)
Net income $ 702 $ 527 $ 2,971 33 (76) $ 5,605 $ 15,365 (64)
(a) Includes accounting conformity loan loss reserve provision related to the acquisition of Washington Mutual Bank’s banking operations.
(b) JPMorgan Chase acquired the banking operations of Washington Mutual Bank for $1.9 billion. The fair value of the net assets acquired exceeded the purchase price which resulted in negative goodwill.
In accordance with SFAS 141, nonfinancial assets that are not held-for-sale were written down against that negative goodwill. The negative goodwill that remained after writing down nonfinancial assets was recognized as an extraordinary gain.
(c) On September 30, 2008, the Firm issued $11.5 billion, or 284 million shares, of its common stock at $40.50 per share.
(d) Quarterly ratios are based upon annualized amounts.
(e) Net income applicable to common stock divided by total average common equity (net of goodwill). The Firm uses return on equity less goodwill, a non-GAAP financial measure, to evaluate the operating performance of the Firm. The Firm also utilizes this measure to facilitate comparisons to competitors.
(f) Increase in the third quarter of 2008 predominantly relates to the acquisition of Washington Mutual Bank’s banking operations.
(g) See Corporate/Private Equity Financial Highlights on page 29 of JPMorgan Chase’s Earnings Release Financial Supplement for additional details.
(h) Common equivalent shares have been excluded from the computation of diluted earnings per share for the fourth and third quarters of 2008, as the effect would be antidilutive.
(i) Estimated. Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 1 of 24
EXHIBIT 8
Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 2 of 24 10-K 1 y74757e10vk.htm FORM 10-K
Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K Annual report pursuant to section 13 or 15(d) of The Securities Exchange Act of 1934
For the fiscal year ended Commission file December 31, 2008 number 1-5805 JPMorgan Chase & Co.
(Exact name of registrant as specified in its charter)
Delaware 13-2624428 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.)
270 Park Avenue, New York, NY 10017 (Address of principal executive offices) (Zip code)
Registrant’s telephone number, including area code: (212) 270-6000 Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Common stock The New York Stock Exchange The London Stock Exchange The Tokyo Stock Exchange Depositary Shares each representing a one-fourth interest in a share of 6.15% Cumulative The New York Stock Exchange Preferred Stock, Series E Depositary Shares each representing a one-fourth interest in a share of 5.72% Cumulative The New York Stock Exchange Preferred Stock, Series F Depositary Shares each representing a one-fourth interest in a share of 5.49% Cumulative The New York Stock Exchange Preferred Stock, Series G Depositary Shares each representing a one-four hundredth interest in a share of 8.625% The New York Stock Exchange Non-Cumulative Preferred Stock, Series J Guarantee of 7.00% Capital Securities, Series J, of J.P. Morgan Chase Capital X The New York Stock Exchange Guarantee of 5 7/8% Capital Securities, Series K, of J.P. Morgan Chase Capital XI The New York Stock Exchange Guarantee of 6.25% Capital Securities, Series L, of J.P. Morgan Chase Capital XII The New York Stock Exchange Guarantee of 6.20% Capital Securities, Series N, of J.P. Morgan Chase Capital XIV The New York Stock Exchange Guarantee of 6.35% Capital Securities, Series P, of J.P. Morgan Chase Capital XVI The New York Stock Exchange Guarantee of 6.625% Capital Securities, Series S, of J.P. Morgan Chase Capital XIX The New York Stock Exchange Guarantee of 6.875% Capital Securities, Series X, of J.P. Morgan Chase Capital XXIV The New York Stock Exchange Guarantee of Fixed-to-Floating Rate Capital Securities, Series Z, of JPMorgan Chase The New York Stock Exchange Capital XXVI Guarantee of 7.20% Preferred Securities of BANK ONE Capital VI The New York Stock Exchange Guarantee of 7.8% Preferred Securities of Bear Stearns Capital Trust III The New York Stock Exchange JPMorgan Market Participation Notes Linked to S&P 500® Index due March 31, 2009 The NYSE Alternext U.S. LLC Capped Quarterly Observation Notes Linked to S&P 500® Index due July 7, 2009 The NYSE Alternext U.S. LLC Capped Quarterly Observation Notes Linked to S&P 500® Index due September 21, 2009 The NYSE Alternext U.S. LLC Consumer Price Indexed Securities due January 15, 2010 The NYSE Alternext U.S. LLC Principal Protected Notes Linked to S&P 500® Index due September 30, 2010 The NYSE Alternext U.S. LLC KEYnotes Exchange Traded Notes Linked to the First Trust Enhanced 130/30 Large Cap NYSE Arca, Inc. Index BearLinxSM Alerian MLP Select Index ETN NYSE Arca, Inc. Euro Floating Rate Global Notes due July 27, 2012 The NYSE Alternext U.S. LLC Principal Protected Notes Linked to the Nasdaq-100 Index® Due December 22, 2009 The NYSE Alternext U.S. LLC Principal Protected Notes Linked to the S&P 500® Index Due November 30, 2009 The NYSE Alternext U.S. LLC Principal Protected Notes Linked to the Dow Jones Industrial AverageSM due March 23, The NYSE Alternext U.S. LLC 2011 Medium Term Notes Linked to a Basket of Three International Equity Indices Due The NYSE Alternext U.S. LLC August 2, 2010
Securities registered pursuant to Section 12(g) of the Act: none Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 3 of 24 operations where the functional currency is the U.S. dollar, are The acquisition expands JPMorgan Chase’s consumer branch reported in the Consolidated Statements of Income. network into several states, including California, Florida and Foreclosed property Washington, among others. The acquisition also extends the reach The Firm acquires property from borrowers through loan of the Firm’s business banking, commercial banking, credit card, restructurings, workouts, and foreclosures. Property acquired may consumer lending and wealth management businesses. The include real property (e.g., land, buildings, and fixtures) and acquisition was accounted for under the purchase method of personal property (e.g., aircraft, railcars, and ships). Acquired accounting in accordance with SFAS 141. property is valued at fair value less costs to sell at acquisition. Each The $1.9 billion purchase price was allocated to the Washington quarter the fair value of the acquired property is reviewed and Mutual assets acquired and liabilities assumed using preliminary adjusted, if necessary. Any adjustments to fair value in the first allocated values as of September 25, 2008, which resulted in 90 days are credited/charged to the allowance for loan losses and negative goodwill. The initial allocation of the purchase price was thereafter to other expense. presented on a preliminary basis at September 30, 2008, due to the Statements of cash flows short time period between the closing of the transaction (which For JPMorgan Chase’s Consolidated Statements of Cash Flows, occurred simultaneously with its announcement on September 25, cash is defined as those amounts included in cash and due from 2008) and the end of the third quarter. In accordance with SFAS banks. 141, noncurrent nonfinancial assets that are not held-for-sale, such as the premises and equipment and other intangibles, acquired in Significant accounting policies the Washington Mutual transaction were written down against the The following table identifies JPMorgan Chase’s other significant negative goodwill. The negative goodwill that remained after writing accounting policies and the Note and page where a detailed down the nonfinancial assets was recognized as an extraordinary description of each policy can be found.
gain. As a result of the refinement of the purchase price allocation Fair value measurement Note 4 Page 129 during the fourth quarter of 2008, the initial extraordinary gain of Fair value option Note 5 Page 144 $581 million was increased $1.3 billion to $1.9 billion. The Principal transactions activities Note 6 Page 146 computation of the purchase price and the allocation of the Other noninterest revenue Note 7 Page 148 Pension and other postretirement employee benefit purchase price to the net assets acquired in the Washington Mutual plans Note 9 Page 149 transaction – based upon their respective values as of Employee stock-based incentives Note 10 Page 155 September 25, 2008, and the resulting negative goodwill – are Noninterest expense Note 11 Page 158 presented below. The allocation of the purchase price may be Securities Note 12 Page 158 modified through September 25, 2009, as more information is Securities financing activities Note 13 Page 162 obtained about the fair value of assets acquired and liabilities Loans Note 14 Page 163 assumed. Allowance for credit losses Note 15 Page 166 Loan securitizations Note 16 Page 168 Variable interest entities Note 17 Page 177 Goodwill and other intangible assets Note 18 Page 186 Premises and equipment Note 19 Page 189 Other borrowed funds Note 21 Page 190 Accounts payable and other liabilities Note 22 Page 190 Income taxes Note 28 Page 197 Commitments and contingencies Note 31 Page 201 Accounting for derivative instruments and hedging activities Note 32 Page 202 Off-balance sheet lending-related financial instruments and guarantees Note 33 Page 206
JPMorgan Chase & Co. / 2008 Annual Report 123
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Notes to consolidated financial statements
(in millions)
Purchase price Purchase price $ 1,938 Direct acquisition costs 3
Total purchase price 1,941 Net assets acquired Washington Mutual’s net assets before fair value adjustments $ 38,766 Washington Mutual’s goodwill and other intangible assets (7,566)
Subtotal 31,200
Adjustments to reflect assets acquired at fair value: Securities (20) Trading assets (591) Loans (31,018) Allowance for loan losses 8,216 Premises and equipment 680 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 4 of 24 Accrued interest and accounts receivable (295) Other assets 4,125
Adjustments to reflect liabilities assumed at fair value: Deposits (683) Other borrowed funds 68 Accounts payable and other liabilities (900) Long-term debt 1,127
Fair value of net assets acquired 11,909
Negative goodwill before allocation to nonfinancial assets (9,968) Negative goodwill allocated to nonfinancial assets(a) 8,062
Negative goodwill resulting from the acquisition(b) $ (1,906)
(a) The acquisition was accounted for as a purchase business combination in accordance with SFAS 141. SFAS 141 requires the assets (including identifiable intangible assets) and liabilities (including executory contracts and other commitments) of an acquired business as of the effective date of the acquisition to be recorded at their respective fair values and consolidated with those of JPMorgan Chase. The fair value of the net assets of Washington Mutual’s banking operations exceeded the $1.9 billion purchase price, resulting in negative goodwill. In accordance with SFAS 141, noncurrent, nonfinancial assets not held-for- sale, such as premises and equipment and other intangibles, were written down against the negative goodwill. The negative goodwill that remained after writing down transaction related core deposit intangibles of approximately $4.9 billion and premises and equipment of approximately $3.2 billion was recognized as an extraordinary gain of $1.9 billion. (b) The extraordinary gain was recorded in Corporate/Private Equity. The following condensed statement of net assets acquired reflects the value assigned to the Washington Mutual net assets as of September 25, 2008.
(in millions) September 25, 2008
Assets Cash and due from banks $ 3,680 Deposits with banks 3,517 Federal funds sold and securities purchased under resale agreements 1,700 Trading assets 5,691 Securities 17,220 Loans (net of allowance for loan losses) 206,436 Accrued interest and accounts receivable 3,201 Mortgage servicing rights 5,874 All other assets 16,330
Total assets $ 263,649
Liabilities Deposits $ 159,869 Federal funds purchased and securities loaned or sold under repurchase agreements 4,549 Other borrowed funds 81,622 Trading liabilities 585 Accounts payable and other liabilities 6,523 Long-term debt 6,654
Total liabilities 259,802
Washington Mutual net assets acquired $ 3,847
124 JPMorgan Chase & Co. / 2008 Annual Report
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Merger with The Bear Stearns Companies Inc. In conjunction with the Bear Stearns merger, in June 2008, the Effective May 30, 2008, BSC Merger Corporation, a wholly owned Federal Reserve Bank of New York (the “FRBNY”) took control, subsidiary of JPMorgan Chase, merged with The Bear Stearns through a limited liability company (“LLC”) formed for this purpose, Companies Inc. (“Bear Stearns”) pursuant to the Agreement and of a portfolio of $30 billion in assets acquired from Bear Stearns, Plan of Merger, dated as of March 16, 2008, as amended based on the value of the portfolio as of March 14, 2008. The March 24, 2008, and Bear Stearns became a wholly owned assets of the LLC were funded by a $28.85 billion term loan from subsidiary of JPMorgan Chase. The merger provided the Firm with the FRBNY, and a $1.15 billion subordinated loan from JPMorgan a leading global prime brokerage platform; strengthened the Firm’s Chase. The JPMorgan Chase note is subordinated to the FRBNY equities and asset management businesses; enhanced capabilities loan and will bear the first $1.15 billion of any losses of the in mortgage origination, securitization and servicing; and expanded portfolio. Any remaining assets in the portfolio after repayment of the platform of the Firm’s energy business. The merger is being the FRBNY loan, the JPMorgan Chase note and the expense of accounted for under the purchase method of accounting, which the LLC will be for the account of the FRBNY. requires that the assets and liabilities of Bear Stearns be fair As a result of step acquisition accounting, the total $1.5 billion valued. The total purchase price to complete the merger was purchase price was allocated to the Bear Stearns assets acquired $1.5 billion. and liabilities assumed using their fair values as of April 8, 2008, The merger with Bear Stearns was accomplished through a series and May 30, 2008, respectively. The summary computation of the of transactions that were reflected as step acquisitions in purchase price and the allocation of the purchase price to the net Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 5 of 24 consumer loans. For risk-rated loans (generally loans originated by requires judgment by management about the effect of matters that the wholesale lines of business), it is based on a statistical are inherently uncertain. Subsequent evaluations of the loan calculation, which is adjusted to take into consideration model portfolio, in light of the factors then prevailing, may result in imprecision, external factors and current economic events that have significant changes in the allowances for loan losses and lending- occurred but are not yet reflected in the factors used to derive the related commitments in future periods. statistical calculation. The statistical calculation is the product of At least quarterly, the allowance for credit losses is reviewed by the probability of default (“PD”) and loss given default (“LGD”). These Chief Risk Officer, the Chief Financial Officer and the Controller of factors are differentiated by risk rating and expected maturity. PD the Firm and discussed with the Risk Policy and Audit Committees estimates are based on observable external data, primarily credit- of the Board of Directors of the Firm. As of December 31, 2008, rating agency default statistics. LGD estimates are based on a JPMorgan Chase deemed the allowance for credit losses to be study of actual credit losses over more than one credit cycle. For appropriate (i.e., sufficient to absorb losses that are inherent in the scored loans (generally loans originated by the consumer lines of portfolio, including those not yet identifiable). business), loss is primarily determined by applying statistical loss factors, including loss frequency and severity factors, to pools of The table below summarizes the changes in the allowance for loan loans by asset type. In developing loss frequency and severity losses. assumptions, known and anticipated changes in the economic Year ended December 31, (in millions) 2008 2007 2006 environment, including changes in housing prices, unemployment rates and other risk indicators, are considered. Multiple forecasting Allowance for loan losses at January 1 $ 9,234 $7,279 $7,090 methods are used to estimate statistical losses, including credit loss Cumulative effect of change in accounting principles(a) — (56) — forecasting models and vintage-based loss forecasting. Allowance for loan losses at January 1, Management applies its judgment within specified ranges to adjust adjusted 9,234 7,223 7,090 the statistical calculation. Where adjustments are made to the Gross charge-offs 10,764 5,367 3,884 Gross (recoveries) (929) (829) (842) statistical calculation for the risk-rated portfolios, the determination of the appropriate point within the range are based upon Net charge-offs 9,835 4,538 3,042 Provision for loan losses management’s quantitative and qualitative assessment of the quality Provision excluding accounting conformity 19,660 6,538 3,153 of underwriting standards; relevant internal factors affecting the Provision for loan losses – accounting credit quality of the current portfolio; and external factors such as conformity(b) 1,577 — — current macroeconomic and political conditions that have occurred Total provision for loan losses 21,237 6,538 3,153 but are not yet reflected in the loss factors. Factors related to Addition resulting from Washington Mutual concentrated and deteriorating industries are also incorporated into transaction 2,535 — — Other(c) (7) 11 78 the calculation, where relevant. Adjustments to the statistical calculation for the scored loan portfolios are accomplished in part Allowance for loan losses at December 31 $23,164 $9,234 $7,279 by analyzing the historical loss experience for each major product segment. The specific ranges and the determination of the Components: appropriate point within the range are based upon management’s Asset-specific $ 786 $ 188 $ 118 Formula-based 22,378 9,046 7,161 view of uncertainties that relate to current macroeconomic and Total Allowance for loan losses $23,164 $9,234 $7,279 political conditions, the quality of underwriting standards, and other relevant internal and external factors affecting the credit quality of (a) Reflects the effect of the adoption of SFAS 159 at January 1, 2007. For a the portfolio. further discussion of SFAS 159, see Note 5 on pages 144–146 of this Annual Report. The allowance for lending-related commitments represents (b) Relates to the Washington Mutual transaction in 2008. management’s estimate of probable credit losses inherent in the (c) The 2008 amount represents foreign-exchange translation. The 2007 amount Firm’s process of extending credit. Management establishes an represents assets acquired of $5 million and $5 million of foreign-exchange asset-specific allowance for lending-related commitments that are translation. The 2006 amount represents the Bank of New York transaction. considered impaired and computes a formula-based allowance for performing wholesale lending-related commitments. These are computed using a methodology similar to that used for the wholesale loan portfolio, modified for expected maturities and probabilities of drawdown.
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Notes to consolidated financial statements
The table below summarizes the changes in the allowance for When quoted market prices are not available, the Firm estimates lending-related commitments. the fair value for these retained interests by calculating the present value of future expected cash flows using modeling techniques. Year ended December 31, (in millions) 2008 2007 2006 Such models incorporate management’s best estimates of key Allowance for lending-related commitments at variables, such as expected credit losses, prepayment speeds and January 1 $ 850 $ 524 $ 400 the discount rates appropriate for the risks involved. See Note 4 on Provision for lending-related commitments page 132 of this Annual Report for further information on the Provision excluding accounting conformity (215) 326 117 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 6 of 24 Provision for lending-related commitments – valuation of retained interests. accounting conformity(a) (43) — — The Firm may retain interests in the securitized loans in the form of Total provision for lending-related commitments (258) 326 117 undivided seller’s interest, senior or subordinated interest-only Addition resulting from Washington Mutual 66 — — strips, debt and equity tranches, escrow accounts and servicing Other(b) 1 — 7 rights. The classification of retained interests is dependent upon Allowance for lending-related commitments at December 31 $ 659 $ 850 $ 524 several factors, including the type of interest, whether or not the
Components: retained interest is represented by a security certificate and when it Asset-specific $ 29 $ 28 $ 33 was retained. Interests retained by IB are classified as trading Formula-based 630 822 491 assets. See credit card securitizations and mortgage securitizations
Total allowance for lending- related sections of the note for further information on the classification of commitments $ 659 $ 850 $ 524 their related retained interests. Retained interests classified as AFS
that are rated below “AA” by an external rating agency are subject (a) Related to the Washington Mutual transaction. to the impairment provisions of EITF 99-20, as discussed in Note (b) The 2006 amount represents the Bank of New York transaction. 12 on page 162 of this Annual Report. Note 16 – Loan securitizations The following table presents the total unpaid principal amount of JPMorgan Chase securitizes and sells a variety of loans, including assets held in JPMorgan Chase-sponsored securitization entities, residential mortgage, credit card, automobile, student, and for which sale accounting was achieved and to which the Firm has commercial loans (primarily related to real estate). JPMorgan continuing involvement, at December 31, 2008 and 2007. Chase-sponsored securitizations utilize SPEs as part of the Continuing involvement includes servicing the loans, holding senior securitization process. These SPEs are structured to meet the or subordinated interests, recourse or guarantee arrangements and definition of a QSPE (as discussed in Note 1 on page 122 of this derivative transactions. In certain instances, the Firm’s only Annual Report); accordingly, the assets and liabilities of continuing involvement is servicing the loans. Certain of the Firm’s securitization-related QSPEs are not reflected on the Firm’s retained interests (trading assets, AFS securities and other assets) Consolidated Balance Sheets (except for retained interests, as are reflected at their fair value. described below). The primary purpose of these securitization vehicles is to meet investor needs and to generate liquidity for the Firm through the sale of loans to the QSPEs. These QSPEs are financed through the issuance of fixed, or floating-rate asset- backed securities. The Firm records a loan securitization as a sale when the accounting criteria for a sale are met. Those criteria are: (1) the transferred assets are legally isolated from the Firm’s creditors; (2) the entity can pledge or exchange the financial assets, or if the entity is a QSPE, its investors can pledge or exchange their interests; and (3) the Firm does not maintain effective control to repurchase the transferred assets before their maturity or have the ability to unilaterally cause the holder to return the transferred assets. For loan securitizations that meet the accounting sales criteria, the gains or losses recorded depend, in part, on the carrying amount of the loans sold except for servicing assets which are initially recorded at fair value. At the time of sale, any retained servicing asset is initially recognized at fair value. The remaining carrying amount of the loans sold is allocated between the loans sold and the other interests retained, based upon their relative fair values on the date of sale. Gains on securitizations are reported in noninterest revenue.
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Principal amount outstanding JPMorgan Chase interest in securitized assets(f)(g)(h)(i)
Total Total assets held Assets held interests by Firm- in QSPEs held by December 31, 2008 sponsored with continuing Trading AFS Other JPMorgan (in billions) QSPEs involvement assets securities Loans assets Chase
Securitized related: Credit card $ 121.6 $ 121.6(e) $ 0.5 $ 5.6 $ 33.3 $ 5.6 $ 45.0 Residential mortgage: Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 7 of 24 Prime(a) 233.9 212.3 1.7 0.7 — — 2.4 Subprime 61.0 58.6 — 0.1 — — 0.1 Option ARMs 48.3 48.3 0.1 0.3 — — 0.4 Commercial and other(b) 174.1 45.7 2.0 0.5 — — 2.5 Student loans 1.1 1.1 — — — 0.1 0.1 Auto 0.8 0.8 — — — — —
Total(c)(d) $ 640.8 $ 488.4 $ 4.3 $ 7.2 $ 33.3 $ 5.7 $ 50.5
Principal amount outstanding JPMorgan Chase interest in securitized assets(f)(i)(j)
Total Total assets held Assets held interests by Firm- in QSPEs held by December 31, 2007 sponsored with continuing Trading AFS Other JPMorgan (in billions) QSPEs involvement assets securities Loans assets Chase
Securitized related: Credit card $ 92.7 $ 92.7(e) $ — $ 0.3 $ 18.6 $ 4.6 $ 23.5 Residential mortgage: Prime(a) 78.3 77.7 0.4 — — — 0.4 Subprime 23.7 22.7 0.3 0.1 — — 0.4 Option ARMs — — — — — — — Commercial and other(b) 109.6 3.4 — — — — — Student loans 1.1 1.1 — — — 0.1 0.1 Auto 2.3 2.3 — — — 0.1 0.1
Total(c) $ 307.7 $ 199.9 $ 0.7 $ 0.4 $ 18.6 $ 4.8 $ 24.5
(a) Includes Alt-A loans. (b) Includes co-sponsored commercial securitizations and, therefore, includes non-JPMorgan Chase originated commercial mortgage loans. Commercial and other consists of securities backed by commercial loans (predominantly real estate) and non-mortgage related consumer receivables purchased from third parties. The Firm generally does not retain a residual interest in the Firm’s sponsored commercial mortgage securitization transactions. (c) Includes securitized loans where the Firm owns less than a majority of the subordinated or residual interests in the securitizations. (d) Includes securitization-related QSPEs sponsored by heritage Bear Stearns and heritage Washington Mutual at December 31, 2008. (e) Includes credit card loans, accrued interest and fees, and cash amounts on deposit. (f) Excludes retained servicing (for a discussion of MSRs, see Note 18 on pages 187–188 of this Annual Report). (g) Excludes senior and subordinated securities of $974 million at December 31, 2008, that the Firm purchased in connection with IB’s secondary market-making activities. (h) Includes investments acquired in the secondary market, but predominantly held-for-investment purposes of $1.8 billion as of December 31, 2008. This is comprised of $1.4 billion of investments classified as available-for-sale, including $172 million in credit cards, $693 million of residential mortgages and $495 million of commercial and other; and $452 million of investments classified as trading, including $112 million of credit cards, $303 million of residential mortgages, and $37 million of commercial and other. (i) Excludes interest rate and foreign exchange derivatives that are primarily used to manage the interest rate and foreign exchange risks of the securitization entities. See Note 6 and Note 32 on pages 146–147 and 202–205, respectively, of this Annual Report for further information on derivatives. (j) Excludes senior and subordinated securities of $9.8 billion at December 31, 2007, that were retained at the time of securitization in connection with IB’s underwriting activity or that are purchased in connection with IB’s secondary market-making activities.
Securitization activity by major product type CS maintains servicing responsibilities for all credit card The following discussion describes the nature of the Firm’s securitizations that it sponsors. As servicer and transferor, the Firm securitization activities by major product type. receives contractual servicing fees based upon the securitized loan balance plus excess servicing fees, which are recorded in credit Credit Card Securitizations card income as discussed in Note 7 on pages 148–149 of this The Card Services (“CS”) business securitizes originated and Annual Report. purchased credit card loans. The Firm’s primary continuing involvement includes servicing the receivables, retaining an The agreements with the credit card securitization trusts require the undivided seller’s interest in the receivables, retaining certain senior Firm to maintain a minimum undivided interest in the trusts (which and subordinated securities and the maintenance of escrow generally ranges from 4% to 12%). At December 31, 2008 and accounts. 2007, the Firm had $33.3 billion and $18.6 billion, respectively, related to its undivided interests in the trusts. The Firm maintained an average undivided interest in principal receivables in the trusts of approximately 22% and 19% for the years ended December 31, 2008 and 2007, respectively. These undivided interests in the trusts represent the Firm’s undivided interests in the receivables transferred to the trust that have not been securitized; these undivided interests are not represented by security certificates, are carried at historical cost, and are classified within loans.
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Table of Contents Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 8 of 24 Notes to consolidated financial statements
Additionally, the Firm retained subordinated interest in accrued Mortgage Securitizations interest and fees on the securitized receivables totaling $3.0 billion The Firm securitizes originated and purchased residential and $2.7 billion (net of an allowance for uncollectible amounts) as mortgages and originated commercial mortgages. of December 31, 2008 and 2007, respectively, which are classified RFS securitizes residential mortgage loans that it originates and in other assets. purchases and it typically retains servicing for all of its originated The Firm retained subordinated securities in credit card and purchased residential mortgage loans. Additionally, RFS may securitization trusts totaling $2.3 billion and $284 million at retain servicing for certain mortgage loans purchased by IB. As December 31, 2008 and 2007, respectively, and senior securities servicer, the Firm receives servicing fees based upon the totaling $3.5 billion at December 31, 2008. Of the securities securitized loan balance plus ancillary fees. The Firm also retains retained, $5.4 billion and $284 million were classified as AFS the right to service the residential mortgage loans it sells to the securities at December 31, 2008 and 2007, respectively. Securities Government National Mortgage Association (“GNMA”), Federal of $389 million that were acquired in the Washington Mutual Bank National Mortgage Association (“Fannie Mae”) and Federal Home transaction were classified as trading assets at December 31, 2008. Loan Mortgage Corporation (“Freddie Mac”) in accordance with their The senior AFS securities were used by the Firm as collateral for a servicing guidelines and standards. For a discussion of MSRs, see secured financing transaction. Note 18 on pages 187–188 of this Annual Report. In a limited number of securitizations, RFS may retain an interest in addition to The Firm also maintains escrow accounts up to predetermined limits servicing rights. The amount of interest retained related to these for some credit card securitizations to cover deficiencies in cash securitizations totaled $939 million and $221 million at flows owed to investors. The amounts available in such escrow December 31, 2008 and 2007, respectively. These retained accounts related to credit cards are recorded in other assets and interests are accounted for as trading or AFS securities; the amounted to $74 million and $97 million as of December 31, 2008 classification depends on whether the retained interest is and 2007, respectively. represented by a security certificate, has an embedded derivative, and when it was retained (i.e., prior to the adoption of SFAS 155). IB securitizes residential mortgage loans (including those that it purchased and certain mortgage loans originated by RFS) and commercial mortgage loans that it originated. Upon securitization, IB may engage in underwriting and trading activities of the securities issued by the securitization trust. IB may retain unsold senior and/or subordinated interests (including residual interests) in both residential and commercial mortgage securitizations at the time of securitization. These retained interests are accounted for at fair value and classified as trading assets. The amount of residual interests retained was $155 million and $547 million at December 31, 2008 and 2007, respectively. Additionally, IB retained $2.8 billion of senior and subordinated interests as of December 31, 2008; these securities were retained at securitization in connection with the Firm’s underwriting activity. In addition to the amounts reported in the securitization activity tables below, the Firm sold residential mortgage loans totaling $122.0 billion, $81.8 billion and $53.7 billion during the years ended December 31, 2008, 2007 and 2006, respectively. The majority of these loan sales were for securitization by the GNMA, Fannie Mae and Freddie Mac. These sales resulted in pretax gains of $32 million, $47 million and $251 million, respectively. The Firm’s mortgage loan sales are primarily nonrecourse, thereby effectively transferring the risk of future credit losses to the purchaser of the loans. However, for a limited number of loan sales, the Firm is obligated to share up to 100% of the credit risk associated with the sold loans with the purchaser. See Note 33 on page 209 of this Annual Report for additional information on loans sold with recourse.
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Other Securitizations The Firm also maintains escrow accounts up to predetermined limits The Firm also securitizes automobile and student loans originated for some automobile and student loan securitizations to cover by RFS and purchased consumer loans (including automobile and deficiencies in cash flows owed to investors. These escrow Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 9 of 24 student loans). The Firm retains servicing responsibilities for all accounts are classified within other assets and carried at fair value. originated and certain purchased student and automobile loans. It The amounts available in such escrow accounts as of may also hold a retained interest in these securitizations; such December 31, 2008, were $3 million for both automobile and residual interests are classified as other assets. At December 31, student loan securitizations; as of December 31, 2007, these 2008 and 2007, the Firm held $37 million and $85 million, amounts were $21 million and $3 million for automobile and student respectively, of retained interests in securitized automobile loans loan securitizations, respectively. and $52 million and $55 million, respectively, of retained interests in securitized student loans.
Securitization activity The following tables provide information related to the Firm’s securitization activities for the years ended December 31, 2008, 2007 and 2006. For the periods presented there were no cash flows from the Firm to the QSPEs related to recourse or guarantee arrangements.
Year ended December 31, 2008 Residential mortgage(g) (in millions, except for ratios and where Option Commercial Student otherwise noted) Credit card Prime(h) Subprime ARMs and other loans Auto
Principal securitized $ 21,390 $ — $ — $ — $ 1,023 $ — $ — Pretax gains 151 — — — — — — All cash flows during the period: Proceeds from new securitizations $ 21,389(f) $ — $ — $ — $ 989 $ — $ — Servicing fees collected 1,162 279 146 129 11 4 15 Other cash flows received(a) 4,985 23 16 — — — — Proceeds from collections reinvested in revolving securitizations 152,399 — — — — — — Purchases of previously transferred financial assets (or the underlying collateral)(b)(c) — 217 13 6 — — 359 Cash flows received on the interests that continue to be held by the Firm(d) 117 267 23 53 455 — 43
Key assumptions used to measure retained interests originated during the year (rates per annum):
Prepayment rate(e) 17.9-20.0% 1.5% PPR CPR
Weighted-average life (in years) 0.4-0.5 2.1 Expected credit losses 4.2-4.8% 1.5% Discount rate 12.0-13.0% 25.0%
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Notes to consolidated financial statements
Year ended December 31, 2007 Residential mortgage (in millions, except for ratios and where Option Commercial Student otherwise noted) Credit card Prime(h) Subprime ARMs and other loans Auto
Principal securitized $ 21,160 $ 32,084 $ 6,763 $ — $ 12,797 $ 1,168 $ — Pretax gains 177 28(i) 43 — — 51 — All cash flows during the period: Proceeds from new securitizations $ 21,160 $ 31,791 $ 6,844 $ — $ 13,038 $ 1,168 $ — Servicing fees collected 1,005 124 246 — 7 2 36 Other cash flows received(a) 4,963 — — — — — — Proceeds from collections reinvested in revolving securitizations 148,946 — — — — — — Purchases of previously transferred financial assets (or the underlying collateral)(b) — 58 598 — — — 431 Cash flows received on the interests that continue to be held by the Firm(d) 18 140 278 — 256 — 89
Key assumptions used to measure retained interests originated during the year (rates per annum):
Prepayment rate(e) 20.4% 13.7-37.2% 30.0-48.0% 0.0-8.0% 1.0-8.0% PPR CPR CPR CPR CPR
Weighted-average life (in years) 0.4 1.3-5.4 2.3-2.8 1.3-10.2 9.3 Expected credit losses 3.5-3.9% 0.0-1.6%(j) 1.2-2.2% 0.0-1.0%(j) —%(j) Discount rate 12.0% 5.8-20.0% 12.1-26.7% 10.0-14.0% 9.0%
Year ended December 31, 2006 Residential mortgage (in millions, except for ratios and where Option Commercial Student otherwise noted) Credit card Prime(h) Subprime ARMs and other loans Auto
Principal securitized $ 9,735 $ 30,254 $ 17,359 $ — $ 13,858 $ — $ 2,405 Pretax gains 67 53 193 — 129 — — Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 10 of 24 All cash flows during the period: Proceeds from new securitizations $ 9,735 $ 30,167 $ 17,635 $ — $ 14,248 $ — $ 1,745 Servicing fees collected 973 76 29 — 1 — 52 Other cash flows received(a) 5,281 35 — — 95 — — Proceeds from collections reinvested in revolving securitizations 151,186 — — — — — — Purchases of previously transferred financial assets (or the underlying collateral)(b) — 31 31 — — — 138 Cash flows received on the interests that continue to be held by the Firm(d) 76 48 258 — 73 — 96
Key assumptions used to measure retained interests originated during the year (rates per annum):
Prepayment rate(e) 20.0-22.2% 10.0-41.3% 36.0-45.0% 0.0-36.2% 1.4-1.5% PPR CPR CPR CPR ABS
Weighted-average life (in years) 0.4 1.7-4.0 1.5-2.4 1.5-6.1 1.4-1.9 Expected credit losses 3.3-4.2% 0.1-3.3%(j) 1.1-2.1% 0.0-0.9%(j) 0.3-0.7% Discount rate 12.0% 8.4-26.2% 15.1-22.0% 3.8-14.0% 7.6-7.8%
(a) Other cash flows received include excess servicing fees and other ancillary fees received. (b) Includes cash paid by the Firm to reacquire assets from the QSPEs, for example, servicer clean-up calls. (c) Excludes a random removal of $6.2 billion of credit card loans from a securitization trust previously established by Washington Mutual and an account addition of $5.8 billion of higher quality credit card loans from the legacy Chase portfolio to the legacy Washington Mutual trust in November 2008. These are noncash transactions that are permitted by the trust documents in order to maintain the appropriate level of undivided seller’s interest. (d) Includes cash flows received on retained interests including, for example, principal repayments, and interest payments. (e) PPR: principal payment rate; CPR: constant prepayment rate; ABS: absolute prepayment speed. (f) Includes $5.5 billion of securities retained by the Firm. (g) Includes securitizations sponsored by Bear Stearns and Washington Mutual as of their respective acquisition dates. (h) Includes Alt-A loans. (i) As of January 1, 2007, the Firm adopted the fair value election for IB warehouse and the RFS prime mortgage warehouse. The carrying value of these loans accounted for at fair value approximates the proceeds received from securitization. (j) Expected credit losses for consumer prime residential mortgage, and student and certain other securitizations are minimal and are incorporated into other assumptions.
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Retained securitization interests The following table summarizes the Firm’s retained securitization interests, which are carried at fair value on the Firm’s Consolidated Balance Sheets at December 31, 2008. As of December 31, 2008, 55% of the Firm’s retained securitization interests, which are carried at fair value, were risk rated “A” or better.
Ratings profile of retained interests(c)(d) 2008 Investment Noninvestment Retained December 31, (in billions) Grade grade interest
Asset types: Credit card(a) $ 5.5 $ 3.8 $ 9.3 Residential mortgage: Prime(b) 1.1 0.3 1.4 Subprime — 0.1 0.1 Option ARMs 0.4 — 0.4 Commercial and other 1.7 0.3 2.0 Student loans — 0.1 0.1 Auto — — —
Total $ 8.7 $ 4.6 $ 13.3
(a) Includes retained subordinated interests carried at fair value, including CS’ accrued interests and fees, escrow accounts, and other residual interests. Excludes undivided seller interest in the trusts of $33.3 billion at December 31, 2008, which is carried at historical cost, and unencumbered cash amounts on deposit of $2.1 billion at December 31, 2008. (b) Includes Alt-A loans. (c) The ratings scale is presented on an S&P-equivalent basis. (d) Excludes $1.8 billion of investments acquired in the secondary market, but predominantly held for investment purposes. Of this amount $1.7 billion is classified as investment grade.
The table below outlines the key economic assumptions used at December 31, 2008 and 2007, to determine the fair value as of December 31, 2008 and 2007, respectively, of the Firm’s retained interests, other than MSRs, that are valued using modeling techniques; it excludes securities that are valued using quoted market prices. The table below also outlines the sensitivities of those fair values to immediate 10% and 20% adverse changes in assumptions used to determine fair value. For a discussion of residential MSRs, see Note 18 on pages 187–188 of this Annual Report.
Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 11 of 24 Table of Contents maximum exposure to derivatives qualifying as guarantees, Loan sale and securitization-related indemnifications although exposure to certain stable value derivatives is contractually Indemnifications for breaches of representations and warranties limited to a substantially lower percentage of the notional value. As part of the Firm’s loan sale and securitization activities, as The fair value of the contracts reflects the probability of whether the described in Note 14 and Note 16 on pages 163–166 and 168–176, Firm will be required to perform under the contract. The fair value respectively, of this Annual Report, the Firm generally makes related to derivative guarantees was a derivative receivable of representations and warranties in its loan sale and securitization $184 million and $213 million and a derivative payable of agreements that the loans sold meet certain requirements. These $5.6 billion and $2.5 billion at December 31, 2008 and 2007, agreements may require the Firm (including in its roles as a respectively. The Firm reduces exposures to these contracts by servicer) to repurchase the loans and/or indemnify the purchaser of entering into offsetting transactions, or by entering into contracts that the loans against losses due to any breaches of such hedge the market risk related to the derivative guarantees. representations or warranties. Generally, the maximum amount of future payments the Firm would be required to make for breaches In addition to derivative contracts that meet the characteristics of a under these representations and warranties would be equal to the guarantee under FIN 45, the Firm is both a purchaser and seller of current amount of assets held by such securitization-related SPEs credit protection in the credit derivatives market. For a further plus, in certain circumstances, accrued and unpaid interest on such discussion of credit derivatives, see Note 32 on pages 202-205 of loans and certain expense. this Annual Report. At December 31, 2008 and 2007, the Firm had recorded a Securities lending indemnification repurchase liability of $1.1 billion and $15 million, respectively. Through the Firm’s securities lending program, customers’ securities, via custodial and non-custodial arrangements, may be Loans sold with recourse lent to third parties. As part of this program, the Firm provides an The Firm provides servicing for mortgages and certain commercial indemnification in the lending agreements which protects the lender lending products on both a recourse and nonrecourse basis. In against the failure of the third-party borrower to return the lent nonrecourse servicing, the principal credit risk to the Firm is the securities in the event the Firm did not obtain sufficient collateral. cost of temporary servicing advances of funds (i.e., normal servicing To minimize its liability under these indemnification agreements, the advances). In recourse servicing, the servicer agrees to share credit Firm obtains cash or other highly liquid collateral with a market risk with the owner of the mortgage loans, such as the Federal value exceeding 100% of the value of the securities on loan from National Mortgage Association or the Federal Home Loan Mortgage the borrower. Collateral is marked to market daily to help assure Corporation or a private investor, insurer or guarantor. Losses on that collateralization is adequate. Additional collateral is called from recourse servicing predominantly occur when foreclosure sales the borrower if a shortfall exists, or collateral may be released to proceeds of the property underlying a defaulted loan are less than the borrower in the event of overcollateralization. If a borrower the sum of the outstanding principal balance, plus accrued interest defaults, the Firm would use the collateral held to purchase on the loan and the cost of holding and disposing of the underlying replacement securities in the market or to credit the lending property. The Firm’s loan sale transactions have primarily been customer with the cash equivalent thereof. executed on a nonrecourse basis, thereby effectively transferring the risk of future credit losses to the purchaser of the mortgage- Also, as part of this program, the Firm invests cash collateral backed securities issued by the trust. At December 31, 2008 and received from the borrower in accordance with approved guidelines. 2007, the unpaid principal balance of loans sold with recourse Based upon historical experience, management believes that risk of totaled $15.0 billion and $557 million, respectively. The increase in loss under its indemnification obligations is remote. loans sold with recourse between December 31, 2008 and 2007, was driven by the Washington Mutual transaction. The carrying Indemnification agreements – general value of the related liability that the Firm had recorded, which is In connection with issuing securities to investors, the Firm may representative of the Firm’s view of the likelihood it will have to enter into contractual arrangements with third parties that may perform under this guarantee, was $241 million and zero at require the Firm to make a payment to them in the event of a December 31, 2008 and 2007, respectively. change in tax law or an adverse interpretation of tax law. In certain cases, the contract also may include a termination clause, which Credit card charge-backs would allow the Firm to settle the contract at its fair value in lieu of Prior to November 1, 2008, the Firm was a partner with one of the making a payment under the indemnification clause. The Firm may leading companies in electronic payment services in a joint venture also enter into indemnification clauses in connection with the operating under the name of Chase Paymentech Solutions, LLC licensing of software to clients (“software licensees”) or when it sells (the “joint venture”). The joint venture was formed in October 2005, a business or assets to a third party (“third-party purchasers”), as a result of an agreement by the Firm and First Data Corporation, pursuant to which it indemnifies software licensees for claims of its joint venture partner, to integrate the companies’ jointly-owned liability or damages that may occur subsequent to the licensing of Chase Merchant Services and Paymentech merchant businesses. the software, or third-party purchasers for losses they may incur The joint venture provided merchant processing services in the due to actions taken by the Firm prior to the sale of the business or United States and assets. It is difficult to estimate the Firm’s maximum exposure under these indemnification arrangements, since this would require an assessment of future changes in tax law and future claims that may be made against the Firm that have not yet occurred. However, based upon historical experience, management expects the risk of loss to be remote.
JPMorgan Chase & Co./2008 Annual Report 209
Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 12 of 24 234 JPMorgan Chase & Co. / 2008 Annual Report
Table of Contents
Short-term and other borrowed funds The following table provides a summary of JPMorgan Chase’s short-term and other borrowed funds for the years indicated.
(in millions, except rates) 2008 2007 2006
Federal funds purchased and securities loaned or sold under repurchase agreements: Balance at year-end $192,546 $ 154,398 $ 162,173 Average daily balance during the year 196,739 196,500 183,783 Maximum month-end balance 224,075 222,119 204,879 Weighted-average rate at December 31 0.97% 4.41% 5.05% Weighted-average rate during the year 2.37 4.98 4.45
Commercial paper: Balance at year-end $ 37,845 $ 49,596 $ 18,849 Average daily balance during the year 45,734 30,799 17,710 Maximum month-end balance 54,480 51,791 20,980 Weighted-average rate at December 31 0.82% 4.27% 4.80% Weighted-average rate during the year 2.24 4.65 4.49
Other borrowed funds:(a) Balance at year-end $177,674 $ 117,997 $ 108,541 Average daily balance during the year 118,714 100,181 102,147 Maximum month-end balance 244,040 133,871 132,367 Weighted-average rate at December 31 3.65% 4.93% 5.56% Weighted-average rate during the year 4.29 4.91 5.00
FIN 46 short-term beneficial interests: (b)
Commercial paper: Balance at year-end $ — $ 55 $ 3,351 Average daily balance during the year 3 919 17,851 Maximum month-end balance — 3,866 35,757 Weighted-average rate at December 31 NA% 4.38% 4.67% Weighted-average rate during the year 3.23 4.82 4.53
Other borrowed funds: Balance at year-end $ 5,556 $ 6,752 $ 4,497 Average daily balance during the year 5,703 5,361 5,267 Maximum month-end balance 7,325 6,752 9,078 Weighted-average rate at December 31 1.13% 3.04% 1.99% Weighted-average rate during the year 2.69 3.02 1.61
(a) Includes securities sold but not yet purchased. (b) Included on the Consolidated Balance Sheets in beneficial interests issued by consolidated variable interest entities.
Federal funds purchased represent overnight funds. Securities generally have maturities of one year or less. At December 31, loaned or sold under repurchase agreements generally mature 2008 and 2007, JPMorgan Chase had no lines of credit for general between one day and three months. Commercial paper generally is corporate purposes. issued in amounts not less than $100,000 and with maturities of 270 days or less. Other borrowed funds consist of demand notes, term federal funds purchased and various other borrowings that
JPMorgan Chase & Co. / 2008 Annual Report 235
Table of Contents
Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.
Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 13 of 24 JPMorgan Chase & Co. (Registrant)
By: /s/ JAMES DIMON
(James Dimon Chairman and Chief Executive Officer)
Date: March 2, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the date indicated. JPMorgan Chase does not exercise the power of attorney to sign on behalf of any Director.
Capacity Date
/s/ JAMES DIMON Director, Chairman and Chief Executive Officer
(James Dimon) (Principal Executive Officer)
/s/ CRANDALL C. BOWLES Director March 2, 2009
(Crandall C. Bowles)
/s/ STEPHEN B. BURKE Director
(Stephen B. Burke)
/s/ DAVID M. COTE Director
(David M. Cote)
/s/ JAMES S. CROWN Director
(James S. Crown)
/s/ ELLEN V. FUTTER Director
(Ellen V. Futter)
236
Table of Contents
Capacity Date
/s/ WILLIAM H. GRAY, III Director
(William H. Gray, III)
/s/ LABAN P. JACKSON, JR. Director
(Laban P. Jackson, Jr.)
/s/ DAVID C. NOVAK Director March 2, 2009
(David C. Novak)
/s/ LEE R. RAYMOND Director
(Lee R. Raymond)
/s/ WILLIAM C. WELDON Director
(William C. Weldon)
/s/ MICHAEL J. CAVANAGH Executive Vice President
(Michael J. Cavanagh) and Chief Financial Officer (Principal Financial Officer)
/s/ LOUIS RAUCHENBERGER Managing Director and Controller
(Louis Rauchenberger) (Principal Accounting Officer) Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 14 of 24 EX-21.1 21 y74757exv21w1.htm EX-21.1: LIST OF SUBSIDIARIES OF JPMORGAN CHASE & CO.
Exhibit 21.1
JPMorgan Chase & Co. List of subsidiaries JPMorgan Chase had the following subsidiaries at December 31, 2008:
Percentage of voting Organized under the securities owned by Name the laws of immediate parent
Banc One Building Management Corporation Wisconsin 100 Banc One Capital Holdings LLC Delaware 100 BOCP Holdings Corporation Ohio 100 Banc One Capital Partners IV, Ltd. Ohio 100 Banc One Capital Partners VIII, Ltd. Ohio 83 BOCP Energy Partners, L.P. Ohio 95 Banc One Stonehenge Capital Fund Wisconsin, LLC Delaware 100 BOCF, LLC Delaware 100 BOCNY, LLC Delaware 100 JPM Mezzanine Capital, LLC Delaware 100 Chase Investment Services Corp. Delaware 100 Banc One Deferred Benefits Corporation Ohio 98 Banc One Financial LLC Delaware 100 JPMorgan Capital Corporation Delaware 100 Bank One Investment Corporation Delaware 100 OEP Holding Corporation Delaware 100 Banc One Equity Capital Fund II, L.L.C. Delaware 99.5 Banc One Equity Capital II, L.L.C. Delaware 100 One Equity Partners II, L.P. Cayman Islands 99.9(1) One Equity Partners III, L.P. Cayman Islands 99.7 One Equity Partners LLC Delaware 99.9(2) First Chicago Capital Corporation Delaware 100 JPMorgan Capital (Canada) Corp. Canada 100 One Mortgage Partners Corp. Vermont 100 First Chicago Leasing Corporation Delaware 100 First Chicago Lease Holdings, Inc. Delaware 100 Palo Verde Leasing Corporation Delaware 100 First Chicago Lease Investments, Inc. Delaware 100 FM Holdings I, Inc. Delaware 100 GHML Holdings I, Inc. Delaware 100 GHML Holdings II, Inc. Delaware 100 GTC Fund III Holdings, Inc. Delaware 100 GTC Fund IV Holdings, Inc. Delaware 100 GTC Fund V Holdings, Inc. Delaware 100 JPMorgan Housing Corporation Delaware 100 Cooper Project, L.L.C. Delaware 100 J.P. Morgan Structured Fund Management SAS France 100 Protech Tax Credit Fund II, LLC United States 0.01(3) NLTC Fund Holdings I, Inc. Delaware 100 OX FCL Two, Inc. Delaware 100 SAHP 130 Holdings, Inc. Delaware 100 Banc One Neighborhood Development Corporation Ohio 100 BOI Leasing Corporation Indiana 100 Bridge Acquisition Holdings, Inc. Delaware 100 CCC Holding Inc. Delaware 100 Chase Commercial Corporation Delaware 100 Chase Capital Holding Corporation Delaware 100 Chase Capital Corporation Delaware 100 Chase Capital Credit Corporation Delaware 100 Chase Lincoln First Commercial Corporation Delaware 100 Chase Manhattan Realty Leasing Corporation New York 100
240 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 15 of 24
Percentage of voting Organized under securities owned by Name the laws of immediate parent
Palo Verde 1-PNM August 50 Corporation Delaware 100 Palo Verde 1-PNM December 75 Corporation Delaware 100 PV2-APS 150 Corporation Delaware 100 PV2-PNM December 35 Corporation Delaware 100 Chatham Ventures, Inc. New York 100 J.P. Morgan Partners (BHCA), L.P. California 80(4) CVCA, LLC Delaware 100 Chemical Equity Incorporated New York 100 Chemical Investments, Inc. Delaware 100 Clintstone Properties Inc. New York 100 CMRCC, Inc. New York 100 Credit Markets Investment Corporation Delaware 100 Custodial Trust Company New Jersey 99 Hambrecht & Quist California California 100 H&Q Holdings Inc. Delaware 100 Hatherley Insurance Ltd. Bermuda 100 Homesales, Inc. Delaware 100 J.P. Morgan Capital Financing Limited England 100 Aldermanbury Investments Limited England 100 J.P. Morgan Chase International Financing Limited England 100 Robert Fleming Holdings Limited England 100 Robert Fleming Investment Trust Limited England 100 J.P. Morgan Chase Community Development Corporation Delaware 100 J.P. Morgan Chase National Corporate Services, Inc. New York 100 J.P. Morgan Corporate Services Limited England 100 Robert Fleming Holdings Inc. Delaware 100 J.P. Morgan Equity Holdings, Inc. Delaware 100 CMC Holding Delaware Inc. Delaware 100 Chase Bank USA, National Association United States 100 Chase BankCard Services, Inc. Delaware 100 J.P. Morgan Investor Services Co. Delaware 100 Ixe Tarjetas, S.A. de C.V., Sociedad Financiera de Objeto Multiple, Entidad Regulada Mexico 50(5) J.P. Morgan Trust Company of Delaware Delaware 100 JPMorgan Bank and Trust Company, National Association United States 100 JPM Capital Corporation Delaware 100 JPMC Wind Assignor Corporation Delaware 100 JPMC Wind Investment LLC Delaware 49.995(6) J.P. Morgan Finance Holdings (Japan) LLC Delaware 100 J.P. Morgan Finance Japan YK Japan 100 J.P. Morgan Funding Corp. England 99.99(7) J.P. Morgan Futures Inc. Delaware 100 J.P. Morgan GT Corporation Delaware 100 J.P. Morgan Insurance Holdings, L.L.C. Arizona 100 Banc One Insurance Company Vermont 100 Chase Insurance Agency, Inc. Wisconsin 100 J.P. Morgan International Holdings LLC Delaware 100 J.P. Morgan Trust Company (Bahamas) Limited Bahamas, The 100 J.P. Morgan Trust Company (Cayman) Limited Cayman Islands 100 JPMAC Holdings Inc. Delaware 100 J.P. Morgan Invest Holdings LLC Delaware 100 J.P. Morgan Retirement Plan Services LLC Delaware 100 J.P. Morgan Partners (23A Manager), Inc. Delaware 100 J.P. Morgan Private Investments Inc. Delaware 100 J.P. Morgan Securities Inc. Delaware 100 J.P. Morgan Clearing Corp. Delaware 100 J.P. Morgan Services Asia Holdings, Inc. Delaware 100 J.P. Morgan Services Asia Holdings Limited Mauritius 100 J.P. Morgan Services India Private Limited India 99.99957515(8) J.P. Morgan Services Inc. Delaware 100 JPM International Consumer Holding Inc. Delaware 100 Brysam Global Partners, L.P. Cayman Islands 98.0392 Brysam BPO Ltd Mauritius 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 16 of 24 Brysam Mexico II, LLC Delaware 100 JPMorgan Asset Management Holdings Inc. Delaware 100 Highbridge Capital Management, LLC Delaware 77.5
241
Percentage of voting Organized under securities owned by Name the laws of immediate parent
Highbridge Capital Management (Hong Kong), Limited Hong Kong 100 Highbridge Capital Management (UK), Ltd. England 100 Highbridge Principal Strategies, LLC Delaware 100 Highbridge Principal Strategies (UK) I, Ltd England 100 Highbridge Principal Strategies (UK), LLP England 50(9) J.P. Morgan Alternative Asset Management, Inc. Delaware 100 J.P. Morgan Investment Management Inc. Delaware 100 JPMorgan Global Absolute Return Strategy Fund, LLC Delaware 100 JPMorgan Asset Management (Asia) Inc. Delaware 100 JF Asset Management (Singapore) Limited Singapore 100 JF Asset Management Limited Hong Kong 99.99998(10) JPMorgan Funds (Asia) Limited Hong Kong 99.9999998(11) JPMorgan Asset Management (Taiwan) Limited Taiwan 100 JPMorgan Asset Management (Japan) Limited Japan 100 JPMorgan Funds (Taiwan) Limited Taiwan 100 JPMorgan Asset Management (Canada) Inc. Canada 100 JPMorgan Asset Management International Limited England 100 JPMorgan Asset Management Holdings (UK) Limited England 100 JPMorgan Asset Management (UK) Limited England 100 JPMorgan Asset Management Holdings (Luxembourg) S.à r.l. Luxembourg 100 JPMorgan Asset Management (Europe) S.à r.l. Luxembourg 100 JPMorgan Asset Management Societa di Gestione del Risparmio SpA Italy 99.9(12) JPMorgan Asset Management Luxembourg S.A. Luxembourg 99.99(13) JPMorgan Asset Management Advisory Company S.à r.l. Luxembourg 99.97(14) JPMorgan Asset Management Marketing Limited England 100 JPMorgan Equity Plan Managers Limited England 100 JPMorgan Funds Limited Scotland 100 Save & Prosper Insurance Limited England 100 Save & Prosper Pensions Limited England 100 JPMorgan Investments Limited England 100 JPMorgan Life Limited England 100 JPMorgan LDHES LLC Delaware 100 Security Capital Research & Management Incorporated Delaware 100 JPMorgan Chase Bank, Dearborn Michigan 100 JPMorgan Chase Bank, National Association United States 100 Banc One Acceptance Corporation Ohio 100 Banc One Arizona Leasing Corporation Arizona 100 Banc One Building Corporation Illinois 100 Banc One Community Development Corporation Delaware 100 Protech Tax Credit Fund III, LLC United States 0.01(15) Banc One Equipment Finance, Inc. Indiana 100 Banc One Kentucky Leasing Corporation Kentucky 100 Banc One Kentucky Vehicle Leasing Company Kentucky 100 Banc One National Processing Corporation Delaware 100 Banc One Real Estate Investment Corp. Delaware 100 Bank One Education Finance Corporation Ohio 100 Bank One Equity Investors - BIDCO, Inc. Louisiana 100 Bear Stearns Commercial Mortgage, Inc. New York 100 Bear Stearns Credit Products Inc. Delaware 100 Bear Stearns Forex Inc. Delaware 100 Bear Stearns Mortgage Capital Corporation Delaware 100 Bear, Stearns Funding, Inc. Delaware 100 Blue Box Holdings Inc. Delaware 100 BOC Southeast Holdings Company Delaware 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 17 of 24 BOILL IHC, Inc. Nevada 100 Chase BankCard LLC Delaware 100 BONA Capital I, LLC Delaware 100 BONA Capital II, LLC Delaware 100 BOTAC, Inc. Nevada 100 California Reconveyance Company California 100 Cedar Hill International Corp. Delaware 100 Chase Auto Finance Corp. Delaware 100 Chase Community Development Corporation Delaware 100 Chase Equipment Leasing Inc. Ohio 100 Chase Funding Corporation Delaware 100
242
Percentage of voting Organized under securities owned by Name the laws of immediate parent
Chase Home Finance Inc. Delaware 100 Chase Home Finance LLC Delaware 100 Chase Mortgage Holdings, Inc. Delaware 100 Chase New Markets Corporation Delaware 100 Chase Preferred Capital Corporation Delaware 100 CPCC Delaware Statutory Trust Delaware 100 CPCC Texas Limited Partnership Texas 99.5(16) CPCC Massachusetts Business Trust Massachusetts 100 Chase Student Loan Services, Inc. Delaware 100 Collegiate Funding Services, L.L.C. Virginia 100 CFS Servicing, LLC Delaware 100 Chase Student Loan Servicing, LLC United States 100 Chase Student Loans, Inc. United States 100 Collegiate Funding of Delaware, L.L.C. United States 100 Collegiate Funding Services Education Loan Trust 2003A United States 100 Collegiate Funding Services Education Loan Trust 2003B United States 100 Collegiate Funding Services Education Loan Trust 2004A United States 100 Collegiate Funding Services Education Loan Trust 2005A United States 100 Collegiate Funding Services Education Loan Trust 2005B United States 100 Chase Ventures Holdings, Inc. United States 100 Commercial Loan Partners L.P. United States 58.6275(17) Cross Country Insurance Company United States 100 CSL Leasing, Inc. United States 100 DNT Asset Trust United States 100 Ventures Business Trust United States 100 FA Out-of-State Holdings, Inc. United States 100 Ahmanson Marketing, Inc. United States 100 FA California Aircraft Holding Corp. United States 100 Pacific Centre Associates LLC United States 54.86(18) WMRP Delaware Holdings LLC United States 97.84(19) Irvine Corporate Center, Inc. United States 100 Rivergrade Investment Corp. United States 32.8(20) Savings of America, Inc. United States 100 WaMu Insurance Services, Inc. United States 100 Washington Mutual Community Development, Inc. United States 100 FC Energy Finance I, Inc. United States 100 FC Energy Finance II, Inc. United States 100 FDC Offer Corporation United States 100 Paymentech, Inc. United States 100 FNBC Leasing Corporation United States 100 ICIB Fund I Holdings, Inc. United States 100 Georgetown/Chase Phase I LLC United States 99(21) Georgetown/Chase Phase II, LLC United States 99(22) Harvest Opportunity Holdings Corp. United States 100 HCP Properties, Inc. United States 100 J.P. Morgan Electronic Financial Services, Inc. United States 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 18 of 24 J.P. Morgan International Inc. United States 100 Bank One International Holdings Corporation United States 100 Bank One Europe Limited England 100 J.P. Morgan International Finance Limited United States 100 Banco J.P. Morgan S.A. Brazil 99.27(23) J.P. Morgan Corretora de Cambio e Valores Mobiliarios S.A. Brazil 100 J.P. Morgan S.A. Distribuidora de Titulos e Valores Mobiliarios Brazil 100 BOL (C) II, Inc. Delaware 100 BOL Canada II Sub, Inc. United States 100 BOL Canada II Trust United States 100 BO Leasing II ULC Canada 100 BOL Canada I, Inc. United States 100 BOL Canada I Sub, Inc. United States 100 BO Leasing I ULC Canada 100 BOL Canada III, Inc. United States 100 BOL Canada III Sub, Inc. United States 100 BO Leasing III ULC Canada 100 Brysam Global Partners (AV-1), L.P. Cayman Islands 98.0392 AEF, LLC United States 100
243
Percentage of voting Organized under securities owned by Name the laws of immediate parent
Apoyo Economico Familiar, S.de R.L. de C.V. Mexico 100 CB “J.P. Morgan Bank International” (LLC) Russia 99(24) Chase Manhattan Holdings Limitada Brazil 99.99 Dearborn Merchant Services, Inc Canada 100 Chase Paymentech Solutions Canada 51(25) First Data/Paymentech Canada Partner ULC Canada 100 Inversiones J.P. Morgan Limitada Chile 99.942(26) J.P. Morgan (Suisse) SA Switzerland 100 J.P. Morgan Bank (Ireland) plc Ireland 100 J.P. Morgan Administration Services (Ireland) Limited Ireland 100 JPMorgan Hedge Fund Services (Ireland) Limited Ireland 100 J.P. Morgan Bank Canada Canada 100 J.P. Morgan Bank Luxembourg S.A. Luxembourg 99.99(27) J.P. Morgan Beteiligungs- und Verwaltungsgesellschaft mbH Germany 99.8(28) J.P. Morgan AG Germany 100 J.P. Morgan Capital Holdings Limited England 72.727(29) J.P. Morgan Chase (UK) Holdings Limited England 100 J.P. Morgan Chase International Holdings England 100 J.P. Morgan EU Holdings Limited England 100 J.P. Morgan Equities Limited South Africa 100 J.P. Morgan Europe Limited England 100 Crosby Sterling (Holdings) Limited England 79(30) J.P. Morgan Markets LLP England 36.02(31) J.P. Morgan Chase Finance Limited England 65(32) JPMorgan Cazenove Holdings England 50.01 J.P. Morgan Securities Ltd. England 98.947(33) J.P. Morgan Securities Ltd. - Milan Branch Italy 100 Morgan Property Development Company Limited England 100 Robert Fleming (Overseas) Number 2 Limited England 100 J.P. Morgan plc England 100 J.P. Morgan Holdings B.V. Netherlands 100 J.P. Morgan Chase Bank Berhad Malaysia 100 J.P. Morgan Chile Limitada Chile 99.8(34) J.P. Morgan Funding South East Asia Private Limited Singapore 100 J.P. Morgan (S.E.A.) Limited Singapore 100 J.P. Morgan Grupo Financiero S.A. De C.V. Mexico 99.66(35) Banco J.P. Morgan S.A., Institucion de Banca Multiple, J.P. Morgan Grupo Financiero Mexico 99.99(36) Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 19 of 24 Banco J.P. Morgan Socio Liquidador Mexico 100 J.P. Morgan Casa de Bolsa, S.A. de C.V., J.P. Morgan Grupo Financiero Mexico 99.99(37) J.P. Morgan Servicios, S.A. de C.V., J.P. Morgan Grupo Financiero Mexico 99(38) J.P. Morgan Holdings (Hong Kong) Limited Hong Kong 99.8(39) Copthall Mauritius Investment Limited Mauritius 100 J.P. Morgan Futures (Korea) Limited Korea, South 100 J.P. Morgan Securities (Far East) Limited Hong Kong 99.9999999(40) J.P. Morgan Broking (Hong Kong) Limited Hong Kong 99.99999(41) J.P. Morgan Futures Co., Limited China, Peoples Republic of 49 J.P. Morgan International Derivatives Ltd. Jersey 100 J.P. Morgan International Holdings Limited Cayman Islands 100 J.P. Morgan India Securities Holdings Limited Mauritius 55.714(42) J.P. Morgan India Private Limited India 99.9999726(43) J.P. Morgan Indonesia Holdings (B.V.I.) Limited British Virgin Islands 100 J.P. Morgan Securities Singapore Private Limited Singapore 100 J.P. Morgan Securities Thailand Holdings Limited British Virgin Islands 100 PGW Limited Thailand 99.9997 JPMorgan Securities (Thailand) Limited Thailand 50.100001(44) Jadeling Malaysia Holdings Limited British Virgin Islands 100 JPMorgan Securities (Malaysia) Sdn. Bhd. Malaysia 100 J.P. Morgan Investimentos e Financas Ltda. Brazil 99.79(45) J.P. Morgan Luxembourg International S.à r.l. Luxembourg 100 J.P. Morgan Malaysia Ltd. Malaysia 100 J.P. Morgan Overseas Capital Corporation United States 100 J.P. Morgan Australia Group Pty Limited Australia 100 J.P. Morgan Operations Australia Limited Australia 100 J.P. Morgan Administrative Services Australia Limited Australia 100 J.P. Morgan Australia Limited Australia 100
244
Percentage of voting Organized under securities owned by Name the laws of immediate parent
J.P. Morgan Portfolio Services Limited Australia 100 JFOM Pty Limited Australia 100 OMG Australia Pty Limited Australia 100 J.P. Morgan Securities Australia Limited Australia 100 JPMorgan Investments Australia Limited Australia 100 J.P. Morgan Markets Australia Pty Limited Australia 100 J.P. Morgan Espana S.A. Spain 100 J.P. Morgan International Bank Limited England 100 J.P. Morgan Securities Canada Inc. Canada 100 J.P. Morgan Whitefriars Inc. United States 100 J.P. Morgan Whitefriars (UK) England 99.99(46) JPMorgan Corporacion Financiera S.A. Colombia 90(47) PT J.P. Morgan Securities Indonesia Indonesia 42.5(48) J.P. Morgan Pakistan Broking (Private) Limited Pakistan 99.999 J.P. Morgan Partners (CMB Reg K GP), Inc. United States 100 J.P. Morgan Saudi Arabia Limited Saudi Arabia 95(49) J.P. Morgan Securities (C.I.) Limited Jersey 100 J.P. Morgan (Jersey) Limited Jersey 100 J.P. Morgan Securities (Taiwan) Limited Taiwan 72.3(50) J.P. Morgan Securities Asia Private Limited Singapore 100 J.P. Morgan Securities Holdings (Hong Kong) Limited Hong Kong 86.38172(51) J.P. Morgan Securities (Asia Pacific) Limited Hong Kong 99.99999(52) J.P. Morgan Securities Holdings (Caymans) Limited Cayman Islands 99.9999(53) J.P. Morgan Securities India Private Limited India 89.99999(54) J.P. Morgan Securities Philippines, Inc. Philippines 99.9997 J.P. Morgan Securities South Africa (Proprietary) Limited South Africa 100 JPMorgan Administration Services (Proprietary) Limited South Africa 100 J.P. Morgan Structured Products B.V. Netherlands 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 20 of 24 J.P. Morgan Trust Company (Jersey) Limited Jersey 100 JPMorgan Holdings (Japan) LLC United States 100 JPMorgan Securities Japan Co., Ltd. Japan 85.042735(55) Bear Stearns (Japan), LLC United States 100 JPMorgan Trust Bank Limited Japan 72.1625613(56) Norchem Holdings e Negocios S.A. Brazil 48.97(57) NorChem Participacoes e Consultoria S.A. Brazil 50 Vastera Bermuda LP Bermuda 99.99(58) Vastera Netherlands B.V. Netherlands 100 J.P. Morgan Mortgage Acquisition Corp. United States 100 J.P. Morgan Treasury Technologies Corporation United States 100 JPMorgan Chase Bank (China) Company Limited China, Peoples Republic of 100 JPMorgan Chase Bank, N.A. - Asia Pacific Area Office Hong Kong 0 JPMorgan Chase Vastera Inc. United States 100 JPMorgan Chase Vastera Professional Services Inc. United States 100 JPMorgan Investment Advisors Inc. United States 100 JPMorgan Xign Corporation United States 100 Manufacturers Hanover Leasing International Corp. United States 100 Meliora Holding Corp. United States 100 Pike Street Holdings, Inc. United States 100 Providian Bancorp Services United States 100 Seafair Securities Holding Corp. United States 100 Second and Union, LLC United States 100 South Cutler Corporation United States 100 Stockton Plaza, Incorporated United States 100 Washington Mutual Brokerage Holdings, Inc. United States 100 WaMu Investments, Inc. United States 100 Washington Mutual Mortgage Securities Corp. United States 100 WM Marion Holdings, LLC United States 100 Cranbrook Real Estate Investment Trust United States 100 Washington Mutual Preferred Funding LLC United States 100 WM Specialty Mortgage LLC United States 100 WM Winslow Funding LLC United States 100 WMB Baker LLC United States 100 WMICC Delaware Holdings LLC United States 100 JPMorgan Chase Funding Inc. United States 100 J.P. Morgan Ventures Energy Corporation United States 100
245
Percentage of voting Organized under securities owned by Name the laws of immediate parent
BE Investment Holding Inc. United States 100 Arroyo Energy Investors LLC United States 100 Argonaut Power LP United States 99(59) Arroyo DP Holding LP United States 100 Brush Gas Holdings, LLC United States 99(60) Central Power Holdings LP United States 100 Okwari CB Holdings LP United States 100 Okwari UCF LP United States 100 Thermo Holdings LP United States 100 JPMorgan Ventures Energy (Asia) Pte Ltd Singapore 100 PropPartners Master Fund L.P. Cayman Islands 99.9(61) JPMorgan Distribution Services, Inc. United States 100 JPMorgan Funds Management, Inc. United States 100 JPMorgan Private Capital Asia Corp. United States 100 JPMorgan Private Capital Asia General Partner, L.P. Cayman Islands 100 JPMorgan Private Capital Asia Fund I, L.P. Cayman Islands 100 JPMorgan PCA Holdings (Mauritius) I Limited Mauritius 100 JPMorgan Securities Holdings LLC United States 100 J.P. Morgan Commercial Mortgage Investment Corp. United States 100 J.P. Morgan Institutional Investments Inc. United States 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 21 of 24 Neovest, Inc. United States 100 JPMorgan Special Situations Asia Corporation United States 100 JPMorgan Mauritius Holdings VI Limited Mauritius 100 Harbour Victoria Investment Holdings Limited Mauritius 100 Indocean Financial Holding Limited Mauritius 100 JPMorgan Mauritius Holdings II Limited Mauritius 100 JPMorgan Mauritius Holdings IV Limited Mauritius 100 JPMorgan Mauritius Holdings VII Limited Mauritius 100 JPMorgan Special Situations (Mauritius) Limited Mauritius 100 J.P. Morgan Advisors India Private Limited India 99.9999995(62) Magenta Magic Limited British Virgin Islands 100 J.P. Morgan Partners, LLC United States 100 JPMP Capital, LLC United States 100 J.P. Morgan Capital, L.P. United States 99.5(63) J.P. Morgan Investment Holdings, LLC United States 100 JPMCC Belgium S.P.R.L. Belgium 100 JPMCC Belgium (SCA) United States 100 J.P. Morgan Partnership Capital Corporation United States 100 J.P. Morgan Partnership Investment Corporation United States 100 Peabody Real Estate Partnership Corporation United States 100 The Peabody Fund Consultants, Inc. United States 100 JPMREP Holding Corporation United States 100 JPMorgan Real Estate Partners, L.P. United States 99.9(64) PIM Commons, LLC United States 100 Patriot-JPM Conti Charlotte Holdings, LLC United States 90 PIM/KMG Norwood, LLC United States 80 PIM/Waterton Portland Hotel, LLC United States 85 PIM Winchester, LLC United States 100 LabMorgan Corporation United States 100 LabMorgan Investment Corporation United States 100 MorServ, Inc. United States 100 NBD Community Development Corporation United States 100 Offshore Equities, Inc. United States 100 Park Assurance Company United States 100 Special Situations Investing Inc. United States 100 The Bear Stearns Companies LLC United States 100 383 Corporate Funding Inc. United States 100 383 Corporate Funding LLC United States 100 Arctos Partners Inc. United States 100 Bear Growth Capital Partners, LP United States 100 Bear Hunter Holdings LLC United States 59.63(65) Bear Stearns Asset Management Inc. United States 100 Bear Stearns Access Fund III, L.P. United States 1(66) Bear Stearns Access Fund IV, L.P. United States 1(67) Bear Stearns Access Fund V, L.P. United States 1
246
Percentage of voting Organized under securities owned by Name the laws of immediate parent
Bear Stearns Access Fund VI, L.P. United States 1 Bear Stearns Access Fund VII, L.P. United States 1 Bear Stearns Private Equity Opportunity Fund II, L.P. United States 1 Bear Stearns Fund of Hedge Funds Associates LLC United States 100 BX, L.P. United States 100 Bear Stearns Private Opportunity Ventures, L.P. United States 1.07 Bear Stearns Venture Partners, L.P. United States 100 BSAM Capital Investments Limited England 100 Measurisk, LLC United States 80 Bear Stearns Capital Markets Inc. United States 100 Bear Stearns Alternative Assets II Inc. United States 100 Bear Stearns Alternative Assets III Inc. United States 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 22 of 24 Bear Stearns Global Alternative Assets International Limited Cayman Islands 100 Bear Stearns Alternative Assets International Limited Cayman Islands 100 Bear Stearns Caribbean Asset Holdings Ltd. Barbados 100 Bear Stearns Corporate Lending Inc. United States 100 Bear Stearns Equity Strategies RT LLC United States 100 Bear Stearns Financial Products Inc. United States 100 Bear Stearns Global Lending Limited Cayman Islands 100 Bear Stearns International Funding I, Inc. United States 100 Bear Stearns International Funding (Bermuda) Limited Bermuda 50(68) Bear Stearns Overseas Funding Unlimited England 100 Bear Stearns International Funding II, Inc. United States 100 Bear Stearns Investment Products Inc. United States 100 Aircraft Certificate Seller LLC United States 100 Alpha Financing BS LLC United States 100 Bear Stearns Irish Holdings Inc. United States 100 Bear Stearns International Funding I S.à r.l. Luxembourg 100 Bear Stearns International Funding II S.à r.l. Luxembourg 100 Bear Stearns International Funding III S.à r.l. Luxembourg 100 Bear Stearns Ireland Limited Ireland 100 Bear Stearns Bank plc Ireland 100 Bear Stearns Services Inc. United States 100 Bear Stearns UK Holdings Limited England 100 Bear Stearns Holdings Limited England 100 Bear Stearns International Trading Limited England 100 Bear, Stearns International Limited England 100 Bear Strategic Investments Corp. United States 100 Bear Stearns Singapore Holdings Pte Ltd Singapore 100 Bear Stearns Singapore Management Pte. Ltd. Singapore 100 Bear Stearns Financial Services (India) Private Ltd. India 99.9999983(69) Bear UK Mortgages Limited England 100 Rooftop Funding Limited England 100 Rooftop Mortgages Limited England 100 Bear, Stearns International Holdings Inc. United States 100 Bear Stearns Hong Kong Limited Hong Kong 99.999(70) Bear Stearns Asia Limited Hong Kong 99.9999667(71) BSG Insurance Holdings Limited England 93 Minster Insurance Company Limited England 100 Bear, Stearns Netherlands Holding B.V. Netherlands 100 Bear, Stearns Realty Investors, Inc. United States 100 BSC Life Settlement Holdings, LLC United States 100 Thyme Settlements Limited Ireland 100 CL II Holdings LLC United States 100 Commercial Lending II LLC United States 99(72) Commercial Lending III LLC United States 99(73) Community Capital Markets LLC United States 100 Commercial Lending LLC United States 99(74) Constellation Venture Capital II, L.P. United States 0.89 Constellation Venture Capital Offshore II, L.P. United States 0.56 eCAST Settlement Corporation United States 100 EMC Mortgage Corporation United States 100 EMC Mortgage SFJV 2005, LLC United States 70 SFJV 2005, LLC United States 70 Gregory/Madison Avenue LLC United States 100
247
Percentage of voting Organized under securities owned by Name the laws of immediate parent
Indiana Four Holdings LLC United States 99(75) Indiana Four LLC United States 99(76) Madison Insurance Company, Inc. United States 100 Madison Vanderbilt Holdings, LLC United States 100 Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 23 of 24 MV Partners Fund I, L.P. United States 100 Max Recovery Australia Pty Limited Australia 100 MAX Recovery Inc. United States 100 MAX Flow Corp. United States 100 Max Recovery Limited England 100 MLP Investment Holdings, Inc. United States 100 New Castle Holding, Inc. United States 100 Plymouth Park Tax Services LLC United States 100 Madison Tax Capital, LLC United States 100 Principal Real Estate Funding Corporation Limited England 100 Strategic Mortgage Opportunities REIT Inc. United States 100 Max Recovery Canada Company United States 100
(1) OEP General Partner II, L.P. owns 0.1% (2) OEP Management LLC owns 0.1% (3) First Chicago Leasing Corporation owns 99.99% (4) JPMP Master Fund Manager, L.P. owns 20% (5) Ixe Banco, S.A., Institucion de Banca Multiple, Ixe Grupo Financiero owns 50% (6) JPMC Wind Assignor Corporation owns 50.005% (7) J.P. Morgan Financial Investments Limited owns 0.01% (8) J.P. Morgan International Finance Limited owns 0.00042485% (9) Highbridge Principal Strategies (UK) II, Ltd owns 50% (10) JPMorgan Asset Management Holdings Inc. owns 0.00002% (11) JPMorgan Asset Management (Asia) Inc. owns 0.0000002% (12) JPMorgan Asset Management (Europe) S.à r.l. owns 0.1% (13) JPMorgan Asset Management (Europe) S.à r.l. owns 0.01% (14) JPMorgan Asset Management Holdings (Luxembourg) S.à r.l. owns 0.03% (15) FNBC Leasing Corporation owns 99.99% (16) CPCC Massachusetts Business Trust owns 0.5% (17) Savings of America, Inc. owns 41.3725% (18) Stockton Plaza, Incorporated owns 32.4% and Irvine Corporate Center, Inc. owns 12.74% (19) Stockton Plaza, Incorporated owns 2.16% (20) Ahmanson Marketing, Inc. owns 1.4% and Commercial Loan Partners L.P. owns 25% and JPMorgan Chase Bank, National Association owns 25.8% and Savings of America, Inc. owns 15% (21) Easton Phase I SPE Corp. owns 1% (22) Easton Phase II SPE Corp. owns 1% (23) Chase Manhattan Holdings Limitada owns 0.4226% (24) J.P. Morgan plc owns 1% (25) First Data/Paymentech Canada Partner ULC owns 49% (26) J.P. Morgan International Inc. owns 0.008% and Chase Manhattan Overseas Finance Corporation owns 0.05% (27) Chase Manhattan Overseas Finance Corporation owns 0.01% (28) J.P. Morgan AG owns 0.2% (29) J.P. Morgan Overseas Capital Corporation owns 27.272% and J.P. Morgan International Inc. owns 0.001% (30) J.P. Morgan Chase International Holdings owns 21% (31) J.P. Morgan plc owns 27.07% and J.P. Morgan Securities Ltd. owns 27.29% and J.P. Morgan Whitefriars (UK) owns 9.62% (32) J.P. Morgan Securities Ltd. owns 35% (33) J.P. Morgan Capital Financing Limited owns 1.053% (34) J.P. Morgan Overseas Capital Corporation owns 0.2% (35) J.P. Morgan Overseas Capital Corporation owns 0.34% (36) J.P. Morgan International Finance Limited owns 0.01% (37) J.P. Morgan International Inc. owns 0.01% (38) J.P. Morgan International Finance Limited owns 1% (39) Fledgeling Nominees International Limited owns 0.2% (40) Fledgeling Nominees International Limited owns 0.0000001% (41) J.P. Morgan Holdings (Hong Kong) Limited owns 0.00001% (42) Fledgeling Nominees International Limited owns 44.286% (43) J.P. Morgan International Finance Limited owns 0.0000274% (44) Fledgeling Nominees International Limited owns 0.000003% and J.P. Morgan Holdings (Hong Kong) Limited owns 0.000003% and J.P. Morgan International Finance Limited owns 30.283423% and J.P. Morgan International Holdings Limited owns 19.616564% and J.P. Morgan Secretaries (B.V.I.) Limited owns 0.000003% and J.P. Morgan Securities (Far East) Limited owns 0.000003% (45) J.P. Morgan Overseas Capital Corporation owns 0.21% (46) J.P. Morgan Financial Investments Limited owns 0.01% (47) J.P. Morgan International Finance Limited owns 10% (48) J.P. Morgan Securities Asia Private Limited owns 13.75% and J.P. Morgan Indonesia Holdings (B.V.I.) Limited owns 42.5% (49) J.P. Morgan International Inc. owns 5% (50) J.P. Morgan International Holdings Limited owns 27.7% (51) Fledgeling Nominees International Limited owns 0.0001% and J.P. Morgan Holdings (Hong Kong) Limited owns 0.00001% and J.P. Morgan Securities (Far East) Limited owns 2.84613% and JPMorgan Securities Japan Co., Ltd. owns 10.77214% (52) Chase Manhattan Overseas Finance Corporation owns 0.00001% Case 1:09-cv-01656-RMC Document 54-11 Filed 11/22/10 Page 24 of 24 (53) Fledgeling Nominees International Limited owns 0.0001% (54) J.P. Morgan Overseas Capital Corporation owns 10.00001% (55) J.P. Morgan Luxembourg International S.à r.l. owns 14.957265%
248
(56) J.P. Morgan Chase International Holdings owns 27.8374387% (57) Chase Manhattan Holdings Limitada owns 29.2735% (58) Vastera Bermuda, LLC owns 0.01% (59) Arroyo Power GP Holdings LLC owns 1% (60) Arroyo Power GP Holdings LLC owns 1% (61) J.P. Morgan Ventures Investment Corporation owns 0.01% (62) JPMorgan Special Situations Asia Corporation owns 0.0000005% (63) J.P. Morgan Capital Management Company, L.P. owns 0.5% (64) JPMREP General Partner, L.P. owns 0.1% (65) Bear Strategic Investments Corp. owns 40.37% (66) The Bear Stearns Companies LLC owns 99% (67) The Bear Stearns Companies LLC owns 99% (68) Bear Stearns International Funding II, Inc. owns 50% (69) Bear Stearns Singapore Holdings Pte Ltd owns 0.0000017% (70) The Bear Stearns Companies LLC owns 0.001% (71) The Bear Stearns Companies LLC owns 0.0000333% (72) CL II Management LLC owns 1% (73) CL III Management LLC owns 1% (74) NMTC Management LLC owns 1% (75) Bear Stearns N.Y., Inc. owns 1% (76) Bear Stearns N.Y., Inc. owns 1%
249 Case 1:09-cv-01656-RMC Document 54-12 Filed 11/22/10 Page 1 of 12
EXHIBIT 9
10-K 1 e82150e10vk.htm FORM 10-K Case 1:09-cv-01656-RMC Document 54-12 Filed 11/22/10 Page 2 of 12 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K Annual report pursuant to section 13 or 15(d) of The Securities Exchange Act of 1934
For the fiscal year ended Commission file December 31, 2009 number 1-5805 JPMorgan Chase & Co.
(Exact name of registrant as specified in its charter)
Delaware 13-2624428 (State or other jurisdiction of (I.R.S. employer incorporation or organization) identification no.)
270 Park Avenue, New York, NY 10017 (Address of principal executive offices) (Zip code)
Registrant’s telephone number, including area code: (212) 270-6000 Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Common stock The New York Stock Exchange The London Stock Exchange The Tokyo Stock Exchange Warrants, each to purchase one share of Common Stock The New York Stock Exchange Depositary Shares each representing a one-fourth interest in a share of 6.15% Cumulative Preferred Stock, Series E The New York Stock Exchange Depositary Shares each representing a one-fourth interest in a share of 5.72% Cumulative Preferred Stock, Series F The New York Stock Exchange Depositary Shares each representing a one-fourth interest in a share of 5.49% Cumulative Preferred Stock, Series G The New York Stock Exchange Depositary Shares each representing a one-four hundredth interest in a share of 8.625% Non-Cumulative Preferred Stock, Series J The New York Stock Exchange Guarantee of 7.00% Capital Securities, Series J, of J.P. Morgan Chase Capital X The New York Stock Exchange Guarantee of 5 7/8% Capital Securities, Series K, of J.P. Morgan Chase Capital XI The New York Stock Exchange Guarantee of 6.25% Capital Securities, Series L, of J.P. Morgan Chase Capital XII The New York Stock Exchange Guarantee of 6.20% Capital Securities, Series N, of J.P. Morgan Chase Capital XIV The New York Stock Exchange Guarantee of 6.35% Capital Securities, Series P, of J.P. Morgan Chase Capital XVI The New York Stock Exchange Guarantee of 6.625% Capital Securities, Series S, of J.P. Morgan Chase Capital XIX The New York Stock Exchange Guarantee of 6.875% Capital Securities, Series X, of J.P. Morgan Chase Capital XXIV The New York Stock Exchange Guarantee of Fixed-to-Floating Rate Capital Securities, Series Z, of JPMorgan Chase Capital XXVI The New York Stock Exchange Guarantee of Fixed-to-Floating Rate Capital Securities, Series BB, of JPMorgan Chase Capital XXVIII The New York Stock Exchange Guarantee of 7.20% Preferred Securities of BANK ONE Capital VI The New York Stock Exchange KEYnotes Exchange Traded Notes Linked to the First Trust Enhanced 130/30 Large Cap Index NYSE Arca, Inc. Alerian MLP Index ETNs due May 24, 2024 NYSE Arca, Inc. Buffer Notes Based Upon S&P 500® Index due November 24, 2010 NYSE Arca, Inc. Euro Floating Rate Global Notes due July 27, 2012 The NYSE Alternext U.S. LLC Principal Protected Notes Linked to S&P 500® Index due September 30, 2010 The NYSE Alternext U.S. LLC Principal Protected Notes Linked to the Dow Jones Industrial AverageSM due March 23, 2011 The NYSE Alternext U.S. LLC Medium Term Notes, Linked to a Basket of Three International Equity Indices due August 2, 2010 The NYSE Alternext U.S. LLC
Securities registered pursuant to Section 12(g) of the Act: none
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. x Yes o No Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. o Yes x No Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): x Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company (Do not check if a smaller reporting company)
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No The aggregate market value of JPMorgan Chase & Co. common stock held by non-affiliates of JPMorgan Chase & Co. on June 30, 2009 was approximately $133,193,936,622. Number of shares of common stock outstanding on January 31, 2010: 3,973,010,673
Documents incorporated by Reference: Portions of the Registrant’s Proxy Statement for the annual meeting of stockholders to be held on May 18, 2010, are incorporated by reference in this Form 10-K in response to Items 10, 11, 12, 13 and 14 of Part III.
JPMorgan Chase & Co. / 2009 Annual Report Case 1:09-cv-01656-RMC Document 54-12 Filed 11/22/10 43 Page 3 of 12
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Management’s discussion and analysis
In the Retail Banking segment within Retail Financial Services, although management of all these factors, management currently expects CS to report net losses in each of the expects underlying growth, results will be under pressure from the credit environment and first two quarters of 2010 (of approximately $1 billion in the first quarter and somewhat less ongoing lower consumer spending levels. In addition, the Firm has made changes, than that in the second quarter) before the effect of any potential reserve actions. Results in consistent with (and in certain respects, beyond) the requirements of newly-enacted the second half of 2010 will likely be dependent on the economic environment and potential legislation, in its policies relating to non-sufficient funds and overdraft fees. Although reserve actions. management estimates are, at this point in time, preliminary and subject to change, such Commercial Banking results could be negatively affected by rising credit costs, a decline in changes are expected to result in an annualized reduction in net income of approximately loan demand and reduced liability balances. $500 million, beginning in the first quarter of 2010. Earnings in Treasury & Securities Services and Asset Management will be affected by the In the Consumer Lending segment within Retail Financial Services, at current production and impact of market levels on assets under management, supervision and custody. Additionally, estimated run-off levels, the Home Lending portfolio of $263 billion at December 31, 2009, is earnings in Treasury & Securities Services could be affected by liability balance flows. expected to decline by approximately 10–15% and could possibly average approximately $240 billion in 2010 and approximately $200 billion in 2011. Based on management’s Earnings in Private Equity (within the Corporate/Private Equity segment) will likely be volatile preliminary estimate, which is subject to change, the effect of such a reduction in the Home and continue to be influenced by capital markets activity, market levels, the performance of Lending portfolio is expected to reduce 2010 net interest income in the portfolio by the broader economy and investment-specific issues. Corporate’s net interest income levels approximately $1 billion from the 2009 level. Additionally, revenue could be negatively and securities gains will generally trend with the size of the investment portfolio in affected by elevated levels of repurchases of mortgages previously sold to, for example, Corporate; however, the high level of trading gains in Corporate in the second half of 2009 is government-sponsored enterprises. not likely to continue. In the near-term, Corporate quarterly net income (excluding Private Equity, merger-related items and any significant nonrecurring items) is expected to decline to Management expects noninterest expense in Retail Financial Services to remain at or above approximately $300 million, subject to the size and duration of the investment securities 2009 levels, reflecting investments in new branch builds and sales force hires as well as portfolio. continued elevated servicing, default and foreclosed asset related costs. Lastly, with regard to any decision by the Firm’s Board of Directors concerning any increase Card Services faces rising credit costs in 2010, as well as continued pressure on both in the level of the common stock dividend, their determination will be subject to their charge volumes and credit card receivables growth, reflecting continued lower levels of judgment that the likelihood of another severe economic downturn has sufficiently consumer spending. In addition, as a result of the recently-enacted credit card legislation, diminished, that overall business performance has stabilized, and that such action is management estimates, which are preliminary and subject to change, are that CS’s annual warranted taking into consideration the Firm’s earnings outlook, need to maintain adequate net income may be adversely affected by approximately $500 million to $750 million. Further, capital levels, alternative investment opportunities, and appropriate dividend payout ratios. management expects average Card outstandings to decline by approximately 10-15% in When in the Board’s judgment, based on the foregoing, the Board believes it appropriate to 2010 due to the run-off of the Washington Mutual portfolio and lower balance transfer levels. increase the dividend to an annual payout level in the range of $0.75 to $1.00 per share, As a result the Board would likely move forward with such an increase, and follow at some later time with an additional increase or additional increases sufficient to return to the Firm’s historical dividend ratio of approximately 30% to 40% of normalized earnings over time.
44 JPMorgan Chase & Co. / 2009 Annual Report
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CONSOLIDATED RESULTS OF OPERATIONS
This following section provides a comparative discussion of JPMorgan Chase’s Consolidated loss of $2.3 billion from the tightening of the Firm’s credit spread on certain structured Results of Operations on a reported basis for the three-year period ended December 31, liabilities and derivatives, compared with gains of $2.0 billion in the prior year from widening 2009. Factors that related primarily to a single business segment are discussed in more spreads on these liabilities and derivatives. The Firm’s private equity investments produced detail within that business segment. For a discussion of the Critical Accounting Estimates a slight net loss in 2009, a significant improvement from a larger net loss in 2008. For a Used by the Firm that affect the Consolidated Results of Operations, see pages 127–131 of further discussion of principal transactions revenue, see IB and Corporate/Private Equity this Annual Report. segment results on pages 55–57 and 74–75, respectively, and Note 3 on pages 148–165 of this Annual Report. Revenue Lending- and deposit-related fees rose from the prior year, predominantly reflecting the
impact of the Washington Mutual transaction and organic growth in both lending- and Year ended December 31, (in millions) 2009 2008 2007 deposit-related fees in RFS, CB, IB and TSS. For a further discussion of lending- and Investment banking fees $ 7,087 $ 5,526 $ 6,635 Principal transactions 9,796 (10,699) 9,015 deposit-related fees, which are mostly recorded in RFS, TSS and CB, see the RFS segment Lending- and deposit-related fees 7,045 5,088 3,938 results on pages 58–63, the TSS segment results on pages 69–70, and the CB segment Asset management, administration and commissions 12,540 13,943 14,356 results on pages 67–68 of this Annual Report. Securities gains 1,110 1,560 164 Mortgage fees and related income 3,678 3,467 2,118 The decline in asset management, administration and commissions revenue compared with Credit card income 7,110 7,419 6,911 the prior year was largely due to lower asset management fees in AM from the effect of Other income 916 2,169 1,829 lower market levels. Also contributing to the decrease were lower administration fees in
Noninterest revenue 49,282 28,473 44,966 TSS, driven by the effect of market depreciation on certain custody assets and lower Net interest income 51,152 38,779 26,406 securities lending balances; and lower brokerage commissions revenue in IB, predominantly
Total net revenue $100,434 $ 67,252 $71,372 related to lower transaction volume. For additional information on these fees and
commissions, see the segment discussions for TSS on pages 69–70, and AM on pages 71– 2009 compared with 2008 73 of this Annual Report. Total net revenue was $100.4 billion, up by $33.2 billion, or 49%, from the prior year. The increase was driven by higher principal transactions revenue, primarily related to improved Securities gains were lower in 2009 and included credit losses related to other-than- performance across most fixed income and equity products, and the absence of net temporary impairment and lower gains on the sale of MasterCard shares of $241 million in markdowns on legacy leveraged lending and mortgage positions in IB, as well as higher 2009, compared with $668 million in 2008. These decreases were offset partially by higher levels of trading gains and investment securities income in Corporate/Private Equity. Results gains from repositioning the Corporate investment securities portfolio in connection with also benefited from the impact of the Washington Mutual transaction, which contributed to managing the Firm’s structural interest rate risk. For a further discussion of securities gains, increases in net interest income, lending- and deposit-related fees, and mortgage fees and which are mostly recorded in Corporate/Private Equity, see the Corporate/Private Equity related income. Lastly, higher investment banking fees also contributed to revenue growth. segment discussion on pages 74–75 of this Annual Report. These increases in revenue were offset partially by reduced fees and commissions from the Mortgage fees and related income increased slightly from the prior year, as higher net effect of lower market levels on assets under management and custody, and the absence of Case 1:09-cv-01656-RMCmortgage servicing Document revenue was largely offset 54-12 by lower production Filed revenue. 11/22/10 The increase in Page 4 of 12 proceeds from the sale of Visa shares in its initial public offering in the first quarter of 2008. net mortgage servicing revenue was driven by growth in average third-party loans serviced Investment banking fees increased from the prior year, due to higher equity and debt as a result of the Washington Mutual transaction. Mortgage production revenue declined underwriting fees. For a further discussion of investment banking fees, which are primarily from the prior year, reflecting an increase in estimated losses from the repurchase of recorded in IB, see IB segment results on pages 55–57 of this Annual Report. previously-sold loans, offset partially by wider margins on new originations. For a discussion of mortgage fees and related income, which is recorded primarily in RFS’s Consumer Principal transactions revenue, which consists of revenue from trading and private equity Lending business, see the Consumer Lending discussion on pages 60–63 of this Annual investing activities, was significantly higher compared with the prior year. Trading revenue Report. increased, driven by improved performance across most fixed income and equity products; modest net gains on legacy leveraged lending and mortgage-related positions, compared Credit card income, which includes the impact of the Washington Mutual transaction, with net markdowns of $10.6 billion in the prior year; and gains on trading positions in decreased slightly compared with the prior year, Corporate/Private Equity, compared with losses in the prior year of $1.1 billion on markdowns of Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) preferred securities. These increases in revenue were offset partially by an aggregate
JPMorgan Chase & Co. / 2009 Annual Report 45
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Management’s discussion and analysis due to lower servicing fees earned in connection with CS securitization activities, largely as of investment banking fees, which are primarily recorded in IB, see IB segment results on a result of higher credit losses. The decrease was partially offset by wider loan margins on pages 55–57 of this Annual Report. securitized credit card loans; higher merchant servicing revenue related to the dissolution of In 2008, principal transactions revenue declined by $19.7 billion from the prior year. Trading the Chase Paymentech Solutions joint venture; and higher interchange income. For a further revenue decreased by $14.5 billion to a negative $9.8 billion, compared with positive discussion of credit card income, see the CS segment results on pages 64–66 of this Annual $4.7 billion in 2007. The decline in trading revenue was largely driven by net markdowns of Report. $5.9 billion on mortgage-related exposures, compared with $1.4 billion in net markdowns in Other income decreased from the prior year, due predominantly to the absence of the prior year; net markdowns of $4.7 billion on leveraged lending funded and unfunded $1.5 billion in proceeds from the sale of Visa shares during its initial public offering in the commitments, compared with $1.3 billion in net markdowns in the prior year; losses of first quarter of 2008, and a $1.0 billion gain on the dissolution of the Chase Paymentech $1.1 billion on preferred securities of Fannie Mae and Freddie Mac; and weaker equity Solutions joint venture in the fourth quarter of 2008; and lower net securitization income in trading results, compared with a record level in 2007. In addition, trading revenue was CS. These items were partially offset by a $464 million charge recognized in 2008 related to adversely affected by additional losses and costs to reduce risk related to Bear Stearns the repurchase of auction-rate securities at par; the absence of a $423 million loss incurred positions. Partially offsetting the decline in trading revenue were record results in rates and in the second quarter of 2008, reflecting the Firm’s 49.4% share of Bear Stearns’ losses currencies, credit trading, commodities and emerging markets, as well as strong Equity from April 8 to May 30, 2008; and higher valuations on certain investments, including seed Markets client revenue; and total gains of $2.0 billion from the widening of the Firm’s credit capital in AM. spread on certain structured liabilities and derivatives, compared with $1.3 billion in 2007. Private equity results also declined substantially from the prior year, recording losses of Net interest income increased from the prior year, driven by the Washington Mutual $908 million in 2008, compared with gains of $4.3 billion in 2007. In addition, the first transaction, which contributed to higher average loans and deposits. The Firm’s interest- quarter of 2007 included a fair value adjustment related to the adoption of new FASB earning assets were $1.7 trillion, and the net yield on those assets, on a fully taxable- guidance on fair value measurement. For a further discussion of principal transactions equivalent (“FTE”) basis, was 3.12%, an increase of 25 basis points from 2008. Excluding revenue, see IB and Corporate/Private Equity segment results on pages 55–57 and 74–75, the impact of the Washington Mutual transaction, the increase in net interest income in 2009 respectively, and Note 3 on pages 148–165 of this Annual Report. was driven by a higher level of investment securities, as well as a wider net interest margin, which reflected the overall decline in market interest rates during the year. Declining interest Lending- and deposit-related fees rose from 2007, predominantly resulting from higher rates had a positive effect on the net interest margin, as rates paid on the Firm’s interest- deposit-related fees and the impact of the Washington Mutual transaction. For a further bearing liabilities decreased faster relative to the decline in rates earned on interest-earning discussion of Lending- and deposit-related fees, which are mostly recorded in RFS, TSS assets. These increases in net interest income were offset partially by lower loan balances, and CB, see the RFS segment results on pages 58–63, the TSS segment results on pages which included the effect of lower customer demand, repayments and charge-offs. 69–70 and the CB segment results on pages 67–68 of this Annual Report. 2008 compared with 2007 The decline in asset management, administration and commissions revenue compared with Total net revenue of $67.3 billion was down $4.1 billion, or 6%, from the prior year. The 2007 was driven by lower asset management fees in AM, due to lower performance fees decline resulted from the extremely challenging business environment for financial services and the effect of lower market levels. This decline was partially offset by an increase in firms in 2008. Principal transactions revenue decreased significantly and included net commissions revenue, related predominantly to higher brokerage transaction volume within markdowns on mortgage-related positions and leveraged lending funded and unfunded IB’s Equity Markets revenue, which included additions from Bear Stearns’ Prime Services commitments, losses on preferred securities of Fannie Mae and Freddie Mac, and losses on business; and higher administration fees in TSS, driven by wider spreads in securities private equity investments. Also contributing to the decline in total net revenue were losses lending and increased product usage by new and existing clients. For additional information and markdowns recorded in other income, including the Firm’s share of Bear Stearns’ losses on these fees and commissions, see the segment discussions for IB on pages 55–57, RFS from April 8 to May 30, 2008. These declines were largely offset by higher net interest on pages 58–63, TSS on pages 69–70 and AM on pages 71–73 of this Annual Report. income, proceeds from the sale of Visa shares in its initial public offering, and the gain on The increase in securities gains compared with the prior year was due to the repositioning the dissolution of the Chase Paymentech joint venture. of the Corporate investment securities portfolio, as part of managing the structural interest Investment banking fees were down from the record level of the prior year due to lower debt rate risk of the underwriting fees, as well as lower advisory and equity underwriting fees, both of which were at record levels in 2007. These declines were attributable to reduced market activity. For a further discussion
46 JPMorgan Chase & Co. / 2009 Annual Report
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Firm; and higher gains from the sale of MasterCard shares. For a further discussion of assets. Growth in consumer and wholesale loan balances also contributed to the increase in securities gains, which are mostly recorded in the Firm’s Corporate/Private Equity business, net interest income. see the Corporate/Private Equity segment discussion on pages 74–75 of this Annual Report. Mortgage fees and related income increased from the prior year, driven by higher net Provision for credit losses
a portfolio of positions is usually less than the sum of the risks of the positions themselves. (f) Trading VaR includes predominantly all trading activities in IB; however, particular risk parameters of certain products are not fully captured, for example, correlation risk. TradingCase VaR does1:09-cv-01656-RMC not include VaR Document 54-12 Filed 11/22/10 Page 5 of 12 related to held-for-sale funded loans and unfunded commitments, nor the debit valuation adjustments
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Management’s discussion and analysis
RETAIL FINANCIAL SERVICES
measure, to evaluate the underlying expense trends of the business. Including CDI amortization expense in the overhead ratio calculation would result in a higher overhead ratio in the earlier years and a lower Retail Financial Services, which includes the Retail Banking and Consumer overhead ratio in later years; this method would therefore result in an improving overhead ratio over time, all Lending businesses, serves consumers and businesses through personal things remaining equal. The non-GAAP ratio excludes Retail Banking’s core deposit intangible amortization service at bank branches and through ATMs, online banking and telephone expense related to the Bank of New York transaction and the Bank One merger of $328 million, banking, as well as through auto dealerships and school financial-aid $394 million and $460 million for the years ended December 31, 2009, 2008 and 2007, respectively. offices. Customers can use more than 5,100 bank branches (third-largest 2009 compared with 2008 nationally) and 15,400 ATMs (second-largest nationally), as well as online Net income was $97 million, a decrease of $783 million from the prior year, as the increase and mobile banking around the clock. More than 23,900 branch salespeople in provision for credit losses more than offset the positive impact of the Washington Mutual assist customers with checking and savings accounts, mortgages, home transaction. equity and business loans, and investments across the 23-state footprint from New York and Florida to California. Consumers also can obtain loans Net revenue was $32.7 billion, an increase of $9.2 billion, or 39%, from the prior year. Net through more than 15,700 auto dealerships and nearly 2,100 schools and interest income was $20.5 billion, up by $6.3 billion, or 45%, reflecting the impact of the universities nationwide. Washington Mutual transaction, and wider loan and deposit spreads. Noninterest revenue was $12.2 billion, up by $2.8 billion, or 30%, driven by the impact of the Washington Mutual transaction, wider margins on mortgage originations and higher net mortgage servicing On September 25, 2008, JPMorgan Chase acquired the banking operations of Washington revenue, partially offset by $1.6 billion in estimated losses related to the repurchase of Mutual from the FDIC for $1.9 billion through a purchase of substantially all of the assets previously sold loans. and assumption of specified liabilities of Washington Mutual. Washington Mutual’s banking operations consisted of a retail bank network of 2,244 branches, a nationwide credit card The provision for credit losses was $15.9 billion, an increase of $6.0 billion from the prior lending business, a multi-family and commercial real estate lending business, and nationwide year. Weak economic conditions and housing price declines continued to drive higher mortgage banking activities. The transaction expanded the Firm’s U.S. consumer branch estimated losses for the home equity and mortgage loan portfolios. The provision included network in California, Florida, Washington, Georgia, Idaho, Nevada and Oregon and created an addition of $5.8 billion to the allowance for loan losses, compared with an addition of the nation’s third-largest branch network. $5.0 billion in the prior year. Included in the 2009 addition to the allowance for loan losses was a $1.6 billion increase related to estimated deterioration in the Washington Mutual Selected income statement data purchased credit-impaired portfolio. To date, no charge-offs have been recorded on Year ended December 31, (in millions, except ratios) 2009 2008 2007 purchased credit-impaired loans; see page 62 of this Annual Report for the net charge-off
Revenue rates, as reported. Home equity net charge-offs were $4.7 billion (4.32% excluding Lending- and deposit-related fees $ 3,969 $ 2,546 $ 1,881 purchased credit-impaired loans), compared with $2.4 billion (2.39% excluding purchased Asset management, administration and commissions 1,674 1,510 1,275 credit-impaired loans) in the prior year. Subprime mortgage net charge-offs were $1.6 billion Mortgage fees and related income 3,794 3,621 2,094 (11.86% excluding purchased credit-impaired loans), compared with $933 million (6.10% Credit card income 1,635 939 646 excluding purchased credit-impaired loans) in the prior year. Prime mortgage net charge-offs Other income 1,128 739 883 were $1.9 billion (3.05% excluding purchased credit-impaired loans), compared with Noninterest revenue 12,200 9,355 6,779 $526 million (1.18% excluding purchased credit-impaired loans) in the prior year. Net interest income 20,492 14,165 10,526
Total net revenue 32,692 23,520 17,305 Noninterest expense was $16.7 billion, an increase of $4.7 billion, or 39%. The increase reflected the impact of the Washington Mutual transaction and higher servicing and default- Provision for credit losses 15,940 9,905 2,610 related expense. Noninterest expense Compensation expense 6,712 5,068 4,369 Noncompensation expense 9,706 6,612 5,071 Amortization of intangibles 330 397 465
Total noninterest expense 16,748 12,077 9,905
Income before income tax expense/(benefit) 4 1,538 4,790 Income tax expense/(benefit) (93) 658 1,865
Net income $ 97 $ 880 $ 2,925
Financial ratios
ROE —% 5% 18% Overhead ratio 51 51 57 Overhead ratio excluding 50 50 55 core deposit intangibles(a)
(a) Retail Financial Services uses the overhead ratio (excluding the amortization of core deposit intangibles (“CDI”)), a non-GAAP financial
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2008 compared with 2007 Selected metrics
Net income was $880 million, a decrease of $2.0 billion, or 70%, from the prior year, as a Year ended December 31, significant increase in the provision for credit losses was partially offset by positive MSR risk (in millions, except headcount and ratios) 2009 2008 2007 management results and the positive impact of the Washington Mutual transaction. Selected balance sheet data Total net revenue was $23.5 billion, an increase of $6.2 billion, or 36%, from the prior year. (period-end) Net interest income was $14.2 billion, up $3.6 billion, or 35%, benefiting from the Assets $387,269 $419,831 $256,351 Washington Mutual transaction, wider loan and deposit spreads, and higher loan and deposit Loans: balances. Noninterest revenue was $9.4 billion, up $2.6 billion, or 38%, as positive MSR risk Loans retained 340,332 368,786 211,324 must be allocated to the SPE’s investors and other parties that have rights to those cash Generally, Firm-sponsored asset management funds are considered voting entities as the flows. SPEs are generally structured to insulate investors fromCase claims on the1:09-cv-01656-RMC SPE’s assets funds do not meet Documentthe conditions to be VIEs. 54-12 In instances whereFiled the Firm 11/22/10 is the general Page 6 of 12 by creditors of other entities, including the creditors of the seller of the assets. partner or managing member of limited partnerships or limited liability companies, the non- affiliated partners or members have the substantive ability to remove the Firm as the general There are two different accounting frameworks applicable to SPEs: the qualifying SPE partner or managing member without cause (i.e., kick-out rights), based on a simple (“QSPE”) framework and the variable interest entity (“VIE”) framework. The applicable unaffiliated majority vote, or have substantive participating rights. Accordingly, the Firm does framework depends on the nature of the entity and the Firm’s relation to that entity. The not consolidate these funds. In limited cases where the non-affiliated partners or members QSPE framework is applicable when an entity transfers (sells) financial assets to an SPE do not have substantive kick-outs or participating right, the Firm consolidates the funds. meeting certain defined criteria. These criteria are designed to ensure that the activities of the entity are essentially predetermined at the inception of the vehicle and that the transferor of the financial assets cannot exercise control over the entity and the assets therein. Entities meeting these
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Private equity investments, which are recorded in other assets on the Consolidated Balance Fair value measurement Note 3 Page 148 Sheets, include investments in buyouts, growth equity and venture opportunities. These Fair value option Note 4 Page 165 investments are accounted for under investment company guidelines. Accordingly, these Derivative instruments Note 5 Page 167 investments, irrespective of the percentage of equity ownership interest held, are carried on Noninterest revenue Note 6 Page 175 the Consolidated Balance Sheets at fair value. Pension and other postretirement employee benefit plans Note 8 Page 176 Employee stock-based incentives Note 9 Page 184 Assets held for clients in an agency or fiduciary capacity by the Firm are not assets of Noninterest expense Note 10 Page 186 JPMorgan Chase and are not included in the Consolidated Balance Sheets. Securities Note 11 Page 187 Securities financing activities Note 12 Page 192 Use of estimates in the preparation of consolidated financial statements Loans Note 13 Page 192 The preparation of Consolidated Financial Statements requires management to make Allowance for credit losses Note 14 Page 196 estimates and assumptions that affect the reported amounts of assets and liabilities, revenue Loan securitizations Note 15 Page 198 and expense, and disclosures of contingent assets and liabilities. Actual results could be Variable interest entities Note 16 Page 206 different from these estimates. Goodwill and other intangible assets Note 17 Page 214 Premises and equipment Note 18 Page 218 Foreign currency translation Other borrowed funds Note 20 Page 219 JPMorgan Chase revalues assets, liabilities, revenue and expense denominated in non-U.S. Accounts payable and other liabilities Note 21 Page 219 currencies into U.S. dollars using applicable exchange rates. Income taxes Note 27 Page 226 Commitments and contingencies Note 30 Page 230 Gains and losses relating to translating functional currency financial statements for U.S. Off–balance sheet lending-related financial instruments and guarantees Note 31 Page 230 reporting are included in other comprehensive income/(loss) within stockholders’ equity. Gains and losses relating to nonfunctional currency transactions, including non-U.S. Note 2 – Business changes and developments operations where the functional currency is the U.S. dollar, are reported in the Consolidated Statements of Income. Decrease in Common Stock Dividend On February 23, 2009, the Board of Directors reduced the Firm’s quarterly common stock Statements of cash flows dividend from $0.38 to $0.05 per share, effective for the dividend payable April 30, 2009, to For JPMorgan Chase’s Consolidated Statements of Cash Flows, cash is defined as those shareholders of record on April 6, 2009. amounts included in cash and due from banks. Acquisition of the banking operations of Washington Mutual Bank Significant accounting policies On September 25, 2008, JPMorgan Chase acquired the banking operations of Washington The following table identifies JPMorgan Chase’s other significant accounting policies and the Mutual Bank (“Washington Mutual”) from the Federal Deposit Insurance Corporation (“FDIC”) Note and page where a detailed description of each policy can be found. for $1.9 billion. The acquisition expanded JPMorgan Chase’s consumer branch network into several states, including California, Florida Washington, Georgia, Idaho, Nevada and Oregon and created the third largest branch network in the U.S. The acquisition also extends the reach of the Firm’s business banking, commercial banking, credit card, consumer lending and wealth management businesses. The acquisition was accounted for under the purchase method of accounting, which requires that the assets and liabilities of Washington Mutual be initially reported at fair value. In 2008, the $1.9 billion purchase price was preliminarily allocated to the Washington Mutual assets acquired and liabilities assumed, which resulted in negative goodwill. In accordance with U.S. GAAP for business combinations, that was in effect at the time of this acquisition, noncurrent nonfinancial assets that were not held-for-sale, such as the premises and equipment and other intangibles, acquired in the Washington Mutual transaction were written down against the negative goodwill. The negative goodwill that remained after writing down the nonfinancial assets was recognized as an extraordinary gain of $1.9 billion at December 31, 2008. The final total extraordinary gain that resulted from the Washington Mutual transaction was $2.0 billion.
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Notes to consolidated financial statements The final summary computation of the purchase price and the allocation of the final total purchase price of $1.9 billion to the net assets acquired of Washington Mutual – based on their respective fair values as of September 25, 2008, and the resulting final negative goodwill of $2.0 billion are presented below.
(in millions)
Purchase price Purchase price $ 1,938 Direct acquisition costs 3
Total purchase price 1,941 Net assets acquired Washington Mutual’s net assets before fair value adjustments $ 39,186 Washington Mutual’s goodwill and other intangible assets Case 1:09-cv-01656-RMC Document 54-12 Filed(7,566) 11/22/10 Page 7 of 12
Subtotal 31,620
Adjustments to reflect assets acquired at fair value: Securities (16) Trading assets (591) Loans (30,998) Allowance for loan losses 8,216 Premises and equipment 680 Accrued interest and accounts receivable (243) Other assets 4,010
Adjustments to reflect liabilities assumed at fair value: Deposits (686) Other borrowed funds 68 Accounts payable, accrued expense and other liabilities (1,124) Long-term debt 1,063
Fair value of net assets acquired 11,999
Negative goodwill before allocation to nonfinancial assets (10,058) Negative goodwill allocated to nonfinancial assets(a) 8,076
Negative goodwill resulting from the acquisition(b) $ (1,982)
(a) The acquisition was accounted for as a purchase business combination, which requires the assets (including identifiable intangible assets) and liabilities (including executory contracts and other commitments) of an acquired business to be recorded at their respective fair values as of the effective date of the acquisition and consolidated with those of JPMorgan Chase. The fair value of the net assets of Washington Mutual’s banking operations exceeded the $1.9 billion purchase price, resulting in negative goodwill. Noncurrent, nonfinancial assets not held-for-sale, such as premises and equipment and other intangibles, were written down against the negative goodwill. The negative goodwill that remained after writing down transaction-related core deposit intangibles of approximately $4.9 billion and premises and equipment of approximately $3.2 billion was recognized as an extraordinary gain of $2.0 billion.
(b) The extraordinary gain was recorded net of tax expense in Corporate/Private Equity. Condensed statement of net assets acquired The following condensed statement of net assets acquired reflects the final value assigned to the Washington Mutual net assets as of September 25, 2008.
(in millions) September 25, 2008
Assets Cash and due from banks $ 3,680 Deposits with banks 3,517 Federal funds sold and securities purchased under resale agreements 1,700 Trading assets 5,691 Securities 17,224 Loans (net of allowance for loan losses) 206,456 Accrued interest and accounts receivable 3,253 Mortgage servicing rights 5,874 All other assets 16,596
Total assets $ 263,991
Liabilities Deposits $ 159,872 Federal funds purchased and securities loaned or sold under repurchase agreements 4,549 Other borrowed funds 81,636 Trading liabilities 585 Accounts payable, accrued expense and other liabilities 6,708 Long-term debt 6,718
Total liabilities 260,068
Washington Mutual net assets acquired $ 3,923
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Merger with The Bear Stearns Companies Inc. on May 30, 2008, JPMorgan Chase completed the merger. As a result of the merger, each Effective May 30, 2008, BSC Merger Corporation, a wholly owned subsidiary of JPMorgan outstanding share of Bear Stearns common stock (other than shares then held by JPMorgan Chase, merged with The Bear Stearns Companies Inc. (“Bear Stearns”) pursuant to the Chase) was converted into the right to receive 0.21753 shares of common stock of Agreement and Plan of Merger, dated as of March 16, 2008, as amended March 24, 2008, JPMorgan Chase. Also, on May 30, 2008, the shares of common stock that JPMorgan and Bear Stearns became a wholly owned subsidiary of JPMorgan Chase. The merger Chase and Bear Stearns acquired from each other in the share exchange transaction were provided the Firm with a leading global prime brokerage platform; strengthened the Firm’s cancelled. From April 8, 2008, through May 30, 2008, JPMorgan Chase accounted for the equities and asset management businesses; enhanced capabilities in mortgage origination, investment in Bear Stearns under the equity method of accounting. During this period, securitization and servicing; and expanded the platform of the Firm’s energy business. The JPMorgan Chase recorded reductions to its investment in Bear Stearns representing its merger was accounted for under the purchase method of accounting, which requires that the share of Bear Stearns net losses, which was recorded in other income and accumulated assets and liabilities of Bear Stearns be fair valued. The final total purchase price to other comprehensive income. complete the merger was $1.5 billion. In conjunction with the Bear Stearns merger, in June 2008, the Federal Reserve Bank of The merger with Bear Stearns was accomplished through a series of transactions that were New York (the “FRBNY”) took control, through a limited liability company (“LLC”) formed for reflected as step acquisitions. On April 8, 2008, pursuant to the share exchange agreement, this purpose, of a portfolio of $30 billion in assets acquired from Bear Stearns, based on the JPMorgan Chase acquired 95 million newly issued shares of Bear Stearns common stock (or value of the portfolio as of March 14, 2008. The assets of the LLC were funded by a 39.5% of Bear Stearns common stock after giving effect to the issuance) for 21 million $28.85 billion term loan from the FRBNY, and a $1.15 billion subordinated loan from shares of JPMorgan Chase common stock. Further, between March 24, 2008, and May 12, JPMorgan Chase. The JPMorgan Chase note is subordinated to the FRBNY loan and will 2008, JPMorgan Chase acquired approximately 24 million shares of Bear Stearns common bear the first $1.15 billion of any losses of the portfolio. Any remaining assets in the portfolio stock in the open market at an average purchase price of $12.37 per share. The share after repayment of the FRBNY loan, the JPMorgan Chase note and the expense of the LLC exchange and cash purchase transactions resulted in JPMorgan Chase owning will be for the account of the FRBNY. approximately 49.4% of Bear Stearns common stock immediately prior to consummation of the merger. Finally,
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related commitments at December 31, 2009 and 2008. The amounts in the table below for Loans 289.0 342.3 credit card and home equity lending-related commitments represent the total available credit Trading assets and other Case 1:09-cv-01656-RMC 76.8 98.0 Document 54-12 Filed 11/22/10 Page 8 of 12 for these products. The Firm has not experienced, and does not anticipate, that all available Total assets pledged(a) $874.3 $927.9 lines of credit for these products will be utilized at the same time. The Firm can reduce or (a) Total assets pledged do not include assets of consolidated VIEs. These assets are not generally used to satisfy liabilities to third parties. See Note 16 on pages 206–214 of this Annual Report for additional cancel these lines of credit by providing the borrower prior notice or, in some cases, without information on assets and liabilities of consolidated VIEs. notice as permitted by law. In 2008, the Firm resolved with the IRS issues related to compliance with reporting and withholding requirements for certain accounts transferred to The Bank of New York Mellon Corporation (“BNYM”) in connection with the Firm’s sale to BNYM of its corporate trust business. The resolution of these issues did not have a material effect on the Firm.
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Off-balance sheet lending-related financial instruments, guarantees and other commitments
Contractual amount Carrying Value(h) December 31, (in millions) 2009 2008 2009 2008 Lending-related Consumer: Home equity – senior lien $ 19,246 $ 27,998 $ — $ — Home equity – junior lien 37,231 67,745 — — Prime mortgage 1,654 5,079 — — Subprime mortgage — — — — Option ARMs — — — — Auto loans 5,467 4,726 7 3 Credit card 569,113 623,702 — — All other loans 11,229 12,257 5 22
Total consumer 643,940 741,507 12 25 Wholesale: Other unfunded commitments to extend credit(a) 192,145 189,563 356 349 Asset purchase agreements 22,685 53,729 126 147 Standby letters of credit and financial guarantees(a)(b)(c) 91,485 95,352 919 671 Unused advised lines of credit 35,673 36,300 — — Other letters of credit(a)(b) 5,167 4,927 1 2
Total wholesale 347,155 379,871 1,402 1,169
Total lending-related $ 991,095 $ 1,121,378 $ 1,414 $ 1,194
Other guarantees and commitments Securities lending guarantees(d) $ 170,777 $ 169,281 $ NA $ NA Residual value guarantees 672 670 — — Derivatives qualifying as guarantees(e) 87,191 83,835 762 5,418 Equity investment commitments(f) 2,374 2,424 — — Loan sale and securitization-related indemnifications: Repurchase liability(g) NA NA 1,705 1,093 Loans sold with recourse 13,544 15,020 271 241
(a) Represents the contractual amount net of risk participations totaling $24.6 billion and $26.4 billion for standby letters of credit and other financial guarantees at December 31, 2009 and 2008, respectively, $690 million and $1.1 billion for other letters of credit at December 31, 2009 and 2008, respectively, and $643 million and $789 million for other unfunded commitments to extend credit at December 31, 2009 and 2008, respectively. In regulatory filings with the Federal Reserve Board these commitments are shown gross of risk participations.
(b) JPMorgan Chase held collateral relating to $31.5 billion and $31.0 billion of standby letters of credit and $1.3 billion and $1.0 billion of other letters of credit at December 31, 2009 and 2008, respectively.
(c) Includes unissued standby letter of credit commitments of $38.4 billion and $39.5 billion at December 31, 2009 and 2008, respectively.
(d) Collateral held by the Firm in support of securities lending indemnification agreements was $173.2 billion and $170.1 billion at December 31, 2009 and 2008, respectively. Securities lending collateral comprises primarily cash, and securities issued by governments that are members of the Organization for Economic Co-operation and Development (“OECD”) and U.S. government agencies.
(e) Represents notional amounts of derivatives qualifying as guarantees. The carrying value at December 31, 2009 and 2008, reflects derivative payables of $981 million and $5.6 billion, respectively, less derivative receivables of $219 million and $184 million, respectively.
(f) Includes unfunded commitments to third-party private equity funds of $1.5 billion and $1.4 billion at December 31, 2009 and 2008, respectively. Also includes unfunded commitments for other equity investments of $897 million and $1.0 billion at December 31, 2009 and 2008, respectively. These commitments include $1.5 billion at December 31, 2009, related to investments that are generally fair valued at net asset value as discussed in Note 3 on pages 148-165 of this Annual Report.
(g) Indemnifications for breaches of representations and warranties in loan sale and securitization agreements. For additional information, see Loan sale and securitization-related indemnifications on page 233 of this Note.
(h) For lending-related products the carrying value represents the allowance for lending-related commitments and the fair value of the guarantee liability, for derivative-related products the carrying value represents the fair value, and for all other products the carrying value represents the valuation reserve.
Other unfunded commitments to extend credit Also included in other unfunded commitments to extend credit are commitments to Other unfunded commitments to extend credit include commitments to U.S. domestic states investment- and noninvestment-grade counterparties in connection with leveraged and municipalities, hospitals and other not-for-profit entities to provide funding for periodic acquisitions. These commitments are dependent on whether the acquisition by the borrower tenders of their variable-rate demand bond obligations or commercial paper. Performance by is successful, tend to be short-term in nature and, in most cases, are subject to certain the Firm is required in the event that the variable-rate demand bonds or commercial paper conditions based on the borrower’s financial condition or other factors. The amounts of cannot be remarketed to new investors. The amount of commitments related to variable-rate commitments related to leveraged acquisitions at December 31, 2009 and 2008, were demand bonds and commercial paper of U.S. domestic states and municipalities, hospitals $2.9 billion and $3.6 billion, respectively. For further information, see Note 3 and Note 4 on and not-for-profit entities was $23.3 billion and $23.5 billion at December 31, 2009 and pages 148-165 and 165-167 respectively, of this Annual Report. 2008, respectively. Similar commitments exist to extend credit in the form of liquidity facility agreements with nonconsolidated municipal bond VIEs. For further information, see Note 16 Guarantees on pages 206-214 of this Annual Report. The Firm considers the following off-balance sheet lending-related arrangements to be guarantees under U.S. GAAP: certain asset
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Table of Contents Notes to consolidated financial statements Case 1:09-cv-01656-RMC Document 54-12 Filed 11/22/10 Page 9 of 12 purchase agreements, standby letters of credit and financial guarantees, securities lending million and $9 million, respectively, for the allowance for lending-related commitments, and indemnifications, certain indemnification agreements included within third-party contractual $108 million and $138 million, respectively, for the fair value of the guarantee liability. arrangements and certain derivative contracts. The amount of the liability related to guarantees recorded at December 31, 2009 and 2008, excluding the allowance for credit Standby letters of credit losses on lending-related commitments and derivative contracts discussed below, was Standby letters of credit (“SBLC”) and financial guarantees are conditional lending $475 million and $535 million, respectively. commitments issued by the Firm to guarantee the performance of a customer to a third party under certain arrangements, such as commercial paper facilities, bond financings, acquisition Asset purchase agreements financings, trade and similar transactions. The carrying values of standby and other letters of Asset purchase agreements are principally used as a mechanism to provide liquidity to credit were $920 million and $673 million at December 31, 2009 and 2008, respectively, SPEs, predominantly multi-seller conduits, as described in Note 16 on pages 206–214 of which was classified in accounts payable and other liabilities on the Consolidated Balance this Annual Report. Sheets; these carrying values include $553 million and $276 million, respectively, for the allowance for lending-related commitments, and $367 million and $397 million, respectively, The carrying value of asset purchase agreements was $126 million and $147 million at for the fair value of the guarantee liability. December 31, 2009 and 2008, respectively, which was classified in accounts payable and other liabilities on the Consolidated Balance Sheets; the carrying values include $18
The following table summarizes the type of facilities under which standby letters of credit and other letters of credit arrangements are outstanding by the ratings profiles of the Firm’s customers as of December 31, 2009 and 2008. The ratings scale represents the current status of the payment or performance risk of the guarantee, and is based on the Firm’s internal risk ratings, which generally correspond to ratings defined by S&P and Moody’s.
2009 2008 Standby letters Standby letters of credit and other Other letters of credit and other Other letters December 31, (in millions) financial guarantees of credit financial guarantees of credit(d)
Investment-grade(a) $ 66,786 $ 3,861 $ 73,394 $ 3,772 Noninvestment-grade(a) 24,699 1,306 21,958 1,155
Total contractual amount(b) $ 91,485(c) $ 5,167 $ 95,352(c) $ 4,927
Allowance for lending-related commitments $ 552 $ 1 $ 274 $ 2 Commitments with collateral 31,454 1,315 30,972 1,000
(a) Ratings scale is based on the Firm’s internal ratings which generally correspond to ratings defined by S&P and Moody’s.
(b) Represents the contractual amount net of risk participations totaling $24.6 billion and $26.4 billion for standby letters of credit and other financial guarantees at December 31, 2009 and 2008, respectively, and $690 million and $1.1 billion for other letters of credit at December 31, 2009 and 2008, respectively. In regulatory filings with the Federal Reserve Board these commitments are shown gross of risk participations.
(c) Includes unissued standby letters of credit commitments of $38.4 billion and $39.5 billion at December 31, 2009 and 2008, respectively.
(d) The investment-grade and noninvestment-grade amounts have been revised from previous disclosures.
was $87.2 billion and $83.8 billion at December 31, 2009 and 2008, respectively. The Derivatives qualifying as guarantees notional value generally represents the Firm’s maximum exposure to derivatives qualifying In addition to the contracts described above, the Firm transacts certain derivative contracts as guarantees, although exposure to certain stable value derivatives is contractually limited that meet the characteristics of a guarantee under U.S. GAAP. These contracts include to a substantially lower percentage of the notional value. The fair value of the contracts written put options that require the Firm to purchase assets upon exercise by the option reflects the probability of whether the Firm will be required to perform under the contract. holder at a specified price by a specified date in the future. The Firm may enter into written The fair value related to derivative guarantees were derivative receivables of $219 million put option contracts in order to meet client needs, or for trading purposes. The terms of and $184 million and derivative payables of $981 million and $5.6 billion at December 31, written put options are typically five years or less. Derivative guarantees also include 2009 and 2008, respectively. The Firm reduces exposures to these contracts by entering into contracts such as stable value derivatives that require the Firm to make a payment of the offsetting transactions, or by entering into contracts that hedge the market risk related to the difference between the market value and the book value of a counterparty’s reference derivative guarantees. portfolio of assets in the event that market value is less than book value and certain other conditions have been met. Stable value derivatives, commonly referred to as “stable value In addition to derivative contracts that meet the characteristics of a guarantee, the Firm is wraps”, are transacted in order to allow investors to realize investment returns with less both a purchaser and seller of credit protection in the credit derivatives market. For a further volatility than an unprotected portfolio and are typically longer-term or may have no stated discussion of credit derivatives, see Note 5 on pages 167-175 of this Annual Report. maturity, but allow the Firm to terminate the contract under certain conditions. Securities lending indemnification Derivative guarantees are recorded on the Consolidated Balance Sheets at fair value in Through the Firm’s securities lending program, customers’ securities, via custodial and non- trading assets and trading liabilities. The total notional value of the derivatives that the Firm custodial arrangements, may be lent to deems to be guarantees
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Table of Contents third parties. As part of this program, the Firm provides an indemnification in the lending At December 31, 2009 and 2008, the Firm had recorded repurchase liabilities of $1.7 billion agreements which protects the lender against the failure of the third-party borrower to return and $1.1 billion, respectively. The repurchase liabilities are intended to reflect the likelihood the lent securities in the event the Firm did not obtain sufficient collateral. To minimize its that JPMorgan Chase will have to perform under these representations and warranties and liability under these indemnification agreements, the Firm obtains cash or other highly liquid is based on information available at the reporting date. The estimate incorporates both collateral with a market value exceeding 100% of the value of the securities on loan from presented demands and probable future demands and is the product of an estimated cure the borrower. Collateral is marked to market daily to help assure that collateralization is rate, an estimated loss severity and an estimated recovery rate from third parties, where adequate. Additional collateral is called from the borrower if a shortfall exists, or collateral applicable. The liabilities have been reported net of probable recoveries from third-parties may be released to the borrower in the event of overcollateralization. If a borrower defaults, and predominately as a reduction of mortgage fees and related income. During 2009, the the Firm would use the collateral held to purchase replacement securities in the market or to Firm settled certain current and future claims for certain loans originated and sold by credit the lending customer with the cash equivalent thereof. Also, as part of this program, Washington Mutual Bank. the Firm invests cash collateral received from the borrower in accordance with approved guidelines. Loans sold with recourse The Firm provides servicing for mortgages and certain commercial lending products on both Indemnification agreements – general a recourse and nonrecourse basis. In nonrecourse servicing, the principal credit risk to the In connection with issuing securities to investors, the Firm may enter into contractual Firm is the cost of temporary servicing advances of funds (i.e., normal servicing advances). arrangements with third parties that require the Firm to make a payment to them in the In recourse servicing, the servicer agrees to share credit risk with the owner of the mortgage event of a change in tax law or an adverse interpretation of tax law. In certain cases, the loans, such as Fannie Mae or Freddie Mac or a private investor, insurer or guarantor. contract also may include a termination clause, which would allow the Firm to settle the Losses on recourse servicing predominantly occur when foreclosure sales proceeds of the contract at its fair value in lieu of making a payment under the indemnification clause. The property underlying a defaulted loan are less than the sum of the outstanding principal Firm may also enter into indemnification clauses in connection with the licensing of software balance, plus accrued interest on the loan and the cost of holding and disposing of the to clients (“software licensees”) or when it sells a business or assets to a third party (“third- underlying property. The Firm’s securitizations are predominantly nonrecourse, thereby party purchasers”), pursuant to which it indemnifies softwareCase licensees for1:09-cv-01656-RMC claims of liability effectively transferring Document the risk of future credit54-12 losses to the Filed purchaser 11/22/10of the mortgage- Page 10 of 12 or damages that may occur subsequent to the licensing of the software, or third-party backed securities issued by the trust. At December 31, 2009 and 2008, the unpaid principal purchasers for losses they may incur due to actions taken by the Firm prior to the sale of balance of loans sold with recourse totaled $13.5 billion and $15.0 billion, respectively. The the business or assets. It is difficult to estimate the Firm’s maximum exposure under these carrying value of the related liability that the Firm has recorded, which is representative of indemnification arrangements, since this would require an assessment of future changes in the Firm’s view of the likelihood it will have to perform under this guarantee, was tax law and future claims that may be made against the Firm that have not yet occurred. $271 million and $241 million at December 31, 2009 and 2008, respectively. However, based on historical experience, management expects the risk of loss to be remote. Credit card charge-backs Loan sale and securitization-related indemnifications Prior to November 1, 2008, the Firm was a partner with one of the leading companies in Indemnifications for breaches of representations and warranties electronic payment services in a joint venture operating under the name of Chase As part of the Firm’s loan sale and securitization activities, as described in Note 13 and Note Paymentech Solutions, LLC (the “joint venture”). The joint venture was formed in 15 on pages 192–196 and 198–205, respectively, of this Annual Report, the Firm generally October 2005, as a result of an agreement by the Firm and First Data Corporation, its joint makes representations and warranties in its loan sale and securitization agreements that the venture partner, to integrate the companies’ jointly owned Chase Merchant Services and loans sold meet certain requirements. These agreements may require the Firm (including in Paymentech merchant businesses. The joint venture provided merchant processing services its roles as a servicer) to repurchase the loans and/or indemnify the purchaser of the loans in the United States and Canada. The dissolution of the joint venture was completed on against losses due to any breaches of such representations or warranties. Generally, the November 1, 2008, and JPMorgan Chase retained approximately 51% of the business under maximum amount of future payments the Firm would be required to make for breaches the Chase Paymentech name. under these representations and warranties would be equal to the unpaid principal balance Under the rules of Visa USA, Inc., and MasterCard International, JPMorgan Chase Bank, of such loans held by purchasers, including securitization-related SPEs, that are deemed to N.A., is liable primarily for the amount of each processed credit card sales transaction that is have defects plus, in certain circumstances, accrued and unpaid interest on such loans and the subject of a dispute between a cardmember and a merchant. If a dispute is resolved in certain expense. the cardmember’s favor, Chase Paymentech will (through the cardmember’s issuing bank) credit or refund the amount to the cardmember and will charge back the transaction to the merchant. If Chase Paymentech is unable to collect the amount from the merchant, Chase Paymentech will bear the loss for the amount credited or refunded to the cardmember. Chase Paymentech mitigates this risk by withholding future settlements, retaining cash reserve accounts or by obtaining other security. However, in the unlikely event that: (1) a merchant ceases operations and is unable to deliver products, services or a refund; (2) Chase Paymentech does not have sufficient collateral from the merchant to provide customer refunds; and (3) Chase Paymentech does not have sufficient financial resources to provide customer refunds, JPMorgan Chase Bank, N.A., would be liable for the amount of the
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Notes to consolidated financial statements transaction. For the year ended December 31, 2009, Chase Paymentech incurred aggregate building for the amount of the then outstanding indebtedness of the lessor, or to arrange for credit losses of $11 million on $409.7 billion of aggregate volume processed, and at the sale of the building, with the proceeds of the sale to be used to satisfy the lessor’s debt December 31, 2009, it held $213 million of collateral. For the year ended December 31, obligation. If the sale does not generate sufficient proceeds to satisfy the lessor’s debt 2008, Chase Paymentech incurred aggregate credit losses of $13 million on $713.9 billion of obligation, the Firm is required to fund the shortfall, up to a maximum residual value aggregate volume processed, and at December 31, 2008, it held $222 million of collateral. guarantee. As of December 31, 2009, there was no expected shortfall and the maximum The Firm believes that, based on historical experience and the collateral held by Chase residual value guarantee was approximately $670 million. Paymentech, the fair value of the Firm’s charge back-related obligations, which are representative of the payment or performance risk to the Firm is immaterial. Note 32 – Credit risk concentrations
Credit card association, exchange and clearinghouse guarantees Concentrations of credit risk arise when a number of customers are engaged in similar The Firm holds an equity interest in VISA Inc. During October 2007, certain VISA-related business activities or activities in the same geographic region, or when they have similar entities completed a series of restructuring transactions to combine their operations, economic features that would cause their ability to meet contractual obligations to be including VISA USA, under one holding company, VISA Inc. Upon the restructuring, the similarly affected by changes in economic conditions. Firm’s membership interest in VISA USA was converted into an equity interest in VISA Inc. JPMorgan Chase regularly monitors various segments of its credit portfolio to assess VISA Inc. sold shares via an initial public offering and used a portion of the proceeds from potential concentration risks and to obtain collateral when deemed necessary. Senior the offering to redeem a portion of the Firm’s equity interest in Visa Inc. Prior to the management is significantly involved in the credit approval and review process, and risk restructuring, VISA USA’s by-laws obligated the Firm upon demand by VISA USA to levels are adjusted as needed to reflect management’s risk tolerance. indemnify VISA USA for, among other things, litigation obligations of Visa USA. The accounting for that guarantee was not subject to initial recognition at fair value. Upon the In the Firm’s wholesale portfolio, risk concentrations are evaluated primarily by industry and restructuring event, the Firm’s obligation to indemnify Visa Inc. was limited to certain geographic region, and monitored regularly on both an aggregate portfolio level and on an identified litigations. Such a limitation is deemed a modification of the indemnity by-law and, individual customer basis. Management of the Firm’s wholesale exposure is accomplished accordingly, became subject to initial recognition at fair value. The value of the litigation through loan syndication and participation, loan sales, securitizations, credit derivatives, use guarantee has been recorded in the Firm’s financial statements based on its then fair value; of master netting agreements, and collateral and other risk-reduction techniques. In the the net amount recorded (within other liabilities) did not have a material adverse effect on consumer portfolio, concentrations are evaluated primarily by product and by U.S. the Firm’s financial statements. In addition to Visa, the Firm is a member of other geographic region, with a key focus on trends and concentrations at the portfolio level, associations, including several securities and futures exchanges and clearinghouses, both in where potential risk concentrations can be remedied through changes in underwriting the United States and other countries. Membership in some of these organizations requires policies and portfolio guidelines. the Firm to pay a pro rata share of the losses incurred by the organization as a result of the The Firm does not believe that its exposure to any particular loan product (e.g., option default of another member. Such obligations vary with different organizations. These ARMs), portfolio segment (e.g., commercial real estate) or its exposure to residential real obligations may be limited to members who dealt with the defaulting member or to the estate loans with high loan-to-value ratios results in a significant concentration of credit risk. amount (or a multiple of the amount) of the Firm’s contribution to a member’s guarantee Terms of loan products and collateral coverage are included in the Firm’s assessment when fund, or, in a few cases, the obligation may be unlimited. It is difficult to estimate the Firm’s extending credit and establishing its allowance for loan losses. maximum exposure under these membership agreements, since this would require an assessment of future claims that may be made against the Firm that have not yet occurred. For further information regarding on-balance sheet credit concentrations by major product However, based on historical experience, management expects the risk of loss to be remote. and geography, see Note 13 on pages 192-196 of this Annual Report. For information regarding concentrations of off-balance sheet lending-related financial instruments by major Residual value guarantee product, see Note 31 on pages 230-234 of this Annual Report. In connection with the Bear Stearns merger, the Firm succeeded to an operating lease arrangement for the building located at 383 Madison Avenue in New York City (the “Synthetic Lease”). Under the terms of the Synthetic Lease, the Firm is obligated to make Federal funds purchased represent overnight funds. Securities loaned or sold under term federal funds purchased, and various other borrowings that generally have maturities of repurchase agreements generally mature between one day Caseand three months. 1:09-cv-01656-RMC Commercial one year or less. DocumentAt December 31, 2009, 54-12 2008 and 2007, FiledJPMorgan Chase11/22/10 had no lines of Page 11 of 12 paper generally is issued in amounts not less than $100,000, and with maturities of credit for general corporate purposes. 270 days or less. Other borrowed funds consist of demand notes,
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Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf of the undersigned, thereunto duly authorized.
JPMorgan Chase & Co. (Registrant)
By: /s/ JAMES DIMON
(James Dimon Chairman and Chief Executive Officer)
Date: February 24, 2010
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacity and on the date indicated. JPMorgan Chase & Co. does not exercise the power of attorney to sign on behalf of any Director.
Capacity Date
/s/ JAMES DIMON Director, Chairman and Chief Executive Officer
(James Dimon) (Principal Executive Officer)
/s/ CRANDALL C. BOWLES Director February 24, 2010
(Crandall C. Bowles)
/s/ STEPHEN B. BURKE Director
(Stephen B. Burke)
/s/ DAVID M. COTE Director
(David M. Cote)
/s/ JAMES S. CROWN Director
(James S. Crown)
/s/ ELLEN V. FUTTER Director
(Ellen V. Futter)
/s/ WILLIAM H. GRAY, III Director
(William H. Gray, III)
/s/ LABAN P. JACKSON, JR. Director
(Laban P. Jackson, Jr.)
/s/ DAVID C. NOVAK Director
(David C. Novak)
/s/ LEE R. RAYMOND Director
(Lee R. Raymond)
/s/ WILLIAM C. WELDON Director
(William C. Weldon)
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Capacity Date
/s/ MICHAEL J. CAVANAGH Executive Vice President
(Michael J. Cavanagh) and Chief Financial Officer (Principal Financial Officer) February 24, 2010
/s/ LOUIS RAUCHENBERGER Managing Director and Controller
(Louis Rauchenberger) (Principal Accounting Officer)
261 Case 1:09-cv-01656-RMC Document 54-12 Filed 11/22/10 Page 12 of 12 Case 1:09-cv-01656-RMC Document 54-13 Filed 11/22/10 Page 1 of 7
EXHIBIT 10
Case 1:09-cv-01656-RMC Document 54-13 Filed 11/22/10 Page 2 of 7 10-Q 1 y86142e10vq.htm FORM 10-Q
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2010 Commission file number 1-5805 JPMORGAN CHASE & CO. (Exact name of registrant as specified in its charter)
Delaware 13-2624428
(State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.)
270 Park Avenue, New York, New York 10017
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code (212) 270-6000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
þ Yes o No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
þ Yes o No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer þ Accelerated filer o Non-accelerated filer o Smaller reporting company o (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o Yes þ No
Number of shares of common stock outstanding as of October 31, 2010: 3,909,181,427
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Loan modifications The Firm modifies loans that it services, including loans that were sold to off-balance sheet SPEs, pursuant to the U.S. Treasury’s Making Home Affordable (“MHA”) programs and the Firm’s other loss-mitigation programs. During the three and nine months ended September 30, 2010, for both the Firm’s on-balance sheet loans and loans serviced for others, mortgage modifications of approximately 95,000 and 378,000, respectively, were offered to borrowers; and permanent mortgage modifications of more than 47,000 and 171,000, respectively, were approved. See Consumer Credit Portfolio on pages 82-94 of this Form 10-Q for more details on these loan modifications.
Off-balance sheet lending-related financial instruments, guarantees and other commitments JPMorgan Chase uses lending-related financial instruments (e.g., commitments and guarantees) to meet the financing needs of its customers. The contractual amount of these financial instruments represents the maximum possible credit risk should the counterparty draw upon the commitment or the Firm be required to fulfill its obligation under the guarantee, and the counterparty subsequently fail to perform according to the terms of the contract. These commitments and guarantees often expire without being drawn, and even higher proportions expire without a default. As a result, the total contractual amount of these instruments is not, in the Firm’s view, representative of its actual future credit exposure or funding requirements. For further discussion of lending-related commitments and guarantees and the Firm’s accounting for them, see Lending-related commitments on page 80 and Note 22 on pages 174-178 of this Form 10-Q; and Lending-related commitments on page 105 and Note 31 on pages 230-234 of JPMorgan Chase’s 2009 Annual Report. The following table presents, as of September 30, 2010, the amounts by contractual maturity of off-balance sheet lending-related financial instruments, guarantees and other commitments. The amounts in the table for credit card and home equity lending-related commitments represent the total available credit for these products. The Firm has not experienced, and does not anticipate, that all available lines of credit for these products would be utilized at the same time. The Firm can reduce or cancel these lines of credit by providing the borrower prior notice or, in some cases, without notice as permitted by law. The table excludes certain guarantees that do not have a contractual maturity date (e.g., loan sale and securitization-related indemnifications). For further discussion, see discussion of repurchase liability below and Note 22 on pages 174-178 of this Form 10-Q, and Note 31 on pages 230-234 of JPMorgan Chase’s 2009 Annual Report. Off—balance sheet lending-related financial instruments, guarantees and other commitments
September 30, 2010 Dec. 31, 2009 Due after Due after 3 years By remaining maturity Due in 1 year 1 year through through Due after (in millions) or less 3 years 5 years 5 years Total Total
Lending-related Consumer: Home equity — senior lien $ 527 $ 2,649 $ 6,116 $ 8,664 $ 17,956 $ 19,246 Home equity — junior lien 930 6,520 11,429 13,578 32,457 37,231 Prime mortgage 1,487 — — — 1,487 1,654 Subprime mortgage — — — — — — Option ARMs — — — — — — Auto loans 5,731 152 9 — 5,892 5,467 Credit card 547,195 — — — 547,195 569,113 All other loans 9,164 257 99 963 10,483 11,229
Total consumer $ 565,034 $ 9,578 $17,653 $23,205 $615,470 $ 643,940
Wholesale: Other unfunded commitments to extend credit(a)(b) 64,711 104,357 25,193 4,326 198,587 192,145 Asset purchase agreements(b) — — — — — 22,685 Standby letters of credit and other financial guarantees(a)(c)(d) 26,121 47,561 14,637 4,736 93,055 91,485 Unused advised lines of credit 35,932 4,389 78 199 40,598 35,673 Other letters of credit(a)(d) 3,646 2,254 472 — 6,372 5,167
Total wholesale 130,410 158,561 40,380 9,261 338,612 347,155
Total lending-related $ 695,444 $ 168,139 $58,033 $32,466 $954,082 $ 991,095
Other guarantees and commitments Case 1:09-cv-01656-RMC Document 54-13 Filed 11/22/10 Page 4 of 7 Securities lending guarantees(e) $ 183,715 $ — $ — $ — $183,715 $ 170,777 Derivatives qualifying as guarantees(f) 5,008 909 40,364 27,796 74,077 87,191 Unsettled reverse repurchase and securities borrowing agreements(g) 63,806 — — — 63,806 48,187 Equity investment commitments(h) 1,234 6 33 1,012 2,285 2,374 Building purchase commitment(i) 670 — — — 670 670
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(a) At September 30, 2010, and December 31, 2009, represents the contractual amount net of risk participations totaling $546 million and $643 million, respectively, for other unfunded commitments to extend credit; $23.2 billion and $24.6 billion, respectively, for standby letters of credit and other financial guarantees; and $890 million and $690 million, respectively, for other letters of credit. In regulatory filings with the Federal Reserve these commitments are shown gross of risk participations.
(b) Upon the adoption of the new consolidation guidance related to VIEs, $24.2 billion of lending-related commitments between the Firm and Firm-administered multi-seller conduits were eliminated upon consolidation. The decrease in lending-related commitments was partially offset by the addition of $6.5 billion of unfunded commitments directly between the multi-seller conduits and clients; these unfunded commitments of the consolidated conduits are now included as off-balance sheet lending-related commitments of the Firm.
(c) At September 30, 2010, and December 31, 2009, includes unissued standby letters of credit commitments of $40.9 billion and $38.4 billion, respectively.
(d) At September 30, 2010, and December 31, 2009, JPMorgan Chase held collateral relating to $36.0 billion and $31.5 billion, respectively, of standby letters of credit; and $2.4 billion and $1.3 billion, respectively, of other letters of credit.
(e) At September 30, 2010, and December 31, 2009, collateral held by the Firm in support of securities lending indemnification agreements totaled $185.7 billion and $173.2 billion, respectively. Securities lending collateral comprises primarily cash and securities issued by governments that are members of the Organisation for Economic Co-operation and Development (“OECD”) and U.S. government agencies.
(f) Represents notional amounts of derivatives qualifying as guarantees.
(g) For further information, refer to Unsettled reverse repurchase and securities borrowing agreements in Note 22 on page 177 of this Form 10- Q.
(h) At September 30, 2010, and December 31, 2009, includes unfunded commitments of $1.1 billion and $1.5 billion, respectively, to third-party private equity funds; and $1.2 billion and $897 million, respectively, to other equity investments. These commitments include $1.0 billion and $1.5 billion, respectively, related to investments that are generally fair valued at net asset value as discussed in Note 3 on pages 114-128 of this Form 10-Q.
(i) For further information refer to Building purchase commitment in Note 22 on page 178 of this Form 10-Q.
Repurchase liability In connection with the Firm’s loan sale and securitization activities with Fannie Mae and Freddie Mac (the “GSEs”) and other loan sale and private-label securitization transactions, the Firm has made representations and warranties that the loans sold meet certain requirements. For transactions with the GSEs, these representations include type of collateral, underwriting standards, validity of certain borrower representations in connection with the loan, that primary mortgage insurance is in force for any mortgage loan with a loan-to-value ratio (“LTV”) greater than 80%, and the use of the GSEs’ standard legal documentation. The Firm may be, and has been, required to repurchase loans and/or indemnify the GSEs and other investors for losses due to material breaches of these representations and warranties; however, predominantly all of the repurchase demands received by the Firm and the Firm’s losses realized to date are related to loans sold to the GSEs. To date, the repurchase demands the Firm has received from the GSEs primarily relate to loans originated from 2005 to 2008. Demands against the pre-2005 and post-2008 vintages have not been significant; the Firm attributes this to the comparatively favorable credit performance of these vintages and to the enhanced underwriting and loan qualification standards implemented progressively during 2007 and 2008. From 2005 to 2008, excluding Washington Mutual, loans sold to the GSEs subject to representations and warranties for which the Firm may be liable were approximately $380 billion; this amount represents the principal amount of loans sold throughout 2005 to 2008 and has not been adjusted for subsequent activity, such as borrower repayments of principal or repurchases completed to date. See the discussion below for information concerning the process the Firm uses to evaluate repurchase demands for breaches of representations and warranties, and the Firm’s estimate of probable losses related to such exposure. From 2005 to 2008, Washington Mutual sold approximately $150 billion of loans to the GSEs subject to certain representations and warranties. Subsequent to the Firm’s acquisition of certain assets and liabilities of Washington Mutual from the FDIC in September 2008, the Firm resolved and/or limited certain current and future repurchase demands for loans sold to the GSEs by Washington Mutual, although it remains the Firm’s Case 1:09-cv-01656-RMC Document 54-13 Filed 11/22/10 Page 5 of 7 position that such obligations remain with the FDIC receivership. Nevertheless, certain payments have been made with respect to certain of the then current and future repurchase demands, and the Firm will continue to evaluate and pay certain future repurchase demands related to individual loans. In addition to the payments already made, the Firm has a remaining repurchase liability of approximately $250 million as of September 30, 2010, relating to unresolved and future demands on the Washington Mutual portfolio. After consideration of this repurchase liability, the Firm believes that the remaining GSE repurchase exposure related to the Washington Mutual portfolio presents minimal future risk to the Firm’s financial results. The Firm also sells loans in securitization transactions with Ginnie Mae; these loans are typically insured by the Federal Housing Administration (“FHA”) or the Rural Housing Administration (“RHA”) and/or guaranteed by the U.S. Department of Veterans Affairs (“VA”). The Firm, in its role as servicer, may elect to repurchase delinquent loans securitized by Ginnie Mae in accordance with guidelines prescribed by Ginnie Mae, FHA, RHA and VA. Amounts due under the terms of these loans continue to be insured and the reimbursement of insured amounts is proceeding normally. Accordingly, the Firm has not recorded any repurchase liability related to these loans. From 2005 to 2008, the Firm and certain acquired entities sold or deposited approximately $450 billion of residential mortgage loans to securitization trusts in private-label securitizations they sponsored and, in connection therewith, made certain representations and warranties related to these loans. While the terms of the transactions vary, they generally differ from loan sales to GSEs in that, among other things: (i) in order to direct the trustee to investigate loan files, the security holders must make a formal request for the trustee to do so, and typically, this requires agreement of the holders of a specified percentage of the outstanding securities; (ii) generally, the mortgage loans are not required to meet all GSE eligibility criteria; and (iii) in many cases, the party demanding repurchase is required to demonstrate that a loan-level breach of a representation or warranty has materially and adversely affected the value of the loan. To date, loan-level repurchase demands in private-label securitizations have been limited. As a result, the Firm’s repurchase reserve primarily relates to loan sales to the GSEs and is predominantly derived from repurchase activity with the GSEs. While it is possible that the volume of repurchase demands in private-label securitizations will increase in the future, the Firm cannot offer a reasonable estimate of those future demands based on historical experience to date. In addition, with respect to private-label securitizations originated by Washington Mutual, it is the Firm’s position that such repurchase obligations remain with the FDIC receivership. Thus far, claims related to private-label securitizations (including from insurers that have guaranteed certain obligations of the securitization trusts) have generally manifested themselves through securities-related litigation. Reference is made to Part II, Item 1, Legal Proceedings, “Mortgage-Backed Securities Litigation and Regulatory Investigations.” The Firm separately evaluates its exposure to such litigation in establishing its litigation reserves.
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Repurchase Demand Process The Firm first becomes aware that a GSE is evaluating a particular loan for repurchase when the Firm receives a request from the GSE to review the underlying loan file (“file request”). Upon completing its review, the GSE may submit a repurchase demand to the Firm; historically, most file requests have not resulted in repurchase demands. The primary reasons for repurchase demands from the GSEs relate to alleged misrepresentations primarily driven by: (i) credit quality and/or undisclosed debt of the borrower; (ii) income level and/or employment status of the borrower; and (iii) appraised value of collateral. Ineligibility of the borrower for the particular product, mortgage insurance rescissions and missing documentation are other reasons for repurchase demands. Beginning in 2009, mortgage insurers more frequently rescinded mortgage insurance coverage. The successful rescission of mortgage insurance typically results in a violation of representations and warranties made to the GSEs and, therefore, has been a significant cause of repurchase demands from the GSEs. The Firm actively reviews all rescission notices from mortgage insurers and appeals them when appropriate. As soon as practicable after receiving a repurchase demand from a GSE, the Firm evaluates the request and takes appropriate actions based on the nature of the repurchase demand. Loan-level appeals with the GSEs are typical and the Firm seeks to provide a final response to a repurchase demand within three to four months of the date of receipt. In many cases, the Firm ultimately is not required to repurchase a loan because it is able to resolve the purported defect. Although repurchase demands may be made for as long as the loan is outstanding, most repurchase demands from the GSEs historically have related to loans that became delinquent in the first 24 months following origination. When the Firm accepts a repurchase demand from one of the GSEs, the Firm may either a) repurchase the loan or the underlying collateral from the GSE at the unpaid principal balance of the loan plus accrued interest, or b) reimburse the GSE for its realized loss on a liquidated property (a “make-whole” payment).
Estimated Repurchase Liability To estimate the Firm’s repurchase liability arising from breaches of representations and warranties, the Firm considers: (i) the level of current unresolved repurchase demands and mortgage insurance recission notices,
(ii) estimated probable future repurchase demands considering historical experience, Case 1:09-cv-01656-RMC Document 54-13 Filed 11/22/10 Page 6 of 7
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Participants in the Firm’s stock-based incentive plans may have shares withheld to cover income taxes. Shares withheld to pay income taxes are repurchased pursuant to the terms of the applicable plan and not under the Firm’s share repurchase program. Shares repurchased pursuant to these plans during the third quarter of 2010 were as follows:
For the nine months ended Total shares Average price paid September 30, 2010 repurchased per share
First quarter 2,444 $ 41.88
Second quarter 393 30.01
July 173 36.45 August 36 37.09 September 84 39.79
Third quarter 293 37.49
Year-to-date 3,130 $ 39.98
Item 3 Defaults Upon Senior Securities None
Item 4 Submission of Matters to a Vote of Security Holders Not applicable.
Item 5 Other Information Steven D. Black, Vice Chairman, has advised the Firm that he plans to leave the Firm early in 2011 and has stepped down from the Firm’s Operating Committee and Executive Committee.
Item 6 Exhibits 31.1 — Certification 31.2 — Certification 32 — Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101.INS XBRL Instance Document(a)(b) 101.SCH XBRL Taxonomy Extension Schema Document(b) 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document(b) 101.LAB XBRL Taxonomy Extension Label Linkbase Document(b) 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document(b) 101.DEF XBRL Taxonomy Extension Definition Linkbase Document(b)
(a) Pursuant to Rule 405 of Regulation S-T, includes the following financial information included in the Firm’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2010, formatted in XBRL (eXtensible Business Reporting Language) interactive data files: (i) the Consolidated Statements of Income for the three and nine months ended September 30, 2010 and 2009, (ii) the Consolidated Balance Sheets as of September 30, 2010, and December 31, 2009, (iii) the Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income for the nine months ended September 30, 2010 and 2009, (iv) the Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009, and (v) the Notes to Consolidated Financial Statements.
(b) Filed herewith.
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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the Case 1:09-cv-01656-RMC Document 54-13 Filed 11/22/10 Page 7 of 7 undersigned thereunto duly authorized.
JPMORGAN CHASE & CO. (Registrant)
Date: November 8, 2010 By /s/ Louis Rauchenberger
Louis Rauchenberger
Managing Director and Controller [Principal Accounting Officer]
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INDEX TO EXHIBITS
EXHIBIT NO. EXHIBITS
31.1 Certification
31.2 Certification
32 Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002†
101.INS XBRL Instance Document††
101.SCH XBRL Taxonomy Extension Schema Document††
101.CAL XBRL Taxonomy Extension Calculation Linkbase Document††
101.LAB XBRL Taxonomy Extension Label Linkbase Document††
101.PRE XBRL Taxonomy Extension Presentation Linkbase Document††
101.DEF XBRL Taxonomy Extension Definition Linkbase Document††
† This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that Section. Such exhibit shall not be deemed incorporated into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.
†† As provided in Rule 406T of Regulation S-T, this information shall not be deemed “filed” for purposes of Section 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 or otherwise subject to liability under those sections.
204 Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 1 of 10
EXHIBIT 11
Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 2 of 10 424B7 1 d424b7.htm PRELIMINARY PROSPECTUS SUPPLEMENT
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Filed Pursuant to Rule 424(b)(7) Registration Statement No. 333-146731
The information in this preliminary prospectus supplement is not complete and may be changed. This preliminary prospectus supplement and the accompanying prospectus are not an offer to sell these securities nor are they soliciting any offer to buy these securities in any jurisdiction where the offer or sale is not permitted.
Subject to Completion. Dated December 8, 2009 Preliminary Prospectus Supplement (to Prospectus Dated October 16, 2007)
88,401,697 Warrants Each to Purchase One Share of Common Stock The United States Department of the Treasury (referred to in this prospectus supplement as the “selling security holder” or “Treasury”) is offering to sell up to 88,401,697 warrants, each of which represents the right to purchase one share of our common stock, par value $1.00 per share, at an exercise price of $42.42 per share. Both the exercise price and the number of shares that will be acquired upon the exercise of a warrant are subject to adjustment from time to time in the manner described in this prospectus supplement. We will not receive any of the proceeds from the sale of the warrants being sold by the selling security holder. The warrants expire on October 28, 2018. We originally issued the warrants to Treasury in a private placement. Prior to this offering, there has been no public market for the warrants. We have applied to list the warrants on the New York Stock Exchange (the “Exchange”) under the symbol “JPM WS.” Our common stock is listed on the Exchange under the symbol “JPM.” On December 7, 2009, the last reported sale price of our common stock on the Exchange was $41.25 per share. The public offering price and the allocation of the warrants in this offering will be determined by an auction process. While the auction process is ongoing, potential bidders will be able to place bids at any price (in increments of $0.25) at or above the minimum bid price of $8.00 per warrant. The minimum size for any bid is 100 warrants. If the selling security holder decides to sell the warrants being offered, the public offering price of the warrants will be equal to the auction process clearing price. If bids are received for 100% or more of the offered warrants, the clearing price will be equal to the highest price at which 100% of the offered warrants can be sold in the auction, and the selling security holder may (but is not required to) sell no less than all of the warrants offered during the auction process at the clearing price. If bids are received for half or more, but less than all, of the offered warrants, then the clearing price will be equal to the minimum bid price per warrant, and the selling security holder may (but is not required to) sell, at the clearing price, as many warrants as it chooses to sell up to the number of bids received in the auction, so long as at least half of the warrants are sold. In certain cases described in this prospectus supplement, bidders may experience pro-ration of their bids. If bids are received for less than half of the offered warrants, the selling security holder will not sell any warrants in this offering. Even if bids are received for all of the warrants, the selling security holder may decide not to sell any warrants, regardless of the clearing price set in the auction process. In addition, we may bid in the auction for some or all of the warrants. The method for submitting bids and a more detailed description of this auction process are described in “Auction Process” beginning on page S-18 of this prospectus supplement. Investing in our warrants and our common stock involves risks. See “Risk Factors” on page S-6 of this prospectus supplement and the sections entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2008 and subsequently filed Quarterly Reports on Form 10-Q to read about factors you should consider before investing in our securities. The warrants and the underlying common stock are neither deposits nor savings accounts, and are not guaranteed by the United States Department of the Treasury or insured by the Federal Deposit Insurance Corporation or any other governmental agency or instrumentality. You must meet minimum suitability standards in order to purchase the warrants. You must be able to understand and bear the risk of an investment in the warrants and should be experienced with respect to options and option transactions. You should reach an investment decision only after careful consideration, with your advisers, of the suitability of the warrants in light of your particular financial circumstances and the information in this prospectus supplement. The warrants involve a high degree of risk, are not appropriate for every investor and may expire worthless. None of the Securities and Exchange Commission, any state securities commission nor any other regulatory body has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus supplement or the accompanying prospectus. Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 3 of 10 Any representation to the contrary is a criminal offense.
Per Warrant Total Public offering price $ $ Underwriting discounts and commissions $ $ Proceeds, before expenses, to the selling security holder $ $
The underwriters expect to deliver the warrants in book-entry form only, through the facilities of The Depository Trust Company, against payment on or about December , 2009. Deutsche Bank Securities
Ramirez & Co., Inc. The Williams Capital Group, L.P. Utendahl Capital Group, LLC The date of this prospectus supplement is December , 2009.
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TABLE OF CONTENTS Prospectus Supplement
About This Prospectus Supplement S-ii Where You Can Find More Information S-ii Forward-Looking Statements S-iii Summary S-1 Risk Factors S-6 Auction Process S-18 Use of Proceeds S-25 Description of Warrants S-26 Selling Security Holder S-31 Certain United States Federal Income Tax Considerations S-33 Certain ERISA Considerations S-39 Underwriting S-40 Legal Matters S-45
Prospectus
Summary 2 Consolidated Ratios of Earnings to Fixed Charges and Preferred Stock Dividend Requirements 6 Where You Can Find More Information About JPMorgan Chase 7 Important Factors that May Affect Future Results 9 Use of Proceeds 10 Description of Debt Securities 11 Description of Preferred Stock 20 Description of Common Stock 25 Description of Securities Warrants 25 Description of Currency Warrants 26 Book-Entry Issuance 28 Plan of Distribution 31 Experts 32 Legal Opinions 32
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ABOUT THIS PROSPECTUS SUPPLEMENT Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 4 of 10 This prospectus supplement and the accompanying prospectus are part of a registration statement that we filed with the Securities and Exchange Commission (the “SEC”) using a shelf registration process. Both this prospectus supplement and the accompanying prospectus include or incorporate by reference important information about us, the warrants, our common stock and other information you should know before investing. You should read this prospectus supplement and the accompanying prospectus as well as additional information described under “Where You Can Find More Information” in this prospectus supplement.
You should rely only on the information contained or incorporated by reference in this prospectus supplement, the accompanying prospectus and any relevant free-writing prospectus we have filed or may file with the SEC. Neither we nor any underwriter or agent nor the selling security holder have authorized anyone to provide you with information that is different. This prospectus supplement, the accompanying prospectus and any relevant free-writing prospectus do not constitute an offer to sell or a solicitation of an offer to buy by anyone in any jurisdiction in which such offer or solicitation is not authorized, or in which the person is not qualified to do so or to any person to whom it is unlawful to make such offer or solicitation. You should not assume that the information contained or incorporated by reference in this prospectus supplement, the accompanying prospectus or any relevant free-writing prospectus is accurate as of any date other than its respective date. If the information set forth in this prospectus supplement or any relevant free-writing prospectus differs in any way from the information set forth in the accompanying prospectus, you should rely on the information set forth in this prospectus supplement or the relevant free-writing prospectus.
Unless otherwise mentioned or unless the context requires otherwise, all references in this prospectus supplement to “JPMorgan Chase,” “we,” “our” and “us” refer to JPMorgan Chase & Co., a Delaware corporation.
WHERE YOU CAN FIND MORE INFORMATION
We have filed a registration statement with the SEC. The accompanying prospectus is part of the registration statement, and the registration statement also contains additional information and exhibits. In addition, we are subject to the information and reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under which we have filed and will file annual, quarterly and special reports, proxy statements and other information with the SEC. Copies of those reports, proxies and information statements may be examined at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549, where copies of all or a portion of such materials can be obtained. You can call the SEC for further information about its public reference room at 1-800-732-0330. Such material is also available at the SEC’s website at www.sec.gov or at our website at www.jpmorganchase.com. Information on our website does not constitute a part of this prospectus supplement and is not incorporated by reference herein.
The SEC allows us to incorporate documents by reference in this prospectus supplement. This means that if we list or refer to a document that we have filed with the SEC in this prospectus supplement, that document is considered to be a part of this prospectus supplement and should be read with the same care. Documents that we file with the SEC in the future that are incorporated by reference will automatically update and supersede information incorporated by
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Table of Contents reference in this prospectus supplement and the accompanying prospectus. The documents listed below are incorporated by reference into this prospectus supplement:
• Our Annual Report on Form 10-K for the year ended December 31, 2008 (including the information incorporated from our definitive
Proxy Statement on Schedule 14A filed on March 31, 2009);
• Our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009, June 30, 2009 and September 30, 2009;
• Our Current Reports on Form 8-K, filed on January 7, 2009, January 15, 2009, February 24, 2009, March 3, 2009, March 30, 2009, April 15, 2009, April 16, 2009, May 8, 2009 (Item 8.01 and Exhibit 99.1 only), May 20, 2009, May 29, 2009, June 2,
2009, June 19, 2009, July 16, 2009, September 1, 2009, October 14, 2009, October 27, 2009, November 20, 2009 and December 8, 2009; and
• Any documents filed by us pursuant to Section 13(a), 13(c), 14 or 15(d) of the Exchange Act on or after the date of this prospectus supplement and before the termination of the offering of the securities (which filed documents do not include any portion thereof
containing information furnished rather than filed under either Item 2.02 or 7.01, or any related exhibit, of any Current Report on Form 8-K).
You may request a copy of any or all of these filings from us, at no cost, by writing or telephoning us at 270 Park Avenue, New York, NY 10017, Attention: Office of the Secretary, telephone: (212) 270-4040.
FORWARD-LOOKING STATEMENTS Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 5 of 10 This prospectus supplement, the accompanying prospectus, any relevant free writing prospectus, and the information incorporated by reference in them may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are based upon the current beliefs and expectations of JPMorgan Chase’s management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause JPMorgan Chase’s actual results to differ materially from those described in the forward-looking statements can be found under the heading “Risk Factors” below and in JPMorgan Chase’s Annual Report on Form 10-K for the year ended December 31, 2008 and in its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009, June 30, 2009 and September 30, 2009, filed with the Securities and Exchange Commission and available on JPMorgan Chase’s website (www.jpmorganchase.com) and on the Securities and Exchange Commission’s website (www.sec.gov) to which reference is hereby made. Except as expressly provided in this prospectus supplement or the accompanying prospectus, information on these websites does not constitute part of this prospectus supplement or the accompanying prospectus. JPMorgan Chase does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.
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SUMMARY
This summary highlights selected information contained elsewhere or incorporated by reference in this prospectus supplement and may not contain all the information that you need to consider in making your investment decision. You should carefully read this entire prospectus supplement and the accompanying prospectus, as well as the information to which we refer you and the information incorporated by reference herein, before deciding whether to invest in the warrants or the common stock. You should carefully consider the sections entitled “Risk Factors” in this prospectus supplement and the documents incorporated by reference herein to determine whether an investment in the warrants and the common stock is appropriate for you.
The Issuer
JPMorgan Chase & Co. is a leading global financial services firm and one of the largest banking institutions in the United States, with $2.0 trillion in assets, $162.3 billion in stockholders’ equity and operations in more than 60 countries as of September 30, 2009. JPMorgan Chase is a leader in investment banking, financial services for consumers and businesses, financial transaction processing and asset management. Under the J.P. Morgan and Chase brands, JPMorgan Chase serves millions of customers in the United States and many of the world’s most prominent corporate, institutional and government clients.
JPMorgan Chase is a financial holding company and was incorporated under Delaware law on October 28, 1968. JPMorgan Chase’s principal bank subsidiaries are JPMorgan Chase Bank, National Association, a national banking association with branches in 23 states, and Chase Bank USA, National Association, a national bank that is JPMorgan Chase’s credit card issuing bank. JPMorgan Chase’s principal nonbank subsidiary is J.P. Morgan Securities Inc., its U.S. investment banking firm.
The principal executive office of JPMorgan Chase is located at 270 Park Avenue, New York, New York 10017-2070, U.S.A., and its telephone number is (212) 270-6000.
Recent Developments
On November 19, 2009, JPMorgan Chase and Cazenove Group Limited (“Cazenove”) announced that they had agreed to a transaction under which their joint venture, J.P. Morgan Cazenove, will become wholly owned by JPMorgan Chase. The transaction will be structured as a purchase of all of the share capital of Cazenove. Cazenove ordinary shareholders will receive £5.35 per share, consisting of £5.10 upon closing for the sale of their shares and a dividend of 25 pence per share in December 2009. Completion of the transaction, which is subject to approval by Cazenove shareholders, is expected in early 2010.
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The Offering
The following summary contains basic information about the warrants, the common stock and the auction process and is not intended to Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 6 of 10 be complete. It does not contain all the information that is important to you. For a more complete understanding of the warrants and the common stock, you should read the section of this prospectus supplement entitled “Description of Warrants” and the sections of the accompanying prospectus entitled “Description of Securities Warrants” and “Description of Common Stock.”
Issuer JPMorgan Chase & Co.
Warrants offered by the selling security holder 88,401,697 warrants, each of which represents the right to purchase one share of our common stock, par value $1.00 per share, at an exercise price of $42.42 per share (subject to adjustment). The number of warrants sold will depend on the number of bids received and whether the selling security holder decides to sell any warrants in the auction. The exercise price of the warrants cannot be paid in cash and is payable only by netting out a number of shares of our common stock issuable upon exercise of the warrants equal to the value of the aggregate exercise price of the warrants. The warrants are currently exercisable and expire on October 28, 2018. See “Auction Process.”
Common stock outstanding after this offering 4,104,933,895 shares (1), (2).
Auction process The selling security holder and the underwriters will determine the public offering price and the allocation of the warrants in this offering through an auction process conducted by Deutsche Bank Securities Inc. (“Deutsche Bank Securities”), the sole book-running manager, in its capacity as the auction agent. The auction process entails a modified “Dutch auction” mechanic in which bids may be submitted through the auction agent or one of the other brokers that is a member of the broker network (collectively, the “network brokers”) established in connection with the auction process. Each broker will make suitability determinations with respect to its own customers wishing to participate in the auction process. The auction agent will not provide bidders (including us) with any information about the bids of other bidders or auction trends, or with advice regarding bidding strategies, in connection with the auction. We may bid (but we are not required to bid) in the auction for some or all of the warrants. We encourage you to discuss any questions regarding the bidding process and suitability determinations applicable to your bids with your broker. For more information about the auction process, see “Auction Process.” (1) The number of shares of common stock outstanding immediately after the closing of this offering is based on 4,104,933,895 shares of common stock outstanding as of November 30, 2009. (2) The number of shares of common stock outstanding excludes shares issuable upon exercise of the warrants and 163,692,216 shares of our common stock held in treasury and 494,629,041 shares issuable under our stock-based compensation plans.
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Minimum bid price and price increments The offering will be made using an auction process in which prospective purchasers are required to bid for the warrants. During the auction period, bids may be placed by qualifying bidders at any price (in increments of $0.25) at or above the minimum bid price of $8.00 per warrant. See “Auction Process.”
Minimum bid size 100 warrants
Submission deadline The auction will commence at 8:00 a.m., New York City time, on the date specified by the auction agent via press release prior to the opening of the equity markets on such day, and will close at 6:30 p.m., New York City time, on the same day (the “submission deadline”).
Irrevocability of bids Bids that have not been modified or withdrawn by the time of the submission deadline are final and irrevocable, and bidders who submit successful bids will be obligated to purchase the warrants allocated to them. The auction agent is under no obligation to reconfirm bids for any reason; however, the auction agent may require that bidders Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 7 of 10 confirm their bids at its discretion before the auction process closes. See “Auction Process.”
Clearing price The price at which the warrants will be sold to the public will be the clearing price set by the auction process. The clearing price will be determined based on the valid, irrevocable bids at the time of the final submission deadline as follows:
• If valid, irrevocable bids are received for all or more of the number of warrants being offered, the clearing price will be equal to the highest price in the auction process at
which the quantity of all bids at or above such price equals 100% or more of the number of warrants being offered in the auction.
• If bids are received for half or more, but less than all, of the offered warrants, the
clearing price will be equal to the minimum bid price of $8.00 per warrant. Unless the selling security holder decides not to sell any warrants or as otherwise described below, the warrants will be sold to bidders at the clearing price. Even if bids are received for 100% or more of the warrants being offered, the selling security holder may decide not to sell any warrants in the auction, regardless of the clearing price. If the selling security holder decides to sell warrants in the auction, after the selling security holder confirms its acceptance of the clearing price (and, in the case where bids are received for fewer than 100% of the warrants being offered, the number of warrants to be sold), the auction agent and each network broker that has submitted bids will notify successful bidders that the auction process has closed and that their bids have been accepted. The clearing price and number of warrants being sold are also expected to be announced via press
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release prior to the opening of the equity markets on the business day following the end
of the auction process. See “Auction Process.”
Number of warrants to be sold If bids are received for half or more, but less than all, of the offered warrants, then the selling security holder may (but is not required to) sell, at the minimum bid price in the auction process (which will be deemed the clearing price) as many warrants as it chooses to sell up to the number of bids received in the auction process, so long as at least half of the offered warrants are sold. If bids are received for less than half of the offered warrants, the selling security holder will not sell any warrants in this offering. Even if bids are received for all of the warrants, the selling security holder may decide not to sell any warrants, regardless of the clearing price. If bids are received for all of the offered warrants and the selling security holder elects to sell warrants in the auction process, the selling security holder must sell all of the offered warrants. See “Auction Process.”
Allocation; pro-ration If bids for all the warrants offered in this offering are received, and the selling security holder elects to sell warrants in the offering, then any bids submitted in the auction above the clearing price will receive allocations in full, while any bids submitted at the clearing price may experience pro-rata allocation. If bids for half or more, but fewer than all, of the warrants offered in this offering are received, and the selling security holder chooses to sell fewer warrants than the number of warrants for which bids were received, then all bids will experience equal pro-rata allocation. See “Auction Process.”
Our participation in the auction We are permitted to participate in the auction by submitting bids for the warrants. Although we are under no obligation to participate in the auction, if we elect to participate we will not receive preferential treatment of any kind and would participate on the same basis as all other bidders, except that we are required to submit any final bid we may enter by 6:00 p.m., New York City time, on the day on which the auction Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 8 of 10 process is conducted. You will not be notified by either the auction agent, the network brokers or the selling security holder whether we have bid in the auction process or, should we elect to participate in the auction process, the terms of any bid or bids we may place.
Use of proceeds We will not receive any proceeds from the sale of any of the warrants offered by the selling security holder.
Risk factors See “Risk Factors” and other information included or incorporated by reference in this prospectus supplement and the accompanying prospectus for a discussion of factors you should consider carefully before deciding to invest in the warrants.
Listing We have applied to list the warrants on the Exchange under the symbol “JPM WS”. Our common stock is listed on the Exchange under the symbol “JPM”.
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Warrant agent Mellon Investor Services LLC.
Auction agent Deutsche Bank Securities Inc.
Network brokers See page S-19 for a list of brokers participating as network brokers in the auction process.
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RISK FACTORS
An investment in our securities involves certain risks. You should carefully consider the risks described below and the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2008 and our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009, June 30, 2009 and September 30, 2009, as well as the other information included or incorporated by reference in this prospectus supplement and the accompanying prospectus, before making an investment decision. Our business, financial condition or results of operations could be materially adversely affected by any of these risks. The trading price of the warrants and/or our common stock could decline due to any of these risks, and you may lose all or part of your investment. This prospectus supplement also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by us that are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008 and our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009, June 30, 2009 and September 30, 2009 and those that are described below and elsewhere in this prospectus supplement and the accompanying prospectus.
The risk factors included in the prospectus supplement are intended to supplement and update the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2008 and our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009, June 30, 2009 and September 30, 2009.
Risks Related to the Company
Proposed legislative and regulatory reforms may, if enacted or adopted, have a significant impact on our business and results of operations. Recent events in the financial services industry and, more generally, in the financial markets and the economy, have led to various proposals for changes in the regulation of the financial services industry. Earlier in 2009, legislation proposing significant structural reforms to the financial services industry was introduced in the U.S. Congress. Among other things, the legislation proposes the establishment of a Consumer Financial Protection Agency, which would have broad authority to regulate providers of credit, savings, payment and other consumer financial products and services. Additional legislative proposals call for heightened scrutiny and regulation of any financial firm whose combination of size, leverage, and Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 9 of 10 interconnectedness could, if it failed, pose a threat to the country’s financial stability, including the power to restrict the activities of such firms and even require the break-up of such firms at the behest of the relevant regulator. New rules have also been proposed for the securitization market, including requiring sponsors of securitizations to retain a material economic interest in the credit risk associated with the underlying securitization.
Other recent initiatives also include:
• the Federal Reserve’s proposed guidance on incentive compensation policies at banking organizations;
• proposals to limit a lender’s ability to foreclose on mortgages or make such foreclosures less economically viable, including by allowing Chapter 13 bankruptcy plans to “cram down” the value of certain mortgages on a consumer’s principal residence to its market value and/or reset interest rates and monthly payments to permit defaulting debtors to remain in their home;
• accelerating the effective date of various provisions of the Credit Card Accountability Responsibility and Disclosure Act of 2009 (the “CARD Act”), which restrict certain credit and charge card practices, require expanded disclosures to consumers and provide consumers with the right to opt out of interest rate increases (with limited exceptions); and
• proposed legislation concerning the comprehensive regulation of the “over-the-counter” derivatives market, including robust and
comprehensive prudential supervision (including strict capital and margin
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requirements) for all “over-the-counter” derivative dealers and major market participants and central clearing of standardized “over-
the-counter” derivatives.
While there can be no assurance that any or all of these regulatory or legislative changes will ultimately be adopted, such changes, if enacted or adopted, may impact the profitability of our business activities, require we change certain of our business practices, require us to divest certain business lines, materially affect our business model or affect retention of key personnel, and could expose us to additional costs (including increased compliance costs). These changes may also require us to invest significant management attention and resources to make any necessary changes, and could therefore also adversely affect our businesses and operations.
Increases in FDIC insurance premiums may adversely affect our earnings. During 2008 and continuing in 2009, higher levels of bank failures have dramatically increased resolution costs of the Federal Deposit Insurance Corporation (the “FDIC”) and depleted the deposit insurance fund. In addition, the FDIC instituted two temporary programs to further insure customer deposits at FDIC insured banks: deposit accounts are now insured up to $250,000 per customer (up from $100,000) and non- interest bearing transactional accounts are currently fully insured (unlimited coverage). These programs have placed additional stress on the deposit insurance fund.
In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased assessment rates of insured institutions. In addition, on November 12, 2009, the FDIC adopted a rule requiring banks to prepay three years’ worth of premiums to replenish the depleted insurance fund.
We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures we may be required to pay even higher FDIC premiums than the recently increased levels. These announced increases and any future increases or required prepayments of FDIC insurance premiums may adversely impact our earnings.
Defective and repurchased loans may harm our business and financial condition. In connection with the sale and securitization of loans (whether with or without recourse), the originator is generally required to make a variety of customary representations and warranties regarding both the originator and the loans being sold or securitized. We and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, have made such representations and warranties in connection with the sale and securitization of loans (whether with or without recourse), and we will continue to do so as part of our normal Consumer Lending business. Our obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and relate to, among other things, compliance with laws and regulations; underwriting standards; the accuracy of information in the loan documents and loan file; and the characteristics and enforceability of the loan.
A loan that does not comply with such representations and warranties may take longer to sell, or may be unsaleable or saleable only at a significant discount. More importantly, if a loan that does not comply with such representations and warranties is sold, we may be obligated to repurchase the loan and bear any associated loss directly, or we may be obligated to indemnify the purchaser against any such loss. Accordingly, such repurchase and/or indemnity obligations arising in connection with the sale and securitization of loans (whether with or without recourse) by us and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, could Case 1:09-cv-01656-RMC Document 54-14 Filed 11/22/10 Page 10 of 10 materially increase our costs and lower our profitability, and could materially and adversely impact our results of operations and financial condition.
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Risks Related to the Auction Process
The price of the warrants could decline rapidly and significantly following this offering. The public offering price of the warrants, which will be the clearing price, will be determined through an auction process conducted by the selling security holder and the auction agent. Although we have applied to list the warrants on the Exchange, prior to this offering there has been no public market for the warrants, and the public offering price may bear no relation to market demand for the warrants once trading begins. We have been informed by both Treasury and Deutsche Bank Securities as the auction agent that they believe that the bidding process will reveal a clearing price for the warrants offered in the auction. If there is little or no demand for the warrants at or above the public offering price once trading begins, the price of the warrants would likely decline following the offering. Limited or less-than-expected liquidity in the warrants, including decreased liquidity due to a sale of less than all of the warrants being offered or a purchase of warrants by us in the auction, could also cause the trading price of the warrants to decline. In addition, the auction process may lead to more volatility in, or a decline in, the trading price of the warrants after the initial sales of the warrants in the offering. If your objective is to make short-term profit by selling the warrants you purchase in the offering shortly after trading begins, you should not submit a bid in the auction process.
The minimum bid price that the auction agent has set for the warrants in this offering may bear no relation to the price of the warrants after the offering. Prior to the offering, there has been no public market for the warrants. The minimum bid price set forth in this prospectus supplement was agreed by Deutsche Bank Securities, the sole book-running manager of this offering, and Treasury. We did not participate in the determination of the minimum bid price and therefore cannot provide any information regarding the factors that Treasury and Deutsche Bank Securities considered in such determination. An analysis of the value of complex securities such as the warrants is necessarily uncertain as it may depend on several key variables, including for example the volatility of the trading prices of the underlying security. The difficulty associated with determining the value of the warrants is further increased by the substantial time period during which the warrants can be exercised. We cannot assure you that the price at which the warrants will trade after completion of the offering will exceed this minimum bid price, or that the Treasury will choose to or will succeed in selling any or all of the warrants at a price equal to or in excess of the minimum bid price.
The auction process for this offering may result in a phenomenon known as the “winner’s curse,” and, as a result, investors may experience significant losses. The auction process for this offering may result in a phenomenon known as the “winner’s curse.” At the conclusion of the auction, successful bidders that receive allocations of warrants in this offering may infer that there is little incremental demand for the warrants above or equal to the public offering price. As a result, successful bidders may conclude that they paid too much for the warrants and could seek to immediately sell their warrants to limit their losses should the price of the warrants decline in trading after the auction is completed. In this situation, other investors that did not submit successful bids may wait for this selling to be completed, resulting in reduced demand for the warrants in the public market and a significant decline in the price of the warrants. Therefore, we caution investors that submitting successful bids and receiving allocations may be followed by a significant decline in the value of their investment in the warrants shortly after this offering.
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The auction process for this offering may result in a situation in which less price sensitive investors play a larger role in the determination of the public offering price and constitute a larger portion of the investors in this offering, and, therefore, the public offering price may not be sustainable once trading of warrants begins. In a typical public offering of securities, a majority of the securities sold to the public are purchased by professional investors that have significant experience in determining valuations for companies in connection with such offerings. These professional investors typically have access to, or conduct their own, independent research and analysis regarding investments in such offerings. Other investors typically have less access to this level of research and analysis, and as a result, may be less sensitive to price when participating in the auction process. Because of the auction process, these less price sensitive investors may have a greater influence in setting the public offering price (because a larger number of higher bids may cause the clearing price in the auction process to be higher than it would otherwise have been absent such bids) and may have a higher level of participation in this offering than is normal for other such offerings. This, in turn, could cause the auction process to result in a