The Wamu Way

It seems hard to believe, because even at 57 he still looks young for the job, but Kerry Killinger has been chairman and chief executive officer at Seattle-based Washington Mutual Inc. for 16 years. And over that time, Killinger and the company’s board of directors have wrought a dramatic transformation in the once stodgy thriftu00e2u20ac”essentially turning it into a trend-setting consumer bank that operates on both coasts.

With $350 billion in assets, Washington Mutual now ranks as the sixth-largest U.S. depository institution, slipping in between two better-known names in the world of bankingu00e2u20ac”Wells Fargo & Co. at number five and U.S. Bancorp at number seven. It’s safe to say that Wamu, as the company is often called, has garnered a lot less attention than either Wells or U.S. Bancorp, despite being just as aggressive and, in some ways, more innovative. Maybe it’s because the only Seattle companies that anybody seems to notice are Starbucks and Microsoft. Or perhaps it’s because Wamu has retained its thrift charter despite becoming more bank-like under Killinger, and no one has paid much attention to thrifts since the entire industry went up in flames in the late 1980s. Either way, Washington Mutual may be the best banking company that you don’t know much about.

Much of the company’s makeover has been driven by an ambitious acquisition program that Killinger has pursued with dogged determination. According to SNL Financial, a research company in Charlottesville, Virginia, Killinger has done 16 deals since March 1996. Most of them were comparatively smallu00e2u20ac”but a couple of them were transformational. Wamu doubled in size in March 1997 when it paid $7 billion to acquire Chatsworth, California-based Great Western Financial Corp., and doubled again one year later when it bought HF Ahmanson & Co. in Irwindale, California for nearly $10 billion. The two thrifts gave Wamu the second-largest market share among California’s retail banks.

Three years later, Killinger leaped across the continental United States into the intensely competitive New York banking market when he acquired Dime Bancorp Inc. for $5.2 billion. In June 2005, Wamu also paid just under $7 billion for Providian Financial Corp., a San Francisco-based credit card company. And in its most recent deal, in April of this year, Wamu bought Commercial Capital Bancorp Inc.u00e2u20ac”an Irvine, California-based thrift that specializes in multifamily lending.

Anyone who pays close attention to retail banking knows that Washington Mutual is much more than just an acquisition vehicle. In recent years, the company has pursued an aggressive de novo branching strategy as Killinger has strived to open between 200 and 250 new branches a year. Wamu has put 171 new branchesu00e2u20ac”stores as the company calls themu00e2u20ac”in the greater Chicago area since October 2002, and also used the Dime acquisition as a platform to expand throughout the Greater New York area, where it now has 301 branches including locations in Connecticut and New Jersey. Key components in Wamu’s de novo program have been its enthusiastic embrace of free checking and a unique design that makes each of its branches look more like a trendy boutique than, well, a branch.

Taken together, the company’s de novo expansion and Killinger’s dealmaking have given Washington Mutual a national (if not exactly nationwide) retail footprint and much greater asset diversification than it used to have. For example, prime home loans and mortgage-backed securities accounted for a whopping 76% of Wamu’s asset mix in 1999, compared to 42% in March of this year. The recent cooling off of the mortgage market due to higher interest rates has forced Killinger to retool Washington Mutual’s home loan operation, but the company is much less exposed to mortgages than it used to be. Comparatively speaking, the market’s swoon has resulted in heartburn instead of a heart attack.

Killinger has worked closely with Washington Mutual’s board to develop the company’s various strategic growth initiatives; acquisitions must promise to deliver an internal rate of return in the high teens or better and be accretive to earnings per share within 12 months. “Those are tough criteria, but when we found [deals] that met them, they added a lot to our shareholder value,” he says.

Don’t be surprised if Killinger looks to diversify Wamu’s business mix further if the right deal comes along. Also don’t be surprised if the company ends up being an attractive acquisition target to another large banku00e2u20ac”like, say, Charlotte-based Wachovia Corp.u00e2u20ac”which is drawn to its valuable, California franchise.

To get a first-hand account of these and other initiatives, Bank Director Senior Editor Jack Milligan recently spoke to Killinger about his approach to strategic expansion at Washington Mutual.

How do you decide whether to expand through acquisition or by going to an area and opening new branches?

Each June we go through a two-day strategic planning retreat in which we review all of the key business strategies we have; we update our rolling five-year business plan and we take a look at all the critical elements facing the company. Among the things we’ll talk about are the growth incentives we have and the relative merits of doing acquisitions versus de novo growth. There have been many times over the years when we’ve felt that acquisitions were the best utilization of shareholder capital as the primary avenue for growth. And we’ve had other periodsu00e2u20ac”more recentlyu00e2u20ac”where we felt that de novo growth provided a better return for our shareholders than acquisitions.

What are some of the economic factors that come into play in determining whether the best use of capital is to invest in new branches or to invest in an acquisition?

All capital investments for us, whether it’s opening a new branch or making an acquisition, are reviewed and analyzed in a variety of ways, including internal rates of return. We also look at the returns on economic capital, and we will make our best judgments about what the return potentials are at a given point in time. In years past, we have been able to make acquisitions that were consistently in the high teens or above in terms of their internal rates of return on investment, and we continue to use that as our benchmark. In recent years, we have found relatively few acquisitions that have met those criteria. Conversely, we’re seeing today that we have organic growth opportunities that have returns on capital substantially in excess of our threshold returns for the company, which are in the high teens.

Are there also situations, like your acquisition of Providian Financial last year, where you’re pursuing a diversification strategy and want to get into a new business line, and that can only be done through an acquisition?

Yes, and Providian is an excellent example of a transaction that did improve the diversification of the company. It clearly met a strategic goal of increasing that part of our balance sheet that was in credit card receivables, and also provided a product for our customer base that helped our cross-sell ratios. So it fit all those strategic measures, but I also insisted that the financial returns on the transaction meet or exceed our internal hurdle rates, which are in the high teens. We also require transactions to be accretive to earnings per share within the first year.

It seems as though your recently announced acquisition of Commercial Capital Bancorp followed a similar vein. You were able to make significant inroads into a businessu00e2u20ac”multifamily lendingu00e2u20ac”more efficiently through an acquisition than trying to grow it organically.

We like the multifamily business very much. We are already the national leader in terms of multifamily lending and saw an opportunity with Commercial Capital to increase our market share further. That strengthened our position from a strategic standpoint, but that acquisition again met our stringent criteria of having a rate of return in the high teens and being accretive to earnings within the first year.

I’d just back up and say that for any acquisition, we have four criteria we require of our deals. First, it has to fit our core strategic plan; it has to be in an area where we want to expand the company. Second, we have to be able to integrate it operationally in a timely manner; we like to get things integrated on the operations side within the first six months. Third, it cannot present any significant credit issues for the company. And fourthu00e2u20ac”and this is the toughest criteriau00e2u20ac”it has to meet or exceed our high-teens internal-rate-of-return requirements, and it has to be accretive to earnings per share within 12 months. I’ve had those same criteria for acquisitions for the last 20 years and over that period, we’ve made 35 or so. Those are tough criteria, but when we have found [deals] that met them, they have added a lot to our shareholder value.

What do you see happening with your de novo program going forward? Is it something you will continue to emphasize?

In our retail banking group, our goal is to increase our net customer base by 8% to 10% per year. That means we like to see our net growth in customer base grow by 750,000 to one million customers a year. It’s our job as management to figure out the most cost-effective way to add net growth in customers. The three major avenues that we have are to [open] de novo stores, make acquisitions, or grow customers through newer distribution channels like the Internet. In recent years, we felt that the best return on investment for our shareholders was to emphasize de novo banking stores. So for several years, we were opening 200 to 250 new stores per year. As we move forward, I think there are still really good opportunities to open de novo stores, but I’ve also seen other trends that are causing us to reduce the number of stores we are opening. First, from a competitive side, more and more banks are opening bank branches. That and other factors are driving [up] the cost of real estate, and thus the returns on new stores are accordingly lower today than what they were a few years ago. So that’s one trend I’m watching very carefully.

The second trend is that we are finding extraordinary success in opening new customer accounts directly through the Internet. Earlier this year, we launched technology that has given us the ability to open checking accounts online with virtually no paperwork for the consumer, and we are approaching about 1,000 [new] checking accounts a day through that medium. As a result of that, I’m able to achieve our goals in customer growth without having to open as many new stores as we have in the past. This year we have given guidance to Wall Street that we’re likely to open 150 to 200 stores, whereas in recent years we have generally been opening 200 to 250. We’re going to continue to monitor this very carefully, but I’m seeing some attractive alternatives to opening de novo stores to achieve our customer growth targets.

Are these new Internet accounts coming primarily from within your current footprint or are they outside the footprint as well? For those on the outside, how then do you deal with the issue of ATM access and making deposits?

This is something we just started earlier in the year, and I’ve been very pleased with how fast it is ramping up. In terms of the geographic location of those customers, certainly a number of those are in markets where we already have a store presence, but I am also seeing a rapid growth in customers outside our footprint area. I don’t yet know what the balance will be over time, but this is allowing us to increase our customer base into new geographies that we hadn’t previously penetrated. We do not charge our customers for using somebody else’s ATM, though they may get surcharged by that other bank.

Describe the strategic planning process at Washington Mutual.

This is very timely, because we’re just getting ready for the summer planning retreat with our directors. First, on the logistic side, it’s done offsite. We use our Leadership Center at Cedarbrook, which we built a few years ago. It’s an off-site facility with overnight accommodations and meeting rooms. We’ll hold the retreat there. It is a two-day event that’s attended by all of our top executives. And then there will be a few additional people, invited for parts of the session, to do some other presentations as well. The governance committee of the board meets prior to the retreat to review the agenda and we get a lot of feedback as to the topics, formats, and presentations that would be most helpful to the directors at the meeting. We take their input and use that to build the agenda.

I would say in general the directors prefer to have the reports or the presentations very concise and focused on the changes we want to consider in terms of our strategies. The directors desire a lot of time for interaction and questions, and they would far prefer to have an interactive dialogue than a one-way presentation. So we will have plenty of time to get input from all the business units and support units that are implementing the various strategies and then we will spend several hours, as part of the retreat, in executive session, talking informally as a board about which elements of the plan make sense, which issues need more discussion, and the like. A very large percent of the time is [spent] in executive session interaction between me and the board.

Also, at each [regular board] meeting throughout the year, I give an update to the directors about the key changes I see going on from a strategic front and we talk about those in executive session.

During these strategy discussions with your directors, what is their value added?

It’s a key role of the board to question and to probe and to ultimately agree with the basic strategic direction of the company. So what I’m looking for the board to do is understand what recommendations we’re making, probe the risk that the plan might entail, and bring their perspectives as to the likely positives of that strategy and also the risk factors that they would perceive. I think it’s very important for management to know that the board is in sync and is going to be supportive of the strategy it’s trying to execute; that management will be held accountable for executing that strategy; and that everybody is on the same page, so that as we come back in each of the subsequent meetings throughout the year, we have very good reference points about what we’ve agreed to do strategically, and also agreement on the key performance indicators and the key measures we’re going to use to judge the success and execution of that strategy.

Could Washington Mutual itself ever be acquired?

Part of what we do when we’re having the strategic planning sessions is take a detailed look at how we believe we can create superior returns for our shareholders over time. So we’ll go through and look at the earnings projections for the next several years. We will make judgments about how that can be reasonably translated into returns for our shareholders, and make judgments about whether that is the appropriate course for the company to take. As part of the annual cycle, the directors will also have investment bankers review the activities going on in the marketplace in terms of merger and acquisitions. They will look at potential acquisition considerations we have or who we might want to acquire. And then the board’s judgment is one of whether we think we can create superior returns for our shareholders as an independent company. It will go through a process of reviewing that and then we’ll typically come out of that session [with] a course of action for the company. And in recent years, the directors have felt that we could create superior returns for our shareholders by executing [our] strategy and doing that as an independent company.

Where will the growth come for Washington Mutual over the next five years?

We currently have four main business units and we have plans in place that we think will achieve double-digit growth over the next several years. If I take our retail banku00e2u20ac”I mentioned earlier that our goals are to increase our net customer base by three-quarters of a million to one million customers a yearu00e2u20ac”and we will do that by opening new branches, by increasing our presence on the Internet, and potentially by adding to it with acquisitions. As we execute [that strategy], we expect to see double-digit fee income growth in our retail bank. For this year we have given guidance to Wall Street that we think we can grow our retail banking fees in the neighborhood of 12% to 14%, and I think that core growth rate in retail banking business [puts us] in the top tier of the major banks in the United States.

We’ve been able to accelerate Providian’s growth rate by making its credit cards available to the Washington Mutual customer base and by bringing to that operation the lower funding costs we have as a depository [institution] compared to what it had as a monoline credit card company. Accordingly, we think prospects are very good that we’ll be able to grow the card receivable base in the low- to mid-teens for the next several years. And again, I think that will turn out to be a top-tier growth [rate] in the credit card industry.

Now if I take our third business, which is commercial, we have the leading market share in multifamily lending, and we also focus on small commercial real estate. Here we see the opportunity to continue to grow that portfolio in the low- to mid-teens, and I think that also will turn out to be one of the better growth rates among the major banks.

Finally, in the mortgage lending space, this is an area where we have had to make a major adjustment in our core business model. We have elected to move away from the commoditized businessu00e2u20ac”which we define as conforming 30-year fixed-rate mortgagesu00e2u20ac”and to emphasize higher-margin products like option ARMs, alt-A lending, subprime, and home equity lending. So we are in a period of transition where we are decreasing efforts in the commoditized part of the business and increasing these other parts. That’s giving us the opportunity to materially adjust our cost structure, so I view 2006 as a year of transition as we make all of those changes. Then I think we’ll be very well positioned for double-digit growth in that business beginning next year.

Do you foresee the possibility of further diversifying the company through acquisitions that add new business lines?

We would like to continue to diversify our balance sheet away from prime residential loans to a diversified portfolio of consumer and small-business and commercial loans. I think we’ll continue to look for acquisitions that can accelerate that diversification and remixing. We talked earlier about the Commercial Capital acquisition, which gave us the opportunity to further our diversification into multifamily and small commercial real estate. Similarly, the Providian acquisition allowed us to accelerate the diversification into credit card loans. So again, I think we’ll continue to be on the outlook [for deals] that help us [with] that diversification.

What impact have rising interest rates had on your residential mortgage business and Washington Mutual’s profitability in 2006?

As the Federal Reserve continues to raise short-term interest rates, that causes our net-interest margin to compress. A normalized net-interest margin for us is in the 3.1% to 3.2% range. As a result of a series of rate increases by the Federal Reserve, our net-interest margin is currently about 2.75%. Once the Federal Reserve stops increasing interest rates, our margin will start to improve or [return to a] normalized margin of 3.1% to 3.2% over the subsequent four quarters. This has clearly been a challenging interest-rate environment, but we are cautiously optimistic that we’re nearing the end of the Fed’s tightening cycle.

The second factor we watch on interest rates is the shape of the yield curve, and a flat yield curve like we have today has a negative impact on us because it increases our hedging costs for our mortgage servicing rights, and it also causes the net-interest spread on our mortgages in our pipeline to compress. With the yield curve virtually flat at this point, that is also having a negative impact on our MSR hedging costs. The net of it is that this is a very challenging environment, and we look forward to the time when the Federal Reserve is done tightening interest rates.

From Washington Mutual’s perspective, what is most importantu00e2u20ac”controlling inflation, which may require even more tighteningu00e2u20ac”or finally getting to the end of the rate cycle?

Clearly there’s some balancing that the Fed needs to do between controlling inflation, promoting reasonable economic growth, and [ensuring] stability in the financial system. I think the signs are pointing to significant slowing in housing and to likely moderation in [economic growth] in the second half of the year. I think the evidence shows we are getting pretty close to a reasonably balanced position of having interest rates at a level that is not fueling inflation [yet] is supporting reasonable economic growth. Judgments the Fed will need to make, if it continues to increase interest rates, are at what point will that cause the economy to slow down more significantly than what it would like? And, what is the likely course of inflation? It appears to us that [the] balance [between the two] is starting to get quite reasonable and that there will be fewer pressures to raise rates at some time in the future.

Do you have confidence in the abilities of Fed Chairman Ben Bernanke and the bank’s Federal Open Market Committee to make the right call?

I think they are all striving to find the right balance, [and] I think they are very capable people in [terms of] making that judgment. I think they’re looking at the right data. I think they’re very intelligent folks, and I think they have a very good likelihood of being able to make a good call on this.

Why does Washington Mutual retain a thrift charter when the story of the past couple of years has been its transformation into something that looks much more like a bank from the perspective of its product set and its asset and funding mix?

The primary advantage of our thrift charter is that it gives us excellent flexibility. We’re able to operate in all of the businesses we would like with clear powers and authority. The thrift charter also has a very good history and legal support for the [concept of] federal preemption. For those of us operating on a national basis, it’s important that we be able to operate consistently in various states around the country, and the thrift charter is very good for doing that. There is also an advantage for us in that at the holding company level we have grandfathered powers that allow us to purchase both financial and nonfinancial companies. That is not something we have utilized to date [but] is certainly a valuable option for our shareholders.

So for example, you could acquire a real estate firm if you wanted to?

We could hypothetically buy virtually any company in any financial or nonfinancial business.

Have you ever seriously considered flipping your charter?

We continually review the advantages and disadvantages of the various charters, and certainly we have the financial flexibility to do whatever charter makes the most sense for us at a point in time.

Have you ever felt that Wall Street and institutional investors look at you differently just because you’re a thrift, even though you’ve gone through this transformation?

Yes, I think there has been a valuation discount assigned by some investors to the thrift charter over time, and I think there is evidence that price-to-earnings ratios [for banks] tend to be a little bit higher. That is a factor we consider in terms of the choices on charters that we might operate under. At the same time, I’m seeing a significant shift occur in our shareholder base. We are getting purchased more and more by [investors] who view us as a bank and [see] our future as a bank and believe there is an opportunity in the potential revaluation of our company if we’re able to make that successful change. I’d also note that we are now being followed by a number of banking analysts whereas five years ago, we were basically followed only by specialty finance or thrift analysts. So there is also a major shift going on in the coverage of our company.

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