Kerry Killinger has a thing for housing.
As a University of Iowa undergraduate in the 1960s, Killinger bought a dilapidated building in Iowa City, fixed it up and rented it out to fellow students. With the income, he supported his wife and baby son - they lived in a mobile home - while earning his bachelor’s degree and MBA in four years.
A few years later, as a young hard charger at Murphey Favre, a Spokane, Washington-based brokerage, Killinger spent his off hours buying, renovating and reselling old homes. He plowed his take into Murphey Favre stock, quickly becoming one of the firm’s directors and biggest shareholders. He made a killing in 1982, when Murphey Favre sold out to Washington Mutual.
“I learned early on how to do just about anything in building and repairing a home,” says Killinger, now chief executive of Washington Mutual. “I really feel good when I have a hammer in my hand.”
Killinger still wields a mean hammer. In a decade as CEO, he has taken a piddling operation and, in what amounts to a corporate gut renovation, refashioned it into the nation’s largest thrift and biggest home lender. From $6.4 billion in assets and 121 offices in three Western states in 1988, WaMu, as the bank is commonly known, had grown to $243 billion in assets and 2,300 locations from coast to coast at year-end 2001. In size it ranks just behind Bank One Corp., the nation’s sixth-largest commercial bank; only Wells Fargo & Co. has more assets among West Coast financial houses. Profits have followed. Even as one bank after another announced dreary credit-related problems, WaMu’s earnings surged 56 percent in the fourth quarter, to a record $842 million; for the year earnings rose by two thirds, to $3.1 billion, making it the fourth most profitable banking company in the country. And that came after loan-loss provisions of $575 million for the year. Over the past ten years, WaMu’s shares have been among the best performing anywhere, rising nearly six-fold to a recent $33.
Brash and ambitious, Killinger has a simple, audacious goal: He wants WaMu to become, as he says, “the leading national franchise in consumer banking.”
Are you listening, Sandy Weill?
Indeed, nothing underscores Killinger’s ambitions and his bottomless self-confidence more than his plans for New York City. In January WaMu closed the purchase of the city’s largest thrift, $28 billion-in-assets Dime Bancorp, for $5.2 billion. Now Killinger is gearing up to bring his “high touch” style of banking to the Big Apple, revamping the Dime’s 123 branches in an effort to pry customers away from Citigroup and J.P. Morgan Chase & Co., the behemoths that between them command 57 percent of the city’s deposits.
Killinger thinks neglected and dissatisfied New Yorkers will respond to his simple formula: free checking, friendly service and free-flowing mortgages. And, having succeeded in carving market share from one incumbent after another in every market he has entered, he has some grounds for optimism. Private surveys that Killinger has commissioned show that only 28 percent of New Yorkers would recommend their bank to a friend. At home in Washington and Oregon, WaMu scores 80 percent on that test. Killinger thinks that if he can make it anywhere, he can make it in New York.
“They will take share,” warns Richard Hartnack, vice chairman for community banking at Union Bank of California, who has been competing against Washington Mutual since the late 1990s. Of WaMu’s free checking strategy, he says, “It’s been really disruptive.”
Killinger is so self-confident that he sees New York City as something of a stepping-stone. “We’re seeing some really good opportunities, particularly in New York, to expand to a much larger presence,” Killinger says. “This company has an excellent capability to do large-size deals like the Dime on a continuous basis.”
Adds William Longbrake, WaMu’s longtime chief financial officer: “We have enough size and mass and leadership to become a leading player in national financial services. It’s not just New York or the East Coast. It’s national. Our goal over the next few years is to be in every major metropolitan area in the country.”
In truth, Killinger’s biggest problem today isn’t cracking New York; it’s explaining his success. Fairly or not, WaMu fits the profile of companies that, post-Enron, have begun to make investors nervous. A high-growth outfit built up through a series of rapid acquisitions, it has remained, some analysts say, less than completely up front about its financial reporting. That’s one reason, despite Killinger’s achievements, that WaMu still sports an anemic forward price-earnings ratio of 10, which trails the depressed 11.1 P/E of the Sanford C. Bernstein & Co. big-bank index and that of such tarred banking companies as PNC Financial Services Group, which trades at 12 times earnings. Without greater transparency, say analysts, WaMu’s P/E is likely to remain stuck on the ground floor. And that, in turn, will limit Killinger’s ability to make more acquisitions.
WaMu’s main business is deceptively simple. It takes in lots of deposits through its free checking, and it makes and holds an extraordinary amount of mortgages. (Last year it originated $174 billion in new loans, 163 percent more than in 2000; the next closest lender was J.P. Morgan Chase, with $128 billion.) WaMu has other consumer lines, including a fledgling investment services arm that sells securities, but analysts figure that 68 percent of its revenues come from interest income, and most of that is generated by the mortgage portfolio.
Home lending is not terribly complicated, but - as evidenced by the savings and loan disasters of the 1980s - correctly predicting interest rates is. Mortgage lenders need to be hedged. Is WaMu? There’s the rub. Executives like Killinger and Longbrake insist that it is. But Wall Street analysts say they can’t be sure.
“WaMu is not producing the information that’s necessary to do a legitimate job of analyzing it. The transparency is dismal,” grouses Jonathan Gray, senior research analyst with Sanford C. Bernstein. “The investment community is uncomfortable with the mortgage business. I don’t like it when 30 percent of a company is opaque.”
WaMu likes to say that it employs a “natural hedge,” balancing its origination business with a massive $535 billion portfolio of mortgage servicing, in which it processes loan payments and routes the proceeds to nominal holders of, or investors in, those loans. The servicing portfolio erodes when interest rates fall and borrowers refinance; that, in turn, sends fee income from originations soaring. Conversely, when rates rise, loan originations decline, but WaMu collects handsome servicing fees. In the fourth quarter, as rates continued to fall, WaMu took a $1 billion charge for so-called impairment of mortgage servicing rights. But the company also realized $289 million in gains from sales of fixed-rate loans. That, in addition to income from securities sales and hedging transactions, more than offset the $1 billion write-down.
WaMu insists this setup covers it for high rates and low, housing busts and booms. Being both a lender and servicer “allows us to take the cyclicality out of the business,” explains WaMu home lending chief Craig Davis. “We take the valleys out. It’s just a matter of time until the market recognizes what’s unique about our strategy.”
Maybe. But natural hedges aside, WaMu, like any other mortgage institution, also relies heavily on synthetic confections - complicated strategies built around derivatives, swaps and guaranteed investment contracts designed to cushion the impact of interest rate swings. Analysts complain that WaMu is not particularly forthcoming with details about how it hedges.
“They’ve built a $20 billion derivatives book to hedge the mortgage servicing portfolio. Revenue from the sale of just one of these hedges - a rate-floor agreement tied to LIBOR - added 20 basis points to their net interest margin at the end of 2001,” says Sanford C. Bernstein’s Gray. “I’ve been asking them since December to disclose information about the notional value of the derivatives book and its impact on the net interest margin.”
WaMu may at last be responding; it has started to restructure its financial operations and promised additional disclosure. Last month Longbrake, who had been CFO since 1982 except for two short breaks (one of which was a 19-month stint as CFO of the Federal Deposit Insurance Corp. in the mid-'90s), switched to head up a new corporate-wide risk management job. Killinger plans to hire a new CFO, who will handle corporate finance and budgeting, financial and internal management reporting, taxes and financial accounting as well as investor relations, and report to him. “It just made more sense to split the jobs up,” Longbrake says. “We’ll have someone in place in three months, if we’re lucky.”
Just as important, Longbrake says the company will increase its disclosure of derivatives and other hedging activities in its next 10-K, which will be filed this month.
To be sure, WaMu is not the only financial company facing the clamor for greater transparency. J.P. Morgan Chase, PNC and SunTrust Banks have recently responded to concerns about their accounting and their off-balance-sheet risks by promising to be more forthcoming.
“It goes without saying that the current environment did increase the pressure,” says Longbrake. “There is external pressure right now in response to Enron.” He wouldn’t provide specifics about what WaMu will disclose, except to say that he doubts it will fully satisfy analysts like Gray.
Killinger, 52, started on his hard-driving journey as the second of four children in a musical family in Des Moines, Iowa. His father, Karl, was a junior high and high school music teacher and band leader. Kerry’s younger brother, David, stuck with the family business and is now the music director of Ringling Bros. and Barnum & Bailey circus. Kerry took up the trumpet; and that led him to his future wife, Debbie, whom he met in the school band. (They divorced last year, after 31 years of marriage.)
At the University of Iowa, from 1967 to 1971, Killinger was a student in a hurry. Besides dabbling in real estate and repairing musical instruments for extra income, he managed to squeeze in a bachelor’s degree in economics and his MBA. “We had a passion to get out and see what we could get accomplished,” says Killinger, who, disconcertingly, often refers to himself in the first person plural.
Fresh from college, he joined Bankers Life Insurance Co. in Lincoln, Nebraska, as a junior analyst. After five years and the arrival of a second son, he was anxious to move on. “We knew that if we wanted to be successful in accumulating net worth, we had to have ownership equity,” he says.
In 1976 Killinger joined Murphey Favre as vice president of research. Two years later, just 29, he was elected to the board, after having launched the firm’s first money market mutual fund. With interest rates at 18 percent, money rolled in. “We were all working 14-hour days,” recalls William Papesh, a Murphey Favre colleague who is now president of WM Advisors, Washington Mutual’s $11 billion-in-assets mutual fund business. “We put four desks in our conference room, but we still needed more room. It would have cost $1,500 to hire a contractor. So Kerry and I came in on a Saturday and took a wall out ourselves.”
As it grew, Murphey Favre needed processing help and access to capital. Meanwhile, Washington Mutual CEO Louis Pepper was trying to turn around the Seattle thrift, after two money-losing years. Killinger and Papesh proposed a merger, and in 1982 WaMu bought the brokerage for $12 million. A year later the thrift converted from mutual ownership into a publicly traded stock company.
It was a heady, tumultuous time in the thrift business; liberal regulations permitted WaMu to venture far afield from traditional lending. Pepper put Killinger in charge of diversification into nonbanking activities, including benefits consulting, brokerage, property and casualty insurance, even running a travel agency. Those activities never contributed much to earnings, which remained dominated by mortgage fees and spreads.
For Killinger, the diversification experience was sobering. When he became president and heir apparent, in 1988, he laid out a vision for the future that harked back to the institution’s roots as a mutual savings bank. The linchpin of the strategy, as it has remained ever since, was growth fueled by home loans.
Killinger became CEO in 1990, and it was off to the races. In 1993 he did his first significant savings bank purchase - in all he has overseen 25 - buying Seattle-based Pacific First Financial Corp. from the Royal Trustco of Toronto. In a stroke, the transaction doubled WaMu’s assets, to $12 billion.
Killinger has strict rules for acquisitions: They have to be accretive to earnings in the first year and produce returns on capital of at least 18 percent. “Pacific First was a really big deal for us,” he says. “It helped us refine our internal growth rates and got us positioned for the next phase.”
Next came California and Irvine-based American Savings Bank, once the U.S.'s biggest thrift, which Texas billionaire Robert Bass had purchased in 1988 for $550 million in the federal government’s thrift-bailout fire sale. When Keystone Holdings, the Bass company that owned American Savings, signaled that it was looking for a way out, Lehman Brothers investment banker Philip Erlanger brought the parties together. WaMu agreed to buy the thrift for $1.2 billion in stock during the summer of 1996. WaMu’s assets had doubled again, to $40 billion, but the institution’s biggest growth spurt was yet to come.
With the purchase of American Savings, two deal makers affiliated with Keystone - J. Taylor Crandall, now the managing partner of Oak Hill Capital Management, and David Bonderman, a founding partner of private equity firm Texas Pacific Group - joined the WaMu board and counseled Killinger on his next steps. “I told him that, hopefully, we wouldn’t stop with just American Savings. My hope was that we could grow this thing even bigger,” says Crandall.
And grow they did. WaMu set its sights on the only two thrifts that were then larger - a pair embroiled in a takeover fight. In March 1997 WaMu, acting as a white knight, offered $6.5 billion for Chatsworth, California-based Great Western Financial Corp., topping a $6.08 billion hostile bid from rival H.F. Ahmanson & Co. After several months of legal wranglings, WaMu won Great Western for $6.8 billion.
“The outcome was that we had a national franchise in mortgage origination and consumer finance,” says Killinger. Once again WaMu had doubled in assets, to $89 billion, while gaining retail offices in Florida. The following year an exhausted and humbled Ahmanson offered itself to Washington Mutual for $10 billion, bringing another $57 billion in assets and 529 offices in California, Texas and Florida. For the efficiency payoff, WaMu closed 170 branches and cut 3,500 jobs. Says Bonderman: “There are a lot of cost savings when you put institutions like that together. Washington Mutual was a better operator than either of them. It was more efficient and had lower credit losses.”
The rapid growth “made us very nervous,” says WaMu board member and former University of Washington president William Gerberding. “If someone had predicted in the 1980s that we would have bought the three largest thrifts in California, we would have thought he was smoking something. But opportunities arose, and Kerry picked them off.”
In 1999, while Killinger was hammering together his West Coast megadeals, Dime Bancorp put itself up for sale. Only North Fork Bancorp, taking aim at New York City from its base in Melville on Long Island, showed any interest; Dime rejected its $2 billion bid out of hand. Reaching for a higher valuation, Dime then went on the defensive, buying back 12.5 percent of its stock and selling 22 percent to private equity firm Warburg Pincus. Warburg installed Anthony Terracciano, a former Chase Manhattan Bank and Mellon Bank Corp. executive, as Dime’s chairman, to oversee a cost-cutting campaign.
In 2000 Killinger, armed with his market research, met Terracciano for breakfast. “He was interested in New York and wanted to make more than one acquisition here,” says Terracciano. “He felt a certain critical mass was required. He went about this very logically, very statistically.”
WaMu and Dime sealed their $5.2 billion deal last June at $41 a share, 141 percent above the North Fork bid and $6, or 17 percent, higher than the market price for Dime’s shares. Because it would be WaMu’s initial venture into New York, Killinger could promise that there would be little in the way of layoffs.
“New York reminds me of California a few years ago,” Killinger says. “It is dominated by two large commercial banks and has many medium-size thrifts. The opportunity will be for someone to put together a larger network than any one of those medium-size thrifts has today.”
Can Killinger make it in New York? Certainly, WaMu isn’t the only out-of-town outfit targeting a seemingly receptive city. Cherry Hill, New Jersey-based Commerce Bancorp began opening New York City branches last year; it now has 72 in the metropolitan area and wants to add 328 over the next few years. “There’s tremendous opportunity in the area, particularly in New York City,” says Vernon Hill II, Commerce’s chairman, president and CEO. “Chase and Citi have completely degraded the retail delivery model.”
Investment research and analysis firm SNL Securities reports that Chase has lost nearly 2 percentage points of its New York City market share in the past year. Citi is up, but mostly because of its July purchase of European American Bank.
WaMu’s no-fee checking has unmistakable appeal. Typically targeting the mass-market banking customer - those earning between $30,000 and $50,000 per year who are scorned by many big commercial banks - WaMu is opening new checking accounts nationally at a rate of about 200,000 per quarter. But many bankers doubt whether free checking can be anything more than a loss leader.
“It has a competitive advantage in the short run, but we have real questions about the long-term economics of the model,” says Union Bank of California’s Hartnack. “They are a bigger competitor for the smaller-balance accounts, those under $1,000, but I don’t want an $800 account that doesn’t pay me anything, anytime, anywhere.”
In contrast, WaMu loves the low-balance customer. R. Jay Tejera, a banking analyst at Seattle-based brokerage Ragen MacKenzie, estimates that WaMu makes as much money on its checking accounts, which average $1,000, as big banks do on theirs, which average $3,500. How? By charging $20 per bounced check. WaMu’s customers bounce about six checks per year, on average. They also rack up $40 in debit card and ATM fees per year, and profits on float add another $60 per account. The total is not that far from the $275 per account that the big banks make.
Free checking also appeals to young people in their first jobs, or to those who are still in school. If WaMu can get customers when they’re starting out financially and grow with them, the low-balance account eventually can reap great rewards. On the mortgage side WaMu does well because it offers a wide array of products, including both fixed- and variable-rate loans, which appeals to the real estate agents and mortgage brokers who direct much of the lending business.
WaMu’s special appeal is service. It gives its branch managers a good deal of autonomy, and much of their pay comes from incentives. WaMu may bring to New York a newfangled branch setup that it calls “Occasio” - Latin for “favorable opportunity” - where customers are helped by uniformed personnel using handheld computers. The branches, which WaMu has opened in several Western cities as well as Atlanta, also feature play areas for kids; computers to bank online; an abundance of ATMs; and shops where customers can buy financial planning books, teller dolls and baseball-type cards featuring Washington Mutual branch staff (complete with loan-sale statistics on the back).
True to form, WaMu will spend heavily on advertising in the New York market. So far the campaign has been limited to taxis sporting its slogan, “The Power of Yes,” and giant billboards in Times Square - with life-size cutouts of houses - promising that “whatever your dream home is, we have your loan.” Designed by Seattle-based Sedgwick Rd., WaMu’s longtime ad agency, the campaign will expand this spring to print and television as well as to Yankee Stadium, where WaMu inherits Dime’s space on the rotating billboard behind home plate. The thrift typically invests a good deal in radio advertising, which it has found effective in other big cities.
This strategy has worked for WaMu in markets where there has been a lot of banking consolidation and a decline in service - places like California, Florida and Texas. “That’s why they think it will work in New York,” Ragen MacKenzie’s Tejera says.
In Florida, for example, WaMu’s share of deposits rose from 3.9 percent on June 30, 1998, to 4.4 percent two years later. And in Texas for the same time period, its share jumped from 1.7 percent to 4.3 percent. But according to Charlottesville, Virginia-based SNL Securities, WaMu didn’t hold those recent gains: The Florida number fell to 3.2 percent and Texas to 2.8 percent as of June 30, 2001.
New York bankers are prepared to put up a fight. “We have two kinds of customers,” says George Engelke Jr., president and CEO of $22.7 billion-in-assets Astoria Federal Savings and Loan, who has known Killinger for many years and says that he “oozes ambition.” Engelke describes his market as “people who have lived here for a very long time, and immigrants. Both groups tend to be ferociously loyal to their banks. Our savers go to see the people they know. Washington Mutual will have some work to do.”
“You’re never standing still,” says Killinger. “You’re either growing or faltering.”
The question now is whether Killinger can keep growing without faltering.
“There are some who think he has a size complex,” says Tom Brown, CEO of New York-based bank hedge fund Second Curve Capital. “He believes in economies of scale. But he underestimates how tough it is to run something that big.”
Not so, says WaMu’s Longbrake. “Kerry has a great sense of the capabilities of the company. He can take us to the limits of our capabilities but not past those limits.”
But there’s no getting around WaMu’s fundamental nature as a mortgage lender tied to market cycles. Banc of America Securities mortgage finance analyst Robert Ryan says that WaMu’s performance this year will hinge on three key factors: the post-merger integration of Dime; accounting and disclosure issues; and the interest rate environment. If rates rise, as many expect they will, then all thrifts - WaMu most notably - could suffer. “There is a perception of interest rate sensitivity,” Ryan states. “Washington Mutual is the largest thrift by a factor of four - it’s the definition of the group.”
Says banking analyst Tejera, “Nobody can hedge against a deep recession.” But he predicts that even in the worst case, “Washington Mutual would perform better than other mortgage shops,” because it extends both adjustable and fixed-rate loans. Golden West Financial Corp., a California thrift that makes only adjustable-rate loans, does well when rates are rising but “is sucking wind now because it doesn’t have a quality fixed-rate product,” says Tejera. WaMu, with 72 percent of its loans at fixed rates, “is competitive in both environments.”
Critics might worry about excessive size or unhedged risks, but Oak Hill Capital’s Crandall believes WaMu’s balance sheet is strong enough to provide a margin for error that the thrift lacked earlier. “If something had gone wrong with American Savings, WaMu would have been toast,” he says. “Now we have a net worth and an equity base that are more resilient. The recession may even create opportunity like the downturn in California did. That’s the nature of the beast.”
