Downey Financial Stands Alone, But Questions Remain

(Update 1: corrected reference to regulatory capital ratios) Washington Mutual Inc., Wachovia Corp., IndyMac Bancorp. and Countrywide Financial Corp. — all were in the top five originators of option ARMs during the housing market’s recent heyday in 2004 through 2006, and all are now gone, either failed or acquired before failing. Only one of the top five still stands on its own: Newport Beach, Calif.-based Downey Financial Corp. (DSL), which said earlier this week that it lost $81.1 million, or $2.89/share, during the third quarter. While it’s the proverbial last man standing in the option ARM market, for now, plenty of questions remain about the little bank’s ability to continue to operate amid a quickly souring portfolio of negatively-amortizing loans that borrowers are increasingly unable to repay. Of the bank’s $12.8 billion in total assets, $5.7 billion come in the form of option ARMs held in portfolio; deposits totaled just $9.6 billion at quarter end, down $1 billion from one year ago as depositors withdrew funds over concerns about the bank’s future. Total assets have fallen 11.4 percent over year-ago levels, as a result. Surprisingly, despite ongoing mortgage woes, loan origination volume at Downey actually increased during the third quarter, totaling $804 million, and up 15.8 percent from $694 million originated a year ago. And those numbers don’t account for all of the emergency loan mods the lender is looking to push through for its at-risk option ARM borrowers — those that haven’t already defaulted or aren’t too far underwater already, at least. A problem of performance Non-performing assets increased at Downey during the quarter by $44 million to over $2 billion, and represented nearly 16 percent of total assets, compared with 7.8 percent at year-end 2007 and 2.9 percent a year ago. Against this rising tide of non-performing assets, Downey held $763 million in loss reserves — a loss coverage ratio of less than 100 percent, often a red-flag for any bank with significant option ARM exposure. The bank set aside $130.3 million in loss provision charges during the third quarter, and net loan charge-offs totaled $97.6 million (meaning net-net, loss reserves grew by just $32.7 million). Option ARM mortgages were very popular with banks during the recent housing boom, as borrowers opting not to make their full payment helped pump up balance sheets in the form of deferred interest. During the third quarter, approximately 10 percent of Downey’s $169 million in loan interest income represented negative amortization, down from 15 percent in the second quarter 2008. Like other lenders, Downey has stopped making option-ARM loans and is looking for new investors or a buyer; it also closed its wholesale lending division and laid off 200 employees as it looks to consolidate and refocus its operations. In September, the U.S. Office of Thrift Supervision and Downey agreed to a consent order that required the bank to maintain a minimum core capital ratio of 7 percent and a minimum risk-based capital ratio of 14 percent at the end of every new quarter. It exceeded both ratios at the end of the quarter, according to the earnings statement. Disclosure: The author held no positions in any of the stocks mentioned when this story was published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.

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